The opinion of the court was delivered by: ABRUZZO
This action is brought by the United States of America against the Peelle Company under Section 7403 of the Internal Revenue Code of 1954 to foreclose federal income tax liens assessed under Title 26, United States Code, § 3670 (now Section 6321 of the Internal Revenue Code of 1954). The complaint was filed in the Office of the Clerk of this Court on January 28, 1955. On that date a temporary Receiver of the Peelle Company was appointed pursuant to subdivision (d) of Section 7403 of the Internal Revenue Code of 1954. An order was subsequently made directing the temporary Receiver be made permanent. D.C., 131 F.Supp. 341. An appeal was taken to the Circuit Court of Appeals for the Second Circuit, 224 F.2d 667, and the order appointing the permanent Receiver was affirmed.
The Receiver has been operating the Peelle Company and, in spite of all the misgivings with respect to the damaging effect which a receiver might have on the business of this company (arguments strenuously advanced on the appeal), the various reports made to this Court from time to time indicate that the business has prospered, the morale of the employees is excellent and its financial position better than before the appointment of this Receiver.
The case was tried before this Court on various dates in June, September and October of this year. Final briefs reached the Court the latter part of November. It will be noted that there are various defendants but the only one properly served was the Peelle Company, the corporation, and, therefore, for the purpose of brevity it will be natural to refer to the United States of America as the plaintiff and the Peelle Company as the defendant.
The Receiver, after his appointment, requested that John R. Bartels, former Judge of the Supreme Court, Kings County, be appointed as his attorney. Such an order was made.
The Peelle Company was represented at the time of the beginning of the trial in June of this year by Blaisdell and Dunne. The firm of Parker, Chapin & Flattau represented the two main stockholders, Henry E. Peelle, Jr., and Robert B. Peelle, sons of Henry E. Peelle, Sr. These two controlled approximately 52 per cent of the stock of the corporation, and a brother of Henry E. Peelle, Sr., John W. Peelle, owned or controlled a minority stockholding of approximately 48 per cent. John W. Peelle was represented by the firm of Leve, Hecht, Hadfield & McAlpin. During the trial John W. Peelle discharged his attorney. He is not represented by an attorney at this time. The firm of Parker, Chapin & Flattau was substituted in the middle of the trial in place of Blaisdell and Dunne. The case on behalf of the defendant was tried by Judge Bartels, and at the conclusion of the trial he submitted both a main brief and a reply brief. The firm of Parker, Chapin & Flattau which appeared for the two officers and main stockholders as aforesaid through Mr. Russell S. Knapp, of counsel, requested that Judge Bartels try the case on behalf of the Peelle Company, and Judge Bartels complied with that request. The firm of Leve, Hecht, Hadfield & McAlpin made a similar request. Judge Bartels was assisted by Mr. Knapp and Mr. William D. Dunne of Blaisdell and Dunne.
The amounts of the liens and the years involved are as follows:
Year Nature of Tax fraud penalty
1945 Income and excess profits $227,533.55
1947 Income 173,736.78
1948 Income 377,040.34
1949 Income 351,795.87
Total Assessment and Liens $1,130,106.54
The Peelle Company is a New York corporation, engaged in the manufacture of fireproof doors and the sale thereof and the manufacture of moving stairs and the sale thereof. The defendant has a subsidiary, the Richmond Fireproof Door Company, Richmond, Indiana, acquired in 1919, and the Receiver has been in complete control of this subsidiary.
From 1945 to 1949, the officers according to the minute book of the defendant (Govt. Ex. 35) were as follows:
Henry E. Peelle President & General Manager
Arthur A. Allen Vice President & General
James F. Peelle Vice President
Paul R. Saurer Vice President (1946 to 1949)
Robert B. Peelle Vice President (1946 to 1949)
John W. Peelle Secretary & Treasurer
Margaret F. Smith Assistant Secretary
Henry E. Peelle, Jr. Assistant Treasurer (1948-1949)
When the trial of the issues commenced it was very apparent that it would be a difficult task requiring many court days to try the issue of the increase in taxable net income for the years 1945, 1947, 1948 and 1949. A great number of items were in dispute. At the Court's suggestion both the plaintiff and the defendant agreed that the accountants for both the plaintiff and the defendant would explore the figures with a view to making some stipulation which would avoid the tedious task of going into each and every item for these taxable years. Pursuant to that request a stipulation was eventually entered into by both the plaintiff and the defendant (Govt. Ex. 29(b)). It was stipulated that there were to be increases in taxable net income for the four years in question as follows:
Amount of Increase
Year Taxable Net Income
1945 $ 103,056.14
Total $ 1,283,940.29
Many of these conferences were held before the Court, and a great many of the debatable items were weighed and yielded by the plaintiff which resulted in the eventual stipulation (Govt. Ex. 29(b)). Both sides are to be commended for the spirit of give and take and helpfulness in arriving at these figures. There is no doubt that the statute of limitations has run against the assessment of any tax for these taxable years and, unless the plaintiff is able to prove fraud in the income tax returns for the years 1945, 1947, 1948 and 1949, plaintiff must be non-suited. The plaintiff concedes this. The plaintiff further concedes that the burden of proving fraud is upon it.
The defendant filed federal income tax returns for the years 1945, 1946, 1947, 1948 and 1949 in Brooklyn, New York (Govt. Exs. 5, 6, 7, 8 and 9). The returns for each of these five years were made on an accrual basis. The net taxable income reported by the defendant and the tax reported due for each of these years 1945-1949 pursuant to these income tax returns are as follows:
Net Taxable Income Tax
Year Reported Reported Due
1945 $ 613.73 $ 153.43
1946* (- 114,799.66) -0-
1947 ( - 9,755.55) -0-
1948 222,026.45 84,370.05
1949 14,988.15 3,347.27
* The income tax return for the year 1946 is not involved in this litigation.
The 1945, 1946 and 1947 returns were signed by Henry E. Peelle, as president, and John W. Peelle, his brother, as treasurer; 1948 and 1949 by Henry E. Peelle, as president, and Henry E. Peelle, Jr., his son, as assistant treasurer.
The plaintiff sets forth six categories of fraud as follows:
1. Unreported receipt of income
2. Unidentified deposits in bank accounts showing inactive balances on the company's books
3. Personal expenses of officers charged to company expense
4. Fictitious expenditures
5. Devaluation of inventory
6. Investment improperly charged to expense
These six categories contain the items of extra income which resulted in the stipulation (Govt. Ex. 29). There are upwards of 1,200 pages of testimony. Of necessity, therefore, only a few of these items can be reviewed.
The defendant claims there was no fraud. Its defense might be summarized as follows:
1. None of the officers knew what Henry E. Peelle, Sr., was doing.
2. Henry E. Peelle, Sr., was incompetent.
3. Henry E. Peelle, Sr., was guilty of embezzlement.
4. None of the co-officers of Henry E. Peelle, Sr., was negligent.
5. Even if they were negligent this is not fraud, for as a basis of fraud there must be an intent.
The defendant maintained four checking accounts in the Bank of the Manhattan Company, divided as follows: a general fund account, a special account, a payroll account, and an account for employees' taxes. These deposits admittedly were recorded on the company books. Three other bank accounts were maintained by the defendant: at Boulevard Bank (known after May, 1948, as the Sterling National Bank & Trust Company); at Pennsylvania Exchange Bank; and at Corn Exchange Bank Trust Company. The Boulevard Bank account was opened pursuant to a resolution of the defendant company dated November 12, 1929. Prior to May, 1948, Henry E. Peelle, Sr., was a director of Boulevard Bank. In September, 1948, the defendant by a resolution of the board of directors authorized the opening of an account and the deposit of moneys in the Pennsylvania Exchange Bank. On October 7, 1948, a like resolution was passed by the board of directors designating the Corn Exchange Bank Trust Company a depository. The resolution with respect to all of these accounts directed that checks were to be signed by two or more officers of the defendant corporation.
Throughout the prosecution period there were substantial company deposits made in these three banks which were not truly reflected on the books of the defendant. These three last accounts, while in the defendant company name, were controlled by Henry E. Peelle, Sr., as president and chief executive officer, and Margaret F. Smith, assistant secretary, chief accountant and head of the bookkeeping department. Miss Smith had a desk just outside the office of Henry E. Peelle, Sr. It appears that the manner of making these deposits in these three banks followed a definite pattern. Each morning all of the checks constituting the morning's receipts of the defendant were received by Miss Smith at her desk. Miss Smith prepared a statement setting forth the bank balance at the close of the previous day, the amount of receipts, the anticipated payments and the anticipated bank balance at the end of the day. This statement and checks which had come in were then handed to Henry E. Peelle, Sr. Some of these checks were returned to Miss Smith who gave them to her assistants to be entered on the books and deposited in the Bank of the Manhattan Company. Some of them were not deposited in the Bank of the Manhattan Company but were deposited in one of the other three banks. For the prosecution years involved it appears from the evidence that some three-quarters of a million dollars were deposited in the three banks, to wit, Boulevard, Pennsylvania Exchange and Corn Exchange.
The defendant owned a factory building which a tenant by the name of Hilo Varnish Corporation occupied. This tenant paid the defendant $ 30,000 rental per year, payable monthly. Miss Smith testified that Henry E. Peelle, Sr., usually retained the Hilo rent check when it was received and deposited it in either the Boulevard, Pennsylvania Exchange or Corn Exchange banks. None of the Hilo checks so deposited in the latter three banks was ever included in the defendant's income tax returns. Some of the Hilo checks were not retained by Henry E. Peelle, Sr., but were recorded in the cash receipts book and general ledger of the company. Of the sixty Hilo rent checks received, $ 110,000 was deposited in the three so-called outside banks and not included in the tax returns, and sixteen checks totaling $ 40,000 were deposited in the Bank of Manhattan Company. Thirteen other sources constituting income to the defendant during the prosecution period were deposited in the three outside banks. Some of these deposits were made by Peelle, Sr., directly, and some by Miss Smith. These items included rental, commission and interest income from a subsidiary, the Richmond Fireproof Door Company, royalty income from Otis-Fensom, Ltd., Westinghouse Electric Corporation and Security Fire Door Company; proceeds of sales of Peelle Company products to Otis Elevator Company and Yunker Metals Products Company; proceeds of sales of scrap steel to Bethlehem Steel Corporation; interest on bonds, dividends on stocks; and insurance refunds. The thirteen sources alluded to constituted a category which is shown by the following table:
1945 ................ $ 97,614.81
1947 ................ 46,988.62
1948 ................ 110,725.10
1949 ................ 122,659.50
Total $ 441,848.34
These items were not included in the income tax returns. There were other sources of income which could not be identified. The deposits were made in these three outside banks. These deposits were made as follows:
1945 ........... $ 7,879.28
1946 ........... 6,047.38
1947 ........... 12,934.41
1948 ........... 22,372.81
1949 ........... 4,545.55
The principal officers of the defendant company paid their personal expenses for such items as refrigerators, automobiles, landscape gardening services, venetian blinds, hot water heaters, carpeting, house paint, insurance premiums and payments of personal income taxes which were charged off to company expense and taken as deductions on the company's income tax returns during the prosecution period. The officers whose personal expenses were paid by the defendant are as follows:
Henry E. Peelle, President Paul R. Saurer, Vice President Arthur A. Allen, Vice President Robert B. Peelle, Vice President John W. Peelle, Secretary-Treasurer
The personal expenses of Henry E. Peelle, Sr., included moneys spent for private homes at Ocean Grove, New Jersey; Rochester, New York; Miami Beach, Florida; and Manhasset, Long Island; and also the home of a son-in-law, Robert E. Rath, at Morristown, New Jersey.
In 1949, the income taxes of Henry E. Peelle, Sr., in the sum of $ 5,500 were paid by the defendant and charged to expenses. It is difficult to enumerate the amounts expended for each of these benefits to Peelle, Sr. It might be well to allude to and highlight some of the important expenditures. It appears that the Croton Hotel, Miami Beach, Florida, was purchased on January 15, 1947, in the name of Henry Peelle and Margaret W. Peelle (wife of John W. Peelle who was secretary-treasurer of the defendant company). Henry E. Peelle, Sr., and John W. Peelle were brothers. The purchase price of this hotel was $ 200,000 and it was bought subject to three mortgages aggregating $ 70,000. The balance was paid in equal shares by Henry E. Peelle, Sr., and John W. and Margaret W. Peelle, his wife, out of their respective personal funds. During the period from January 15, 1947, to December 31, 1949, mortgage payments on the hotel in addition to payments of all the premiums due on the fire insurance policies were paid by the defendant, charged to the expense account on the company's books and taken as deductions on its income tax returns. These expenses for the three years, 1947, 1948 and 1949, amounted to $ 21,257.62. Many of the expenses for his other homes were similarly paid.
Paul R. Saurer was elected vice president of the company in 1946 and during this prosecution period he was known as sales manager of the company. His salary varied from $ 7,020 a year in 1946, a loss year, to $ 15,000 in 1949. In addition to his salary he was allowed to draw $ 800 per month for expenses and it was understood that he was to give no accounting to the company for this money. Some of his personal expenses were paid by the defendant, for instance, automobile insurance premiums, farm supplies, and personal income taxes, all charged to expense on the company books and taken by the defendant as income tax deductions on its returns. He did not know, nor did he ever ascertain, how these items had been charged on the company books, but he did know they were not deducted from his salary. He testified that in 1950 he received a bonus of approximately $ 6,000 which wiped out all that he had owed the company for personal expenses. These appeared to be some confusion in his testimony as to whether he obtained the $ 6,000 to pay a deficiency assessment made against his taxes in 1950 or whether the company had first given him this money as a loan.
Arthur A. Allen was vice president and general superintendent in charge of production during the prosecution period. In addition to his salary he was given approximately $ 400 per month as an expense account for which he accounted only irregularly and verbally. Some of his personal expenses were paid by company checks and he personally authorized their payment. The expenses so paid included insurance premiums, a gas range, a hot water heater, and a kitchen sink. They were charged as expenses on the company books and taken as deductions on its income tax returns. Allen testified that he did not report these expenses as income in his own personal tax return, did not repay the company, and considered them as additional salary. He testified that what was done for him was done with all the officers.
Robert B. Peelle, a son of Henry E. Peelle, Sr., was elected vice president of the company in 1947. In addition to his salary some of his personal expenses were paid. They included tuition for one of his children, landscape gardening services, fertilizer, and grass seed. These expenses were not deducted from his salary or charged to him. He authorized these payments as an officer of the company. In many instances he authorized the payment of personal expenses of Henry E. Peelle, Sr., his father. These items included house paint, light bills, water bills and plumbing bills.
Henry E. Peelle, Jr., a brother of Robert B. Peelle and a son of Henry E. Peelle, Sr., was assistant treasurer of the Peelle Company in 1948 and 1949. In that capacity he signed checks constituting payment for officers' personal expenses.
John W. Peelle, a brother of Henry E. Peelle, Sr., was secretary-treasurer of the company and during the prosecution period received a salary totaling $ 49,500. He testified that he came to the company once or twice a year. He was also a stockholder and controlled through his own stockholdings and others close to him 48 per cent of the stock of the defendant. He was convicted in this Court as a tax evader. He testified that he did not know whether any non-corporate expenses had ever been charged on the books of the defendant as corporate expenses.
He is the John W. Peelle who was part-owner of the Croton Hotel upon which hotel $ 21,000 of expenses were paid out of the corporate funds during 1947, 1948 and 1949. In 1948 John W. Peelle caused the defendant company to enter into a contract signed by him as treasurer with Warsaw Elevator Company, Warsaw, New York, whereby Warsaw installed an elevator in a personal building of John W. Peelle in Watkins Glen, New York, at a cost to defendant of $ 7,203. This debt was offset by the defendant against an account receivable from Warsaw Elevator Company and was never paid to the defendant by John W. Peelle or charged to him. The defendant did not include this item in its tax return, thereby receiving a tax benefit. John W. Peelle testified that although his signature appeared on some of the minute books he did not remember signing any corporate minutes. He did concede that his signature did appear on certain other books and papers, to wit, a notice of meeting of stockholders, minutes of directors' meeting, and copies of three documents relating to an amendment of the certificate of incorporation of the defendant company.
Fictitious expenditures were charged. It appeared that in the latter part of 1948 the company was making considerable profit and that Henry E. Peelle, Sr., and Miss Smith would have to discover a way of taking cash out of the regular account which would not be reported as profit because of the tax cost. At the end of each month the amount of cash available would be determined. A fictitious list of expenses with no basis in fact would be drawn containing fictitious names and amounts. The names and amounts would be entered on the books and a check drawn for them. These checks and lists of fictitious expenses were destroyed by Miss Smith and a check equal to the aggregate amount of the destroyed checks would be drawn and deposited in the outside bank accounts. Ninety-three checks during the years 1948 and 1949 were thus drawn and they were charged off on the books as contract material, miscellaneous purchase material, factory overhead, legal expense, and administrative expense. They would in turn be taken as tax deductions on defendant's income tax returns. None of these checks so deposited was reflected on the balance sheet submitted by the defendant on either the 1948 or 1949 income tax returns.
There was a devaluation of inventory in 1948 and 1949. Henry E. Peelle, Sr., and Miss Smith, assistant secretary, were the officers who made this devaluation. At the close of 1948 and 1949 the inventory was arbitrarily reduced on the books by approximately $ 200,000 for the two-year period. This reduction in the closing inventory of the books of the defendant had the effect of reducing by that amount the cost of sales and gross profits as reported on the income tax return. A sizable tax was therefore saved. The defendant was the only beneficiary of the saving in taxes by virtue of this devaluation. The manner in which it was done was as follows:
Near the end of the year 1948 the inventory as shown on the books of the defendant amounted to $ 342,073.40. The actual value was in fact $ 333,165.33. The accounting department was instructed to make entries in the books reducing the book value of the closing inventory to the false figure of $ 166,582.67, instead of the true figure of twice that sum. It, therefore, had the effect of understating the profit for the year in the amount so reduced.
In 1949 the same procedure was followed except the amount involved was $ 32,460.25. There was no attempt to hide these figures in the books. An examination of the books would have shown these two devaluations in 1948 and 1949.
In 1949 the defendant made an investment of $ 130,000 in the capital stock and inventory of a newly acquired subsidiary Multiscope, Inc. One thousand shares of Multiscope, Inc., were bought, being all of the outstanding shares, at a price of $ 568 per share, payable in installments to the Condon National Bank, Coffeyville, Kansas, an escrow agent, with an immediate down payment of $ 115,000. It was the purpose of the defendant in purchasing this stock to manufacture moving stairs. Defendant acquired certain patent rights and the method of making moving stairways. It was intended to increase the number of products made by the defendant and lead to greater profits. At first this investment was entered on the books as investment of capital, thereby making it a non-deductible item for income tax purposes. Subsequently, pursuant to instructions from Henry E. Peelle, Sr., this payment of $ 115,000 was charged to contract expense. Multiscope, Inc., had an inventory of $ 15,870. This sum was added to the down payment of $ 115,000 and both charged off on the books of the defendant as contract material and taken as a deduction on the income tax return for 1949.
Defendant's Answer to this Evidence
The defendant does not seriously dispute a great portion of the proof offered by the plaintiff under Part IV.
1. They offered evidence that none of the officers knew anything whatever of the three outside bank accounts or so-called 'secret' bank accounts.
2. They were not familiar with the books or records of the corporation, nor with the bookkeeping practices of the company during the said period.
3. They did not know to what accounts disbursements made by the company, including their own personal expenses, were charged.
4. They did not know whether any non-corporate expenses were charged on the books of the company as corporate expenses.
5. They did not prepare, nor had anything to do with the preparation of the income tax returns for the years 1945 to 1949, inclusive, or that they were in any way inaccurate or false.
The defendant sets forth two affirmative ...