Pedone v. United States

LARAMORE, Judge.

I respectfully dissent from the opinion of the majority in this case for what I think aye some very cogent reasons.

Plaintiffs concede that they made wage payments in excess of máximums established pursuant to section 405(b), but argue that the value of the services rendered by the aforementioned employees are, because of their nature, elements of the cost of goods sold and, therefore, constitutionally exempt from taxation. They contend that to permit an income tax on these wages would be to tax capital, and since the 16th Amendment to the Constitution permits income taxation only on “income” the tax would be unconstitutional. Plaintiffs argue that the provision “income” in the 16th Amendment does not mean gross receipts and that the term, by its very nature, permits an exclusion from the gross receipts of the cost of the goods sold before arriving at the income taxable under the 16th Amendment. The cost of the goods sold, it is argued, is capital. The goods sold in plaintiffs’ cases were services, they argue, thus, when the partnership is paid in money for the value of the services rendered, the payment represents merely a return of the capital expenditure for wages. Therefore, plaintiffs continue, to the extent that receipts embrace a repayment of the capital expenditure, that is, to the extent that the receipts are reimbursement for the cost of goods sold, they are constitutionally exempt from taxation, hence, the Commissioner of Internal Revenue cannot exclude the value of such services in determining the income subject to taxation, despite the Defense Production Act or General Order No. 15 of the Economic Stabilization Agency which were the basis of the Commissioner’s actions in these cases. Taxpayers argue, however, that there is no authority in the act or the order to empower the Commissioner to disallow the wages in question as the act speaks only of “expenses” and the order of “deductions,” both of which are words of art which have a carefully defined meaning under the Internal Revenue Code. Plaintiffs contend that the Defense Production Act and the order by the. use of those terms provide only for the disallowance of the deduction of expenses which are normally deductible under section 23 of the Internal *293Revenue Code,1 but that Congress did not intend to disallow the offset against gross receipts for cost of goods sold as it was without the authority to do so, the cost of goods sold being a constitutionally exempt item.

Plaintiffs further argue that to the extent that the Defense Production Act permits the interpretation placed upon it by the Commissioner of Internal Revenue it is unconstitutional.

Defendant, on the other hand, feels that section 405(b) of the Defense Production Act, supra, authorizes the Commissioner of Internal Revenue to disregard any amount in arriving at taxable income upon receipt of a Certificate of Disallowance. In arguing that the Commissioner’s actions in subtracting the subject amount in determining taxable income was correct despite the fact that the sum may properly have been an element of the plaintiffs’ cost of goods sold, defendant says that the fallacy of taxpayers’ argument is that Congress intended to control all wages paid by any employer covered by the act, not just wages which are not included as part of the cost of goods sold. Defendant argues also that the word “costs” in section 405(b) of the act indicates the congressional intent to cover all items including labor costs which are part of the cost of goods sold. Defendant asserts that a tax on the excluded amount would not constitute a tax on capital as plaintiff contends, because capital is broadly that which they, plaintiff, invested in their business as their contribution to the partnership and later net profits which had been allowed to accumulate.

Defendant further argues that to support plaintiffs’ contentions would frustrate the intent of the act to regulate wages; however, in this respect plaintiffs point to other sections of the act which provide criminal and civil sanctions, the purposes of which are to enforce the act.

As to the word “costs” in section 405 (b) plaintiffs argue that it has reference to costs or expenses under any contract made by or on behalf of the United States or for the purpose of laws other than the revenue laws and that section-4(a) (2) of the Economic Stabilization Agency’s General Order ,No. 15 supports this view.

Despite the argument of the defendant and the feeling of the majority of this court, I believe I should point out the fallacy of the argument that Congress intended to cover all wages even, if part of the cost of goods sold; to wit, if, as plaintiffs contend, the subject amount of wages is constitutionally, exempt from taxation, then it matters not that Congress, by the Defense Pro-' duction Act, intended that overpayments ' of such wages should be excluded in determining taxable income because, in *294such a case, it would be without Congress’ jurisdiction to do so. Congress certainly has the power to regulate wages of all kinds by any means available to it, but, if constitutional provisions exempt an item from taxation, the mere fact that the payment of that item represents the violation of a statute does not empower the Congress to levy a tax upon it. The Constitution is supreme and Congress cannot act except in accordance with it.

By the same reasoning, if plaintiffs’ argument is correct, and defendant’s is also correct to the extent that the word “costs” contained in section 405(b) was intended by the Congress to mean or refer to the cost of goods sold, then Congress’ action by the use of the term in trying to regulate the cost of goods sold was improper and, hence, ineffectual and unconstitutional.

Thus, as I see it, the issues in this case are whether the cost of goods sold may be subject to income taxation in light of the 16th Amendment and, if not, are the wages in question paid by the plaintiffs to their employees charged with doing the plastering work truly an element of the cost of goods sold of the partnership. If the first question can be answered in the negative and the second in the affirmative, plaintiffs can recover, otherwise they must fail.

I am of the opinion that the cost of goods sold is constitutionally exempt from taxation and that the wages here in question are truly an element of the cost of goods sold.

The basis of the present income tax laws is the 16th Amendment to the Constitution which provides as follows:

“The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.” [Emphasis supplied.]

While, over the years, there has been some dispute as to whether the term “income” contained therein means “gross income” or “net income,” the cases are quite settled on the point that it does not mean “gross receipts.”

“ * * * In order to determine whether there has been gain or loss, and the amount of the gain, if any, we must withdraw from the gross proceeds an amount sufficient to restore the capital value that existed at the commencement of the period under consideration.” Doyle v. Mitchell Brothers Co., 247 U.S. 179, 185, 38 S.Ct. 467, 469, 62 L.Ed. 1054.

On this subject Mertens, Law of Federal Income Taxation, volume 1, section 5.10, and the cases cited therein, are quite explanatory:

“The history of the income tax in this country from its crude beginning as a war-time measure in 1861 to the present day, shows a development of the idea that such a tax should be imposed upon net income. The Sixteenth Amendment does not, however, define income and does not specify whether the tax is to be imposed upon net income or gross income. Although under our present statutory scheme the tax is imposed essentially upon net incomes, the question whether such a tax may be imposed upon gross income is not academic; it arises in the allowance or disallowance of statutory deductions, and particularly in determining whether taxable income must allow for exhaustion of the asset producing the receipts, that is, whether such receipts include a return of capital.
“It is now generally agreed that the income tax is not limited to ‘net income’ but may under certain circumstances be imposed upon gross income. The courts have repeatedly viewed deductions as matters of legislative grace, so that ‘net income’ becomes a statutory rather than an economic concept under which items which might be considered as gross income by the busi*295ness man are treated as taxable income by statute.
“To say that items of gross income may be taxed is not the same as to say' that under all circumstances the courts mil countenance a tax on gross receipts. The terms ‘gross income’ and ‘gross receipts’ are not synonymous. ‘Gross receipts’ is a broader term, including within it receipts which may constitute capital as well as income, and, * * * returns of capital may not be taxed.” [Citations omitted and emphasis supplied.]

Section 5.06 of the cited volume states, at page 171, as follows:

“While there has been and still is considerable groping in determining when increment in capital has been realized so as to be taxable, there is substantial agreement that amounts received as a return of capital or investment are not income within the general meaning of that term and may not be taxed under the Sixteenth Amendment.” [Citations omitted and emphasis supplied.]

This view has also been expounded by Roswell Magill in his work Taxable Income, and cases therein cited, at page 359 wherein he states:

“This line of decisions, from Doyle v. Mitchell Bros. Co. down to date, indicates that the term ‘income’ does not mean total gross receipts from the sale of property. Although the decisions are expressly worded in terms of statutory construction, some of them actually go beyond that, since under the specific terms of the act considered in Goodrich v. Edwards, for example, there would have been a taxable profit, whereas the Court held that no gain or income was realized. This requirement that the capital investment must be returned before the proceeds become taxable as income results from the somewhat sharp distinction, at least in this regard, between income and capital. It would seem clear to the ordinary person that only the gain over the original cost is income. The Court has adopted the same view. Hence, the cost of goods sold must be allowed as a deduction from gross receipts in arriving at the income which is subject to tax under the amendment and the revenue laws.” [Citations omitted and emphasis supplied.]

I am in agreement with the above quotations and feel quite emphatically that “gross receipts” cannot be designated as the “income” specified in the 16th Amendment subject to income taxation. “Income” in both its generic and technical sense connotes some gain.

Therefore, income tax, pursuant to the 16th Amendment, can be assessed only on “income” and not on “gross receipts.” The term gross receipts embodies within it that expenditure of capital that was spent for the product sold. Before there can be income, that expenditure of capital must be recovered. After it has been recovered, then, and only then, is there income which may be subject to taxation under the 16th Amendment.

There seems little doubt that this is the proper construction of the 16th Amendment. Congress itself apparently recognized the limitations placed upon it by the amendment as the revenue laws since 1918 have consistently used “gross income” as the starting point of all income taxation and the courts have interpreted it as meaning just that and not “gross receipts.” See Sullenger v. Commissioner, 11 T.C. 1076, 1077; Edenfield v. Commissioner, 19 T.C. 13, 22; Scales v. Commissioner, 18 T.C. 1263, 1276; Commissioner v. Weisman, 1 Cir., 197 F.2d 221, 224. Section 22 of the Internal Revenue Code of 1939, 26 U.S.C. § 22, is indicative of this use of the term “gross income.” Congress has not attempted to levy an income tax on gross receipts since the ratification of the 16th Amendment by the states.

Thus, I believe that the true cost of goods sold cannot, under the present state of the Constitution, be subject to *296income taxation since items properly falling within that category represent capital and not income, and are constitutionally exempt from taxation. However, merely because an item of expense has been placed in that category by the accountant does not mean that it is rightly there. The courts must determine whether or not the item is truly a cost of the product sold. Such is a question of fact and must be determined with reference to the peculiar facts of the case then under consideration.

In the plaintiffs’ cases the product allegedly sold was the services of its employees. If that is so, the cost to plaintiffs of the rendition of those services would represent an expenditure of capital on their part and would have to be recovered before any income tax could be assessed pursuant to the constitutional amendment.

It is well settled that labor costs, as such, may, depending on the nature of the labor, be an element of the cost of goods sold. United Carbon Co. v. Commissioner, 32 B.T.A. 1000, reversed on other grounds, 4 Cir., 1937, 90 F.2d 43; Woodside Acres, Inc. v. Commissioner, 46 B.T.A. 1124, affirmed, 2 Cir., 1934, 134 F.2d 793; Edenfield v. Commissioner, supra. The court in Woodside Acres stated as follows 46 B.T.A. at page 1129:

“* * * Expenditures included in the cost of production of the milk ' certainly include the cost of feed for the cows and the wages of the men who took care of the animals and milked them. The milk then had to be separated from the cream and had to be pasteurized. The butter had to be churned. The wages of the men who put the product through these processes are properly a part of the cost of production.”

The Tax Court has also held that wages in a construction business where the primary product sold is the services of its employees are actually a part of the cost of goods sold, Edenfield v. Commissioner, supra. In that case, it was the ■Commissioner of Internal Revenue who

argued that the labor of an electrical contracting business was properly an element of the cost of goods sold. The Commissioner’s argument was sustained by the decision of the Tax Court with the following language 19 T.C. at page 22:

“Petitioner claims $758,004.18 ' gross income was reported from his business of Edenfield Electric Co. Of course, if he is correct as to that, then clearly section 275(e) does not have any application. But it seems to us that petitioner confuses gross receipts with gross income and obviously the two are not the same. The expenses in question constitute a part of the cost of operations of ■ the Edenfield Electric Co. and, as such, these expenses are to be deducted from gross receipts in arriving at gross income. The Internal Revenue Code authorizes no deduction for cost of goods sold or cost ' of operation but such costs must be deducted in arriving at gross income.”

In that case the Government stood to gain by the inclusion of the labor in the cost of goods sold because the issue there was whether the taxpayer had omitted on his return 25 percent of his gross income so as to bring into effect the 5-year statute of limitations, thereby lifting the bar of the 3-year statute. The taxpayer claimed that the wages he paid were not part of his cost of goods sold and that only his materials were. With the inclusion of labor as part of the cost of goods sold it reduced taxpayer’s gross income to an amount, which when added to other income, made the amount reported less than 25 percent of the true gross income and thereby brought into operation the 5-year statute of limitations against plaintiff. The Government’s argument and the Tax Court decision in that case seem to indicate that the Government and the Tax Court recognize that labor costs of the nature in question in the instant suit, that is, labor costs of a construction business where the pri*297mary product sold is services, are truly a part of the cost of goods sold of the business.

While these cases establish that certain wages may be properly included as part of the cost of goods sold and, also, that an item properly includible in the cost of goods sold should be accorded tax treatment consistent with that terminology, they do not involve the question of whether wages paid in excess of ceilings prescribed pursuant to statute can be excluded therefrom by the Commissioner of Internal Revenue when that statute gives the President the authority to certify to the various governmental departments the extent to which that department should disallow the amount of the overpayment in determining the costs and expenses of the violator. However, it seems quite clear, based on what I have said above, that if the wages in question are truly an element of the cost of goods sold they cannot be excluded therefrom by the Commissioner of Internal Revenue despite the Stabilization Act; indeed, even the Congress cannot exclude them from the cost of goods sold if they are truly an element thereof. Moreover, any revenue act that attempts to reach the actual cost of goods sold and deny its inclusion in arriving at gross income is unconstitutional. The Constitution is supreme and all else subordinate thereto. However, I do not think the Defense Production Act of 1950 is unconstitutional. I simply say that a construction cannot be placed upon that act that would attempt to tax a constitutionally exempt item. Section 401 of the 1950 act states that “all agencies dealing with the subject matter of this title, within the limits of their authority and jurisdiction, shall cooperate in carrying out these purposes.” Thus, it can be seen that Congress had no intention of attempting to give the Commissioner of Internal Revenue a power he did not otherwise have. The act specifically said he could act only within the limits of his authority, and his authority was limited by the Constitution which allows him to assess income tax on income only, not on capital.

It is my opinion that all the wages paid ■ by plaintiffs to those employees charged with the duty of doing the plastering work are truly part of the partnership’s cost of goods sold and on no theory can ■ such labor be excluded from the cost of ' goods sold. They are constitutionally . exempt from taxation. To tax them would be to levy an income tax on capital and not on income.

Further, it is my opinion that the excessive wage payments of $13,535 here in question are also truly part of the cost of goods sold; hence, the Commissioner of Internal Revenue does not have the authority to exclude them from those ' costs in arriving at taxable income notwithstanding the Defense Production ' Act. This is not to say that in a situation involving wages which are not a part of the cost of goods sold but otherwise deductible as ordinary and neces- ■ sary business expenses under section 23 of the 1939 Internal Revenue Code the Commissioner would not have the power to exclude excessive payments as deductions in arriving at taxable income when he received a Certificate of Disallowance. He would clearly have the authority to do so in such a case as it was given him by section 405(b) of the Defense Production Act.

I feel that there is no element of unconstitutionality in section 405(b) and that “costs and expenses” therein used and “deductions” used in the Economic Stabilization Agency General Order No. 15 relate, insofar as the Internal Revenue Code is concerned, only to those items properly déductible or excludible under the code. Since such deductions or exclusions are matters of legislative grace, they can be taken away by Congress as well.

I think it would be appropriate to note that my views here do not tend in any way to defeat the purpose of the act • which was, inter alia, to prevent inflation by holding wages to certain prescribed ' máximums, nor do they tend to put the *298Government in the position “of subsidizing the violation of its law or public policy,” as the majority suggests, since sections 409 and 706 of the act provide civil and criminal penalties which are sufficiently adequate to insure substantial compliance. Among other things, those sections make a violator of the law subject to a $10,000 fine and imprisonment for one year. Also, I do not feel that a decision as suggested by this opinion would frustrate any law or public policy as the majority believes it would. It seems to me that the Constitution, the basic law of the land, is the framework for all public policy. The Congress apparently has the power to regulate wages but in so doing it cannot reduce or cut across the announced policy of the Constitution as it relates to income taxation, that is, that only income, not capital, is subject to income taxation.

I think the plaintiffs are entitled to a judgment for the entire amount claimed, plus interest as provided by law.

LITTLETON, Judge, joins in the foregoing dissent.

. Section 23 of the Internal Revenue Code of 1939, 26 U.S.C. § 23, follows:

“Sec. 23. Deductions from gross income.

“In computing net income there shall be allowed as deductions:

“(a) Expenses.

“(1) Trade or business expenses.

“(A) In general. All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business; and rentals or other payments required to be made as a condition to the con-turned use or possession, for purposes of tbe trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity. In the case of any sports program conducted for the benefit of the American National Red Cross, expenses described in section 22(b) (16) (B) shall be allowable under this subparagraph only to the extent that such expenses ex--ceed the amount excluded from gross in — , come by section 22(b) (16).”

Section 23 continues from subsection (b) through subsection (if) (4) and re-> lates to other items not covered in the above paragraph but which the code specifically denominates as deductible in arriving at taxable income under the code.

Section 24 deals with items specifically not deductible.