Opinion
Docket Nos. 37737 37753 37796.
1954-05-13
CLAY H. BROCK, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.DAN S. BROCK AND ANNIE B. BROCK, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.ELLWOOD T. PFAU, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Vincent F. Kilborn, Esq. , for the petitioners. G. Goodwin Sweatt, Esq. , and J. Frost Walker, Esq. , for the respondent.
1. Taxpayer arranged to open stock and commodity trading accounts with a broker in the names of each of eight relatives. He was granted a limited power of attorney to give ‘buy and sell’ orders to the broker. Taxpayer made the initial deposits as well as subsequent deposits in each of the accounts. Such deposits were not gifts or loans to the relatives. No relative contributed any funds to these accounts. The understanding between taxpayer and each relative was that profits to be derived from the account in such relative's name were to belong equally to them, but that such relative would not bear any part of the loss of the amounts advanced to the account by the taxpayer, and that, prior to any division of profits, withdrawals from the account should be applied first to reimburse taxpayer for the amounts advanced by him. The various accounts were in fact managed by the taxpayer, utilizing his judgment, skill, and acumen. Held, that taxpayer is accountable in full for the profits derived from the capital furnished by him. Held, further, that to the extent that profits were allowed to remain in the accounts and reinvested, such amounts represented additional capital contributed by taxpayer and the relative, and the subsequent profits derived from such additional capital are chargeable to taxpayer and the relative in accordance with their respective interests in such subsequent profits.
2. Additions to tax under section 293(b), Internal Revenue Code, disallowed because of failure to prove that deficiencies were due in part to fraud with intent to evade tax.
3. Petitioner's use of composite rate of depreciation over a 6-year period on certain coin-operated machines used in his trade or business held reasonable. Vincent F. Kilborn, Esq., for the petitioners. G. Goodwin Sweatt, Esq., and J. Frost Walker, Esq., for the respondent.
In Docket No. 37737, the Commissioner determined deficiencies in the income tax of petitioner Clay Brock and additions to tax because of fraud under section 293(b) of the Internal Revenue Code as follows:
+--------------------------------+ ¦Year¦Defletency¦Addition to tax ¦ +----+----------+----------------¦ ¦1943¦$13,770.67¦$6,885.34 ¦ +----+----------+----------------¦ ¦1944¦24,807.34 ¦12,403.67 ¦ +----+----------+----------------¦ ¦1945¦14,666.56 ¦7,333.28 ¦ +----+----------+----------------¦ ¦1946¦32,533.49 ¦16,266.75 ¦ +----+----------+----------------¦ ¦1947¦172,686.99¦86,343.50 ¦ +--------------------------------+
The Commissioner also determined the following deficiencies in income tax:
+----------------------------------------------------------+ ¦Docket No.¦Petitioner ¦Year¦Deficiency¦ +----------+-------------------------------+----+----------¦ ¦37753 ¦Dan S. Brock and Annie B. Brock¦1945¦$75.31 ¦ +----------+-------------------------------+----+----------¦ ¦37796 ¦Ellwood T. Pfau ¦1945¦41.00 ¦ +----------------------------------------------------------+
The principal issue presented in the case of petitioner Clay Brock is whether the gains or losses arising from certain commodity and security trading accounts are to be attributed in whole to petitioner Clay Brock or in part to his relatives in whose names the accounts were carried. An additional issue relates to the proper amount to be allowed as a deduction for depreciation on certain property used in a trade or business of Clay Brock. The resolution of the issues in the cases of the other petitioners, which were consolidated for hearing and decision with the case of Clay Brock, depends on the decision arrived at on the principal issue, as stated above. The respondent also contends that a part of the deficiencies for each of the years in the case of Clay Brock was due to fraud with intent to evade tax.
FINDINGS OF FACT.
Some of the facts have been stipulated and are incorporated herein, as part of our finding of fact, by reference.
Petitioner Clay Brock (sometimes also referred to hereinafter as petitioner and Brock) is a resident of Mobile, Alabama. Petitioners Dan S. Brock and Annie B. Brock are residents of Cuba, Alabama; they filed a joint income tax return for the year 1945. Petitioner Ellwood T. Pfau is a resident of Fairfield, Alabama. All of the income tax returns of each of the petitioners for the years in controversy were filed with the collector of internal revenue for the district of Alabama.
In about 1922, petitioner began to acquaint himself with the operations of the stock and commodities markets and from time to time made modest investments. He also made a study of the history of commodities transactions occurring during the period of the First World War and formed the conclusion that in another period of war, the market would react similarly. He decided that in the event of such war he would invest in commodity futures so as to take advantage of the pattern which he thought he discerned from his study of the market during the First World War. His investments, until about 1940, generally resulted in losses, but from 1940 to 1942, he made profits of less than $10,000 a year. He maintained a personal account with the brokerage firm of Merrill, Lynch, Pierce, Fenner & Beane (hereinafter referred to as the broker) through which he bought and sold commodities, principally cotton, usually in ‘margin’ transactions. No person other than petitioner had any interest in that account (referred to hereinafter as the personal account) and, with negligible exceptions, all gains made or losses incurred in transactions carried on through that account for the years 1942 through 1947 were reported on his Federal income tax returns for those years. He had made a thorough study of the capital gain and loss provisions of the Federal tax laws; and he was highly alert to the objective of managing his trading in such fashion as to take his losses while they were short-term while realizing gains on a long-term basis, with the result that each dollar of loss would offset two dollars of gain.
Petitioner was separated from his wife. He had two daughters, Winona and Claydell, who in 1942 were minors and resided with him. Other relatives of petitioner were two brothers, Lofton, a paperhanger living in Knoxville, Tennessee, and Dan, a farmer living about 140 miles from Mobile, Alabama, in the cotton belt; two sisters, Grace Pfau, married to petitioner Ellwood T. Pfau, who in 1942 worked for the War Production Board and lived near Birmingham, Alabama, and Mary Bruister, the wife of J. Herbert Bruister, a farmer living at Yantley, Alabama; and two nephews, Thomas E. Bruister, who during 1942 was living with his parents, and H. Glenn Bruister, who during 1942 worked principally for petitioner as a mechanic and a collector in connection with petitioner's coin-operated machine business, which will be discussed hereinafter.
After the commencement of the Second World War Brock began to think of applying his theories concerning trading on the market. A plan was formulated to put such theories into operation and to enable his relatives to benefit if such theories proved successful.
Under the plan as devised it was agreed that an account would be opened with a broker in the name of a ‘partner’ of petitioner. Such partner will, for convenience, hereinafter be referred to as the account owner. Petitioner agreed to furnish the initial deposit to the account for the purpose of trading in the stock and commodities markets. Such deposit was not a loan or gift made by petitioner to the account owner; it was repayable to petitioner only from the funds in the account. No account owner contributed any funds to the account standing in his or her name, apart from permitting profits earned by the account to remain in the account. Petitioner was to bear that risk of loss with respect to any advance made by him to the account, but was not to be personally liable for any further amounts that might become due the broker. Profits from the transactions carried on through the account were to belong to petitioner and the account owner equally. Withdrawals from the account were first to be used to repay petitioner for any deposits made in the account and then to be divided equally. The account owner agreed to report on his income tax return all profits and losses, resulting from account transactions, until petitioner recovered all deposits made in the account. Petitioner was to be given a power of attorney to enable him to enter into transactions on behalf of the account owner.
Petitioner entered into agreements, similar to the one explained above, with each of his following relatives and separate accounts were opened with the broker as follows:
+----------------------------------------------------------------------------+ ¦Date ¦Name ¦Initial ¦Date of ¦ ¦ ¦ ¦deposit ¦deposit ¦ +-------------+----------------------------------+-------------+-------------¦ ¦Feb. 3, 1942 ¦H. Glenn Bruister ¦$800 ¦Feb. 5, 1942 ¦ +-------------+----------------------------------+-------------+-------------¦ ¦Mar. 9, 1942 ¦J. Herbert Bruister ¦800 ¦Mar. 12, 1942¦ +-------------+----------------------------------+-------------+-------------¦ ¦Mar. 18, 1942¦Dan S. Brock ¦800 ¦Mar. 21, 1942¦ +-------------+----------------------------------+-------------+-------------¦ ¦Mar. 26, 1942¦Ellwood T. Pfau ¦1,600 ¦May 28, 1942 ¦ +-------------+----------------------------------+-------------+-------------¦ ¦Sept. 21, ¦Lofton L. Brock ¦2,000 ¦Sept. 23, ¦ ¦1942 ¦ ¦ ¦1942 ¦ +-------------+----------------------------------+-------------+-------------¦ ¦July 19, 1943¦Winona Brock (Kittrell) ¦1,500 ¦July 23, 1943¦ +-------------+----------------------------------+-------------+-------------¦ ¦Nov. 6, 1944 ¦Mrs. N. A. Bertolotti (Claydell ¦2,000 ¦Nov. 8, 1944 ¦ ¦ ¦Brock) ¦ ¦ ¦ +-------------+----------------------------------+-------------+-------------¦ ¦July 20, 1945¦Thomas E. Bruister ¦2,000 ¦July 25, 1945¦ +----------------------------------------------------------------------------+ After making the initial deposits listed above, petitioner, from time to time, made additional deposits in these accounts, and there was the same understanding between petitioner and the respective account owners in regard to such additional deposits as existed with respect to the initial deposits.
All of the above named persons executed account cards for the opening of the various accounts and powers of attorney in favor of petitioner. With the exception of the power of attorney executed by Thomas E. Bruister, all such powers of attorney were limited powers authorizing petitioner to buy and sell for the particular account, but no authorization was given for petitioner to withdraw any funds from the account. The power of attorney executed by Thomas E. Bruister was a general power which was broader than the limited powers of attorney and authorized petitioner to make cash withdrawals from his account. Petitioner was given the general power of attorney in this instance because at the time the account was opened Thomas E. Bruister was serving in the United States Army. All of the powers of attorney were revocable at any time at the option of the principals.
The account cards executed by the various account owners were effective to open accounts for securities trading as well as commodity accounts, and in some instances securities accounts were in fact opened for trading purposes. The operation of such securities accounts and the agreement concerning division of profits and losses from such accounts were the same as in the case of the commodity accounts.
None of the persons in whose names trading accounts with the brokers were opened, except Ellwood T. Pfau, had had any previous experience in making investments in the commodities market.
Petitioner generally made all of the decisions in determining what action to take with respect to trading for the various accounts. On occasions when he saw his relatives they held discussions concerning the status of the accounts and policies to be followed in the future. Such discussions were comparatively infrequent, and the relatives did not in general contribute any significant advice in regard to the management of the accounts. In the day-to-day trading at the market petitioner issued the buy and sell orders to the broker on the basis of his opinion at that time of the course which the market might follow.
All amounts deposited by petitioner in the several accounts were considered by him as ‘loans' to the accounts. He kept a written record of such loans and accurately recorded the amount of ‘indebtedness' of any particular account to him at any particular time. Profits earned in the accounts during the years 1943, 1944, and 1945 were generally reinvested in other commodities or commodity futures for the particular account which had earned such profits without any withdrawals first being made. When withdrawals were made, the broker issued a check payable to the account owner, which mayn have been given directly to the account owner or delivered to petitioner. At times petitioner requested that the broker issue a check for part of the balance in an account and a check payable to the account owner was accordingly issued. During the years 1943, 1944, and 1945, the bulk of any withdrawals that were made was generally turned over to petitioner as reimbursement for deposits in the account. That part of any amount withdrawn which was not turned over to petitioner (either as reimbursement for deposits made in the account or as petitioner's share of the profits) was retained by the account owner. The powers of attorney held by petitioner, except the power granted by Thomas E. Bruister, did not authorize petitioner to make withdrawals of cash from the accounts. Petitioner never exercised his power to withdraw cash balances from the account of Thomas E. Bruister. The broker sent reports on the execution of all orders placed for the account directly to the account owner. Statements of balances in the accounts were also sent monthly to such persons. Petitioner received only oral confirmation of orders placed by him on behalf of the accounts, but he maintained his own records of account transactions.
During 1946 the agreements between petitioner and Dan Brock, Ellwood T. Pfau, H. Glenn Bruister, Winona Brock (Kittrell), Claydell Brock Bertolotti, and J. Herbert Bruister were modified to the extent that profits for the year 1946 would be distributed 60 per cent to Brock and 40 per cent to the account owner. No such modification was made in the agreements with Lofton Brock and Thomas E. Bruister. This modification was in effect only during 1946. The H. Glenn Bruister account was closed in 1946. In 1947, the original agreement for an equal division of profits was restored in all the remaining accounts except those in the names of petitioner's daughters, Winona and Claydell. Petitioner relinquished all interest in the accounts standing in his daughters' names, thereby leaving each daughter with full beneficial interest in her account.
Petitioner, on his income tax returns for the years 1942 through 1945, inclusive, did not report any profits or losses from trading in the various accounts or dividends on the securities held in the security accounts, except those from his personal account. The account owners reported on their individual returns for those years substantially all of the profits, losses, and dividends from their respective accounts.
Petitioner reported on his income tax return for the year 1946 a share of the profits from trading and dividends realized in the various accounts. He reported 60 per cent of gains and losses realized in the accounts standing in the names of Ellwood T. Pfau, H. Glenn Bruister, Dan Brock, Winona Brock (Kittrell), Mrs. N. A. Bertolotti (Claydell Brock), and J. Herbert Bruister. Each of those account owners reported, on his or her income tax return for that year, 40 per cent of gains or losses realized during the year with respect to his or her account. Petitioner's income tax return for the year 1946 was the first return filed by him which reported any gains or losses realized in any of the 8 accounts. Petitioner did not report any gains or losses for the year 1946 from the accounts of Lofton Brock and Thomas E. Bruister. For the year 1946, the Lofton Brock account showed an excess of gains over losses realized on sales of commodities held for a period longer than 6 months in the amount of $219,630 and an excess of losses over gains on sales of commodities held for a period shorter than 6 months of $106,710. The account of Thomas E. Bruister for the year 1946 realized a net gain in the amount of $161,528.50 on sales of commodities held for a period longer than 6 months and a net loss in the amount of $80,795 on sales of commodities held for a period shorter than 6 months.
H. Glenn Bruister frequently expressed his own views concerning market transactions and in 1946 he desired to withdraw from the agreement. The power of attorney which he had given to Brock was revoked and the account was closed. It was reopened toward the end of 1947 but no transactions having any tax consequences herein occurred in that year.
At the end of the year 1946 Brock and his two daughters terminated their agreements. He continued to manage the accounts in 1947 as theretofore, but had no further interest in profits to be earned by such accounts.
In February 1947, § 50,000 was withdrawn from the account of Lofton Brock and deposited in another account, under his name, with another brokerage firm in Knoxville, Tennessee. That account was managed by Lofton Brock. Clay Brock and Lofton Brock had equal rights to the profits made therein and had equal interests in the account.
On or about February 14, 1948, petitioner Clay Brock sent to the collector of internal revenue at Birmingham, Alabama, a letter with an enclosed check. The letter with an attached computation purported to be an ‘Amended Report for the Years 1943–1944–1945.’ The check was intended to be payment for additional taxes due for those years. The computation was purportedly made by including in income Brock's one-half share of the profits realized in the 8 accounts for those years not reported by him originally. The letter, computation, and check were sent after the investigation of Brock's tax liability had been commenced.
Clay Brock for a number of years prior to 1942 was in the business of operating and distributing coin-operated machines. He also to a lesser extent conducted some farming operations. In about 1942, petitioner began to liquidate his coin machine business and had completely liquidated that business by the end of 1946.
The machines used in that business were slot machines, phonographs, pinball machines, and the like. The machines used by petitioner in his business had useful lives of varying lengths. In 1936 or 1937 petitioner was advised by an agent of the Bureau of Internal Revenue, who had been conducting an audit of his records, to take depreciation on such machines on a composite basis over a period of 6 years depreciating the equipment 10 per cent in the first and last years and 20 per cent in each of the intervening 4 years. Petitioner thereafter followed that method in computing his deductions for depreciation. Petitioner had no machinery left to be depreciated in 1947. A reasonable composite rate for depreciation on his coin machines is the rate used by the petitioner.
OPINION.
RAUM, Judge:
1. The principal question presented is whether petitioner Clay Brock is taxable on all of the income from transactions carried on through the medium of certain commodities and securities trading accounts which were opened in the names of some of his relatives. The situation may be summarized briefly as follows:
Brock was an experienced trader and had developed certain theories concerning the course the market would follow in the event of a World War. After the commencement of the Second World War, he entered into an arrangement with some of his relatives whereby commodities and securities trading accounts were opened, in the names of his relatives, with a brokerage firm. He made the initial deposits into such accounts to be used for trading purposes, and from time to time thereafter made additional deposits. As between the broker and the relatives in whose names the accounts were opened, the ‘owners' of the accounts were the various relatives. According to the arrangements between Brock and the relatives, he was given revocable powers of attorney which granted him complete control to buy and sell for the accounts, but no power to withdraw account funds.
The amounts deposited by Brock were neither gifts nor loans to his relatives, in whole or in part. It was agreed between Brock and the relatives that he would bear all losses with respect to such deposits, that gains were to be divided equally between them,
The power of attorney given him by Thomas E. Bruister was a general power of attorney and according to its terms Brock was also empowered to withdraw account funds.
but that, prior to any division of profits, withdrawals from the account were to be applied first to reimburse Brock for the deposits that he had made in the account involved. The accounts were operated by Brock, and withdrawals from the accounts were in fact distributed in accordance with the understanding between Brock and his relatives.
This agreement was modified to give Brock 60 per cent of the profits earned during the year 1946 in the case of some of the accounts.
We do not accept the Government's contention that these arrangements constituted a mere sham. However, it has long been estalished that income is taxed to him who earns it, either through his labor or capital, and that an agreement whereby a person's income shall belong to another, even though valid as between the parties, is ineffective to shift the tax consequences attached to the earning of that income from one person to another. Lucas v. Earl, 281 U.S. 111. There is no disagreement between the parties concerning the correctness of the general rule. Each party has cited a number of cases endeavoring to show how the rule has been applied in various factual situations and its applicability to the instant case. Each of the cases cited, however, applied the principle to its own facts and this case must be decided in a similar manner.
The income involved herein was earned from transactions in the commodities and securities markets made through accounts, carried in the names of Brock's relatives. Whatever ‘labor’ that was involved in the earning of such income consisted almost entirely of Brock's utilizing his experience on the market in determining what transactions to initiate or terminate.
The ‘capital’ used for trading purposes was furnished by Brock through what were, in form, deposits in or ‘advances' to the accounts. If, in fact, such deposits were in whole or in part bona fide loans to the persons in whose names the accounts stood, some of the ‘capital’ was furnished by them. However, these deposits were not in fact loans to the account owners, but remained in substance the property of Brock, so that the capital, at least to that extent, was furnished by him. These deposits were repayable only from account funds and not from the personal funds of the account owner; and if the deposits were lost due to entering into unprofitable transactions, such losses were borne entirely by Brock. In these circumstances, it seems clear that the capital represented by Brock's deposits, as well as the labor, was furnished solely by him, and income earned therefrom is taxable to him.
The evidence that Brock consulted his relatives in connection with his trading was pitifully weak, and, with but a single exception, we cannot accept the position that the acumen, skill, or judgment of anyone other than Brock played any substantial part in executing any of the trades involved. That single exception related to the separate account that was opened and managed by Lofton Brock in Knoxville in 1947.
The situation changed, however, after profits had been earned which produced a balance that was greater than the amounts of Brock's deposits in the particular account. For, at that point, according to the agreement between Brock and the account owner, the profits were to belong equally to Brock and the account owner. If the arrangement were terminated at that time the account owner was entitled to take 50 per cent of such profits as his own. If such profits were allowed to remain in the account for further investment, a portion of the capital was, then, furnished by the account owner, and Brock's services were thereafter performed, in part, as the owner's agent. To the extent that such profits remained undivided and were reinvested, any subsequent profits or losses with respect thereto are chargeable to both Brock and his coventurer in accordance with their agreement.
The amounts of deposits made by Brock into the various accounts, the profits and losses of the accounts, and the withdrawals therefrom have all been stipulated and incorporated by reference as part of our findings of fact, which can be used by the parties as a basis for the computation to be submitted under Rule 50.
2. The additions for fraud asserted by the Commissioner are based on the theory that the arrangements entered into by Brock and his relatives were a sham. We have heard the witnesses and have carefully studied the record, and we are satisfied that fraud has not been proved.
3. A minor issue relating to depreciation remains to be discussed. The petitioner Clay Brock had a number of coin-operated machines on which he had been using a composite rate of depreciation. The Commissioner contends here that the machines should have been fully depreciated over a period of two years and made adjustments in the determination of the deficiencies on that basis.
From about 1936 or 1937 the petitioner had been using the composite rate and depreciating the property over a period of 6 years. He introduced evidence to the effect that such method was a reasonable one. The composite rate method has been approved by the Treasury Department. See United States Treasury Department Bulletin ‘F’ (revised January 1942), p. 6. We agree that the petitioner's method was proper, and that the rate employed was reasonable.
It was conceded by petitioner's counsel at the hearing that no depreciation should be allowed on such machines for the year 1947. This concession may be taken into account in making the Rule 50 computation.
Decisions will be entered under Rule 50.