1 Opinion of the Court performance in the job, responsibility, length of service, and prospective value to the company. No evidence as to the total compensation paid to employees in like jobs in similar companies was introduced, and no such comparison was attempted. The defendant did not introduce any evidence tending to prove unreasonableness of the payments if considered compensation, nor did it attempt to refute the above testimony of reasonableness of the payments with the conceded exceptions. The defendant steadfastly maintained that the payments were preferential dividends. There is little doubt that plaintiff's purchasing, sales, and management personnel were highly efficient, as studies by a competitor disclosed that plaintiff often bought its tobacco at the auction markets very close to the "floor" price, and that plaintiff's cost of manufacturing cigarettes was from three to five cents lower per thousand than that of its competitors. Testimony by the former president of this competitor, the Brown & Williamson Tobacco Corporation, indicated that the fixed salaries paid to plaintiff's sales and purchasing personnel were low in comparison to other companies. The refunds sought in this suit were initially requested on March 13, 1950, when plaintiff filed with the Commissioner of Internal Revenue claims for refund, those claims being filed only after a determination by the Deputy Commissioner of Internal Revenue, on December 28, 1949, pursuant to a written request by plaintiff, that payments made by it pursuant to its 1949 amended bylaw would constitute compensation for personal services rendered and, therefore, would be deductible to the extent reasonable. The above ruling, however, was revoked by letter to plaintiff on November 13, 1951, on the ground that the changes in the bylaw effected by the 1949 amendment "were not material to the question presented." The claims for refund were thus denied on July 9, 1952, pursuant to the 1951 letter revoking the 1949 ruling. 'The "floor" price represents that price placed on the various grades of tobacco plus one cent. To illustrate, if the government grader has placed a price of 40 cents on a particular grade, unless that tobacco is bid in at 41 cents, it reverts to the Government pool and the Government pays the farmer. Opinion of the Court 138 C. Cls. The plaintiff claims refunds of income and excess-profits taxes for certain years which would result by the deduction from income of certain profit-sharing dividends paid to employees who owned shares of the corporation. The plaintiff contends that such dividends were, in effect, additional compensation to employees. At the outset we must determine whether the sums paid under the bylaw are reasonable compensation or some sort of preferential dividend, for any payment made by an employer to its employees, to be deductible as compensation, must have been paid for services actually rendered. William S. Gray & Co. v. United States, 68 C. Cls. 480; Woodcliff Silk Mills v. Commissioner, 1 B. T. A. 715. To determine whether the payments in the case at bar were compensation or dividends, we must look to the bylaw under which the payments were made, and its history, together with the section of the Internal Revenue Code of 1939 under which plaintiff claims relief. The bylaw proposed by the board of directors and adopted on August 23, 1912, provided as follows: Participation by Officers and Employees in Certain Profits All of the Company's Officers and Employees who have owned its stock and been in its employ for not less than twelve months, may be allowed, in the discretion and at the option of the Board of Directors, beginning with the year 1912, to participate, in proportion to the stock thus owned, in the Company's Annual Profits which are in excess of the percentage of profits earned during the year 1910, to-wit: 22.19%, not exceeding, however, 10% of those profits, in excess of 22.19% of its entire outstanding issue of common stock, taking into account pro rata, any increase or decrease thereof, made during the year. In 1915 the bylaw was amended as follows: Participation by Officers and Employees in Certain All of the Company's officers and employees who have owned its Common Stock and been in its employ for not less than twelve months, then next preceeding may be allowed, in the discretion and at the option of the Board of Directors, beginning with the year 1912, to 1 Opinion of the Court participate in proportion to the Common Stock thus owned, in the Company's annual profits which are in excess of the percentage of profits earned during the year 1910, to wit: 22.19%, not exceeding, however, 10% of those profits in excess of 22.19% of its entire outstanding issue of Common Stock, taking into account pro rata any increase or decrease thereof made during the year. The Common Stock owned by an officer or employee, for the purpose of this By-Law, beginning with the year 1916, shall include any stock purchased during the year from an officer or employee or from the personal representative of a deceased officer or employee, provided such stock would have entitled the former owner to participate in proportion thereto had it been held for the entire 12 months' period. Thereafter, the bylaw remained in effect until it was again amended in 1949. It is for the period before the 1949 amendment that plaintiff here claims. The profit-sharing plan was adopted by stockholders of the corporation in 1912. The purpose of the plan was obviously to encourage employees to become owners of a share of the business, and, by reason of such ownership, would have a greater interest in its profitable operations and would give their best efforts to this end. The plan provided that such employee owners would not only share equally with other stockholders in regular dividend distributions, but would receive special profit-sharing distributions from profits which would result from the greater interest of workers. The basis of distribution of the profit-sharing dividends was pro rata to the number of shares held by all employees and in proportion to the number of shares held by each, without regard to the position held or services rendered. In order to construe such distributions as increased compensation for services rendered it must be found that the employee holding the greatest number of shares contributed the most valuable service, or that such employee was previously underpaid for the work he had performed, or that other employees who purchased no shares, contributed nothing to the increased profits from which such dividends were distributable. This has not been proved. In plaintiff's plan, employment as well as investment by the employee was necessary before participation was possible. 449492-58- -3 Opinion of the Court 138 C. Cls. The defendant contends that this requirement of investment before participation affixes the label of dividends to payments under the bylaw. In other words, the payments came about as a result of the employee's investment and not because of services rendered. Thus, defendant argues that the payments in no way take on the character of compensation for services rendered so as to be deductible as ordinary and necessary business expense under section 23 (a)(1)(A) of the 1939 Internal Revenue Code, which provides in part, as follows: In General.-All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; * ** We agree with defendant's contention. Bearing in mind that the bylaw adopted by plaintiff was prior to the enactment of the income tax laws, we cannot say that the plan was not designed to incite greater efforts on the part of its employees because of investment in the company. Further, we cannot say that the plan was designed for tax avoidance. However, conceding that the plan was designed for incentive purposes, the payments must have been reasonable compensation and not dividends in order to be deductible under section 23 (a)(1)(A) of the Internal Revenue Code of 1939 because the two were mutually exclusive. The payments are the very essence of dividends; i. e., distribution of the company's earnings made by the directors in their discretion and in direct proportion to stock holdings. Even if there were doubt as to whether the payments were dividends, the treatment of them by plaintiff should certainly remove it. Historically, plaintiff treated the bylaw payments as dividends as is evidenced by the following facts of record: In tax matters generally the taxpayer treated the payments as dividends. In its return for 1940 to 1948, inclusive, the taxpayer never claimed the payments as deductions for any purposes; payments were not claimed or allowed for deductions in determining taxpayer's base in the years 1936 1 Opinion of the Court to 1939, inclusive, for excess-profits tax purposes; in computing its undistributed profits tax for 1936 to 1939 inclusive, taxpayer claimed that the payments were dividends and received substantial tax benefits thereby; taxpayer did not claim the payments as deductions in its State income tax returns; by and large the payments were shown as unallowable deductions or nondeductible items on the tax returns; the treatment of the items by taxpayer was approved by taxpayer's auditors as being in conformity with generally accepted accounting principles; in computing its social security and withholding taxes the payments were not treated by taxpayer as compensation; in 1942 taxpayer applied to the Commissioner for a ruling as to whether the payments should be treated as compensation in determining whether they could be properly made under salary stabilization laws and regulations, and stated that the payments had consistently been treated as dividends. The Commissioner so ruled; in filing forms 10-K with the Securities and Exchange Commission for the years 1946 to 1948 inclusive, plaintiff referred to the payments as dividends; plaintiff's retirement plans, adopted in 1929 and 1946, defined the terms "wage" and "compensation" so as to exclude bylaw payments for purposes of computing pensions; plaintiff's explanatory letter of August 8, 1912, stated that the payments were to be in proportion to stock bona fide owned by officers and employees of taxpayer; the payments were always in exact proportion to the common stock owned by the employee and were in addition to fixed compensation, regardless of the duties and responsibilities of the employee; plaintiff has admitted that under the plan large amounts sued for in the petition could not possibly be treated as reasonable compensation; fixed salaries and hourly wages to employees below directors and officers were at the going rate in the community. When plaintiff gave acrossthe-board pay increases to hourly workers and supervisory personnel it did so without regard to stock ownership. The resolution of taxpayer's board for 1940 to 1945 referred to the payments as "participating dividends"; in the case of Brookman v. R. J. Reynolds Tobacco Co., 138 N. J. Eq. 312, 48 A. 2d 646, taxpayer in its answer alleged that the payments were dividends, and the court so held. |