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138 C. Cls. Opinion of the Court tiff on this point was not refuted by the defendant, it is held that plaintiff's proof is insufficient to justify a holding that the payments were reasonable compensation. To reach a conclusion that the distributions were increased compensation it would have to be shown that the employees holding the greatest number of shares rendered the most valuable service to the company. This was not proved in the instant case nor was it shown that other employees, who purchased no shares, con

tributed nothing to the profits of the company. Internal Revenue 2166 Same; employees of subsidiary company.—Plaintiff's payments to em

ployees of its subsidiary company are not deductible for tax purposes. The board of directors of one corporation is without

authority to compensate the employees of another company. Internal Revenue - 550

Mr. Marion N. Fisher for the plaintiff. Mr. Leon L. Rice, Jr., Mr. W. P. Sandridge, Mr. Philip C. Potter, Jr., Messrs. Davis, Polk, Wardwell, Sunderland & Kiendl, and Messrs. Womble, Carlyle, Sandridge & Rice were on the briefs.

Mr. Homer R. Miller, with whom was Mr. Assistant Attorney General Charles K. Rice, for the defendant. Mr. Andrew D. Sharpe and Mr. Thomas Hogan were on the brief.

LARAMORE, Judge, delivered the opinion of the court:

This action is brought to recover income and excess profits taxes allegedly improperly assessed against plaintiff for the years 1940 to 1948, inclusive, in the amount of $8,352,851.83, plus interest. • The issue in the case is whether certain payments made by the plaintiff to its employees pursuant to a company bylaw passed in 1912 and paid proportionate to the employees' stockholdings in the company constitute compensation and are, therefore, deductible in arriving at taxable income. If the payments are considered compensation, they are deductible to the extent reasonable pursuant to section 23(a)(1)(A) of the Internal Revenue Code of 1939. If the payments are not considered compensation, the question is whether the payments are otherwise ordinary and necessary expenses of the business. If not, they repre

1 Subsequent to the Aling of the suit with this court the plaintiff has conceded that $1,320,697.90 of previously claimed deductions are improper. The claim for refund is, therefore, altered to the extent that that amount would affect the overall tax liability.

Opinion of the Court sent distributions of capital and are disallowable expenses in arriving at taxable income.

There is also the subsidiary question as to the nature of payments purportedly made pursuant to the above mentioned bylaw by plaintiff to the employees of a wholly owned subsidiary, the Glenn Tobacco Company. This will be discussed separately later in the opinion.

The Commissioner of Internal Revenue disallowed all of the above payments as deductions for tax purposes contending that they were preferential dividends. The defendant before this court reiterates the Commissioner's position contending that no part of the payments are deductible. Defendant argues that the purpose of the bylaw was to encourage the employees to acquire a proprietary interest in the company and thereby acquire voting control. Such a purpose, it contends, would necessarily defeat the alleged compensatory nature of the payments. Defendant also points to the historical treatment of the bylaw payments by the plaintiff on its books and tax returns as dividends as establishing that the payments are dividends and argues that on the basis of equitable estoppel it cannot now assert that the payments were compensatory in nature.

Plaintiff alleges that all sums of money paid pursuant to the bylaw, with the exception of certain sums now conceded by it to have been excessive, were compensation to the employees for services rendered. Plaintiff supports its contention by alleging that the purpose of the bylaw payment plan was to create incentive in the employees and to cause them to work harder for the company. The necessary result would be, it contends, that any amounts paid would be for services rendered, hence, deductible in arriving at taxable income.

Plaintiff also contends that payments made by it, allegedly pursuant to the bylaw, to the employees of its subsidiary are part of its cost of goods sold arguing that since the entire function of that subsidiary was to purchase foreign leaf tobaccos for it, any payments made to the employees of the company are a necessary element of the cost of the goods acquired by that company for the plaintiff.

138 C. Cls. Opinion of the Court The pertinent facts of the case may be stated as follows: On August 23, 1912, the plaintiff corporation passed a bylaw providing for a distribution of the company's annual profits in excess of a base figure computed at 22.19 percent of the outstanding common stock in an amount up to but not exceeding 10 percent of the profits in excess of such base figure. The distribution was to be to employees who had been in plaintiff's employ and held its stock for not less than 12 months with the distribution to be in proportion to the stockholdings of the employee. The bylaw was amended in 1915, the amendment permitting stock purchased from another officer or employee or from the personal representative of a deceased officer or employee to participate if the stock so purchased would have entitled the former owner to participate had it been held for the entire 12month period. The bylaw was not substantially changed thereafter until 1949 and is the same bylaw that was in effect during the period in question, 1940 through 1948.? From 1912 through 1948 the plaintiff had an unbroken record of paying dividends on all of its outstanding stock. It likewise made distributions under the above bylaw every year through 1948, and thereafter, to the eligible employees.

Since 1922, when the Glenn Tobacco Company, a wholly owned subsidiary of plaintiff, was organized, the employees of that company who owned common stock of plaintiff have participated under the bylaw notwithstanding the fact that the bylaw makes no reference to them. The Glenn Company was engaged exclusively in the purchase of leaf tobacco in foreign countries for plaintiff and filed separate income tax returns. Plaintiff furnished it with all funds on open account to cover all the expenses and costs of acquiring foreign leaf tobaccos during the years in question.

It was plaintiff's intention when the bylaw profit distribution plan was set up in 1912 that it would provide its employees with a greater incentive, the feeling being that they would be more likely to take the company to heart if they owned stock in it.

* For the substance of the changes in the bylaw by the 1949 amendment, see finding 71.

1

Opinion of the Court As originally planned, the plaintiff wanted only those employees "who had the interest of the company at heart” to participate and did not want any one employee to acquire an excessive amount of stock in relation to his value to the company and the job performed. The plan was supervised by a company committee with this in mind. It was the desire of plaintiff that the participating stock should not be acquired without company approval, but there was no corporate resolution concerning the manner or method under which acquisition could or would be made and no express directions to employees as to the amount of stock which they could acquire. The view of management that it should approve common stock acquisitions by employees was passed by word of mouth on an informal basis. Those employees could purchase the stock if they felt financially able and thereby share in subsequent distributions under the bylaw. Plaintiff's founder, R. J. Reynolds, in the early years of the plan, financed many purchases of the plaintiff's employees. Up until 1933, plaintiff itself extended substantial credit to its employees for the purchase of its stock; however, the loans by the company were restricted in amount to the book value of the stock and the stock was held as collateral. Until 1935, when Security Exchange Commission sanctions prohibited it, plaintiff bought its own stock for resale to its employees. The purchases were made from various sources, including nonemployee stockholders and officers or other employees upon their death or resignation.

Over the years, however, two imperfections developed in the plan. Some employees acquired too much stock and others did not acquire as much as was considered appropriate to the extent that their positions and records would have entitled them in the management's view. Employees sometimes acquired the eligible stock by gift, exchange, inheritance, purchase from other employees and holders of the stock, or purchase on the Stock Exchange, without advance notice to the company. Sometimes excessive stock ownership came about as a result of the company having encouraged ownership by an individual whose prospects of future value to the company were misjudged.

138 C. Cls. Opinion of the Court However, no employees were ever discharged for acquiring too much stock. Plaintiff's management felt that these imperfections in the practical operation of their plan did not affect the overall success of the plan through the years and, in fact, credited the plan as being a large factor in the growth of the company from the smallest of the four principal tobacco companies in 1912 to the second largest and with a proportionate increase in size since 1912 greater than any of the other companies. During the period in question, 1940 through 1948, plaintiff had a higher ratio of earnings to sales and of earnings to equity than did the others.

Fixed salaries and hourly wages paid to plaintiff's employees on the levels below directors, officers, and junior officers, and other key employees, were at the going rate in the community. Salaried employees did not have fixed salaries larger than comparable positions in the next four or five largest companies in Winston-Salem, North Carolina, the location of plaintiff's plant, and in the view of the employees themselves, the salaries were in many cases lower. The fixed salaries paid by plaintiff to its buyers and salesmen were low in comparison to competitors'. These two groups were particularly encouraged to invest in the stock and the large majority of them did so and thereby increased their total income.

There was no evidence relating to the duties of the various individual officers and directors, or the responsibilities of each, or the amounts the individual officers and directors of the other companies received as compensation. There was no evidence introduced by plaintiff as to the reasonableness of the payments made to the other employees other than the testimony of four of the plaintiff's executives to the extent that they completely reviewed the records of all the participating employees for the years in question and determined that all bylaw payments to them were reasonable with the exception of certain sums conceded to have constituted unreasonable compensation for the services performed. In arriving at this determination of reasonableness, plaintiff's executives took into consideration the employee's fixed salary and bylaw payments in relation to his ability,

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