C. S. DENMAN, PETITIONER, V. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Docket Nos. 38030, 44028. Promulgated December 8, 1932. The trustees of a municipally owned waterworks system do not exercise an essential governmental function in supplying water to the inhabitants of the proprietary city or to the city for its own uses. A. F. Schaetzle, Esq., for the petitioner. OPINION. LANSDON: The respondent has asserted deficiencies in income tax for the years 1925, 1926 and 1927, in the respective amounts of $68.33, $128.94 and $775.18. The only issue is whether all or any part of the petitioner's salary as a manager of the municipally owned waterworks of the City of Des Moines is exempt from Federal income tax. The two proceedings were duly consolidated for hearing. Petitioner is an individual residing in Des Moines, Iowa, where he is the manager of the municipally owned and operated waterworks of that city. In each of the years here involved he received an annual salary of $8,000, which was paid to him by the city through the trustees of the waterworks system. The City of Des Moines owns, maintains and operates a waterworks system through a board of trustees under authority conferred by the General Assembly of the State of Iowa. It furnishes all the water used by the city and its inhabitants. Water supplied to private purchasers is metered and a flat charge based on the mileage of mains is made for that consumed by the city. Prior to municipal ownership, water was supplied to the City of Des Moines by a private corporation. The essential governmental activities of the republic are not taxable by the states and the corresponding activities of the states are not taxable by the republic. McCulloch v. State of Maryland, 4 Wheat, 316; Weston v. City Council of Charleston, 2 Pet. 449; Collector v. Day, 11 Wal. 113, 127; Indian Motorcycle Co. v. United States, 283 U. S. 570. Any difficulty in the application of the principle arises from the necessity of differentiating between functions that are essentially and usually governmental in character and those which are proprietary. Petitioner here contends that the supplying of water to the city and its inhabitants is an essential governmental function that has now become usual throughout the republic, and in his brief calls attention to evidence adduced in this proceeding that a very large proportion of the cities of the United States own and operate waterworks systems. This contention is not in harmony with the decisions of the courts and of the Board. In Flint v. Stone Tracy Co., 220 U. S. 107, the Supreme Court said: It is no part of the essential governmental functions of a State to provide means of transportation, supply artificial light, water and the like. These objects are often accomplished through the medium of private corporations, and, though the public may derive a benefit from such operations, the companies carrying on such enterprises are, nevertheless, private companies, whose business is prosecuted for private emolument and advantage. For the purpose of taxation they stand upon the same footing as other private corporations upon which special franchises have been conferred. The true distinction is between the attempted taxation of those operations of the States essential to the execution of its governmental functions, and which the State can only do itself, and those activities which are of a private character. The former, the United States may not interfere with by taxing the agencies of the State in carrying out its purposes; the latter, although regulated by the State, and exercising delegated authority, such as the right of eminent domain, are not removed from the field of legitimate Federal taxation. In Blair v. Byers, 35 Fed. (2d) 326, the United States Circuit Court of Appeals, in a case in which an attorney employed and paid by the trustees of the Des Moines Municipal Water Works sought to have salary received therefrom exempted from Federal taxation, the court said: Clearly the government is not prohibited from taxing the instrumentalities of a state or a political subdivision of a state, when these are employed in the exercise of a proprietary function. The Supreme Court, in South Carolina v. United States, 199, U. S. 437, 26 S. Ct. 110, 116, 59 L. Ed. 261, 4 Ann. Cas. 737, held that: "The exemption of state agencies and instrumentalities from national taxation is limited to those which are of a strictly governmental character, and does not extend to those which are used by the state in the carrying on an ordinary private business." In the Byers opinion supra, the court relied on Stone Tracy Co., supra, and also the following from City of Winona v. Botzet, 169 Fed. 321: In the City of Winona v. Botzet, 169 F. 321, 333, 23 L. R. A. (N. S.) 204, this court decided that: "The power of a city to construct and operate waterworks is not a political or governmental, but a private or corporate, power, granted and exercised, not to enable it to control its people, but to authorize it to furnish to itself and to its inhabitants water for their private advantage." In a very recent proceeding, T. P. Wittschen, 25 B. T. A. 46, in which the attorney of a California utility district sought tax exemption for the salary received therefrom, there is a full discussion of all the questions here involved. We think that the result reached in that proceeding is controlling here. As an alternative, petitioner contends that, even if we should hold that supplying water to inhabitants by a municipally owned waterworks is a proprietary function, nevertheless, the supplying of water to the city itself for flushing sewers and streets and for use in the school and other public buildings is an essential and usual governmental function. In this connection the evidence shows that an average of about 40 per cent of all the water pumped by the Des Moines Water Works in the taxable years was used by the city. On this showing petitioner contends that at least 40 per cent of his salary should be exempt from Federal income tax. We can not adopt this theory. Whether water is sold to inhabitants or to the city, the nature of the transaction is the same. It is a function that is not essentially governmental. Decision will be entered for the respondent. CROSSETT WESTERN COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Docket Nos. 46278, 63823. Promulgated December 8, 1932. 1. The petitioner and the Gales Creek Logging Company were incorporated prior to the year 1924. During that year the Gales Creek Logging Company's outstanding voting stock was held as follows: 72.701 per cent by petitioner, 21.482 per cent by 11 of petitioner's 28 stockholders, and 5.817 per cent by outsiders. Held, the two companies were not affiliated. 2. Respondent denied a request that the accounts of the two companies be consolidated for the year 1924. Held, no error. 3. The two companies became affiliated on November 15, 1928. Held, under the Revenue Act of 1928 the periods January 1 to November 15, and November 16 to December 31, 1928, each constituted a taxable year for the purpose of computing net loss. 4. One of the affiliates sustained net losses for several successive years prior to and including the year of affiliation. Held, such losses can not be deducted from the combined income of the year when affiliation took place. Robert T. Jacob, Esq., for the petitioner. W. E. Davis, Esq., for the respondent. These proceedings, which were consolidated for hearing and decision, are for the redetermination of deficiencies in income tax asserted by the respondent for the years 1924 and 1929 in the amounts of $20,110.41 and $2,045.24, respectively. The errors alleged are: (1) Failing and refusing to allow petitioner and the Gales Creek Logging Company to file consolidated returns as to affiliates for the years 1924, 1926 and 1927, and for the period January 1, 1928, to and inclusive of November 15, 1928, and (2) holding that the periods January 1 to November 15, 1928, and November 16 to December 31, 1928, each constituted a taxable year for the said Gales Creek Logging Company. FINDINGS OF FACT. From a stipulation by the parties and the pleadings we find the following facts. Prior to the year 1923 members of the Crossett, Watzek and Gates families had organized three corporations, which acquired extensive timber interests in Oregon and Washington and conducted logging operations. In 1922 the same interests organized the Gales Creek Logging Company, hereinafter called the Logging Company, to log certain timber in Oregon. In 1923, in order to simplify the Oregon operations, the petitioner was organized as a merger of the three earlier companies, but the Logging Company was not included in the merger. It was, however, managed and always treated as a unit of the petitioner, and from the first the exchange of personnel and business between the two companies was that of a single organization. Supplies for both companies were purchased by petitioner at wholesale and only the pro rata wholesale price was charged against the Logging Company for what it used. Managers, engineers and similar officials of the petitioner rendered like services to the Logging Company. The latter paid one-fifth the salary of the joint general manager, but paid no part of the salaries of the others. Both companies held their stockholders' and directors' meetings at the same time and place. Equipment was frequently loaned by petitioner to the Logging Company, often without any charge therefor; when charges were made, they were materially lower than the current rental rate for such articles. With one exception, the directorates of both companies were composed entirely of members of the Crossett, Watzek and Gates families. The same was true with respect to the officers of both companies. The Logging Company did not maintain an office and it owned very little office equipment. All of its office work was carried on in petitioner's offices by petitioner's employees. The Logging Company was considered a branch of petitioner rather than an independent corporation. In January, 1924, a uniform cost-accounting and bookkeeping system was installed at the head office in Chicago. It included all conditions of all the Crossett-Watzek-Gates corporations. The same system was installed in the local Oregon offices of petitioner and the Logging Company during the same month. At the close of 1924 the voting stock of petitioner and of the Logging Company was held as follows: In 1925 nine of petitioner's stockholders held 17.504 per cent of the Logging Company's stock, 79.607 per cent was held by petitioner itself, and the balance by nonholders of petitioner's stock. In 1926 only eight of petitioner's stockholders held Logging Company stock, amounting to 13.849 per cent, and petitioner's own holdings were 83.242 per cent. That condition was unchanged throughout the year 1927. On November 15, 1928, petitioner had acquired a total of 2,695 shares, or 97.966 per cent of Logging Company's stock. Six of petitioner's stockholders held one qualifying share each. The balance of the Logging Company stock, 50 shares, was acquired by petitioner in 1929. None of the employees who subscribed for stock in either company ever attended stockholders' meetings and their stock was always voted by proxies given to members of the Crossett, Watzek, or Gates families. The net income or loss for the period here involved, for each company, is as follows: Petitioner duly requested respondent to consolidate the accounts of the two companies for the year 1924. For the years 1924 to 1929, inclusive, petitioner and the Logging Company filed consolidated income tax returns. Respondent denied the request for consolidation of accounts in his deficiency notice dated September 27, 1929, respecting petitioner's 1927 tax liability. Petitioner's stockholdings in the Logging Company were increased from 83.242 per cent to 97.966 per cent on November 15, 1928. Respondent determined the companies became affiliated on that date and treated the period January 1 to November 15, 1928, as one |