Reade Manufacturing Company, Inc., A Corporation of The State of New Jersey v. United States, 301 F.2d 803, 3rd Cir. (1962)
Reade Manufacturing Company, Inc., A Corporation of The State of New Jersey v. United States, 301 F.2d 803, 3rd Cir. (1962)
2d 803
Appellant was denied the right to deduct certain payments as necessary and
ordinary business expenses.
notes "there is not included under any of the items listed under `Liabilities' the
said claim made by Staley against the partnership." The Stipulation also shows
that the proposal to sell (which included the above statement) with the
proposal's acceptance by the corporation constituted the purchase agreement
between the partnership and the corporation. Of the 300 shares of no par value
paid stock issued, Leonard J. Reade received 150, Charles H. Reade 149 and
Charles F. Reade 1. Those three persons became the corporation's sole officers,
stockholders and directors. The assets and liabilities appearing on the statement
were transferred to the books of the corporation. The Stipulation states "The
Staley claim never appeared on the books of the corporation."
3
On November 19, 1948 Staley sued the partnership on its claim for damages,
alleged to total $1,050,000. The Reades after consultation with their attorney
"felt that they could successfully defend the suit and they therefore decided to
fight the case." A year later Staley filed an amended complaint restating its
cause of action against the partnership and joining the taxpayer as a defendant
on the theory it had assumed the partnership's liability for payment of the
Staley claim. The taxpayer filed an answer denying that allegation.
It is stipulated that the directors of the taxpayer determined that the suit with its
consequent publicity posed a serious threat to the continued existence of the
corporation; they felt the banks would not allow further credit or loan; that the
corporation's credit with its raw material supplies would be affected; that its
ability to perform its contracts would be doubted by the railroads. The
Stipulation reads: "The directors further felt that the obtaining of the loans and
credit was vital to the continued existence of the corporation, and it was
therefore determined that steps must be taken immediately to settle the Staley
litigation. The corporation had been advised by the banks from which it had
been accustomed to borrow, that unless the Staley case were settled at once, no
further loans or credit would be extended to the corporation."
It appears from the Stipulation that around that time the Staley claim against
both the partnership and the corporation could be settled for $50,000. The
corporation did not possess this sum and for business credit reasons was unable
to finance it. The Stipulation language then reads:
"17. The Staley suit against the partnership and the taxpayer was compromised
under an agreement whereby the taxpayer's two chief stockholders, Leonard J.
Reade and Charles H. Reade, gave their personal promissory note in the
amount of $50,000, payable to Staley at the rate of $5,000 per year beginning
on September 1, 1950."
Thereafter on September 1 of each of the years 1950, 1951, 1952 and 1953, the
taxpayer paid the installments on the note to Staley. It deducted each such
payment as an ordinary and necessary business expense for the particular year.
After that the two Reades agreed with Staley to settle the $30,000 balance of
their note to Staley for $22,000. Taxpayer paid that amount and deducted it as
ordinary and necessary business expense for its fiscal year ending April 30,
1955.
The Commissioner disallowed the 1953 $5,000 payment and the 1954 $22,000
payment. The taxpayer paid the amounts assessed, filed its claim for refund
which was refused and started its present action. The case was tried to the court
on the referred to Stipulation of Facts and as stated resulted in a judgment in
favor of the defendant.
Taxpayer argues earnestly that "The Corporation's payments to Staley under the
settlement which the Corporation was required to effect in order to preserve its
business from destruction were deductible as ordinary and necessary business
expenses."1 This case was tried on a formal written Stipulation of Facts. The
latter bluntly sets out serious and reasonable fear of business disaster if the
Staley litigation was not closed out. It also unmistakably reveals that the
settlement with Staley was made by the individuals Leonard J. Reade and
Charles H. Reade who comprised the Reade partnership and who were also, as
the Stipulation points out, "The taxpayer's two chief stockholders." Staley's
grievance was against the partnership. The face amount of damages sought was
over a million dollars. The Reade partnership would seem to have been a
general one, carrying the ordinary personal responsibility of the firm members.
The Staley matter therefore of necessity was of major concern to the Reades
individually. In addition it was undoubtedly important to them as stockholders
of the corporation not so much from the standpoint of the corporation's
responsibility for the claim since it had not assumed the obligation2 as from the
resultant damaging publicity.
10
In the situation it was the taxpayer's burden to go forward and establish its right
under the statute to the deductions, i. e. that they are "* * * ordinary and
necessary expenses paid or incurred during the taxable year in carrying on any
trade or business * * *." Internal Revenue Code 1954, 26 U.S.C. (1958 ed.)
162.
11
The taxpayer urges that "the entire transaction stemmed from a single purpose.
The preservation and protection of its existing business in the face of a serious
threat to its continued existence." It places its reliance upon Catholic News
Publishing Co., 10 T.C. 73 (1948) asserting that the facts here are
indistinguishable from that decision. Actually they differ fundamentally. In
Catholic News, the president of the corporation was only a ten per cent
stockholder. The balance of the stock was owned by his son and his father's
estate. The president was involved in a bitter personal feud with a publisher's
association relative to some moneys collected during his term as treasurer
thereof. The dispute became of vital concern to the corporation. The president
refused to make any payment to the association. "Finally (as the Findings of
Fact state p. 75) to prevent further criticism injurious to petitioner's reputation
and to its business, its board of directors flatly instructed Ridder to effect an
immediate settlement of the dispute. He would have prolonged the dispute
indefinitely, except for the directors of the board; * * *." The Tax Court held
(p. 76) "From that point on Ridder was acting not as a mere individual to settle
a personal claim against himself. Rather he was acting as an agent of the
petitioner to bring about the settlement of a controversy which, in the opinion
of the directors, materially and adversely affected its business."
12
In this appeal we do have the corporation opinion that the Staley suit would
materially and adversely affect its business. There is no other element helpful to
taxpayer. The two Reades, the partners with the unquestioned primary and
personal responsibility, individually initiated, conducted and concluded the
settlement. At the time the suit was instituted against the partnership alone, the
Reades, after talking with their lawyer, felt they could successfully defend the
suit and they therefore decided to fight the case. After that the corporation was
joined as a defendant and answered, denying it had ever assumed liability for
the Staley claim. Then without pressure or directive from the corporation, with
no agreement whatsoever that the corporation would pay all or part of a
settlement or reimburse them for payments they might make, the Reades,
completely on their own, disposed of the Staley law suit and claim. There was
no authentic agency relationship between the Reades and the taxpayer. With the
facts in this suit as they are the Catholic News decision has no application.
13
The payments before us in the Staley settlement were made by the taxpayer in
1953 and 1954. Both those dates were years after the settlement which had
eliminated the source of danger to the corporation business. It follows that the
payments did not qualify under the statute as "necessary".
14
That brings us to the question of whether there was a moral obligation on the
part of the taxpayer to make the payments and if so, does that bring it within
Section 162. In Catholic News the Tax Court held, "And, even if there was no
express understanding, petitioner was obligated in equity and good conscience
to reimburse Ridder, * * * in view of the fact that it had directed him to settle a
claim for which he denied all personal liability and which he would not have
otherwise paid." None of those elements is present in this appeal. The
corporation did not direct or intimate that the Reades should settle; the Reades
would have been personally liable in the event the partnership product was
found to be responsible for the damage caused by the soy sauce; there is no
indication that at the time the Reades settled with Staley, they would not have
done so except for the corporation situation. Clearly, no moral obligation of the
taxpayer to take care of the personal obligation of the Reades has been
established.3 Rather the payments were gratuitously assumed by the Reade
corporation. It cannot be glossed over that the Reades were the partnership;
they are the corporation. The settlement eliminated a possibly substantial
personal liability; the way it was paid out was helpful to them taxwise by their
corporation obtaining a deduction under Section 162. That deduction cannot be
sustained under the facts or law.
15
Notes:
1
It would seem that appellant's first point is not pressed; whether it is or not, we
find it without merit. It does not call for discussion
Holding as we do, there is no need of our now examining at length the problem
of whether an authentic moral obligation is sufficient to justify a deduction
under Section 162. We simply note that in Farnsworth v. Commissioner, 270
F.2d 660 (3 Cir. 1959), taxpayer inter alia felt himself bound by a moral
obligation. He also had strong family reasons for his action. We accepted the
Tax Court's finding that he had gratuitously assumed the obligations and that
therefore his settlement payments were not a business necessity. And in
Commissioner of Internal Revenue v. Gilt Edge Textile Corporation et al., 173
F.2d 801 (3 Cir. 1949), we held that the corporation's payment was a gift to its
president majority stockholder for his sole benefit and that consequently no
moral obligation existed