Article VII

For the purpose of making the computation in Article VI, paragraph D, Mills shall be represented by Mr. L. L. Goodman, or in the event of his failure or inability to serve, Mr. J. A. Goodman, Mr. H. V. Kobin, and Mr. A. J. Barskin, in the order named, and Industries shall be represented by Mr. I. E. Solar, or in 17 T.C. 231">*244 the event of his failure 1951 U.S. Tax Ct. LEXIS 104">*132 or inability to serve, by Mr. Samuel J. Mantel, and Mr. J. B. Perry, Jr., in the order named.

In the event that the representatives of each of the parties shall fail to come to an agreement acceptable to both of them, then they shall select a third party, mutually agreeable to both of them, as arbitrator, and his decision shall be final and binding on both parties.

Nothing in this agreement shall exclude Industries, at any time, from making such provisions as it may decide to make for finishing or selling its own products, but Industries agrees that the merchandising rights shall be exclusively granted to Mills for the term of this agreement.

The computation described in Article VI, Paragraph D, shall be made at least once annually as of the close of business of the fiscal year of Mills, but can be made more often, if convenient and agreeable to both parties.

This agreement shall expire on the 30th day of June, 1945.

* * * *

The Industries-National agreement did not fix specific charges for the services to be performed by National, but left the charges to be worked out in the future according to such criteria as were mentioned in the provisions quoted 1951 U.S. Tax Ct. LEXIS 104">*133 from the agreement. Periodically the amounts owed by Industries to National were settled by agreement between them, and in the settlement of these amounts Industries was represented by Solar and National was represented by L. L. Goodman and Kobin. On occasion, J. A. Goodman also participated in the settlement of these amounts.

While the National-Knitting agreement, later taken over by Hosiery, provided that expenses incident to filling of orders should be prorated between the parties, it did not describe the expenses with any particularity and was ambiguous as to the manner in which proration was to be made. When there was any question as to allocation of such expenses, the matter was submitted to Stevens. Usually, however, there was no dispute. The amounts which were allocated to Hosiery are evidenced by Hosiery's partnership returns. Those returns, for the fiscal periods 1942-1943 and 1943-1944, respectively, report "other deductions" of $ 72,264.53 and $ 42,302.88, and these sums are explained on the returns as including sales expense billed by National in the amounts of $ 70,764.46 and $ 40,691.14 for those respective periods. "Other deductions" were reported in the returns 1951 U.S. Tax Ct. LEXIS 104">*134 for 1940-1941 and 1941-1942, without breakdown, in the respective amounts of $ 112,028.98 and $ 122,595.64.

17 T.C. 231">*245 The Industries-Hosiery agreement, in providing for the division of proceeds derived from the sale of the finished product, used such flexible terms as "efficiency in greige manufacturing," "low cost and efficient finishing as supervised by Mills," "efficient selling as supervised by Mills," and "a fair and reasonable estimate of the value of any merchandising plans * * * developed by Mills." Such terms remained to be interpreted, and in the settlement between the parties their interpretation and specific application was left to Stevens, who was given a free hand in this regard although he might consult with such persons as L. L. Goodman and Kobin. In practice, an agreement was always reached as to the amounts to be paid Industries.

The relationships between Industries, Hosiery, and National developed as follows: Industries manufactured hosiery in the grey and shipped it to National for dyeing and finishing. The hosiery finished by National for Industries was kept by National separately from National's own hosiery. Except for the few large customers obtained directly by the Goodmans 1951 U.S. Tax Ct. LEXIS 104">*135 and Kobin, the Industries hosiery was sold by National's sales organization and by the same salesmen who sold National's hosiery. Customers were invoiced by National and usually in National's name, but some invoices were made out in Hosiery's name. Some customers made payment to Hosiery; others paid National. National deducted from the proceeds it received a charge for the use of its sales force, including therein an allocated portion of its sales expenses and an amount for a reasonable profit, and remitted the balance to Hosiery. National's charge for finishing and dyeing, consisting of the costs of finishing and dyeing plus a reasonable profit, was paid by Industries. Notwithstanding the provisions of Article VI of the agreement of June 24, 1940, Industries "billed" Hosiery for the hosiery in the grey, its charge consisting of an amount representing the fair market price for hosiery in the grey but in no event an amount less than the total costs of Industries attributable to production of the hosiery in the grey, plus the cost to it of dyeing and finishing the hosiery at National, plus such other charges as Industries might incur after the point of manufacture. The amount so "billed" 1951 U.S. Tax Ct. LEXIS 104">*136 was remitted to Industries by Hosiery out of the sales proceeds received from National, and the balance was retained by Hosiery as its "profit" or "compensation." There were inter-company accounts between Hosiery and Industries, and when remittance by check was received by Hosiery from National, Hosiery in turn might endorse the check to Industries in liquidation of those accounts.

Although the hosiery in the grey was "billed" by Industries to Hosiery, and although there was reference in the evidence to the "price" paid by Hosiery for the hosiery and the "cost" to Hosiery of 17 T.C. 231">*246 goods sold, Industries retained title to the hosiery when finished, and in fact, Hosiery never purchased or acquired any hosiery from Industries. The hosiery involved belonged to Industries, and was sold to the trade by National's sales organization, except in the case of several large purchasers (such as Sears, Roebuck & Co.) who dealt directly with the Goodmans or Kobin, purporting to represent Hosiery. But even in the latter situation it was Industries' hosiery that was being sold. The only other function performed by Hosiery in relation to Industries' product was to provide styling and "merchandising" services.

L. 1951 U.S. Tax Ct. LEXIS 104">*137 L. Goodman, J. A. Goodman, and Kobin, during the tax years here involved, rendered valuable services in the styling, merchandising, marketing, and selling of the hosiery produced by Industries. In rendering these services, the Goodmans and Kobin were acting as employees of Hosiery, and Hosiery provided these services to Industries. No other employees of Hosiery, if there were any, rendered any services of consequence in relation to Industries' product, nor did the partners of Hosiery render any such services.

Generally, a good price is available for hosiery in the grey when the market is strong, but such hosiery promptly feels the effect of a weakening in the market. When the demand for hosiery is weak, the seller of hosiery in the grey is at a disadvantage because of the lack of a brand name to support its selling power. Branded hosiery is better able to retain a market and maintain its prices. The services of the Goodmans and Kobin established brand names and a market for Industries' hosiery, assuring Industries of steady operation and the sale of its product in the finished market at the best prices, thereby reducing the insecurity and uncertainty otherwise attending the manufacture 1951 U.S. Tax Ct. LEXIS 104">*138 and sale of hosiery in the grey. The Goodmans and Kobin supervised the merchandising aspects of the manufacturing, dyeing and finishing operations so as to create products which most appealed to the public; they styled and designed the hosiery and were responsible for features being incorporated in the course of these operations which attracted the public; and they introduced and supervised sales ideas and programs which provided wide distribution for the finished hosiery. This was particularly important in view of the novelty of the single-unit type hosiery Industries undertook to manufacture, the quality and worth of which had to be proven to the trade and a market for which had to be created.

During the tax years in question, the Goodmans and Kobin received salaries paid by Hoisery. The amounts of the salaries paid them by Hosiery were established with their agreement, and they took part in deciding what those amounts would be. The amounts so decided upon were considered fair salaries. For the fiscal year 17 T.C. 231">*247 ended June 30, 1941, the partnership return of Hosiery disclosed salaries and wages in the aggregate amount of $ 82,908.44, substantially all of which was paid to the Goodmans 1951 U.S. Tax Ct. LEXIS 104">*139 and Kobin. The aggregate wages and salaries similarly paid by Hosiery for the succeeding fiscal years ending June 30, were as follows: 1942, $ 20,000; 1943, $ 8,151.29; 1944, $ 8,320.

During the years involved there were in the United States independent experts in the hosiery industry who provided merchandising and styling services for fees ranging from $ 10,000 to $ 25,000 a year.

Waste is a common by-product of the manufacture and processing of hosiery. Salvage of such waste in the manner earlier described is one of the phases of the hosiery industry. Ordinarily an individual mill does not have enough waste to justify organizing a salvage department. Most mills do not have their own salvage department, although Real Silk did have such a department.

Neither Industries nor National had such a department, and up to 1942 they sold their waste to dealers. By that time, however, nylon yarn, which had come into use in the manufacture of hosiery, was very scarce, and salvage operations therefore became increasingly important. In January 1942, Abar Process Company (hereinafter referred to as "Abar") was formed, as a partnership under Indiana law, to engage in the salvage of hosiery waste. 1951 U.S. Tax Ct. LEXIS 104">*140 The Goodmans and Kobin were instrumental in the formation of Abar, and Barskin, who was then associated with National, also became the operating head of Abar. The partners of record in Abar at the time of its formation were the two Goodmans, Kobin's wife and Barskin. They executed a partnership agreement dated January 2, 1942, which provided:

THIS INDENTURE entered into this 2nd day of January, 1942, WITNESSETH AN AGREEMENT by and between J. A. GOODMAN, hereinafter referred to as First Party, L. L. GOODMAN, hereinafter referred to as Second Party, FLORENCE S. KOBIN, hereinafter referred to as Third Party, and A. J. BARSKIN, hereinafter referred to as Fourth Party, all of Indianapolis, Marion County, Indiana.

* * * *

(3) The initial capital of this partnership shall be $ 1,000.00, of which the First and Second Parties agree to contribute $ 350.00 each, the Third Party $ 200.00, and the Fourth Party $ 100.00. Should further capital be required for carrying on the business, such additional capital shall be advanced by the partners in the above ratio. * * *.

(4) All checks, notes, and other evidence of indebtedness pertaining to the partnership may be executed, for and on behalf of said 1951 U.S. Tax Ct. LEXIS 104">*141 partnership, by J. A. Goodman, L. L. Goodman, A. J. Barskin, and H. V. Kobin, whom Florence S. Kobin has designated as her attorney-in-fact for such purpose, or by any nominee or designee which any of the foregoing may name in writing. The salaries to be paid to any partner or employee of said partnership shall be based upon services rendered to said partnership and contribution to the administration 17 T.C. 231">*248 and success of the business, and shall be in such amounts as may from time to time be determined by said partners.

(5) All expenses pertaining to the operation of said partnership shall be borne, paid and discharged by the parties hereto in the following ratio: By the First Party 35%; by the Second Party 35%; by the Third Party 20%; and by the Fourth Party 10%; and all gains, profits and increases that shall come or arise from or by means of such partnership business shall accrue to the parties hereto in such percentages, and all losses resulting from depreciation, bad debts or otherwise, shall be borne and paid by the parties hereto, in accordance with such percentages.

* * * *

(11) The First Party and the Second Party are each creating trusts and contemplate assigning to such trusts their 1951 U.S. Tax Ct. LEXIS 104">*142 respective interests in and to this partnership. Each of the partners hereby consent to such assignments upon the condition that the provisions of this partnership agreement shall be binding upon the trustees of such trusts, and upon the further provision that any distribution by the Trustees of such trusts shall, for the purpose of this agreement, be considered as a sale of a partnership interest, and shall be subject to the terms and conditions herein set out and pertaining to the sale of any partnership interest.

(12) The business policy of this partnership shall be determined by J. A. Goodman, L. L. Goodman, H. V. Kobin, as Attorney-in-Fact for Florence S. Kobin, and A. J. Barskin. In determining such policy J. A. Goodman and L. L. Goodman shall each have 35 votes; H. V. Kobin 20 votes; and A. J. Barskin 10 votes. The majority vote shall prevail. * * *.

It is the sense of this agreement that the business policy of this partnership shall be determined by those above designated, subject to the terms and conditions hereinabove set out, and that no heir, executor, administrator, successor, beneficiary, or assign shall have any right to participate in the determination of such policy 1951 U.S. Tax Ct. LEXIS 104">*143 unless and until those who still retain voting power shall in writing consent thereto.

* * * *

Subsequently, Ronia Solar was made a partner of record in Abar to the extent of a 9.09 per cent interest by an agreement dated October 9, 1943, and the interests of the other partners were changed proportionately.

The interests of the partners of record in Abar, for the periods indicated, were as follows:

17 T.C. 231">*249 Abar's machinery consisted essentially of several old coning machines formerly used by National and Fulton Hosiery Mills (hereinafter referred to as "Fulton"), adjusted to unravel and rewind yarn according to a method invented by Barskin. Fulton had been organized by the Goodmans who, by 1937, transferred their Fulton interests to their wives or to certain of the trusts for their children. Abar either did not acquire or did not retain ownership of the machines so used by it. Depreciation does not appear as 1951 U.S. Tax Ct. LEXIS 104">*144 a claimed deduction on the tax returns of Abar introduced in evidence.

After Abar was organized, Industries and National sold their waste to Abar, and purchased reclaimed yarn from Abar. The prices paid to and by Abar in these transactions were the established market prices. Abar also purchased waste from other sources, and, during the scarcity in materials, bought waste wherever it could be found. While Abar sold reclaimed yarn to other buyers, most of its sales of yarn were made to Industries, National, and Fulton. Defective hosiery purchased by Abar was mended by it and was finished by National, and then was sold by Abar to jobbers. National's charge to Abar for finishing this hosiery was at the prevailing market price.

During the tax years here in issue, separate books of account were kept for Industries, National, Hosiery, and Abar. Preparation and maintenance of their accounting records and reports were all under the control and supervision of Stevens at Indianapolis. The books of National, Hosiery, and Abar were kept at Indianapolis; the general ledgers of Industries were kept at Indianapolis and its subsidiary records, which were usually kept in Mississippi, at times were 1951 U.S. Tax Ct. LEXIS 104">*145 sent to Indianapolis. The tax returns of all these companies, including the returns of Industries, were prepared at Indianapolis under Stevens' direction. Stevens also prepared the Goodman's tax returns, and advised the Goodmans and Kobin as to arrangement of their business affairs so as to incur the minimum taxes. The returns for the trusts created by them were also prepared by Stevens.

From at least July 1, 1940, to the last half of 1943, the J. A. Goodman, L. L. Goodman, and Kobin families and Barskin were the record owners of all the common stock of Industries and National, substantially all the preferred stock of Industries and National, and the entire partnership interests in Hosiery and Abar. During this period, the proportionate interests of the J. A. Goodman, the L. L. Goodman, the Kobin families, and Barskin were, with insignificant variation, identical in the common stock of Industries, the common stock of National, and in the Hosiery and Abar partnerships. These proportionate interests were as follows: J. A. Goodman family -- 35 per cent; L. L. Goodman family -- 35 per cent; Kobin family -- 20 per cent; Barskin -- 10 per cent.

17 T.C. 231">*250 These interests in the common stock of Industries1951 U.S. Tax Ct. LEXIS 104">*146 and National continued unchanged during 1943 and throughout the remainder of the tax years here in issue. By a written agreement dated July 17, 1943, Solar's wife, Ronia, was admitted to a 9.09 per cent interest of record in Hosiery, and by a written agreement dated October 9, 1943, she was also admitted to a 9.09 per cent record interest in Abar. The other record interests in both Hosiery and Abar were then adjusted accordingly to the following: J. A. Goodman family -- 31.82 per cent; L. L. Goodman family -- 31.82 per cent; Kobin family -- 18.18 per cent; Barskin -- 9.09 per cent.

The interests of the J. A. Goodman, L. L. Goodman, and Kobin families were held, as record owners, in the names of their wives or the trusts for their children. But those family interests were in fact owned or controlled directly or indirectly by J. A. Goodman, L. L. Goodman, and Kobin respectively. Similarly, when Ronia Solar was made a record partner in Hosiery and Abar, the interests ascribed to her were in fact owned or controlled directly or indirectly by her husband, Israel E. Solar. Thus, although Kobin's wife and the trusts for his two children were the record holders of an aggregate 20 per 1951 U.S. Tax Ct. LEXIS 104">*147 cent interest in National's common stock, the true situation was reflected in National's income tax returns for 1940 and 1942, which state that Kobin owned 20 per cent of the common stock of National.

The ultimate control over the management and operation of Industries, National, Hosiery and Abar, was exercised by J. A. Goodman, L. L. Goodman, Kobin and Barskin.

None of the Goodman and Kobin children, whose trusts were record owners of interests in these businesses, ever had any experience or training in the hosiery industry, or took any part in the business affairs of Industries, National, Hosiery, or Abar. There is no evidence that the Goodman, Kobin, or Solar wives had any such experience or training or participated in the affairs of these businesses. The Goodmans and Kobin originally were the trustees under some of the trusts they set up for their children; by the end of 1942, Stevens was the sole trustee under all these trusts for the Goodman and Kobin children. Control of the accounting and tax affairs of all these businesses as well as of the trusts for the children was concentrated in Stevens.

Hosiery's "Gross receipts from business or profession" and its "net" income as reported 1951 U.S. Tax Ct. LEXIS 104">*148 on its returns, and its "net" income as adjusted by respondent, were as follows:

17 T.C. 231">*251 These reports of gross receipts consisted largely, if not entirely, of the receipts from the sales of Industries' hosiery, and belonged to Industries rather than to Hosiery. It was thus necessary, in computing net income on Hosiery's returns to subtract large amounts each year ($ 1,631,293.46 for 1941, $ 1,478.81 for 1942, $ 1,071, 262.49 for 1943, and $ 1,492,153.36 for 1944) as the cost of "merchandise bought for sale," notwithstanding the fact that Hosiery did not buy any goods for sale, and therefore had no such costs.

Abar reported the following net income in its returns:

Respondent attributed to Hosiery an annual allowance of 10 per cent on a capital of $ 4,286.25, amounting to $ 428.63, plus $ 1,000 as salary for Barskin. Respondent attributed to Abar an annual allowance 1951 U.S. Tax Ct. LEXIS 104">*149 of $ 1,000 on a capital of $ 1,000, plus a salary of $ 1,000 for Barskin. The remainder of Hosiery's adjusted income and Abar's reported income were allocated to Industries and National in the following amounts:

The notices of deficiency sent to petitioners each stated:

Pursuant to the provisions of section 45 of the Internal Revenue Code portions of the gross income attributed to "Grenada Hosiery Mills", a purported partnership, have been allocated to you and included in your net income for the taxable years and in the amounts set forth below, to-wit:

* * * *

In the alternative it is held that said purported partnership is without substance and that said portions of the income which were attributed to said purported partnership are taxable to you under the provisions of section 22 (a) of the Internal Revenue Code.

Each notice of deficiency also made the same statement respecting the allocations of Abar's income to petitioners.

17 T.C. 231">*252 The notices of deficiency 1951 U.S. Tax Ct. LEXIS 104">*150 did not show the method of allocation of Hosiery's and Abar's income. There were introduced in evidence, however, a revenue agent's reports on Industries and on National. The amounts allocated to them by respondent were identical with the allocations made of Hosiery's and Abar's income in these reports, and these reports show the computations by which these allocations were reached.

National, Industries, Hosiery, and Abar were separately existing and functioning organizations, trades, or businesses, but were owned or controlled directly or indirectly by the same interests. Allocation of Abar's income to petitioners was arbitrary and unreasonable, and such allocation was not necessary to prevent evasion of taxes or clearly to reflect petitioners' income. Allocation of Hosiery's income to National was likewise arbitrary and unreasonable. But respondent's allocation of Hosiery's income to Industries was reasonable and was necessary to prevent evasion of taxes or clearly to reflect Industries' income. The value of the services rendered by Hosiery to Industries was no greater than the salaries and wages paid by Hosiery during each of the years involved.

OPINION.

1. At the outset, we 1951 U.S. Tax Ct. LEXIS 104">*151 dispose of respondent's contention that the asserted deficiencies are supported by section 22 (a) of the Internal Revenue Code. Throughout the argument based upon section 22 (a) there is implicit the suggestion that the entities of Hosiery and Abar should be disregarded and that their income be attributed to Industries and National. We cannot accept that position.

Hosiery and Abar were functioning entities. Each in fact rendered valuable services. True, all four organizations were actually controlled by the same persons, and neither Hosiery nor Abar had any employees who were not also officers or employees of Industries or National, so that all of the functions discharged by Hosiery and Abar could have been performed just as readily by Industries and National. But the fact is that Hosiery and Abar were valid partnerships, and they actually did play real parts in the hosiery business. Hosiery did furnish styling and merchandising services to Industries: Abar did engage in the business of salvaging defective hosiery. There is no basis, upon this record, for disregarding the organizational entities of Hosiery and Abar. Cf. Chelsea Products, Inc., 16 T.C. 840; Estate of Julius I. Byrne, 16 T.C. 1234; 1951 U.S. Tax Ct. LEXIS 104">*152 Seminole Flavor Co., 4 T.C. 1215, 1234-1235.

The income actually earned by Hosiery and Abar may not be attributed to Industries or National under section 22 (a). This does not mean, however, that either Industries or National was at liberty, taxwise, 17 T.C. 231">*253 to deflect to Hosiery or Abar any portion of the income really earned by Industries or National. In such circumstances the general provisions of section 22 (a) are undoubtedly sufficient to charge the income to the one that actually earned it. Cf., e. g., Lucas v. Earl, 281 U.S. 111">281 U.S. 111; Griffiths v. Commissioner, 308 U.S. 355">308 U.S. 355; Helvering v. Eubank, 311 U.S. 122">311 U.S. 122; Commissioner v. Sunnen, 333 U.S. 591">333 U.S. 591; Lyman A. Stanton, 14 T.C. 217, affd. (C. A. 7, 1941) 189 F.2d 297. But in the case of organizations under common control, the detailed provisions of section 45 of the Code ^{31951 U.S. Tax Ct. LEXIS 104">*153 1951 U.S. Tax Ct. LEXIS 104">*154} explicitly authorize the Commissioner to unscramble any such situation, so that income may be charged to the organization that earned it. Thus, to the extent that section 45 may be applicable, section 22 (a) adds nothing to the strength of respondent's position here. We pass, therefore, to a consideration of section 45.

2. That all four organizations were "owned or controlled directly or indirectly by the same interests" within the meaning of section 45 is abundantly clear on this record. All four organizations were dominated primarily by the two Goodmans, and to a lesser degree by Kobin and Barskin. We are satisfied that Solar and Stevens were subservient to the wishes of the Goodmans and Kobin. ^{41951 U.S. Tax Ct. LEXIS 104">*155}

It is immaterial that the record ownership of the various stock and partnership interests may not have been in the identical persons or trusts at the same times. Throughout the years in question the J. A. 17 T.C. 231">*254 Goodman family owned 35 per cent, the L. L. Goodman family 35 per cent, the Kobin family 20 per cent, and Barskin 10 per cent of the common stock of Industries and National. The same percentage interests were applicable to both partnerships, Hosiery and Abar, until 1943, when they were changed slightly (but in the same proportion) so as to admit Solar's wife as a record partner with a 9.09 per cent interest -- an event which in no way affected the control or management of either enterprise. Although it is true that the record ownership of the stock or partnership interests may not have been in the same persons or the same 1951 U.S. Tax Ct. LEXIS 104">*156 family trusts, the fact is that the 35-35-20-10 ratio (representing the proportionate interests of the Goodman and Kobin families and Barskin in relation to each other) was at all times maintained and that the actual control at all times material, represented by those interests, was really exercised by J. A. Goodman, L. L. Goodman, Kobin, and Barskin.

Section 45 speaks in sweeping terms. It refers to "two or more organizations, trades, or businesses (whether or not incorporated, * * * and whether or not affiilated) owned or controlled directly or indirectly by the same interests." The type of control contemplated by these provisions is reflected in the regulations which deal with the concept in all-embracing language as follows (Regulations 111, sec. 22.45-1 (3)):

The term "controlled" includes any kind of control, direct or indirect, whether legally enforceable, and however exercisable or exercised. It is the reality of of the control which is decisive, not its form or the mode of its exercise. * * *

It is wholly unimportant that the Goodman trusts which owned stock in National and Industries were not the same Goodman trusts which were the record partners in Hosiery and Abar. The 1951 U.S. Tax Ct. LEXIS 104">*157 significant thing is that each of the two Goodmans in fact exercised control that was commensurate with the holdings of his family, and that Kobin in fact exercised control commensurate with the holdings of his family. We have no doubt that all four organizations were "owned or controlled directly or indirectly by the same interests." Cf. Forcum-James Co., 7 T.C. 1195, 1215-1216.

3. The existence of the requisite common ownership or control is not sufficient, however, to justify the application of section 45. The Commissioner may make a distribution, apportionment or allocation under section 45 only "if he determines [that it] is necessary in order to prevent evasion of taxes or clearly to reflect the income of such [owned or controlled] organizations, trades, or businesses." The purpose of section 45 is not to punish the mere existence of common control or ownership, but to assist in preventing distortion of income and evasion of taxes through the exercise of that control or ownership. It is where there is a shifting or deflection of income from 17 T.C. 231">*255 one controlled unit to another that the Commissioner is authorized under section 45 to act to right the balance and to keep tax collections 1951 U.S. Tax Ct. LEXIS 104">*158 unimpaired. Asiatic Petroleum Co. v. Commissioner (C. A. 2), 79 F.2d 234, 236, certiorari denied 296 U.S. 645">296 U.S. 645; Treas. Regs. 111, sec. 29.45-1; cf. Gordon Can Co., 29 B. T. A. 272.

It has been said many times that the Commissioner has considerable discretion in applying section 45, and that the determinations required of him under the statute must be sustained unless that discretion has been abused. Our review of those determinations is not de novo, and we may reverse them only where the taxpayer proves that they are unreasonable, arbitrary, or capricious. See, e. g., G. U. R. Co. v. Commissioner (C. A. 7), 117 F.2d 187, 189; National Securities Corp., 46 B. T. A. 562, 564, affd. (C. A. 3) 137 F.2d 600, 602, certiorari denied 320 U.S. 794">320 U.S. 794; Seminole Flavor Co., 4 T. C. at 1228.

Applying this standard, we conclude that the allocations of Abar's income were arbitrary as to both Industries and National, that the allocation of Hosiery's income to Industries was reasonable and justified by section 45, and that the allocation of Hosiery's income to National was not authorized by section 45.

a. Abar. Abar purchased waste and defective hosiery from Industries and National, as well as from 1951 U.S. Tax Ct. LEXIS 104">*159 other sources, paying established market prices therefor. It either repaired the hosiery or reclaimed the yarn. In the case of the repaired hosiery, Abar would have it dyed and finished by National, paying standard charges for such services, and would then sell the hosiery to jobbers. The reclaimed yarn it would sell primarily to Industries, National, and Fulton (an organization controlled by the Goodmans), although it made some sales to other purchasers. It received established market prices for its reclaimed yarn. We think that the Commissioner's attempt to make allocations of Abar's income was arbitrary and unauthorized by section 45.

Nor is a contrary conclusion warranted because it was not shown that independent capital was an important factor in Abar's operations, or that it had any employees independently of those of petitioners or some other similarly controlled organization; or because its machinery was owned by petitioners or another similarly controlled organization, and its operations were carried on at the premises of one of those organizations; or because its mended hosiery was finished by National. Cf. Miles-Conley Co., 10 T.C. 754, affirmed on another issue (C. 1951 U.S. Tax Ct. LEXIS 104">*160 A. 4), 173 F.2d 958; Buffalo Meter Co., 10 T.C. 83; Seminole Flavor Co., 4 T.C. 1215; Briggs-Killian Co., 40 B. T. A. 895. The area in which Abar operated was a separate and distinct phase of the industry, and it was, moreover, a phase never before entered either by National or Industries. And despite all the intertwining relationships, 17 T.C. 231">*256 the fact remains that Abar paid and received fair market prices, as though its transactions had been carried on with strangers. No more could be expected of it. While the interests controlling Industries and National could have set up salvage departments within those corporations, the uncontradicted testimony was that a single mill usually did not have enough waste to justify such a step, and, in any case, there was no obligation to adopt the course which carried the greater tax burden. Cf. Central Cuba Sugar Co., 16 T.C. 882, at p. 892.

b. Hosiery. It is important that Hosiery's position in the scheme of things be clearly understood. Industries had a so-called grey mill at Grenada, Mississippi. It had no facilities for dyeing or finishing its product. It shipped its hosiery in the grey directly to National at Indianapolis, where the hosiery 1951 U.S. Tax Ct. LEXIS 104">*161 was dyed and finished, at standard prices for such services, which included a fair profit above costs to National. Title to the hosiery remained in Industries. This arrangement was worked out directly between Industries and National as early as April 1938.

Hosiery's predecessor, Knitting, was first organized in March 1938. At some undisclosed time, Knitting entered into an oral agreement with Industries to furnish styling and merchandising services to Industries and to arrange for the sale of Industries' products. Neither Knitting nor Hosiery had any machinery or plant; neither had a sales organization; there is no evidence that either of them had any tangible physical assets of any consequence; the address of both was the same as National's address; neither Knitting nor Hosiery had any employees who were not also officers or employees of Industries or National; the initial capital of Hosiery was fixed at the comparatively nominal amount of $ 4,286.25, and even that amount was not contributed in cash or assets other than notes. Capital was not a factor in Hosiery's operations which consisted almost entirely, as far as we have been able to determine from this record, of part-time 1951 U.S. Tax Ct. LEXIS 104">*162 or occasional services rendered by the two Goodmans and Kobin.

The foregoing summary is not intended to suggest that Hosiery should be disregarded as a sham; indeed, we have already concluded that Hosiery's separate entity will be recognized. But it is highly relevant to examine the functions performed by Hosiery in correct perspective, in order to determine whether income that was really earned by Industries has been artifically diverted to Hosiery; and a helpful guide in seeking the answer to that inquiry is whether the charges made by Hosiery for its services were disproportionate to the value of such services.

What was the nature of the services performed by Hosiery? There is no evidence that any of the record partners in Hosiery performed services; we are informed only of services alleged to have been performed 17 T.C. 231">*257 by the two Goodmans and Kobin, as employees of Hosiery. Each of these three persons, however, was also actively engaged in the hosiery business as an officer or employee of other organizations, such as National. Thus, National's returns for 1941 state that Kobin devoted full time to its business, and its returns for 1942 disclose that he devoted three-fourths of his time 1951 U.S. Tax Ct. LEXIS 104">*163 to its business. It is plain that the services of the two Goodmans and Kobin, as employees of Hosiery, were only on a part-time or occasional basis.

These were, nevertheless, valuable services, and included furnishing ideas for design and styling of Industries' product, the establishment of various brand names for that product, as well as the development of other merchandising ideas and plans. In addition, they procured directly several large purchasers for Industries' product, such as Sears, Roebuck & Company. However, apart from the few large purchasers, Hosiery did not, through its employes, do any selling. The great bulk of the sales was made by National's sales organization, and for those services National was paid its costs plus a fair profit. Petitioners contend that Hosiery "engaged" National's services. Certainly, this is not true as to National's services in dyeing and finishing Industries' hosiery, for, by contract of April 12, 1938, National agreed directly with Industries to perform such services for Industries. And although Hosiery may have gone through the formality of "engaging" National's sales organization, we think it contributed nothing of value to Industries 1951 U.S. Tax Ct. LEXIS 104">*164 in that respect, for Industries could have arranged that matter directly with National, just as it had made direct arrangements with National to dye and finish its hosiery.

Petitioners contend that this is an inappropriate case for the application of section 45, since Industries received a fair price for its hosiery in the grey. But the fatal defect of that contention is that Industries did not sell its hosiery in the grey. Had Hosiery purchased Industries' product in the grey, thereby assuming all responsibility as well as the risk of the market from that point forward, there would be substance to that position. But that was not the case. Industries manufactured hosiery in the grey; it shipped the hosiery to National for dyeing and finishing, for which it paid standard charges; and it at all times retained title to its product. Hosiery did render styling and merchandising services, as well as sales services in the case of a few large purchasers. But Hosiery did not buy Industries' product for resale. Nor did it guarantee that Industries would receive any fixed or minimum return on its product. It was Industries' finished product that was being sold to the trade, not the product 1951 U.S. Tax Ct. LEXIS 104">*165 of Hosiery. And it is wholly fallacious to contend that Industries was entitled to receive only a fair price for its hosiery in the grey. It was entitled to receive the full price paid for its finished 17 T.C. 231">*258 product minus such fair charges as may have been incurred for dyeing, finishing, and sales services furnished by National, and minus also such fair charges for styling, merchandising, and other services actually rendered by Hosiery. To the extent that the arrangement between Hosiery and Industries resulted in a larger concentration of profits in the hands of Hosiery, to the detriment of Industries, this case presents a typical situation for the application of section 45.

What, then, was the fair value of the services rendered by Hosiery? As we have indicated above, the partnership, as such, furnished nothing of value to Industries, apart from the services of the two Goodmans and Kobin -- services which Industries could have engaged directly, if Hosiery (or its predecessor, Knitting) had not been created. However, Hosiery was entitled to receive the fair value of the services rendered by the two Goodmans and Kobin as its employees. The evidence as to that value was not entirely satisfactory, 1951 U.S. Tax Ct. LEXIS 104">*166 and the best measure we can find, in the evidence before us, of the value of those services is the salaries that were in fact paid for them. Cf. Welworth Realty Co., 40 B. T. A. 97, 100-101. There was testimony that those salaries were fixed by agreement with the Goodmans and Kobin; that they participated in determining the amounts of the salaries; that in fixing those salaries they considered the reasonable value of their services; and that the salaries as fixed were considered fair compensation.

It may be that the amounts of these salaries were in some way affected by the fact that the employer, Hosiery, was controlled by the employees, the Goodmans and Kobin, and that its profits would directly or indirectly benefit them or persons closely related to them. The fact that the salaries declined in later years is not enough to establish that any special concession was made; another plausible explanation for the decrease appears in the evidence. L. L. Goodman testified that the major merchandising job came in the earlier years, with the task of establishing a market for Industries' product, and that "once the brand got established and the public repeated on it, it from then on went 1951 U.S. Tax Ct. LEXIS 104">*167 on its own momentum." In the later years, therefore, the Goodmans' and Kobin's services were reduced, and a reduction in their compensation was not at all surprising. This, in substance, seems to be affirmed by petitioners in their brief, where they say that "These compensations were not in the category of 'salaries' for continuing services, which ordinarily are more or less uniform through the years."

In any event, the burden was on Industries to prove the value of the services Hosiery rendered, and it has provided no more convincing evidence of that value than the salaries in question. Petitioners insist that once they have shown application of section 45 and the allocations thereunder to be arbitrary, the burden shifted to respondent 17 T.C. 231">*259 to prove a proper allocation. While there may be doubt as to the validity of this contention, we need not consider it, because we do not believe that Industries can establish that the allocation of Hosiery's income made to it by respondent was arbitrary without showing the value of the services it received from Hosiery.

L. L. Goodman's testimony suggests in a general and undefined fashion that Hosiery's services to Industries extended beyond the merchandising 1951 U.S. Tax Ct. LEXIS 104">*168 and other services already noted, performed by the Goodmans and Kobin, and that therefore it was not unreasonable for Industries to pay Hosiery more than just the value of those services. We find nothing in that testimony or in other evidence to show exactly what these additional functions were, and we are not convinced that in fact there were any. The claim itself seems to amount to little more than that the experience, interest, and resources of the Goodmans and Kobin were marshalled behind Industries' product. To the extent that this was reflected in the services they rendered, compensation therefor must be taken to be included in the salaries they received. Over and beyond that there was nothing Industries did not already derive from its own connections and relations with the Goodmans and Kobin. Cf. R. O. H. Hill, Inc., 9 T.C. 153, 157-158.

Petitioners challenge the deficiencies on the further ground that the respondent made allocations of Hosiery's "net" income, and not of its "gross" income. Cf. Chelsea Products, Inc., 16 T.C. 840. There is confusion in the record as to the label to be applied to the amounts allocated by respondent. The respondent's deficiency notices, 1951 U.S. Tax Ct. LEXIS 104">*169 which form the basis for these proceedings, refer to the amounts as "gross" income, whereas reports of a revenue agent, introduced in evidence to show the detailed computations, refer to the amounts as "net" income. We think that respondent's explicit determination in his statutory notices of deficiency that he was allocating "gross" income cannot be reversed, in view of the nature of the transactions carried on between Hosiery and Industries. Hosiery itself neither bought nor sold the product manufactured by Industries, but only provided certain services respecting that product. Therefore, contrary to the manner in which it executed its tax returns, the amounts at which Industries' finished product was sold were not Hosiery's "gross receipts" but those of Industries; Hosiery had no "cost of goods sold," and no "inventory"; and the expense of finishing, dyeing, and selling Industries' product was in fact the expense of Industries and not of Hosiery. Hosiery's returns, which were based upon the theory that it sold its own goods, were therefore misleading. In fact, other than the salaries paid by Hosiery and some small tax liability, ⁵ it is not clear that 17 T.C. 231">*260 Hosiery had any expense 1951 U.S. Tax Ct. LEXIS 104">*170 of operation. We approve an allocation of Hosiery's gross income to the extent that such gross income in fact exceeded the fair value of the services rendered by Hosiery to Industries, and we think that, in essence, respondent did substantially that here (after making an allowance of a 10 per cent return on the partners' capital). The deficiencies proposed against Industries are no greater than they would have been, had Hosiery filed returns which accurately set forth its gross income and had the Commissioner made explicit allocations of portions of those amounts -- allocations which we approve. In the circumstances, we find no error in the proposed deficiencies against Industries.

However, the Commissioner did more than make an allocation of a portion of Hosiery's income to Industries; he also allocated a portion thereof to National. We think that 1951 U.S. Tax Ct. LEXIS 104">*171 action was unauthorized by section 45. National received a fair price, including a reasonable profit, for the dyeing, finishing, and sales services which it rendered with respect to Industries' product. Thus, National's earnings in relation to such services were accurately reflected in its returns, and there is no basis on which to attribute to National any further profits growing out of the sale of Industries' product. We therefore disapprove the deficiencies asserted against National to the extent that they reflect allocations from Hosiery.

Decisions will be entered under Rule 50.