The opinion of the court was delivered by: GORBEY
This action, to recover taxes paid by the plaintiff after the defendant disallowed deduction of certain payments, as being improperly taken under § 162(a) of the Internal Revenue Code of 1954, was tried without a jury. The payments in question were made by the plaintiff corporation and it was absorbing the business operations of these competitors.
The factual background against which these payments were made is as follows:
The combination of the business operations resulted from a series of events which follow. During 1961, discussions of possible mergers were held between Frankford and Penn Mutual. Similarly, during that year, discussions were held between Frankford and Quaker. As a result of these discussions and investigation by counsel, statutory mergers between Frankford and Penn Mutual and Frankford and Quaker were rejected. However, an agreement to combine the operations of Frankford and Penn Mutual and a plan to carry out the combination were set forth in a January 31, 1962 letter. The terms of agreement were modified in a February 15, 1962 document. An agreement to combine the operations of Frankford and Quaker and a plan to carry out the combination were set forth in a letter dated February 5, 1962. This agreement was modified in a February 27, 1962 amendment. Penn Mutual ceased operations on January 31, 1962 and was subsequently liquidated. Quaker ceased operations on May 10, 1963 and was subsequently liquidated.
The Frankford-Penn Mutual Plan required acceptance by at least 80% of Penn Mutual shareholders. It provided for a tentative exchange of stock at a 2 to 1 ratio which would be subject to a later reduction to adjust for the ultimate liquidation price of Penn Mutual. The February 15th modification provided for severance payments to some 16 employees of Penn Mutual and required that suitable non-competitive agreements be signed by these employees. The February 5th plan for the integration of Frankford and Quaker also required acceptance by 80% of Quaker shareholders. It provided a tentative exchange ratio for the stock which would ultimately be subject to the liquidation price of Quaker shares. In addition, it required that the Board of Directors of Frankford be increased to 17 which would include 5 members to be designated by Quaker. It provided for the liquidation of Quaker at the sole discretion of the Frankford Directors. It also provided that the Frankford Grocery Co. would change its name to Frankford-Quaker Grocery Co. The February 27th agreement between Frankford and Quaker provided for payments to certain Quaker employees. These payments were made contingent upon Quaker grocers continuing their withdrawals at 90% or more of their previous level for the three-year period following acceptance. The corporate agreement further provided that the payments were conditioned upon execution of individual non-competitive agreements.
Before the agreement, Frankford had approximately 1800 member grocers; Penn Mutual had approximately 200 member grocers; and Quaker had approximately 600 member grocers. After the liquidation of Penn Mutual and Quaker, Frankford-Quaker had approximately 2600 member grocers. Frankford-Quaker hired 111 former employees of Penn Mutual and Quaker. At the time of the negotiations, the Frankford Board had 15 members, subsequently the board was expanded to 17 members, 4 of the old members resigned, 5 members selected by Quaker were added and 1 member selected by Penn Mutual was added. Frankford-Quaker acquired the inventories of both Penn Mutual and Quaker. The inventory of Penn Mutual was acquired at a price determined by arbitration. The inventory of Quaker was acquired at Quaker's cost. Frankford-Quaker did not acquire Penn Mutual's warehouse facilities. Frankford-Quaker bought all rolling stock and some warehouse equipment of the Quaker Co. at an appraised price. The name of the Frankford Grocery Co. was changed to Frankford-Quaker Grocery Co.
The plaintiff agreed to the combination of the business operations in order to enable the member retailers of Penn Mutual and Quaker to remain competitive. From time to time, retail members of Penn Mutual and Quaker had applied to the plaintiff for membership, but were refused.
During this period of time, the plaintiff made several payments, the tax status of which is now at issue.
On June 29, 1963, the plaintiff paid Quaker $85,000 and deducted this payment as an expense on its tax return for the fiscal year ending June 29, 1963. After Frankford and Quaker entered into the agreement, Quaker continued to operate its warehouse until its lease expired in June, of 1963. To facilitate integration of the operations, Frankford began to service some 35 to 50 of Quaker's largest members from its warehouse in early 1962, i. e. before April 1962. The remainder of Quaker's members were not transferred until Quaker ceased operations in May, 1963. The transfer of customers prior to liquidation resulted in an increase in Frankford's marginal income of $90,364.00, and a resulting decrease in Quaker's marginal income of $84,199.00. Accordingly. Frankford's Board in June, 1963, approved a payment to Quaker of $85,000 to reimburse them for the loss of income during the transition period.
Second, $25,685.50 was paid by the plaintiff to former employees of Penn Mutual. As employees of Penn Mutual became unemployed, due to the acceptance of the Frankford proposal by Penn Mutual members and the termination of operations, Frankford made severance payments to them based on one week's pay for every two years they had been employed by Penn Mutual. Each of the employees of Penn Mutual who received these severance payments was required to, and did, execute an agreement that they would not enter into competition with Frankford-Quaker. Some payments were made to clerical employees who had no unique skills which would injure Quaker if they were employed by a competitor. Payments were also made to employees who spent most of their professional lives in the wholesale grocery business. All parties knew that these employees would, of necessity, become employees again in the wholesale grocery business. No officer or employee of the plaintiff ever actively attempted to determine if any of the employees who signed the agreement engaged in employment in a competing business within a year following the termination of this employment with Penn Mutual.
Third, during the fiscal year of 1962, the plaintiff paid its counsel $7,000, which both parties agree was reasonable, for the services performed. During that year, counsel attended numerous conferences with the officers and directors of Penn Mutual, Quaker and Frankford to explore the possibilities of a statutory merger. As a result of the conferences, and the analysis of the facts by its counsel, Frankford was advised not to consent to the statutory merger with either Penn Mutual or Quaker. Counsel also performed services in connection with the processing, financing and assimilation of a large number of grocers and employees into the plaintiff's organization. The services effecting necessary financial arrangements with Frankford's bank were of the sort usually performed by Frankford's counsel in connection with handling new members. Frankford's counsel is not only its legal advisor but also its principal financial advisor.
Each of the aforementioned payments was disallowed by the Internal Revenue Service as an ordinary and necessary expense of the plaintiff taxpayer's business.
"§ 162 Trade and business expenses.
(a) In general. -- There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business . .."
It is the defendant's position that these expenditures should have been treated as capital expenditures under § 263 of the Internal Revenue Code of 1954. That section provides in part:
§ 263 Capital expenditures.
(a) General rule. -- No deduction shall be ...