1948 U.S. Tax Ct. LEXIS 194">*194
1. Petitioners are copartners, carrying on a manufacturing business under the name of Union Manufacturing Co. They have two children. Each owns an undivided one-half interest in the business and is entitled to receive one-half of the profits each year. As of January 1, 1943, each petitioner purportedly gave an undivided, one-sixteenth interest in the business to each child. Neither child contributed any capital originating with himself, and during 1943 neither child performed any services in the business. Under the facts,
2. Each petitioner paid personal income taxes to the State of California for the year 1942 under the California income tax law. The California income taxes were not paid in connection with the carrying on of a trade or business, or otherwise, within the meaning of
10 T.C. 818">*818 Respondent has determined deficiencies in income tax as follows:
Petitioner | Docket No. | 1943 | 1944 |
Anna Harris | 12984 | $ 5,662.73 | $ 18,136.67 |
Morris Harris | 12985 | 6,035.87 | 18,693.10 |
There are two questions presented, whether two children are1948 U.S. Tax Ct. LEXIS 194">*197 members of a partnership, and whether income taxes of the State of California are deductible in computing the victory tax net income for the year 1943.
Petitioners filed separate income tax returns with the collector for the sixth district of California.
10 T.C. 818">*819 FINDINGS OF FACT.
Morris Harris and Anna Harris are husband and wife. They reside in Los Angeles, California. Albert J. Harris and Betty Harris are children of petitioners. They were nineteen years old and sixteen years old, respectively, in 1943.
Petitioners are associated together as equal copartners under the firm name of Union Manufacturing Co. They had been associated in partnership for many years prior to 1943. Each owns a one-half interest in the partnership and profits, under a written agreement dated April 1, 1937, which covers a term of 10 years.
Union Manufacturing Co. has its main plant in Los Angeles. It carries on the business of the manufacture and sale of men's work and sport clothes.
In 1909 Morris Harris began this enterprise. The capital employed has been built up by retaining profits from year to year. Morris Harris is the manager. In 1941 the volume of sales was around $ 2,000,000. In 1942 1948 U.S. Tax Ct. LEXIS 194">*198 about 400 people were employed in the Los Angeles plant. Union Manufacturing Co. had a second place of business in 1942 in El Paso, Texas, where around 100 people were employed; and the employment in El Paso increased to about 300 later. Morris Harris owns the land and building where the Los Angeles plant is located, and it does not appear as an asset in the balance sheet of the firm. In 1942 the Los Angeles plant and real estate had a value of around $ 300,000, without equipment. The equipment which is used in the plant consists of various kinds of machinery and sewing machines. In the manufacturing departments there are several floor ladies under one superintendent. The goods manufactured are sold all over the United States. In 1942 the market was limited to the Rocky Mountain and Pacific coast regions and 10 or 12 salesmen were employed on a commission basis. In 1942, and thereafter, goods were sold in chain stores. Morris receives a salary of about $ 200 a week, which constitutes a drawing account against his share of the profits.
As of December 31, 1942, the Union Manufacturing Co. had assets of $ 945,975.23, of which inventory amounted to $ 538,992. Liabilities amounted1948 U.S. Tax Ct. LEXIS 194">*199 to only $ 9,065.40, leaving net assets of $ 936,909.83.
As of December 31, 1942, after the addition of one-half of 1942 profits, the balance of the capital account of Morris Harris was $ 471,351.04, and the balance of the capital account of Anna Harris was $ 465,558.79.
The balance sheet of the partnership as of December 31, 1942, was as follows:
ASSETS | |||
Petty cash | $ 35.49 | ||
Union Bank & Trust Co. checking acct | 166,571.62 | ||
Union Bank & Trust Co. pay roll acct | 100.00 | ||
State National Bank, El Paso, Tex | $ 7,797.08 | ||
Accounts receivable -- good | 187,880.36 | ||
Accounts receivable -- doubtful | 1,788.20 | ||
Loans to employees | 106.73 | ||
Inventory 12/21/42 | 538,992.70 | ||
Machinery | 40,211.68 | ||
Furniture and fixtures | 694.09 | ||
Automobile | 859.80 | ||
Stationery and printing | 400.00 | ||
Prepaid insurance | 537.48 | ||
Total | 945,975.23 | ||
LIABILITIES | |||
Employees -- salaries, commissions, etc | 449.94 | ||
Social Security -- employees | 2,240.74 | ||
Social Security -- firm | 6,374.72 | ||
9,065.40 | |||
CAPITAL | |||
M. Harris | $ 359,705.94 | ||
Less: | |||
Drawing acct | $ 28,050.00 | ||
Income tax 1941 | 86,238.30 | ||
Income tax 1940 (add.) | 92.08 | 114,380.38 | |
245,325.56 | |||
Plus 1/2 1942 profits | 226,025.48 | 471,351.04 | |
A. Harris | 334,699.14 | ||
Less: | |||
Drawing acct | $ 14,949.35 | ||
Income tax 1941 | 80,216.48 | 95,165.83 | |
239,533.31 | |||
Plus 1/2 1942 profits | 226,025.48 | 465,558.79 | |
Total | 945,975.23 |
1948 U.S. Tax Ct. LEXIS 194">*200 10 T.C. 818">*820 The son of petitioners, Albert, finished high school in June 1941; he entered the University of Virginia in the fall of 1941. He continued in the University of Virginia for the academic year 1941-1942, returning to Los Angeles in June of 1942. During the summer of 1942 he attended evening classes at the University of Southern California, where he took special courses in textiles. In September 1942 he entered the textiles school of the University of North Carolina at Raleigh, North Carolina. He returned home for the Christmas holidays of 1942. He enlisted in the Army in December 1942. Thereafter, he returned to Raleigh, North Carolina, where he remained at the University of North Carolina until April 1943, when he was called for active duty in the armed forces. He was in the service from April 10 T.C. 818">*821 1943 until January 1946. Upon his discharge from the service he returned to Los Angeles and went to work in the business of Union Manufacturing Co.
Betty, petitioners' daughter, attended school during the years 1943 and 1944 at either University High School, Flintridge School, or Mills College, in California.
In 1942, in the summer months and at Christmas, petitioners1948 U.S. Tax Ct. LEXIS 194">*201 discussed the matter of making a gift of an interest in the partnership to their son, and they considered it fair to do the same for their daughter. The arrangement discussed was not carried to any formal agreement; there was no written agreement; and there were no instruments of gifts or assignments or transfers drawn up or executed. In the discussions, Anna Harris was to make gift of part of her partnership interest to her son Albert, and Morris Harris was to make gift of part of his interest to his daughter Betty. The gifts were to be made on or about January 2, 1943.
On September 16, 1943, book entries were made in the capital accounts of Anna and Morris Harris, and ledger sheets were made opening capital accounts in the names of Albert and Betty. However, instead of making book entries to show a transfer of an interest from Anna to her son Albert, and from Morris to his daughter Betty, the entries which were made transferred an amount out of Anna's capital account to Betty, and an amount out of Morris' capital account to Albert. These bookkeeping entries did not correspond with or reflect statements which were made on Form 709, gift tax return, to the effect that Anna Harris1948 U.S. Tax Ct. LEXIS 194">*202 had made gift to Albert Harris on January 2, 1943, of an undivided one-sixteenth interest in the property and assets of Union Manufacturing Co., and that Morris Harris had made gift to Betty Harris on January 2, 1943, of an undivided one-sixteenth interest in the property and assets of Union Manufacturing Co. The gift tax return of each petitioner was dated September 27, 1943.
The capital account of Morris Harris on September 16, 1943, was debited with the amount $ 34,083.70, and a capital account in the name of Albert Harris was credited with the same amount as of January 1, 1943, by a transfer from the capital account of Morris Harris.
The capital account of Anna Harris was debited on September 16, 1943, in the amount of $ 34,083.70, and a capital account in the name of Betty Harris was credited with the same amount as of January 1, 1943, by transfer from the capital account of Anna Harris.
Entries were made in the general journal on September 16, 1943, of the same debits and credits from and to capital accounts as were made in the four respective ledger capital accounts, with the notation:
To transfer above interest in company to Albert and Betty Harris, son and daughter, one-sixteenth1948 U.S. Tax Ct. LEXIS 194">*203 each, based on M. Harris' interest, $ 270,049.36 and A. Harris' interest, $ 275,289.73.
10 T.C. 818">*822 The business of Union Manufacturing Co. was conducted during 1943 and 1944 in the same way as it had been conducted in 1942 and prior thereto. No services were rendered to or in the business by the children, Albert and Betty, during 1943 and 1944. Neither one of the children contributed any capital of their own to the existing partnership business in 1943 or 1944, or in 1942 or prior thereto.
When, prior to 1943, Albert went to the place of business to do work of some general type which a school boy could do, after school hours and during school vacations, he was not paid any amount.
Neither Albert nor Betty withdrew any sum from the Union Manufacturing Co. during 1943 and 1944. However, debits to each of their capital accounts were made at the end of 1942 and 1943 for taxes on income which was attributed to each under bookkeeping entries made in their capital accounts. At the end of 1943 and of 1944, the capital account of Albert and of Betty were each credited with one-sixteenth of the earnings for each year. At the end of 1943 the balance in the capital account of each of the 1948 U.S. Tax Ct. LEXIS 194">*204 children was $ 46,074.86.
During 1943 and 1944, the partnership, carrying on business under the name of Union Manufacturing Co., had two members only, Anna and Morris Harris. Albert and Betty Harris were not bona fide members of the partnership. There was no creation of a new and bona fide partnership of four members in 1943.
Personal income taxes for the year 1942 were paid to the State of California by Morris Harris in the amount of $ 26,746.65, and by Anna Harris in the amount of $ 25,256.18. Petitioners, in computing their victory tax liability for the year 1943, deducted the above amounts of California tax in their respective returns. Respondent disallowed each deduction in determining each petitioner's net income subject to 1943 victory tax.
OPINION.
Anna and Morris Harris are copartners in the partnership which conducts business as Union Manufacturing Co. The partnership, consisting of the petitioners, is not questioned by the Commissioner. But respondent has determined that their son and daughter were not members of a copartnership with petitioners, and he has taxed to petitioners income which was reported as the children's shares of the earnings of Union Manufacturing1948 U.S. Tax Ct. LEXIS 194">*205 Co. in 1943 and 1944. The question is whether one-sixteenth of the earnings of the above business is taxable to Albert Harris, and the same proportion to Betty Harris, as partners in Union Manufacturing Co., as petitioners contend; or whether such portions of the earnings are taxable to petitioners as part of the share of each in the earnings of the partnership of which they are indisputably partners.
Admittedly, Albert and Betty Harris did not have capital of their 10 T.C. 818">*823 own to contribute to a business venture as the contribution of partners. Petitioners allege that they made gifts of undivided one-sixteenth interests in a going business venture and that, thereupon, each child recontributed what he is said to have received, namely, an undivided interest. Respondent does not admit that any completed gifts
The petitioners contend that a partnership was created on January 1, 1943, in which each child was a copartner, and that the partnership should be recognized for Federal income tax purposes. This question is put in issue by the pleadings of the petitioners that on January 2, 1943, the four members of the family agreed to associate themselves as copartners, which pleading the respondent has denied.
Petitioners state that they are familiar with the rule set forth in
Petitioners are in no better position in this case than were the taxpayers in
Here, as in the
* * * A partnership is generally said to be created when persons join together their money, goods, labor, or skill for the purpose of carrying on a trade, * * * or business, and when there is a community of interest in the profits and losses. * * * A husband and wife [parent and child] may, under1948 U.S. Tax Ct. LEXIS 194">*210 certain circumstances, become partners for tax, as for other, purposes. If she [the wife or child] either invests capital originating with her or substantially contributes to the control and management of the business, or otherwise performs vital additional services, or does all of these things she may be a partner as contemplated by * * * 26 U.S. C. A. Int. Rev. Code, pars. 181, 182.
The contention that the daughter, Betty, was a partner in the Union Manufacturing business is particularly without merit. There is no evidence that she desired to, or intended to, or did carry on the business enterprise in partnership with her parents in the taxable years. She was about seventeen years old in 1943; she had no capital of her own; and she performed no services in the business. There is no evidence of a completed transfer of an interest in the business to her such as would put in her complete dominion and control over an interest in the business and the earnings thereof, and such as would remove from the alleged donor (mother or father, whichever claims to have made 10 T.C. 818">*825 the gift -- the record on this point being confused) control over his or her purported interest and share of1948 U.S. Tax Ct. LEXIS 194">*211 earnings. See
In support of their contention that the son, Albert, was a copartner with them in their business during 1943 and 1944, petitioners refer us to certain cases where it has been held, upon particular facts, that a father and son were copartners. The holdings in such cases do not provide these petitioners authority in support of their contention. Such cases are distinguishable on their particular facts. Also,
Albert had an ambition to go into his father's business. He had done various things about the plant and office, without pay, during vacations and after school prior to 1943. But none of his activities, considering his youthful age and consequent limitations, had been sufficiently substantial to have taken him into any substantial or important work in the business before 1943. Cf.
Albert contributed no capital to the Union Manufacturing Co. business originating with himself. Furthermore, the evidence is not present to show that the purported gift to Albert of an interest in the business was a completed gift
Upon consideration of all of the facts, we can not find that Albert was a bona fide copartner in the business in 1943 and 1944. Applying the rationale of the
The second question is whether state income taxes1948 U.S. Tax Ct. LEXIS 194">*214 are deductible in computing victory tax net income.
Section 172 (a) of the 1942 Revenue Act enacted a new tax, called the victory tax, which was to be levied upon income in years beginning after December 31, 1942. Section 172 (a) of the 1942 Revenue Act added new provisions to the
It must be kept in mind that all deductions are a matter of legislative grace. The question which is now raised by the petitioners under the victory tax net income provisions of the Internal Revenue Code must be considered upon the basis of the specific statutory provisions which allow deductions.
(a) Definition. --
* * * *
(3) Taxes. -- Amounts allowable as a deduction by
The subsection above quoted contains a limitation. First, there is cross-reference to
However, the limitation contained in
It is our understanding that the California income tax is a personal income tax, which, like the Federal income tax, is imposed upon income derived from all sources. Petitioners do not cite any cases which give contrary construction of the California statute. We do not have the personal income tax returns of the petitioners in evidence -- neither the state nor the Federal returns. It is assumed that most of the income of the petitioners which was reported for both state and Federal income tax was derived chiefly from the partnership business. Petitioners argue that the state income tax was a tax which was paid1948 U.S. Tax Ct. LEXIS 194">*217 or incurred in connection with the carrying on of a business within the meaning of
The construction which the petitioners would have placed upon
The specific question raised by petitioners is covered by a ruling of the Commissioner,
Petitioners think that the ruling set forth in
1. See Senate Report No. 1631, 77th Cong., 2d sess. (C. B. 1942-2, p. 509), where the following is stated:
"Since the victory tax does not allow any deduction for state income taxes your Commitee deemed it advisable to provide that the total income tax and victory tax should not exceed 90% of the taxpayer's net income * * *."↩