Klein v. Commissioner , 25 T.C. 1045 ( 1956 )

Frederick S. Klein, Petitioner, v. Commissioner of Internal Revenue, Respondent. Estate of Ross Nadeau, Deceased, John F. McNamee, R. Arthur Nadeau and National State Bank of New Jersey, Co-Executors, Petitioners, v. Commissioner of Internal Revenue, Respondent

Klein v. Commissioner

Docket Nos. 43026, 43464, 46287, 46314

United States Tax Court

25 T.C. 1045; 1956 U.S. Tax Ct. LEXIS 267;

February 17, 1956, Filed

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Decisions will be entered under Rule 50.

1. Under a partnership agreement, one partner was first to receive 5 per cent of the partnership gross sales, and the remaining partnership net income or net loss was then to be divided between the partners in a 25-75 per cent ratio. During certain years, the first partner was not credited with his percentage of sales; but after threatened litigation, the same was allowed to him in a later year. Held, that the distributive shares of the partners in the undisputed ordinary net income or ordinary net loss of the partnership should be determined in accordance with the partnership agreement; and that the distributive share of each partner must be included in his gross income for the year in which the taxable year of the partnership ended, without regard to the time of actual distribution or receipt.

2. Held, where, by agreement of the partners, one partner was required to pay certain partnership expenses out of his own funds, without reimbursement, he is entitled to deduct the same from his individual gross income; and the amounts so deductible for certain travel and entertainment expenses are determined.

Andrew B. Crummy, Esq ., for petitioner in Docket Nos. 43026 and 46314.

Edward Baumgarten, Esq., and David Zuckerman, Esq., for petitioners in Docket Nos. 43464 and 46287.

Scott A. Dahlquist, Esq., for the respondent.

Pierce, Judge.

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PIERCE

Respondent has determined deficiencies in income tax in these proceedings as follows:

Docket No.	Petitioner	Year	Amount
43026	Frederick S. Klein	1946	$ 31,149.50
43464	Ross Nadeau 1	1946	19,142.84
46287	Ross Nadeau 1	1947	6,343.59
46314	Frederick S. Klein	1947	7,748.62

The proceedings were consolidated for hearing. Two of the issues raised in Klein's petition for 1947, one increasing income from dividends and interest, and the other increasing net long-term capital gain, were conceded by petitioner at the hearing.

The issues for decision are: (1) What were the distributive shares of Klein and Nadeau in the undisputed net income or loss of Glider Blade Company, a partnership, for its fiscal years ended February 28, 1946 and 1947, and its final fiscal period ended August 31, 1947? (2) What deductions, if any, should be allowed to Klein for certain travel and entertainment expenses?

FINDINGS OF FACT.

Petitioner Frederick S. Klein (hereinafter called Klein) filed his individual income tax returns for each of the years involved with the collector of internal revenue for the fifth district of New Jersey, at Newark. Decedent Nadeau (hereinafter called Nadeau) filed his individual income tax returns for the taxable years involved with the same collector.

On April 19, 1943, but effective as of March 15, 1943, Klein and Nadeau executed articles of co-partnership, whereby they became the members of a partnership styled the Glider Blade Company (hereinafter called Glider), to carry on the business of purchasing, selling, and manufacturing razor blades. Net profits or losses were, pursuant to the articles, to be divided on the basis of 25 per cent to Klein and 75 per cent to Nadeau. Later in the same year, but also effective as of March 15, 1943, an oral agreement was entered into between Klein and Nadeau, amending the articles of co-partnership in the following regard: In computing the distributive shares of the net income or loss of Glider, an amount (sometimes designated by the parties as a "commission") equal to 5 per cent of Glider's gross sales was first to be credited to Klein; and the net profits or losses remaining after such credit were then to be divided between Klein and Nadeau in the above-mentioned 25-75 per cent ratio.

Glider's books were kept and its partnership information returns were filed in accordance with the accrual method of accounting and on the basis of fiscal years ending on the last day of February. The amounts of Glider's sales and net income (or loss) for the taxable periods here involved, which are undisputed, were as follows:

Fiscal year or period ended	Sales	Net income (or loss)
Feb. 28, 1946	$ 963,482.03	$ 184,861.35
Feb. 28, 1947	234,594.57	27,759.99
Aug. 31, 1947	16,229.85	(6,051.41)

For the fiscal years ended February 29, 1944, and February 28, 1945, the years prior to those involved in the instant proceedings, the distributive shares of the partners were computed in accordance with the articles of co-partnership, as amended (hereinafter called the amended partnership agreement). However, the partners' distributive shares for the fiscal years ended February 28, 1946 and 1947, were entered on the books in the 25-75 per cent ration, without crediting Klein with the above-mentioned 5 per cent of sales; and the original partnership information returns for said years reflected this same division. These returns were prepared by accountants from Glider's books and from information supplied by the partner who signed the return. Klein signed the return for the fiscal year 1946 and Nadeau signed that for the fiscal year 1947.

At the end of the 1946 fiscal year, Klein's withdrawals from the partnership exceeded the amount credited to him on the partnership books by the amount of $ 12,760.44. For the 1947 fiscal year, the amount of his excess withdrawals per books was $ 13,473.76, bringing his total excess withdrawals per books to $ 26,234.20.

In July 1947 Klein retained counsel, and caused a bill of complaint to be prepared for filing in the Chancery Court of New Jersey, in which Nadeau and others were named as defendants. Klein's position in the complaint and supporting affidavit, as so prepared, was in substance that he and Nadeau had agreed in the amended partnership agreement that he would receive "5% of sales of the partnership for each year in addition to the 25% of the profits"; that for 1946, he should have been credited with 5 per cent "commissions" on sales in the amount of $ 48,174.10, and with profits of $ 34,171.81, or a total of $ 82,345.91; that for 1947, he should have been credited with 5 per cent commissions on sales in the amount of $ 11,729.72, and with profits of $ 3,632.57, or a total of $ 15,362.29; that he had, under protest, signed the 1946 partnership return which did not reflect the 5 per cent of sales, for the reasons that it had been prepared during his absence, and was already overdue, and that Nadeau had assured him "the matter of the 5% commission on sales due [him, i. e., Klein] would be adjusted * * * later on"; that his withdrawals from the partnership were "against the commissions and profits due to him" so that his account actually was not overdrawn; and that the audits and tax returns were not correct and true. The prayer of the complaint, so far as is here material, was that Nadeau be ordered to make an accounting and payment to Klein of all money due him; that the partnership be dissolved; and that Nadeau and the partnership be enjoined from instituting any suit against Klein for any moneys claimed to be due from him by reason of the partnership operations.

The complaint was never filed, but a settlement between the partners was effected on September 2, 1947, under which Glider was dissolved, and Nadeau agreed to pay Klein $ 18,000 in full settlement of all claims "for compensation or otherwise" that Klein might have against the partnership. This amount was to be paid in two installments of $ 9,000 each, on December 1, 1947, and March 1, 1948. Nadeau gave Klein two nonnegotiable, non-interest-bearing promissory notes for $ 9,000 each; and he deposited with escrowees certain stocks and bonds of the value of $ 20,000, to secure payment. Nadeau paid and Klein received $ 9,000 in December 1947, and a like amount on March 1, 1948. The settlement also included general releases by each partner to the other; and a sale, for a separately stated consideration, of all partnership net assets to Nadeau.

At some time after September 2, 1947, Nadeau informed the accountants who had been handling the partnership books, of the settlement. On the basis of such information, the capital account of Klein, as then shown on the partnership books, was adjusted so as to credit him with the 5 per cent of sales for each of the fiscal years ended February 28, 1946 and 1947, plus 25 per cent of the remaining net income. As regards Nadeau, his capital account was adjusted so as to credit him with only 75 per cent of Glider's net income remaining after the allowance to Klein for the 5 per cent of sales. Entries also were made in the partnership books for the taxable period ended August 31, 1947, to reflect a distribution of profits in accordance with the amended partnership agreement. Thereafter, amended partnership information returns for the fiscal years 1946 and 1947, and both original and amended returns for the final 6-month period, were filed to reflect the book adjustments. Klein was not notified of these actions. The effect of the above-mentioned adjustments was to eliminate the overdrafts which had been charged against Klein, to credit him with a distributive share of the 1946 partnership net income in an amount equal to that which Klein had claimed in his prepared complaint was due him under the amended partnership agreement; to credit Klein with a 1947 distributive share, which was slightly in excess of the amount he claimed under the amended partnership agreement; and to credit Nadeau with distributive shares for both years which likewise reflected the amended partnership agreement.

Klein reported on his individual return for the calendar year 1946, as his income from the Glider Blade Company, his distributive share as shown on the partnership books before their adjustment. On his 1947 return, he reported as income from the partnership, his withdrawals from Glider during its fiscal year ended February 28, 1947, and also the first payment of $ 9,000 received from Nadeau under the settlement; but he did not report any income or loss with respect to the final fiscal period ended August 31, 1947.

Nadeau reported in his individual return for the calendar year 1946, his distributive share as shown on the partnership books before their adjustment; but in his 1947 return, he reported as income from the partnership for its two fiscal periods ending in that year, an amount which reflected the partnership books after they had been adjusted.

Respondent, in determining the deficiencies against Klein, increased his distributive shares of the Glider net income for all periods involved, to reflect the partnership's books as adjusted. However, in order to protect the revenues, respondent determined Nadeau's distributive shares in a manner which reflected the books before their adjustment.

During the years 1946 and 1947, Klein conducted the selling activities for the Glider partnership. He traveled extensively throughout the United States; and he also attended various trade association conventions, where he engaged hotel rooms for the entertainment of customers. His expenses of this travel and entertainment were reimbursed to him by Glider; and the same were deducted on the partnership information returns, without objection by respondent, in the following amounts:

		Entertainment
Fiscal period ended	Travel expense	expense
Feb. 28, 1946	$ 7,216.59	$ 912.20
Feb. 28, 1947	9,618.64	1,368.15
Aug. 31, 1947	1 1,736.48

No dispute regarding these items is here involved.

In addition to the above reimbursed traveling and entertainment expenses, Klein expended other amounts of similar character on behalf of the partnership, which were not reimbursed to him. The unreimbursed travel expense was claimed to have been occasioned by his calling on partnership customers in the vicinity of New York City, in his personal automobile; and it was claimed to include such items as gasoline, tires, repairs, meals, and lodging. The unreimbursed entertainment expense was incident to his entertaining partnership customers who came to New York City; and it included the expense of taking such customers to dinner or the theater, and that of entertaining them in his home.

Klein presented no receipts, memoranda, or other records respecting the amounts of such unreimbursed travel and entertainment expenses. He estimated that the entertainment portion of the same was $ 110 per week. The amounts for which he claimed deductions in respect of such items, on his income tax returns, were as follows:

	Travel	Entertainment
Year	expense	expense
1946	$ 1,500	$ 5,500
1947	1,340	3,915

Respondent disallowed $ 842.34 of the amount so claimed for travel expense in 1947, and he disallowed all the other items in their entirety.

OPINION.

1. The first issue involves a dispute between Nadeau's executors and Klein as to the determination of the distributive shares of the partners in the ordinary net income or ordinary net loss of the Glider Blade Company. There is no controversy as to the amounts of such partnership net income or net loss for any of the periods involved; and also no dispute as to the amounts of the partnership's gross sales for these periods, which are here a factor in the determination of the distributive shares. Moreover, there appears to be no dispute that the amended partnership agreement specifically provided how the distributive shares of the partners should be determined; and no dispute that said amended partnership agreement was in effect during all periods here involved. Counsel for both petitioners, in their petitions and briefs to this Court, have relied on the amended partnership agreement. Also, Klein, in the complaint which he prepared for filing in the State court, relied on such amended agreement to support his claim that he should have been paid the 5 per cent of partnership sales, in addition to 25 per cent of the remaining partnership net income. And, under the settlement which eliminated the filing of such complaint, Klein actually received, in cash and by release from liability for excess withdrawals, allowances equal to the full amounts which he had claimed to be due him under the terms of the amended partnership agreement.

The crux of the controversy between Nadeau's executors and Klein is, rather, as to the time when the allowances to Klein for 5 per cent of the partnership's sales should be included in his gross income for income tax purposes. Klein's position is that he actually did not receive these allowances until after the 1947 settlement with Nadeau; and that by reason of such fact, he should not have to include them in his gross income prior to their actual receipt. Nadeau's executors contend, on the other hand, that irrespective of the dispute and settlement between the partners, each partner must include in his individual gross income for each of his taxable years, his distributive share of the partnership ordinary net income or net loss for any taxable period of the partnership which ended within the taxable year of the partner.

It is our opinion that Klein's position is without merit, and that the position of Nadeau's executors is the correct one. The pertinent provisions of the Internal Revenue Code (1939) are as follows:

SEC. 181. PARTNERSHIP NOT TAXABLE.

Individuals carrying on business in partnership shall be liable for income tax only in their individual capacity.

SEC. 182. TAX ON PARTNERS.

In computing the net income of each partner, he shall include, whether or not distribution is made to him --

* * * *

(c) His distributive share of the ordinary net income or the ordinary net loss of the partnership, * * *

SEC. 188. DIFFERENT TAXABLE YEARS OF PARTNER AND PARTNERSHIP.

If the taxable year of a partner is different from that of the partnership, the inclusions with respect to the net income of the partnership, in computing the net income of the partner for his taxable year, shall be based upon the net income of the partnership for any taxable year of the partnership * * * ending within or with the taxable year of the partner.

The foregoing provisions of the statute are specific and free from ambiguity. The distributive share of each partner mentioned in said statute is to be determined in accordance with the provisions of the partnership agreement. Schwerin v. Commissioner, (C. A., D. C.) 139 F.2d 843">139 F. 2d 843, affirming a Memorandum Opinion of this Court; Hellman v. United States, (Ct. Cl.) 44 F.2d 83">44 F. 2d 83. Also, as provided by the statute, these distributive shares are taxable to the partners, whether or not actual distribution is made to them; and the fact that distribution may have been delayed because of a dispute between the partners is immaterial for income tax purposes. Kurt H. deCousser, 16 T. C. 65; Bell v. Commissioner, (C. A. 5) 219 F.2d 442">219 F. 2d 442, affirming a Memorandum Opinion of this Court.

In the instant case the allowance to Klein of the 5 per cent of the partnership gross sales was a factor in determining his distributive share; and, even if such allowance be considered compensation from the partnership to the partner for personal services, it is to be regarded for income tax purposes as part of the partner's distributive share. Cf. Estate of S. U. Tilton, 8 B. T. A. 914.

We hold, therefore, on the first issue, that the undisputed ordinary net income of the Glider partnership for its fiscal period ended February 28, 1946, is includible by the partners in their respective gross incomes for their 1946 taxable years; that the ordinary net income and ordinary net loss of the partnership for its taxable periods ended February 28, 1947, and August 31, 1947, respectively, should be reflected in the incomes of the partners for their 1947 taxable years; and that the amounts of the distributive shares of Klein and Nadeau in such net income or net loss of the partnership for each of its taxable periods involved, should be determined in accordance with the provisions of the amended partnership agreement.

2. As regards the second issue, the general rule is that a partner may not deduct partnership expenses on his individual return. Hiram C. Wilson, 17 B. T. A. 976; Western Construction Co., 14 T. C. 453, 471. There is, however, an exception to this rule to the effect that where, under a partnership agreement, a partner has been required to pay certain partnership expense out of his own funds, he is entitled to deduct the amount thereof from his individual gross income. Siarto v. Commissioner, (C. A. 6) 171 F.2d 203">171 F. 2d 203, affirming a Memorandum Opinion of this Court; O. D. 1122, 5 C. B. 121; O. D. 947, 4 C. B. 137; A. R. R. 551, 4 C. B. 215. Cf. J. C. Nichols, 42 B. T. A. 618.

In the instant case, the evidence does not disclose the exact terms of the amended partnership agreement; but Klein testified, in substance and without contradiction, that in making payment of the unreimbursed travel and entertainment expenses, he had followed a partnership practice which had become "routine"; and that such practice arose through his acquiescence in Nadeau's position that Klein must bear such partnership expenses, by reason of the additional allowance for 5 per cent of sales being made to him under the amended partnership agreement. It is our opinion that such arrangement was tantamount to an agreement between the partners that Klein should bear the above-mentioned unreimbursed expenses out of his personal funds. We hold, therefore, that Klein is entitled to deduct such expenses from his individual gross income, to the extent that they actually were paid by him and were ordinary and necessary expenses of the partnership.

As to the amounts so to be allowed as deductions, the evidence adduced by Klein in support of his claims is indefinite and unsatisfactory. It consists principally of general descriptions of his activities, and of unsupported estimates as to the amounts paid. His testimony, which is the only evidence offered with respect to his claims, reveals no specific trip made, no particular customer entertained, and no description of the entertainment on any particular occasion. We have observed, also, that the amounts reimbursed to Klein for travel and entertainment expense were substantial; and we have grave doubts as to whether all the claimed unreimbursed amounts represented ordinary and necessary expenses of the partnership, as distinguished from Klein's personal expenses. Nevertheless, we are convinced that Klein did pay some additional amounts for travel and entertainment on behalf of the partnership for which he was not reimbursed. Therefore, applying the doctrine of Cohan v. Commissioner, (C. A. 2) 39 F. 2d 540, we hold that Klein should be allowed deductions for unreimbursed travel expenses in amounts equal to 50 per cent of those claimed for such items on his income tax returns; and that, in addition, he should be allowed deductions for unreimbursed entertainment expenses in amounts equal to 33 1/3 per cent of those claimed for such items on his returns.

Decisions will be entered under Rule 50.

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Footnotes

• 1. Ross Nadeau died on July 24, 1953, after his petition to this Court had been filed, and prior to the trial. Accordingly, the Estate of Ross Nadeau, deceased, John F. McNamee, R. Arthur Nadeau, and National State Bank of New Jersey, Co-executors, have been substituted as petitioners in Docket Nos. 43464 and 46287, and the captions of these proceedings have been changed to reflect the substitution.↩

• 1. Both types of expenses for this period were grouped together, and one deduction was claimed under the title "Travel and Entertaining."↩