Petition for Rehearing — Bernstein v. United States

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< October Term, 1955 <e

No. 393

GEORGE BERNSTEIN, ET ALS., |

| "Petitioners,

versus

UNITED STATES OF AMERICA, EY

PETITION FOR AN ORDER ENLARGING TIME -

10 FILE A PETITION FOR REHEARING OB row.

LEAVE TO FILE A PETITION FOR REHEARING ©

PETITION FOR REHEARING |

CLAUDE PEPPER

PHILIP T.. WEINSTEIN

ARTHUR B. CUNNINGHAM

87 N, E. First Avenue

- Miami 82, Florida

Attorneys for Petitioners

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IN THE

Supreme Court of the United States

October Term, 1955

No. 393

GEORGE BERNSTEIN, ET ALS.,

Petitioners,

versus

UNITED STATES OF AMERICA,

Respondent.

PETITION FOR AN ORDER ENLARGING TIME

TO FILE A PETITION FOR REHEARING OR FOR

LEAVE TO FILE A PETITION FOR REHEARING

To the Supreme Court of the United States or a Justice

Thereof:

The petitioners respectfully petition the Supreme

Court of the United States for an order enlarging the time

within which to file a Petition for Rehearing in the above-

entitled and numbered cause, or for an order granting

leave to file a Petition for Rehearing, and as grounds

therefor show the Court as follows:

1. Accompanying this Petition is a Petition for Re-

a

hearing in the above-entitled and numbered cause. This

Petition is based upon what counsel believe to be inter-

vening circumstances of substantial and controlling effect

within Rule 58(2) of this Court.

2. Heretofore, by order of this Court, dated Novem-

ber 19, 1956, the Petition for a Writ of Certiorari was

denied.

3. The intervening circumstances upon which the

accompanying Petition for Rehearing is based is decision

of the Court of Appeals for the Sixth Circuit, rendered on

December 3, 1956. It was not until December 13, 1956,

that this decision was published in the fastest known re-

porting service, i.e., Prentice-Hall Federal Tax Report

Bulletin, and it was not until December 17, 1956, that said

report was available by mail to petitioners’ counsel. Coun-

sel allege that by no degree of greater diligence could they

have been earlier aware of this decision.

4. In the case of Clark v. Manufacturers’ Trust Co.,

cert. den., 335 U.S. 910 (January 17, 1949), cert. granted,

337 U.S. 953 (June 27, 1949), this Court entertained and

granted an untimely Petition for Rehearing. In other

cases orders denying certiorari were vacated and the cases

were restored to the docket long after the time for rehear-

ing had expired. Goldbaum v. United States, cert. denied,

346 U.S. 857 (October 19, 1953) ; McFee v. United States,

cert. denied, 347 U.S. 927 (March 15, 1954). Restored to

docket 347 U.S. 1007.

5. This Court has held that an opportunity to pre-

sent a Petition for Rehearing of a denial of certiorari

under Rule 58 is a substantial right and is not to be deemed

cs

3

an empty formality. Flynn v. United States, 99 L. Ed.

1298.

Wherefore, the petitioners urge this Court that the

interest of justice requires that the accompanying Petition

for Rehearing be considered on its merits and that an

Order should be made enlarging the time for filing a

Petition for Rehearing, or in the alternative the Court

should consider said Petition, although filed untimely.

RESPECTFULLY SUBMITTED,

CLAUDE PEPPER

PHILIP T. WEINSTEIN

ARTHUR B. CUNNINGHAM

37 N. E. First Avenue

Miami 32, Florida

Attorneys for Petitioners

Claude Pepper

Arthur B. Cunningham

SSeS ssisssaSiessninehentsniestesssetinsinseeesiosp

Philip T. Weinstein

PORE EN AMAB b. OE Dal Coie

IN THE

Supreme Court of the United States

October Term, 1955

No. 393

GEORGE BERNSTEIN, et als.,

Petitioners,

versus

UNITED STATES OF AMERICA,

Respondent.

PETITION FOR REHEARING

The petitioners, in accordance with Rule 58(2), of

the Rules of the Supreme Court of the United States, re-

spectfully move the Court for a rehearing of the Court’s

order dated November 19, 1956, denying the petition for

a writ of certiorari in the above-entitled and numbered

cause, and the petitioners assign the following reasons

for the granting of this petition for rehearing.

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6

REASONS FOR GRANTING

PETITION FOR REHEARING

I. In the petition for certiorari heretofore filed by

the petitioners, the First Question presented for review

was as follows:

Where, by indictment and bill of particulars,

petitioners were accused of attempted individual

income tax evasion for failure to report certain

“dividends”, could petitioners be convicted where,

under applicable laws, the Government failed to

prove the existence (and petitioners were not al-

lowed to show the non-existence) of any accumu-

lated or current earnings or profits of the corpo-

ration out of which dividends could be paid?

II. The reasons assigned for granting the writ were

in substance and effect as follows:

1. The Government, by indictment and bill of par-

ticulars, charged the petitioners with having

wilfully attempted to evade their income taxes

by failing to report “dividends”.

2. “Dividends”, reportable as income, are defined

by Statute.

(a) Distributions to a stockholder, out of other

than earnings or profits, are not taxable

as “dividends”.

(4) To determine availability of taxable “divi-

dends” all federal tax liabilities must first

be deducted from net profits.

3. The Government’s evidence failed to show that

the Selray Corporation had earnings and prof-

its available for distribution as dividends.

4. Petitioners were denied the right to show the

Corporation had no earnings or profits out of

which to pay “dividends”.

5. The Court of Appeals in failing to reverse on

this ground is in conflict with the applicable

decisions of this Court, and has decided a novel

and important question of Federal Law in ad-

mitted conflict with the Tax Court of the United

States.

III. The rendition of an answer to the above-stated

questions was necessarily contained in the decision of the

Court of Appeals affirming the conviction of the peti-

tioners, because of the following facts in the case at bar:

(a) The Government by its bill of particulars

charged petitioners with having received

“dividends” from the Selray Corporation.

(b) The petitioners sought to show that after

all taxes and fraud penalties chargable to

the Selray Corporation had been deducted

from its current earnings or accumulated

surplus, that there would be no earnings

or profits out of which “dividends”, as

defined by Statute, might be paid.

(c) The method by which the petitioners at-

tempted to present their individual de-

OT ee

Ne ar SR,

8

fenses was by proffering an accountant’s

testimony and computations showing that

after accruing all of the corporation’s pro-

posed income tax liabilities and proposed

penalties thereto, there were no earnings

or profits remaining, and that thus, as-

suming additional unreported corporate

receipts had been received by the peti-

tioners, such funds could not, under the

law, be taxable as dividends.

IV. In affirming the conviction of the petitioners,

the Court of Appeals held to be correct the various actions

of the trial court in denying to the petitioners this defense;

and in so holding the Court of Appeals was necessarily

required to, and did,’ squarely reject the decision of the

Tax Court of the United States in the case of Esther M.

Stein v. Commissioner, 25 T.C. 940, whereby it was held

that all taxes and fraud penalties must first be deducted

from a corporation before a determination could be made

of the earnings and profits available for distribution as

dividends.

V. Since the denial of the petition for a writ of cer-

tiorari in this cause, the Court of Appeals for the Sixth

Circuit in the case of Drybrough v. Commissioner, F.

2d (C.A. 6, December 3, 1956) (Appendix) has, on facts

substantially similar to those of the case at bar, followed

1 “Moreover, it is not consistent with our ideas of proper accounting

practice for officers and directors of a corporation to be permitted

to conduct the affairs of their corporation in such a way as to de-

fraud the government and then assert the existence of a fraud pen-

alty as a corporate liability, and thus translate what would otherwise

be a dividend distribution to themselves into a distribution of capital.

If the Tax Court case of Stein v. Commissioner, 25 T.C. 940 holds to

the contrary we are not disposed to follow it. * * * " Bernstein et al.

» United States, 234 F. 2d 475, 482 (C.A. 5, May 31, 1956).

the rule announced in the Esther M. Stein case, supra, that

all corporate taxes and fraud penalties must first be de-

ducted from corporate earnings before a determination

of profits available as dividends could be made.?

VI. The issuance, on December 3, 1956, of the

opinion of the Court of Appeals for the Sixth Circuit, in

the Drybrough case, supra, is an intervening circumstance

of substantial effect within the meaning of Rule 58(2),

and in accordance with standards promulgated by this

Court in Sanitary Refrigerators Co. v. Winters, 280 U.S.

30, 34.

VII. The effect of the decision in the aforementioned

Drybrough case is to create a square conflict between the

decisions on the same matter by the Fifth and Sixth Cir-

cuits, within the meaning of Rule 19 (1) (b) of the rules

of this Court.

VUI. This conflict on this important question and

the resulting confusion in the law should be finally de-

termined by this Court. Not only is there the aforemen-

tioned square conflict of the Fifth and Sixth Circuits, but

a similar question was recently raised in Davis v. United

States, 226 F. 2d 331 (C.A. 6, 1955), cert. den., 350 U.S.

965 (1956), and will be raised and left unanswered in

many cases in which corporate funds are diverted and not

reported for income tax purposes. Unless certiorari is

2 “We conclude that the earnings and profits available for dividends in

each taxable year in issue should be reduced by the deficiencies de-

termined against the corporation for that year. We further conclude

that the fraud penalties for which the corporation has been found

liable should be deducted from earnings and profits for the respective

years in which the fraudulent returns were filed. Estate of Esther M.

Stein, 25 T.C. 940, 966-67 (1956): see Dawkins v. Commissioner, __

F.(2d)___, - (8 Cir., November 5, 1956).” Drybrough v. Commis-

sioner. F. 2d . (C.A. 6, December 3, 1956).

10

granted and this issue concluded it appears that there will

be an indefinite continuation of a gravely dangerous trend

which has already developed (see Appendix ii, Par. 3)

whereby different rules for the computation of taxes and

taxable income will be applied in civil and criminal cases,

although but one set of rules was intended by Congress.

RESPECTFULLY SUBMITTED,

CLAUDE PEPPER

PHILIP T. WEINSTEIN

ARTHUR B. CUNNINGHAM

37 N. E. First Avenue

Miami 32, Florida

Attorneys for Petitioners

Claude : Pepper

Arthur B. Cunningham

Philip. 7. Weinstein

ll

CERTIFICATE OF GOOD FAITH

I, Arthur B. Cunningham, one of the attorneys for

the petitioners herein and a member of the bar of this

Court, do hereby certify that the above and foregoing

Petition for Rehearing is presented in good faith and not

for delay, ard I do further certify that the said Petition

is restricted to what are believed to be intervening cir-

cumstances ¢ substantial or controlling effect.

PROOF OF SERVICE

I, Arthur B. Cunningham, one of the attorneys for

George Bernstein, et als., petitioners herein, and a member

of the Bar cf the Supreme Court of the United States,

hereby certify that, on the , day of December, 1956, I

served copies of the ‘Petition for Rehearing and copies of

the Petition ‘or An Order Enlarging Time To File a Pe-

tition For Rehearing or For Leave To File a Petition For

Rehearing or the several parties thereto, as follows:

On the Jnited States, by leaving a copy thereof at

the office of James L. Guilmartin, Esq., United States At-

torney for the Southern District of Florida, Federal Build-

ing, Miami, Florida, and by mailing a copy in a duly ad-

dressed envelope, with air mail postage prepaid, to the

- Solicitor General, Department of Justice, Washington 25,

go Fes

|

APPENDIX

F. W. DRYBROUGH vy. COMMISSIONER; L. N. SIMP-

SON v. COMMISSIONER (U. S. Court of Appeals, Sixth Circuit,

Nos. 12747; 12748, December 3. 1956)

Before Simons, Chief Judge, Martin and Stewart. Circuit Judges.

Stewart, Circuit Judge:

These are petitions to review decisions of the Tax Court in con-

solidated proceedings. The facts are set out in detail in that court’s

findings and opinion. 23 T.C. 1105 (1955) (sub nom. United Mer-

cantile Agencies, Inc.)

Stripped of details, the facts are appallingly simple. The petitioners

owned or controlled all the stock of a corporation engaged in the busi-

ness of conducting a collection and mercantile agency. The corporation

and both petitioners kept their books and filed their tax returns on the

cash basis. During the years 1942 through 1946 the petitioners systemat-

ically removed from the corporation’s incoming mail basket checks pay-

abie to the corporation, cashed them and divided the proceeds. These

secretly diverted funds, amounting to more than $200,000 over the five

year period, were not reflected upon the corporation’s records or tax

returns and were not reported by the petitioners on their individual

returns.

Since the appropriated checks represented either fees for collection

services or final payments on purchased accounts, the costs of which had

been recovered, they constituted income to the corporation and were

subject to a ninety-five per cent excess profits tax. The petitioners took

the checks in order to evade the payment of this corporate tax,

Their defalcations were brought to light by an internal revenue

agent in 1946. The corporation and each of the petitioners were subse-

quently indicted in the United States District Court for the Western

District of Kentucky and jointly charged with knowingly and willfully

attempting to defeat the corporation’s federal taxes for the years in-

volved. Pleas of nolo contendere were entered, and all three defendants

were fined. In addition, both of the petitioners were sentenced to prison.

After their release from Prison they restored to the corporation the full

amount they had taken.

The Commissioner asserted deficiencies and civil fraud penalties

of approximately $300,000 against the corporation for failure to report

receipt of the diverted funds in its income and excess profits tax returns

for the years in which the diversions occurred. The Commissioner

further determined that the abstracted funds constituted taxable divi-

dends to the petitioners, and accordingly asserted deficiencies and fraud

Ra RD EE MR NR 0 a

ll

penalties of more than $300,000 against them individually. The Tax

Court upheld the Commissioner’s determinations against the corporation,

and no petition for review of that decision has been filed by the corpo-

ration. The Tax Court also sustained the Commissioner's determinations

of deficiencies and fraud penalties against the petitioners personally,

deciding that the funds diverted were taxable as dividends to them

(except to the extent that one of the petitioners received such funds

attributable to stock belonging to his wife), and that at least part of the

deficiencies was due to fraud with intent to evade tax,

On this review the petitioners attack the Tax Court's decisions

upon several alternative grounds. They argue that in diverting the cor-

porate funds they were acting merely as officers and agents of the cor-

poration in furthering its criminal purpose of evading its taxes. But if

the conclusion be reached that they were acting for their own benefit,

they say that they were embezzlers and that the purloined checks were

therefore not taxable to them. Commissioner v. Wilcox, 327 U.S. 404

(1946). In any event, they contend that funds which from the begin-

ning were owed to the United States cannot be taxed both as income

to the corporation and as dividends to them, particularly where, as

here, the amounts were returned in full to the corporation, the deficien-

cies and penalties assessed against the corporation more than exhausted

those funds, and the corporation was thereby rendered insolvent. As to

the fraud penalties, the petitioners concede that they were guilty of

fraud with respect to the corporation’s returns, but maintain that there

was no proof of fraud in their personal returns because there was no

evidence that they knew they had personally received taxable income

when they secretly abstracted checks payable to the corporation,

Before turning to these arguments, it is appropriate to observe that

there is not before us in this case any issue as to the petitioners’ criminal

culpability. It is abundantly clear that the petitioners carried out a de-

liberate and calculated scheme to cheat their government out of substan-

tial tax revenues at a time when honest taxpayers were called upon to

pay levies of unprecedented magnitude; and many citizens were making

far greater sacrifices in the waging of a world war, For their criminal

conduct they have been punished by fines and imprisonment. Moreover,

much more than the full amount abstracted has already been assessed

in favor of the government by way of the deficiencies, penalties and

interest determined against the corporation. The sole question here is

the extent of the petitioners’ individual civil liability for taxes and pen-

alties, and the correct resolution of that question will not be promoted

by the importation of punitive concepts. The decisions in criminal cases

relied on by the respondent are consequently of little assistance in de-

ciding the issue before us. See e.g., Davis v. United States, 226 F.(2d)

331 (6 Cir., 1955), cert. den. 350 U.S. 965 (1956) ; Currier v. United

States, 166 F.(2d) 346 (1 Cir., 1948); Jolly v. United States. 229

F.(2d) 180 (6 Cir., 1956), cert. den. 351 U.S. 963 (1956).

e—

The petitioners contend that since their Purpose in taking the cor-

poration’s checks was to evade the payment of the corporation's tax, as

the Tax Court found, they were merely acting as agents in promoting

the fraud of the corporation, owing at all times a duty to hold the funds

subject to the demands and needs of the corporation, and that there-

fore, they cannot be charged with the receipt of income. Cf. Lashells’

Estate v. Commissioner, 208 F.(2d) 430 (6 Cir., 1953). This argument

is completely specious. Whatever their initial motives may have been, it

clearly appears that through the fraudulent transactions in which they

were engaged the petitioners received money over which they had com-

plete and unrestricted control, which they took and treated as their

own, and for which they doubtless never would have been required to

account had it not been for the discovery of their fraud.

Alternatively, the petitioners argue that the funds they received

were embezzled by them and therefore did not constitute taxable in-

come under the rule of Commissioner v. Wilcox, 327 U.S. 404 (1946).

The petitioners point out that twenty per cent of the cornmon stock of

the corporation was owned by the wife of one of them. who did not

even learn of the withdrawals until 1947 after their discovery by the

internal revenue agent. They further argue that their actions constituted

embezzlement under the law of the state where they took place. Reinicke

v. Bailey, 33 Ky. L. Rep. 977, 112 S.W. 569 (1908).

How much vitality continues to reside in the Wilcox rule since the

Supreme Court's decision in Rutkin vy. United States, 343 U.S. 130

(1952) is a question not easy to answer. Compare Kann v, Commis-

sioner, 210 F.(2d) 247 (3 Cir., 1954), cert. den. 347 U.S. 967 (1954)

with J. J. Dix, Inc. y. Commissioner, 223 F.(2d) 436 (2 Cir.. 1955),

cert. den. 350 U.S, 894 (1955).1 We are convinced in any event that

whatever authority the Wilcox rule retains is too narrow to encompass

the facts of the present case. The petitioners were not employees who

embezzled from an unwitting employer, but officers, directors and stock-

holders in complete domination and control of their corporation. We

think the Tax Court was clearly correct in concluding that the peti-

tioners took the corporation's funds under a claim of right and with the

implied consent of the corporation. North American Qi] Consolidated

v. Burnet, 286 U.S. 417 (1932) ; United States y. Lewis, 340 U.S. 590

(1951); Rutkin v. United States, 343 U.S. 130 (1952): Healy vy.

Commissioner, 345 U.S. 278 (1953) .2

1 See “Taxation of Misappropriated Property: The Decline and Incom-

plete Fall of Wilcox,” 62 Yale L. J. 662 (1953).

2 Both the petitioners testified that they knew that a ninety-five per

fact is that no tax attributable to any check withdrawn was due at

the time it was taken.

iv

Yet. even though received by petitioners under a claim of right,

the funds are taxable as dividends only to the extent that the corpora-

tion had earnings and profits for the years in which they were with-

drawn. Section 115(a) Internal Revenue Code of 1939; Commissioner

vy. Timkin, 141 F.(2d) 625 (14) 630 (6 Cir., 1944) ; United States v.

Lesoine, 203 F.(2d) 123. 125 (9 Cir., 1953); Charles G. Duffy, 2

T.C. 568, 569 (1943).

The Tax Court held that in determining the earnings and profits

available for dividends the corporation’s tax liabilities could not be con-

sidered, because the corporation kept its books on the cash basis. We are

not convinced that the corporation’s accounting method requires such a

conclusion.

Whether a corporation keeps its accounts and makes its returns on

the cash or accrual basis is a question generally relevant only in deter-

mining its own income and deductions as a taxpayer. Section 41, Internal

Revenue Code of 1939; United States v. Anderson, 269 U.S. 423

(1926); Spring City Foundry Co. v. Commissioner, 292 U.S. 182

(1934) ; Ohmer Register Co. v. Commissioner, 131 F.(2d) 682 (6 Cir.,

1932), Moreover, when that is the determination to be made, the

question of federal income taxes does not arise, whether the taxpayer

is on the cash or accrual basis, because such taxes are generally not de-

ductible.$

Here the question ts obviously quite different. It has been recog-

nized that when it becomes necessary to determine the amount of a

corporation’s earnings and profits in order to determine the character

of distributions to a shareholder, the usual principles as to accruability

do not apply. 4 or example, in determining its own net income, taxes

cannot be deducted by an accrual basis corporation if they are disputed

or denied. Security Flour Mills Co. v. Commissioner, 321 U.S. 281

(1944) (federal processing tax) ; Dixie Pine Products Co. v. Commis-

sioner, 320 U.S. 516 (1944) (state gasoline tax). Yet, in determining |

the amount of such a corporation's earnings and profits, the Tax Court

has not hesitated to recognize a different principle. Estate of Esther M.

Stein, 25 T.C. 9490, 965-67 (1956); Stern Brothers & Co., 16 T.C.

295, 322-23 (1951). In both those cases the court reduced the amount

of earnings and profits by the amount of disputed federal income taxes

in order to arrive at the corporation’s true financial status.

In analogous situations courts have refused to distinguish between

cash and accrual basis corporations where it would be unrealistic to do

so. Thus a cash basis personal holding company can deduct accrued but

unpaid federal income taxes from its personal holding company incom?

3 “Although they of course material for such purposes as excess

profits and personal holding company taxes. See discussion below.

v

although § 50S5(a)(1) Internal Revenue Code of 1939 provides for

deduction of “taxes paid or accrued during the taxable year.” Birming-

ham v. Loetscher Co., 188 F.(2d) 78 (8 Cir., 1951) ; Aramo-Stiftung

v. Commissioner, 172 F.(2d) 896 (2 Cir., 1949); Commissioner v.

Clarion Oil Co., 148 F.(2d) 671 (D.C. Cir., 1945), cert. den, 325

U.S. 881 (1945) ; Wm. J. Lemp Brewing Company, 18 T.C. 586, 600

(1952). A similar result has been reached in applying the § 102 penalty

surtax. Harry M. Stevens, Inc. v. Johnson, 115 F. Supp. 310 (S.D.

N.Y., 1953). Moreover for the purpose of asserting transferee liability,

corporate insolvency in the year of the transfer has been established

by deducting tax liability which was unknown at the time of the transfer

and was not assessed until a later year. Vestal v. Commissioner, 152

F.(2d) 132, 134 (D.C. Cir., 1945); Scott v. Commissioner, 117

F.(2d) 36 (8 Cir., 1941).

In M. H. Alworth Trust, 46 B.T.A. 1045 (1942) the question for

decision was substantially the same as that presented here, although it

arose in a quite different context. The conclusion of the Board of Tax

Appeals was expressed in the following language:

“To permit the distribution of gross earnings and profits with-

out making allowance for outstanding obligations would leave such

obligations as a chayge on capital regardless of the method by

which the corporation keeps its books and reports its income for

Federal income tax purposes, and any method of accounting which

reflects an amount of earnings and profits as being available for

distribution as dividends in excess of net earnings and profits act-

ually existing must under general corporation law give way to real-

ities and can not control. We think it follows that in determining

gains or profits available for distribution as dividends, as the term

‘dividend’ is generally defined, accrued but unpaid taxes must be

taken into account.” 46 B.T.A. 1047.

This decision was reersed in Helvering vy. Alworth Trust. 136

F.(2d) 812 (8 Cir., 1943), and the respondent here relies on that

opinion. See also Paulina duPont Dean, 9 T.C. 256, 266-67 (1947).

The practical issue presented to the Court of Appeals in the Alworth

case, however, was whether corporate tax liability should reduce earn-

ings and profits in 1937 or 1938. Here, by contrast, the practical issue

is whether a corporation’s earnings and profits can ever be effectively

adjusted by taxes owed and subsequently paid, in order to prevent a

distribution of capital from being taxed as ordinary income. In resolving

that issue we are persuaded by the reasoning of the Board of Tax Ap-

peals in the Alworth case.

Nothing in Healy v. Commussioner, 345 U.S. 278 (1953) implies

a contrary result. There taxpayers who had received salaries from

closely held corporations had been required in a later year as transferees

vi

to pay tax deficiencies assessed against their corporations because part

of their salaries had been held to be unreasonable and therefore not de-

ductible by the corporations. The Court held that their incomes were

to be adjusted in the year of payment of transferee liability, not in the

vear the salaries were originally received. No question of earnings and

profits was involved.*

In the present case the petitioners knew that the corporation was

properly chargeable with a ninety-five per cent excess profits tax on the

funds which they were diverting. They subsequently had to pay the

money back to the corporation to enable it to meet its tax obligations.

Both common sense and realism require the conclusion that the corpo-

rate taxes attributable to the diverted income should be excluded from

the corporation’s earnings and profits under the circumstances of this |

case: We conclude that the earnings and profits available for dividends |

in each taxable vear in issue should be reduced by the deficiencies de-

termined against the corporation for that year. We further conclude

that the fraud penalties for which the corporation has been found liable

should be deducted from earnings and profits for the respective years

in which the fraudulent returns were filed. Estate of Esther \1. Stein.

25 T.C. 940, 966-67 (1956); see Dawkins v. Commissioner, . . . F.

(2d) ... (8 Cir.. November 5, 1956). To the extent of earnings and

profits thus determined the diverted funds will be taxed to petitioners

as ordinary income in the years received. Withdrawals in excess of earn-

ings and profits will be taxed as capital gains after the adjusted basis

of petitioners’ stock has been exhausted. Sections 115(a), 115(d) In-

ternal Revenue Code of 1939.5

4 id ee a

There remains only the question of the petitioners’ fraud with re-

spect to their individual returns. As to that we are convinced the Tax

Court's findings are correct. By their own admission the petitioners

knew that even if they had filed honest returns on behalf of the corpo-

ration they would have been subject to individual tax liability on at

least five per cent of their withdrawals. Yet they did not report am

of the diverted funds in their tax returns. Only part of a deficiency

need be shown to be due to fraud with intent to evade tax in order to

4 + Similarly, in Bennett E. Myers, 21 T.C. 331, 346 (1953) fictitious sal-

aries were involved. In Eugene Vassallo, 23 T.C. 656,-662-63 (1955)

the question of the corporation’s earnings and profits were not dis-

cusssd.

5 Whether and to what extent petitioners are entitled to deductions for

the year 1951 when they paid the funds back to the corporation are

questions not now before us. See Healy v. Commissioner, 345 U.S. 278

(1953); Arrowsmith v. Commissioner, 344 U.S. 6 (1952); Crellin’s

Estate v. Commissioner, 203 F.(2d) 812 (9 Cir., 1953). If no such

deductions have been claimed, the statute of limitations would now

seem to be a formidable impediment. See cases collected in Mertens

Law of Federal Income Taxation, Section 58.39.

vu

invoke a civil fraud penalty, Section 293(b) Internal Revenue Code of

1939. The petitioners must therefore pay fraud penalties on the de-

ficiencies which will be found due on remand to the Tax Court.

The decisions of the Tax Court are set aside and the cases are re-

manded for proceedings consistent with the views expressed in this

opinion,