Hitchcock v. Commissioner , 12 T.C. 22 ( 1949 )

Ralph C. Hitchcock, Petitioner, et al., ^* v. Commissioner of Internal Revenue, Respondent

Hitchcock v. Commissioner

Docket Nos. 13617, 13618, 13619, 13620, 13621, 13622, 13623

United States Tax Court

12 T.C. 22; 1949 U.S. Tax Ct. LEXIS 298;

January 24, 1949, Promulgated

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">*298 Decisions will be entered under Rule 50.

From 1916 to June 2, 1941, petitioner conducted as a sole proprietorship a pattern-making and foundry business. On the latter date he conveyed to each of his six children an undivided one-seventh interest in the real and personal property used by him in the business. Thereafter, he filed a petition in the probate court requesting that he be appointed guardian of the persons and property of the three minor children. Immediately following the granting of this petition, petitioner and his six children executed articles of limited partnership which named the father and two eldest sons as both general and limited partners and designated the remaining four children solely as limited partners. A bill of sale, conveying all of the personal property formerly held by the father, and a lease of the real estate to the partnership were executed by the parties. Thereafter, the business was conducted by the father and the two eldest sons as general partners, the four other children exercising no control over the management or operation of the business. Held, that the four youngest children were not bona fide members of the partnership in question">*299 and that the income allocated to them during 1942, 1943, and 1944 was properly taxed by the Commissioner to the father.

R. H. Fryberger, Esq., for the petitioners.

Harold H. Hart, Esq., for the respondent.

Arundell, Judge.

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ARUNDELL

">*22 These proceedings, which were consolidated for trial and hearing, involve the following deficiencies:

	Income and	Income tax
Taxpayer	victory tax
	1943	1944
Ralph C. Hitchcock	$ 114,728.04	$ 92,502.76
Harold M. Hitchcock	1,439.71	1,149.66
Carleton C. Hitchcock	1,481.86	1,174.35
Claude R. Hitchcock	1,397.92	1,096.59
Margaret Ann Hitchcock	1,398.85	1,096.59
Ralph C. Hitchcock, Jr	1,401.82	1,096.60
Lucy Utter Hitchcock	1,401.82	1,096.59

The tax liability of the various petitioners for the year 1942 is also involved in the deficiencies for 1943, due to the provisions of the Current Tax Payment Act of 1943.

Part of the deficiency determined with respect to Ralph C. Hitchcock and the whole of the deficiencies determined against the other ">*23 petitioners relate to depreciation claimed and deducted by R. C. Hitchcock & Sons which was reflected in the individual income tax returns of each petitioner for ">*300 the years 1942, 1943, and 1944. The issues raised in relation to these deficiencies have been adjusted by stipulation, subject to the determination of this Court on the principal issue herein.

The single question presented is whether the Commissioner was correct in taxing to Ralph C. Hitchcock the income allocated by the partnership of R. C. Hitchcock & Sons to four of his children upon the basis that these children were not, during 1942, 1943, and 1944, bona fide partners in the business for Federal income tax purposes.

The facts stipulated by the parties are incorporated herein and, in so far as necessary to the disposition of the issue, are set forth in our findings of fact.

FINDINGS OF FACT.

Ralph C. Hitchcock, hereinafter sometimes referred to as the petitioner, is a widower and the father of six children, Harold M. Hitchcock, Carleton C. Hitchcock, Claude R. Hitchcock, Margaret Ann Hitchcock Lind, Ralph C. Hitchcock, Jr., and Lucy Utter Hitchcock. All of the named individuals are residents of the State of Minnesota and the income tax returns of each were filed for the years involved with the collector of internal revenue for the district of Minnesota.

Petitioner has been a ">*301 pattern maker by trade since 1904. From 1916 to June 2, 1941, he operated a pattern business known as the "Modern Pattern Co." as a sole proprietorship. In 1927 petitioner added a foundry to this business.

In 1927 petitioner's eldest son, Harold, was employed by the Modern Pattern Co. on a salary basis. Carleton, his second son, was also employed on a salary basis by the company in the summer of 1932, following the death of the mother in that year. Carleton had shown great interest and talent in the foundry business since it had been established by his father in 1927. Upon entering into full time duties at the foundry, Carleton devoted much of his time to acquiring a knowledge of the business from reading, experimentation, and research.

Petitioner had never personally operated the foundry, but had hired a supervisor to conduct that phase of the business under his overall supervision. Approximately a year after Carleton entered the foundry he became engaged in a controversy with the supervisor over the reason for the excessive number of defective castings then being produced. As a result, the supervisor quit his position and Carleton was installed in his place.

Thereafter, Carleton">*302 and Harold confined themselves to the operation and expansion of the foundry. By 1937 Harold had taken over ">*24 the casting-cleaning department and the testing, inspection, and shipping detail. By 1939 they had full management of the foundry business to the extent that they made the customer contacts and hired and fired employees, the father taking no part in its active management. Petitioner, however, still exercised an over-all control and overruled his sons when Carleton suggested in 1937 that they acquire facilities for heat-treating aluminum castings, and again, in 1938, when it was proposed that the foundry engage in the making of magnesium castings. However, he was prevailed upon by his sons, and a small building was erected in 1939 to experiment in the making of magnesium castings, and aluminum heat-treating facilities were installed in 1940.

Sometime in 1939 Carleton and Harold approached their father with regard to obtaining an interest in the business. They informed petitioner that they had been offered positions in other firms and would accept the offers or start a foundry of their own if he refused to allow them to acquire a share in the business.

Family discussions">*303 and arguments with respect to whether the father would give the two sons an interest began in 1939 and continued over a period of about two years, until the beginning of 1941.

Petitioner initially refused to consider the proposal. He felt that if he were to give a share of the business to Carleton and Harold he should divide the property in equal proportions among all of his six children. Carleton and Harold objected to the petitioner's third son, Claude, receiving any interest. Claude during this period was attending the University of Minnesota and had renounced any interest in entering his father's business in favor of a medical career. No objection was made to Margaret's receiving a share, as Carleton and Harold were of the opinion that she was making a contribution by managing the household and assuming the responsibility of raising Ralph and Lucy. In 1939 Margaret, then eighteen years of age, had left the university after one year to take over these duties. Prior to this time petitioner had retained a housekeeper for this purpose. The two sons also expected that young Ralph would eventually come into the business, and that Lucy would carry on in the household as Margaret">*304 had done, so no objection was made to their receiving equal shares. Claude, Margaret, Ralph, Jr., and Lucy were residing in the father's home and both Carleton and Harold were married at this time and had established separate homes for their families.

During the period from 1939 to 1941, petitioner consulted various business friends and his attorney, R. H. Fryberger, relative to the course he should pursue in dividing his business assets. The possibility of forming a corporation was discussed, but was rejected because of the "red tape" involved, the possibility that one or more of the children might subsequently dispose of their shares to outsiders, and ">*25 the high Federal taxes on corporate profits. These discussions culminated in the decision to form a limited partnership among the petitioner and his six children.

On June 2, 1941, petitioner executed two warranty deeds conveying to each of his six children an undivided one-seventh interest in the real estate and a bill of sale conveying to each an undivided one-seventh interest in the personal property used by him in the business of the Modern Pattern Co. Thereafter, and on the same date, petitioner presented to the Probate">*305 Court of Hennepin County, Minnesota, a petition asking that he be appointed guardian of the persons and estate of his three minor children, Margaret, Ralph, Jr., and Lucy. This petition contained the following statements pertinent to the question herein:

3. That your petitioner has a family consisting of six children, including the three above named minors, and is desirous of making a fair and equitable distribution of his property during his lifetime; that two of his older boys have been active in said business and will continue to be more active therein as time goes on.

4. That in order to accomplish the foregoing your petitioner did as of the 2nd day of June, 1941, make a gift by Bill of Sale to each of his said children of an undivided one-seventh interest in said business and as of said date has conveyed to each of his said children an undivided one-seventh interest in and to the improved real estate used in connection with said business; * * *

* * * *

7. That said gifts were made by your petitioner solely on condition that the business shall continue, shall remain intact, and continue to operate as it has in the past, and that the interests received therein by each of his said">*306 children shall be and remain as part of said business, and that your petitioner proposes to continue to supervise and direct said business in conjunction with his two oldest children.

8. That to accomplish the purpose of your petitioner the interest of each of said children and the interest remaining therein in your petitioner and retained by him, it is proposed, shall be conveyed and transferred to a limited partnership organized under the laws of the State of Minnesota for a term of twenty-five years, and known as R. C. Hitchcock & Sons; * * *

* * * *

10. That the consummation of said gifts and the carrying out of said plan and program to continue said business is conditioned on the Court duly making and entering its order in the premises authorizing your petitioner as said guardian to retain said property as an investment of the funds of said minors, and to execute such papers and documents as may be necessary to effectuate the purposes aforesaid.

11. That your petitioner considers that said gifts are conditioned solely by virtue of the premises and are made upon conditions that the program and procedure will be carried out as hereinbefore set forth.

* * * *

As required by the ">*307 order of the probate court entered the same day granting this petition, the father gave his bond as guardian and his sons Claude and Harold signed as sureties.

Immediately after petitioner was appointed guardian, the articles ">*26 of limited partnership of R. C. Hitchcock & Sons were signed by petitioner individually and for his minor children and by his adult sons. A bill of sale conveying all of the personal property formerly held by the Modern Pattern Co. and a lease of the real estate to the partnership was executed in the same manner. Federal gift tax returns were duly filed and the tax thereon paid by the petitioner.

The articles of limited partnership of R. C. Hitchcock & Sons, hereinafter referred to as the partnership, named the father, Carleton, and Harold as both general and limited partners and designated the remaining four children as limited partners. These articles also provided:

IX

The share of the profits and other compensation by way of income which each Limited Partner shall receive by reason of his or her contribution shall be equal to one-seventh of all of the net earnings of said Limited Partnership, payable to them, and each of them, from time to time, ">*308 as determined by the General Partners, provided however, that a reasonable wage or salary may be paid to and deducted by the said General Partners for the management and conduct of the business of said Limited Partnership as deductible item or items in ascertaining the net earnings of said Limited Partnership as the same is herein to be considered.

X

No Limited Partner shall have a right to substitute an assignee as contributor in his place except upon the unanimous consent of all the Limited Partners in writing and filed with the General Partners.

The purported gifts by Ralph C. Hitchcock to his six children were not absolute and complete, but were made upon the condition that the property would remain in the business.

On the books of the partnership, capital accounts were established for the father and six children as of June 1, 1941. The opening entries gave a credit to each child of $ 17,549.78.

Subsequent to the formation of the partnership on June 2, 1941, and throughout 1942, 1943, and 1944, the business expanded at a rapid rate. Total sales were:

1939	(approx.)	$ 155,000.00
1940	(approx.)	200,000.00
1/1/41 to 6/1/41		176,399.21
6/1/41 to 12/31/41		335,137.54
1942		923,535.15
1943		1,295,784.56
1944		1,392,954.87

">*309 Total castings delivered by the company during the period 1940 to 1944, inclusive, were as follows:

1940	650,104 lbs.
1941	1,440,230 lbs.
1942	2,086,666 lbs.
1943	2,442,696 lbs.
1944	2,390,650 lbs.

">*27 The number of employees of the business increased as follows:

1940	19-35
1941	38-65
1942	66-134
1943	151-193
1944	152-177

Throughout these years petitioner remained active in the business. Due to the fact that the expansion was confined chiefly to the foundry phase of the business with which Carleton and Harold were particularly familiar, the procuring of war contracts, personnel problems, and the development of new techniques in casting processes were handled principally by them, and the father assisted in the office work, made suggestions, and served in an advisory capacity. During these years the salaries, which were determined by the three general partners, were as follows:

	1942	1943	1944
Ralph C. Hitchcock	$ 8,100.01	$ 9,600.00	$ 9,600.03
Carleton C. Hitchcock	8,175.01	9,600.01	9,600.00
Harold M. Hitchcock	6,791.71	8,182.51	8,400.00

The partnership thereafter operated entirely with its own capital and never at any time borrowed">*310 money from the Government or private loaning institutions. Substantial improvements were made to the buildings and real estate then and still owned by the individuals, all of which was paid out of the earnings of the business and deducted pro rata from the account of each limited partner. The amounts of these improvements were as follows:

	1942	1943	1944
Addition to land	$ 1,490.35		$ 5,970.32
Addition to buildings	8,082.95	$ 17,940.45	5,312.73

On June 2, 1941, Margaret was 20, Ralph, Jr., was 12, and Lucy was 9 years of age. None of these children nor Claude performed any services in the business either before or after June 1, 1941. Prior to June 1, 1941, these four children lived at home and the father contributed to their support and education.

At the time of the formation of the partnership, Claude was attending a medical school. In May 1941 he entered the Army as a private and thereafter was paid accordingly by the Government. He was permitted to continue his medical studies at the University of Minnesota until his graduation in 1944, at which time he entered upon a two-year tour of active duty. Until this time he continued to reside in his father's ">*311 home. After the formation of the partnership, he ">*28 withdrew money to cover the cost of his education, to buy medical equipment, to pay insurance, and to buy bonds, clothing, photographs, car licenses, and the like.

When Margaret became of age on March 9, 1942, her guardianship was terminated and the probate court discharged petitioner as her guardian. After she became of age, she drew money from the partnership to purchase and repair her automobile, to make a trip to New York, to buy clothes, and for other miscellaneous expenses. The amounts so withdrawn by Claude and Margaret were charged to their capital accounts. The father agreed to this arrangement and authorized an employee of the partnership to turn over money to them at their request.

Lucy and Ralph, Jr., also continued to reside in the father's home. Provisions were made by the order of the probate court authorizing the father as their guardian to use their funds for their support and maintenance. Annual accounts of these expenditures were duly filed by the petitioner in the probate court. On May 3, 1943, the father caused $ 2,375 to be withdrawn from the capital account of each to reimburse him for their living">*312 expenses.

On December 31, 1944, the father caused the following amounts to be transferred from the capital accounts of his four youngest children to the credit of his capital account: Claude, $ 9,000; Margaret, $ 9,000; Ralph, Jr., $ 3,500; and Lucy, $ 3,500. The explanation given on the books of the partnership was that the transfer was to reimburse the father for maintaining the home and paying educational and other expenses for the children. After the formation of the partnership, the father took no further deductions from his income tax by reason of support of the minor children.

The returns of income filed by R. C. Hitchcock & Sons for 1942, 1943, and 1944 contained the following division of income:

	1942	1943	1944
Ralph C. Hitchcock	$ 30,867.21	$ 36,563.39	$ 47,536.06
Carleton C. Hitchcock	30.942.21	36,563.40	47,536.03
Harold M. Hitchcock	29,558.91	35,145.90	46,336.03
Claude R. Hitchcock	22,767.20	26,963.39	37,936.03
Margaret Ann Hitchcock	22,767.20	26,963.39	37,936.03
Ralph C. Hitchcock, Jr	22,767.20	26,963.39	37,936.03
Lucy Utter Hitchcock	22,767.20	26,963.39	37,936.03
Total	182,437.13	216,126.25	293,152.24

It has been determined">*313 by the Commissioner that for the calendar years 1942, 1943, and 1944 the father's distributive share of the net income of the partnership after adjustment for salaries was five-sevenths thereof. Respondent concedes that if this Court should sustain his determination, the deficiencies asserted against the four youngest children for these years are not due and that these children ">*29 are entitled to refunds of all Federal income taxes paid for such years.

The dispute between the parties relating to the allowable depreciation of the partnership during the years involved has been settled by stipulation and the proper amounts will be computed in accordance therewith under Rule 50.

In Docket Nos. 13618 and 13619, the cases of the two eldest sons, Harold and Carleton, respectively, the Commissioner did not attempt to tax their share of the distributive income of the partnership to their father, and he recognizes that both sons rendered valuable services during the years in question in the operation of the business. However, the adjustment of the depreciation allowance of the partnership for 1942, 1943, and 1944, as agreed upon by the parties herein, will result in deficiencies being">*314 due from the two sons for the years 1943 and 1944, which will be computed by the parties under Rule 50.

OPINION.

The sole issue presented in this proceeding is whether four children of the petitioner, namely, Claude, Margaret, Ralph, Jr., and Lucy, were bona fide partners for income tax purposes during the years 1942, 1943, and 1944, in the limited partnership known as R. C. Hitchcock & Sons. Respondent has included in the taxable income of the petitioner the partnership income distributable to those children in each of those years, contending that their inclusion in the partnership served no business purpose and was solely a superficial arrangement for allocating business income among an intimate family group.

The principle applicable to the taxability of a family partnership of the type presented in the present case was concisely stated in , as follows:

Notwithstanding the fact that there is no Federal statute which makes the gift of a partnership interest to a member of the taxpayer's family illegal, or that expressly lays the tax upon a husband or father who makes a lawful gift of a partnership ">*315 interest to members of his family, and although it has long been, and is still, the law that a taxpayer has the right to avoid or lessen his taxes by means that are lawfully available, it is now well settled that such means must be realities, not shams, substance, not shadows. Family partnerships are not ipso facto illegal under Federal law but such partnerships must be shown to be accompanied by investment of capital, participation in management, rendition of services by the family partners, or by such other indicia as will definitely demonstrate the actuality, the reality, and the bona fides of the arrangement.

The record demonstrates beyond any doubt that petitioner's four children, Claude, Margaret, Ralph, Jr., and Lucy, in no way participated in the management of the partnership business or rendered any services in its operation.

">*30 We have stated in our findings that petitioner's conveyance of the one-seventh interest in the real and personal property used in the business to each of his four younger children was not a valid gift in praesenti. The evidence shows that the so-called gifts were made "solely on condition that the business shall continue, shall remain intact, ">*316 and continue to operate as it has in the past, and that the interests received therein by each of his said children shall be and remain as part of said business" and on the condition that the court authorized him as guardian to retain the property as an investment of the funds of the minors. Partnership earnings were payable to each of the four children as limited partners only, "as determined by the General Partners," and then after reasonable wages or salaries had been fixed by and paid to the general partners. As a limited partner each of the four children was denied the "right to substitute an assignee as contributor in his place except by the unanimous consent of all the Limited Partners in writing and filed with the General Partners." These documents, taken in their entirety, negative any suggestion that the petitioner, as donor, intended to absolutely and irrevocably divest himself of the dominion and control of the subject matter of his purported gifts. Thus, the property conditionally conveyed by the petitioner to his children did not constitute capital contributions originating with them when it was subsequently transferred to the newly formed partnership.

It is also ">*317 interesting to note in passing that the District Court for the Fourth Judicial District of Minnesota, in State of Minnesotav. Hitchcock, upheld the State in its imposition of an additional income tax for the year 1942, charging the petitioner on the entire income of the business except the portion given to his two eldest sons. The decision of the district court, which is part of the record in the instant proceeding, indicates that that court, upon substantially the same facts as now confront us, made the following conclusions of law:

That the conditional and incomplete transfer by defendant to Claude R. Hitchcock, Margaret Ann Hitchcock, Ralph C. Hitchcock, Jr. and Lucy Utter Hitchcock, was ineffective for income tax purposes to divest defendant of title, dominion and control of the subject of the gift, and that such title, dominion and control remained in defendant.

That no real and valid partnership was created by the execution of articles of partnership on June 2, 1941, as respects said Claude R. Hitchcock, Margaret Ann Hitchcock, Ralph N. Hitchcock, Jr., and Lucy Utter Hitchcock, and that defendant is liable for payment of a tax upon net earnings of the business in the">*318 sum of $ 91,068.80, distributed as aforesaid to the said four children under the agreement of partnership.

However, petitioner submits that capital was contributed by each of these children subsequent to the formation of the partnership by virtue of the distributable earnings of each that were left in the business. In our opinion, this argument possesses little merit when applied to ">*52 the facts in the instant case. This is not a case where the children were at liberty at any time to withdraw or assign their interests in the business or where they possessed an unqualified right to receive their full share of each year's earnings. We think it time to meet petitioner's argument on this point when a case is presented wherein the donees' rights and interests are more definitive and uncontrolled.

Petitioner also contends that he divested himself of the control and operation of the business under the partnership agreement and attempts on this ground to distinguish the facts in the instant case from those presented in . In that case it was pointed out that the taxpayer, under the partnership agreement, continued">*319 to have the controlling voice in the business as to purchases, sales, salaries, the time of distribution of income, and all other essentials. After the partnership agreement in question was consummated, the petitioner legally possessed power to control the partnership only as one of three general partners. However, the other two general partners, who, together with petitioner, could exercise complete control over the policies and operation of the business, were his two eldest sons, who had been engaged in business with their father since leaving school. The Court in the Tower case observed that transactions between husband and wife calculated to reduce family taxes should always be subjected to special scrutiny. In our opinion, this principle is equally applicable to a partnership between a father and his children. By requiring the unanimous consent of all the limited partners before any partner had the right to assign his interest, the petitioner was secure in his purported desire that the partnership would remain in the control of his family. Although petitioner relinquished some measure of control to Harold and Carleton, the other four children obtained no greater control">*320 over their father's business by virtue of the partnership agreement than they possessed in the business he operated as a sole proprietorship.

Petitioner points out that the Court in the Tower case stated that the issue in such case is, "Who earned the income?" Petitioner goes to great lengths in an effort to demonstrate that the partnership income was largely earned by his two sons, Claude and Harold, and not by himself. Without underestimating the contribution made by these two boys to the success of the business, it is our opinion that a variety of circumstances was responsible for the large earnings of the taxable years. During these years, the Nation was at war and practically all of the profits earned by the partnership were realized on war contracts. Although personal services are of value in a business of this type, the capital necessary to establish and operate such a business is of equal importance. In our opinion, the earnings of the partnership were the result of a combination of the efforts of the ">*32 sons and the established business built up by petitioner over the past twenty-five years.

One fact made abundantly clear from the evidence is that the four youngest">*321 children contributed nothing towards this end. It should also be noted that the respondent recognizes the fact that Harold and Carleton rendered valuable services throughout the years in question and no effort is being made by him to tax their distributable shares of partnership income to the father.

While it may be, as petitioner contends, that the occasion for the distribution of his property was on the urging of his two eldest sons, we think that the transfers to the four other children were purposely made in a manner to retain in petitioner a substantial control over such property and to permit him to enjoy the tax advantages that might arise in the conduct of the partnership. It is interesting to note, as set out in our findings, that, with the establishment of the partnership, petitioner no longer carried out his duty to support and maintain his minor children, but transferred portions of their purported earnings to his own account to cover expenditures he made for their board and keep. In fact, he followed the same practice with reference to his son Claude and his daughter Margaret after the latter had quit school to undertake the management of his household and the care">*322 of the minor children.

On the facts of the whole record, it is our opinion that Claude, Margaret, Ralph, Jr., and Lucy were not bona fide members of the partnership in question and that the respondent's determination that petitioner is taxable on the four-sevenths of the partnership income distributed to these children during the taxable years in issue must be sustained. To permit the readjustment of depreciation as stipulated by the parties herein and to permit the respondent to effect refunds of the income taxes paid by each of the four youngest children on the partnership income allocated to them in each of the taxable years before us,

Decisions will be entered under Rule 50.

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Footnotes

• *. Proceedings of the following petitioners are consolidated herewith: Harold M. Hitchcock; Carleton C. Hitchcock; Claude R. Hitchcock; Margaret Ann Hitchcock; Ralph C. Hitchcock, Jr.; and Lucy Utter Hitchcock.↩