TODD et al. v. COMMISSIONER OF INTERNAL REVENUE, 153 F.2d 553

DENMAN, Circuit Judge. This is a review of a decision of the Tax Court determining deficiencies in the income taxes for the calendar years 1940 and 1941 of each of the petitioners, for over twenty years equal partners under the name of Western Door and Sash Co., in a business of buying and selling, in the State of California, lumber products such as doors, wooden frames and sash.

Both partners have been married and living with their wives in California since before July 29, 1927, when the present community property law in California was enacted, and the wives acquired a half-interest in the earnings of their husbands. United States v. Malcolm, 282 U.S. 792, 51 S.Ct. 184, 75 L.Ed. 714. The parties here are agreed that on January 1, 1936, the partners had invested in their lumber business as their separate property $144,366.81, and that at least that sum remained as their separate capital in the business in 1940 and 1941, the tax years here in question.

The capital in the business had increased by plowing back much of its earnings in 1936, 1937, 1938, and 1939, until on January 1, 1940, it amounted to $226,890.77 and on January 1, 1941, to $285,678.98. The dispute between the parties concerns the portion of the income of these last two years attributable (

a) to capital, the separate income of the husbands, and (

b) the amount arising from the taxpayers’ management of the business. All the income from capital contributed by the husbands is taxable to the husbands as separate property, plus one-half of the income from managing the business. The Commissioner found that a very considerable portion of the increased capital came from leaving in the business, in each of the years from 1936 to 1939 inclusive, the money product of the capital as well as a portion of that from the managerial activities of the taxpayers, and the evidence sustains the finding.

It is contended by the taxpayers that despite this constantly increasing capital from both sources, the Commissioner and the Tax Court erred in refusing to. hold that the limit of the separate capital investment for 1940 and 1942 was what it was on January 1, 1936, $144,360.81. With this we cannot agree. The income from the separate property left in the business remains separate property and is entitled to its share of the income thereafter.

Taxpayers further contend that the separate property capital is entitled to a return not exceeding the legal rate of interest in California of 7%, and that in no event'is it entitled to a return exceeding 8% for either year. Taxpayers properly summarize the law respecting the return on the separate capital of one of the California spouses : “But the California rule of property law is that where the spouse has an investment in a business at the time of marriage which he continues to conduct during marriage, that investment continues to be his separate property.

What part of the subsequent profits is separate income and what part thereof is community income is to be determined by the facts in the case.

Whatever arises from the use of the capital by the community is separate property, and whatever arises from the personal activity, ability, or capacity of the spouse is community property.” The statement then continues: “The California rule of property law is that where the separate capital investment of the spouse is definitely determined in amount as of the date of marriage, the income attributable thereto is interest thereon at a rate not in excess of the legal interest rate of seven percent unless the facts in the case show that it is entitled to a greater return than legal interest.” Under the federal income tax law it is the duty of the Commissioner of Internal Revenue to determine from “the facts in the case” the amount of the return on the taxpayer’s capital.

He has determined that the facts shown that the product of the capital is not only in excess of 7%, the legal rate in California, but much more than 8%. We think there is evidence from which the Commissioner and the Tax Court properly could find that the return on the capital exceeded the California legal rate of 7% for the tax years in question.

There is evidence from which the Commissioner and Tax Court could infer that the lumber business is a highly fluctuating one of large profits, succeeded by large losses — that is, a merchandising business in which a higher rate of return is necessary in good years to offset the losses of bad years. It also appears that in 1940 the war in Europe and war preparations in this country caused a constant increase in demand for lumber, and with it a corresponding increase in prices and in value of inventories.

It was stated by one of the partners that the money was left in the business as “a sort of investment” for the “inflation in inventory.” They “let it lay there in the business in the way of inventory.” He stated that the taxpayers could have done the same volume of business with half the inventories but the fact is that they preferred to take the war-caused increasing value in the inventories. Hence, as stated, the Commissioner and the Tax Court were warranted in inferring that there was a substantial gain in capital value of inventory as distinguished from earnings from new business obtained.

The Commissioner’s method of allocation between the separate capital income and the managerial community earnings is a rational one. The capital of the business was constantly increasing. Eight percent of the. average capital balance in each of these years is held the base of the capital earnings. Salaries for services are found annually for the base of the community earnings. The two are added together and the percentage each base bares to the total constitute the proportions of the total income attributable to capital and to services.

Beginning in 1936, when the capital on January 1st was admittedly $144,360.81, the average capital for the year was computed as $151,980.71. Upon this the 8% was computed at $12,158.46. This was. added to the $10,000 salary, making a total of $22,158.46. The percentage of the income attributable to capital earnings is 54.87%, and to managerial earnings is the remaining 45.13%. 54.87 % of the 1936 partnership income of $26,990.92 is $14,809.92 attributable to capital earnings. This was left in the business and added to the partnership capital of 1937.

The 45.13% of $26,990.92 is $12,-818 attributable to community earnings. However, all this was not left in the business. $11,763 of it was taken out as personal expenses — that is, under the California law presumed taken from the community income. Van Camp v. Van Camp, 53 Cal.App. 17, 25, 199 P. 885. The remainder was left in the business as community capital to share in the total earnings of future years as taxable community income.

Pursuing this method for the succeeding years, the Commissioner and the Tax Court found the partners’ separate capital of the partnership in 1940 to be increased to $242,-380.68 and that the community had left in the business, above withdrawals' of living expenses, $13,904.19. Applying the above formula of the shares of the 8% on capital added to an increased salary factor of $15,000, the Commissioner and the Tax Court fixed the taxes and deficiencies for each of the equal partners on the total partnership income of $46,204.96, as follows: Percent Total (Per Ex-Total Community Husband’s Wife’s hibit

A) Income Income Share Share Income from husband’s separate capital ............ Community income: 54.62 $25,237.14 $25,237.14 Community capital ...... 3.13 1,J46.22 $ 1,446.22 723.11 $ 723.11 Income from services.... 42.25 19,521.60 19,521.60 9,760.80 9,760.80 Totals ................... 100% $46,204.96 $20,967.82 $35,721.05 $10,483.91 Reported on returns........ 29,284.21 16,469.97 Net adjustment ........... $ 6,436.84 $(5,986.06) For 1941 there was a similar computation showing a deficiency in the husband’s income of $8,515.97.

It is claimed that the figures showing the average of capital balances during the years 1940 and 1941 fail to show certain sums attributable to the separate and community shares of the capital. Since the Commissioner’s plan of allocation is a rational one, the burden of showing error in computing in its application is upon the taxpayers. Helvering v. Taylor, 293 U.S. 507, 515, 55 S.Ct. 287, 79 L.Ed. 623; Lucas v. Kansas City Structural Co., 281 U.S. 264, 271, 50 S.Ct. 263, 74 L.Ed. 848; Welch v. Helvering, 290 U.S. 111, 115, 54 S.Ct. 8, 78 L.Ed. 212. This they have failed to do.

This case was argued and submitted to us by both parties on the theory that the findings in the following assignments of error were actually made by the Tax Court: “6. The evidence does not support the finding that the capital invested in the partnership business had earned or was entitled to be credited with a return thereon for either of the years 1940 or 1941 greater than eight per cent which the Commissioner determined and the Court found to be a fair return thereon. * * * * * * “8.

The evidence does not support the finding that the capital invested in the partnership business had earned or was entitled to be credited with a return thereon for either of the years 1940 or 1941 greater than seven per cent.” (Emphasis supplied.) No such findings of fact were made by the Tax Court or findings substantially like them.

The case is ordered remanded to the Tax Court to make findings with regard to the issue as to the respective amounts attributable to capital and to the petitioners’ management of the business and its decision thereon, having in view the agreement of the parties here that such findings were made. Cf. Oliver v. Commissioner, Jan. 1, 1945, 4 T.C. 684.

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