1978 Tax Ct. Memo LEXIS 282 | Tax Ct. | 1978
MEMORANDUM FINDINGS OF FACT AND OPINION
HALL,
Petitioner | Year | Deficiency |
Murray G. and Esther G. Gurentz | 1973 | $ 3,558.96 |
James S. and Vivian J. Ezell | 1973 | 15,392.18 |
James S. and Vivian J. Ezell | 1974 | 26,297.10 |
These cases have been consolidated for purposes of trial, briefing and decision. The issues for decision are:
1. Whether Central State Trucking Co., Inc., petitioner's electing small business corporation, is entitled to deduct under
2. Whether undistributed taxable income of Central State Trucking Co., Inc., which petitioners Ezell reported as earned income in 1973 and 1974 is subject to the maximum tax limitations provided in
1978 Tax Ct. Memo LEXIS 282">*284 FINDINGS OF FACT
Some of the facts have been stipulated by the parties and are found accordingly.
At the time they filed their petitions, all petitioners were residents of Dallas, Texas. Esther Gurentz and Vivian Ezell are parties only by virtue of having filed joint returns with their husbands. When we hereafter refer to petitioners, we will be referring to Murray Gurentz and James Ezell.
In the 1950s petitioners formed Central State Trucking Co., Inc. ("Central State") which was in the business of buying and selling poultry, poultry by-products, and other meat products. Petitioners were equal owners of the stock of Central State until January 31, 1974, at which time Gurentz sold his Central State stock to Ezell. During the years in issue, Ezell was President and Gurentz was Vice-President of Central State. Ezell ran the day-to-day trading business of Central State, while Gurentz handled the financial and credit aspects of the business. Gurentz's services were not as valuable to Central State as those performed by Ezell.
During the years in issue, Central State was an electing small business corporation (a "subchapter S" corporation) with a fiscal year ending September1978 Tax Ct. Memo LEXIS 282">*285 30. For its fiscal year ending September 30, 1973, Central State paid each petitioner a $ 65,000 salary. For its fiscal year ending September 30, 1974, Central State paid salaries of $ 95,000 to Ezell and $ 48,000 to Gurentz. These were reasonable salaries. Central State had undistributed taxable income of $ 123,606.86 and $ 169,243.51 for its fiscal years 1973 and 1974, respectively.
From 1970 to 1973 Central State's sales increased rapidly. 2 The business of Central State primarily involved buying and selling poultry and poultry by-products. Central State purchased fryer necks and backs from poultry processors and sold them to pet food manufacturers. The usual minimum purchase was one carload, or approximately 40,000 pounds of chicken parts. In early 1973 chicken parts cost approximately five cents per pound, or $ 2,000 a carload. By the end of 1973 the price had risen to 20 cents per pound, or $ 8,000 per carload. Normally Central State's transactions involved more than one carload. One transaction involved 200 carloads. All the trading was done by Ezell.
1978 Tax Ct. Memo LEXIS 282">*286 Some of the companies to which Central State sold chicken parts during the years in question were "one man" shops. At the end of fiscal 1973, for example, Central State had accounts receivable of $ 52,200.20 from Chester Frantz and $ 9,360 from Rio Foods, both "one man" operations. Similarly, at the end of fiscal 1974, Central State had accounts receivable of $ 3,479.45 from Rio Foods and $ 15,375 from Poultry Foods (another "one man" operation). These "one man" operations probably would be unable to pay their debts if anything happened to the individual in charge. 3 The bulk of Central State's business, however, was with large companies like Quaker Oats and Star Kist. These large accounts comprised the greater percentage of Central State's accounts receivable during the fiscal years in question. 4
Central State's rapid increase in sales was1978 Tax Ct. Memo LEXIS 282">*287 matched by a rapid increase in its accounts receivable. Receivables as of the end of its fiscal year climbed from $ 49,536 in 1970 to $ 363,454 in 1973. In the recession of 1974 both sales and receivables declined slightly: receivables at the end of Central State's fiscal year 1974 were $ 341,397. 5
1978 Tax Ct. Memo LEXIS 282">*288 Despite its large accounts receivable, Central State had an excellent record of debt collection. From fiscal 1968 through fiscal 1976 Central State incurred bad debts in only two years, $ 41,345.81 in fiscal 1970 and $ 33,000 in fiscal 1976. The 1970 amount of $ 41,345.81 consisted of the following specific accounts receivable: W.S. Distributing Co., $ 40,190.55; John S. Sneed Co., $ 410.41; R.W. Zant, $ 483.25; H.J. Heinz Co., $ 261.60. The fiscal 1976 bad debt was $ 33,000 owed by Rio Foods. Both W.S. Distributing Co. and Rio Foods were "one man" operations.
Central State employed the accrual method of accounting and utilized the reserve method for deducting losses from bad debts during the years in issue. The closing reserves for bad debts (rounded to the nearest dollar, after additions have been made) were as follows from fiscal 1968 through fiscal 1976:
1968 | $ 8,195.00 |
1969 | $ 8,880.00 |
1970 | $ 4,990.00 |
1971 | $ 6,451.00 |
1972 | $ 7,838.00 |
1973 | $ 18,354.00 |
1974 | $ 25,182.00 |
1975 | $ 25,182.00 |
1976 | $ 11,705.00 |
The reductions in the reserve in 1970 and 1976 occurred when Central State "deducted" the bad debts mentioned above from the reserve.
1978 Tax Ct. Memo LEXIS 282">*289 On its Small Business Corporation returns, Central State claimed deductions for additions to its reserve for bad debts of $ 10,515.47 in fiscal 1973 and $ 6,827.96 in fiscal 1974. Central State obtained the figure for 1973 through use of the so-called
1978 Tax Ct. Memo LEXIS 282">*290 Since Central State was an electing Small Business Corporation during the years in issue, Gurentz and Ezell, its two shareholders, reported its undistributed taxable income on their tax returns. Ezell reported $ 61,803.43 in 1973 and $ 142,435 in 1974, and Gurentz reported $ 61,803.43 in 1973 and $ 26,808.46 in 1974. Gurentz received the same amount as Ezell in 1973 because they were equal shareholders of Central State then. However, Gurentz sold all his shares to Ezell on January 31, 1974. Gurentz owned one-half of Central State's shares for 1/3 of its taxable year ending September 30, 1974; he reported approximately 1/6 of its undistributed taxable income that year. Both Gurentz and Ezell reported their shares of Central State's undistributed taxable income as "income other than wages;" however, Ezell claimed in both years that his share of Central State's undistributed taxable income was subject to the maximum tax on earned income provided in
In the statutory notices sent to Ezell and Gurentz, respondent determined that Central State was not entitled to any additions to its reserve for bad debts for either of the fiscal years in issue. As a result of this1978 Tax Ct. Memo LEXIS 282">*291 determination, the undistributed taxable income of Central State was increased in both years. In the statutory notice respondent sent to Ezell, respondent further determined that income in the amounts of $ 61,803.43 in 1973 and $ 142,435 in 1974 that Ezell reported as earned income was not earned income subject to the maximum tax provisions of
OPINION
I.
The first issue is whether Central State Trucking Co., Inc. ("Central State"), a subchapter S corporation, is entitled to a deduction under
In fiscal 1973 Central State computed its addition to the reserve by using the
Central State relied on the
Central State's year-end reserve was $ 7,834.97 in fiscal 1972, and the claimed addition in fiscal 1973 raised the year-end reserve to $ 18,354.44.This addition was appropriate since Central State's annual sales grew in one year from $ 1,869,884 to $ 4,227,883 and its year-end accounts receivable grew from $ 138,804 to $ 363,454.Moreover, 1978 Tax Ct. Memo LEXIS 282">*295 two of these 1973 year-end accounts receivable were debts owed by "one man" shops and therefore were more susceptible to default then debts of large, publicly held corporations. 9 In addition, the cost of the poultry traded had increased from 5 cents per pound to 20 cents per pound, so that the cost per carload had increased from approximately $ 2,000 to $ 8,000. Since Central State's trades were in carload lots, this increase in prices made it likely that even a single default would exceed the amount of Central State's previous reserve. In addition, two expert witnesses testified that the addition to the reserve was reasonable. In fact, both experts concluded that the addition was, if anything, too small given the increase in accounts receivable, the volatility of the business, the number of accounts with "one man" shops, and the general price instability during the years in issue.
Respondent contends that the addition was not reasonable. Respondent points out that all the accounts receivable at year-end were in fact collected within several weeks of the end of fiscal1978 Tax Ct. Memo LEXIS 282">*296 1973. Central State had a remarkable and enviable record of collecting its debts. Respondent's contention that none of the debts were in fact bad, however, misses the basic point that the reserve is meant to be only an estimate. The net effect of respondent's contention is to negate the distinction between the reserve method and the specific charge-off method of accounting for bad debts. Moreover, respondent relies on events which occurred after the close of the year which is contrary to Reg.
Second, respondent contends that Central State did not need an addition to its reserve for bad debts since most of its customers were large, solvent corporations. However, some of the accounts receivable which Central State had outstanding on September 30, 1973, were from "one man" shops. The outstanding balance of these accounts exceeded Central State's year-end reserve for bad debts. Although hindsight proves that these debts did not become uncollectible, petitioner was justified in viewing these accounts as volatile.
Respondent contends, third, that Central State1978 Tax Ct. Memo LEXIS 282">*297 had an excellent debt collection record and that it had, in fact, incurred no bad debts in the two preceding years.We believe that this argument is misplaced, since the
Finally, respondent contends that the use of the
Having concluded that the addition to its reserve which Central State claimed in fiscal 1973 was reasonable, we now turn to the question whether respondent's disallowance of the addition was arbitrary and an abuse of discretion. See
Respondent's determination in this case gives little heed to the changes which occurred in Central State's business.Although Central State's accounts receivable had greatly increased, respondent determined that Central State was not entitled to increase its reserve for bad debts. Respondent's disregard of a taxpayer's changed circumstances can constitute an abuse of discretion.
In light of the reasonableness1978 Tax Ct. Memo LEXIS 282">*299 of Central State's addition to its reserve, respondent's disregard of Central State's changed circumstances, and the agent's error in applying the
For fiscal 1974, however, we reach a different conclusion. Again, petitioners have a heavy burden of proof--they must prove not only that the addition was reasonable but also that respondent's adjustment was an abuse of discretion. Because we do not find an abuse of discretion in this year, we do not consider the reasonableness of the addition claimed in fiscal 1974.
In fiscal 1974 Central State changed accountants and began to use the services of a national accounting firm. That firm recommended that Central State change the method by which it computed its reserve for bad debts; the new method provided an annual addition to its reserve of two percent of year-end accounts receivable. Central State adopted this method and claimed a deduction for the resulting addition to its reserve for bad debts1978 Tax Ct. Memo LEXIS 282">*300 in fiscal 1974.
We find no circumstances which indicate that respondent abused his discretion. Had Central State continued to apply the
II.
The next issue is whether undistributed taxable income of Central State, which Ezell reported as earned income on his returns for 1973 and 1974, is subject to the maximum tax limitation provided in
For purposes of this section, the term "earned income" means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered, but does not include that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation which represents a distribution of earnings or profits rather than a reasonable allowance as compensation for the personal services actually rendered. In the case of a taxpayer engaged in a trade or business in which both personal services and capital are material income-producing factors, under regulations prescribed by the Secretary or his delegate, a reasonable allowance as compensation for the personal services rendered by the taxpayer, not in excess of 30 percent of his share of the net profits of such trade or business, shall be considered as earned income.
1978 Tax Ct. Memo LEXIS 282">*302
The term [earned income] does not include such income as dividends (including an amount treated as a dividend by reason of
In this case Ezell received as salary $ 65,000 in 1973 and $ 95,000 in 1974, which respondent concedes was a reasonable salary. Central State's undistributed taxable income was allocated equally to its two shareholders in 1973 and apparently stock ownership was the basis of its allocation in 1974 as well. Ezell contends, however, that the undistributed taxable1978 Tax Ct. Memo LEXIS 282">*303 income was meant to be compensation to him for services rendered; Ezell points especially to Gurentz's testimony to that effect.Since the undistributed taxable income apparently represents Central State's earnings and profits, Ezell contends that we should look to the substance of the undistributed taxable income rather than its form.
The facts of this case strongly indicate that the undistributed taxable income was allocated with respect to the stock of the corporation, not with respect to services provided. In 1973 Gurentz reported undistributed taxable income equal to that reported by Ezell, yet Gurentz admitted that he did not perform equal services.Rather, the basis for an equal distribution was equal ownership of the stock of Central State. Gurentz owned one-half of Central State's stock for four months of its fiscal year ending September 30, 1974, and he reported approximately one-sixth of its undistributed taxable income. This amount apparently represents his time of ownership (one-third of the year) times his percentage ownership (one-half) of Central State. On the facts of this case we must conclude that the undistributed taxable income represents a distribution of1978 Tax Ct. Memo LEXIS 282">*304 Central State's earnings and profits, not compensation for services.
This case is indistinguishable from
While we might be inclined to go along with petitioners' substance over form argument in the area of
Footnotes
1. All statutory references are to the Internal Revenue Code of 1954, as in effect during the years in issue.↩
2. Central State's sales from fiscal 1968 through fiscal 1976 were as follows:
↩ 1968 $ 1,756,785 1969 $ 1,375,389 1970 $ 869,548 1971 $ 1,272,301 1972 $ 1,869,984 1973 $ 4,227,883 1974 $ 3,805,209 1975 $ 2,570,909 1976 $ 3,518,733 $ 3. Chester Frantz was approximately 70 years old; the man in charge of Poultry Foods was in poor health. ↩
4. E.g., the accounts receivable from major purchasers (Quaker Oats, Star Kist, Lowrey's) constituted 83 and 94 percent of Central State's accounts receivable as of September 30, 1973, and September 30, 1974, respectively.↩
5. Central State's accounts receivable at the end of its fiscal years from 1968 through 1976 were as follows:
1968 $ 52,680.00 1969 $ 68,579.00 1970 $ 49,536.00 1971 $ 146,018.00 1972 $ 138,804.00 1973 $ 363,454.00 1974 $ 341,397.00 1975 $ 118,627.00 1976 $ 311,290.00 The specific accounts receivable as of September 30, 1973, and 1974, were as follows:
↩ September 30, 1973 Account Balance Date of Payment Steve Bodner $ 1,722.00 10/11/73 Chester B. Frantz 52,200.20 10/09/73 Lowreys Friskies, Inc. 59,039.00 10/02/73 Mike Dipp-Rio Foods 9,360.00 10/02/73 Quaker Oats Foods 159,016.96 10/02/73 Star Kist Foods 82,116.05 10/1/73 to 10/9/73 Total $ 363,454.21 September 30, 1974 Rio Foods $ 3,479.45 10/10/74 Lowreys 55,301.40 10/07/74 Star Kist Foods 61,763.25 10/1/74 Poultry Foods 15,375.00 10/7/74 Quaker Oats 205,478.70 10/1/74 to 10/18/74 Total $ 341,397.80 6. This formula is derived from
(1940), affd.Black Motor Company v. Commissioner, 41 B.T.A. 300">41 B.T.A. 300125 F.2d 977">125 F. 2d 977↩ (6th Cir. 1942) .7. For example, Central State's calculation for fiscal 1973 using the
Black Motor Company formula was as follows:Accounts Receivable Fiscal Years on September 30 Bad Debt Recovery 1968 $ 52,680.61 0 0 1969 68,579.89 0 0 1970 49,536.76 $ 41,345.81 0 1971 146,018.35 0 0 1972 138,804.78 0 0 1973 363,454.21 0 0 Six Vr. Total $ 819,074.60 $ 41,345.81 0 AVERAGE $ 136,512.43 $ 6,890.96 0 ↩ 1. % Average Loss $ 6,890.96 / $ 136,512.43 = 5.05% 2. 5.05% of $ 363,454.21 $ 18,354.44 Total Reserve Requirement 3. Less Reserve on Sept. 30, 1973 -7,838.97 4. Addition to Reserve $ 10,515.47 8.
(1940), affd.Black Motor Company v. Commissioner, 41 B.T.A. 300">41 B.T.A. 300125 F. 2d 977↩ (6th Cir. 1942) .9. Central State was owed $ 9,360 by Rio Foods and $ 52,200.20 by Chester Frantz, both "one man" shops.↩