REFERENCE: Art. 168, Regulations 62: "A taxpayer who has incurred expenses in his business for . . . work of an experimental nature calculated to result in improvement of his facilities or his product, may at his option deduct such expenses from gross income for the taxable year in which they are incurred or treat such articles as a capital asset to the extent of the amount so expended. In the latter case, if the period of usefulness of any such asset may be estimated from experience with reasonable accuracy, it may be the subject of depreciation allowances spread over such estimated period of usefulness. The facts must be fully shown in the return or prior thereto to the satisfaction of the Commissioner." NOTE: The same rule would apply in the case of a corporation. PROBLEM 88 Illustrating Deductions From Gross Income-Expenses Incurred in Connection with Automobile Used Partly for Business FACTS: Henry Holmes in 1921 expends $600 in the operation and upkeep of an automobile used partly for personal convenience, and partly for business purposes. QUESTION: Is the above amount deductible in Mr. Holmes' income-tax return? ANSWER: The Committee on Appeals and Review has ruled that where a taxpayer uses an automobile as the means of transportation from his residence to his place of business, such expense is personal and not deductible; but where it is necessary to use a personal automobile, at least in part, for purely business purposes, that portion of the upkeep and operating expenses which can be properly allocated to such use constitutes an allowable deduction. REFERENCE: Bul. 26-21-1707; A. R. R., 551: “... With reference to the taxpayer's claim for a deduction to cover the amount expended by him. . . in the operation of an automobile used by him for business purposes. . . the Committee is of the opinion. . . if it is ascertained that in order to earn his salary . . ." the taxpayer "was responsible for the discharge of certain duties and that the said automobile was owned and used by him in the performance of those duties, that" a deduction ". . . in such an amount as will cover the actual expenses satisfactorily shown to have been incurred in the operation of the automobile for business purposes" should "be allowed as an ordinary and necessary business expense. . ." A similar ruling was made in Bul. 41-20-1230; A.R.R., 266. PROBLEM 89 Illustrating Deductions From Gross Income-Payments to Workmen's Compensation Insurance Fund Required FACTS: by State Law James Gordon, owning and operating a drain-tile manufacturing establishment, is required by the statute of the State in which his factory is located to make certain payments each year into a workmen's compensation insurance fund, the fund being the property of the State. QUESTION: How are these payments to be treated on Mr. Gordon's incometax return? ANSWER: Since the payments are required by the law to be made to an insurance fund of the State, such payments are deductible from gross income. However, had the law permitted or required the employer to maintain a fund with a trust company as a reserve from which payments would be made as compensation for injuries as such occur, the periodical deposits to such a fund would not be deductible, but the actual amounts paid to the employees as compensation when injuries occur would be deductible. REFERENCE: Bul. 27-21-1712; O. D., 964: "... Where the employer makes the periodical payments to the insurance fund of a State such payments are allowable deductions for the year in which paid or accrued. "If, however, the employer maintains a fund actually depositing periodically in a trust company an amount to be held in reserve as a special fund for the payment of compensation as injuries occur, the amount thus deposited is not an allowable deduction from gross income, since there is no means of determining how much of this fund will be used for the purpose for which it is held. In such case the actual amount paid during a year to the employes as compensation where injuries occur is a proper deduction for that year whether the amount so paid is greater or less than the deposits made during the period to the fund which is maintained." NOTE: The same ruling would apply in case the taxpayer were a corporation. FACTS: PROBLEM 90 Illustrating Deductibility of Bonus to Employees Harris, Peters & Cook, a Wall Street brokerage firm, for many years past followed the practice of paying its employees a fixed compensation together with bonuses at the end of each year, which bonuses were based upon the profits for the year and the relative importance of the several employees in producing these profits. The firm had no written contract with its employees that it would make such bonus payments. They were, nevertheless, made each year in varying amounts and were paid as additional compensation for services actually rendered by the employees. For the year 1921 the employees whose salaries during the year were $2,000 or under received a bonus. of 20% of such salary. Employees whose salaries were in excess of $2,000, but less than $5,000, received a bonus of 25% of said salaries. Employees whose salaries were in excess of $5,000, received a bonus of 30% of said salaries. None of these employees had any proprietary interest in the firm. Taking into consideration the plan of compensation above described, the salaries paid plus the bonuses did not together exceed reasonable compensation for the services rendered. QUESTION: Do the bonuses for 1921 represent allowable deductions from gross income? ANSWER: REFERENCE: Art. 107, Regulations 62: "Bonuses to employees will constitute allowable deductions from gross income when such payments are made in good faith and as additional compensation for the services actually rendered by the employees, provided such payments, when added to the stipulated salaries, do not exceed a reasonable compensation for the services rendered. . . . Donations made to employees and others, which do not have in them the element of compensation or are in excess of reasonable compensation for services, are considered gratuities and are not deductible from gross income." PROBLEM 91 Illustrating Deductibility of Salaries-Salaries in Part Payment for Property not Deductible. FACTS: Cauldwell & Rogers, a partnership, were engaged in the business of manufacturing furniture in the City of Jamestown, N. Y. In the year 1916 the partnership sold its assets and business to the High-Class Furniture Company. The agreement of sale provided that both Mr. Cauldwell and Mr. Rogers were to enter the employ of the High-Class Furniture Company and continue in the management of the Jamestown works of the old partnership. This agreement also provided that the old partnership was to receive $400,000 for the tangible property and nothing specifically for the intangible property, although the said intangible property had a value at the date of sale of $500,000. The agreement was that Mr. Cauldwell and Mr. Rogers were to receive, by way of salary, $100,000 each for the years 1917, 1918 and 1919 and that thereafter their salary was to be $15,000 each per annum. The High-Class Furniture Co. in preparing its income tax returns for the years 1917, 1918, and 1919 included as deductions from gross income the salaries of $100,000 each paid to Mr. Cauldwell and Mr. Rogers. An agent of the Bureau of Internal Revenue made an examination of the company's returns early in 1922 and upon reviewing the facts as stated above, came to the conclusion that the salaries paid to Mr. Cauldwell and Mr. Rogers were excessive and should not be allowed as deductions from gross income, and informed the treasurer of the High-Class Furniture Company that he would recommend to the Bureau at Washington that of the salaries thus paid to Messrs. Cauldwell and Rogers the company be allowed as deductions from gross income only $15,000 for Cauldwell and $15,000 for Rogers. QUESTION: Will the Revenue Agent's recommendations be sustained by the Bureau of Internal Revenue at Washington, and if so how should Messrs. Cauldwell and Rogers treat the excess of the amounts received by them over the amount allowed to the corporation as a deduction? ANSWER: From the circumstances as stated it would apear that the payments made to Messrs. Cauldwell and Rogers in the form of salaries constituted, in a very large part, payment for the goodwill of their business and that, therefore, the excess of these payments over a reasonable amount for salaries will be disallowed by the Bureau as deductions from gross income. It is quite likely that under the circumstances the Bureau will not allow more than $15,000 each as a reasonable compensation to Cauldwell and Rogers. The Bureau will probably regard the salary paid Cauldwell and Rogers in 1920 and thereafter as more nearly representing reasonable compensation. From the viewpoint of Cauldwell and Rogers, the excess paid |