The opinion of the court was delivered by: MEANEY
This is a suit for the recovery of income taxes for the years 1954 and 1955, with interest, aggregating approximately $ 18,500. The facts have been agreed upon and are contained in the stipulation submitted to the court, a photostatic copy of which is annexed hereto.
In the course of this opinion the plaintiff will be referred to as the corporation, and the Reade brothers' partnership, Reade Manufacturing Company, will be referred to as the partnership.
In the final analysis the case is resolvable into two questions of law:
1. Did the plaintiff corporation assume liability for the Staley tort claim when it acquired the business?
2. Were the payments made by the plaintiff corporation ordinary and necessary expenses paid or incurred in carrying on the business?
As to the first matter to be discussed, reference must be had to the terms and circumstances of the taking over of the partnership by the corporation, formed for tax purposes and owned almost exclusively by the partnership made up of Charles H. Reade and Leonard J. Reade (to whom were issued stocks in the corporation in the following amounts: Charles H. Reade 149 shares, Leonard J. Reade 150 shares, the single remaining qualifying share going to one Charles F. Reade). These three persons were and are the sole stockholders, officers and directors of the corporation.
Reference to the proposal to sell the partnership business to the corporation, and the acceptance thereof by the corporation, with statements in the minutes of the corporation, indicates the true state of affairs at the time of taking over of the affairs of the partnership, and the construction to be given to the agreement. The first minutes of the corporation state that the offer of sale made to the taxpayer included 'all of the assets and good will of the partnership business * * * subject, however, to the outstanding liabilities.' There is then set forth a letter signed by Charles H. Reade and Leonard J. Reade which lists the assets to be transferred and the existent liabilities, the difference showing the sum of $ 20,000 excess of assets over liabilities. The letter also included a statement that the corporation was to take over the business as a going concern. It further stated that it was understood that the company is not to assume any of the personal liabilities of the partners as distinguished from partnership liabilities, nor any past or present partnership income tax liabilities. Thereafter by resolution the said offer as set forth in the said proposal was approved and accepted, and it was further resolved that the proposed agreement for the assignment and sale of the said business be approved, and necessary authority was given to the officers to execute the agreement, effected by issuance of stock.
In the list of liabilities there was no inclusion of nor any reference to any claim of the Staley Company against the partnership.
It may be well at this time to advert to the Staley claim, its nature and its origin. In April, 1947 the partnership herein referred to sold two tank cars of liquid caustic soda which was ultimately purchased by A. E. Staley Manufacturing Company (herein referred to as Staley) to be used in the manufacture of soy sauces. Certain persons using the sauce became ill from arsenic poisoning and sued Staley, recovering approximately $ 800,000. In the same year Staley informed the partnership that Staley intended to hold the partnership liable for its losses because of the use of the partnership product in the manufacture of the soy sauces.
Before suit on this claim was started the plaintiff corporation was formed on May 1, 1948 to acquire the business of the partnership.
In November, 1948 Staley instituted suit against the partnership for over a million dollars, and in November, 1949 the corporation was joined in this suit as a defendant, it being alleged that the corporation had assumed the partnership liability for the Staley claim. This was denied by the corporation.
At no point either in the proposal or the minutes of the corporation is there to be found reference to the Staley claim as one of the partnership liabilities. At the time of the transfer of assets and liabilities, the partnership had not been sued. According to the stipulation made by the parties to this suit, the partners, on consultation with counsel, after receiving notice of the Staley claim, decided that they could successfully defend the suit and decided to 'fight the case.'
From the foregoing it appears that neither the proposal hereinbefore referred to, nor the acceptance, regarded the Staley claim as a liability, contingent or otherwise, to be assumed by the corporation. The proposal was explicit in the list of assets and liabilities and nothing else appears to have been in contemplation of the parties. The proposal nowhere mentions that all of the liabilities of the partnership are to be assumed by the corporation. Under the accepted rules of construction of contracts, the specific language of the agreement seems clear, such repugnancies as may appear to exist being solvable to accord with the expressed purpose evident in the proposal. Moreover, it would seem absurd for the corporation to have assumed a formidable contingent liability such as would have rendered it patently insolvent from the moment of such assumption.
It is court's opinion that the Staley claim was not assumed by the corporation.
Comes now the second question. Further facts stipulated to by the parties hereto show that subsequent to the joining of the corporation as a party defendant in the suit initiated by Staley against the partnership, the directors of the corporation, fearful of the destructive results of publicity of the allegations of the amended Staley complaint, decided that steps must be taken straightway to settle the Staley litigation. They concluded that their credit would be disastrously affected, and that the corporation's railroad customers, vital to the continuance of its business, would be lost because of doubts about the corporation's ability to perform its contracts. Its business was seasonal and the fluctuating financial conditions attendant thereon made it necessary that the corporation have ready access to credit sources at the ebbing periods as they arrived. Lack of faith on the part of banks in the ability of the corporation to carry on to the period of flow in its business, would render it impossible for the corporation to secure the credit vital to its operations. It was therefore a prime necessity to dispose of the menace of the impending suit by settlement if at all feasible.
On April 25, 1950 the suit of Staley against the partnership and the corporation was settled by the partners (who now for all practical intents and purposes were the sole owners of the stock of the corporation) who gave their personal note to Staley for $ 50,000, payable $ 5,000 per year. Thereafter the corporation, by resolutions entered in its minutes, authorized the payment to Staley of $ 5,000 on September 1, 1950, $ 5,000 on September 1, 1951, $ 5,000 on September 5, 1952, and $ 5,000 on September 2, 1953 in satisfaction of the personal note installments due Staley from the Reades. Then on July 12, 1954 a resolution was passed authorizing the payment by the corporation of a lump sum settlement of $ 22,000 in full settlement of unpaid balance of the Reades' note.
The corporation made the payments in installments because it did not have cash to effect the settlement and any attempt to borrow money or assume the liability would have an adverse influence of its credit with banks.
In its income tax returns the corporation claimed deductions for the payments made to Staley. The deductibility of the most recent $ 5,000 payment and the $ 22,000 payment was challenged by the Internal Revenue Service.
The point to be settled is whether the payments were ordinary and necessary business expenses within the ambit of the statute concerning deductions for such expenditures. 26 U.S.C. § 23(a)(1)(A) (I.R.C.1939) provides in part:
'* * * there shall be allowed as deductions * * * all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business * * *'.
The corporation urges that it had been advised by the banks that the Staley tort claim, unless settled, would cause the cutting off of credit from them. The corporation could not execute the note itself because of jeopardy to its balance sheet position, and it did not have cash on hand sufficient to pay the amount of the settlement. Hence the necessity for the execution of the $ 50,000 note by the Reades personally, for the protection of the corporation. Of course in the event of failure of the Reades to pay the note, recourse could not be had to the corporation and the note presumably constituted an accord and satisfaction of the tort claim. However, the corporation asserts a moral obligation to pay on behalf of the Reades since it 'induced' the Reades to bring about the settlement.
There are a number of cases which support the contention that a moral obligation is sufficient basis for a deduction where the payment is made to promote or protect the taxpayer's business. See Dunn & McCarthy v. Commissioner, 2 Cir., 1943, 139 F.2d 242; First National Bank of Skowhegan v. Commissioner, 1937, 35 B.T.A. 876; Canton Cotton Mills v. United States, 1951, 94 F.Supp. 561, 119 Ct.Cl. 24; Commissioner v. Doyle, 7 Cir., 1956, 231 F.2d 635; and Catholic News Publishing Co. v. Commissioner, 1948, 10 T.C. 73, among others. In these cases payments were made to protect good will and credit already established in contradistinction to the theory of Welch v. Helvering, 1933, 290 U.S. 111, 54 S. Ct. 8, 78 L. Ed. 212, where payments were made to create good will.
The interpretation of the words of the statute 'ordinary and necessary' is subject to the compulsive effect of circumstances in each individual case. In the Third Circuit in the case of Commissioner v. Gilt Edge Textile Corp., 3 Cir., 1949, 173 F.2d 801, the court refused to pass on the validity of the doctrine that 'even a moral obligation, arising out of a business transaction, will support a loss deduction' since the facts did not warrant it. However, in footnote 3 the court indicates that 'while discharge of a moral obligation may be laudable' it does not follow that it permits a tax deduction therefor. Further manifestation of the tendency of the Third Circuit Court of Appeals to look with a jaundiced eye on claims of payment made in pursuance of a 'moral obligation' may be found in Farnsworth v. Commissioner, 3 Cir., 1959, 270 F.2d 660, where a partner compromised claims for individual and partnership state income taxes against himself and his ...