# Patton v. Commissioner of Internal Revenue

> Court of Appeals for the Sixth Circuit · April 19, 1948 · 168 F.2d 28

URL: https://www.frixlaw.com/law-library/cases/9650715

## Case

- **Full name:** PATTON Et Al. v. COMMISSIONER OF INTERNAL REVENUE
- **Court:** Court of Appeals for the Sixth Circuit
- **Decided:** April 19, 1948
- **Citations:** 168 F.2d 28; 36 A.F.T.R. (P-H) 1009; 1948 U.S. App. LEXIS 3902
- **Precedential status:** Published
- **Opinion:** Dissent by McALLISTER
- **Judges:** Hicks, McAllister, Miller
- **Cited by:** 20 later opinions in the Frix Law Library

## Citator (automated)

- No negative treatment found by the automated citator. That is not the same as a confirmation that the case is good law; read the citing cases.
- Full citator and citing cases: https://www.frixlaw.com/law-library/cases/9650715

## Opinion text

McALLISTER, Circuit Judge
(dissenting).
According to Section 23 of the Internal Revenue Code, to which reference has been made, petitioners are entitled to a deduction in their taxes for all “the ordinary and necessary expenses paid or incurred during the taxable year in carrying on” their business, “including a reasonable allowance for salaries or other compensation for personal services actually rendered.” The issue is whether the compensation which was paid to Kirk, in accordance with his contract of employment, was a reasonable allowance. As is said in the prevailing opinion, there is a presumption that, as between the parties to the contract, the compensation agreed to be paid was reasonable. But it is declared that as between petitioners herein and the Commissioner, such a presumption is not controlling in a controversy of this nature before the Tax Court, and Botany Worsted Mills v. United States, 278 U.S. 282, 292 , 49 S.Ct. 129, 133 , 73 L.Ed. 379 , is cited as authority to sustain this conclusion.
It does not seem to me that the Botany Mills case controls the controversy before us. There, the stockholders of a corporation adopted a bylaw providing for the payment of more than 50% of the annual net profits to the members of the board of directors, for their services, in addition to their regular annual salaries of $9,000 *32 each. In 1917, the tax year there in controversy, the amount paid out of net profits to the board of directors was $1,565,-739.39, or a payment to each director of $156,573.93, in addition to his salary. Under a statute, similar in phrasing to the one before us, providing for deductions of all “the ordinary and necessary expenses paid within the year in the maintenance and operation of its business,” 39 Stat. 756 , the court held that this amount so greatly exceeded the amounts which are usually paid to directors for their attendance at meetings of the board and the discharge of their customary duties, as to raise a strong inference that the “amount paid to the directors was not in fact compensation for their services, but merely a distribution of a fixed percentage of the net profits that had no relation to the services rendered.” (Emphasis supplied.) The Botany Mills case cites three other cases, hereinafter briefly discussed, that seem to me to elucidate the reason for the court’s decision.
In Jacobs & Davies v. Anderson, 2 Cir., 228 F. 505, 506 , it appeared that two men, who had been partners, incorporated their business a few months before the enactment of the Corporation Tax Act of 1909, and forthwith entered into a contract with the corporation to devote their services to the business, for stated salaries, and with the further provision that the net surplus profits should be divided between them on the basis of their stock holdings. The court held that the payments of net profits to the parties on the basis of their ownership of stock were not payments of compensation, but were merely the profits of the business, subject to tax. The court said that the amount paid out in dividends could not be deducted for the purpose of ascertaining the net income of the corporation. “The distribution of surplus profits was not an ordinary and necessary expense paid in the maintenance and operation of the business.”
In United States v. Philadelphia Knitting Mills Co., 3 Cir., 273 F. 657, 658 , the court said: “As the board of directors is charged with the duty and clothed with the discretion of fixing the salaries of the corporation’s officers, the Government has no right (until expressly granted by statute) to inquire into and determine whether the amounts thereof are proper, that is, whether they are too much or too little. But, while the amount of salary fixed by a board of directors is presumptively valid, it is not conclusively so, because the Government may inquire whether the amount paid is salary or something else. Admittedly the Government has a right to collect taxes on net income of a corporation based on profits after all ordinary and necessary expenses, including salaries, are paid. It has a right, therefore, to attack the action of a board of directors and show by evidence, not that a given salary is too much, but that, in the circumstances, the whole or some part of it is not salary at all but is profits diverted to a stockholding officer under the guise of salary and as such is subject to taxation.”
In Becker Bros. v. United States, 2 Cir., 7 F.2d 3, 6 , where the general manager of a corporation owned 240 out of 250 shares of its stock, and entered into a contract with the corporation providing that his salary should be 85% of the net annual profits, the court said: “There can be no doubt that the corporation was entitled to deduct from the income it received all the ordinary and necessary expenses incurred in carrying on its business, including a reasonable compensation to its officers and employees. But the salaries which are paid in order to constitute an allowable deduction must be a reasonable and fair compensation for the services rendered. The expenses which can be deducted are the ‘ordinary and necessary expenses.’ If a corporation sees fit to pay its employees extraordinary, unusual, and extravagant salaries, distributing the profits of the business in the guise of salaries to its officers, who hold the stock and control its affairs, such salaries manifestly do not constitute the ‘ordinary and necessary expenses’ of the business, which can be deducted under the statute. The government is not bound or concluded either by any resolution which the corporation adopts, or by its method of keeping its books, upon the question as to whether any particular payment is a salary payment or a division of surplus.” (Emphasis supplied.)
*33 In all of these cases, the amounts were paid to officers who were really the beneficial owners of the corporation and who controlled its action in contracting for and paying them the unusually high salaries based upon net profits. The reasons the courts have held such salaries were not deductible as “ordinary and necessary expenses,” were because they were not, in fact, compensation, but merely a distribution of profits; that such profits, divided on the basis of stock holdings, were not payments of compensation; that the claimed salaries were not salaries at all, but profits diverted to stock holding officers under the guise of salaries; and that a distribution of profits “under the guise of salaries” to officers who held the stock of a company and controlled its affairs, is not an ordinary and necessary expense, within the meaning of the statute.
In this case, Kirk was not an owner or part owner of the company, directly or indirectly. His contract of employment, providing for a salary, based on profits, was not a distribution of profits under the guise of a salary. There is no question that the contract of employment was bona fide. As was said in United States v. Philadelphia Knitting Mills Co., supra, the Government has no right to inquire into and determine whether the amount of the salary was proper, or whether it was too much or too little, but only “whether the amount paid is salary or something else.”
Although much importance is seemingly attached by the Government to the fact that, before the contract of employment was entered into between Kirk and petitioners, his salary for the preceding four years was only $939, $1,230, $1,385, and $1,855, the Commissioner finally allowed a deduction on the basis of a salary to Kirk in the amount of $13,000. It can easily be perceived from the evidence that this was a purely arbitrary allowance on the part of the Commissioner. If it was based on the previous earnings of Kirk or upon what he actually did, it was obviously excessive. If it was arrived at by taking the contract for his services into consideration, it was clearly inadequate. It is impossible to escape the conclusion that the Commissioner based his allowance on the ground that the amount -of compensation provided by the contract eventually turned out to be too high, merely because the profits during the years in question were so great. No such arbitrary determinations are valid, either in administrative decisions or in court adjudications. The decision that the amount provided by the contract of employment was too high was, as has been stated by the courts, no business or concern of the Government. The decisive question is whether the amount paid to Kirk was salary or a distribution of profits paid under the guise of salary. It was not a distribution of profits, for Kirk has no interest in the company.
It is admitted in this case that the amount paid to Kirk was salary, and there is nothing in the case to overcome the presumption that such compensation was reasonable. In my opinion, the partners were entitled to deduct the payment of such salary as an ordinary and necessary expense incurred during the taxable year, and the decision of the Tax Court to the contrary should be reversed.

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Source: Frix Law Library, https://www.frixlaw.com/law-library/cases/9650715. Public record. Not legal advice.