The opinion of the court was delivered by: JUDD
Opinion and Findings of Fact
This suit for refund of corporate income taxes, tried without a jury, involves the right of a food purveyor to deduct gratuities paid by its salesmen to the employees of its customers.
A similar issue for the same company was resolved by the Internal Revenue Service in 1947 after conference in the office of the Internal Revenue Agent in Charge, and deduction of all but a small portion of the payments was permitted for 1947 and for the next ten years. In 1957, after a similar deduction for such payments had been allowed on the original audit, the ruling was reversed on recommendation of a Regional Analyst, and a deficiency was assessed.
The amounts involved are so large that the result may be crucial to the taxpayer's solvency. The payments amount to approximately ten percent of gross sales. The deductions disallowed for 1957 on review amounted to $187,819, resulting in a tax deficiency of $98,262.45, which has been paid. Since the review took place several years after the return was filed, taxpayer's transactions for two other years (1958 and 1959) may be affected by the decision of this case. Taxpayer's total net worth at December 31, 1957 was $193,133.
Five points must be considered in reaching a decision. In order to succeed in the case, the taxpayer must carry the burden of proving three things:
(1) That it paid out the sums claimed as deductions;
(2) That they were ordinary and necessary business expenses; and
(3) That records of the expenses were kept in conformity with published I.R.S. rules and regulations.
The taxpayer urges an alternative argument with respect to record-keeping:
(4) That it was entitled to notice from I.R.S. before being required to change its method of record-keeping.
The government urges a separate point which would undercut all the taxpayer's arguments, namely:
(5) That public policy requires disallowance of the payments as commercial bribes.
Two statutory provisions are involved with respect to deductibility of the expenses.
Section 162(a) of the Internal Revenue Code of 1954 provides that:
"There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. * * *"
With respect to record-keeping, Section 6001 of the Internal Revenue Code of 1954 provides that:
"Every person liable for any tax imposed by this title, or for the collection thereof, shall keep such records, render such statements, make such returns, and comply with such rules and regulations as the Secretary or his delegate may from time to time prescribe. Whenever in the judgment of the Secretary or his delegate it is necessary, he may require any person, by notice served upon such person or by regulations, to make such returns, render such statements, or keep such records, as the Secretary or his delegate deems sufficient to show whether or not such person is liable for tax under this title."
In both instances, the 1954 Code provisions involved no significant departure from the language of the Internal Revenue Code of 1939.
1. Payments of Gratuities by the Taxpayer
During 1957 the taxpayer expended $205,829 in gifts and gratuities on gross sales of $2,280,951. The payments were made on the basis of vouchers drawn up each week by Julius Domash, the taxpayer's general manager. These vouchers showed the total sales made since the last payment of gratuities to the customers on whom the taxpayer's fifteen salesmen were expected to call during the following week. Opposite the sales figure, each voucher contained a figure of approximately ten percent of the sales, representing the amount to be distributed among employees of the customers such as chefs, stewards, maitre d's, receiving clerks, and storeroom men. Each week a check for the total amount of gifts and gratuities was drawn to cash, entered on the check stub and on the books as "commissions and brokerage" and distributed in person to the local salesmen and by ordinary mail to the out-of-town salesmen.
Julius Domash testified that the payments were in fact made to the salesmen. The government was furnished with the names of the salesmen, and the dates and amounts of each payment to each salesman, as part of the plaintiff's answers to interrogatories in this case.
The government makes two attacks on this testimony. First, it describes the testimony as self-serving - an objection which became invalid when parties were first given the right to testify in court. 2 Wigmore, Evidence (3d ed. 1940) §§ 576-577. Second, it argues that there is an inconsistency between Julius Domash's testimony and an affidavit which Samuel Domash, the taxpayer's sales manager and treasurer, signed early in 1958, saying that the payments ranged from five percent to fifteen percent, rather than a flat ten percent, and that they were sent to the customers' employees directly rather than to the salesmen. One weakness in this argument is that the affidavit was prepared by an Internal Revenue Service agent in Philadelphia, after conversation with the manager of taxpayer's Philadelphia warehouse (who was not shown to have direct knowledge of the facts), mailed by the agent to Samuel Domash for signature, and signed by him in the exact form in which I.R.S. had prepared it. Another explanation of the claimed discrepancy is that the I.R.S. agent's notes referred to payments of five percent to an individual employee, with a maximum of ten percent to any firm. Two subsequent affidavits in the same pattern do not persuade the court to disbelieve Julius Domash's testimony.
Testimony of one of the salesmen was offered at the trial. Sidney Kay, a director, stockholder and secretary of the taxpayer, received $22,850 during 1957, and testified that he distributed the entire amount as gifts and gratuities to employees of his customers. Since the names of all salesmen were available to the government as well as the taxpayer, the fact that the taxpayer did not call other salesmen creates no inference that can be helpful to the government.
The Revenue agent who audited the tax return for 1957 spoke to some of Conway's salesmen and formed an opinion that "probably the bulk of them had received the money" and that "a good part of that was undoubtedly paid out."
Taxpayer's salesmen reported the distribution of the cash given to them each week by returning to Julius Domash the memorandum which they received with the cash, marked to show that the gratuities had been paid. These memoranda were kept until the preparation of the next memorandum for the same group of customers, and then were destroyed. The original vouchers listing the payments for each customer were retained, however, and 58 vouchers for 1957 were received in evidence.
On the basis of the entire record, the court finds that the taxpayer in fact paid $205,829 to its salesmen for commissions and brokerage, to be distributed as gifts and gratuities to employees of customers, and that the money was paid out by the salesmen.
2. The Expenses Were Ordinary and Necessary
The president of the taxpayer, Albert P. Heinemann, testified that payments of gratuities to customers' employees had been the general practice of food wholesalers for whom he had worked before the incorporation of Conway Import Company, Inc., and that he had learned of the practice from his father, who conducted the business of Heinemann Brothers.
From the founding of the taxpayer corporation in 1921, its practice was to distribute amounts equivalent to about ten percent of its gross sales as cash gifts or gratuities to employees of its customers. Its customers were mainly hotels, restaurants, private clubs, and institutions. Its products were mainly salad dressing, cooking oils, pickles, and condiments. The original justification for the payments was that the stewards, chefs and sous-chefs of plaintiff's customers came largely from France, Italy and Switzerland, where the practice of making gifts to such employees was general and where salaries were so low that the owners must have expected the employees to supplement their income in this way.
Once having instituted such a practice, the taxpayer would understandably feel obliged to continue it. There was testimony that failure to make such payments would risk a sharp decline in sales. The testimony of plaintiff's witnesses made it clear that it was both useful to the taxpayer corporation and necessary for its business to expend these sums in question.
After a widespread survey of "kick-backs" to chefs and stewards by wholesale food purveyors catering to the hotel, private club and institutional trade, an Internal Revenue agent reported to his Group Supervisor that:
"The survey referred to (in which the Intelligence Division cooperated) demonstrated that payment of tribute of this kind is universally practiced by nearly all firms engaged in the wholesale food industry. Even old-established and highly respected firms feel that they must engage in this practice in order to deny to less scrupulous rival firms the unfair competitive advantage it would otherwise confer upon them."
A Special Agent from the Philadelphia office of the Internal Revenue Service stated that he had investigated ten or twelve major suppliers and that the majority of them had the practice of making such payments.
In its answers to interrogatories, the taxpayer listed the names of its eight largest competitors. Although the income tax returns of these competitors were presumably available to the government, it did not call any of them as witnesses. Instead, it produced three witnesses from other companies to testify to the absence of payments. One of these had no salesmen and made the calls himself; the second had nothing to do with sales and was not familiar with practices in 1957; and the third worked for a company that had only minor institutional sales. Their testimony had little relevance to the issue before the court.
The government relies on United Draperies, Inc. v. Commissioner of Internal Revenue, 340 F.2d 936 (7th Cir. 1964), cert. denied, 382 U.S. 813, 86 S. Ct. 30, 15 L. Ed. 2d 61 (1965), where the majority opinion stated as a matter of common knowledge that "kick-backs" are not an ordinary means of securing or promoting business. What may be common knowledge in Illinois cannot counteract solid evidence of what took place in New York and Philadelphia. Moreover, in the United Draperies case, the payments were made to only three customers and none were made to nine other important customers.
The government's suggestion that the payments must in any event be treated as capital expenditures, because of the statement that they were made to maintain ...