*195 Decisions will be entered for the respondent.
1. X and Y, so-called nonprofit corporations not exempt from tax, sold water or furnished water services only to their shareholders. Each also received substantial income from sources unrelated to its water business. Each fixed its water charges to its shareholders below cost so that its water and non-water income together would annually approximate its water costs and leave it without profit. Held, to the extent that the water costs were in excess of the charges to the shareholders for such water or water services, the expenses were not deductible as "ordinary and necessary" business expenses under section 23(a)(1)(A) of the 1939 Code and section 162 of the 1954 Code.
2. Y corporation reported the rental income from and expenses paid in connection with land it held as cotenant with X and Z corporations. Held, such income and expenses should be allocated to each cotenant in proportion to its ownership in the land.
*1072 The respondent determined deficiencies in income tax for the years and in the amounts as follows:
| Year | Docket No. | Docket No. |
| 72128 | 72129 | |
| 1952 | $ 39,219.33 | $ 2,274.34 |
| 1953 | 35,009.46 | 3,114.28 |
| 1954 | 35,366.29 | 5,306.44 |
The issues to be resolved are: (1) Whether the respondent was correct in determining that water costs claimed by Anaheim Union *1073 Water Company and Santa Ana River Development Company for the years 1952, 1953, and 1954 are not allowable ordinary and necessary business expenses to the extent that they exceeded proceeds from the sale of water; (2) whether the respondent was correct in allocating rental income for 1952 and 1953 and rental expenses for 1952, 1953, and 1954 reported by Santa Ana River Development Company to Anaheim Union Water Company, its cotenant in certain rental property.
FINDINGS OF FACT.
The stipulated facts are incorporated herein by reference.
Petitioner Anaheim Union Water Company, hereinafter called Anaheim, is a California so-called nonprofit mutual irrigation corporation, whose calendar year income*197 tax returns for the years here involved were filed with the director of internal revenue, Los Angeles, California.
Anaheim was formed on January 25, 1884, as a California corporation for the stated purposes of selling and distributing water to its shareholders who owned land within Anaheim's irrigation district. The articles were amended in 1934 to provide that the water was to be supplied "at cost." Anaheim has a legal right to divert one-half of the surface flow of the Santa Ana River. It is diverted at its headgate and transported along a canal into two reservoirs for storage. The water is carried to the shareholders through distribution lines, and utilized by them solely for agricultural purposes. No water is resold. Additional lands were purchased from time to time by Anaheim in accord with its corporate purpose.
Anaheim was ruled tax exempt in 1934 under
During the years under consideration Anaheim's income fell *198 into three categories: Proceeds from the sale of water, oil royalties, and land rentals and miscellaneous income. During the years 1942 through 1954 its income and expenses were as follows:
| Water | Water | Oil | Rental and | |
| Year | sales | expense | income | miscellaneous |
| income | ||||
| 1942 | $ 77,372.16 | $ 105,798.77 | $ 23,096.92 | $ 2,894.53 |
| 1 1943 | 97,761.04 | 100,588.20 | 30,010.94 | 4,387.44 |
| 1944 | 51,114.41 | 102,585.69 | 53,626.16 | 11,645.52 |
| 1945 | 52,162.21 | 115,218.94 | 63,031.53 | 9,086.40 |
| 1946 | 46,688.05 | 129,543.81 | 80,536.29 | 5,103.09 |
| 1947 | 62,471.88 | 156,875.13 | 119,787.12 | 5,395.35 |
| 1948 | 61,974.23 | 179,572.73 | 144,498.17 | 13,601.86 |
| 1949 | 44,971.05 | 186,498.28 | 123,667.65 | 3,276.73 |
| 1950 | 57,643.29 | 185,111.35 | 94,648.78 | 2,506.90 |
| 1951 | 92,592.26 | 167,476.00 | 103,831.45 | 3,840.64 |
| 1952 | 67,260.44 | 180,910.23 | 119,335.84 | 10,821.70 |
| 1953 | 85,159.20 | 195,538.93 | 112,467.96 | 3,169.92 |
| 1954 | 76,381.72 | 191,804.54 | 102,877.35 | 13,690.44 |
*199 *1074 During the period 1952-1954 Anaheim had approximately 700 shareholders. The shares were not appurtenant to the land. In 1952 approximately 550 of these shareholders purchased water, but this number decreased to 500 in 1954. This decrease was due to the subdivision into homesites of certain areas served by Anaheim. Each shareholder was entitled to buy a certain amount of water per share per month, the amount being specified in the bylaws of the corporation and the price being set by the board of directors. Additional water beyond the shareholders' ration could be purchased by paying an extra rate which was approximately double the basic rate. A shareholder was also permitted to rent shares from other shareholders in order to obtain water at the basic rate.
Santa Ana Valley Irrigation Company, hereinafter called SAVI, another irrigation company operating in an area adjacent to that of Anaheim, also has the right to withdraw one-half of the surface flow of the Santa Ana River at its diversion point along the river, which was downstream from Anaheim's headgate. From 1900 to 1907, Anaheim and SAVI joined together in purchasing several tracts of land upstream from their*200 diversion points, to protect their interests in the flow of the Santa Ana River.
Petitioner Santa Ana River Development Company, hereinafter referred to as SARD, is a so-called nonprofit Nevada corporation, with 28 shares of issued and outstanding stock, par value $ 100 per share. Of this number 14 are owned by Anaheim, the other 14 by SAVI. It was organized by SAVI and Anaheim in order to facilitate the successful operation of their irrigation operations. Its functions were to clear brush and clean and cement channels as well as to drill wells and pump water for the purpose of increasing the flow of water. SARD filed its Federal income tax returns for the years at issue with the director of internal revenue at Los Angeles, California.
SARD has a five-man board of directors, three appointed by SAVI, and two by Anaheim. A vote of four directors is required before SARD can take any action other than the payment of bills in the amount of $ 500 or less. Any expenditure in excess of $ 500 must receive independent approval from the boards of Anaheim and SAVI.
SARD was incorporated in 1907 at which time Anaheim and SAVI conveyed certain jointly held lands to SARD for a stated consideration*201 of $ 150,000. Anaheim and SAVI each received from SARD a demand note for $ 75,000 bearing interest at the rate of 5 percent per annum. By contract in 1907, SARD was to render certain water services to Anaheim and SAVI for $ 7,500 per year plus any expenses incurred by SARD. Another contract in 1909 amending the 1907 contract provided that the income from the lands conveyed should be applied against these costs. By an agreement in 1944, SARD agreed to furnish certain water services to Anaheim and SAVI, the consideration *1075 being that Anaheim and SAVI were each to pay one-half of the operating expenses of SARD, after SARD had applied toward the operating expenses, any rents, issues, and profits which it might take from the lands owned by SARD. SARD purchased additional land at the instruction of Anaheim and SAVI with funds furnished equally by Anaheim and SAVI.
In 1940, SARD conveyed an undivided one-half interest in certain lands to each of its shareholders. In 1949, a one-sixth interest in these lands was reconveyed to SARD by Anaheim and SAVI in order to permit SARD to rent the lands and take part in threatened litigation concerning water rights.
SARD's rental income, *202 expenses, and charges to stockholders during the period at issue were:
| Year | Gross rental | Expenses | Charges to |
| income | stockholders | ||
| 1952 | $ 25,458.20 | $ 31,349.77 | $ 5,891.57 |
| 1953 | 25,341.33 | 40,426.46 | 15,085.13 |
| 1954 | 18,861.48 | 39,818.13 | 20,956.65 |
The rental income and expenses reported by SARD on its 1952 and 1953 Federal income tax returns included amounts which were received from lands in which SARD was a cotenant with Anaheim and SAVI. In determining the deficiencies for 1952 and 1953 the respondent added to Anaheim's income, the rental income attributable to Anaheim's interest in such lands and allowed a deduction to Anaheim for its proportionate share of the related expenses. In 1954, the rental income was properly allocated on the returns filed by SARD, Anaheim, and SAVI, but the expenses were not so allocated; they were all claimed by SARD. The respondent allocated to Anaheim its proportionate share of these expenses in determining the deficiencies against Anaheim and SARD for that year. These amounts, so adjusted to reflect SARD's and Anaheim's proportionate shares of the income and expenses from the rental lands, are as follows:
| 1952 | 1953 | 1954 | |
| Rental income reported by SARD | $ 25,458.20 | $ 25,341.33 | $ 18,861.48 |
| Less rental income attributable to | |||
| cotenants, Anaheim and | |||
| SAVI | 11,877.06 | 8,960.40 | 0 |
| Rental expenses reported by SARD | 15,184.37 | 28,387.80 | 27,623.08 |
| Less rental expenses attributable to | |||
| cotenants, Anaheim and | |||
| SAVI | 8,339.28 | 15,761.99 | 14,181.41 |
| Rental income allocated to Anaheim | 5,938.53 | 4,480.20 | 0 |
| Rental expenses allocated to Anaheim | 4,169.64 | 7,880.99 | 7,090.71 |
*203 Respondent determined that SARD's water expenses for the period were:
| Year | Water expenses |
| 1952 | $ 9,571.98 |
| 1953 | 17,270.93 |
| 1954 | 19,863.18 |
*1076 Anaheim's water expenses or costs were not ordinary and necessary business expenses to the extent that they exceeded the amounts which Anaheim received from its shareholders for such water. SARD'S water expenses or costs were not ordinary and necessary business expenses to the extent that they exceeded the amounts received or receivable from its shareholders for water or water services furnished by it to its shareholders.
OPINION.
1. Although Anaheim was at one time an exempt corporation, it had ceased to be such for a number of years because of the substantial income which it had been receiving from oil royalties and other sources. 1 There is no dispute between the parties that Anaheim is a taxable corporation, and this case must be decided upon that assumption. The Commissioner determined that Anaheim's water costs or expenses incurred in the distribution of water to its shareholders were not deductible as ordinary and necessary business expenses to the extent that they exceeded the revenue received by it from the sale*204 of such water.
It is plain from the record before us that the directors deliberately fixed the water rates at such level that when the amounts paid by the shareholders for the water are added to the corporation's income from oil and other sources the sum will be such that after subtracting the cost of supplying the water no net taxable income remains. In substance the corporation distributed its oil royalties and other income to its shareholders through*205 the medium of charging them less than cost for water. Although the question for decision has been variously stated by the parties from time to time -- and subtle differences may perhaps be thought to turn upon the form of the statement -- we think that the real issue before us is whether the water costs or expenses incurred by Anaheim are ordinary and necessary expenses on this record to the extent that they exceeded the amounts which Anaheim obtained for such water from its shareholders. We hold that to the extent of such excess they do not qualify as "ordinary and necessary" expenses.
The question is not whether such expenses might be "ordinary and necessary" in other situations. The question rather is whether such expenditures in this case, known in advance to be in excess of what the corporation would obtain for the water sold to its shareholders, *1077 can fairly be classified as "ordinary and necessary." We think that they are neither "ordinary" nor "necessary." Indeed, it appears to us to be "in a high degree extraordinary," cf.
*208 We have not been directed to any decisions squarely in point. However, there are cases which, although perhaps distinguishable, nevertheless point the way to the proper disposition of this controversy. In
Our own decision in
*212 2. A similar issue is presented in SARD's case, since it appears from the record that SARD charged its shareholders, Anaheim and SAVI, less than cost for the water services it furnished them during the tax years in question because it, too, applied non-shareholder income to the payment of its expenses. We think a like decision is called for in respect of the Commissioner's adjustments relating thereto. Unlike Anaheim, SARD by agreement with its shareholders in 1944 was specifically required to apply its "rents, issue, and profits" from its land to its water service expenses before billing its shareholders for them. However, we do not consider this difference crucial. It is no more "ordinary and necessary" for a corporation by agreement to expend more for its services than it is paid than it is to do the same thing without an agreement. The agreement merely tends to make explicit in SARD's case what was apparent in the absence of an agreement in Anaheim's, namely, that a corporation which charges its shareholders less than cost for its goods or services and uses otherwise taxable income to pay for the expense differential is, in effect, merely making a distribution of such taxable*213 income to the shareholders without a formal declaration of dividends.
3. There remains finally the issue whether rental income in 1952 and 1953 and rental expenses in 1952, 1953, and 1954 reported by SARD should have been allocated to Anaheim as cotenant of the rental property as determined by the respondent. The respondent contends that SARD is a separate entity and that its rental income and expenses should have been allocated to the parties, Anaheim and SAVI, to whom such income and expenses are attributable. Anaheim, on the other hand, claims that SARD is merely an agent created to carry on upstream water conservation activities on behalf of the two downstream water companies, Anaheim and SAVI.
*1080 SARD, Anaheim, and SAVI are each separate corporate entities. The fact that SARD may have performed functions as an agent for Anaheim and SAVI in no way permits SARD to report on its own returns the entire rental income and expense from those lands in which it was a cotenant with Anaheim and SAVI. The aggregate rental income derived from these properties should have been allocated together with the corresponding rental expenses to each of the three corporations and so reported*214 by them.
The respondent's determination that the rental income reported by SARD in 1952 and 1953 and the rental expense deducted by SARD in 1952, 1953, and 1954 should have been allocated to the parties to whom such rental income and expense is attributable, is sustained. There is nothing in the record which would demonstrate that the allocation made by the respondent of the income and expenses was arbitrary or unreasonable and we approve the allocation as made.
Decisions will be entered for the respondent.
Turner, J., concurring: As I see this case, the result must still be the same even if Anaheim should be sustained in its contention that its entire outlay in producing the water sold to its stockholders represented ordinary and necessary expenses in the conduct of its business and was thereby deductible in full. Under its bylaws, as amended in 1934, it was to supply water to its stockholders at cost. It would accordingly follow that the stockholders were obligated to pay cost. If then*215 Anaheim should be held to be correct in its contentions, the shareholders must be said to have paid the cost when Anaheim's rent and oil royalty income was applied, together with the money actually paid by the water purchasers, in satisfaction of their water purchase obligations. The gross receipts from water sales would thus be increased to the same extent that Anaheim's rent and oil royalty income was so applied. And with the receipts from water sales thus being exactly the amount of the outlay in production thereof, Anaheim's rent and oil royalty income would be left intact as net taxable income, allowance, of course, being made for any proper deductions attributable to the production of such income.
Furthermore, as the opinion of the Court herein suggests, it does not seem to me that the fact that the transactions of SARD with Anaheim and SAVI were pursuant to written agreement presents a crucial difference with respect to those transactions.
*1081 Withey, J., concurring: I concur that there are deficiencies in the income tax of petitioner based on the amount of the oil royalties and rentals received by it in the years at issue. It should not be held, however, that*216 the actual costs incurred in taking the water from the river, storing it, delivering it to petitioner's stockholder customers, and maintaining the facilities to do so are not ordinary and necessary business expenses. There is no dispute here as to the amount of such costs or its reasonableness. Such being the case, to hold they do not constitute ordinary and necessary expense merely because they were in part defrayed by application of oil royalties and rentals acquired from a separate enterprise to such water costs does violence to the basic concept of taxation upon net business income.
Petitioner is taxable on the oil royalties and rentals because, in substance, they or the water into which they were converted are clearly surplus after the conversion which was distributed to petitioner's stockholder customers at an amount less than the water's value exactly corresponding to such royalties and rentals. In substance then the royalties and rentals were so distributed as dividends. As stated, such dividends were paid from a water surplus. For illustration, it is considered that a gallon of water reaches petitioner's headgate in the river. At that point it has no intrinsic value*217 to petitioner for it then must be taken, stored, and delivered and the facilities to do so maintained. By the application of its oil royalties and rentals to that processing, the gallon of water immediately upon being taken from the river begins to acquire value to the extent such royalties, rentals, and the rate paid by the customer are applied to its processing. At the point where the gallon of water is about to be turned over to the customer it is worth at least the cost of bringing it to that point -- for the sake of discussion let us say 10 cents. One cent of the cost is paid by the stockholder customer and 9 cents defrayed from royalties and rentals. The 9 cents thus distributed is then in substance clear surplus in petitioner's hands and a distribution by way of a dividend to such customers. The surplus is taxable business net income.
Tietjens, J., dissenting: The purpose for which Anaheim was formed was to furnish water to shareholders. That purpose still persists although a substantial portion of Anaheim's revenues is now obtained from oil. It is amply clear that the expenses which are here in issue were incurred in carrying out Anaheim's business of furnishing*218 water -- they were actual expenses of the business and in our opinion they were ordinary and necessary expenses. To deny that they were ordinary and necessary, as the majority opinion does to the extent that they exceeded the amount charged to shareholders, seems to say *1082 that it is the source of the funds used to pay the expenses, rather than the character of the expenses themselves, which determines whether or not they are deductible. I think this is wrong.
This case is not the same as
This case is also different from
And in
As pointed out in the majority opinion,
In *220 conclusion I point out that the only question urged by the parties is the deductibility or nondeductibility of the claimed expenses. Accordingly, that is the only question which should here be decided. We need not pass upon or evaluate theories not advanced by the parties or abandoned on brief, such as increasing the petitioner's gross receipts by the amount of the water costs not charged to shareholders or the possibility that constructive dividends were paid.
I find no warrant in the internal revenue laws for disallowing the claimed expenses and respectfully dissent.
Footnotes
1. Of the $ 97,761.04 water sales, $ 24,352 was refunded to the shareholder-users in December 1943.↩
1. The exemption was based upon
section 101(10)↩ of the Revenue Act of 1934 (and cognate provisions of other revenue acts) which included among exempt corporations "mutual ditch or irrigation companies, * * * or like organizations; but only if 85 per centum or more of the income consists of amounts collected from members for the sole purpose of meeting losses and expenses." The administrative ruling that Anaheim was exempt was withdrawn in 1939, since its oil and other income was of such magnitude as to render it incapable of complying with the 85 percent requirement.2. In 1943, the one year in which Anaheim's directors accidentally set a water rate which together with the non-water income yielded a net profit, the following revealing item appeared in the minutes of Anaheim's board of directors under date of December 20, 1943:
"The Secretary reported that he had prepared estimates on income and expense for the year 1943, this estimate included the actual income and expense for eleven months plus an estimate for December, 1943. The result was that we would show a net profit from operations of approximately $ 22,500.00. He stated that he had consulted Mr. Diehl of the firm of Diehl and Company, Accountants, and that the income tax on this amount would amount to approximately $ 5,000.00. The Secretary further stated that he had discussed with Mr. Diehl a refund to water users. Water deliveries would be approximately $ 97,700.00, and a refund of 25% would amount to approximately $ 24,400.00. Whereupon * * * [motion was made and unanimously carried for a refund]."↩
3. Compare
Pomeroy Cooperative Grain Co., 31 T.C. 674">31 T.C. 674 , 685↩, where the Court pointed out that in determining what patronage dividends were to be excluded from gross income the problem "is controlled by Federal law" and not by State law (in that case Iowa) which provided how and to whom the earnings of the cooperative might be distributed.