Max Rosenn, and James Rosen, Circuit Judges and Teitelbaum, District Judge.
MAX ROSENN, Circuit Judge.
This is an appeal from a judgment of the United States District Court for the District of New Jersey which held that the appellants in these consolidated cases were not entitled to recover income tax and deficiency interest paid by them as transferees of the assets of Frankay Laboratories, Inc., a New Jersey corporation. The case raises several issues of first impression in this circuit.
The facts found by the district court which are relevant to our discussion and decision may be summarized as follows: Frankay, in the business of making and selling ethical pharmaceuticals, was incorporated on November 4, 1947, and dissolved on May 13, 1959. The appellants were shareholders throughout its existence. For federal income tax purposes, Frankay reported its income and deductions on the accrual method of accounting, and filed returns with the District Director of Internal Revenue on the basis of a fiscal year ending on October 31st.
By agreement dated March 23, 1959, Frankay sold its entire assets and business to Cooper Tinsley Laboratories, Inc. (Cooper Tinsley). The sale, closed on April 30, 1959, was made pursuant to a plan of liquidation adopted in conformity with the provisions of Section 337 of the Internal Revenue Code of 1954. Frankay fully complied with Section 337.
The sales contract of March 23, 1959, provided, in part, that:
Of the aggregate consideration for which the buyer is purchasing the assets and business of the Seller pursuant to this Agreement, $375,464 is paid as follows:
Prepaid advertising $40,000.
Substantially all of Frankay's advertising was prepared and supervised since 1954 by the Robert E. Wilson Agency (Wilson). Wilson handled Frankay's advertising campaigns during Frankay's fiscal year 1958 and the fiscal period of 1959, as it did in other years. Wilson's control of the advertising process was almost complete. Wilson paid all costs, then billed Frankay for its commission as well as the costs incurred, with the exception of the cost of sample pills manufactured by a subsidiary of Frankay called Arlington Laboratories. The advertising supplied by Wilson consisted of circulars, sample "sleeves" to doctors, and magazine advertisements in medical journals.
During the fiscal year ending October 31, 1958, Frankay incurred and paid advertising expenses of $99,087.50, and deducted that amount on its income tax return filed for that year. During the fiscal period beginning November 1, 1958, and ending May 13, 1959, Frankay incurred, paid, and deducted advertising expenses of $82,036.85.
Among the expenses incurred by Frankay in connection with the sale of its assets and its subsequent liquidation were legal fees, in the amount of $3,500. Although accrued and expensed on the books and records of Frankay, these legal fees were paid by Cooper Tinsley on June 26, 1959. Of the $3,500 charged for attorney's fees, $500 was charged for services concerning the sale of Frankay's business, and $3,000 was charged for services concerning the liquidation and dissolution of Frankay.
Pursuant to the plan of liquidation, Frankay distributed to its shareholders on May 22, 1959, all the assets which remained after the sale to Cooper Tinsley. Thereafter, the Internal Revenue Service audited Frankay's income tax return for the fiscal period ending May 13, 1959. The Commissioner ...