Opinion
Docket Nos. 43652 43653 43654.
1955-07-27
JACK ROSE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.MAE ROSE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.JACK ROSE AND MAE ROSE, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
George A. Cavalletto, Esq., and Arthur A. Henzell, Esq., for the petitioners. R. E. Maiden, Jr., Esq., for the respondent.
1. Deficiency notices were sent more than 3 years but within a 5-year period (as extended by waivers) after income tax returns for 1943 had been filed. Held, assessment of deficiencies barred. In determining whether there had been an omission of more than 25 per cent of gross income within the meaning of section 275(c), 1939 Code, the individual returns filed by petitioners must be considered together with a partnership return that was filed with respect to a business owned by them as community property where the partnership return had been filed merely to facilitate the reporting of their community income.
2. In 1944 each of petitioners created an ‘irrevocable’ trust for the benefit of one of their two minor children and purported to give to each trust an undivided interest in certain specified assets, but not in all the assets, of two stores. Thrust instruments, which were identical except that each had different donor and beneficiary, contained no provision as to amount of income each trust was to receive. Partnership returns were filed for each store for the years 1944 to 1948, inclusive, in which each trust was treated as a partner entitled to a distributive share of 24 per cent of the net income of one store and 12 per cent of the net income of the other. No partnership agreement was ever executed. The trust indentures effected no real change in the management, control, or operation of stores. No part of the income of the stores was actually paid to trusts. Petitioners abandoned their position that the trusts were bona fide partners, but contend that the trusts were entitled to a ‘reasonable rate of return.’ Held, the Commissioner correctly determined that the income of each store, shown to be distributable to the trusts on the partnership returns the petitioners for those years.
3. Useful business life of building for depreciation purposes held to be 40 years.
4. Allowable deductions for charitable contributions determined.
5. Claim for allowance of depreciation on improvements to ranch property denied where the ranch was the personal home of petitioners and where there was no showing that the ranch was operated as a business. George A. Cavalletto, Esq., and Arthur A. Henzell, Esq., for the petitioners. R. E. Maiden, Jr., Esq., for the respondent.
In these proceedings, which were consolidated for hearing, the respondent determined deficiencies in income tax and Victory tax, and additions to tax for negligence, as follows:
+----+ ¦¦¦¦¦¦ +----+
Year Jack Rose Mae Rose Jack and Mae Rose Additions to tax 1943 1 $13,668.03 1 $17,465.56 $683.40 (Jack Rose) 873.28 (Mae Rose) 1944 26,275.82 25,992.83 1945 29,524.32 31,601.92 1946 18,190.10 17,421.89 1947 10,115.89 10,044.26 1948 4,679.41 4,562.36 1949 $35,601.46
The principal issues involve: (1) The applicability of the 5-year period of limitations, section 275(c) of the Internal Revenue Code of 1939, with respect to the year 1943; and (2) the propriety of including in the income of each petitioner for the years 1944-1948 one-half of that portion of the income of each of two stores reported in returns of trusts established for the two minor children of petitioners. In addition, there are presented issues relating to depreciation of a Ventura store building, charitable contributions, and depreciation on certain ranch properties. Other issues have been agreed to by the parties and will be given effect upon settlement under Rule 50.
FINDINGS OF FACT.
Some of the facts have been stipulated and they are incorporated herein by reference as part of our findings.
General Findings and Statute of Limitations Issue.
Petitioners, husband and wife, are residents of Santa Barbara County, California. They filed separate income tax returns for the years 1942 to 1948, inclusive, and a joint income tax return for the year 1949 with the collector of internal revenue for the sixth district of California.
Petitioners were married on April 15, 1934. They have two sons, Ronald L. Rose, who was born on November 6, 1935, and Lawrence S. Rose, who was born on May 18, 1939.
Jack Rose is engaged in the business of merchandising high style ladies' ready-to-wear clothing. He has operated his own store in Ventura, California, from 1925 to the present time. He started another ladies' ready-to-wear store in Santa Barbara, California, in 1933, and sold it in 1949. The first store will hereinafter be referred to as the Ventura store and the second as the Santa Barbara store. Both were operated under the name ‘Jack Rose Shop.’
Louis Rose, brother of Jack Rose, was made a partner in the Santa Barbara store operation as of January 1, 1936, and withdrew from the partnership as of January 1, 1947. During the existence of the partnership, each partner owned an undivided one-half interest in the business.
The individual income tax returns of Jack Rose and Mae Rose for the year 1943 were filed with the collector of internal revenue for the sixth California district on March 15, 1944.
More than 3 years but less than 5 years after these returns were filed consents were executed by the petitioners, and accepted by the Commissioner, extending the period of limitation upon assessment of income tax for the year 1943 to and including June 25, 1952. On the latter date notices of deficiencies for the year 1943 (including the year 1942 by reason of the forgiveness features of the Current Tax Payment Act of 1943) were mailed to each of the petitioners.
In petitions filed with this Court on August 25, 1952, each of the petitioners alleged that the respondent erred in not determining that the assessment and collection of taxes for the taxable year 1943 were barred by the provisions of section 275 of the Internal Revenue Code of 1939.
On the income tax returns of the Ventura store and the Santa Barbara store for 1943, there was an overstatement of the cost of merchandise bought for sale by reason of a failure to deduct from such cost certain earned discounts. The portion of these earned discounts not deducted which is allocable to Jack Rose is $13,020.22 and to Mae Rose is $13,020.22.
The merchandise inventories on the books of account of both the Ventura store and the Santa Barbara store were at all times kept on a cost basis.
On the returns of the operations of the Ventura and Santa Barbara stores for the years 1942 to 1949, inclusive, opening and closing inventories were marked down by approximately one-third of the cost of the merchandise, thus increasing the cost of goods sold during 1943 and some of the other years involved. This practice of marking down opening and closing inventories began in 1926 and was continued thereafter up to and including the year 1949 whether or not it resulted in a benefit tax-wise. It was adopted in order to reflect what Jack Rose estimated to be the depreciation in the value of merchandise on hand at the end of each year. The merchandise handled by the two stores was turned over six or eight times a year. Merchandise not sold at the end of 2 months was considered old merchandise and was sold at a reduced price in order to dispose of it. Revenue agents who examined the returns and audited the books of the two stores for years prior to 1942 were aware of the practice of marking down opening and closing inventories and indicated that it was permissible because it was consistently followed.
In determining the deficiencies for the years 1943 to 1949, inclusive, the respondent made adjustments to the net income reported by Jack Rose and Mae Rose in their individual returns for the years 1949, to reflect the amounts shown on the books of the Ventura and Santa Barbara stores for opening and closing inventories. For the years 1942 to 1946, inclusive, these adjustments resulted in additions to reported net income and for the years 1947 to 1949, inclusive, in reductions of reported net income. The amounts by which the net income of each petitioner was increased or reduced were as follows:
+----------------+ ¦1942¦$5,308.27 ¦ +----+-----------¦ ¦1943¦4,926.75 ¦ +----+-----------¦ ¦1944¦1,113.26 ¦ +----+-----------¦ ¦1945¦4,596.01 ¦ +----+-----------¦ ¦1946¦2,684.30 ¦ +----+-----------¦ ¦1947¦(7,706.97) ¦ +----+-----------¦ ¦1948¦(7,477.24) ¦ +----------------+
The adjustment for 1949 resulted in a reduction in the net income reported in the joint return of petitioners of $27,826.75.
Partnership returns were filed for the Santa Barbara store for the calendar years 1936 to 1943, inclusive,
the distributive income being shown as allocable one-half of Louis Rose and one-half to Jack Rose. Since Jack Rose's interest represented community property, one-half of his share was transferred to his individual return and the other one-half to the individual return of Ame Rose.
Income and Victory tax.
Partnership returns were also filed for the Santa Barbara and Ventura stores for the years 1944 to 1948, inclusive, and will be considered in connection with the Trust Issue. 2. The Santa Barbara store was sold in 1949.
Partnership returns were filed for the Ventura store for the calendar years 1938 to 1943, inclusive.1 Each year, one-half of the net income appearing on the Ventura partnership returns was transferred to the individual return of Jack Rose and the other one-half was transferred to the individual return of Mae Rose. Although there was no partnership in fact with respect to the Ventura store, partnership returns were filed, at the suggestion of a revenue agent, in order to facilitate the reporting of the community income of petitioners derived from that store.
All withdrawals of funds and distribution of profits from the Ventura store and the Santa Barbara store were charged on the books and distributed to Jack Rose, with the exception of funds withdrawn and profits distributed from the Santa Barbara store to Louis Rose.
After the marriage of Jack Rose and Mae Rose, all of their property, including their interests in the Ventura store and the Santa Barbara store, constituted their community property and they so regarded it. They did not enter into any agreement or do any acts intending to change the community character of their property.
Jack Rose did not enter into any oral or written partnership agreement with Mae Rose at any time, and she never was a partner in the business of the Ventura store or the Santa Barbara store.
In the individual income and Victory tax return of Jack Rose for 1943, he reported the following income:
+-------------------------------------------------+ ¦Dividends ¦$25.00 ¦ +--------------------------------------+----------¦ ¦Interest on government obligations ¦68.75 ¦ +--------------------------------------+----------¦ ¦Rents and royalties ¦1,751.22 ¦ +--------------------------------------+----------¦ ¦Net profit from business or profession¦3,087.59 ¦ +--------------------------------------+----------¦ ¦Income from partnerships ¦43,220.48 ¦ +--------------------------------------+----------¦ ¦Total income ¦$48,153.04¦ +-------------------------------------------------+
In the individual income and Victory tax return of Mae Rose for 1943, she reported the following income:
+---------------------------------------------+ ¦Dividends ¦$25.00 ¦ +----------------------------------+----------¦ ¦Interest on government obligations¦68.75 ¦ +----------------------------------+----------¦ ¦Income from partnerships ¦43,220.48 ¦ +----------------------------------+----------¦ ¦Total income ¦$43,314.23¦ +---------------------------------------------+
The amount of $3,087.59 reported in the return of Jack Rose represents the difference between income from the operation of a farm of $7,436.94 and deductions of $4,349.35, taken from Form 1040-F, a schedule of farm income and expenses for 1943, which was attached to his return.
The amount of $43,220.48, reported in the returns of both Jack Rose and Mae Rose, consists of $22,139.29, representing one-half of their combined community share in the net income of the Santa Barbara store partnership for 1943; $22,954.84, representing one-half of the net income of the Ventura store for 1943 reported on the partnership return filed for that store; and $1,873.65, representing one-half of the net income of the Ventura Drug Company.
In the partnership return filed for the Santa Barbara store for the year 1943, the gross receipts were reported to be $563,236.61, cost of goods sold $347,696.82, and gross profit $215,539.79. The deductions claimed amounted to $126,907.64, and the net income $91,557.15.
In the partnership return filed for the Ventura store for 1943, the gross receipts were reported to be $271,580.31, cost of goods sold $167,561.90, and gross profit $104,018.41. The deductions claimed amounted to $58,108.74, and the net income $45,909.67.
The assessment and collection of the deficiencies in the income and Victory tax of Jack Rose and Mae Rose for 1943, determined by the respondent, are barred by section 275 of the Internal Revenue Code of 1939.
Trust Issue.
On January 2, 1944, Jack Rose executed a declaration of trust naming his son, Ronald L. Rose, as beneficiary. On the same date, Mae Rose executed a declaration of trust naming her son, Lawrence S. Rose, as beneficiary. Jack Rose was named trustee of both trusts which were identical in all material respects. The trust instruments provided that Jack Rose, as trustee, ‘does hold in an irrevocable trust the personal property, hereinafter described and mentioned,‘ for the benefit of the named beneficiary; that he could retain in the trust, for such time as he deemed desirable, any property received by him; and that he had the power with respect to the trust property, or any part thereof, and upon such terms and in such manner as he might deem advisable, to sell, convey, exchange, convert, improve, repair, and manage and control it. They also provided that he could hold securities, or other property in the trust in his name as trustee, or in his own name, or in the name of his nominee; that all income from the trust estate collected or received by him should be added to the principal of the trust estate; that, in his sole discretion, he could pay to or for the beneficiary, for the beneficiary's use or benefit, any sum necessary to take care of any and all circumstances; that upon any division of the trust property, partial or final, his decision as to what constituted a proper division of the trust estate should be binding upon the beneficiary; and that the beneficiary could not alienate, encumber, or hypothecate his interest in the principal or income of the trust. The trust for the benefit of Ronald L. Rose was to terminate when he attained the age of 35 years and the trust for the benefit of Lawrence S. Rose was to terminate when he attained the age of 32 years.
Each trust instrument provided that the property of the trust estate should consist of the following:
+-----------------------------------------------------------------+ ¦Interest in Ventura store of Jack Rose Shop:¦ ¦ ¦ +--------------------------------------------+---------+----------¦ ¦Accounts receivable ¦$4,817.23¦ ¦ +--------------------------------------------+---------+----------¦ ¦C.O.D.'s ¦512.11 ¦ ¦ +--------------------------------------------+---------+----------¦ ¦Merchandise inventory ¦16,933.14¦ ¦ +--------------------------------------------+---------+----------¦ ¦Fixtures ¦426.18 ¦$22,688.66¦ +-----------------------------------------------------------------+
Interest in Santa Barbara store of Jack Rose Shop: Accounts receivable $7,304.69 C.O.D.'s 416.13 Merchandise inventory 10,741.24 Fixtures 4,690.78 23,152.84 $45,841.50 Accounts payable 7,493.90 $38,347.60
Jack Rose filed a gift tax return for 1944 reporting a gift to the Ronald L. Rose Trust, and Mae Rose filed a gift tax return for 1944 reporting a gift to the Lawrence S. Rose Trust. The reported value of each gift was redetermined by the Commissioner to be $50,304.15, and gift taxes were paid on this amount by each of the petitioners.
Capital accounts were set up on the books of the Ventura store and the Santa Barbara store, as of January 1, 1944, for the Ronald L. Rose Trust and the Lawrence S. Rose Trust. In the partnership returns filed for each store for the years 1944 to 1948, inclusive, each trust was treated as a partner entitled to distributive shares of 24 per cent of the net income of the Ventura store and 12 per cent of the net income of the Santa Barbara store. The distributive shares shown on these partnership returns were credited to the capital accounts set up on the books of the two stores for the trusts and were reported on fiduciary returns filed for each trust. Jack Rose drew checks for the payment of the income tax liabilities shown to be due on these returns and the payments were charged to the respective capital accounts. No bank accounts were ever set up or maintained in any bank in the name of either of the trusts, and the profits credited on the books to the capital account of each trust were never withdrawn by or for the trusts, except for the aforementioned tax payments.
There was no written agreement entered into with the Ronald L. Rose Trust or the Lawrence S. Rose Trust indicating that they were partners in the Jack Rose Shop, Ventura, or the Jack Rose Shop, Santa Barbara. There were no representations made to banks or other financial institutions or in trade channels that the Ronald L. Rose Trust and the Lawrence S. Rose Trust were partners in the Jack Rose Shop, Ventura, and the Jack Rose Shop, Santa Barbara. There was no notation that the Ronald L. Rose Trust or the Lawrence S. Rose Trust were partners in the Jack Rose Shop, Ventura, or the Jack Rose Shop, Santa Barbara, on social security returns, unemployment insurance or sales tax returns, or on insurance policies. he net income of the Ventura and Santa Barbara stores for 1949, and of the Ventura store for 1950 to 1952, inclusive, was reported on returns filed by petitioners, and no part of the net income of the stores for those years was reported by the trusts.
The respondent determined that the Ronald L. Rose Trust and the Lawrence S. Rose Trust were not partners in the businesses of the Ventura store and the Santa Barbara store, and that one-half of the income reported by each of the trusts for the years 1944 to 1948, inclusive, was includible in the taxable income of Jack Rose and the remaining one-half in the taxable income of Mae Rose for those years. The amounts included in the taxable income of each petitioner were as follows:
+----------------+ ¦1944¦$33,256.90 ¦ +----+-----------¦ ¦1945¦34,720.06 ¦ +----+-----------¦ ¦1946¦25,582.44 ¦ +----+-----------¦ ¦1947¦6,416.61 ¦ +----+-----------¦ ¦1948¦2,112.29 ¦ +----------------+
Neither the Ronald L. Rose Trust nor the Lawrence S. Rose Trust was a partner in the Ventura store or in the Santa Barbara store during the years 1944 to 1948, inclusive.
On November 27, 1953, Jack Rose filed two petitions with the Superior Court of the State of California in and for the County of Santa Barbara, one pertaining to the Lawrence S. Rose Trust and the other to the Ronald L. Rose Trust. In each petitioner he asked the court to issue an order accepting his resignation as trustee and appoint a bank as his successor, direct him to turn over the property of the trust to the bank, direct him to render a final accounting of his trusteeship, instruct him as to the rate of return to be allowed to each trust as payment for the use of the undivided interest in and to its assets invested in the business of the two stores, issue an order discharging and releasing him as trustee after the approval of his final account, and appoint a guardian ad litem for Lawrence S. Rose and Ronald L. Rose.
On December 1, 1953, Lawrence and Ronald each filed a petitioner with the court asking that David S. Licker, an attorney, be appointed guardian ad litem of each of them. On December 2, 1953, the court issued orders appointing David S. Licker guardian ad litem of Lawrence and Ronald and authorized him to appear and act in their behalf in the proceedings relating to the trusts.
On December 14, 1953, a hearing was held in the Superior Court of the State of California in and for the County of Santa Barbara on the petitioners filed by Jack Rose. David S. Licker represented Ronald and Lawrence Rose. Testimony was adduced at the hearing as to the proper return which should be allowed on an investment by each trust of $50,000 in a business similar to that of the Ventura and Santa Barbara stores.
On February 19, 1954, the Superior Court of the State of California in and for the County of Santa Barbara signed the orders and instructions and specifically found: That the Ronald L. Rose Trust and the Lawrence S. Rose Trust were valid trusts under California law; that the trusts are still in existence and are irrevocable; that Ronald L. Rose and Lawrence S. Rose are the sole living beneficiaries of their respective trusts; that the assets placed in trust did not constitute an undivided interest in all, but only certain assets of the Ventura store and the Santa Barbara store; that the trusts were not partners in these stores; that the assets of the trusts have been continually invested in the Ventura store and the Santa Barbara store, since the creation of the trusts; that the value of the original assets of each trust was $50,304.15; and that such an investment being subject to substantial economic risk should earn a return of 15 per cent per year. The court then instructed and ordered Jack Rose, as trustee, to file an account of his administration of the two trusts using a 15 per cent yearly return on the original investment and on all yearly accumulations allowed to remain invested in these businesses.
On March 11, 1954, Jack Rose filed an account for each trust with the court. The accounts were identical except for the name of the trust. The material portions of each account read as follows:
JACK ROSE, as Trustee of the above entitled Trust, in account with said Trust and pursuant to the order of this Court entered February 19, 1954 wherein the Court found that the value of the assets originally placed in said Trust to be Fifty Thousand Three Hundred Four and 15/100ths Dollars ($50,304.15), and that such investment should earn a return of fifteen percent (15%) per annum, charges himself as follows:
DEBITS
The Trustee of the above entitled Trust charges himself with all of the assets coming into his hands as Trustee under the Trust Agreement, dated January 2, 1944 at the value fixed by the Court by Order of February 19, 1954:
+-------------+ ¦¦¦$50,304.15 ¦ +-------------+
ADDITIONAL DEBITS December 31, 1944 Interest at 15% on $50,304.15 for the 7,545.62 period January 2, 1944 to December 31, 1944. March 15, 1945 Interest at 15% on $57,849.77 for the 1,807.81 period January 1, 1945 to March 15, 1945. April 15, 1945 Interest at 15% on $43,450.88 for the 543.14 period March 16, 1945 to April 15, 1945. December 31, 1945 Interest at 15% on $43,118.61 for the 4,581.35 period April 16, 1945 to December 31, 1945. March 15, 1946 Interest at 15% on $47,699.96 for the 1,490.62 period January 1, 1946 to March 15, 1946. April 15, 1946 Interest at 15% on $31,988.94 for the 399.86 period March 16, 1946 to April 15, 1946. December 31, 1946 Interest at 15% on $31,311.60 for the period 3,326.86 April 16, 1946 to December 31, 1946. March 15, 1947 Interest at 15% on $34,638.46 for the period 1,082.45 January 1, 1947 to March 15, 1947. April 15, 1947 Interest at 15% on $28,062.72 for the period 350.78 March 16, 1947 to April 15, 1947. December 31, 1947 Interest at 15% on $28,002.46 for the period 2,975.26 April 16, 1947 to December 31, 1947. March 15, 1948 Interest at 15% on $30,977.74 for the period 968.05 January 1, 1948 to March 15, 1948. April 15, 1948 Interest at 15% on $30,967.88 for the period 387.10 March 16, 1948 to April 15, 1948. December 31, 1948 Interest at 15% on $31,324.81 for the period 3,328.26 April 16, 1948 to December 31, 1948.
+--------+ ¦CREDITS ¦ +--------¦ ¦ ¦ ¦ ¦ +--------+
The Trustee is entitled to the following Credits: March 15, 1945 1944 Federal tax paid $16,206.70 April 15, 1945 1944 California tax paid 875.41 March 15, 1946 1945 Federal tax paid 17,201.64 April 15, 1946 1945 California tax paid 1,077.20 March 15, 1947 1946 Federal tax paid 7,658.19 April 15, 1947 1946 California tax paid 411.02 March 15, 1948 1947 Federal tax paid 977.91 April 15, 1948 1947 California tax paid 30.17 March 15, 1949 1948 Federal tax paid 212.00
On March 22, 1954, a hearing was held in the Superior Court of the State of California, in and for the County of Santa Barbara, on an accounting by Jack Rose, as trustee, for the Ronald L. Rose Trust and the Lawrence S. Rose Trust and a petitioner for release of Jack Rose as trustee and appointment of the County National Bank & Trust Company of Santa Barbara, California, as successor trustee. No person appeared at the hearing to contest the account or the settlement thereof.
On March 22, 1954, the Superior Court of the State of California in and for the County of Santa Barbara signed orders settling and allowing the account of Jack Rose as trustee of the Ronald L. Rose Trust and the Lawrence S. Rose Trust and releasing him as trustee and appointing County National Bank & Trust Company of Santa Barbara, California, as successor trustee; and further ordering the successor trustee to distribute the corpus of the Ronald L. Rose Trust and the Lawrence S. Rose Trust to Ronald L. Rose and Lawrence S. Rose, respectively, upon their reaching their 35th and 32d birthdays, respectively.
Depreciation— Ventura Store Building.
In the latter part of 1948, Jack Rose completed a new store building in Ventura, California, for his ladies' ready-to-wear business. The cost of this building, exclusive of land, was $458,294.85. It was architecturally planned for the ladies' ready-to-wear business. It was constructed of reinforced concrete and steel. It had a basement and three floors, consisting of a main floor, mezzanine, and second mezzanine, and a long circular stairway which was used for fashion shows. The front of the building was almost all glass extending to a high ceiling, and the rear entrance was of glass.
In the joint return of Jack Rose and Mae Rose for the year 1949, depreciation was claimed on the building on the basis of a 40-year useful life. The respondent determined that the useful life of the building was 50 years, and that it should be depreciated at the rate of 2 per cent per year.
The useful life of the Ventura store building was 40 years.
Charitable Contributions Issue.
The respondent disallowed for lack of substantiation amounts claimed by the petitioners as contributions in the years 1947, 1948, and 1949, as follows:
+---+ ¦¦¦¦¦ +---+
Jack Rose Mae Rose Jack and Mae Rose 1947 $1,200 $675 1948 535 350 1949 $635
The parties have stipulated that certain listed contributions to charitable organizations claimed by petitioners as business (advertising) expenses of the Ventura store and the Santa Barbara store are allowable as personal deductions of Jack Rose and Mae Rose for the years 1947, 1948, and 1949. They have also stipulated that in addition to these deductions, other deductions for contributions claimed on the petitioners' returns for those years, and disallowed by the respondent in determining the deficiencies, are to be allowed to the extent they are shown to have been made in addition to those stipulated to be allowable.
The charitable contributions shown to have been made in addition to those stipulated as allowable are the following:
+--------------------------------------------------------+ ¦ ¦ ¦Allocation ¦ +-----------------------------+-------+------------------¦ ¦Organization ¦Amount ¦ ¦ ¦ +-----------------------------+-------+---------+--------¦ ¦ ¦ ¦1/2 to ¦1/2 to ¦ +-----------------------------+-------+---------+--------¦ ¦ ¦ ¦Jack Rose¦Mae Rose¦ +-----------------------------+-------+---------+--------¦ ¦1947 ¦ ¦ ¦ ¦ +-----------------------------+-------+---------+--------¦ ¦Ventura County Jewish Council¦$75.00 ¦$37.50 ¦$37.50 ¦ +-----------------------------+-------+---------+--------¦ ¦Police Boys Club ¦146.14 ¦73.07 ¦73.07 ¦ +-----------------------------+-------+---------+--------¦ ¦Firemen's Relief Assn ¦45.00 ¦22.50 ¦22.50 ¦ +-----------------------------+-------+---------+--------¦ ¦S. B. Firemen's Relief Assn ¦25.00 ¦12.50 ¦12.50 ¦ +-----------------------------+-------+---------+--------¦ ¦Totals ¦$291.14¦$145.57 ¦$145.57 ¦ +-----------------------------+-------+---------+--------¦ ¦ ¦ ¦ ¦ ¦ +--------------------------------------------------------+
1948 American Red Cross $150.00 $75.00 $75.00 Community Chest 27.37 13.68 13.69 Community Chest 60.25 30.13 30.12 S. B. Firemen's Relief Assn 25.00 12.50 12.50 Totals $262.62 $131.31 $131.31
Ranch Depreciation.
Jack Rose and Mae Rose owned as their community property during the years 1945 to 1949, inclusive, a 12-acre avocado ranch in Carpinteria, California. They purchased this ranch in 1944. Since 1945 they have been living on it and using it as their ‘personal home.’
In late 1945, the following improvements were made on the ranch:
+------------------------+ ¦Improvement ¦Cost ¦ +--------------+---------¦ ¦Pipe line ¦$1,943.00¦ +--------------+---------¦ ¦Pump ¦1,025.22 ¦ +--------------+---------¦ ¦Tank ¦684.03 ¦ +------------------------+
These improvements were in full use during the year 1946 and thereafter.
The water used on the ranch contains large amounts of sulphur which causes metal to corrode, thus requiring early replacement of pipe, pumps, and tanks.
The probable useful life of the improvements made on the ranch in 1945 is 10 years.
In January 1949, the following improvements were made on the ranch:
+------------------------+ ¦Improvement ¦Cost ¦ +--------------+---------¦ ¦Well ¦$7,783.00¦ +--------------+---------¦ ¦Pump ¦3,172.96 ¦ +------------------------+
The probable useful life of these improvements is 10 years.
OPINION.
RAUM, Judge:
1. Deficiencies for 1943; Statute of Limitations.
Petitioners urge that the assessment of the deficiencies determined for the year 1943 is barred by limitations because the statutory notices were mailed more than 3 years after the expiration of the 3-year period provided in section 275(a) of the Internal Revenue Code of 1939.
While conceding that the notices were mailed within the 5-year period provided in section 175(c), as extended by waivers, they urge that that section has no application because (a) there was no ‘omission’ from gross income, and (b), in the alternative, if there was an ‘omission’ from gross income, it did not amount to 25 per cent of the gross income stated in their returns.
SEC. 275. PERIOD OF LIMITATION UPON ASSESSMENT AND COLLECTION.Except as provided in section 276—(a) GENERAL RULE.— The amount of income taxes imposed by this chapter shall be assessed within three years after the return was filed, and no proceeding in court without assessment for the collection of such taxes shall be begun after the expiration of such period.(c) OMISSION FROM GROSS INCOME.— If the taxpayer omits from gross income an amount properly includible therein which is in excess of 25 per centum of the amount of gross income stated in the return, the tax may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time within 5 years after the return was filed.
The burden of proving that the 5-year period provided in section 275(c) is applicable is on the respondent. The deficiencies which he determined for the year 1943 result principally from his addition to the net income disclosed in the return for that year filed by each petitioner of the amount of $17,946.97. In his answers to the petitions, the respondent alleges that Jack Rose in his 1943 return reported gross income of $48,153.04 and Mae Rose in her return for that year gross income of $43,314.23; that each of petitioners failed to include $17,946.97 in gross income;
and that each petitioner, therefore, omitted from gross income an amount properly includible therein which was in excess of 25 per centum of the gross income reported in their returns. The alleged omissions of $17,946.97 each, or a total of $35,893.94, were attributable to the failure to deduct from cost of merchandise, bought for sale by the Ventura and Santa Barbara stores, certain earned discounts amounting to $26,040.44, and to the practice of marking down opening and closing inventories of the two stores by one-third of cost which in 1943 resulted in an understatement of income in the amount of $9,853.50.
On brief respondent contends for the first time that Mae Rose omitted an additional amount representing her community interest in farm income of $7,436.94 reported in the return of Jack Rose. This contention comes too late.
The petitioners do not contest the correctness of the Commissioner's action in including in their income the earned discounts which were not reported. They do urge, however, that the $9,853.50 markdown in inventories of the stores should not be included in their income for 1943, on the ground that this practice had been consistently followed. The books kept for each of the stores showed inventories only at cost. Yet, for purposes of income tax returns, the inventories were reduced by one-third to reflect a decline in market value. Petitioners do not undertake to defend this practice on the merits, and indeed concede it was improper for 1943 and cannot be sustained on the grounds of consistency.
The petitioners' principal contention is that section 175(c) is inapplicable because the failure to reflect cash discounts in the returns and the adjustment of inventories in the circumstances of this case merely resulted in an overstatement of the cost of goods sold, and an overstatement of cost of goods sold is not an ‘omission’ from gross income within the meaning of that section, citing Uptegrove Lumber Co. v. Commissioner, 204 F.2d 570 (C.A. 3).
Our decision in J. W. Gibbs, Sr., 21 T.C. 443, is to the contrary. However, we do not find it necessary to pass upon this point because, for reasons that we shall set forth, the $17,946.97 understatement of gross income of each petitioner in the circumstances of this case was not in any event in excess of 25 per centum of the gross income stated in their returns.
Cf. Slaff v. Commissioner, 220 F.2d 65 (C.A. 9), and Deakman-Wells Co. v. Commissioner, 213 F.2d 894 (C.A. 3).
The petitioners are residents of California, a community property State. During 1943, all of the property of petitioners, including their interests in the two stores, was community property. During 1943, the Santa Barbara store was operated by a partnership composed of Jack Rose and Louis Rose in which each owned a 50 per cent interest, and a partnership return was properly filed reporting gross and net income. Inasmuch as Jack and Mae Rose each had a community interest in his share of the net income from this store, each reported in his or her individual return one-fourth of the net income shown in the partnership return. Respondent in his brief states that ‘a valid partnership return may be read with the individual return to arrive at the total gross income stated in the return. See I.T. 3981, 1949-2 C.B. 78’ and that he does not rely upon L. Glenn Switzer, 20 T.C. 759, in which this Court expressed a different view, and which was remanded by the Court of Appeals for the Ninth Circuit on September 17, 1954, with directions (in accordance with stipulation of parties) to vacate our decisions and enter decisions for the petitioners. Cf. Harry Landau, 21 T.C. 414, 421, in which this Court said: ‘The general rule is that an individual partner is deemed to own a share interest in the gross income of the partnership.’
The Ventura store was not operated by a partnership. It was community property of the petitioners and the income therefrom was community income. Each of the petitioners, therefore, should have reported one-half of the gross income from the business. Leslie A. Sutor, 17 T.C. 64, 67. The respondent urges that they did not do so in their individual returns, and that their failure to do so is an omission from gross income by each of them. But we think it is unrealistic to say that the petitioners did not report the gross income of the Ventura store (with the exception of the $17,946.97 which each of them omitted). They did so on Form 1065, a ‘partnership return.’ Although there was no partnership between them in the business of this store, Form 1065 returns were filed for the years 1938 to 1948, inclusive, at the suggestion of a revenue agent to facilitate the reporting of the community income of the store. The so-called partnership return filed for 1943 reported the gross income of the Ventura store in which petitioners each had an equal interest. It was not the return of another taxable entity. Cf. Corrigan v. Commissioner, 155 F.2d 164, 166 (C.A. 6); Elvina Ratto, 20 T.C. 785, 789. It showed income of the community, a nontaxable entity. In the circumstances we think that the so-called partnership return filed for the Ventura store was merely an adjunct to the individual returns of Jack and Mae Rose and must be considered together with such individual returns and treated as part of them. This case is thus distinguishable from the Switzer case where the return in question was a proper partnership return, whereas here it was nothing unless it was an adjunct to the individual returns. But if the Commissioner is now and henceforth to concede, contrary to our decision in the Switzer case, that a valid partnership return may be read with the return of an individual partner to arrive at the total gross income stated in the partner's return, then, a fortiori, the Form 1065 return in this case which was filed merely to facilitate the reporting of community income of the petitioners, similar returns having been accepted for a number of years for that purpose by the Commissioner, would have to be read together with the individual returns of the partners to ascertain how much gross income was reported by each of them. Cf. Germantown Trust Co. v. Commissioner, 309 U.S. 304; Atlas Oil & Refining Corporation, 22 T.C. 552, 557. We hold, therefore, that one-half of the gross income appearing on the Ventura store ‘partnership’ return must be imputed to the individual return filed by each petitioner in determining the total gross income stated therein for the purposes of section 275(c).
The following computation submitted by petitioners which we find to be correct, demonstrates that when the Ventura ‘partnership’ return is considered together with the individual return of each petitioner for 1943 (even without giving any effect to the gross income reported in the Santa Barbara partnership return) the omission of $17,946.97 by each petitioner was not in excess of 25 per cent of the gross income stated in his or her return.
+-----------------------------------------------------------------------------+ ¦Jack Rose ¦ +-----------------------------------------------------------------------------¦ ¦ ¦ ¦ ¦ +------------------------------------------------------+-----------+----------¦ ¦Gross income shown on individual return ¦ ¦$48,153.04¦ +------------------------------------------------------------------+----------¦ ¦Less share of net income of Ventura store reported in individual¦ ¦ +------------------------------------------------------------------+----------¦ ¦return ¦22,954.84 ¦ +------------------------------------------------------------------+----------¦ ¦Balance ¦ ¦$25,198.20¦ +------------------------------------------------------------------+----------¦ ¦Plus 1/2 the gross income shown on Ventura store “partnership” ¦ ¦ +------------------------------------------------------------------+----------¦ ¦return ¦52,009.20 ¦ +------------------------------------------------------------------+----------¦ ¦Total gross income for sec. 275(c) purposes ¦ ¦$77,207.40¦ +------------------------------------------------------+-----------+----------¦ ¦25% of $77,207.40 is ¦ ¦$19,301.85¦ +------------------------------------------------------+-----------+----------¦ ¦Alleged “omissions” per notice of deficiency— ¦ ¦ ¦ +------------------------------------------------------+-----------+----------¦ ¦Earned discounts ¦$13,020.22 ¦ ¦ +------------------------------------------------------+-----------+----------¦ ¦Inventory adjustments ¦4,926.75 ¦$17,946.97¦ +------------------------------------------------------+-----------+----------¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------------------------------+
Mae Rose Gross income shown on individual return $43,314.23 Less share of net income of Ventura store reported in individual return 22,954.84 Balance $20,359.39 Plus 1/2 the gross income shown on Ventura store “partnership” return $52,009.20 Total gross income for sec. 275(c) purposes $72,368.59 25% of $72,368.59 is $18,092.15 Alleged “omissions” per notice of deficiency— Earned discounts $13,020.22 Inventory adjustments 4,926.75 $17,946.97
Accordingly, we have made a finding, and hold, that the assessment and collection of deficiencies in income and Victory tax of Jack Rose and Mae Rose for 1943, determined by respondent, are barred by section 275 of the Internal Revenue Code of 1939. Since the deficiencies for 1943 are barred the addition to tax for negligence for that year must likewise be disapproved.
2. Trust Issue.
The Commissioner determined that the two trusts created for the benefit of each of petitioners' children, Ronald and Lawrence, were not partners in the business of the Jack Rose Shops at Ventura and Santa Barbara, and that the income from those enterprises ascribed to the trusts for the years 1944 to 1948, inclusive, must be charged to petitioners.
On January 2, 1944, petitioners had two minor sons, Ronald and Lawrence. On that date Jack Rose executed an instrument purporting to establish a trust for the benefit of Ronald, and Mae executed a similar instrument for the benefit of Lawrence. Jack rose was named trustee in both instruments. The trusts were described as irrevocable and were to terminate in approximately 27 years. All income was to be added to principal but the trustee in his sole discretion could pay out any sum for the beneficiary's use ‘to take care of any and all circumstances'; and upon any division or distribution of the property the trustee was given absolute and binding discretion in determining what constitutes a proper division. The corpus of each trust was stated to consist of ‘Accounts Receivable,’ ‘C.O.D.‘s,’ ‘Merchandise Inventory,‘ and ‘Fixtures,’ in specified dollar amounts in each of the two Jack Rose Shops. No specific assets were transferred to the trusts; the foregoing represented merely undivided interests in each of the four categories of assets described. Nor were any interests in real estate or other assets of the businesses transferred to the trusts. Gift tax returns were filed with respect to each of these trusts and the reported value of each gift was redetermined to be $50,304.15. A capital account was set up for each trust on the books of each of the Jack Rose Shops. At the end of each year, 24 per cent of the net income of the Ventura store and 12 per cent of the net income of the Santa Barbara store were credited to the capital account of each trust. Income tax returns were filed on the theory that each of the trusts was a partner in each of the two stores. However, there were no written partnership agreements in which either of the trusts appeared as a partner. No representations were made to financial institutions or in the business world that the trusts were partners, nor was any such partnership disclosed on insurance policies or social security, unemployment insurance, or sales tax returns. No income was in fact paid over to the trusts, nor were any amounts paid out for the benefit of the trusts other than for the purpose of paying taxes on income that was being ascribed to the trusts.
It is altogether too plain that the alleged partnerships were a sham, and petitioners have abandoned their position that these were bona fide partnerships.
Petitioners contend, however, that even if the trusts were not partners, each trust was entitled to a ‘reasonable rate of return’ based upon the value of the corpus, and to the extent of such reasonable rate of return income of the enterprises otherwise chargeable to petitioners must be attributed instead to the trusts. Petitioners' theory is not entirely clear, and the statutory basis for such result is not articulated.
Petitioners argue that the trusts were entitled to a 15 per cent rate of return, and they rely heavily upon certain proceedings initiated in the California courts after the present cases had been docketed in this Court. Those proceedings were plainly nonadversary in character, and it is highly dubious whether they should have any controlling effect in the present litigation. Cf. Estate of Ralph Rainger v. Commissioner, 183 F.2d 587 (C.A. 9), affirming 12 T.C. 483; Saulsbury v. United States, 199 F.2d 578, 580 (C.A. 5); Lois J. Newman, 19 T.C. 708, affirmed, 222 F.2d 131 (C.A. 9); Estate of Arthur Sweet, 24 T.C. 488.
As already noted, petitioners have not pointed to specific statutory provisions upon which they rely. In speaking of a ‘reasonable rate of return,’ they may perhaps be referring to interest payable to creditors. If so, they must be relying upon section 23(b) of the Internal Revenue Code of 1939 which allows a deduction for interest. However, petitioners in fact paid no interest to the trusts during the years in question,
and since there is no contention that they are on any basis other than the cash basis, they certainly cannot obtain the benefit of interest deductions for the years before us.
The payment of income taxes of the trusts on the theory that they were partners can hardly qualify as payments of interest on an indebtedness.
Wofford v. Commissioner, 207 F.2d 749 (C.A. 5), upon which petitioners rely, is distinguishable. There the trust was treated as having a one-third interest in the entire business in question, and, whatever may be thought of the correctness of that decision, the situation there presented was different from the one before us. There the trust was regarded as entitled to a fraction of the profits of the enterprise; here, petitioners argue that a specified rate of return (15 per cent) must be allowed to the trusts regardless of the earnings of the two Jack Rose Shops.
Petitioners' position here is plainly an afterthought. There was an attempt to treat the trusts as partners during the years 1944-1948. However, the partnership theory was spurious, and petitioners abandoned it. Thereafter, for the years 1949, 1950, and 1951, no income was allocated to the trusts and no income tax returns were filed for them.
Regardless of whether the subsequent nonadversary proceedings in the California courts may be taken as an authoritative disposition of the question whether valid trusts were created, they certainly cannot control the Federal tax consequences which flow from such ruling. If petitioners' reasonable-rate-of-return theory is one turning upon the interest deduction, it is not available here for reasons already set forth above. On the other hand, if it is one which depends upon statutory provisions (not identified) akin to the partnership provisions, then petitioners must also fail for the same reason that the partnership theory would be ineffective to relieve petitioners of tax upon the income. ‘The crucial question,‘ as the Supreme Court said in Commissioner v. Sunnen, 333 U.S. 591, 598, ‘remains whether the assignor retains sufficient power and control over the assigned property or over receipt of the income to make it reasonable to treat him as the recipient of the income for tax purposes.’
The management and control of the business of both the stores was in Jack Rose prior to the purported gifts, and remained in him thereafter. Under the terms of the trust instruments he was given broad powers of control and management of the trust assets. He could hold them, as trustee, in his own name, or in the name of his nominee. He could sell, convey, or exchange them, or manage or control them, on such terms and in such manner as he deemed desirable. His decision as to a proper division of the trust property, partial or final, was binding on the beneficiary. In his discretion he could pay to or for the beneficiary any sum necessary to take care of ‘any and all circumstances.’ These powers enabled him to use the assets of the trust in the business of the two stores as they would have been used if the trusts had not been created. The trust indentures, therefore, effected no real change in the operation of the stores. Neither did they change the relationship and control which the petitioners had over their family property. The business, assets, and income of both stores continued to be controlled and dominated by Jack Rose. He could and did keep the assets and any proceeds of their sale or other disposition in the businesses. No bank account was opened for the trusts and no part of the income of the two stores was ever actually distributed to them. As we view the evidence, we have here another instance where a husband and wife assigned interests in their respective shares of community property to their children while retaining effective control over both property and income. Jack Rose controlled both his and his wife's interest in that property and income prior to the assignments, and continued to do so thereafter. We find it difficult to perceive how the economic position of either was materially changed by the creation of the trusts.
Petitioners have not shown that the Commissioner's determination in respect of the trust issue was in error. Cf. Losh v. Commissioner, 145 F.2d 456 (CA.A. 10); Christopher v. Campbell, 223 F.2d 124 (C.A. 5); Eisenberg v. Commissioner, 161 F.2d 506 (CA.A. 3).
3. Depreciation of Ventura Store Building.
This issue involves depreciation claimed by petitioners in their joint return for 1949 on the new Ventura store building which was completed in the latter part of 1948. The petitioners contend that the useful life of this building is 40 years and that depreciation should be allowed on this basis. The respondent determined that its useful life was 50 years and that a reasonable allowance for depreciation was 2 per cent for 1949. The burden was on the petitioners to prove that the respondent's determination was erroneous.
The building was constructed of reinforced concrete and steel, and had a basement and three floors. It had a glass front extending to a high ceiling, and architecturally planned for the ladies' ready-to-wear business. Evidence was introduced by petitioners to the effect that the front of the building should be changed within 10 to 25 years in order to attract business and that frequent changes should also be made in the interior of the building. Jack Rose and another witness engaged in the ladies' ready-to-wear business testified that the building had a useful life of from 30 to 35 years. We have carefully considered this and other evidence submitted by petitioners and are satisfied that the useful life of the building is 40 years.
4. Charitable Contributions.
This issue relates to the amount of deductions for charitable contributions for the years 1947, 1948, and 1949 to which the petitioners are entitled in addition to those stipulated by the parties to be allowable as deductions for those years. We have made a finding that contributions made by petitioners in addition to those stipulated to be allowable totaled $291.14 in 1947 and $262.62 in 1948, one-half of which is allocable to and deductible by each petitioner. The deduction of other amounts, claimed as contributions in petitioners' returns for the years 1947, 1948, and 1949 and not included in the stipulation as allowable, is denied for lack of substantiation.
5. Ranch Depreciation.
Petitioners, by amendments to their petitions, make claim for allowance of depreciation on various improvements made on their 12-acre ranch in Carpinteria, California, for the taxable years 1946 through 1949. Mae Rose testified that this ranch was their personal home. In returns filed for the taxable years the petitioners did not report the receipt of any income from the operation of the ranch. There is no evidence that the ranch was operated as a business, and we do not agree with petitioners' statement on brief that the very size of the ranch, 12 acres, indicates that it was operated as a business rather than as a hobby. In the circumstances, the petitioners' claim for allowance of depreciation must be denied. Cf. Bradley v. Commissioner, 184 F.2d 860, 863 (C.A. 7).
Decisions will be entered under Rule 50.