Opinion
Docket Nos. 299-67 — 308-67.
Filed September 29, 1969.
WBB obtained a restaurant franchise for the State of Wisconsin. It set up and, in one case, acquired from its shareholders, wholly owned subsidiaries each for the purpose of operating restaurants under a subfranchise agreement. WBB also set up two corporations as commissaries to serve the restaurants. Each subsidiary was so completely managed and controlled by WBB that WBB, in effect, earned the income arising from their operation. Held, the Commissioner's allocations to WBB of all the gross income and deductions of the subsidiaries under sec. 482 were not arbitrary, capricious, or unreasonable.
Jacquin D. Bierman and Lloyd S. Jacobson, for the petitioners.
Denis J. Conlon, for the respondent.
Respondent determined deficiencies in the following cases which have been consolidated for trial and briefing:
Individual petitioners will be referred to herein by the short name in parentheses.
The Commissioner assessed the portions of the deficiencies in issue for all petitioners except WBB by disallowing their surtax exemptions under section 269.
At trial and on brief the Commissioner also chose to rely on section 1551 for its disallowance of the surtax exemptions for each petitioner except WBB.
Respondent states on brief that his disallowance of the surtax exemptions is an alternative position to the deficiencies assessed against WBB. If we uphold the respondent as to WBB, he concedes the deficiencies assessed against the other petitioners are improper.
FINDINGS OF FACT
The parties stipulated some facts and exhibits which are incorporated herein.
Petitioners are corporations located in Wisconsin which filed their income tax returns for the years in issue with the director of internal revenue in Milwaukee, Wis.
Ben Marcus (hereinafter Marcus) and Gene Kilburg (hereinafter Kilburg) were business associates residing in Milwaukee, Wis. During the summer of 1957 Marcus and Kilburg learned of a restaurant franchise operation controlled by two California corporations headed by Robert C. Wian (hereinafter Wian). Those corporations were Big Boy Franchises, Inc. (hereinafter California Big Boy, the reference name used in relevant contracts) and Robert C. Wian Enterprises, Inc. (hereinafter Enterprise). Wian had developed a philosophy of how to produce and market food items as short orders through a system of franchised restaurants using a hamburger sandwich called the "Big Boy" as a principal product.
Marcus and Kilburg became interested in obtaining a franchise agreement and contacted Wian. They also, together and individually, investigated and visited various restaurant operations including several Big Boy franchise operations of varying sizes in several States including Wisconsin, Ohio, Kentucky, Pennsylvania, Tennessee, California, and Arizona. They talked with operators and other personnel connected with the restaurants and with Wian's employees regarding business risks involved and the economics and methods of operation. They tried to obtain a maximum of information. In late 1957 or early 1958, they reached an oral agreement with Wian for a franchise.
One of the major, if not the primary, reasons Marcus and Kilburg decided to enter the franchise agreement was to take advantage of the Big Boy goodwill and reputation which they believed was favorable throughout the United States.
The first corporation formed was Bon Host Food Service, Inc. It was incorporated as a restaurant under the laws of the State of Wisconsin on January 28, 1958. Its name was changed to Marc's Big Boy-Capitol, Inc., on October 10, 1961. It will be referred to as Capitol throughout this opinion in order to avoid confusing it with Bon Host Service Corp., a commissary, which is also a petitioner herein. Capitol's original capitalization consisted of 1,000 shares of $1 par value common stock issued to its officers at par as follows: Shares
Ben Marcus, president ......................... 500 Gene Kilburg, vice president .................. 250 Ceil Marcus, treasurer, secretary ............. 250
All officers were also directors. Ceil Marcus was Ben's wife.
In early 1958 Marcus and Kilburg, with Wian's personal assistance, investigated and chose a location for the restaurant in the area of 72d Street and Capitol Drive in Milwaukee. With the help of a real estate agent Marcus contacted and personally negotiated an agreement with the owner of the property. On June 19, 1958, Capitol entered a written agreement for the construction and leasing of a restaurant at this site.
WBB was incorporated under the laws of Wisconsin on July 29, 1958, and it issued 5,000 $1 par value common shares for $2 per share as follows: Ben Marcus 2,250, Ceil Marcus 1,500, and Gene Kilburg 1,250. The above persons were directors and held the same offices in WBB as they held in Capitol.
On or about Feb. 1, 1962, Steve Marcus, Ben's son, became the secretary and a director of WBB and of Capitol.
A written franchise contract between WBB, as the licensee, and California Big Boy and Enterprises, as licensors, was executed on August 29, 1958. The contract recited that Enterprises owned the trademark "Big Boy" and designs incidental thereto as applied to food and food products and that it had designated California Big Boy as its agent to select and grant exclusive franchises for the use of the trademarks and designs by restaurant operators in designated areas.
The franchise contract granted WBB the exclusive right, limited to the State of Wisconsin, to use the Big Boy trademark and all designs incidental thereto in connection with the making and selling of double-deck hamburger sandwiches and other food items. WBB also acquired the exclusive right to use menus, recipes, formulas, and products provided or developed by the licensors. The licensors agreed to furnish "to the Licensee, without charge, counseling and advisory services and suggestions in planning, developing and promoting the restaurant business of" WBB and its sublicensees and the sale of Big Boy products —
including specifically, advice, counsel and suggestions relating to the following: Menu planning and printing; recipes; selection of restaurant location; building plans; traffic planning and ground layout; advertising plans; specifications and use of trade symbols and promotional materials; business promotions and operations; pricing; employee training; and the establishment of systems of operation, including accounting and commissary operations. * * *
There was no provision for other administrative type services to be furnished by the licensors. The licensors also agreed to furnish certain advertising, promotional and training materials at the licensee's expense.
The franchise contract provided that the licensors would maintain a staff of employees or advisers necessary to render the services required under the contract. It provided that the licensors would furnish such selected key personnel as they deemed necessary to enable WBB to commence operations of its restaurants.
The contract contained several provisions regarding the dimensions, ingredients, and quality of the double-deck hamburger sandwich. It provided also that employees of the licensee must refer to this sandwich as the "Big Boy" and not as a "hamburger." The franchise contract specified certain general operating procedures relating to operation of restaurants in a dignified manner, licensee's use of its "best efforts" in merchandising food products, presentation of food products to the public in a favorable and dignified manner, compliance with the rules or regulations of the licensors attached to the contract document or subsequently established (the record does not reveal any such rules or regulations).
WBB agreed to maintain full and accurate books of account disclosing its sales, and to make them available to the licensors. The contract provided that the licensee would obey appropriate governmental laws and regulations, maintain certain financial records, and carry products liability insurance in minimum amounts of $100,000 and $300,000 covering each restaurant it operated. WBB also agreed to join and maintain membership in local and national restaurant associations and to obtain the highest sanitation, health, and quality classification awarded by the appropriate governmental authority.
WBB agreed to grant sublicenses under this contract only upon the written approval of California Big Boy. However, the contract provided that if the licensee or "persons in control" of the licensee owned the majority of the voting stock of a corporate sublicensee, California Big Boy's consent was not required. In addition, WBB agreed to grant sublicenses "only to persons, firms or corporations of good reputation who shall assume and shall be subject to all of the terms and obligations of this license contract and the rules and regulations set forth or referred to herein."
The contract provided that, generally, the licensee would pay the licensors an annual license or franchise fee of 1 percent of the gross sales, as defined, of the licensee and its sublicensees.
The licensors granted WBB an option for 1 year to include within its exclusive franchise area all or part of the States of Iowa and Minnesota upon the terms and conditions as provided for in the franchise contract. Within 1 year from August 29, 1958, WBB exercised its option to expand its franchise agreement to include the States of Iowa and Minnesota.
On October 1, 1959, Capitol became a wholly owned subsidiary of WBB when its shareholders transferred their stock to WBB. In addition to Capitol, it is stipulated that WBB has the following wholly owned subsidiary corporations which are connected with its Big Boy subfranchise operation: fn_ fn2 fn_ fn_ fn_ fn_ fn2 fn_ fn2 fn_ fn2 fn_ fn2 fn_ fn2 fn_ fn2 fn_ fn2 fn2
WBB's income tax returns for 1963-65 list the following wholly owned subsidiaries and dates acquired:
Date Subsidiary corporation acquired
Capitol ............................... 7/28/59 Port .................................. 10/ 7/59 Point Loomis .......................... 8/ 2/60 Appleton .............................. 9/13/60 Prospect .............................. 3/24/61 MBB-100 ............................... 3/24/61 MBB-5th ............................... 10/10/61 Manitowoc ............................. 3/ 1/63 Green Bay ............................. 5/14/63 Layton ................................ 8/22/63 Marc's Big Boy — Mayfair, Inc. ....... Not given. Specialty Products .................... Do. Marc's Big Boy — Juneau, Inc. ........ Do. Marc's Big Boy — Plankinton, Inc. .... Do. Bon Host .............................. 10/11/62 Marx Snax — Appleton, Inc. ........... 1961 Marx Snax — Madison, Inc. ............. 1962
Capitol opened 11/19/58.
The starred corporations are not petitioners but Layton, Manitowoc and Green Bay relate to WBB's case by virtue of respondent's adjustments.
Does not appear in the record.
"Bordens" was a dairy company whose products the restaurants used. The Bordens loans were separate equipment loans for each corporation, executed by such corporation, without any guarantee or endorsement.
"Percentage" refers to the percentage of some portion of the restaurant's gross sales which was either in lieu of or in addition to a stated amount of rent.
The "Other Loans" by Capitol were borrowings from the members of Ben Marcus' family or from entities controlled by them.
Unless otherwise indicated, statutory references are to the Internal Revenue Code of 1954.
Specialty Products which were commissaries and did not conduct restaurant operations.
The officers and directors of each of the subsidiaries of WBB were the same as those of WBB both before and after February 1, 1962. For the years in issue only WBB reported officers' salaries on its income tax returns. It reported $20,800 paid to Kilburg each year for devoting his full time to WBB. No other corporation here involved reported officers' salaries on its returns.
See fn. 6, supra.
During the years 1963, 1964, and 1965 there were seven corporations in Metropolitan Milwaukee, each operating a restaurant under the "Marc's Big Boy" name. These were Capitol, Port, Point Loomis, Prospect, MBB-5th, MBB-100, and Layton. During that time separate corporations also operated restaurants in the Wisconsin cities of Appleton, 104 miles from Milwaukee, Manitowoc, 89 miles from Milwaukee, and Green Bay, 119 miles from Milwaukee. Each petitioner, however, listed its address on its income tax returns as 1201 North 35th Street in Milwaukee which was the actual location of WBB.
Other restaurants, not here in issue, were operated under the name "Marc's Big Boy" or "Marc's Carryout" or "Marx Snax."
WBB entered separate written subfranchise or sublicense contracts with its various subsidiary restaurant corporations involved herein.
Each subfranchise contract was patterned after and worded substantially the same as WBB's franchise contract regarding the obligations of the parties except for certain significant additions or modifications.
Significant provisions in the subfranchise contract which do not have counterparts in the franchise contract relate to continuing administrative services to be furnished by WBB for a fee. These portions are set out in the text, infra. Significant provisions in the franchise contract that do not have counterparts in the subfranchise contract relate to the key operating personnel which the licensors were to furnish to WBB in order to commence operation of restaurants. The text of this opinion states other significant differences and discusses them. The parties do not discuss a number of provisions without counterparts or with modified counterparts, and we shall not discuss them either since we do not find them to be helpful.
Recognizing that WBB had the exclusive Big Boy franchise for the State of Wisconsin, the subfranchise contract defined each sublicensee's exclusive area as the area within a 1-mile radius of the sublicensee's restaurant location except no exclusive area was defined for MBB-5th because of its location on the principal shopping street in the central business district of Milwaukee.
The contract between Point Loomis and WBB, submitted in evidence as typical, provided that WBB would —
furnish from time to time * * * administrative counseling and advisory services and suggestions in planning, developing and promoting the restaurant business of the sublicensees and the sale of "BIG BOY" products, including specifically, advice, counsel and suggestions relating to the following: Menu planning and printing; recipes; selection of restaurant location; building plans; traffic planning and ground layout; advertising plans; specifications and use of trade symbols and promotional materials; business promotions and operation; pricing; employee training; and the establishment of systems of operation, including accounting and commissary operations. WISCONSIN BIG BOY shall administer for the sublicensee the recruitment, selection and training of personnel and shall maintain a complete supervisory staff, and shall perform bookkeeping and accounting services for sublicensee. * * * [Emphasis is added to indicate words in the subfranchise contract which do not appear in the franchise contract.]
Under the subfranchise contract WBB agreed to provide promotional, merchandising, advertising, and training materials to the sublicensee at cost without profit to WBB. The Point Loomis subfranchise contract was signed by Marcus as president for WBB and by Kilburg as vice president of the sublicensee, Point Loomis.
The annual sublicense or subfranchise fee payable to the sublicensor (WBB) was 1 percent of the sublicensee's gross sales. This is the same fee WBB was to pay California Big Boy as a franchise fee. The term "gross sales" had the same definition in this contract as it had in the franchise contract.
The subfranchise contract also provided that the sublicensee would pay the sublicensor an administration fee at the end of each 4-week period. The fee was stated to be 3 percent of gross sales unless gross sales during each 52-week period of operation failed to exceed $400,000. In that case the fee was to be 2 percent of gross sales for that period and appropriate credits for the amount over 2 percent actually paid were to be made. However, it was provided that no administration fee would be charged if the sublicensee's "net profit before taxes" was less than $1,000 during the 52-week period.
Bon Host was a foodstuffs commissary and purveyor operation which purchased several food items in large quantities at wholesale prices and distributed them to WBB's subsidiary restaurants after having processed or prepared them. The restaurants also purchased food supplies from outside sources. Each restaurant paid Bon Host the cost of the goods plus a markup of 2.4 percent of the restaurant's gross sales, which sales included supplies bought from other sources. Prior to the formation of Bon Host each restaurant obtained and prepared these items itself.
Bon Host deducted cost of goods sold and administration expenses on its income tax returns for the years involved as follows: 1963 1964 1965
Cost of goods sold ........ $72,402.83 $359,393.53 $410,912.95 Administration expense .... None 7,182.57 9,583.20Figures for sales and net profits are reported below.
Specialty Products was set up as a broker dealing only in potatoes. Large quantities of potatoes were purchased and sold in its name only to the restaurants owned by WBB. This procedure allowed the restaurants to purchase potatoes at less cost than they could acting separately.
On its income tax return for 1965, Specialty Products reported gross sales of $38,325.26, cost of goods sold of $27,192.77, "Administration charge" of $1,536.15 which left taxable income of $9,116.53 after other deductions for Wisconsin income tax and organizational expense.
All of WBB's subsidiary corporations which are in issue actually received $1,000 cash for their stock upon formation. They obtained borrowed funds from banks and credit from suppliers partly because of Marcus' business reputation. As set forth in the following schedule, these petitioners borrowed additional funds for the purchase of leasehold improvements, equipment, and for lease deposits but normally not for working capital because current operations were expected to generate sufficient cash to meet such needs: fn3 fn2
Marcus, acting for each of the corporations, negotiated and signed a separate note for the bank loans. The Manitowoc bank loan was from the First National Bank of Manitowoc. It was not guaranteed or endorsed by any other person or entity. All of the other bank loans were from the Marine National Exchange Bank of Milwaukee, Wis., and were personally guaranteed by Marcus. WBB did not guarantee any of said bank loans.
The Commissioner stated his reasons for the deficiencies as follows:
"It is determined that the corporate entities listed in schedule 7 attached hereto, are to be disregarded for income tax purposes and that the gross income and deductions reported and claimed by such corporations on their separate federal income tax returns are attributable and taxable to you in accordance with section 61 of the Internal Revenue Code of 1954.
"Alternatively, it is further determined that all of the gross income and deductions of each of the corporate entities listed in schedule 7 attached hereto, are allocable to you under the provisions of section 482 of the Internal Revenue Code of 1954 in order to prevent the evasion of taxes and to clearly reflect your income."
During the first 5 years of the lease periodic payments increased the deposit to $30,000.
LEASE SUMMARY
fn2 Lessor's Corporate operator Date of Term right to lease Original lessee Percentage audit books Capitol .................... 6/19/58 10 yrs. from 10/1/58 .... Capitol .......... 5 Yes Point Loomis ............... 10/5/59 15 yrs .................. WBB .............. 5 Yes Port ....................... 1/30/60 10 yrs .................. WBB .............. 5 No Prospect ................... 11/1/60 15 yrs. from 4/1/58 ..... WBB .............. 5 Yes Appleton ................... 1/10/61 10 yrs. from 2/1/61 ..... WBB .............. 5 No MBB-5th .................... 10/11/61 10 yrs .................. MBB-5th .......... 5 Yes MBB-100 .................... 2/1/62 10 yrs. from 3/15/62 .... MBB-100 .......... 5 No Green Bay .................. 3/27/63 20 yrs .................. WBB .............. None No Manitowoc .................. 4/1/63 10 yrs .................. WBB .............. None No Layton ..................... 11/12/63 15 yrs .................. WBB .............. 5 Yes Bon Host ................... 11/30/62 7 1/2 yrs ............... Bon Host ......... None No WBB acquired leases in its name as lessee when the landlord or the mortgagee desired its liability on the respective lease. Marcus was involved in the negotiations of each lease. As president of the corporate lessor, Diane Building Corp., he executed the leases under which Port, MBB-100, and Manitowoc eventually operated. Also Marcus appears to have been associated with the persons acting for the corporate lessor on the lease under which Appleton eventually operated. Marcus intended that WBB would never operate restaurants under its own name, and the leases were assigned to the particular corporate restaurant operator.The two leases executed in 1963 under which Green Bay and Layton, respectively, operated contained the following language with respect to the lessee's (WBB's) use of the premises: "Said premises shall be used by the LESSEE for the conduct of a restaurant business similar to the business conducted by LESSEE in Marc's Big Boys in the Milwaukee, Wisconsin area, * * *." MBB-5th's lease executed in 1961, provided: "Said Lessee [MBB-5th] agrees to operate a restaurant of a similar nature to those now being operated by associated companies of Lessee on the Port Washington Road [Port] and Capitol Drive [Capitol], * * *." No other lease in evidence made specific reference to other restaurants in the provision regarding the use of the premises.
A proper location is an important factor in the success of a restaurant, and Marcus and Kilburg chose the locations themselves based upon their investigations (except to the extent of Wian's participation in Capitol's location, described above).
For each restaurant WBB tried to create the public image of offering similar food products, quality of service, and prices as offered by all Marc's Big Boy restaurants. The franchise contract between California Big Boy, Enterprises, and WBB as well as those between WBB and its sublicensees contained several provisions designed to achieve an image of uniformity. The restaurants also tried to create the image of serving nationally famous food items. In actual operations menu prices in Big Boy operations varied more nationally than locally in various Big Boy restaurants, but the content of and prices in menus were similar nationally as well as locally.
All Marc's Big Boy restaurants here in issue were listed on the menus of each restaurant. Those in the Metropolitan Milwaukee area were listed in both the commercial and noncommercial portions of the Milwaukee telephone directory under the name "Marc's Big Boy Coffee Shops and Car Service Restaurants."
Of the two newspaper advertisements in evidence, both of which prominently display the name "Marc's Big Boy," one sets out only the address of Port while the other, dated February 15, 1966, consisted of a full page setting out a map showing the location of MBB-5th and another restaurant which was probably Marc's Big Boy-Plankinton, Inc., and is not in issue here. At the bottom of the latter advertisement was a line calling attention generally to other Marc's Big Boy family coffee shops in Milwaukee, Appleton, Green Bay, and Manitowoc and one to be opened soon in Juneau Village.
Advertisements for employees in the help-wanted section of the newspapers, which are in evidence, were either over the name "Big Boy Corp." or "Marc's Big Boy" and shall be discussed further below.
The design and physical appearance of the restaurants and their respective storefront signs also bore similarities.
The name "Marc's" derived from "Marcus." The name "Marc's" was not registered as a trade name or trademark under the laws of the United States or under any particular State. However, it was usually portrayed in a distinctive and recognizable style in restaurant advertising. Restaurant menus also displayed the name "Marc's" prominently and distinctively, and a customer could easily and reasonably conclude from the menus that all the restaurants listed thereon were under the same management.
No attempt was made to inform the public that separate corporations operated each restaurant.
The employees of all of WBB's subsidiaries were insured under master insurance policies covering workmen's compensation, group hospitalization, and life insurance. Until March 18, 1964, the group hospitalization policy also covered employees of two other companies with which Marcus was associated.
A single pension plan, entitled "Marc's Big Boy Pension Trust," covered employees of Bon Host and all the restaurants involved herein, and another pension plan covered WBB. Specialty Products was not covered in the restaurant plan in evidence for 1965.
The restaurant pension-plan agreement was executed May 7, 1964. Previously, an insurance agent representing WBB had asked the licensors about its profit-sharing plan. In the February 1963 response, a copy of which was sent to Kilburg, the licensor described the following purposes and advantages of its plan:
This plan was established for two purposes: (1) to accumulate funds for employees to use as capital when granted a Big Boy Franchise, and (2) to provide funds for retirement for long term employees, such as executives and management.
* * * * * * *
In permitting our employees to accumulate funds in this type of plan, when it is time to set them up in a franchise, we pick those in management with the greatest seniority in the company (which means, of course, they have the most funds accumulated in the plan), these funds are used for operating capital and as part of their investment in their own business. Thus, we have recovered from tax money a means of expanding which would not otherwise be possible.
With regard to Item No. 2 — Our profit sharing plan gives to the executive who is a long term career man in the company, a sizable sum of "capital gains" funds to enable him to help plan his own retirement. These funds, along with what he should be able to save from his salary, can help him look forward to a comfortable retirement.
Another factor that has been helpful in having this type of plan is that it enables us to move out our serving personnel who have been with us for from seven to ten years, in favor of younger employees. * * *
Since our employees are not eligible to participate in the plan until they have been with us five years, we do not feel it has too much value in employee recruitment. Its main value is to keep seasoned employees, who are, after all, the backbone of our business.
The restaurant's pension plan followed the pattern of that of the licensor. The restaurant corporations deducted their respective contributions to the pension plan in computing their taxable income.
The Marc's Big Boy Pension Trust agreement provided "that additional corporations or organizations affiliated with Marc's Big Boy organization" might be permitted to join, and that contributions made to plans of such organizations could be brought into this pension trust. Employees of WBB and other organizations which might join this trust were entitled to have such previous "employment period applied for purposes of eligibility hereunder." Signatory on the trust agreement for Bon Host and each of the restaurants here involved was "Ben Marcus, Pres." with attestation by "S. Marcus" as secretary. Ben S. Marcus and Gene Kilburg were listed as trustees to "serve at the pleasure" of "the majority of the respective Boards of Directors."
At the time of trial in February 1968 there had not been a sale of a franchise interest to any Marc's Big Boy employee (other than to the officers as described above).
Each restaurant was covered by at least the minimum amounts of products liability insurance called for in the franchise agreements. Marcus obtained liability insurance protection for the restaurants under a master policy which also covered theaters which were owned or managed by Marcus or another company he owned. This master policy was obtained with great difficulty and two or three were canceled and replaced each time with another insurance company.
Lawrence Kerski, WBB's controller and office manager, maintained the books, records, and checkbooks for WBB and each of its subsidiaries at WBB's offices.
WBB and each of its subsidiaries in issue had its own minute book and stockbook, a separate bank account or accounts, separate books and records reflecting income and expenses including payments for purchases and payroll, a separate payroll record, including separate State of Wisconsin unemployment compensation accounts, and separate Federal Insurance Contribution Act reporting and separate returns for income taxes withheld from wages. Each subsidiary was separately licensed (for restaurants and commissary purposes where applicable), applied for and received a separate State sales permit, and reported and paid its own State sales tax.
Checks were actually written at WBB to pay for inventory supplied by all outside suppliers as well as for inventory supplied by other WBB subsidiaries. Accounts payable by one subsidiary to another for inventory arose only when merchandise was actually transferred.
Each restaurant received its own utility bills directly from the utility involved. These bills and the cost of each restaurant's proportionate share of joint advertising in the yellow pages of the telephone directory were paid out of each restaurant's bank account by checks written at WBB's office.
During the years in issue bills normally were paid by check by WBB out of each corporation's bank account. During the years in issue Marcus caused all bills to be paid out of a clearing account maintained by WBB in order to reduce the check-writing workload and to obtain discounts for quick payment. Each subsidiary corporation reimbursed WBB for these expenditures by a single check drawn by WBB against the subsidiary's bank account after every 28-day accounting period.
Also, at the end of every 28-day accounting period, each subfranchisee paid WBB an administration or management fee as set out in the subfranchise contract. The amount of the fee charged by WBB to its subsidiaries was determined by Marcus and Kilburg. As described above, the contract provided for a fee of 3 percent of gross sales unless gross sales failed to exceed $400,000 in which case the fee would be 2 percent. No fee was charged if "net profits before taxes" for a 52-week period was less than $1,000. Marcus and Kilburg attempted to charge a percentage of gross sales that would allow WBB what they felt would be a small profit for the supervision.
California Big Boy, pursuant to its franchise agreement with WBB, assisted in the opening of each new restaurant by sending people to train the personnel who would operate the restaurant. After training, the local personnel took over and California Big Boy's staff withdrew. Thereafter, each store became responsible for maintaining required standards.
Each restaurant began its business day at 7 a.m. and closed the following morning at 2 a.m. Menus were designed for breakfasts, lunches, and suppers.
Restaurant managers supervised the actual operation of a specific restaurant. They supervised and participated in the preparation and serving of food.
Each manager interviewed at least some of his prospective staff. A newspaper advertisement in evidence over the name "Marc's Big Boy" directed applicants for positions as busboys and dishwashers to apply to the manager "at one of Marc's Big Boy many locations." Managers were also responsible for training personnel and for coordinating and scheduling their work hours. The managers approved the time records used to compute the payroll for their respective store. They ordered all inventory directly from suppliers, including Bon Host and Specialty Products. They then sent the time records and inventory invoices to WBB for payment.
Each restaurant manager deposited his store's daily receipts in his restaurant's bank account which was in a bank selected for its proximity of location. Managers made daily reports of receipts.
Although a bank account was maintained for each restaurant, the managers did not sign checks. Only Marcus, Steve Marcus or a Mr. Lowe associated with WBB had the authority to sign checks for WBB and its subsidiaries.
There were up to three district managers employed by WBB and under the direct supervision of Kilburg and his immediate subordinate, the division manager. Each district manager supervised three to five restaurants so that WBB could maintain the desired standards and uniformity of operations. Kilburg described the district managers as "graduate manager[s]." These district managers sometimes took over the functions of the restaurant managers or assisted them when they were not able to perform their jobs.
Restaurant managers were recruited by means of help-wanted advertisements in newspapers. The two advertisements in evidence were over the names "Mac's Big Boy" and "Big Boy Corp." Each stated that the "Big Boy restaurant chain" sought applicants for positions as "restaurant cook manager" or "manager cooks." One stated that applicants hired would receive accelerated training after which they would "be qualified as a shift manager and later full-fledged restaurant manager with an earnings potential of $8,000 to $10,000 a year plus many company benefits; you may advance to supervisor and later to franchised partner." The other advertisement was similar. It stated that there was a "policy to promote from within" and offered advancement "to positions of ever increasing responsibility leading to a franchise partner with the chain." Both advertisements directed applicants to apply to specified persons at three to four of the restaurant locations. The respective positions of these persons were not stated.
Each restaurant and Bon Host had employees, generated income, and sustained expenses in connection with its particular operation.
The following employment summaries show the total employment of each corporation in issue except Specialty Products (which had no employees) for the years 1963, 1964, and 1965, and shows a breakdown of restaurant employment for a typical week by job classification:
Job classifications for WBB and Bon Host do not appear in the record except as indicated below.
After special credits and net operating loss carryovers.
During the typical week of August 8, 1965, set forth in the table above, Bon Host employed 14 persons classified by operations variously as baker, baker's helpers, food production and inventory, food production and shipping, food preparation, and sanitation.
During that week WBB employed 9 or 10 persons, respectively classified as a division manager, district managers, training supervisors, clerks, a controller and a vice president.
Each petitioner paid income taxes in the amounts shown on its respective income tax return as reflected by the notice of deficiency for each year in issue herein. In years of net profit, the respective petitioners availed themselves of the surtax exemption provided for in section 11, I.R.C. 1954.
The following schedule summarizes the pre-income tax profit or loss shown on income tax returns filed for the indicated period by each petitioner and Layton, Manitowoc, and Green Bay:fn1
PRETAX PROFIT (LOSS) Corporate FYE FYE FYE FYE Operation 5/31/59 5/31/60 5/31/61 5/31/62 WBB ............. $(209.22) $1,305.61 $(22.84) $(96.39) Capitol ......... (35,958.19) (5,636.40) 35,019.37 50,677.12 Port ............ ___________ (5,636.40) 3,811.60 23,985.64 Point Loomis .... ___________ ___________ (135.96) 41,394.70 Appleton ........ ___________ ___________ (11,581.84) 5,645.24 Prospect ........ ___________ ___________ (8,334.49) 18,229.25 MBB-100 ......... ___________ ___________ ___________ (13,117.64) MBB-5th ......... ___________ ___________ ___________ (4,678.44) Bon Host ........ ___________ ___________ ___________ ___________ Manitowoc ....... ___________ ___________ ___________ ___________ Green Bay ....... ___________ ___________ ___________ ___________ Layton .......... ___________ ___________ ___________ ___________ Specialty Products ...... ___________ ___________ ___________ ___________ Corporate FYE FYE FYE Operation 5/31/63 5/31/64 5/31/65 WBB ............. $21,479.00 $30,827.38 $22,430.40 Capitol ......... 26,543.63 54,941.90 41,601.27 Port ............ 24,931.34 31,879.90 26,093.73 Point Loomis .... 47,036.07 69,987.61 53,780.36 Appleton ........ 10,249.75 22,082.94 20,005.50 Prospect ........ 25,941.08 42,714.21 45,215.09 MBB-100 ......... 1,210.72 20,720.57 38,768.12 MBB-5th ......... 43,822.84 67,616.85 62,223.63 Bon Host ........ 22,945.02 31,329.74 34,125.84 Manitowoc ....... __________ (26,418.04) (7,885.35) Green Bay ....... __________ (19,625.84) (1,140.22) Layton .......... __________ __________ 14,179.09 Specialty Products ...... __________ __________ 9,116.53 The next schedule sets forth the amount of gross receipts for each petitioner and restaurant corporation here involved in the reallocation as taken from its respective income tax returns in evidence: GROSS RECEIPTS Fiscal year ending May 31 — 1963 1964 1965 Restaurants: Capitol .................... $564,836.10 $590,846.04 $608,617.01 Port ....................... 465,256.46 494,005.55 504,172.29 Point Loomis ............... 517,867.35 607,775.08 665,181.87 Appleton ................... 262,663.03 213,220.39 344,527.41 Prospect ................... 351,696.14 403,068.39 450,162.33 MBB-100 .................... __________ 572,367.75 630,466.13 MBB-5th .................... 592,973.73 639,392.95 651,714.60 Layton ..................... __________ __________ 474,753.96 Manitowoc .................. __________ 201,573.16 201,070.80 Green Bay .................. __________ 156,173.32 387,791.42 -------------------------------------------- Total for restaurants ........ 2,755,292.81 3,878,422.63 4,918,457.82 ============================================ WBB .......................... 138,447.12 126,976.47 148,484.76 Bon Host ..................... 115,944.72 494,332.71 553,436.51 Specialty products ........... __________ __________ 38,325.26Marcus first entered business in 1935. He became an officer of various corporations operating restaurants, a hotel, motels, about 40 theaters, and a bowling alley and owning real estate. He was president of several corporations, including the Diane Building Corp., some of which elected to be taxed under subchapter S of the Internal Revenue Code, a partner in several active partnerships, and a director of two banks and an insurance company. In his business dealings he generally relied upon his own business judgment and negotiated his own transactions.
Marcus and Kilburg, in effect, pooled their respective resources or talents in setting up and operating the corporations here involved.
Marcus had the responsibility for the financial structure of the business. This involved obtaining the financing necessary for setting new restaurants in operation and for providing adequate working-capital funds.
Marcus set the financial policy for each corporation requiring it to take advantage of quick-payment discounts allowed against current obligations whenever possible. He had the power to determine the amounts, if any, to be allocated to each corporation for officers' salaries. He and Kilburg discussed and determined the amount for which Capitol's and WBB's capital stock was issued. Marcus alone made the determination of the amounts of capital stock issued by the other corporations. He preferred to borrow as much necessary capital funds as possible.
Marcus and Kilburg discussed each new restaurant location. After they agreed on a desirable location, Marcus had the responsibility of negotiating either a lease or the purchase of real estate.
Marcus initiated and handled the incorporation of each restaurant by instructing an attorney to draw up the appropriate documents. Kilburg did not participate in any decision to set up separate corporations.
Because of his considerable experience in and knowledge of the restaurant and foodstuffs businesses, Kilburg's main function in the Marc's Big Boy operations was to set up and supervise the day-to-day routine of obtaining and merchandising foods by all the subsidiary corporations. He oversaw the actual operation of the restaurants utilizing the above-mentioned district managers for this purpose. Kilburg rendered advice as to layout of the resturant premises and supervised the processing and serving of food. Kilburg exercised no supervision over the financial books and records of the various corporations, which job appears to have been the responsibility of Marcus and was accomplished through Kerski.
Marcus and Kilburg became familiar with and practiced Wian's philosophy of operating Big Boy restaurants. Wian envisioned a high-volume, low-margin commodity, short-order operation in which fast service and amiable relations between Big Boy personnel and customers were consistently maintained. In order to permit expansion and to maintain young management this philosophy included a pension or retirement plan, partially described above, to allow employees with managerial ability and with relatively long-term employment to acquire an equity interest in a sublicensed restaurant operation.
ULTIMATE FINDINGS OF FACT
The operation of WBB and its subsidiaries comprised a single integrated business enterprise. There would have been no substantial difference in the operations of the various restaurant and commissary functions if the petitioners and Layton, Green Bay, and Manitowoc had not been incorporated separately.
WBB failed to prove that the dealings between it and its subsidiaries were equivalent to arm's-length dealings between it and uncontrolled taxpayers. WBB failed to show that the Commissioner was arbitrary, capricious, or unreasonable in attributing to WBB the gross income and deductions of its subsidiaries. The allocations of gross income and deductions to WBB were necessary in order to reflect WBB's income clearly.
OPINION
Respondent assessed deficiencies against WBB under sections 61 and 482 by including in WBB's gross income and deductions the gross income and deductions of all the other petitioners plus those of Layton, Manitowoc, and Green Bay in order to prevent evasion of taxes and to reflect WBB's income clearly.
Respondent relies primarily on section 61 and alternatively on section 482. If he is correct under either, it is unnecessary for us to consider the other or to consider respondent's other alternative positions based on sections 269 and 1551 regarding the surtax exemptions of petitioners other than WBB.
WBB
All the restaurants and the commissaries involved in this case were wholly owned by WBB which, in turn, was owned by Marcus and his family and Kilburg. The restaurants were set up and operated as subfranchisees of WBB. The commissaries were set up and operated as adjuncts to the restaurants.
WBB, as franchisee or subfranchisor, passed on its right and obligation under the franchise contract to its subfranchisees. In addition, WBB included in the subfranchise contracts certain provisions with respect to management and administration which were not contained in the franchise contract. By virtue of its ownership of the subsidiaries and the subfranchise contracts, WBB had the power and authority to determine all policy including matters with respect to the financial affairs and operations of the restaurants, leasehold obligations, personnel practices and procedures, advertising, and purchases and sales of goods. WBB exercised this power and authority to determine such policies and implemented them by overseeing and supervising all aspects of the restaurant's business including the services provided by the commissaries. At times personnel directly employed by WBB would step in to perform particular restaurant functions.
For its services to the restaurants, WBB charged a fee based upon a sliding-scale percentage of gross sales. Marcus and Kilburg determined the formula by which such fee was computed.
Section 482, which we hold controls the disposition of this case, provides that the Secretary or his delegate may allocate gross income and deductions among two or more organizations owned or controlled by the same interests if he determines that such allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of such organizations.
SEC. 482. ALLOCATION OF INCOME AND DEDUCTIONS AMONG TAXPAYERS.
In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary or his delegate may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.
The Commissioner has considerable discretion in applying section 482. His determination must be sustained unless he has abused his discretion, and petitioner proves the determination to be arbitrary, capricious, or unreasonable. Bush Hog Manufacturing Co., 42 T.C. 713, 724 (1964), acq. 1964-2 C.B. 4; Pauline W. Ach, 42 T.C. 114, 126 (1964), affd. 358 F.2d 342 (C.A. 6, 1966), certiorari denied 385 U.S. 899 (1966); Hamburgers York Road, Inc., 41 T.C. 821, 833 (1964), acq. 1965-2 C.B. 5; Ballentine Motor Co. v. Commissioner, 321 F.2d 796, 800 (C.A. 4, 1963), affirming 39 T.C. 348 (1962); Grenada Industries, Inc., 17 T.C. 231 (1951), affd. 202 F.2d 873 (C.A. 5, 1953), certiorari denied 346 U.S. 819 (1953). If the record before this Court fails to support the allocation, then we must conclude that the Commissioner abused his discretion. V. H. Monette Co., 45 T.C. 15, 36-37 (1965), affd. 374 F.2d 116 (C.A. 4, 1967), acq. 1966-2 C.B. 6; Bush Hog Manufacturing Co., supra. But if there is substantial evidence supporting the determination, it must be affirmed. Advance Machinery Exch. v. Commissioner, 196 F.2d 1006, 1007-1008 (C.A. 2, 1952), affirming a Memorandum Opinion of this Court, certiorari denied 344 U.S. 835 (1952).
In Hamburgers York Road, Inc., supra at 833, we noted:
The purpose of said statute is to prevent the evasion of taxes by the shifting of profits, the making of fictitious sales, and other methods customarily used to "milk" a taxable entity. H. Rept. No. 2, 70th Cong., 1st Sess., pp. 16-17, reprinted in 1939-1 C.B. (Part 2) 395; S. Rept. No. 960, 70th Cong., 1st Sess., p. 24, reprinted in 1939-1 C.B. (Part 2) 426. Ballentine Motor Co., 39 T.C. 348, 357, affd. 321 F.2d 796 (C.A. 4).
The Commissioner may allocate income and deductions between commonly controlled corporations not because the common owner has the power to shift income but only where there has been actual shifting of income or deductions. V. H. Monette Co., supra at 37; Bush Hog Manufacturing Co., supra at 725. Otherwise the provision would "punish the mere existence of common control or ownership" rather than "assist in preventing distortion of income and evasion of taxes through the exercise of that control or ownership." Grenada Industries, supra at 254-255. See also Asiatic Petroleum Co. ( Delaware) Ltd., 31 B.T.A. 1152, 1154-1158 (1935), affd. 79 F.2d 234 (C.A. 2, 1935), certiorari denied 296 U.S. 645 (1935).
Some cases have involved a specific transaction or transactions between commonly controlled corporations in which the courts were concerned with whether the transaction or transactions resulted from arm's-length bargaining or were fair. See, e.g., Ballentine Motor Co., 39 T.C. 348, 356-361 (1962), affd. 321 F.2d 796 (C.A. 4, 1963), stating that a fair transaction or one resulting from arm's-length bargaining will not be disturbed; see also section 1.482-1(b)(1), Income Tax Regs., which states that the purpose of section 482 is to place a controlled taxpayer on a parity with an uncontrolled taxpayer and that the standard to be applied is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer.
Sec. 1.482-1(c), Income Tax Regs., discusses the application of see. 482:
(c) Application. Transactions between one controlled taxpayer and another will be subjected to special scrutiny to ascertain whether the common control is being used to reduce, avoid, or escape taxes. In determining the true taxable income of a controlled taxpayer, the district director is not restricted to the case of improper accounting, to the case of a fraudulent, colorable, or sham transaction, or to the case of a device designed to reduce or avoid tax by shifting or distorting income, deductions, credits, or allowances. The authority to determine true taxable income extends to any case in which either by inadvertence or design the taxable income, in whole or in part, of a controlled taxpayer, is other than it would have been had the taxpayer in the conduct of his affairs been an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer.
Sec. 1.482-1(a)(6) defines "true taxable income" as "the taxable income * * * which would have resulted to the controlled taxpayer, had it in the conduct of its affairs (or, as the case may be, in the particular contract, transaction, arrangement, or other act) dealt with the other member or members of the group at arm's length. * * *"
In this case, however, respondent assessed the deficiencies against WBB by allocating to its gross income and deductions all the gross income and deductions of the other petitioners herein plus Layton, Green Bay, and Manitowoc. He stated that this allocation was made to prevent evasion of taxes and to clearly reflect WBB's income. Respondent did not base the allocations on any particular transaction or transactions between WBB and its subsidiaries such as payment of salaries advertising expenses, or transfers of inventory. He suggested on brief that certain transactions failed to satisfy the arm's-length standard. His deficiency determination and conduct at trial, however, focused on whether the subsidiaries were formed and operated as separate taxable entities and as separate business enterprises. Petitioner WBB also sees the issues in these terms rather than in terms of specific transactions.
Thus, we shall follow the approach of Hamburgers York Road, Inc., supra, and ask whether petitioners established that respondent was arbitrary, capricious, or unreasonable in his determination which in effect is that, if WBB and its subsidiaries had dealt at arm's length as uncontrolled corporations, WBB would have required all profits of the subsidiaries to be turned over to it. Necessarily we shall examine the nature of the dealings between WBB and its subsidiaries.
"Common control, however, is not the end of the matter; for, as we stated in Ballentine Motor Co., supra, 'taxpayers owned or controlled by the same interests may enter into transactions inter se and if fair, or resulting from arm's length bargaining, such transactions will be undisturbed.' 39 T.C. at 357. Accordingly, if the respondent is to prevail on this issue in the instant case, it must still be found that Hamburger Sons in the conduct of its affairs vis-a-vis York Road and in the transactions which it had with the latter corporation, did not deal with York Road at arm's length, as one uncontrolled corporation would have dealt with another uncontrolled corporation. In the light of the respondent's determination that all taxable income (actually, the equivalent of net profit) of York Road is to be included in the income of Hamburger Sons, our more specific question becomes this: Have the petitioners established that the respondent was arbitrary, capricious, or unreasonable in his determination that if Hamburger Sons and York Road had been dealing at arm's length as uncontrolled organizations, Hamburger Sons would have required that all profits of York Road be turned over to it?" [ Hamburgers York Road, Inc., 41 T.C. at 835.]
This approach appears to be contemplated by the above-cited regulations and is indicated by comments of the Senate Committee on Finance in recommending the provisions for a corporate surtax exemption of $25,000 in the Revenue Act of 1950:
S. Rept. No. 2375, 81st Cong., 2d Sess. (1950), 1950-2 C.B. 533-534. See Dorba Homes, Inc., T.C. Memo 1967-150, partially reversed on other grounds, 403 F.2d 502 (C.A. 2, 1968), which indicates that this approach does not automatically lead to upholding a reallocation under sec. 482 but rather calls for a review of the facts of each case.
The normal tax rate is made applicable to the entire normal tax net income of all corporations; the surtax rate applies to the corporation surtax net income in excess of $25,000. Under this plan, the so-called notch provisions are eliminated. It is not intended, however, that the exemption of the first $25,000 of a corporation's surtax net income from the surtax shall be abused by the splitting up, directly or indirectly of a business enterprise into two or more corporations or the forming of two or more corporations to carry on an integrated business enterprise. It is believed that sections 45 [ now 482] and 129 [ now 269] will prevent this form of tax avoidance. [Emphasis supplied.]
Applying the above principles to the record before us, we uphold the Commissioner's determination based upon section 482. As explained below, we conclude there was a single, integrated, restaurant operation conducted and controlled by WBB through an arrangement which does not appear to have been equivalent to what would have been made had the parties dealt at arm's length.
The framework of the business was the franchise contract between WBB and its licensors, California Big Boy and Enterprises. This contract controlled the principal product to be sold and reserved the right to designate other products, and the trademarks and incidental designs, menus, recipes and formulas to be used in connection with the merchandising of food products.
The contract provided for operating procedures including requirements that WBB, as licensee, use its "best efforts" in merchandising Big Boy food products; maintain and make available to the licensors full and accurate records of sales; carry certain minimum amounts of products liability insurance; comply with all rules and regulations attached to the contract and all reasonable rules and regulations established later; join and maintain membership in local and national restaurant associations; and obtain the highest health, sanitation, and quality classification available from the appropriate governmental authority.
The franchise contract contemplated that WBB might conduct its restaurant operations through subsidiary corporations since it provided that only where WBB or "persons in control" of WBB owned the majority of the voting stock of the corporate subfranchisee was the consent of California Big Boy not required in order to grant a subfranchise. Additionally, WBB obligated itself to see that the terms and conditions imposed on it by the franchise contract were passed onto and observed by all of its subfranchisees. In the subfranchise contracts WBB formally passed on these terms and conditions to its wholly owned restaurant subsidiaries.
The subfranchise contracts were patterned after and worded substantially the same as the franchise contract, except for certain important particulars discussed below. The effect of passing on the terms and conditions of the franchise contract was to define for the restaurants: The products to be merchandised; the menus, recipes, formulas, trademarks, and designs to be used in the marketing process; and the services to be provided to each restaurant in order to commence operations, including the selection of a location, traffic planning and ground layout, training personnel, planning and developing and promoting the restaurant business and Big Boy products, and "the establishment of systems of operation, including accounting and commissary operations." In short, under the packaged deal provided in these contracts, about all WBB, Marcus, and Kilburg needed in order to open a restaurant was to provide personnel and capital and sources of supplies and foodstuffs to implement the grand design of the licensors. They could call on the licensors for the initial push.
As it developed WBB and its subsidiaries sought the help of the licensors in setting up each restaurant and in training personnel. Thus, except for financing, locating restaurants, and arranging leases, the terms and conditions of the franchise contract set the policies and operating procedures of the restaurants owned by WBB.
Integration of WBB and its restaurants was also maintained in the procedures for arranging locations, leases, and financing not because of requirements of the franchise and subfranchise contracts but because Marcus and Kilburg were the common denominators in these areas. Kilburg and Marcus personally chose each restaurant location, after initially calling on Wian's assistance in choosing the first location.
Marcus had the responsibility for obtaining financing and leases. He personally guaranteed the 10 bank loans, 9 of which were with the same bank. He testified that his own reputation was an important factor in obtaining credit for the various corporations. Two restaurants, one of which came into existence before WBB, were required to make security deposits which came from the initial capital obtained by Marcus. WBB was the original lessee for all but three restaurants and Bon Host because, according to Marcus, the lessors and mortgagees wanted WBB to be primarily liable rather than the corporate restaurant operator. This indicates that lessors and mortgagees depended upon WBB's reputation and financial ability rather than that of WBB's subsidiaries. Marcus acted for the lessors as president in three instances, and regarding another lease, was associated with the lessor and the persons acting for the lessor.
The leases under which Layton and Green Bay operated required WBB, as lessee, to conduct "restaurant business similar to the business conducted by Lessee in Marc's Big Boys in the Milwaukee, Wisconsin, area." (Emphasis supplied.) Although other leases in evidence do not contain equivalent language, this language, appearing in these two 1963 leases, clearly indicates that WBB was the moving force behind the various Marc's Big Boy restaurants in Milwaukee and was viewed as such by WBB and these two lessors. Under these circumstances it is quite reasonable to assume that the dominant control of the corporations by Marcus through WBB was the factor which determined the structure of most of the lease transactions. By the same token respondent was not unreasonable in recognizing that this dependence on Marcus and WBB was an additional aspect tending to indicate the integration of the business.
We turn next to the manner in which business was conducted. The framework is set out in the portion of the subfranchise contract dealing with the services to be furnished by WBB. This contract contemplated more than merely opening a restaurant and commencing operation. It also embraced the close administration and supervision of the business on a constant and continuing basis. It provided that WBB would —
furnish from time to time * * * administrative counseling and advisory services and suggestions in planning, developing and promoting the restaurant business of the sublicensees and the sale of "BIG BOY" products, including specifically, advice, counsel and suggestions relating to the following: Menu planning and printing; recipes; selection of restaurant location; building plans; traffic planning and ground layout; advertising plans; specifications and use of trade symbols and promotional materials; business promotions and operation; pricing; employee training; and the establishment of systems of operation, including accounting and commissary operations. WISCONSIN BIG BOY shall administer for the sublicensee the recruitment, selection and training of personnel and shall maintain a complete supervisory staff, and shall perform bookkeeping and accounting services for sublicensee. * * *
Our conclusion that the apparent intent of this language was to impose comprehensive supervision and management by WBB upon its subsidiaries is borne out by WBB's subsequent conduct.
Marcus testified that he intended to use WBB for purposes of managing the restaurants so as to insulate himself from direct ownership. An aspect of this comprehensive management is the bookkeeping and accounting functions performed by WBB at the behest of Marcus. WBB kept separate books and records for each corporation which, of course, would be necessary to a significant extent for several purposes, including the establishment of the amount of rentals contingent upon gross sales, whether or not separate corporations were involved. See Hamburgers York Road, Inc., supra at 838. The address on each of the income tax returns of the subsidiaries was that of WBB. WBB itself paid bills sent to its subsidiaries, the expenses were allocated and charged to each of the subsidiaries according to the portion incurred by each. Checks were written in the name of each subsidiary on its respective checking account to reimburse WBB for these outlays and to meet other expenses generated by its particular activities. The checks, however, could be signed only by Marcus or his son, Steve, or one other WBB employee named Lowe. Restaurant managers had no authority to write checks. Each restaurant manager sent WBB its payroll time records and statements of the amount of inventory acquired so that WBB could make the appropriate payments out of each restaurant's account. The managers also made daily bank deposits and daily reports of receipts to WBB.
Thus, it appears that both the determination of financial and accounting policies and the implementation of these policies occurred in the personage of Marcus and the corporate form of WBB, and these activities of the subsidiary corporations were completely integrated through WBB.
Marcus had the power and responsibility to determine the basis on which salaries of officers for all the corporations were allocated. During the years in issue, however, only WBB reported that it paid any salary to an officer. The other corporations here involved did not report on their returns that any salaries were paid to officers. WBB paid a salary only to Kilburg who was listed as devoting full time to WBB even though he was an officer of each of the other corporations and supervised their activities. The reason for not paying salaries to any of the other officers and for allocating all of Kilburg's salary to WBB was not otherwise explained. These circumstances give rise to a reasonable inference that Kilburg managed his sphere of the business through WBB. And, further, they do not negate the likelihood that the other officers, and particularly Ben Marcus, performed services for all the corporations as representatives of WBB. In fact, it seems probable that the officers themselves regarded the corporations as facets of a single enterprise when the circumstances of this case are viewed in toto.
Likewise, the manner of recruiting and supervising restaurant personnel and the subordinated functions of the restaurant managers are circumstances indicating that the corporations should be viewed as a single enterprise. It appears that WBB exercised the complete control over the recruitment and selection of restaurant personnel as contemplated by the subfranchise contract. WBB employed persons for training managerial personnel also.
Many other aspects of the operations, while again not determinative in themselves, give them a factual context smacking of an integrated business.
The help-wanted advertisements were stated in terms of what the Marc's Big Boy restaurant "chain" could offer applicants. For example, manager cooks were offered accelerated training eventually leading to full-fledged restaurant manager positions at $8,000 to $10,000 per year plus benefits including the possibility of becoming a "franchised partner." Another ad stated that there was a "policy to promote from within." The wording and tone of these advertisements were not that of separate enterprises.
Insurance benefits were provided by means of master policies, and a single pension plan covered all the subsidiaries in issue except Specialty Products. The pension plan contemplated membership by corporations or organizations "affiliated with the Marc's Big Boy organization." The tone and terms of the pension plan contemplated treatment of Marc's Big Boy employees on a uniform basis the same as they would have been had they all been employed by the same single enterprise.
While the restaurant managers performed a large number of functions, some of which may have involved their personal judgment and discretion, they were clearly subordinate to Kilburg, the division manager and WBB's three district managers, whom Kilburg referred to as "graduate managers." The restaurant managers only supervised the daily flow of food products and the conduct of their staffs in their respective stores. They in turn were completely subject to the control and supervision of WBB and the terms and conditions imposed upon them by the franchise contract as passed on by WBB in the subfranchise contract.
Although WBB had been in business only a short time, it possessed the reputation, goodwill, resources, skills, and experience of Marcus and Kilburg and of its licensors by virtue of its franchise contract. WBB had the essential franchise and, in most cases, leasehold rights; it provided the essential experience and financial resources; and it furnished coordination and cohesion through the essential management, supervisory, and administrative services. These attributes were important and substantial factors in the operation of the restaurant business, and make this case similar to others in which like factors helped induce us to hold for respondent. Charles Town, Inc. v. Commissioner, 372 F.2d 415, 419-421 (C.A. 4, 1967), affirming a Memorandum Opinion of this Court, certiorari denied 389 U.S. 841 (1967); Spicer Theatre, Inc., 44 T.C. 198, 207 (1964), affd. 346 F.2d 704 (C.A. 6, 1965); Hamburgers York Road, Inc., supra at 837. Cf. Pauline W. Ach, supra; Local Finance Corp., 48 T.C. 773 (1967), affd. 407 F.2d 629 (C.A. 7, 1969). Even though the operations at different locations were separately incorporated, WBB conducted its affairs and those of its subsidiaries as a single integrated business enterprise in every important respect.
We cannot see how the business would have been conducted any differently had WBB not insulated itself from them by means of a separate corporation. Consequently there is no reason for holding that the Commissioner's reallocations to WBB were arbitrary unless WBB has shown that it was properly compensated for its services.
Several cases have reached similar conclusions on similar facts. In Hamburgers York Road, Inc., supra at 837, we said:
Notwithstanding the foregoing facts and circumstances, petitioners here contend that the net profits of York Road should be fixed by charging against the sales of that store only the net current operating cost of such store, without any consideration being given to the above-mentioned factors of goodwill, trade name, experienced buying and selling organizations, customer lists, and advertising format which Hamburger Sons furnished for the use of York Road. We are confident that Hamburger Sons would not have permitted such an arrangement, if it had dealt with York Road at arm's length. For such use of its business organization and assets, Hamburger Sons would, we believe, have claimed for itself the profits in their entirety of the York Road segment of the integrated business.
Likewise, in Spicer Theatre, Inc., supra at 207, we recognized that —
It was Spicer's reputation and capital that had made these operations profitable, Spicer's facilities were used, and these facilities were operated with Spicer's personnel except that for purposes of reporting to Governmental agencies the employees were listed as being those of Copley. * * * The anticipated profits generated by Spicer's reputation and effort, when projected over the reasonably short term of the lease, properly can be primarily attributed to the activities of Spicer and not Copley. * * *
Again, in Charles Town, Inc., supra at 421, the Court of Appeals affirmed this Court's finding that Charles Town had done "all things necessary to earn the income in question" by operating the two racing meets. Charles Town was a party to the lease, obtained racing licenses in its name, hired and paid the necessary employees, entered into contracts for materials and services, acquired membership in a racing association, elected participation in the West Virginia Workmen's Compensation Plan and filed various State and Federal information tax returns. The Court of Appeals held that these circumstances supported the essentially factual determination of this Court. Local Finance Corporation v. Commissioner, 407 F.2d 629 (C.A. 7, 1969), affirming 48 T.C. 773 (1967), and Pauline W. Ach, supra, are also cases in which the essential services were performed by the petitioner to whom the income was successfully allocated despite the existence of separate corporate entities. Compare Philipp Bros. Chemicals, Inc. ( MD), 52 T.C. 240 (1969), where we refused to permit the reallocation from the domestic sales corporations stating "We have no reason to conclude that these functions [bookkeeping and traffic] were other than purely routine or that 'New York' played any significant part in generating the business of 'Massachusetts.' " We found that all the domestic sales corporations adequately compensated "New York" for its routine services.
The flow of revenues from the subsidiaries to WBB and then to the licensors gives WBB's alleged position an unrealistic glow in view of the extensive control and management reposed in and exercised by WBB. According to the subfranchise contract WBB obtained its revenues from three sources: Franchise or license fees, payments for materials furnished, and administration or management fees. The franchise contract provided that WBB would receive certain materials from the licensors without profit to them; in turn, the sublicense contract provided that WBB would furnish these materials to its subfranchisees without profit to WBB. WBB was obligated, under the franchise contract, to pay the licensors 1 percent of gross sales as a license fee; using the same definition of gross sales the subfranchise contract provided that the sublicensees would pay WBB 1 percent of gross sales as a subfranchise fee. Thus, on two items that one might expect an independent, arm's-length sublicensor to earn profits there could be none because WBB was obligated to pay out all that it was entitled to receive.
WBB's profits of $21,479, $30,827.38, and $22,430.40 in 1963, 1964, and 1965, respectively, must then have come from management and administration fees. Marcus testified that he and Kilburg based WBB's fee for administration and management on gross sales of the restaurant so as to allow WBB "a small profit." There is nothing else to indicate why they arrived at the particular formula. Nor does the testimony in footnote 14, supra, indicate the nature of their investigation or the basis of comparison with other businesses in the industry.
The following is taken from the transcript of the respondent's cross examination of Ben Marcus:
"Q. Who determined the franchise fee that would be charged? I mean, who determined this management fee that would be charged?
"A. I think Mr. Kilburg and I sat down and reviewed our costs of administration and management and figured the — probably a small profit for the supervision.
"Q. Was that fee suggested to you by California?
"A. Well, we checked to see as to what the — generally is being charged in the industry, and there was no set fee. It ranged all the way from two percent to five percent, I think it is.
"Q. Of gross sales?
"A. Of gross sales."
There was no other evidence relating to the basis for the fee nor to the nature of services provided by others in the industry so as to permit comparisons.
The subfranchise contract provided that the sublicensees would pay WBB an administration fee at the end of each 4-week period. The fee was set at 3 percent of gross sales; but if gross sales for each 52-week period failed to exceed $400,000, the fee would be 2 percent. Furthermore, if the pretax net profit of a sublicensee were less than $1,000 during each 52-week period of operation, no administration fee would be charged. This formula does not appear to have enhanced the trend of WBB's gross receipts and profits for the years in issue despite the increase in gross receipts of the restaurants from $2,755,292.81 in 1963 to $4,918,457.82 in 1965.
Such a fee structure between a parent corporation and its subsidiaries must be scrutinized closely whenever it is questioned and there is a presumption that it is inadequate attaching to the Commissioner's reallocation under section 482. The fee structure used by WBB permits a reasonable inference that it was a means for shifting or splitting income so as to avail WBB and its shareholders of the possible tax advantages of maintaining several corporations. Most significant, WBB has not tried to show that its fee structure is the equivalent of an arm's-length result or that it adequately, fairly, or reasonably compensated for the extensive services, resources, and rights provided by WBB to the subsidiaries. In view of WBB's pervasive and complete management and control of its subsidiaries, we feel that a sound explanation is necessary to avoid the conclusion that WBB's reported earnings were substantially less than they should have been; we will not resort to speculation in deciding whether the Commissioner was arbitrary in determining, in effect, that WBB failed to require proper compensation. See Grenada Industries, Inc., supra at 258-259, where we said:
We need not deal with the question of whether these standards are different, and, if so, which one is applicable herein. See Frank v. International Canadian Corporation, 308 F.2d 520, 528-529 (C.A. 9, 1962), and cases cited therein; Eli Lilly Co. v. United States, 372 F.2d 990, 999-1000 (Ct.Cl. 1967).
To the extent that the arrangement between Hosiery and Industries resulted in a larger concentration of profits in the hands of Hosiery, to the detriment of Industries, this case presents a typical situation for the application of section 45 [now 482].
* * * * * * *
In any event, the burden was on Industries to prove the value of the services Hosiery rendered, and it has provided no more convincing evidence of that value than the salaries in question. Petitioners insist that once they have shown application of section 45 and the allocations thereunder to be arbitrary, the burden shifted to respondent to prove a proper allocation. While there may be doubt as to the validity of this contention, we need not consider it, because we do not believe that Industries can establish that the allocation of Hosiery's income made to it by respondent was arbitrary without showing the value of the services it received from Hosiery. [Emphasis supplied.]
Petitioner's contention that respondent did not put the fee structure in issue is not well taken. It is true that there are no specific transactions in issue. Rather it is the entire course of dealing between WBB and its subsidiaries, and the fee structure on which the dealings were based, which are relevant. The deficiency notice cited section 482 in reallocating the income to WBB ( Ballentine Motor Co, 39 T.C. at 358), and its petition (see par. 5) amply demonstrates that it recognized that the issue based on section 482 necessarily involved the nature of the relationship between WBB and the other corporations. See also Nat Harrison Associates, Inc, 42 T.C. 601, 617 (1964), acq. 1965-2 C.B. 5. Obvious aspects of that relationship were the financial arrangements. The regulations and previous case law also indicate the relevance of the fee structure.
What we have said regarding the integrated operation of the restaurants seems to be substantially true for Bon Host and Specialty Products also except that they were not specifically governed by the franchise and subfranchise agreements, although such agreements to which WBB was a party contemplated commissary operations. Bon Host and Specialty Products were, however, set up to serve only the restaurants which were subject to the subfranchise agreements and they dealt with no one else insofar as we can determine. The record does not indicate that WBB treated them any differently than it treated the restaurants. They both reported administration expenses on their tax returns.
It is interesting and helpful to note that Bon Host's 1963 pretax net income of $22,945.02 on sales of $115,944.72 did not increase greatly, in relation to the increase in sales, for 1964 and 1965. Even though gross sales in those jumped to $494,332.71 and $553,436.51, respectively, pretax net income was $31,329.74 and $34,125.84, respectively. In view of the control relationships here involved, these figures lend some support to an inference that WBB artifically shifted income with respect to Bon Host.
The same might be said of Specialty Products which reported pretax net income of $9,116.53 on sales of only $38,325.26 in its first year of operation in 1965. This relatively large return on such relatively small gross sales in 1965, a year in which 7 out of the 10 restaurants here involved had gross sales of over $400,000, and the fact that Specialty Products does not seem to have existed except on paper (as discussed below) tends to render incredible Marcus' uncorroborated testimony that a separate entity was necessary in order to obtain broker's discounts on large volume purchases of potatoes. Moreover, Specialty Products had no employees and no equipment nor is any place of actual operations revealed in the record. The absence of these factors are particularly unusual since Marcus testified that Specialty Products purchased millions of pounds of potatoes, processed them, and sold them to the restaurants.
We were not referred to any law or regulation or other source supporting this testimony. Moreover, such a statute or regulation would not be determinative even if in existence. Local Finance Corp., 48 T.C. at 793-794, and 407 F.2d at 633.
Also, it does not appear that Specialty Products reported figures on its income tax return relating to the processing or distributing of potatoes, nor that it borrowed funds, leased property, or adopted a pension plan. Under all these circumstances it was obviously a sham. Moline Properties v. Commissioner, 319 U.S. 436 (1943); National Carbide Corp. v. Commissioner, 336 U.S. 422 (1949); Aldon Homes, Inc., 33 T.C. 582 (1959).
We need not discuss the sham theory in regard to the other subsidiaries because of our holding under sec. 482. We think that they were not shams under the tests posed by the cases just cited as the facts of this case amply demonstrate.
Further, WBB provided the same bookkeeping and administrative services for Specialty Products and Bon Host as were performed for the restaurants. Since they also were wholly owned by WBB and had the same officers as the restaurants, we think it a fair inference that they were operated as part of the enterprise by WBB in the same dominant manner as the restaurants, with due allowance for the difference in functions.
We hold that the record sustains the Commissioner's determination that WBB generated the income for the years in issue by conducting an integrated business enterprise through its divisions set up as wholly owned subsidiary corporations. We do not impinge upon the limits of those cases holding in favor of the taxpayers where there is a significantly lesser degree of integration of operations. Bush Hog Manufacturing Co., supra; V. H. Monette Co., supra. We are moved primarily by the fact that complete policy-making authority and management control was actually exercised by WBB and by Marcus and Kilburg acting through WBB and by the lack of showing of proper compensation for WBB by the subsidiaries. We conclude that WBB should be charged with earning the income of the controlled corporations in order to prevent distortion of its income. Pauline W. Ach, supra; Hamburgers York Road, Inc., supra.
While there are many factual parallels between Bush Hog Manufacturing Co., supra, and WBB's situation, we note that in that case the subsidiary sales companies paid Manufacturing at least as much for the machinery as would an unrelated distributor and, except for relatively minor sums attributable to compensation of officers, the management fee appears to have been reasonable, there being no evidence that the fee was inadequate. Moreover, respondent's theory that Manufacturing actually earned the income reported by the sales companies rested solely upon a realignment of sales territories upon the formation of new sales companies and a subsequent drop in the income of old sales companies. As petitioner's brief herein recognizes, at page 42, we held that such fact failed to support respondent's determination because —
He [the Commissioner] has not determined that the income and deductions of the new sales companies should be allocated to the old sales companies but rather that the income and deductions of all the sales companies, including the two original ones, should be allocated to Manufacturing. * * * [ Id. at 725]
Respondent's theory under section 482 herein rests upon the nature and extent of the services performed by WBB.
Likewise, there are important dissimilarities with V. H. Monette Co., supra, wherein respondent's —
principal contention for the application of section 482 is that deductions were arbitrarily allocated among the several corporations so that each corporation's net income would fall just under the $25,000 surtax exemption allowed by section 11(c). * * * [ Id. at 36-37]
There again we were unable to find facts supporting respondent's contention. The basis for the Commissioner's reallocation of the keyman's salary was unjustified. Id. at 37. Further, significant operative authority was reposed in and exercised by the various corporations.
The facts in Chelsea Products, Inc., 16 T.C. 840 (1951), affd. 197 F.2d 620 (C.A. 3, 1952), were similar to those at hand. A majority of this Court, however, held that the predecessor to section 482 was not applicable because —
the Commissioner has not distributed, apportioned or allocated gross income, deductions, credits, or allowances between or among such trades or businesses as contemplated by the statute where section 45 is to be applied. On the contrary respondent has "combined" the "net" income of the sales companies with the "net" income of petitioner. Section 45 does not grant such authority to respondent. * * * [ Id. at 851]
Four of the five dissenters felt that section 45 was applicable and that "Petitioner has failed to prove that it received fair value, or that its subsidiaries performed any valuable function." Id. at 853.
In Ballentine Motor Co., supra, fn. 10 at 359, we distinguished Chelsea Products on the ground that the reallocation was based on the theory of disregarding the corporate existence of the three corporations which theory was previously rejected outright because of the principles of Moline Properties v. Commissioner, fn. 17, supra, and National Carbide Corp. v. Commissioner, fn. 17, supra. We need not deal with the Commissioner's tactics in Chelsea Products because he followed the literal language of the statute in making the reallocation of gross income and deductions to WBB. Moreover, see Philipp Bros. Chemicals, Inc. ( MD), 52 T.C. at 251, where we state that the allocation of net income is now proper.
W. Braun Co. v. Commissioner, 396 F.2d 264 (C.A. 2, 1968), reversing a Memorandum Opinion of this Court, based the reversal on a finding that the Lanolin Plus account was transferred to the subsidiary for sound business reasons and that the parent was adequately compensated.
Some of the cases involving section 482 discuss whether there was a proper business purpose for multiple incorporations. Discussions of the purpose of or reason for the transaction are helpful in explaining what was done, but neither tax motivation nor lack of business purpose is necessary to a finding of distortion if the transaction has the effect of distorting income in situations contemplated by section 482.
See Borge v. Commissioner, 405 F.2d 673 (C.A. 2, 1968), affirming a Memorandum Opinion of this Court; Spicer Theater, Inc., 44 T.C. at 206-207; Pauline W. Ach, 42 T.C. 114; Bush Hog Manufacturing Co., 42 T.C. 713; and V. H. Monette Co., 45 T.C. 15.
Philipp Bros. Chemicals, Inc. ( MD), supra at 251; Local Finance Corp., supra; Simon J. Murphy Co., 22 T.C. 1341, 1343 (1954), reversed on other grounds 231 F.2d 639 (C.A. 6, 1956); Eli Lilly Co. v. United States, supra at 999; Dillard-Waltermire, Inc. v. Campbell, 255 F.2d 433, 436 (C.A. 5, 1958).
We recognize that in some cases a partial allocation may be appropriate. Pauline W. Ach, supra; Nat Harrison Associates, Inc., supra at 617-623. Our decision, however, is that the Commissioner was not unreasonable or arbitrary in allocating all the income to WBB. Furthermore, this approach is consistent with the approach of the parties as to the issue involved, and the record affords little or no rational basis for making a partial allocation based upon our guess of what fee should have been charged by WBB.
Cf. Helvering v. Taylor, 293 U.S. 507 (1935); Burnet v. Houston, 283 U.S. 223 (1931); C. L. Nichols, 43 T.C. 135 (1964).
Having upheld the deficiencies assessed against WBB, there is no need to reach the issues posed by the deficiencies alternatively assessed against the other petitioners.
Decision will be entered for the respondent in docket No. 305-67.
Decisions will be entered under Rule 50 in all other dockets.