Dave Fischbein Mfg. Co. v. Commissioner

*338 These cases involve deficiencies in income tax asserted by respondent for petitioners' taxable years as follows:

The parties have reached settlement with respect to three of the initial issues involved in docket No. 1455-70. Irrespective of our further disposition of the remaining issues with regard to Dave Fischbein Co., a Rule 50 computation will be required.

The issues remaining for our decision are: (1) Whether salaries paid by both petitioners in 1965, 1966, and 1967 to Dave Fischbein, *339 founder and chief executive officer of petitioners, were reasonable, in whole or in part; and (2) whether Dave Fischbein Co. must include in its income for 1964 through 1967 under section 951(a)(1)(A)(i) ¹ of the Code, certain income earned in the years 1963 through 1966 by its*24 Belgian subsidiary, Compagnie Fischbein, S.A., from the sale of bag-closing machines on the basis that such income constituted "subpart F" income of the variety defined in section 954(d)(1) as "foreign base company sales income." The former compensation issue has been litigated many times before our Court. The particular subpart F issue involved here, on the other hand, is a matter of first impression before the Tax Court.

FINDINGS OF FACT

Petitioner Dave Fischbein Manufacturing Co. (hereafter DFMC) is a Minnesota corporation with its principal offices during the taxable years in question and at the time it filed its petition with the Tax Court in this case in Minneapolis, Minn. DFMC filed its Federal income tax returns for the fiscal years ended June 30, 1965 (1965), June 30, 1966 (1966), and June 30, 1967 (1967), on the accrual method of accounting with the district director of internal*25 revenue, St. Paul, Minn.

Petitioner Dave Fischbein Co. (hereafter DFC) is a Minnesota corporation with its principal offices during the taxable years in question and at the time it filed its petition with the Tax Court in this case in Minneapolis, Minn. DFC filed its Federal income tax returns for the fiscal years ended February 28, 1963 (1963), February 29, 1964 (1964), February 28, 1965 (1965), February 28, 1966 (1966), and February 28, 1967 (1967), on the accrual method of accounting with the district director of internal revenue, St. Paul, Minn.

DFMC is engaged in the manufacture of bag-closing equipment, including sewing machines and related items. DFMC sells this equipment exclusively to DFC and to Dave Fischbein Westhem Sales Corp., discussed infra. DFMC also sells many of the component parts for such bag-closing equipment to a wholly owned Belgian subsidiary of DFC known as Compagnie Fischbein, S.A. (hereafter CFSA).

DFC is engaged in the sale and service of bag-closing equipment and related items purchased from DFMC to unrelated customers primarily in the United States but also abroad in some cases.

*340 A bag-closing machine is a type of sewing machine used to*26 close the mouth of an open bag. These machines are used in the animal feed, seed, fertilizer, food-processing, and other industries.

David Fischbein (hereafter Dave) was born in Odessa, Russia, in 1883. He immigrated to the United States with his mother and his brothers and sisters in about 1888 when he was 5 years of age. The family made its home in Minneapolis, Minn. In 1906 Dave married the former Clara Wold (hereafter Clara), and they made their home in St. Paul.

During the period 1934 through 1943, Dave and his son, Harold, operated a business under the name of "Dave Fischbein Company," a partnership, the business of which related to repairing industrial sewing machines and selling rebuilt industrial sewing machines.

In 1943, Dave made a decision to design a small bag-closing machine and, with some assistance from Harold, began to work on the project. In 1945, the chaining mechanism essential to a workable machine was perfected. The patent of the idea of a portable electric sewing machine was applied for by Dave in 1945 and issued in 1949. In 1946, Dave applied for two more patents covering the throat plate and work-feed dog parts of the portable electric sewing machine*27 which were later received.

The portable electric sewing machine designed for bag-closing operations was designated model A and introduced to the market at a feed trade show held in Minneapolis in February 1946. Actual deliveries of the model A machines were not begun until February 1947.

In 1947 a slight mechanical design change in the model A machine was made. The machine, with this new improvement incorporated therein, was then redesignated as the model B bag-closing machine.

The trade was ready for an electric portable bag-closing machine and the machine was an immediate success. The Fischbein machine was the first of its kind on the market and at this time, 1947, there was no competition.

DFMC was incorporated on July 1, 1947, for the purpose of taking over the new manufacturing portion of the partnership business. The portable bag-closing machines manufactured by DFMC were to be sold only to DFC which was incorporated on the same day. The authorized capital stock of DFMC at the time of incorporation consisted of 250 shares of common stock with a par value of $ 100 per share. Dave and Harold were each issued 50 shares. However, on July 1, 1947, Dave transferred his shares*28 of DFMC stock to Clara. By the end of 1960, she had disposed of all of these shares. Thereafter, neither Dave nor Clara owned any stock of DFMC.

*341 Dave was DFMC's first president; Clara its first vice president; and Harold its first secretary and treasurer. The initial board of directors consisted of Dave, Clara, and Harold.

In July 1956 Harold was elected to the office of executive vice president while continuing as treasurer. George, Dave's youngest son, was elected secretary. Dave and Clara continued as president and vice president, respectively. In January 1963 Harold was elected vice president, relinquishing the office of executive vice president which thereafter remained vacant.

In January 1964 Dave was elected chairman of the board of directors of DFMC. The new officers were Harold, president; George, vice president and treasurer; and Sam Shark (Sam), Dave's son-in-law, secretary.

During January 1963 George had been elected as a director of DFMC to replace Clara, who had resigned. In January 1965 Sam was elected a director of DFMC. Dave, Harold, George, and Sam continued to serve as directors of DFMC until Dave's death on April 1, 1969.

At the first meeting*29 of DFMC's board of directors held on July 1, 1947, Dave's and Harold's salaries were established at $ 200 per week. Dave's and Harold's salaries continued at this level until July 1953, at which time their salaries were increased to $ 400 per week, effective for the fiscal year ending June 30, 1954, at a special meeting of the board of directors held on July 7, 1953.

Dave's salary continued at the level of $ 400 per week until the date of his death on April 1, 1969. Harold's salary has continued at the rate of $ 400 per week to the date of trial.

At a special meeting of the board of directors held on July 3, 1956, George's salary as the new secretary was set at $ 300 per week, effective for the year ending June 30, 1957. At a special meeting of the board of directors held on July 6, 1965, Sam's salary as the new secretary was set at $ 100 per week, effective for the fiscal year ending June 30, 1966, and has continued at this rate to the date of trial. At a special meeting of the board of directors held on June 28, 1966, bonuses of $ 3,000 were awarded to Harold, George, and Sam for the year ended June 30, 1966. At a special meeting of the board of directors held on July 5, 1966, *30 George's salary was increased to $ 325 per week, effective for the fiscal year ending June 30, 1967, and has continued at this level to the date of trial. Clara received no compensation as an officer of DFMC.

DFC was incorporated on July 1, 1947, for the purpose of buying and selling new and used sewing machines and allied equipment; repairing, *342 rebuilding, and servicing such equipment; and also for the purpose of selling bag-closing machines manufactured by DFMC. The authorized capital stock at the time of incorporation consisted of 250 shares of common stock with a par value of $ 100 per share. Dave and Harold were each issued 50 shares. On July 1, 1947, Dave transferred his 50 shares to Clara. By the end of 1959, Clara had disposed of all of her shares in DFC. Thereafter, neither Dave nor Clara owned any stock of DFC.

Dave was DFC's first president; Clara its first vice president; and Harold its first secretary-treasurer. The initial DFC board of directors consisted of Dave, Clara, and Harold.

In January 1956 Harold was elected executive vice president while also continuing as treasurer, and George was elected secretary. In January 1964 Harold was elected vice *31 president, relinquishing the office of executive vice president, which remained vacant thereafter.

Clara died on May 12, 1963. The following June, George was elected to a directorship to fill the vacancy caused by Clara's death.

At the first meeting of DFC's board of directors held on July 1, 1947, Dave's and Harold's salaries were established at $ 200 per week. Dave's and Harold's salaries continued at this level until March 1950, at which time their salaries were increased to $ 15,400 per year (approximately $ 300 per week), effective for the fiscal year ending February 28, 1951, at a special meeting of the board of directors held on March 2, 1950.

Dave's and Harold's salaries continued at the rate of $ 15,400 per year until March 1953, at which time their salaries were reduced to the previous level of $ 200 per week, effective for the fiscal year ending February 28, 1954. At a special meeting of the board of directors of DFC held on January 8, 1954, bonuses of $ 10,000 each were paid to Dave and Harold.

At a special meeting of the board of directors of DFC held on March 3, 1954, the salaries of Dave and Harold were increased to $ 400 per week, effective for the fiscal year ending*32 February 28, 1955.

Again, at a special meeting of the board of directors of DFC held on March 5, 1956, Harold's salary was increased to $ 450 per week, and George's salary as the new secretary was set at $ 300 per week, both effective for the fiscal year ending February 28, 1957.

Dave's salary continued at the level of $ 400 per week until the date of his death on April 1, 1969. Harold's salary continued at the rate of $ 450 per week to the date of trial.

At a special meeting of the board of directors of DFC held on March 5, 1965, Sam's salary as the new secretary was set at $ 100 per week, effective for the fiscal year ending February 28, 1966, and has *343 continued at this level to the date of trial. At a special meeting of the board of directors of DFC held on March 4, 1966, George's salary was increased to $ 325 per week, effective for the fiscal year ending February 28, 1967, and has continued at this level to the date of trial. Clara received no compensation as an officer of DFC.

In the early 1950's Clara and Dave began to spend most of the winter months each year in California. In 1956 Clara and Dave decided that they preferred Florida over California as a place to*33 spend the winter months. They purchased a home in Miami Beach, Fla., and they spent the winter months in that home from 1956 to the time of Clara's death in May 1963. The family home in Florida was sold in 1964.

On September 19, 1962, Dave suffered an insufficiency of the basilar-carotid arteries, generally referred to in laymen's terms as a "stroke." After Clara's death in May 1963 Dave lived, until the date of his death, with his daughter and son-in-law, Lorraine and Sam, when he was in Minneapolis.

Dave spent the winters after suffering his stroke in the following places:

Dave died on April 1, 1969, at the age of 86.

Dave spent his winters in nursing homes or with relatives in order to have someone around to perform his basic housekeeping*34 and meal needs. He was alone following his wife's death. At Alden HouseDave was not restricted in any fashion; he could come and go as he pleased. His ground floor room there included a private bath, patio, telephone, and television.

At a special meeting of the board of directors of DFC held on March 10, 1964, Dave relinquished his position as president of that corporation that he had held since 1947 and was elected to the position of chairman of the board. The minutes of that meeting state:

The chairman [Dave] stated that this meeting was called primarily to consider the propriety of establishing a new position to be known as "Chairman of *344 the Board." The chairman stated that he had been conferring with the other members of the Board of Directors and with the stockholders of the corporation, and he stated that in view of his advanced age, he felt that he ought to turn over the active management to a younger person who possessed more vitality than he did. He stated that he did not want to give up any of his responsibilities in connection with the management of the corporation but he felt that he could well serve the corporation in a capacity different from president*35 by serving it as Chairman of the Board of Directors.

At the annual meeting of the board of directors of DFMC held on January 20, 1964, Dave relinquished his position as president of the corporation that he had held since 1947 and was elected to the position of chairman of the board. The minutes of that meeting state:

The chairman [Dave] stated that he had long given some thought to turning over the active management of the company to a younger man and he felt that in view of his advanced age, it is unfair to have him continue as president of the corporation. The chairman stated that he was not desirous of retiring but that he felt he could continue in active participation in the management of the company in a different capacity than as president of the company. * * *

Dave Fischbein originated and patented the idea of a portable bag-closing machine and he was the driving force and primary reason for the success of Dave Fischbein Co. (prior to and following its incorporation) and Dave Fischbein Manufacturing Co. Prior to the incorporation of DFC and DFMC in 1947, which was designed to separate somewhat disparate ends of the business, Dave's daily work regimen consisted of long hours*36 and much physical labor.

From 1947 until the time of his 1962 illness, Dave's energies were devoted to performance of his executive and administrative duties as chief executive officer of his two companies.

The illness suffered in 1962 slowed Dave's walk and affected his speech. After 5 to 6 weeks of recovery, Dave returned to his duties, but his health and age necessarily decreased the energy and hours he previously exerted.

The annual meetings of the boards of directors of DFC and DFMC in 1964 and the changes made (creation of the position of chairman of the board and Dave's election thereto in both corporations) reflect Dave's changing but continuing responsible role in his very successful companies.

Still, no important decision was ever made without his prior approval. He maintained his office in the plant and when in Minneapolis he came to the plant to discharge his duties as chairman and review his correspondence every day except on those days when the weather was exceptionally bad. He reviewed sales figures. He participated in meetings of the boards of directors and other business meetings. Dave also continued to observe operations in the factory during this period, *345 *37 making suggestions for improvements in the factory operations where appropriate.

The morale influence that Dave had upon the officers and employees of DFC and DFMC in the 1962-69 years was even more important and pervasive than in prior years. The employees, many of whom had been with Dave for 20 years or more, had strong personal feelings and respect for Dave; and his mere presence increased this respect and bolstered their morale.

The total annual salaries paid by DFC and DFMC to Dave (chairman of the board), Harold (president), George (vice president and treasurer), and Sam (secretary) in 1965, 1966, and 1967 were as follows:

Respondent disallowed all of the salaries paid to Dave by DFC in each of the 3 years and determined that in the case of salaries paid by DFMC that a reasonable allowance would be $ 15,880, $ 15,480, and $ 10,280 for*38 1965, 1966, and 1967, respectively.

On January 2, 1952, Dave Fischbein Westhem Sales Corp. (hereinafter DFWSC) was organized under the laws of the State of Minnesota for the purpose of selling bag closers manufactured by DFMC in the Latin American countries.

In 1949 the model B bag-closing machine was redesigned as the model C as a result of certain design and mechanical changes and improvements.

In 1960 the model D bag-closing machine was introduced to the market. The improvement incorporated in the model D over the model C was a jam-proof looper mechanism. Harold and George obtained a patent covering this mechanism.

On March 1, 1956, DFC organized a wholly owned subsidiary, Compagnie Fischbein, S.A. (hereinafter CFSA), under the laws of Belgium to sell Fischbein bag closers throughout the world. The initial officers of CFSA were as follows:

*346 In April 1957 Van Lerberghe resigned as managing director of CFSA, and Joseph Foulon was named as manager to assume Van Lerberghe's duties.

At the time CFSA was organized it was decided that CFSA would purchase the *39 component parts for bag-closing machines from DFMC and from unrelated suppliers in Belgium rather than purchasing finished machines from DFMC. This decision was based upon two primary reasons. First, it was important that the machines sold by CFSA be of Belgian origin so that they would qualify for Belgian certificates of origin. This was important from the standpoint of tariffs, quantity restrictions, and similar measures in the Common Market. Second, it was cheaper for CFSA to complete its own finished machines in Belgium because of the lower labor and overhead costs in Belgium.

In 1946, CFSA's first year of operations, it had eight employees, including six mechanics (one of whom left during the year) and including Van Lerberghe (later replaced by Foulon). In 1963 through 1966 CFSA had the following number of employees:

The names of the mechanics employed by CFSA and the years in which they were employed during the period from 1963 through 1966, and their prior training or experience were as follows:

*40 In 1956 CFSA was located in Etterbeck, Belgium, a suburb of Brussels in space consisting of three rooms, each approximately 15 feet by 20 feet in size. One room was used as an office, one as the packing and shipping room, and the third as the work area.

In April 1957 CFSA moved to a new two-story building which provided approximately 3,000 square feet of space.

*347 On September 15, 1965, CFSA moved to its present building which contains approximately 8,500 square feet, which was purchased by DFC for $ 98,000 and leased to CFSA at a rental of $ 8,400 per year.

The types of bag-closing machines sold by CFSA in its 1963 through 1967 years were the models C and D and variations thereof, as well as accessories therefor. The number of models C and D and variations thereof sold by CFSA in these years were as follows: *348

*349 CFSA's gross sales for 1963 through 1966, on a country-by-country basis, were as follows (in Belgian francs to United States dollars at 50:1 conversion ratio):