(2) The 1947 U.S. Tax Ct. LEXIS 161">*168 Manufacturer promises and agrees to contract for the aforesaid services of D. S. C. for the period of one year from the date hereof and thereafter shall be continued and automatically renewed for like periods, and to pay for such services by the 15th of every April, July, October and January from the date hereof, an amount equal to -- per centum of the net purchases by the member wholesalers of D. S. C. of the products of the Manufacturer during such previous period, such percentage being arrived at merely for the purpose of evaluating in dollars and cents the amount to be paid to D. S. C. for such services.

The Manufacturer further agrees to all the terms and conditions set forth in the schedule attached hereto.

It is Reciprocally Agreed:

3. That such payment to D. S. C. for the services aforesaid has no relation to any purchases or to the price at which the manufacturer's product is sold to the several D. S. C. member wholesalers.

4. This agreement may be cancelled by either party on thirty days' written notice.

In Witness Whereof, both parties have signed and accepted this agreement on the day and year first above written.

Druggists' Supply Corporation

By: Executive Vice-President

1947 U.S. Tax Ct. LEXIS 161">*169 (Corporate Seal)

(Corporate Seal if a corporation).

The petitioner in the taxable year had written agreements with its 100 stockholder members. A specimen of this agreement reads as follows:

Agreement made the 16th day of October, 1937 by and between Druggists' Supply Corporation, located at New York, New York (hereinafter referred to as "D. S. C.") and    , a member of D. S. C., located at     (hereinafter referred to as "Member");

Witnesseth:

Whereas D. S. C., among its services, is furnishing sales, promotion and advertising services to various selected manufacturers, (hereinafter referred to as "Manufacturers") supplying the drug trade;

Now, Therefore, D. S. C. and the Member, in consideration of their respective reciprocal promises and agreements hereinafter set forth, promise and agree as follows:

First: The Member engages to and will perform the following services for D. S. C. along the following broad lines:

(a) To assist "D. S. C." in every legitimate manner possible in the performance of the services contracted for, all in keeping with the spirit and intent of such organization.

8 T.C. 1343">*1347 Second: D. S. C. agrees to pay to the Member for the aforesaid services, 1947 U.S. Tax Ct. LEXIS 161">*170 as soon after the close of each calendar year's business as may be, after the payment of all expenses of the operation of D. S. C. and the replenishing of any impairment of its capital and after the deduction from its receipts of such an amount for addition to its surplus account as its Board of Directors may determine, the balance then remaining from its operations in proportion to the purchases or sales from, to or through, D. S. C. and its Manufacturers, by said Member for each calendar year as closed; not as a dividend upon the shares of stock of D. S. C. owned by said Member (which right to the payment of a dividend, if any, upon said shares of stock is hereby waived) but as a "participation distribution". This agreement may be cancelled at any time by reciprocal consent of the respective parties hereto.

Third: It is reciprocally agreed that the compensation received by D. S. C. for sales, promotion and advertising services furnished to Manufacturers and the "participation distribution" agreed to be paid by D. S. C. to the Member hereunder, has no relation to or bearing upon the price which the Member pays or agrees to pay to the Manufacturer for merchandise purchased; but1947 U.S. Tax Ct. LEXIS 161">*171 that it is merely an endeavor on the part of the respective parties hereto to reach a fair value in money for the payment for the services rendered by D. S. C., and that of the Member to be rendered hereunder, and shall, so far as legitimately may be, never be taken into consideration by the Member in fixing the resale price of merchandise dealt in by the parties hereto.

Fourth: It is further reciprocally agreed that this agreement is not assignable or transferable by operation of law or otherwise, and shall be binding upon, and inure to the benefit of, the successors, assigns, executors, administrators and representatives of the respective parties hereto.

In Witness Whereof, the parties hereto have caused this agreement to be duly executed the day and year first above written.

Druggists' Supply Corporation,

By:    

(Name of Member)

(Corporate Seal)

By:    

(Corporate Seal)

Petitioner maintained no sales force. It was impossible for it to perform the sales promotional and advertising services it agreed to furnish under its contract with the manufacturers without the cooperation of the wholesale druggists, stockholders of the petitioner, 1947 U.S. Tax Ct. LEXIS 161">*172 who agreed to so cooperate in their individual contracts with the petitioner.

Among the services which petitioner agreed to furnish under its contract with the manufacturers was to arrange an annual exhibition, which is generally held in March at New York City, at which the manufacturers exhibit their products. The exhibition runs for one week. The purpose of the exhibition is to bring the manufacturers and the wholesale druggists, stockholders of petitioner, together. Substantial orders are placed at this annual exhibition. With the idea of getting the wholesale druggists to attend the exhibition, the annual meeting of petitioner's stockholders is generally held on the Saturday 8 T.C. 1343">*1348 preceding the opening of the exhibition. At this meeting of the stockholders' checks representing the "patronage dividend" or "reciprocal distribution" are delivered.

Petitioner sends out a form to the manufacturers and the wholesalers and at each quarter they return the form, reporting sales and purchases. With each quarterly report the manufacturer sends a check covering the agreed percentage of the amount of the respective purchases of its wholesalers. This check is deposited in the petitioner's1947 U.S. Tax Ct. LEXIS 161">*173 bank account and placed in a reserve called "reserve for reciprocal dividends on purchases." The amounts received by petitioner from the manufacturer under its contract were not entered currently to the credit of the wholesaler's account, but are merely listed in the book in tabulated form. The auditor makes the quarterly entries and later renders an annual report to the board of directors and the stockholders at the annual meeting held after the close of the current year. While the gross sales of the wholesalers, stockholders of petitioner, run around $ 300,000,000 annually, their total purchases from the manufacturers under the contracts with petitioner in the taxable year 1940 were less than $ 6,000,000.

The balance sheet of the petitioner as of December 31, 1940, shows that, in addition to its cash and accounts receivable, it held a certificate of the Lawyers Mortgage Co., valued at $ 18,163.08, and a $ 5,000 investment in the capital stock of the Druggists' Importing Co. In 1936 the board of directors placed in surplus the sum of $ 10,000 to cover anticipated costs of an investigation by the Federal Trade Commission. The amount was not needed for such purpose and it now remains1947 U.S. Tax Ct. LEXIS 161">*174 in the surplus of the petitioner.

Petitioner had nothing to do with the purchases made by the wholesalers, nor were there any sales or purchases by or between it and its stockholders.

In 1940 petitioner had contracts with four manufacturers designated "Class B Manufacturers," whose products and contracts were approved by the merchandise committee. These manufacturers made lump sum payments for the privilege of exhibiting their products at the annual exhibition arranged by the petitioner. The total amount received from these four manufacturers in 1940 was $ 7,980, which was applied by petitioner toward defraying its operating expenses.

The total amount of fees received by petitioner in 1940 from the other manufacturers with which it had contracts was $ 235,164.56. Of this amount, $ 182,249.58 was distributed to the petitioner's stockholders as "participation distributions," so called in the membership agreement, or, as designated on petitioner's books, "reciprocal dividends on purchases."

8 T.C. 1343">*1349 The income of petitioner also included direct charges from stockholders of $ 15,000; volume charges of $ 37,914.98; class B Manufacturers, $ 7,980; other revenue of $ 4,017.39, aggregating1947 U.S. Tax Ct. LEXIS 161">*175 $ 64,912.37. In the taxable year petitioner reported gross income of $ 64,912.37 and claimed deductions of a like amount, showing no tax due.

The excess profits tax return for the taxable year has never been filed. Petitioner has always filed corporation income tax returns. It has never claimed it was an exempt corporation, and has never filed an affidavit or questionnaire under Regulations 103, section 19.101-1.

The petitioner has never treated as income the net amount received from manufacturers and distributed to its members, but at all times has shown it on its books as accounts payable to the various members as due for services rendered. On at least two occasions prior to the taxable year revenue agents questioned this treatment of these amounts and on each occasion were advised as to the facts. The question of petitioner's treatment of these items was on each occasion referred by the revenue agents to higher authority. Petitioner was later advised that such treatment was correct. In failing to file an excess profits tax return for the taxable year 1940 petitioner relied on this action of the revenue agents as constituting an approval of that treatment.

OPINION.

The respondent1947 U.S. Tax Ct. LEXIS 161">*176 added to the income of the petitioner in the taxable year the amount of $ 182,249.58. The correctness of his action gives rise to the only issue in controversy. Petitioner contends the amount represents "patronage dividends" and is the property of 100 wholesale druggists who operate petitioner as a cooperative agency, or constitutes payments made pursuant to a definite liability and deductible as an ordinary business expense. Petitioner, organized under the Business Corporation Law of New York State, has, since its incorporation, filed Federal corporate income tax returns. No claim is made that petitioner is an exempt corporation within the meaning of section 101 of the Internal Revenue Code. The gist of petitioner's contention appears to be that, although petitioner is a business corporation, it functions as a cooperative corporation and is merely a collection agency for a voluntary unincorporated association comprising the 100 wholesale druggists who hold the shares of its capital stock in equal proportions. Does the record warrant such a conclusion? We think not.

Petitioner holds regular meetings of its stockholders and directors. The board of directors appoints the officers, 1947 U.S. Tax Ct. LEXIS 161">*177 prescribes and supervises their duties, fixes their salaries, and controls the distribution of its 8 T.C. 1343">*1350 funds. Petitioner enters into contracts with manufacturers to furnish certain services for an agreed fee. That a part of the services which, under the contract, petitioner agrees to furnish, requires the cooperative effort of the 100 wholesalers, does not, we think, alter the situation. The contract is that of petitioner. It alone is entitled to enforce payment for the services contracted for. The payments made by the manufacturers to petitioner, although computed on the basis of the voluntary purchases by the 100 wholesalers, belong to petitioner. Petitioner has income from other sources. It has investments and reserves. The board of directors fixes the amounts to be deducted for operating expenses and the amount of reserves to be retained for emergencies. The functions we have above outlined are clearly beyond the ordinary powers and duties of a mere collection agency. Petitioner neither buys for nor sells anything to the 100 wholesale druggists who constitute its stockholders. Its principal function is to furnish to the manufacturer the services specified in 1947 U.S. Tax Ct. LEXIS 161">*178 its contract. The payments the manufacturer makes under the contract are the property of the petitioner. The wholesale druggist is under no obligation to the manufacturer. Purchases are not compulsory. If no purchases are made, no benefit is received. Under the membership agreement, the wholesaler agrees to "assist" petitioner "in every legitimate manner possible in the performance of the services contracted for, all in keeping with the spirit and intent of such organization." Just what that embraces by way of a legal obligation on the part of the member is difficult to surmise. This indefinite and general provision makes it doubtful whether the "Membership" contract serves a purpose other than as a vehicle for the wholesaler waiving his rights to dividends on his shares of the capital stock in the petitioner, and in lieu thereof to receive these so-called "participation distributions." We perceive in the membership contract no enforceable legal liability on the part of petitioner to make any definite and specific payments so as to entitle it to a deduction of the amounts distributed as ordinary and necessary expenses of the business. The circuitous method adopted for distributing1947 U.S. Tax Ct. LEXIS 161">*179 what is in fact taxable income of the petitioner does not permit it to escape its Federal tax liability.

We think it clear from this record that petitioner was functioning as a business corporation and not as a mere collection agency operating as a cooperative corporation. Our conclusion is based on the particular facts here presented. It will serve no useful purpose to review other authorities. We sustain the respondent's action in adding to petitioner's income, for the taxable year involved, the sum of $ 182,249.58.

There remains for consideration the propriety of respondent's action in assessing a penalty of $ 8,567.56 for failure to file an excess 8 T.C. 1343">*1351 profits tax return for the taxable year 1940. It is conceded that no such return was filed. Under section 291 of the Internal Revenue Code, the penalty is to be imposed "unless it is shown that such failure is due to reasonable cause and not due to willful neglect." For 30 years petitioner has been filing its Federal income tax returns showing no income and showing these service fees credited to members as a liability for accounts payable. On at least two previous occasions the revenue agents have inquired of the petitioner1947 U.S. Tax Ct. LEXIS 161">*180 about such treatment of these service fees. Upon being informed of the facts, those agents referred the question of the proper treatment of these fees to higher authority. Later, the revenue agents advised petitioner that its treatment was approved. Relying on this approval, petitioner filed no excess profits tax return for 1940, because such treatment resulted in no taxable income. We think such facts are even more favorable to the taxpayer than those revealed in Hugh Smith, Inc., 8 T.C. 660, in which we struck the penalty. Under such circumstances, we hold that the failure to file such return was based upon a reasonable belief that it was not required and that the imposition of the penalty is not justified.

Decision will be entered under Rule 50.