1941 WL 265 (T.C. 1941)

A taxpayer cannot avoid income tax liability on commissions earned under a personal services contract by informally assigning the contract to a corporation he controls, especially when the contract explicitly prohibits assignment.

Summary

Humphrey contracted with Amoco to sell petroleum products and receive commissions. He argued that he orally assigned these contracts to his corporation, which performed the work. The Tax Court held that the commissions were taxable to Humphrey, because the contracts were explicitly non-assignable and because the arrangement functioned as a subcontract, with the corporation performing Humphrey’s duties. Humphrey was allowed to deduct payments made to the corporation as business expenses in some years, offsetting his commission income, but substantiation was required.

Facts

Humphrey entered into contractor’s agreements with Amoco to sell and deliver petroleum products, receiving commissions based on the amount and class of products delivered. The contracts specified that they were personal and non-assignable. Humphrey was also the president of a corporation. He claimed to have orally assigned the Amoco contracts to the corporation, which performed the contractual duties using its own employees and equipment. Humphrey endorsed the commission checks to the corporation, which reported the sums as income. The corporation paid Humphrey a salary, which was substantially increased after the alleged assignment.

Procedural History

The Commissioner of Internal Revenue determined that the commissions paid by Amoco were taxable income to Humphrey, resulting in deficiencies for the tax years 1937, 1938, and 1939. Humphrey contested this determination in the Tax Court, arguing that he neither earned, received, nor enjoyed the income because the contracts were assigned to his corporation.

Issue(s)

1. Whether commissions paid by Amoco under the contractor’s agreements constituted income to Humphrey, despite his claim of oral assignment to his corporation.
2. Whether Humphrey was entitled to deduct from his commission income the expenses incurred by the corporation in performing the contractual duties.

Holding

1. Yes, because the contracts were explicitly non-assignable, and the arrangement between Humphrey and his corporation constituted a subcontract rather than a valid assignment.
2. Yes, for the years 1938 and 1939, because the amounts paid to the corporation represented ordinary and necessary business expenses. No, for 1937, because Humphrey failed to provide sufficient evidence of such expenses.

Court’s Reasoning

The court reasoned that the contracts were legally non-assignable. Quoting Williston on Contracts, the court emphasized that an assignment requires the right to have performance rendered directly to the assignee, which was absent here. Amoco was not notified to send payments directly to the corporation, and reports to Amoco continued to be made in Humphrey’s name. The court found that the corporation’s performance was due to its contractual duty to Humphrey, not to Amoco, characterizing the arrangement as a subcontract. The payments to the corporation were therefore considered Humphrey’s expenses in fulfilling his contractual obligations. The court distinguished Clinton Davidson, 43 B. T. A. 576, allowing Humphrey to deduct a reasonable portion of the commissions paid to the corporation, as they were considered ordinary and necessary expenses. However, the court disallowed deductions for 1937 due to insufficient evidence. The court also upheld the Commissioner’s adjustments for travel and entertainment expenses and contributions for 1938 due to lack of substantiation.

Practical Implications

This case illustrates that taxpayers cannot avoid personal income tax liability by informally assigning contracts for personal services to controlled entities, particularly when the contract contains an explicit non-assignment clause. The arrangement will be scrutinized to determine whether it constitutes a true assignment or merely a subcontract. Furthermore, the case reinforces the importance of maintaining meticulous records to substantiate business expense deductions. Taxpayers must demonstrate that expenses are ordinary and necessary and that they directly relate to the earning of income. Later cases applying this ruling would likely focus on the substance of the arrangement, not just the form, to determine the proper tax treatment of income and expenses related to personal service contracts.