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Lewis v. Commissioner of Internal Revenue

February 16, 1931

LEWIS
v.
COMMISSIONER OF INTERNAL REVENUE



Petition to Review an Order of the United States Board of Tax Appeals.

Author: Woolley

Before BUFFINGTON and WOOLLEY, Circuit Judges, and THOMPSON, District Judge.

WOOLLEY, Circuit Judge.

While on its face this petition for review of an order of the United States Board of Tax Appeals, redetermining tax deficiencies, appears to concern only the petitioner, the proceeding is a test case affecting like deficiency determinations with respect to all five members of a partnership, arising from their manner of conducting the business of public shorthand reporting and their method of making returns for income tax purposes.

Guilbert & Lewis, which we shall call "the firm," was under contract to report cases in the United States District Court and was employed from time to time in reporting sundry legal, quasi legal and non-legal proceedings. Admittedly its income from these sources was "taxable income."

The firm was also engaged to act as official stenographer for the Public Service Commission of Pennsylvania and the Board of Viewers of Philadelphia County, both public bodies with power to pay, as they did pay, for such services from public funds. It was claimed that the partnership income from these two sources, being income of an employee of governmental instrumentalities, is exempt from federal taxation, hereafter referred to as "exempt income."

In the conduct of its business the firm maintained offices and an office force involving expenses normally incident to such a business. These expenses (which were substantial) were incurred in earning both its taxable income and exempt income but the several items of expense were not allocated on the books to the respective sources of income.

The firm filed annually a partnership income tax return in which it computed net taxable income by omitting altogether the exempt income (which was large) and deducting from gross taxable income (which was small) all the ordinary and necessary expenses of the partnership incurred in carrying on its entire business, that is, in earning both taxable income and exempt income, with the result that an annual net loss was disclosed and distributed to each partner in proportion to his interest in the partnership.

Coming to the partners, it appears that the petitioner at one time and two of his partners at other times were appointed official stenographers of the Court of Common Pleas, Number Four, of Philadelphia County. For this service they received fixed salaries paid from public funds which they did not turn over to the firm but retained as their own. They were also entitled to certain money received from the sale of copies of testimony to litigants which was handed to the firm and returned by it as taxable income. The partners regarded these state salaries as exempt income and therefore left them out of the computations in their 1919, 1920, 1921 and 1922 returns. But they included in their returns the expenses of earning this claimed exempt income, not by deducting them from the (omitted) exempt income to which they were related but by deducting them from taxable income derived from other sources. And in addition, each partner in his tax returns, under the heading "income from partnerships," set up the amount of his distributive share of the partnership's net loss and thus reduced his tax.

In this situation the Board of Tax Appeals, by its order of redetermination, found certain deficiencies in the returns of all partners for certain years based on a finding of fact, and on at least one conclusion of law, that the firm in its capacity of stenographer for the Public Service Commission and the Board of Viewers for Philadelphia County was not an officer or employee of a government, state or county, and that accordingly the compensation it received for services rendered those two bodies was not exempt income but was taxable income. This finding did two things: It transmuted the firm's reported net loss into a taxable net profit and necessarily withdrew from the partners the right to deduct in their personal returns the proportions of the partnership net loss which had been improperly determined and distributed to them.

With respect to the partners the Board found that their employment by the Court of Common Pleas was within the general law exempting from income tax their compensation for services rendered as officers or employees of a state or a political sub-division of a state. But the Board held as matter of law that the petitioner and his two partners could not, in determining net taxable income, deduct from their gross taxable income the expenses incurred in earning the exempt income but that the expenses incident to earning income of each kind should be allocated to and deducted from them respectively, which the Commissioner did in determining the deficiencies by making deductions for expenses from both taxable income and exempt income in the proportions they bore to the whole income.

No one complains of the Board's finding that the petitioner and certain of his partners were government officers or employees when acting as official court stenographers and that, speaking generally, their salaries so earned were exempt from income tax. That is the first fixed fact in a valid computation of the tax. The next essential fact, disputed yet found by the Board and now to be established on this review, is the character of the employment of the firm by the Public Service Commission and the Board of Viewers of Philadelphia County and, accordingly, the character of the firm's income from these sources, for on this depends the partnership loss or profit distributable to the parthers. Although the decision of the Board, that the firm was not in either instance a governmental employee rendering its income exempt, was made before the decision in Lucas v. Reed, 281 U.S. 699, 50 S. Ct. 352, 74 L. Ed. 1125, it was made after Metcalf & Eddy v. Mitchell, 269 U.S. 514, 46 S. Ct. 172, 70 L. Ed. 384, on which the Supreme Court grounded the Lucas-Reed decision. We hold that Metcalf & Eddy v. Mitchell, rules this case on its facts and that the finding of the Board in this regard must be sustained.

With these facts established and the claimed factor of exempt income out of the way, the return of the firm can easily be adjusted as the Commissioner did it. Thus we arrive at what is the main question in the case affecting the petitioner, a partner, with respect to whom there are now three fixed factors in the tax computation -- taxable income derived from one source, exempt income derived from another, and disallowance of his proportion of the firm's reported net loss. The question is:

Was the petitioning taxpayer, in ascertaining net taxable income, entitled to deduct from his gross taxable income the expenses ...


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