Before GOODRICH, McLAUGHLIN and KALODNER, Circuit Judges.
McLAUGHLIN, Circuit Judge.
We are asked to review two decisions of the Tax Court, 18 T.C. 1032, upholding certain income tax deficiencies and fraud penalties for the years 1936 through 1941. Petitioners are W. L. Kann and Stella H. Kann, his wife, and the representatives of Gustave H. Kann, deceased.*fn1
A summary of the leading facts as stipulated and found follows. G.H. and W. L. Kann were brothers. During all the years in question both were shareholders, directors and officers of Pittsburgh Crushed Steel Company (hereafter called PCS), a Pennsylvania corporation, G. H. Kann being the president and general manager while W. L. Kann was secretary, treasurer and assistant general manager. The brothers Kann were similarly situated with respect to Globe Steel Abrasive Company (hereafter called GSA), an Ohio corporation wholly owned by PCS.
From 1936 through 1941 W. L. Kann personally kept the books and records of PCS and through checks of PCS and overstated credits in the personal accounts of the brothers, all concealed by various deliberately false and fictitious entries consisting chiefly of understated sales and overstated purchases, caused payments in the amount of $675,881.76 to be made to himself and his brother. During this period the brothers also received the sum of $66,000.00 in the form of checks from GSA, none of which were recorded on the books of that corporation. These checks were concealed as understated sales by the Kanns with the assistance and cooperation of the GSA secretary and general manager and the GSA bookkeeper. Neither the payments from PCS nor from GSA were reported as income by the Kanns. In addition to the above sums the brothers, during this period, also failed to report some $151,015.50 representing dividends received from Steelblast Abrasives Company, a corporation. As to these items, it was stipulated that the failure of W. L. and G. H. Kann to report them was due to fraud with intent to evade and defeat tax.
As the litigation was presented below petitioners contested the assessment of the income tax and the fraud penalties on the PCS and GSA payments on the ground that these sums, having been embezzled, did not constitute income under Section 22(a) of the Internal Revenue Code, 26 U.S.C. § 22(a),*fn2 as construed in Commissioner of Internal Revenue v. Wilcox, 327 U.S. 404, 66 S. Ct. 546, 90 L. Ed. 752. Respondent's claim based on the Steelblast dividends was apparently not challenged.The Tax Court, conceding the difficulty of reconciling the embezzlements in the Wilcox case, which had been held not to constitute income, and the extortion in Rutkin v. United States, 343 U.S. 130, 72 S. Ct. 571, 96 L. Ed. 833, which did, decided that the latter case was more nearly applicable to the situation before it and entered deficiencies and penalties aggregating $719,955.96. The court also resolved a second issue against petitioners W. L. Kann and Stella H. Kann, deciding that they had filed joint returns for 1937 and 1938.
A review of the authorities does indeed reveal what appears to be a conflict of views. In North American Oil Consolidated v. Burnet, 286 U.S. 417, 52 S. Ct. 613, 76 L. Ed. 1197, taxpayer had in 1916 disputed beneficial ownership of certain oil lands. A receiver was appointed in that year to operate the property and hold the net income. The United States, as the other party to the dispute, filed a bill in 1917 to establish its rights in the oil lands. Upon the district court's dismissal of the bill in that year the 1916 profits were paid to taxpayer. Appeals followed and the litigation was finally terminated favorably to taxpayer in 1922. In holding that the 1916 income should have been reported in 1917, the court said at 286 U.S. at page 424, 52 S. Ct. at page 615, 76 L. Ed. 1197:
"They [the 1916 profits] became income of the company in 1917, when it first became entitled to them and when it actually received them. If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent."
Although the North American Oil case did not purport to hold that there A be a claim of right before there can be taxable income, the Wilcox case, citing North American Oil, did so state. In Wilcox the taxpayer had been a salaried bookkeeper for a Reno, Nevada, warehouse company.An audit of his books in 1942 disclosed that he had converted $12,748.60 of his employer's money to his own use in 1941. Most of the money was lost in Reno gambling houses. Wilcox was convicted in Nevada of the crime of embezzlement and served a jail term.His employer never condoned or forgave the conversion and still held him liable therefor. Wilcox did not include the embezzled proceeds in his 1941 return. The Commissioner asserted a deficiency and was sustained by the Tax Court. In affirming a reversal by the Court of Appeals the Supreme Court held that Wilcox' embezzlement did not constitute income under Section 22(a). While noting that it was immaterial whether the taxpayer's motive in acquiring the money was reprehensible or the mode of receipt illegal it nevertheless stated at 327 U.S. at page 408, 66 S. Ct. at page 549, 90 L. Ed. 752:
"For present purposes, however, it is enough to note that a taxable gain is conditioned upon (1) the presence of a claim of right to the alleged gain and (2) the absence of a definite, unconditional obligation to repay or return that which would otherwise constitute a gain. Without some bona fide legal or equitable claim, even though it be contingent or contested in nature, the taxpayer cannot be said to have received any gain or profit within the reach of Section 22(a). See North American Oil v. Burnet, 286 U.S. 417, 424, 52 S. Ct. 613, 615, 76 L. Ed. 1197."*fn3
In Rutkin v. United States, supra, however, the majority of the court would seem to have discarded the claim of right test*fn4 in holding that money extorted under death threats was income within Section 22(a).*fn5 In so concluding the court stated that "[an] unlawful gain, as well as a lawful one, constitutes taxable income when its recipient has such control over it that, as a practical matter, he derives readily realizable economic value from it." 343 U.S. at page 137, 72 S. Ct. at page 575, 96 L. Ed. 833. It was further pointed out that the money was taxable as income notwithstanding the taxpayer's freedom to use it was assailable by someone with better title.
We are of the opinion that the Tax Court correctly held the instant case to be controlled by Rutkin, not Wilcox, particularly in view of the gloss put on the Wilcox case by the Rutkin decision. Without indulging unnecessarily in ribbon matching it is manifest that the present appeal differs in several pertinent respects from the facts in Wilcox.
In the first place, although taxpayers here strenuously urge that the Kanns embezzled the money there is not, as the court below emphasized, any external evidence of that crime. They were never indicted or convicted of the alleged embezzlement, nor does it appear that those concerned with the corporate affairs of PCS or GSA, or anyone else, ever urged prosecution.*fn6
Next, while it is clear that Wilcox' victim did not forgive or condone him, the Tax Court here found that there was "no adequate proof that the method if not the act has not been forgiven or condoned." The court further stated that the details of the supposed liability to repay*fn7 were "such as to leave serious doubt whether the whole project was not a false front erected to deceive not the corporation nor its stockholders but the Commissioner of Internal Revenue." To the extent that the above views involved questions of fact and an opportunity to observe G.H. and W. L. Kann, as well as other witnesses, on the stand, they should not lightly be disturbed. The court also properly pointed out that the testimony of the Kanns, ...