Diamond v. Commissioner

*531 The Commissioner determined deficiencies of $ 36,657.57 and $ 16,507.27 in petitioners' income tax for the calendar years 1961 and 1962 respectively. After concessions, the following issues remain for decision: (1) Whether certain commissions received by petitioner Sol Diamond in 1961 must be included in petitioners' gross income for that year under section 61, I.R.C. 1954, and if so, whether purported "consultants fees" paid by him in respect of such commissions during that year are deductible as ordinary and necessary business expenses under section 162, I.R.C. 1954; and (2) whether petitioner Sol Diamond received ordinary *115 income in the amount of $ 40,000 in 1962 as compensation for services rendered, and if so, whether petitioners are entitled to a deduction in that year for petitioner's share of an alleged $ 40,000 loss on termination of a partnership.

FINDINGS OF FACT

The parties have stipulated certain facts which are incorporated herein by this reference.

Petitioners Sol and Muriel Diamond are husband and wife. They filed joint Federal income tax returns for the calendar years 1961 and 1962, prepared on the cash receipts and disbursements method of accounting, with the district director of internal revenue at Chicago, Ill. They resided in Chicago, Ill., at the time the petition in this case was filed.

*532 I

During 1961 and 1962 Sol Diamond (petitioner) was a builder and a mortgage broker. His building activities included the purchase of land, construction of buildings and homes on the land, and ultimately sale of the improved properties. In his capacity as a builder, petitioner served as president of First Federal Townhouses, Inc. From time to time petitioner arranged for loans to be made to that corporation on the basis of real estate mortgages. He arranged for the loans through a mortgage broker, *116 and the corporation paid the broker a percentage commission for each loan.

While engaged in the building business, petitioner became acquainted with Henry Moravec, Sr. (Henry, Sr.), and his son, Henry Moravec, Jr. (Henry, Jr.), who were officers of Marshall Savings & Loan Association (Marshall) of Riverside, Ill., licensed and operated under the laws of the State of Illinois. At all times relevant herein, its deposits were insured by the Federal Savings & Loan Insurance Corporation. During 1961 Marshall was a "mutual association of depositors," and had at least 20,000 depositors. The Moravecs obtained and voted a majority of the depositors' proxies at the association's annual meetings, and as a result, they were able to name and elect a slate of directors at the meetings. Marshall's officers included Henry J. Moravec, Sr., as president, Henry J. Moravec, Jr., as executive vice president and secretary, and Jerome Moravec (Henry, Sr.'s brother) as vice president and treasurer.

During 1960 or 1961, Henry, Jr., suggested that petitioner become a mortgage broker. He told petitioner that Marshall needed responsible and successful builders as borrowers and that, as the result of his contacts *117 in the building industry, petitioner could make more money by bringing borrowers to Marshall than he could by building homes. Petitioner accepted the offer and began work as a mortgage broker.

Both Henry, Sr., and Henry, Jr., instructed petitioner in his duties. As a mortgage broker, petitioner's functions included calling on builders, persuading them that he could provide them with better service than could the brokers with whom they were currently doing business, and assisting them in obtaining "payouts" on loans that he might arrange on their behalf.

Before approving a loan to any of petitioner's clients, Henry, Jr., visited and examined the property to be mortgaged. On occasion he told petitioner how much to charge as a broker's commission for arranging a loan from Marshall. However, Henry, Jr., did not determine whether petitioner in fact received such commissions.

*533 For about 6 months petitioner was unable to produce any business for Marshall. But during 1961 business improved, and petitioner was able to produce a number of builders in need of mortgage loans.

During 1961 petitioner received the following payments as commissions from borrowers with respect to loans which he had *118 placed with Marshall:

The borrowers listed above were successful builders and were consequently considered to be desirable customers for Marshall to have.

At about the time that petitioner received each of the four foregoing commissions identified by an asterisk, he made a payment or payments by check for the benefit of the Moravecs which was equal to approximately 50 percent of the amount of the commission payment. Such payments *119 were made as follows:

(1) Petitioner received a commission from Jack Netchin in the amount of $ 18,610.75 on March 14, 1961, and deposited that amount in his checking account at Peoples National Bank of Chicago. On the same date petitioner also remitted to the Moravecs $ 9,305 by check issued to "Real Consultant Associates." Real Consultant Associates was a partnership, formed in late 1960 or early 1961, and operated for *534 a period of about 1 to 2 years. Its members were Henry, Sr., Henry, Jr., and Jerome Moravec, and it used Marshall's place of business, 3722 South Harlem, Riverside, Ill., as its address. (2) On May 4, 1961, petitioner received a commission from Netchin in the amount of $ 30,000 and deposited that amount in his checking account. Petitioner remitted $ 15,000 to the Moravecs by two checks, issued to Real Consultant Associates and dated April 26, 1961. The checks were deposited and cleared on May 9, 1961. (3) On May 26, 1961, petitioner received a third commission from Netchin in the amount of $ 7,539.50, and again deposited that amount in his checking account. On the same date he remitted $ 3,750 to the Moravecs by a check issued to "M. Bonke." M. Bonke was Marlene *120 Bonke Moravec, the wife of Henry Moravec, Jr. (4) On September 20, 1961, petitioner received a commission from Krilich Builders in the amount of $ 2,687, and deposited that amount in his checking account. On September 21, 1961, he remitted to the Moravecs $ 1,343.50 by a check issued to M. Bonke.

In addition to the payments just described, petitioner made an additional payment by check in the amount of $ 10,000, issued to M. Bonke, and dated August 3, 1961. ¹

Petitioner made the foregoing *121 payments, in the aggregate amount of $ 39,398.50, pursuant to an arrangement between him and Henry, Jr. The amount of each payment was determined at least in part, on the basis of the size and nature of the project being financed and the amount of the loan. There was some disagreement between petitioner and the Moravecs as to the amount or amounts which he owed them, and the final $ 10,000 payment was intended as a settlement of that dispute. The checks were issued to Real Consultant Associates and M. Bonke at the direction of Henry, Jr.

Real Consultant Associates included all of petitioner's payments in income on its 1961 partnership return. It also included in income payments received from three other individuals which were comparable in nature to those made by petitioner. None of Marshall's officers, directors, or depositors, other than the Moravecs, knew of the amounts paid by petitioner and the other three individuals to Real Consultant Associates. Indeed, with the exception of one employee, no one else in the Marshall organization was aware of the existence of the partnership.

*535 In addition to the commissions which they paid to petitioner, the borrowers also paid commissions *122 directly to Marshall.

In December of 1964, the assets of Marshall were taken over by the State of Illinois.

The parties have stipulated that at all times relevant herein sections 2 and 1006 of title 18 of the United States Code² were enforced by the U.S. Department of Justice.

On their 1961 joint Federal income tax return petitioners included *123 in gross income all of the commission payments received from the borrowers and claimed a deduction in the amount of $ 39,398.50 as "Consultants fees," attributable to the six checks issued to Real Consultant Associates and M. Bonke, described above. In his statutory notice of deficiency, the Commissioner disallowed the claimed deduction.

At all times relevant herein, Philip Kargman was involved in real estate activities in Chicago. His general mode of operation was to organize syndicates for the purpose of purchasing real property. The coventurers in such syndicates generally did not know one another and did not enter into partnership agreements. Ordinarily a land trust was established to hold title to the acquired property, and each coventurer retained a beneficial interest proportionate to his contribution to the total purchase price. Kargman managed the syndicates which he organized, and through his sole proprietorship, P. Kargman & Co., managed the acquired properties in return for a commission of about 3 or 4 percent.

In late 1961 Kargman was informed of the availability of a 10-story office building located at 201-207 West Monroe Street in Chicago. On December 6, 1961, the *124 property became the subject of a real estate contract which Zel Kelvin (Kelvin) had executed as the purchaser, and which had not yet been executed by the seller. Kelvin made a deposit of $ 50,000 on the purchase price under the contract of $ 1,100,000. On the same day, December 6, 1961, Kargman and Kelvin entered into an agreement under which Kelvin agreed to assign to Kargman his entire interest in the real estate contract if it should be executed by the *536 seller ³ on or before December 27, 1961. In return Kargman paid Kelvin $ 25,000 (which was to be refunded if the seller had not executed the contract by December 27) and agreed that upon delivery of the assignment he would assume Kelvin's obligations under the real estate contract and reimburse Kelvin for his $ 50,000 deposit. It was also contemplated that Kargman would pay any broker's fees or commissions due as the result of the transaction.

Kargman had known petitioner for many years at the time and was aware that petitioner engaged in a variety *125 of real estate activities. (In fact, at about the same time Kargman and petitioner participated together in the acquisition of an unrelated motel property.) While he was negotiating for the West Monroe Street property, Kargman asked petitioner if he could arrange financing for the acquisition in the amount of $ 1,100,000. In return, Kargman offered to permit petitioner to participate with him in the venture. Petitioner stated that he could arrange for the financing, but insisted on a 60-percent interest in the venture. Although Kargman thought that they should each have 50-percent interests, he accepted petitioner's terms.

Petitioner succeeded in obtaining a mortgage loan from Marshall in the full amount of the $ 1,100,000 purchase price. Petitioner and Kargman executed a document, dated December 15, 1961, setting forth their agreement with regard to the venture. It provided in part as follows:

AGREEMENT

This Agreement, made this 15th day of December, 1961, by and between PHILLIP KARGMAN, hereinafter referred to as Party of the First Part, and SOL DIAMOND, hereinafter referred to as Party of the Second Part,

Witnesseth:

Whereas, Party of the First Part is in the process of purchasing *126 a ten story office building commonly described as 201-7 West Monroe Street, Chicago, Illinois, and

Whereas, Party of the Second Part shall, if the contemplated acquisition is completed, be instrumental in obtaining mortgage financing in the sum of One Million one hundred Thousand ($ 1,100,000.00) Dollars for the Party of the First Part from Marshall Savings and Loan Association, which mortgage shall bear interest not exceeding six and one-half (6 1/2%) per cent and which shall be for a period of not less than twenty-four (24) years and at a service cost not exceeding three (3) points, and

Whereas, said parties hereto are desirous of providing adequate and sufficient compensation to the Party of the Second Part for the services to be rendered by the Party of the Second Part in pursuance of the terms hereinafter recited and by reason thereof are desirous in joining in a joint venture agreement;

Now, Therefore, in Consideration of the sum of One ($ 1.00) each to the other in hand paid and the mutual covenants herein contained, It Is Agreed as Follows:

*537 1. The parties hereto shall be associated as joint venturers, in pursuance of the terms hereof, for the purpose of owning and controlling *127 the property owned by the Party of the First Part.

2. The name of the joint venture shall be "201-7 W. Monroe Street Building", 201-7 W. Monroe Street, Chicago, Illinois, or such other name or names as shall be determined by the parties hereto.

3. The term of this joint venture shall commence immediately upon the acquisition of the subject property and shall continue thereafter for a period of twenty-four (24) years unless sooner terminated by:

(a) Agreement of the parties;

(b) Sale, liquidation or disposition by the parties of all or substantially all of the assets of the venture;

(c) Breach or violation of the terms hereof by Party of the Second Part.

4. All capitals and monies required for the acquisition of said office building in excess of One Million One Hundred Thousand ($ 1,100,000.00) Dollars, shall be contributed by the Party of the First Part, provided, however, that notwithstanding that said capital or monies required shall not be deposited in the same proportion in which they shall be entitled to profits or losses, the Party of the First Part shall receive forty (40%) per cent of the profits and the Party of the Second Part shall receive sixty (60%) per cent of all profits and *128 shall be chargeable with all losses in the same proportions.

5. In the event the premises acquired by the Party of the First Part are sold to a Bona Fide purchaser, it is agreed that the net cash received from the sale price, less all expenditures, including without limitation thereby, closing expenses, professional fees, broker's commission, title charges and deductions for pro-rations, shall be apportioned and paid as follows:

(a) First to the repayment to the Party of the First part of any sums of money spent or required in the acquisition of the subject premises;

(b) The net profits thereafter to be distributed in accordance with the holdings of the parties hereto, namely:

PHILLIP KARGMAN -- 40%

SOL DIAMOND -- 60%

If said sale is consummated on an installment basis, this venture shall not terminate, but shall continue for the duration of such payments, however, provided, from all such installment payments the sums thereunder paid by the purchaser shall be paid and distributed as hereinabove set forth.

On or about January 3, 1962, Kelvin assigned his interest in the real estate contract to Kargman.

On or about January 5, 1962, Kargman and petitioner executed a form "trust agreement," sometimes *129 known as an Illinois land trust. Under the agreement title to the Monroe Street property was to be held by the Exchange National Bank of Chicago as trustee for the benefit of Kargman and petitioner, with beneficial interests of 40 percent and 60 percent, respectively. The trust agreement provided in part as follows:

It Is Understood And Agreed between the parties hereto * * * that the interest of any beneficiary hereunder shall consist solely of a power of direction to deal with the title to said property and to manage and control said property as hereinafter *538 provided, and the right to receive the proceeds from rentals and from mortgages, sales or other disposition of said premises, and that such right in the avails of said property shall be deemed to be personal property, and may be assigned and transferred as such * * * and that no beneficiary now has, and that no beneficiary hereunder at any time shall have any right, title or interest in or to any portion of said real estate as such, either legal or equitable, but only an interest in the earnings, avails and proceeds as aforesaid. * * *

* * * *

It is understood and agreed by the parties hereto and by any person who may hereafter *130 become a party hereto, that said The Exchange National Bank of Chicago will deal with said real estate only when authorized to do so in writing and that (notwithstanding any change in the beneficiary or beneficiaries hereunder) it will on the written direction of

all the beneficiaries

or such other person or persons as shall be from time to time named in writing by the beneficiary or beneficiaries, or on the written direction of such person or persons as may be beneficiary or beneficiaries at the time, make deeds for, or otherwise deal with the title to said real estate, provided, however, that the trustee shall not be required to enter into any personal obligation or liability in dealing with said land or to make itself liable for any damages, costs, expenses, fines or penalties, or to deal with the title so long as any money is due to it hereunder. The trustee shall not be required to inquire into the propriety of any such direction.

The beneficiary or beneficiaries hereunder, in his, her or their own right shall have the management of said property and control of the selling, renting and handling thereof, and shall collect and handle the rents, earnings, avails and proceeds thereof, *131 and said trustee shall have no duty in respect to such management or control, or the collection, handling or application of such rents, earnings, avails or proceeds, or in respect to the payment of taxes or assessments or in respect to insurance, litigation or otherwise, except on written direction as hereinabove provided, and after the payment to it of all money necessary to carry out said instructions. * * *

Closing activities in respect of the acquisition of the West Monroe Street property were commenced on February 15, 1962, and became final on February 18, 1962. The Exchange Bank as trustee took title to the property and executed the mortgage and mortgage note. As arranged previously, the amount of the loan from Marshall was $ 1,100,000. From this amount, $ 38,000 was placed in an escrow account for payment of taxes and insurance, $ 8,596.50 was deducted as interest expense, and $ 33,000 was retained by Marshall as the cost of obtaining the loan. The remainder, $ 1,020,403.50, was initially placed in an escrow account and used to pay the net amount owed to the seller, $ 1,011,598.83. ⁴ In connection with the acquisition of the property Kargman *539 made net cash outlays in the *132 aggregate amount of $ 78,195.33, as follows:

Petitioner advanced no funds whatever in connection with the acquisition of the property. He acquired his interest in the "land trust" relating to that property on February 18, 1962, as compensation for his services theretofore rendered to Kargman in obtaining the mortgage loan from Marshall.

In accordance with the understanding between Kargman and petitioner, the property was managed by Kargman's sole proprietorship, P. Kargman & Co.

During the course of the foregoing events, Kargman was approached by George Liederman with regard to the Monroe Street property. Liederman had originally referred the broker handling the property to Kargman, and complained that therefore he, rather than petitioner, should have participated in the venture. Kargman *133 suggested that Liederman make an offer for petitioner's interest in the land trust. Kargman and Liederman agreed that they would each hold 50-percent interests in the trust if petitioner accepted the offer. Liederman offered petitioner $ 20,000 for his interest and they eventually agreed upon a purchase price of $ 40,000. The sale was effected in the following manner: On March 8, 1962, petitioner assigned his 60-percent interest in the trust to Kargman in exchange for Kargman's check for $ 40,000. Liederman then paid Kargman $ 40,000, practically all of it in cash, and acquired in return a 50-percent interest in the trust. As a result, Kargman's interest in the trust was increased from 40 to 50 percent.

On their 1962 joint income tax return, petitioners reported a $ 40,000 short-term capital gain attributed to "sale of partnership interest, 201 W. Monroe Building." In his statutory notice of deficiency the Commissioner determined that the $ 40,000 reported as short-term capital gain was instead includable in petitioner's ordinary income for 1962. ^5*134

*540 OPINION

1. Payments to the Moravecs. -- In 1961 petitioner Sol Diamond, as a mortgage broker, received an aggregate of $ 145,186.37 in commissions or fees from various borrowers for obtaining some 24 loans on their behalf from Marshall Savings & Loan Association, which was controlled by members of the Moravec family. He reported that amount as income and claimed various deductions as expenses incurred in the conduct of his mortgage brokerage business. Among those deductions was an item of $ 39,398.50 described as "Consultants fees." That item represents the sum of payments made by petitioner to the Moravecs in connection with four of the foregoing loans plus a further payment to them that was not identified with any particular loan. The Commissioner disallowed the claimed deduction. He ruled that the "Consultants fees" item was "not deductible under the provisions of section 162 of the Internal Revenue Code of 1954, or any other section thereof." Section 162(a)grants a deduction for "all the ordinary and necessary expenses paid or incurred * * * in carrying on any *135 trade or business."

In their original petition in this Court petitioners' sole allegation of error was that the Commissioner had erroneously determined that the moneys paid by petitioner Sol Diamond "for services of others in assisting him in arranging and expediting loans was not deductible under Section 162 of the Internal Revenue Code as an ordinary and necessary business expense." It was not until the trial of this case that petitioners filed an amendment to their petition, claiming in the alternative that petitioner acted merely as a conduit for the Moravecs in respect of the amounts paid to them and that the aggregate of such amounts ⁶ should never have been included in gross income in the first instance. While petitioners argue both points on brief, they appear to place their principal emphasis upon their new alternative position. We conclude that they cannot prevail on either theory.

(a) Exclusion from gross income. *136 -- We note at the outset that petitioners' alternative position is inconsistent not only with their 1961 income tax return, which reported the full $ 145,186.37 mortgage loan commissions (unreduced by the payments to the Moravecs), but also with the original petition filed in this Court. Thus, in their original petition they painted a picture of services rendered by the Moravecs, of petitioner's having engaged them to assist him in his activities as a mortgage broker, and of the payments made by him to the Moravecs for such services. The theory of the amended petition was entirely *541 different. It treated the Moravecs as being in complete control of the commissions received by petitioner from the borrowers, and proceeded upon the explicit assumption that the Moravecs merely "permitted Petitioner to retain all commissions other than the amounts" which he paid over to them. Thus, it portrayed petitioner "as a conduit for the Moravecs," and sought to have excluded from the commissions actually received by petitioner the amounts which he paid to them as "Consultants fees." While it is of course open to petitioners to present alternative theories, we must nevertheless evaluate the evidence *137 with particular care to the extent that a new theory depends upon facts that may be inconsistent with allegations in the original petition which petitioners had verified as true.

We accept as sound law the rule that a taxpayer need not treat as income moneys which he did not receive under a claim of right, which were not his to keep, and which he was required to transmit to someone else as a mere conduit. ⁷ But, as we evaluate the evidence, petitioner in this case was no mere conduit.

Petitioner testified that he originally had an understanding with Henry Moravec, Jr., that he would pay over to the Moravecs 50 percent of the *138 commissions he received, but that after making a number of such payments, he was released from his obligation as the result of unexpected expenses which he incurred. We found his testimony altogether unconvincing. To be sure, four of petitioner's five payments to the Moravecs were equal or approximately equal to 50 percent of commissions he received at about the same time. But petitioner made no payments that could be identified with the 20 other commissions he received during 1961. Moreover, the chronology of the commissions and payments belies petitioner's account of his original understanding with Henry, Jr.; payments were not made when the first commissions were received in 1961, nor were they made regularly. Furthermore, although Henry Moravec, Jr., did not testify at the trial herein, the parties have stipulated what his testimony would have been if he had been called to testify. As stipulated, his testimony does not support petitioner's account of their understanding and in some respects conflicts with petitioner's testimony. We conclude that petitioners have failed to carry their burden of proof, that the commissions were received by petitioner under a claim of right, *139 and that they must include all commissions received in 1961 in their gross income. Cf. *542 North American Oil Consolidated v. Burnet, 286 U.S. 417, 424; United Draperies, Inc. v. Commissioner, 340 F. 2d 936, 938 (C.A. 7), affirming 41 T.C. 457, certiorari denied 382 U.S. 813. As we pointed out in Boyle, Flagg & Seaman, Inc., 25 T.C. 43, 48, "If petitioner is to be entitled to a tax benefit with respect to the amounts paid to the [Moravecs] * * *, such benefit must be in the form of a deduction from gross income * * *." ⁸

(b) Ordinary and necessary business expenses. -- We also conclude that petitioners may not deduct the payments made to the Moravecs as ordinary and necessary business expenses. As noted above, the Commissioner's disallowance of the claimed deduction *140 was based generally upon his determination that it failed to comply with the requirements of section 162, which grants a deduction for "ordinary and necessary" business expenses. These provisions have been regarded as excluding those deductions the allowance of which would "frustrate sharply defined national or state policies proscribing particular types of conduct." Commissioner v. Heininger, 320 U.S. 467, 473; Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30; Commissioner v. Tellier, 383 U.S. 687, 694; Dixie Machine Welding & Metal Works, Inc. v. United States, 315 F. 2d 439 (C.A. 5), certiorari denied 373 U.S. 950; Coed Records, Inc., 47 T.C. 422; see also Boyle, Flagg & Seaman, Inc., 25 T.C. 43, 48-51, cited with apparent approval in Tank Truck Rentals, Inc., 356 U.S. at 35. In its opening statement to this Court at the trial, the Government indicated that it was challenging the claimed deduction not only on the grounds that the expenditures were not "ordinary and necessary" to petitioner's business, but also on the further ground that they were in contravention of sharply defined public policy. ⁹ Petitioners were thus put on notice, if such notice were deemed to be necessary, *141 that their burden of proof related to both aspects of the deductions which they sought to defend. And while it is true that the Government's brief, filed after the trial, appears to rely only upon the public policy ground, it is open to this Court to decide this issue upon either ground. ¹⁰

*543 Accordingly, although we think that there is considerable force to the public policy argument that the allowance of the deduction *142 would contr