over the amount allowed to the corporation as a deduction will be regarded as being in payment of the sale of a capital asset and should be so treated by them for income-tax purposes.

REFERENCES:

Art. 105, Regulations 62: "... (1) Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. . . . (b) An ostensible salary may be in part payment for property. This may occur, for example, where a partnership sells out to a corporation, the former partners agreeing to continue in the service of the corporation. In such a case it may be found that the salaries of the former partners are not merely for services, but in part constitute payment for the transfer of their business."

Art. 106, Regulations 62: "As to the treatment of amounts ostensibly paid as compensation, but not allowed to be deducted as such, the following rules apply:

...

"(2) In the case of excessive payments by individuals or partnerships, the amounts disallowed should ordinarily be treated as shares of the profits of a partnership, except that a payment for property should be treated by the individual or partnership as a capital expenditure and by the recipient as part of the purchase price."

PROBLEM 92

Illustrating Deductibility of Salaries-Salaries in the Form of Contingent Compensation

FACTS:

The Indiana Manufacturing Company in the year 1902 engaged the services of Frank P. Whalen as general manager. The contract of employment provided that Mr. Whalen was to receive a fixed salary of $3,000 per annum plus 10% of the yearly profits of the company. Prior to 1917 the company's profits ranged from $25,000 to $150,000 per year, so that Mr. Whalen in this period received yearly compensation ranging from $5,500 to $18,000. As a result, however, of war work performed by the Indiana Mfg. Co. during 1917, 1918 and 1919, the company's profits for these years were $940,000, $2,320,000, and $1,450,000, respectively. As a result Mr. Whalen's additional compensation, based upon the percentage of profits to

which he was entitled, was $94,000, $232,000, and $145,000, for 1917, 1918, and 1919, respectively, which compensation was duly paid and taken as deduction from gross income on the income-tax returns filed by the company for these years.

An Internal Revenue Agent visited the offices of the company in 1921 and upon examination of the returns of the company filed for the years 1917, 1918, and 1919, took the position that the compensation paid Mr. Whalen was in excess of a reasonable salary as provided by the law.

QUESTION:

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Are the payments made to Mr. Whalen, as shown above, to be regarded as coming within the scope of section 234 (a) (1) and allowable as a deduction from gross income as a reasonable allowance for salaries or other compensation for personal services actually rendered?"

ANSWER:

The salaries and other compensation paid Mr. Whalen are not in excess of reasonable compensation under the circumstances. While the additional compensation was of a contingent nature and for the years in question actually worked out at an amount greater than would ordinarily be paid, as such compensation was paid pursuant to a free bargain between the company and Mr. Whalen before the services were rendered, and was not influenced by any consideration other than that of securing at fair and advantageous terms the services of Mr. Whalen, the compensation thus paid him should be allowed as a deduction from gross income for the years in question.

REFERENCE:

Art. 105, Regulations 62: "Among the ordinary and necessary expenses paid or incurred in carrying on any trade or business may be included a reasonable allowance for salaries or other compensation for personal services actually rendered. The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services. This test and its practical application may be further stated and illustrated as follows: ... (2) The form or method of fixing compensation is not decisive as to deductibility. While any form of contingent compensation

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invites scrutiny as a possible distribution of earnings of the enterprise, it does not follow that payments on a contingent basis are to be treated fundamentally on any basis different from that applying to compensation at a flat rate. Generally speaking, if contingent compensation is paid pursuant to a free bargain between the employer and the individual made before the services are rendered, not influenced by any consideration on the part of the employer other than that of securing on fair and advantageous terms the services of the individual, it should be allowed as a deduction even though in the actual working out of the contract it may prove to be greater than the amount which would ordinarily be paid."

"(3) In any event the allowance for the compensation paid may not exceed what is reasonable in all the circumstances. It is in general just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises in like circumstances. . . . The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned."

PROBLEM 93

Illustrating Deductions not Allowed Corporation-Salaries paid in Lieu of Dividends

FACTS:

The Farm Products Company, a domestic corporation, had but two officers, and together they owned or controlled all of its stock. In closing their accounts for the year 1921, they divided the entire profits for the year between themselves as compen

sation.

QUESTION:

Would this division of the profits constitute an allowable deduction by the corporation from its gross income?

ANSWER:

No, except under a very few circumstances, such as where the profits were so small that the compensation was clearly reasonable for the services performed.

REFERENCES:

Sec. 234 (a): "That in computing the net income of a corpora

tion subject to the tax imposed by section 230 there shall be allowed as deductions: (1) All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered.

T. D. 2262-Gives the decision of the U. S. Circuit Court of Appeals for the Second Circuit in the case of Jacob & Davies (Inc.) v. Anderson, collector of internal revenue (228 Fed., 505), wherein it was held that "When a company composed of two stockholders divides the profits between them, calling it compensation, the same cannot be deducted as an expense of business. Money paid out under these circumstances is equivalent to dividend and must be treated as income of the corporation."

Art. 105, Regulations 62: (1) Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. (a) An ostensible salary paid by a corporation may be a distribution of a dividend on stock. This is likely to occur in the case of a corporation having few stockholders, practically all of whom draw salaries. If in such a case the salaries are based upon or bear a close relationship to the stockholdings of the officers or employees, it would seem likely that the salaries, if in excess of those ordinarily paid for similar services, are not paid wholly for services rendered, but in part as a distribution of earnings upon the stock."

PROBLEM 94

Illustrating Deductions Allowed-Interest on Indebtedness Incurred to Purchase and Carry Securities

FACTS:

James Baker is in business as an individual with an established fiscal year ending November 30th, whose returns are filed on a cash basis. His income is derived mainly from underwriting entire issues of stocks and bonds of corporations, States and political subdivisions thereof, which he disposes of among banks and a large circle of other clients. It is often necessary to place large loans with his bankers to purchase and carry such issues until disposed of. His records are kept on lines which enable him to know his gain or loss on each underwriting. From these records he has prepared a statement as follows, covering all interest paid during his fiscal year ending November 30, 1921, showing the amount paid on indebtedness which was incurred to purchase or carry each issue of stocks or bonds:

$7,961.32

Firebrick Tire Co.

8% preferred stock

1,684.57 County of Tuckahoe

5,372.98 Ben Joyce Automobile Co. 7% 2-year notes

52% bonds

Since the interest on the County of Tuckahoe and City of Halsey bonds is tax exempt, the interest shown above as paid to carry these two securities would not be deductible. Interest paid as above on the other four securities would be deductible in full.

REFERENCE:

Sec. 214 (a): "That in computing net income there shall be allowed as deductions: . . . (2) All interest paid or accrued within the taxable year on indebtedness, except on indebtedness incurred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest upon which is wholly exempt from taxation under this title; . . ."

CORPORATIONS.

The above illustration would also apply to corporations subject to the tax imposed by section 230.

REFERENCE:

Sec. 234 (a): "That in computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions: . . (2) All interest paid or accrued within the taxable year on its indebtedness, except on indebtedness incurred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest upon which is wholly exempt from taxation under this title: . . ."

LIFE INSURANCE COMPANIES.

REFERENCES:

Sec. 245 (a): "That in the case of a life insurance company the term 'net income' means the gross income less . . . (8) All in