Opinion
Docket No. 1633-65.
Filed June 24, 1970.
1. Held, the good-faith filing of a Form 1065 partnership return reflecting petitioner's only source of income was not sufficient to start the running of the statute of limitations where petitioner had failed to file an individual return, as required by sec. 6012(a).
2. Held, petitioner incorrectly used the "official" rate of exchange (as opposed to the "commercial" rate of exchange) in converting the cost of Argentinian expenditures, incurred prior to petitioner's emigration to this country, into dollars.
3. Held, respondent's determination not arbitrary or unreasonable where respondent's agents were denied access to various books and records of a discontinued partnership to which petitioner had belonged, notwithstanding that such refusal was predicated on the presence of a special agent and the attendant possibility that such books and records might have been used against petitioner in a criminal proceeding.
4. Held, that in determining petitioner's distributive share of partnership income, respondent erred in disallowing in toto partnership cost of goods sold. (Partnership cost of goods sold determined.) Held, further, though not properly includable in partnership cost of goods sold, petitioner's investment in 72,200 ampules of the product Kositerin constituted a sec. 1231 loss in the year in which such ampules were destroyed as a result of spoilage.
5. Held, petitioner did not act fraudulently in failing to pay income tax for each of the years in issue.
6. Held, reasonable cause existed for petitioner's failure to file a timely declaration of estimated tax during 1954. Held, further, additions to tax for underpayment of estimated tax during the years 1955 through 1958 were proper.
7. Held, petitioner and his wife could not (subsequent to respondent's notice of deficiency) elect to file joint returns for years during which they were married and for which neither filed a return, where respondent had already employed individual taxpayer rates in determining petitioner's deficiency.
Douglas L. Barnes and R. Thomas Howell, Jr., for the petitioner.
Sheldon Chertow, for the respondent.
Respondent determined deficiencies in petitioner's income tax and additions thereto for the following years:
Internal Revenue Code of 1939. All other statutory references, unless otherwise specified, are to the Internal Revenue Code of 1954, as amended.
(1) Whether the good-faith filing of a Form 1065 partnership return reflecting petitioner's only source of income is sufficient to start the running of the statute of limitations where petitioner has failed to file an individual return, as required by section 6012(a).
(2) Whether petitioner should have used the "commercial" rate of exchange as opposed to the "official" rate of exchange in converting the cost of Argentinian expenditures, incurred prior to petitioner's emigration to this country, into dollars.
(3) Whether respondent's determination was arbitrary and unreasonable so as to negate the presumption of correctness which normally attaches thereto.
(4) Whether respondent erred in disallowing in toto partnership cost of goods sold and in assessing petitioner with his distributive share of the partnership income generated by such disallowance.
(5) Whether petitioner was fraudulent in failing to pay tax for each of the years in issue.
(6) Whether respondent properly determined additions to tax for failure to file a timely declaration of estimated tax during 1954 and for underpayment of estimated tax during the years 1955 through 1958.
(7) Whether, subsequent to respondent's notice of deficiency, petitioner and his wife may, contrary to respondent's determination, elect to file joint returns for years during which they were married and in which no returns were filed on the mistaken but good-faith belief that no tax was due.
FINDINGS OF FACT
Some of the facts have been stipulated by the parties. The stipulation of facts, together with the exhibits attached thereto, are incorporated herein by this reference.
Marko Durovic (hereinafter Marko or petitioner) was a resident of Winnetka, Ill., at the time the petition herein was filed. For each of the years in question Marko lived with his wife, Olga, and their then two minor children. On March 10, 1965, petitioner and his wife filed joint income tax returns for the years 1954 through 1958, inclusive, with the district director of internal revenue at Chicago, Ill.
Marko was born in Ulcinj, Yugoslavia (then Montenegro), in 1900. He was educated at the University of Paris and the University of Belgrade, receiving a law degree from the latter in 1923; whereupon for 3 years, he served as an assistant to a judge in a district court in Belgrade. Subsequent to his resignation from the judiciary, Marko engaged in the private practice of law. He was also a director and a one-third shareholder of the Vistad Corp., a company engaged in the large-scale production of armaments and munitions.
Marko practiced law in Yugoslavia until 1941. On April 6, 1941, Yugoslavia was attacked by the Axis powers, and after 2 weeks of resistance the Yugoslav army capitulated. The northern sector of the country (where petitioner lived) was overrun by the Germans, and the southern sector was occupied by the Italians. Petitioner and his young wife of 5 days fled to the southern Italian-occupied sector, where they obtained permission to travel to Rome. Marko's first instinct had been to escape through Switzerland where he maintained sizable bank accounts; however, the then position of the German army necessitated the abandonment of this course of action.
Five months after they arrived in Rome, Marko and Olga were joined by petitioner's brother, Dr. Stevan Durovic (hereinafter Stevan). Stevan had been imprisoned in a concentration camp. His release was accomplished through Marko's efforts and in accordance with certain terms of the Geneva Convention relating to imprisoned physicians. During the latter half of 1942, petitioner, his wife, and brother obtained authorization to leave Italy, and with the assistance of the Vatican obtained visas permitting them to emigrate to Argentina, where, in 1942, they established residence.
Stevan had received the degree of doctor of medicine in 1930. As early as 1931, Stevan (who was an assistant professor at the University of Belgrade) had conducted extensive research in the field of cancer. It was Stevan's theory that if a proper stimulant for the reticuloendothelial system could be found, the defensive and reparative cells comprising this system could be made to produce a substance which would control malignant growth.
In November 1942 (after arriving in Argentina) Stevan contacted a Dr. Canepa, Dean of the Veterinary Faculty of the University of Buenos Aires and proposed that he (Stevan) be allowed to pursue his research at the university. Stevan was thereafter allowed free use of the university's animal clinic facilities as well as its laboratories.
In researching for the above-described stimulant, Stevan conducted experiments on horses and cattle. Briefly, these experiments consisted of the following steps: First, the experimental stimulant developed by Stevan would be introduced into the animal's system by intravenous injection. About a month later the animal would be bled, the blood serum being extracted by means of an organic solvent such as petroleum ether or benzene. There would then follow a series of steps calculated to dissolve the solvent, evaporate the water content, and separate the insoluble component which, when filtered and centrifugated, would yield a white powder — the active substance. Employing this process, the serum extracted from one horse yielded powder sufficient for only forty 1/100-milligram ampules of the active substance. Most of the horses were supplied free by the university; however, Stevan supplied the 18 or 20 cattle used in the experiments.
Beginning in 1943, Stevan was assisted in his work by several distinguished scientists, one of whom, Dr. Fabio Damonte (hereinafter Damonte) was a professor at the Veterinary Faculty. Damonte helped inject the animals with the solution prepared by Stevan. Damonte also aided in extracting the blood serum which was then processed by Stevan in his laboratory. This laboratory was established in 1944. In addition to the laboratory, Stevan also maintained a farm in Villa Elisa which he apparently also used for experimentation.
In 1944, still searching for an active substance against malignant tumors, Stevan, using the stimulant actinobacilus lignieresi, unexpectedly separated a substance which showed activity against hypertension. This substance was named Kositerin.
At about the time of this discovery, Stevan was being assisted by a fellow scientist, Dr. Carlos de la Serna (hereinafter La Serna). La Serna continued to collaborate with Stevan until the latter's departure from the United States in 1949.
Stevan was very interested in his new discovery, and continued his experiments with the new substance, Kositerin. During this period of time, Stevan was aided financially by a Mrs. Ada Bossard von Martini (hereinafter Ada). Ada was the wealthy daughter of one of the founders of the Nestle Co. She was also an aunt of Marko's wife, Olga. Between 1943 and 1946 Ada advanced a total of 500,000 pesos to Stevan. Sometime thereafter Ada became very ill, and her son, France, was empowered to handle her affairs. In reviewing Ada's papers, France became aware of these advances. Accordingly, he contacted Stevan with a view toward making arrangements for repayment of the debt. Unfortunately, Stevan was not in a position to satisfy this obligation. However, at a subsequent meeting Marko agreed to discharge the sum owing to Ada. The 500,000 pesos was paid by Marko in 1949. The transaction took place at the Banco Frances Del Rio de la Plata and the medium of exchange was cash.
To permit increased production of the active substance Kositerin, sometime during 1946 Stevan established a laboratory at Las Heras Street in Buenos Aires. Needing funds to finance this operation, Stevan, on May 23, 1946, entered into an agreement with a corporation known as Urbe. Several of Urbe's investors who were interested in Stevan's discovery contributed 172,887.91 pesos to the establishment of a separate division of Urbe which would finance the production of Kositerin. The agreement was, however, canceled in August 1947 because of the unexpectedly high cost of producing the substance. The persons who had contributed the 172,887.91 pesos were as follows:
Eduardo Gaynor .................. M$N62,387.91 Alicia Gaynor de Leslie ......... 70,000.00 Alfredo Goni .................... 23,000.00 Martin Iguerabide ............... 10,000.00 Estela Gaynor ................... 7,500.00 --------------- Total ..................... 172,887.91
Argentinian pesos designated by the symbol M$N.
These amounts were subsequently repaid to the investors by Stevan.
To finance the operations of the production laboratory, which had been named Instituto Biologico Duga (hereinafter Duga Argentina), a new organization, Instituto Biologico Duga, S.A. (hereinafter Duga S.A.), was formed with an initial capitalization of 544,900 pesos contributed in the main by the following persons:
German Calvo ........................... M$N150,000 Asunsion Iglesias Calvo ................ 120,000 Eduardo Gaynor ......................... 60,000 Alicia Gaynor de Leslie ................ 70,000 Alfredo Goni ........................... 5,000 Martin Iguerabide ...................... 10,000 Humberto Lorentani ..................... 10,000 Olga Wickerhauser de Durovic ........... 1,000 Stevan Durovic ......................... 1,000 Victor Loero ........................... 100,000 Estela Lidia Gaynor .................... 7,500 Roberto Amigorena ...................... 5,000 -------- 539,500
Duga S.A. thereafter purchased from Stevan various pieces of scientific equipment and furniture located at Las Heras Street and at Villa Elisa. It also took over the lease on these two properties. In return, Stevan received 168,708.49 pesos from Duga S.A. which he apparently used in making the 172,887.91 peso payment to the Urbe investors. Stevan also contributed to Duga S.A. raw material sufficient to make 40,000 ampules of Kositerin, for which he was to receive a 70-percent interest in the operations of the business. However, it appears that the raw material was regarded by Stevan and the Duga S.A. investors as a contribution to capital in return for which Stevan would be entitled to 70 percent of the net proceeds from the sale of Kositerin.
Because Duga S.A. failed to comply with sec. 319 of the Argentinian Code of Commerce, which sets forth the procedural prerequisites for incorporation, it never obtained "legal solicitorship" — corporate status. It is, therefore, impossible to ascertain the number of shares to which Stevan (or the other investors) would have been entitled had corporate status been achieved.
This is evidenced by the fact that, excluding Stevan's M$N1,000 investment, Duga S.A., with an authorized capital of M$N1 million (each share being valued at M$N100) was already capitalized to the extent of M$N538,500 at the time the Kositerin raw material was placed at its disposal.
A comparison of the investors of Duga S.A. with those persons who invested in the Urbe division yields the following table: Investment in Duga Investment in Duga Department S.A. as of 8/18/47
Eduardo Gaynor .............. M$N 62,387.91 M$N 65,400 Alicia Gaynor de Leslie ..... 70,000.00 70,000 Alfredo Goni ................ 23,000.00 5,000 Martin Iguerabide ........... 10,000.00 10,000 Estela Gaynor ............... 7,500.00 7,500 -------------------------------------------- Total ................. 172,887.91 157.900 In 1948, Duga S.A. began to experience financial difficulties. As a consequence, Marko was prevailed upon to invest in the company. Marko's investment was in the amount of M$N255,100 which he paid to Duga S.A. on April 8, 1948.Under the technical directorship of Dr. Fernando Galmarini (hereinafter Galmarini) Duga Argentina was licensed to manufacture biological products on December 19, 1946. Also a license to sell Kositerin by prescription was issued by the Bureau of Public Health on August 14, 1947.
During this time Argentinian law required that the cost and price of medical products (such as Kositerin) be established by governmental authority. Prior to November 22, 1949, this function was carried out by the Ministry of Public Health. However, on this date jurisdiction over this administrative duty passed from the Ministry of Public Health (hereinafter MPH) to the Ministry of Commerce and Industry (hereinafter MCI). MPH's function as a licensor of medical products was not affected by this change in pricing and cost analysis jurisdiction.
In the case of Kositerin, Galmarini, on February 10, 1949, submitted a schedule of costs to MPH. This schedule (made under oath) reflected a raw material cost of 30.05 pesos per 2-ampule package of Kositerin and a total product cost of 35.13 per 2-ampule package. Among other things, the product cost schedule showed packaging costs of 1.20 pesos per 2-ampule package. On March 3, 1949, MPH fixed the selling price of Kositerin per 2-ampule package as follows:
Also included in the M$N35.13 cost determination were the following items:
Waste and breakage ........................... M$N0.02 Stamping ..................................... .10 Manufacturing costs .......................... .66 Administrative costs ......................... 1.85 Royalties .................................... 1.25
Drug store .............................. M$N58.90 Pharmacy ................................ M$N67.74 Public .................................. M$N94.85
These prices were based upon the schedule of costs submitted by Galmarini.
On August 11, 1949, MPH revoked Duga Argentina's license to sell Kositerin. However, on December 16, 1949, MPH issued a subsequent order reinstating Kositerin and making null and void its earlier resolution revoking Duga Argentina's authorization to sell Kositerin. Excerpts from the resolution, which are herein pertinent, appear as follows:
That in view of the agreement of the technical reports from the scientific standpoint and the purely administrative bases for the cancelation, a conflict is present between considerations of a scientific nature and others that are merely a matter [ sic] of form; [Emphasis supplied.]
* * * * * * *
Therefore:
The Minister of Public Health of the Nation Resolves:
Article 1. To declare null and void Resolution No. 19235/49 and the provisions on folio 84, in so far as they pertain to the cancelation of the authorization for the sale of the product called INJECTABLE KOSITERIN.
On January 21, 1950, Marko entered into an agreement with the Duga S.A. investors (other than Olga and Stevan) whereby he agreed to reimburse them for their investment in Duga S.A. Pertinent provisions of that agreement are as follows:
In the City of Buenos Aires, Capital of the Argentine Republic, in the year of the Liberator General San Martin, on the twenty-first day of January, nineteen hundred and fifty, * * * [the investors in Duga S.A.] state as follows:
FIRST: That on July twenty-eight nineteen hundred and forty-seven they established the bases for the organization of a joint-stock company under the title of "Instituto Biologico Duga Sociedad Anonima Commercial e Industrial" (Duga Biological Institute, Commercial and Industrial Joint-Stock Company), to have as chief purpose the exploitation and manufacture of chemical products, the authorized capital being fixed at the amount of ONE million pesos Argentine currency, in shares of one hundred pesos each. ______________________________________
SECOND: To the effect of obtaining the legal status of the Company, the pertinent steps were taken * * * by virtue of which the Company was allowed to operate as a joint-stock company; not having up to this date fulfilled the requirements of article three hundred and nineteen of the Code of Commerce, therefore actually the Company has not attained legal corporate existence.
THIRD: That meanwhile, the partners had subscribed and invested in cash the following amounts: * * * which * * * in the aggregate * * * total * * * five hundred and thirty-seven thousand five hundred pesos Argentine currency, without taking into account the investment of Mr. Durovic, which was two hundred and fifty-five thousand one hundred pesos, and that of his wife, Mrs. Olga V. de Durovic, which was one thousand pesos. __________________________________________
FOURTH: That the abovementioned persons, in accordance with Mr. Durovic, have resolved to disassociate themselves completely from the corporate activities, letting Mr. Durovic absolutely free to resolve about the future development of the above mentioned Instituto Biologico Duga, Sociedad Anonima, under organization. That for said reason they have resolved to transfer to him all their corporate investments, consisting of the amounts already expressed, and assign to him therefore their shares in the aforesaid Company being organized, as well as all and every right which they might have in it. __________
FIFTH: That therefore and in accordance with the former statement, Mr. Durovic pays during this act and in cash, to each of the aforementioned persons, before me, Notary Public, and witnesses, I attest, the amount of their corporate investments, in the proportion already expressed * * *; the appearers therefore hand over to Mr. Durovic their assignments and letter of payment in due form, adding once more that they transfer to him all the rights and stocks which correspond to them in the company de facto, as well as those which they could have under the contract signed between them and Dr. Stevan Durovic, and all the rights concerning the elaboration, exploitation and sale of the product called "Kositerin" and they acknowledge that they cannot claim in the future anything from Mr. Durovic, regarding the winding-up of the corporate business or about the results of the contract with Dr. Stevan Durovic, which any of them personally or on behalf of the Company, might have subscribed. Mr. Marcos Durovic, on his side, states that he accepts the present assignment of shares and rights made by the former stockholders, and he adds that by virtue of same, all the obligations determined in the contract subscribed with Dr. Stevan Durovic remain in his exclusive charge, as well as any obligation pending with Mrs. Olga V. de Durovic, as a member of the Company, the assigners remaining therefore completely released and free from any further claim concerning the matter. This means practically that the Joint-Stock Company under organization disappears; and Mr. Marcos Durovic is hereby authorized to take any steps necessary in order to desist before the Executive Power from the obtention of the legal corporate status. * * *
[Emphasis supplied.]
Under the direction of Galmarini, Duga Argentina (whose activities had been conducted under the auspices of Duga S.A.) continued to exist after this agreement was executed. Its primary function, however, was that of a storage place for the 72,200 ampules of Kositerin which had been produced as of January 21, 1950. However, as a result of the January 21 agreement, Duga S.A. no longer operated in its former capacity.
During 1949, studies on the effectiveness of Kositerin were conducted by the School of Medicine at Northwestern University in Illinois. The results of these tests were found to be uncertain. It was apparently this fact which had led to the dissolution of Duga S.A. No Kositerin was ever sold in Argentina. However, in November 1953 a petition was filed with MCI requesting a revised cost schedule reflecting post-1949 storage and administrative costs associated with Kositerin. The reply from MCI, dated January 8, 1954, contained the following pertinent language:
In reference thereto, I must state that pursuant to category "A" in which said drug has been classified by the Ministry of Public Health of the Nation (authorization certificate No. 15899) and bearing in mind the provisions in Article 1 of Resolution MCI No. 753/50, you may launch the sale of said product, which prices shall be verified and definitely fixed at the proper time.
For this purpose, you must after sixty (60) days file in duplicate the justifying factors as to cost in a clear and faithful manner with Department No. 1 (Costs and Prices). The nonperformance of this requirement shall automatically render this authority null and void after one hundred and eighty (180) days from this date.
No indication exists as to whether Galmarini provided MCI with the "justifying factors" as stated above.
Early in 1956, MPH informed Galmarini that all 72,200 ampules of Kositerin would have to be destroyed as a result of spoilage. The destruction of the product was accomplished on February 17, 1956. Marko, who resided in Illinois at this time, returned to Argentina to witness this event. At this time, Duga Argentina was closed, and Marko instructed Ernesto Romagnese, an office employee in charge of commercial books and correspondence to collect all of Marko's commercial papers still in Argentina and mail them to the United States. Alejandro Stefanovic, an old friend of Marko's, supervised the collection and packing of these items. Two parcels were shipped to Marko; however, only the parcel containing certain of Marko's personal effects reached the United States. At the insistence of Stefanovic, an investigation was conducted by the Argentinian authorities; however, the parcel containing Marko's commercial documents was never found.
Following the discovery of Kositerin, Stevan continued research in the area of cancer. Experimenting with different stimulants, in 1947 Stevan came upon a substance derived from the blood serum of horses which had been stimulated by a fungus called actinomyces bovis. The method of preparing and extracting this substance was identical in all respects to the procedure used in obtaining Kositerin, the only difference being that in obtaining the new substance the stimulant used was actinomyces bovis, instead of actinobacilus lignieris. The new substance was referred to as "drug X" (later to be called Krebiozen). During 1947 and 1948, Stevan tested this substance on naturally occurring tumors in dogs and cats. Convinced that the substance possessed properties which made it active against malignant tumors, Stevan related his findings to certain members of the Buenos Aires scientific community. Stevan was assisted in his research by de la Serna and Galmarini.
In March 1949 Stevan left Argentina and traveled to the United States on a temporary visa. In May 1949 Olga (who spoke English) left Argentina to serve as aide and interpreter to Stevan, who was at this time disclosing his findings to several prominent scientists in the United States. She also traveled on a temporary visa.
While in Argentina Stevan's research with drug X had been financed by Juan Manuel Tanoira (hereinafter Tanoira), an industrialist and entrepreneur. By contract dated August 1947 Tanoira, in consideration for a one-half interest in any returns from the sale of drug X, had agreed to finance the development and production of this drug. During the years 1947, 1948, and 1949, Tanoira expended a total of about 3 million pesos on this project. During this time enough drug X (2 grams, 35 centigrams) had been produced to make 200,000 ampules of the product. However, with the departure of Stevan for the United States, Tanoira lost interest in the arrangement, and in the autumn of 1949 contacted Marko with a view toward having the latter recompense Tanoira for his investment.
Discussions relating to the liquidation of Tanoira's investment took place over a period of several months. Tanoira and petitioner differed on the amount of Tanoira's investment. However, since the preparation and extraction process used to obtain drug X was identical to the method used to obtain Kositerin, petitioner offered to pay Tanoira an amount (3,005,000 pesos) which would reflect the preparation and extraction cost (M$N15.025) of one ampule of Kositerin, as determined by MPH on March 3, 1949, multiplied by the number of ampules (200,000) which could be manufactured from the 2 grams, 35 centigrams of drug X which had been produced by Stevan.
During these negotiations, Tanoira hired a public accountant, David Muchenik (hereinafter Muchenik) to make a detailed audit of all the expenses which had been incurred by Tanoira in the development of drug X. Muchenik's report, which included certain prefatory language quoted below, revealed a cumulative expenditure of M$N2,997,500:
The documentation supplied to the undersigned (Muchenik) was the following:
1 inventory book, unmarked, 200 pages.
1 daybook, unmarked, 200 pages.
1 cashbook, unmarked, 400 pages.
1 book of entrances and expenditures of drugs, 200 pages.
7 folders with various documentation.
6 folders containing contracts, invoices and receipts.
Although the books were unmarked, they were prepared according to valid accounting methods, with double entries, and no deficiencies were observed in their preparation.
The undersigned obtained samples of the accounting and compared it with the documentation provided, observing that both coincided, therefore considering it authentic because it was backed by — adequate documentation.
On the basis of this audit (which covered the period beginning on January 1, 1948, and ending on December 10, 1949, and which reflected losses and gains incurred in the disposition of all items and livestock used in the development and production of drug X), and in accordance with Marko's prior offer, the two parties entered into the following agreement dated January 26, 1950:
Mr. JUAN MANUEL TANOIRA, an argentine [ sic] citizen, married, residing at Montevideo 1520, Federal Capital, on the one hand, and Mr. MARCO DUROVIC, residing at Arenales 2120, Capital, on the other, both of legal age and able to enter into contracts, decide the following:
FIRST: Mr. Juan Manuel Tanoira, on the 25th day of August 1947, signed a contract with Dr. Stevan Durovic to finance the production and exploitation of a discovery made by Dr. Durovic, consisting of a drug for the treatment of malignant tumors, to which no name has yet been given, which will henceforth be called DRUG X.
SECOND: The contract provides for a participation in the utilities, in equal parts on a fifty/fifty basis.
THIRD: During the years 1947, 1948, and 1949, Mr. Tanoira financed the production of Drug X, of which a net quantity of two grams, thirty-five centigrams of powder have been produced, with a capacity to produce two hundred thousand doses, dissolved in two hundred thousand ampules of one cubic centimeters each.
FOURTH: During the second part of March, 1949, Doctor Durovic left for the United States of America with the object of experimenting with said drug in the scientific centers.
FIFTH: As Mr. Tanoira has lost interest in the venture and is no longer willing to continue financing the drug in the future, he has agreed to transfer to Mr. Marko Durovic, for the sum of three million five thousand Argentine pesos, all his rights and shares, as well as the total quantity of the product, which consisted of two grams thirty-five centigrams of powder, sufficient to produce about two-hundred thousand doses of "Drug X", * * *
SIXTH: The payment of the price and the delivery of the drug simultaneously, with the present act serving as sufficient receipt and reciprocal letter of payment, with Mr. Tanoira handing over to Mr. Durovic all the documentation he possesses, as well as a copy of his contract with Dr. Stevan Durovic, stating that hereafter he has no right to claim anything whatsoever.
SEVENTH: The parties make it a matter of record that this agreement is authorized by Dr. Stevan Durovic, according to his letter dated January 19, 1950, addressed to Mr. Tanoira, which reads: "January 19th 1950, Winnetka, Dear Mr. Tanoira: I received your letter which I am now answering. My brother Marko had informed me before of talks held with you, as to your desire to withdraw from the partnership in the exploitation of the drug for the treatment of malignant tumors. Understanding your situation and your difficulties, I agree that you transfer everything to my brother Marko Durovic, and I hereby authorize this transaction. — Yours sincerely, Doctor Durovic."
[Emphasis supplied.]
Of the 3,005,000 pesos paid to Tanoira, M$N2 million had been borrowed by Marko from the banking house of Armando Ferrari.
In accordance with the terms specified above, Marko took possession of the 2 grams, 35 centigrams of drug X which Tanoira had been keeping as security. It was the intention of Marko and Stevan that, as of the date of the above agreement, the ampules to be derived from the drug X substance would be the subject matter of a partnership (for the distribution and sale of drug X in the United States) in which each would have a 50-percent interest. Soon, thereafter, Marko left for the United States bringing with him the entire supply of drug X. Drug X (or Krebiozen was never licensed in Argentina.
After arriving in the United States, Stevan was put in contact with Dr. Roscoe Miller (hereinafter Miller) of the medical school at Northwestern University. Miller supervised the study of Kositerin which, as indicated earlier, yielded uncertain results. As a consequence, during July 1949, Miller referred Stevan to Dr. Andrew C. Ivy (hereinafter Ivy), then vice president and head of the Department of Clinical Science of the University of Illinois. Though Kositerin was the intended topic of concern, Ivy's interest in the drug abated quickly with Stevan's disclosure of his work on drug X. This was attributable to the fact that Stevan's research with substances active against malignant tumors was quite similar to research conducted by Ivy as far back as 1917.
Sometime prior to April 1951 and subsequent to his arrival in the United States, Stevan established a laboratory at West Adams Street, Chicago, for the production and distribution of drug X. In addition, further research on drug X was conducted at this building by Stevan, Ivy, and a Dr. Reginald Rabadan. During this time, 200,000 ampules of medicine were derived from the 2 grams, 35 centigrams of available drug X raw material. Ivy, Stevan, and one of Ivy's assistant's tested the drug for toxicity by taking it themselves. Convinced that the drug was nontoxic, Stevan and Ivy made it available free of charge on an experimental basis to physicians whose patients were suffering from advanced or terminal cancer. Detailed diagnostic forms were also supplied to these physicians who were requested to summarize their observations and return the completed forms to Ivy. Ivy was in charge of collating these forms and appraising the results which they reflected. Between 1950 and 1959, approximately 3,000 physicians administered the drug to over 4,000 patients.
In April 1951 a nonprofit organization called the Krebiozen Research Foundation (hereinafter Foundation) was formed. Under the supervision of Ivy, the purpose of the Foundation was to conduct experiments on drug X (now called Krebiozen) and to authorize, oversee, and coordinate the experimentation being conducted by the many physicians who had requested its use. No charge to participating physicians or patients was made for this service, the costs of which were defrayed by Marko and Stevan.
Unless otherwise indicated, drug X will hereinafter be referred to as Krebiozen.
In September 1951 the West Adams Street Laboratory was registered under the name Duga Biological Institutes. On April 5, 1954, the name was changed to Duga Laboratories (hereinafter Duga Illinois). Operated as an equal partnership between Stevan and Marko, Duga Illinois was responsible for the distribution of Krebiozen recommended by the Foundation. Duga Illinois, now operating as a formal business unit, was the outgrowth of the partnership relationship occasioned by Marko's purchase of the active substance, drug X, from Tanoira early in 1950. Prior to April 1954 no charge was made by Duga Illinois for any of the distributed ampules. All costs during this period were paid by the partners.
In the spring of 1951, petitioner and his brother were referred to an attorney, a Mr. Homer L. Bruce of Houston, Tex., for advisory work in connection with possible tax problems relating to the operation of the Foundation and distribution of the drug. On April 23, 1951, a letter signed by Ivy as president of the Krebiozen Research Foundation was sent to the Internal Revenue Service requesting (1) a ruling classifying the Foundation as a tax-exempt organization, and (2) a ruling establishing the cost of the 200,000 ampules of Krebiozen at $1,326,000. Also requested was a determination that no taxable income would be realized by the Durovics should they decide to sell the 200,000 ampules of Krebiozen to the Foundation for $1,326,000.
The cost figures of $1,326,000 had been arrived at pursuant to consultation with petitioner's financial advisers and attorneys. Because Kositerin had been an innocent byproduct of Stevan's search for a substance active against malignant tumors and because the preparation costs and extraction costs of Kositerin were identical to those incurred in producing Krebiozen, petitioner believed that the stated figure should be one which reflected the basic cost of producing the 200,000 ampules of Krebiozen as well as the 72,200 ampules of Kositerin (as determined by MPH on March 3, 1949), increased by the various distribution costs incurred by petitioner and his brother since arriving in the United States. The following schedule summarizes the above cost computation:
Packaging costs did differ.
Kositerin — 72,200 units at 17.565 (based upon a 2-ampule "total product" cost of M$N35.13 = ....... M$N1,268,193
Krebiozen — 200,000 units at 15.025 (based upon a 2-ampule raw material cost of M$N30.05) = ....... 3,005,000 ------------ 4,273,193 Additional Argentine expenses (not explained) .................. 6,800 ------------ Total (rounded to nearest M$N100) ........................ 4,280,000 ============== Converted into dollars ($1 U.S. = M$N3.36) = ...................... $1,273,809.50
To obtain the conversion rate used above, petitioner wrote to the First National Bank of Chicago and was informed that prior to Aug. 29, 1950, Argentinian costs were to be converted at the "official" rate of M$N3.36 to $1 U.S.
Additional U.S. expenses: 1949 to April 1951 ....................... 52,202.15 ------------- Total costs to nearest $100 ...... 1,326,000.00
On May 9, 1951, the Internal Revenue Service issued a reply letter in response to the requested rulings. Pertinent portions of that letter appear below:
In order that this office may be in a position to determine whether the requests for rulings and final closing agreement may be granted, additional information, as indicated hereinafter, is essential.
From the facts presented, it is evident that there are two distinct classifications of property involved: One, the secret formula with reference to which Krebiozen is produced; the other, the product Krebiozen itself. It appears that there is no immediate desire to establish the nature nor the value of the formula itself for income tax purposes, but only that of the manufactured product, which now consists of 200,000 units.
It is stated that the Durovics have expended all of their personal resources in the manufacture of this supply. Although the total costs which they attribute to the 200,000 units is $1,326,000.00, a considerable additional, but unidentified, sum is indicated to have been spent in research in connection with the project.
In view of these circumstances, it is necessary that the specific elements or factors involved in the development of the formula, and the resulting product Krebiozen, together with their respective costs, be furnished in such reasonable detail as will permit of eventual field verification. In other words, for what particular purposes and in what corresponding amounts were the various capital outlays incurred to perfect the formula, and to accomplish production of the actual units of Krebiozen identifying, if any, amounts attributable strictly to the value of the Durovics' time and labor?
On May 31, 1951, Ivy, writing on behalf of the Institute, informed the Internal Revenue Service that the requested rulings were being withdrawn. The reasons for Ivy's action in withdrawing the ruling requests are summarized in a subsequent ruling request, the pertinent provisions of which appear below:
In reference to the items of cost to the Durovics of the 200,000 ampules they propose to sell to us, we hand you copy of letter agreement between them and us of even date with this letter under which they agree to enter into a contract for the sale of said ampules to us and we agree to purchase them, and we hand you copy of the proposed contract referred to in that letter agreement. From the letter agreement you will see that most of their records in reference to the cost of the 200,000 ampules are in Argentina and owing to their passport and permit status, they cannot go to Argentina now to obtain those records. They are therefore willing to make said sale to us, as shown by their letter agreement with us, if we or they can obtain from you a ruling or closing agreement under Section 3760 of the Internal Revenue Code that those ampules are in their hands capital assets and any profit that they might be held to have made on the sale will be treated as a long term capital gain. * * * [Emphasis supplied.]
Their letter agreement, dated May 31, 1951, contained the following pertinent language:
CHICAGO, ILLINOIS May 31, 1951
KREBIOZEN RESEARCH FOUNDATION, Chicago, Illinois.
* * * * * * *
Our said supply of Krebiozen was produced in Argentina and all of our records of the costs incurred by us in Argentina in its production are in that country. For us to get those records into the United States in order that we might substantiate in detail our said cost, it would be necessary for one of us to go to Argentina to get them. However, as you know, we were admitted to the United States on only temporary permits and we have no way of knowing whether, if either of us should return to Argentina, we would be allowed to depart from Argentina or be allowed to re-enter the United States. Under these circumstances it is not feasible for either of us to go to Argentina and therefore at this time it is impossible for us to supply the Commissioner of Internal Revenue with the evidence of these costs requested by him.
* * * * * * *
Yours very truly,
Dr. Stevan Durovic DR. STEVAN DUROVIC
Marco Durovic MARCO DUROVIC
This second ruling request was also withdrawn at a later time. The sale of the Krebiozen ampules to the Institute was never consummated.
Meanwhile, the drug continued to be distributed gratis on an experimental basis. Petitioner's efforts, early in 1954, to obtain a license to sell Krebiozen under prescription were not successful, for a storm of huge proportions regarding the medical efficacy of the drug, Krebiozen, had begun to rage. Nevertheless, free distribution on an experimental basis continued up to April 1954. At this time, Marko and Stevan had exhausted all their resources and, without financial assistance, could no longer underwrite the activities of either the foundation or the laboratory. Accordingly, it was decided to solicit payment from the patients to whom the drug was being administered. To implement this decision, Ivy assisted by James Griffin, attorney to petitioner, drafted a form letter which was circulated to all physicians interested in using Krebiozen. The letter advised that: (a) Krebiozen was an experimental drug available to physicians for clinical investigation purposes to be used in accordance with the rules and regulations of the Federal Food and Drug Administration under the supervision of the Krebiozen Research Foundation; (b) Krebiozen would be supplied by Duga Laboratories upon the instruction of the foundation at a product cost of $9.50 per ampule; but (c) if the patient were unable to contribute the full cost, the judgment of the physician and the patient would determine the contribution to be made for each ampule of the product; and (d) if the patient could not pay anything, Duga Illinois would consider such a case for a charitable distribution. Little indication exists as to how the Institute or Duga Illinois arrived at the $9.50 production cost figure; however, the genesis of the figure seems to be related to the number of ampules (136,097) on hand at the beginning of April 1954 spread over costs computed to that time.
During the years 1954 through 1958 the following net amounts were received by Duga Illinois as payment for distributed Krebiozen:
1954 .................................... $149,694.10 1955 .................................... 205,936.73 1956 .................................... 171,926.98 1957 .................................... 263,336.53 1958 .................................... 217,213.36
These amounts were reported as "Gross receipts from business" on partnership returns timely filed by Duga Illinois for each of the years indicated. Offsetting these amounts on the respective partnership income returns for each of the years in question were the following cost figures shown on the returns as cost of goods sold in each of the years indicated:
1954 .................................... $172,957.74 1955 .................................... 319,682.64 1956 .................................... 244,738.80 1957 .................................... 344,244.24 1958 .................................... 251,611.92
The cost of goods sold for the year 1954 was based upon the following computation:
See page 1377 for the manner in which this dollar amount was determined.
Relying upon Argentinian cost figures supplied by Marko and United States cost figures reflected in records which had been maintained by Olga, Grauer arrived at the 1954 cost-of-goods-sold figure shown above. However, in so doing, Grauer omitted to take into consideration United States expenditures claimed to have been incurred between May 1951 and April 1954, and reflected in Olga's books in the amount of $78,511.33. This amount when combined with the $1,326,000 cost figure yielded a combined cost of $1,404,511.33.
Commencing with Marko's arrival in the United States early in 1950, Olga had assumed responsibility for collecting bills and maintaining a record of daily partnership expenditures. These records and supporting documents were maintained in a chronological file without reference to category or classification. However, in 1955, Grauer instructed Olga to consolidate her records and categorize the various expenditures into appropriate classifications. Accordingly, Olgo prepared an expense journal in which all expenditures incurred by Marko and Stevan subsequent to October 1949 and prior to April 1954 were recorded. In this journal personal expenditures were denoted as same and ultimately separated from the summary of business expenditures.
For the period ending April 1951, non-personal expenses totaled $52,202.15, and for the period commencing May 1951 and ending March 1954, non-personal expenses totaled $78,511.33. However, included in these totals were expenditures attributable to food, travel and lodging incurred by the Durovics prior to July 1952 and treated by Olga as temporary living costs while away from Argentina. (Prior to July 1952, the Durovics were residents of the United States only by virtue of their temporary visas. By act of Congress, permanent residency in this country was granted to them on June 16, 1952.) These items amounted to $10,203.56 prior to May 1951, and $10,749.88 for that part of the subsequent period ending in July 1952. Additionally, $4,372.66 of the non-personal expenditures, though paid by the Durovics, were attributable to the Institute and not the partnership.
Accordingly, for the years 1955 through 1958, cost of goods sold on the partnership returns was computed to reflect a per ampule cost of $10.32 which was obtained by dividing the April 1954 quantity of ampules (136,097) into the adjusted total cost figure of $1,404,511.33. The 1954 return was not amended. In 1959, the Internal Revenue Service examined Duga Illinois' 1957 partnership return. The purpose of the audit was to examine the propriety of the change in per ampule cost which had been initiated in 1955. At the conclusion of the audit, the district director issued a "no change" report dated July 7, 1959, the body of which appears below:
Employment of this per ampule cost yields the following cost-of-goods-sold figures for years 1955 through 1957:
1955 ..................... $316,555.68 ($319,682.64) 1956 ..................... 244,924.56 (244,738.80) 1957 ..................... 348,011.04 (344,244.24)
The cost of goods sold actually claimed in each of these years (see page 1380, supra) is depicted above parenthetically. The record does not reveal the reason for these discrepancies. Since neither party has alluded to these discrepancies on brief, and since, in the aggregate they are de minimis we will not belabor the matter.
DUGA LABORATORIES
343 S. Dearborn Street Chicago, Illinois
In re: Form 1065 Year 1957
GENTLEMEN:
Our recent examination of the above-noted partnership return for the year indicated discloses that no change is necessary with respect to the information contained therein. Accordingly, the return will be accepted as filed.
Very truly yours,
(S) HAROLD R. ALL District Director
In light of the large losses shown on the partnership returns for the years 1954 through 1958, Grauer advised Marko and Stevan that they would not have to file personal income tax returns for these years. Except for interest on a joint savings account (equaling $680 in 1957 and $891.28 in 1958) Marko and Olga had no other income during the years 1954 through 1958.
On September 9, 1963, a preliminary investigation of Marko Durovic, Stevan Durovic, Duga Illinois, and Promak Laboratories (successor to Duga Illinois and operated exclusively by Stevan subsequent to the disbandment of Duga Illinois in 1959) was initiated by Revenue Agent Sanford Schwartz (hereinafter Schwartz) and by Special Agent William Mannie (hereinafter Mannie) of the intelligence division of the Internal Revenue Service. Agents Mannie and Schwartz were primarily concerned with losses reported by Duga Illinois which had been carried forward by Stevan on his 1961 personal income tax return.
An appointment was made with Stevan to review certain Duga Illinois records relating to Stevan's 1961 return and which were maintained at Promak Laboratories (hereinafter Promak). On December 26, 1963, Agents Mannie and Schwartz visited Promak; however, because a special agent was investigating the case, and, on the advice of Stevan's legal counsel, the desired information was not made available to them. Similar requests for these records were made at subsequent meetings between Stevan's counsel and Agents Mannie and Schwartz. However, as long as Special Agent Mannie remained on the case, Stevan's legal advisers continued to withhold the requested records. Finally, in July 1964, both agents contacted Accountant Grauer and from him obtained a complete set of the work papers used in the preparation of the Duga Illinois partnership returns. Also, at about this time, Agents Mannie and Schwartz were informed that neither Stevan nor Marko had filed individual tax returns for the years 1954 through 1958.
On October 28, 1964, Marko Durovic, Dr. Stevan Durovic, and the Krebiozen Research Foundation were indicted by suppressed indictment for introducing mislabeled drugs into interstate commerce in violation of the Food, Drug and Cosmetic Act. A bond of $500,000 was requested by the district attorney for each defendant, alleged by petitioner to be the highest bond ever exacted in the history of the United States. On the same day, October 28, 1964, the Internal Revenue Service made a jeopardy assessment against Marko in the amount of $519,063.05 and levied on all the real estate and other assets owned by petitioner and his wife Olga. The next day petitioner and his brother appeared in Federal District Court in Chicago before Judge Joseph Sam Perry. Present at this hearing were Agents Mannie and Schwartz. Judge Perry withdrew the bond and released Marko and Stevan on their own recognizance. The jeopardy assessment was, however, neither abated nor reduced in amount and still remains extant. More than 15 months later the petitioner, his brother, and all the other defendants were acquitted of all charges related to the Federal indictment after 9 months of trial.
At no time prior to the jeopardy assessment was petitioner ever contacted by either Agent Mannie or Agent Schwartz, notwithstanding that the records and returns obtained from Grauer revealed that Marko was a partner in Duga Illinois. Petitioner's attorney, Douglas L. Barnes, was contacted during November 1964; however, since a special agent was still on the case, once again no information was disclosed to the agents. It appears that respondent was unsuccessful in reaching Marko at this time.
On December 28, 1964, a statutory notice of deficiency, containing the determination set forth earlier, was issued to petitioner. The determination contained therein was in all respects identical to the revenue agent's examination reports filed by Agent Schwartz on November 20, 1964, in which cost of goods sold reported by Duga Illinois for each of the years 1954 through 1958 had been denied in toto with the resultant income being taxed to petitioner and his brother. This report was prepared without either agent ever having had the benefit of any of the Duga Illinois records unsuccessfully sought from Stevan and, later, from Marko's attorney.
In his report, Agent Schwartz computed Marko's taxable income on the basis of a married taxpayer filing an individual return. Accordingly, individual, as opposed to joint, income tax rates were employed in determining Marko's deficiency. Similarly, a standard deduction of only $500 was also allowed to Marko. Nevertheless, as stated earlier, Marko and Olga (who had not previously filed a return for any of the years in question) on March 10, 1965, filed late joint income tax returns for each of the years 1954 through 1958.
OPINION
In 1942, petitioner Marko and his brother, Stevan, emigrated from Europe to Argentina. Stevan was a doctor of medicine and a research scientist. His research had been in the field of cancer. Upon his arrival in South America Stevan contacted various persons in the Argentinian scientific community with a view toward resuming his research work. With financial backing from a relative of Marko's wife, Stevan was able to resume his search for a stimulant active against cancer.
While searching for this stimulant, Stevan, in 1944, unexpectedly discovered a substance (Kositerin) which showed activity against hypertension. During the next 12 years substantial sums were spent in the development and production of this substance. Most of these expenditures were initially defrayed or ultimately absorbed by Marko. The product was destroyed in 1956 due to spoilage. It was then owned by Marko.
In 1947, Stevan's research produced a second substance (Krebiozen) which showed activity against malignant tumors. With financing from Argentinian entrepreneur, Juan Tanoira, Stevan was able to produce enough of this substance for 200,000 ampules of the drug Krebiozen. In 1949, Stevan left Argentina for the United States. The Krebiozen raw material was later brought to the United States by Marko, who had purchased the raw material from Tanoira. Together the brothers, with the assistance of several U.S. scientists, undertook to make the drug available, on an experimental basis, to physicians caring for patients with advanced cancer.
Distribution of the drug was accomplished by a partnership made up of Stevan and Marko. Only after Marko and Stevan had depleted their financial resources did the partnership, in 1954, request payment for ampules of Krebiozen being distributed. The correctness of the cost of goods sold attributed to these ampules and shown on the partnership information returns for each of the years in issue is the central question in this case. However, before reaching this question, we must first consider several preliminary issues raised by the parties.
Issue 1. Statute of Limitations
Section 6501(a) states the general rule that assessment of taxes shall be made within 3 years after the return in question was filed. Two exceptions to this rule are found in sections 6501(c)(1) and 6501(c)(3), which state, respectively, that assessment may be made at any time where a return has either been fraudulently filed or not filed at all.
In the instant case, petitioner, citing section 6501(a), contends that respondent's notice of deficiency (bearing a December 28, 1964, date) was not timely as to the years (1954 through 1958) now before this Court. Respondent disputes this contention, claiming in the alternative that, (a) for purposes of section 6501(c)(3), the partnership returns of information filed by Duga Illinois cannot be treated as petitioner's personal tax returns; and, (b) even if such treatment were proper, section 6501(c) would still permit assessment, it being respondent's alternate position that the partnership returns which were filed were false and fraudulent.
Since we agree with respondent's first argument, we need not consider the question of whether the returns filed on behalf of Duga Illinois were tainted with fraud.
Partnerships, under our system of taxation, are accorded a unique status. Rather than the partnership being held taxable for income generated by its activities, it is the individual partner who is liable for tax on his distributive share of partnership earnings. Sec. 701. Notwithstanding this peculiarity, section 6031 directs that every partnership file an annual return setting forth, inter alia, the items of its gross income and deductions and the names and distributive shares of its members. This provision, for purposes herein pertinent, must be contrasted with section 6012(a) which requires that every individual having a gross income of $600 or more must file a return with respect to income tax. Given this statutory framework, the specific question we must now face is whether, in the absence of an individual tax return, the good-faith filing of a Form 1065 partnership return satisfies the requirements of sections 6012(a) and 6501(c)(3) where such partnership return is (1) complete on its face, and (2) discloses the only source of income of the individual partner in question. As stated above, we believe this question must be answered in the negative.
For purposes of this discussion, and, as will be established at a later point in our opinion, Marko's gross income for each of the years in question is assumed to be in excess of $600.
In support of his position, petitioner cites several cases which have considered the status to be accorded Form 1065 partnership returns within the context of section 6501(e)(1)(A)(ii). See, e.g., Jack Rose, 24 T.C. 755 (1955); Nadine I. Davenport, 48 T.C. 921 (1967); Genevieve B. Walker, 46 T.C. 630 (1966); and Elliott J. Roschuni, 44 T.C. 80 (1965), which extended the reach of clause (ii) to Form 1120-S information returns. In each of these cases the question considered was whether information omitted on the taxpayer's individual return, but disclosed on the partnership return, could be used to satisfy the ameliorating language of clause (ii) of section 6501(e)(1)(A); and in each instance the Court agreed that the partnership return —
SEC. 6501. LIMITATIONS ON ASSESSMENT AND COLLECTION.
(e) SUBSTANTIAL OMISSION OF ITEMS. — Except as otherwise provided in subsection (c) —
(1) INCOME TAXES. — In the case of any tax imposed by subtitle A —
(A) GENERAL RULE. — If the taxpayer omits from gross income an amount properly includible therein which is in excess of 25 percent of the amount of gross income stated in the return, the tax may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time within 6 years after the return was filed. For purposes of this subparagraph —
* * * * * * *
(ii) In determining the amount omitted from gross income, there shall not be taken into account any amount which is omitted from gross income stated in the return if such amount is disclosed in the return, or in a statement attached to the return, in a manner adequate to apprise the Secretary or his delegate of the nature and amount of such item.
Where a corporation elects to conduct its business as a "tax-option" corporation, it is not liable for any of the regular corporate income taxes and does not have to file a Form 1120 corporate return. However, it is required under sec. 6037 of the Code to file an information return on Form 1120-S.
Pursuant to sec. 6501(e)(1)(A), the statute of limitations for assessment of tax is extended to 6 years if the taxpayer omits from gross income an amount properly includible therein which is in excess of 25 percent of the amount of gross income stated in the return. Under clause (ii) thereof, the computation of the "amount * * * omitted from gross income" excludes amounts disclosed in the return.
should be taken into consideration in determining whether any omitted amount was disclosed in the [partnership] return in a manner adequate to apprise [respondent] of the nature and amount of such item. [ Genevieve B. Walker, supra at 637-638.]
See also Rev. Rul. 55-415, 1955-1 C.B. 412.
Though we do not in any way reject the reasoning of the cases cited by petitioner, we do not feel they are apposite to the question at hand. The rationale underlying these cases was that respondent would not be at a disadvantage to detect errors, as envisioned by section 6501(e)(1)(A), see Colony, Inc. v. Commissioner, 357 U.S. 28, 36 (1958), where the taxpayer's individual return, as augmented by a Form 1065 return, was sufficient to furnish respondent with adequate "clues" as to the nature and amount of items omitted from the individual return but disclosed in the partnership return. Benderoff v. United States, 398 F.2d 132 (C.A. 8, 1968); and Elliott J. Roschuni, supra.
The cases in this area did not have to consider the question of whether, for purposes of sections 6012(a) and 6501(c)(3), a partnership return may be accorded the status of a partner's individual return. Even so, since the filing of a partnership return, without more, places respondent at an obvious disadvantage as to nonpartnership items of income (such as interest, dividends, and capital gain) which are shown only on the partner's individual return, we believe petitioner's argument must be rejected under the very same rationale employed by those cases which he looks to for support.
See also sec. 301.6501(e)-1(c), Income Tax Regs., which provides that sec. 6501(e)(1) does not limit the application of sec. 6501(c).
For reasons similar to those expressed above, we also hold that petitioner's reliance on the "wrong return" cases of Germantown Trust Co. v. Commissioner, 309 U.S. (1940), and California Thoroughbred Breeders Association, 47 T.C. 335 (1966), is also misplaced.
In Germantown, taxpayer trust company, on March 15, 1933, filed a Form 1041 fiduciary return for the year 1932, in which it accurately set forth its gross income, deductions, net income, and the respective beneficiaries' shares. All of the beneficiaries included their shares in their individual returns. At a later time it was held that the trust should have been taxed as a corporation. Accordingly, the respondent prepared the appropriate corporation return and, after more than 2 years had expired, gave notice of a tax deficiency.
Under section 275(c) of the then Revenue Act of 1932, an exception to the normal 2-year statute of limitations arose if a corporation made no return of tax. Under this exception corporate tax could be assessed within 4 years after the date on which any shareholder filed his return. The issue in Germantown was whether the Form 1041 filed by the "trust" constituted a tax return for purposes of the statute of limitations.
Relying in part on the fact that the incorrect return filed by the "trust" contained all the data from which a tax could be computed and assessed, the Supreme Court held that the filing of the Form 1041 by a fiduciary in good faith commenced the running of the statute of limitations for assessment of corporate income tax, and that assessment was, therefore, barred. Compare Commissioner v. Lane-Wells Co., 321 U.S. 219 (1944), where it was held that the filing in good faith of a Form 1120 corporate income tax return, in which the corporation denied it was a personal holding company, was not sufficient to start the running of the limitation period for personal holding company surtax (which should have been computed on Form 1120H).
See too F. E. McGillick Co., 30 T.C. 1130, 1150 (1958); John Danz, 18 T.C. 454, 465 (1952); and Automobile Club v. Commissioner, 353 U.S. 180 (1957), where the filing of Form 990 information returns was not sufficient to activate the running of the statute.
In the case of a partnership return filed without more, respondent is not benefited by all the data needed to compute the nonfiling partner's individual tax liability since, even if such partner did not, in fact, realize additional nonpartnership income, there is no way to ascertain this fact absent an individual return. Hence, we are not influenced by the result reached in Germantown. Nor is our conclusion altered in any way by the following language from our opinion in West Coast Ice Co., 49 T.C. 345, 349-350 (1968):
In Lane-Wells the Supreme Court distinguished its decision in Germantown Trust Co. v. Commissioner, 309 U.S. 304 (1940), not, as petitioner claims, upon the ground that the return filed in Germantown Trust contained all the information required in the return which should have been filed, but because: "There [ Germantown Trust] the only liability involved was for a Title I income tax, and the return was addressed to that liability, as to which the court held that it set the statute of limitations running. Here the taxpayer is under liabilities for two taxes and under an obligation to file two returns, * * *"
We distinguish Germantown Trust from the facts of this case for exactly the same reason. * * *
In the case of a Form 1065 partnership return, we need never reach the distinction employed by the Supreme Court in Lane-Wells since the indispensable prerequisite for the consideration underlying such distinction — the assumption that the filed return "showed all the facts necessary for respondent to compute taxes" ( Commissioner v. Lane-Wells Co., supra, quoting from the circuit court opinion in that case) — is herein lacking. For absent from a partnership return are such items as the individual partner's itemized deductions, exemptions, payments, credits, and elections. Without such information there is no practical way in which individual tax liability can be ascertained or the computation thereof accomplished.
We note, too, the following language from Lane-Wells which also contributed to the result reached therein:
"Congress has given discretion to the Commissioner to prescribe by regulation forms of returns and has made it the duty of the taxpayer to comply. * * * The purpose is not alone to get tax information in some form but also to get it with such uniformity, completeness, and arrangement that the physical task of handling and verifying returns may be readily accomplished. * * * [ 321 U.S. at 223 (1944.)]"
Our opinion in California Thoroughbred Breeders Association, supra, in no way conflicts with this rationale. However, even if the California case could be read to support the position taken by petitioner, we believe that case is distinguishable since our holding there was based on the specific language of section 6501(g)(2).
Issue 2. Rate of Exchange
In computing cost of goods sold, Duga Illinois converted Argentinian pesos into American dollars at the official exchange rate which prevailed at the time of the respective Argentinian transactions pertinent to this case. Respondent contests the use of the official exchange rate, and argues that the commercial exchange rate should have been applied. Should we adopt respondent's position, cost of goods sold will have to be adjusted downward, as evidenced by the following table which illustrates the disparity between the two rates of exchange for each of the years shown:
Official rate of Commercial rate of exchange pesos to exchange pesos to Year one dollar one dollar 1942 ..................... 3.36 3.36 1943 ..................... 3.36 3.36 1944 ..................... 3.36 3.77 1945 ..................... 3.36 4.01 1946 ..................... 3.36 4.07 1947 ..................... 3.36 4.06 1948 ..................... 3.36 4.42 1949 ..................... 3.36 5.47 1950 ..................... 5.00 9.66Though our research has failed to uncover any cases which are on all fours with the question before us, many cases have considered the issue of exchange rates in the context of blocked currency. See, e.g., Morris Marks Landau, 7 T.C. 12 (1946), (valuation of blocked pounds for gift tax purposes); Estate of Anthony H. G. Fokker, 10 T.C. 1225 (1948), (valuation of blocked Dutch guilders for estate tax purposes); and Credit Investment Corporation, 47 B.T.A. 673 (1942), (valuation of loss resulting from investment in blocked German marks).
In almost all of these cases the Commissioner asserted deficiencies based upon the official rate of exchange. See Ceska Cooper, 15 T.C. 757 (1950); Estate of Jan Willem Nienhuys, 17 T.C. 1149 (1952); and Credit Investment Corporation, supra. However, in each instance the courts were unwilling to accept this argument where it was patently clear that the official rate of exchange did not reflect the exchange rate at which a foreign currency could be traded for U.S. dollars. See Ceska Cooper, supra, wherein the Court stated:
It is our view that the value of the blocked British pound as determined in the free market of the United States should be used as the measure of petitioner's income in each of the taxable years from the salaries and profits which were credited to her account in England. [ 15 T.C. at 765.]
and Credit Investment Corporation, supra, where the Court framed the issue before it as follows:
Having concluded that the marks used in the purchase of the securities in 1936 were blocked marks, the question remains whether they had a fair market value. * * * [ 47 B.T.A. at 681.]
Explicit in many of the blockage cases cited above is the fundamental consideration that United States taxation is "based on the value of property measured in terms of United States dollars." Estate of Jan Willem Nienhuys, supra at 1163. It is similarly evident from a reading of other foreign exchange cases that where gain or loss must be computed, it is the actual cost of the investment in terms of the number of dollars needed ( Willard Helburn, Inc., 20 T.C. 740 (1953)) which establishes basis, and the obtainable dollar equivalent of the currency received ( Edmond Weil, Inc. v. Commissioner, 150 F.2d 950 (C.A. 2, 1945), affirming a Memorandum Opinion of this Court) which determines return. See also James A. Wheatley, 8 B.T.A. 1246, 1249 (1927).
Compare Eder v. Commissioner, 138 F.2d 27 (C.A. 2, 1943), where the court remanded the decision of the Board, with instructions to measure the return in terms of economic satisfaction. See also Rev. Rul. 64-307, 1964-2 C.B. 163, 166.
The inescapable conclusion we draw from these cases is that taxation of international currency transactions is a pragmatic endeavor. In almost all instances the courts, either in converting the value of property into dollars or in determining the dollar equivalent of gain or loss, have attempted to employ a rule of reason which reflects actual dollar worth in terms of salient market conditions. After all, "Taxation is a practical matter," and should, therefore, attempt to capture the realities of the situation in question.
Edmond Weil, Inc., a Memorandum Opinion of this Court dated Aug. 9, 1944, in which the Court used the commercial rate of exchange where the "evidence [established] that petitioner was never paid the 'official' rate in exchange transactions."
We believe that employment of the commercial rate of exchange permits this result since it is the commercial rate which actually determines the number of dollars which reasonable businessmen dealing at arm's length will be willing to pay for a commodity at a given time. The validity of this result becomes more apparent when submitted to facts of the case at bar; for, here, Duga Illinois and petitioner realized American dollars as a result of expenditures made in Argentina. To value these expenditures at any rate of exchange other than the one which most accurately reflects the number of dollars which would have been required for the same expenditures (i.e., the commercial rate) would, we believe, result in a distortion of income. Accordingly, we hold that the commercial rate of exchange should have been used in determining cost of goods sold.
Issue 3. Presumptive Correctness of Respondent's Determination
Petitioner next contends that the presumption of correctness which normally attaches to respondent's determination, Welch v. Helvering, 290 U.S. 111, 115 (1933), must be negated in this case because of the alleged arbitrary manner in which the respondent denied all of the amounts claimed as cost of goods sold on the information returns filed by Duga Illinois during the years 1954 through 1958. See Helvering v. Taylor, 293 U.S. 507 (1935). Petitioner's primary assertion is that respondent could not have arrived at a rational cost-of-goods-sold determination under circumstances where respondent's agents were prevented access to the books and records needed for such a determination. Cf. Herbert Schellenbarg, 31 T.C. 1269, 1277 (1959). The short answer to this argument is that where the taxpayer has refused to produce books and records requested by respondent's agents, the taxpayer (and not respondent) will be held accountable for any procedural or evidentiary consequences flowing from such a declination. See Estate of Henry Wilson, 2 T.C. 1059, 1086 (1943), where the Court used the following language in upholding an estate tax deficiency which was based upon a return constructed by respondent's agent:
Respondent in making a return is forced by the very nature of things to rely upon the information and testimony given by persons knowing the facts. If they fail or refuse to make a disclosure of pertinent facts respecting the estate, or if they deny the existence of assets includible in the gross estate, respondent can not be charged with arbitrary, capricious, and unreasonable action if after discovery of the existence of such assets, coupled with a continued refusal by the interested parties to make any further disclosure as to assets of the estate, he determines the value of the gross estate from such testimony and information as is available to him and includes therein all assets which may have been jointly held by decedent at death or transferred under circumstances which might bring the property within the estate. Much of what has occurred here is due to petitioners' own acts of omission and commission. If because thereof they find themselves in difficulty with the tax authorities, it is a difficulty of their own making and they should not be heard to complain.
See also Herbert Schellenbarg, 31 T.C. 1269, where, after unsuccessful and repeated requests for supporting records, respondent denied in toto unrecorded expenses which were alleged to have been incurred in conjunction with unrecorded sales to which petitioner admitted. In upholding the deficiency determination which flowed from respondent's denial, we stated that where petitioner is unable, through negligence, to produce books and records requested by respondent's agents and which should have been in his possession, respondent's action, in the absence of such production, will not be deemed arbitrary:
"The great weight of * * * [petitioners'] argument is directed at respondent's failure to offset * * * additional receipts by what * * * [petitioners] claim were unrecorded expenses * * * [related to] unrecorded sales made by them * * *. Yet, in the face of repeated requests by respondent's agents, no evidence was produced to substantiate these unrecorded transactions. * * * In this posture, we cannot say the respondent's determination was arbitrary and excessive as contended by the petitioners. Thus, its presumptive correctness has not been destroyed * * *.
"Though petitioners' inability to offer proof of these unrecorded transactions may work a seeming hardship upon them, it is unquestionably of their own making. [ 31 T.C. at 1277.]"
We start with two basic propositions: (1) all persons subject to tax or required to file an information return must maintain books and records sufficient to establish all matters shown on a tax return or return of information filed by such persons (sec. 1.6001-1, Income Tax Regs.); and (2) these books and records are subject to examination by respondent or his agent whenever the liability of any person for any internal revenue tax is at issue. Sec. 7602.
In the case of a partnership, sec. 6031 provides that every partnership must file an annual return of information containing the information specified in that section. The return, when filed, must bear the signature of at least one partner. Sec. 1.6063-1(a), Income Tax Regs.
In the case at bar, respondent's agents were thwarted in their efforts to review books and records relating to income which petitioner may have been liable for as a result of his partnership interest in Duga Illinois. Consequently, respondent's agents were forced to build their case on accountant's work papers and other secondary evidence made available to them. As a result, cost of goods sold was denied in toto, and respondent's notice of deficiency held petitioner responsible for his distributive share of the recomputed partnership income for each of the years in question. (See sec. 702.)
Though we recognize that Special Agent Mannie of the Intelligence Division was present at all stages of respondent's investigation we do not feel that this fact alone is sufficient to transform petitioner's recalcitrance, notwithstanding that petitioner's attorney may have regarded certain of petitioner's constitutional privileges to be at stake, into a procedural windfall. Indeed, as has been stated in Boren v. Tucker, 239 F.2d 767 (C.A. 9, 1956), in every investigation there exists the possibility that information made available to respondent or one of his agents might lead to criminal prosecution:
In truth, we presume the "Secretary or his delegate" would be unfaithful to his statutory responsibilities if in every examination, once an incorrect return has been demonstrated or established, he did not come to some preliminary conclusion as to whether there existed facts sufficient upon which to base a possible criminal prosecution, without coming to any conclusion as to whether there should be a criminal prosecution. [ 239 F.2d at 772.]
Accordingly, it seems to us that petitioner's position would be no more compelling if the refusal to produce books and records had been made at a time when Special Agent Mannie had not yet been assigned to the case. See and compare United States v. Caiello, 420 F.2d 471, 472 fn. 2 (C.A. 2, 1969). Were we faced with such a set of circumstances, we are confident that petitioner would be denied the procedural parlay which he now seeks. We do not believe that he stands on better footing with the facts of the case now before us.
Moreover, that the records sought may have been immune to process by virtue of the Federal indictment which anteceded the requests made to petitioner's attorney by respondent's agents (see Internal Revenue Agent v. Sullivan, 287 F. 138 (W.D. N Y 1923)) does not assist petitioner. The crucial fact is that such records were denied to respondent's agents. Under such circumstances, we cannot say that respondent's determination, which ultimately was based upon the investigation of Accountant Grauer's workpapers, as well as the other sources of information, was so insubstantial as to render arbitrary the deficiency determination prepared therefrom.
See also United States v. O'Connor, 118 F. Supp. 248 (D. Mass. 1953); cf. Wild v. United States, 362 F.2d 206 (C.A. 9, 1966); and Venn v. United States, 400 F.2d 207 (C.A. 5, 1968), where the production of withheld records was required under sec. 7604(a), notwithstanding the presence of a special agent during the examination and the possibility of subsequent criminal proceedings.
We note that neither petitioner nor his attorney was approached by respondent's agents until after the jeopardy assessment which was levied on Oct. 28, 1964. However, Agent Schwartz did contact Marko's attorney prior to the notice of deficiency on Dec. 28, 1964. Moreover, in previously focusing their attention on Stevan, Agents Mannie and Schwartz were following the most logical course of action available to them since Stevan had led them to believe that he had possession of the Duga Illinois records and that they could be found at Promak Laboratories.
We also note that, although respondent's agents failed to notify petitioner or his brother that a second inspection of Duga Illinois books for the year 1957 would be required, such failure does not affect the result reached herein since the books sought were not made available to respondent. See United States Holding Co., 44 T.C. 323, 327 (1965); and sec. 7605(b).
In arriving at the above result, we have carefully considered the purpose of the presumption of correctness which attaches to respondent's determination and the role which it plays at trial. We note initially that the —
presumption is not evidence in itself and may be rebutted by competent evidence. It operates merely to place upon the opposing party the burden of going forward * * * [ Compton v. United States, 334 F.2d 212, 216 (C.A. 4, 1964).]
As such it is merely a fixation of the procedural posture of the parties. Where as here both parties have come forward at trial with a plethora of evidentiary matter, we feel no compulsion to rearrange this procedural alignment. To receive from petitioner the very evidence previously denied to respondent, and to, at the same time, remove from petitioner the burden of going forward would, we think, be contrary to one of the basic considerations underlying the presumption — that the party who is most familiar with the facts in dispute should also be the party upon whom rests the burden of going forward with the evidence.
Issue 4. Cost of Goods Sold
We come now to the question of whether respondent erred in disallowing cost of goods sold to Duga Illinois for each of the years in issue. More specifically, we must decide whether Duga Illinois was entitled to cost-of-goods-sold deductions during these years; and, if so, the amounts which should have been claimed. We view this issue as being primarily factual.
The record of this case exceeds 1,300 pages. In addition, both parties have benefited us with scores of exhibits and interrogatories. Notwithstanding this mass of evidentiary matter, the picture we have before us of the events which comprise this case is blurred and cracked with age. In some instances witnesses were called upon to reconstruct with clarity events which occurred more than a quarter of a century ago. The uncertain narrative occasioned by the dimmed memories of these individuals only served to compound with inconsistency a case which would have been difficult to try under the most favorable of circumstances. Nevertheless, we have attempted in our findings of fact to weigh all such inconsistencies, and to arrive at a fair and rational narration of the events which occurred herein. For the most part, therefore, the immediate discussion will merely reappraise these facts in the context of the question presented.
Whether or not a business venture conducted by two or more persons will be regarded as a partnership for tax purposes depends, in large measure, on the intent of the persons involved. Claire Giannini Hoffman, 2 T.C. 1160 (1943). The facts in this case indicate that Stevan and Marko were partners for each of the years in question. This partnership, which was formed for the purpose of distributing and selling Krebiozen in the United States, came into being in 1950 shortly after Marko purchased the Krebiozen raw material from Tanoira. Marko's basis in the raw material, for partnership income tax purposes, is derived from the M$N3,005,000 price paid to Tanoira. See sec. 722.
Though we think it reasonable that Marko, at this time, may have intended to make a binding gift to Stevan of one-half of the raw material (which had, in fact, been produced during the term of Stevan's agreement with Tanoira), we cannot assume such an intention from the evidence now before us. Accordingly, for purposes of sec. 704(d), Marko will be treated as having contributed all of the 2 grams, 35 centigrams of raw material to the partnership.
The amount paid to Tanoira, while based upon analogous costs (M$N3,005,000) incurred in the development of Kositerin (as adopted by MPH), also reflected actual cost experience (M$N2,997,500) as computed by Accountant Muchenik. As such, we believe the M$N3,005,000 figure to be a fair indicator of the raw material cost of the 200,000 ampules of Krebiozen produced in the United States. To this extent, Duga Illinois was justified in taking the cost-of-goods-sold deductions claimed on the partnership returns. However, we believe this amount should have been spread over all of the ampules produced (200,000), as opposed to the number of ampules on hand in 1954 (136,097) when the partnership first solicited payment for the drug. Though we fully appreciate the altruistic, as well as practical, considerations which governed the choice of spreading costs over 136,097 ampules as opposed to 200,000 ampules, we are constrained to hold that, for the years 1954 through 1958, this method of apportionment did not clearly reflect income.
In addition to the amounts allowed above, the partnership also incurred extensive research expenses as well as extensive expenses related to sterilizing, ampuling, and packaging the drug. These amounts (totaling $105,387.38) were recorded in an expense journal maintained by Olga and stipulated to by the parties, and are properly allocable between (a) cost of goods sold and (b) research and experimental costs. On our best judgment, we hold that, of these amounts, one-half ($52,693.69) was properly allocable to cost of goods sold. Cohan v. Commissioner, 39 F.2d 540 (C.A. 2, 1930).
Total expenses actually recorded in the journal amounted to $130,713.48. However, of this amount, $20,953.44 was attributable to living costs and was treated by Olga as temporary living expenses while away from home (Argentina). Since petitioner's stay in this country was from the start "indefinite," see Leo M. Verner, 39 T.C. 749 (1963), as opposed to "temporary," see Beatrice H. Albert, 13 T.C. 129, 131 (1949), we view these expenses as being personal in nature. See and compare secs. 1.871-2(a) and (b), Income Tax Regs. Accordingly, the $130,713.78 shown on Olga's books has been reduced by $20,953.44. Additionally, since $4,372.66 is conceded to have been expended in furtherance of Institute, as opposed to partnership, activities, the $130,713.78 has been further reduced by this amount. Netted out, these adjustments yield a total expenditure figure of $105,387.38.
See fn. 11, supra. Stipulation 5 states the following:
"Attached hereto and made a part hereof identified as Exhibit 6 is a copy of an original expense journal prepared by Mrs. Durovic reflecting expenses which were paid from October, 1949 until April, 1954 as identified therein."
See sec. 174 which, in part, permits a taxpayer to treat research and experimental costs, paid or incurred in a taxable year subsequent to Dec. 31, 1953, as noncapital expenditures. Since, as petitioner states on brief, "substantially all the costs in question were incurred prior to the effective date [of sec. 174] of the Internal Revenue Code of 1954," the tax treatment of such costs is governed by the case law pertinent to pre-1954 Code years. The rules developed by these cases are summarized in the following language from John F. Koons, 35 T.C. 1092, 1099 (1961):
"Prior to the enactment of the Code of 1954 there was no statutory provision dealing with the tax treatment to be accorded research and experimental expenditures, and the taxpayer had no option to treat such costs as deductible expenses. To the extent that they were ordinary and necessary business expenses they were deductible; to the extent that they were capital they could be capitalized and were recoverable through depreciation or amortization where the useful life was determinable. Gilliam Manufacturing Co., 1 B.T.A. 967 (1925); Hazeltine Corporation, 32 B.T.A. 110 (1935), affirmed on this issue 89 F.2d 513 (C.A. 3, 1937); Claude Neon Lights, Inc., 35 B.T.A. 424 (1937); Hart-Bartlett-Sturtevant Grain Co., 12 T.C. 760 (1949), affd. 182 F.2d 153 (C.A. 8, 1950); Red Star Yeast Products Co., 25 T.C. 321, 341, 343 (1955). In the event, however, that they were not ordinary and necessary expenses and a period of useful life could not be definitely ascertained, the amortization of such expenditures was not allowable."
(See also Jack R. Miller, "Research and Development Costs," 7th Ann. N.Y.U. Tax Inst. 134 (1949).)
In the case at bar, we think it is clear that the expenditures for research and experimentation were calculated to perfect and improve Krebiozen so that it might be licensed for sale on a nonexperimental basis, and to establish its efficacy to the medical world. We think such expenditures were capital in nature; and, since the benefits to be obtained from such research were neither limited to the ampules already produced, nor susceptible to measurement in terms of useful life, we reluctantly see no way in which to allow amortization of such expenditures for the years in question. See Hart-Bartlett-Sturtevant G. Co. v. Commissioner, 182 F.2d 153 (C.A. 8, 1950), affirming 12 T.C. 760 (1949).
The tax treatment to be accorded these expenditures in the year in which the experiments were abandoned and the partnership dissolved is beyond the pale of this discussion since we do not have before us the year (1959) in which such dissolution occurred. Cf. Hart-Bartlett-Sturtevant G. Co. v. Commissioner, supra.
Summarizing our findings, we arrive at the following cost-of-goods-sold computation for each of the years in question:
Allocable costs:
(1) 3,005,000 M$N converted to U.S. dollars at (9.66 M$N to $1) commercial rate of exchange stipulated to be in force during 1950 ............................... $311,076.60
(2) U.S. expenditures ....................... $52,693.69 ------------- $363,770.29 ============= Number of ampules ............................. 200,000.00
Divided into total allocable costs = .......... $363,770.29
Per ampule cost ............................... $1.82 Number of ampules Cost of goods distributed $1.82 sold
= X 1954 ............... 17,752 X $1.82 $32,308.64 1955 ............... 30,674 X $1.82 55,826.68 1956 ............... 23,733 X $1.82 43,194.06 1957 ............... 33,722 X $1.82 61,374.04 1958 ............... 24,381 X $1.82 44,373.42In arriving at the above conclusion we have rejected petitioner's assertion that Argentinian costs incurred by petitioner and attributable to the development and manufacture of Kositerin should also be considered in computing the basis of the Krebiozen raw material to petitioner and the partnership. See sec. 723. Though the preparation and extraction processes used to produce Kositerin and Krebiozen were identical, and though Kositerin was a direct, though fortuitous, outgrowth of Stevan's early work in the field of cancer, the two drugs — like the stimulants used to produce them — were dealt with separately and financed independently. Even though the brothers may at one time have considered distributing Kositerin through a U.S. partnership, we think it clear that this idea was jettisoned as a result of the unencouraging findings made by Northwestern University. Accordingly, since the Kositerin ampules were never used in or contributed to the activities of Duga Illinois, petitioner's argument must be rejected.
Notwithstanding the above, we do find that after January 21, 1950, the Kositerin ampules were a capital asset in Marko's hands, the uninsured destruction of which gave rise to a section 1231 loss in 1956, the year in which spoilage occurred. As we view the January 1950 transaction between Marko and the Duga S.A. investors, Marko received substantially all ownership rights to and possession of the Kositerin ampules subject to any contractual royalties which may have been reserved to Stevan. The ampules were thereafter placed in storage under the supervision of Galmarini. We think the 1953 application to MCI for an increased cost basis, Galmarini's continued supervision and the special trip Marko made to Argentina in 1956 to witness the destruction of the ampules all evidence the fact that Marko held the ampules for the production of income until the time they were actually destroyed. Accordingly, we cannot agree with respondent that any loss attributable to the Kositerin ampules occurred during an earlier year.
SEC. 1231. PROPERTY USED IN THE TRADE OR BUSINESS AND INVOLUNTARY CONVERSIONS.
(a) GENERAL RULE. * * * For purposes of this subsection —
(1) in determining under this subsection whether gains exceed losses, the gains described therein shall be included only if and to the extent taken into account in computing gross income and the losses described therein shall be included only if and to the extent taken into account in computing taxable income, except that section 1211 shall not apply; and
(2) losses (including losses not compensated for by insurance or otherwise) upon the destruction, in whole or in part, theft or seizure, or requisition or condemnation of (A) property used in the trade or business or (B) capital assets held for more than 6 months shall be considered losses from a compulsory or involuntary conversion.
Since the loss in question occurred in 1956, the uninsured loss provisions contained in the final sentence of sec. 1231(a) (not shown above) do not apply to the facts of this case. See sec. 1.1231-1(e)(2), Income Tax Regs.
The agreement between Marko and the Duga S.A. investors indicates that Olga retained a proportional interest in the Kositerin ampules equivalent to her M$N1,000 investment.
We also reject respondent's assertion that the facts underlying Marko's investment in Kositerin (as well as the transaction with Tanoira in which the Krebiozen raw material was obtained) were not sufficiently pleaded to apprise respondent of the nature of petitioner's case. Though, with regard to these transactions, the pleadings filed by petitioner may have lacked specificity, our observation of the parties during the trial of this case, as well as our examination of the numerous interrogatories and motions filed before trial, lead us to believe that respondent was in no way surprised or prejudiced by the testimony and other evidence elicited during the trial in support of these transactions. Since pleadings are but procedural tools which may, in any event, be amended to conform to the evidence adduced, we see no basis, in the absence of surprise or prejudice, for sharing the view of this matter taken by respondent. See Commissioner v. Finley, 265 F.2d 885, 888 (C.A. 10, 1959), affirming a Memorandum Opinion of this Court and cases therein cited.
The practical result of our findings (with regard to Kositerin) is that Marko incurred an ordinary loss in 1956 which we value at M$N792,600 ($113,357) — the aggregate of Marko's M$N255,100 ($57,715) investment in 1948 and the M$N537,500 ($55,642) outlay in 1950. (Though deductible as a section 1231 loss in 1956, this amount will not be subject to the 2-year carryback nor the 5-year carryforward provisions of section 172, as provided by section 1.172-4(a)(1)(vi), Income Tax Regs., since the loss was not attributable to a trade or business. Sec. 172(d)(4). See Garrigo v. United States, 296 F. Supp. 1110, 1114 (N.D. Tex. 1968); and Mae E. Townend, 27 T.C. 99 (1956). Nor may we consider the language of section 172(d)(4)(C) (which excludes casualty losses from the trade or business requirement of section 172(d)(4)) since petitioner has failed to introduce any evidence tending to establish that the spoilage was sudden and not the result of a "progressive deterioration [of the ampules] through a steadily operating cause." Fay v. Helvering, 120 F.2d 253 (C.A. 2, 1941); Ray Durden, 3 T.C. 1 (1944).)
Since we are without proof as to whether Galmarini complied with the January 8, 1954, MCI cost directive in which MCI requested evidence in substantiation of the post-1949 storage and administrative costs claimed by Galmarini in his November 1953 petition, we are unable to augment our M$N792,600 valuation by the amount of these alleged, but unsupported, costs. Additionally, we find no basis for adding to this valuation the 500,000 pesos which were paid by Marko to the Martinis in 1949. Though part of the whirlwind of events in this case, this payment merely represented the gratuitous satisfaction of obligations incurred by Stevan during his early South American research. Cf. Fromm Laboratories, Inc., v. Commissioner, 295 F.2d 726 (1961), affirming a Memorandum Opinion of this Court.
Issue 5. Additions to Tax for Fraud
We now address ourselves to the question of whether respondent erred in determining that petitioner was fraudulent in failing to pay tax for each of the years in issue.
The existence of fraud is a question of fact. "Fraud" means actual, intentional wrongdoing, i.e., the intent to evade a tax believed to be owing, Mitchell v. Commissioner, 118 F.2d 308 (C.A. 5, 1941); and, as is wont with fraud cases generally, evidence of fraud must be ascertained from the surrounding facts. William C. deMille Productions, Inc., 30 B.T.A. 826 (1934); M. Rea Gano, 19 B.T.A. 518 (1930).
To support a determination of fraud for any of the years in question respondent has the burden of proving fraud by "clear and convincing" evidence. Carter v. Campbell, 264 F.2d 930 (C.A. 5, 1959); Jacob D. Farber, 43 T.C. 407, 419 (1965), reaffirmed in a supplemental opinion 44 T.C. 408 (1965). This, we believe, respondent has failed to do.
It has already been established that petitioner failed to file returns for each of the years in point. Though, as respondent points out, such failure does give rise to an inference of fraud, Nathan Bilsky, 31 T.C. 35 (1958), it is not alone sufficient to meet the clear and convincing evidence test. John Marinzulich, 31 T.C. 487, 490 (1958). Anderson v. Commissioner, 250 F.2d 242, 243 (C.A. 5, 1957). Moreover, in the instant proceeding, we do not think it proper to attach an inference of fraud to petitioner's failure to file. Instead we see a pattern of good-faith reliance on petitioner's legal and tax advisers, who saw no necessity for filing in view of the large partnership losses which they determined. Granted, much of the information placed at their disposal related to transactions which took place in Argentina. However, we are convinced (and the various documents introduced into evidence support our conviction) that the disclosures made to petitioner's advisers fairly and honestly reflected petitioner's out-of-pocket, economic experience while in South America. Cf. Merritt v. Commissioner, 301 F.2d 484, 487 (C.A. 5, 1962). That the tax treatment accorded these expenditures by petitioner's advisers did not comport with what was required is surely not evidence of fraud on the part of petitioner.
The loss, in 1956, of certain records which respondent regards as being central to petitioner's case has been adequately and credibly explained by petitioner and corroborated by the interrogatories of two witnesses. Under such instances, even if we were to agree with respondent as to the essential character of these records, we would not feel justified in attaching any adverse importance to their loss. Cf. Lillian Kilpatrick, 22 T.C. 446 (1954), affd. 227 F.2d 240 (C.A. 5, 1955).
The withdrawal in 1951 of Ivy's requests for revenue rulings adds little to respondent's argument. The ruling requests were made at a time when petitioner and his brother were more preoccupied with establishing a center, the Institute, for the treatment of cancer, than with establishing their tax status. Moreover, the duration of their stay in this country was, at best, uncertain. As stated in the documentation referred to extensively in our Findings of Fact, any effort to leave the country in quest of the Argentinian cost records requested by respondent, could very well have subjected the brothers and, therefore, the Institute to considerable difficulty. Their reluctance to chance this possibility was, in our estimation, reasonable.
Finally, we are told by respondent that petitioner's failure to call Stevan as a witness raises an inference of fraud, Steiner v. Commissioner, 350 F.2d 217 (C.A. 7, 1965). Though we acknowledge that the unexplained failure to call a witness, whose testimony might reasonably be expected to favor the taxpayer, does raise an adverse inference, it is questionable whether, in this case, Stevan's testimony could have shaken loose any evidentiary stones not already overturned. In any event, our very careful consideration of the entire record of this case, Frank Imburgia, 22 T.C. 1002, 1014 (1954), leads us to the firm conclusion that at no time during any of the years in question did petitioner intend to defraud the Government by failing to pay tax. Marko, though sometimes excitable, was at all times a credible witness. Most of the transactions and occurrences of which he spoke, and which respondent now contests, were amply supported by extensive documentation. In all, the transcript, the interrogatories and the exhibits reveal hardly a clue of fraud. Accordingly, we hold that respondent erred in determining additions to tax under section 6653(b).
Issue 6. Additions to Tax for Failure to File Timely Declaration of Estimated Tax (1954) and for Underpayment of Estimated Tax (1955 Through 1958) A. 1954Section 294(d)(1)(A) of the Internal Revenue Code of 1939, which applies to all years beginning before January 1, 1955 (sec. 6654 (h)), provides, in part, as follows:
(A) Failure to File Declaration. — In the case of a failure to make and file a declaration of estimated tax within the time prescribed, unless such failure is shown to the satisfaction of the Commissioner to be due to reasonable cause and not to willful neglect, there shall be added to the tax 5 per centum of each installment due but unpaid, and in addition, with respect to each such installment due but unpaid, 1 per centum of the unpaid amount thereof for each month (except the first) or fraction thereof during which such amount remains unpaid. * * * Since there is no evidence that petitioner filed a declaration of estimated tax at any time during 1954, the only question raised by section 294(d)(1)(A) is whether petitioner's failure to file was due to reasonable cause. We think such reasonable cause did, in fact, exist.
Where a taxpayer exercises ordinary business care and prudence, his failure to file a declaration of estimated tax, pursuant to section 294(d)(1)(A), within the prescribed time will not be deemed negligent. George S. Van Schaick, Supt. of Insurance, 32 B.T.A. 736, 744 (1935). When warranted, reliance on a certified public accountant or an attorney will constitute ordinary care and prudence. Estate of H. B. Hundley, 52 T.C. 495, 514 (1969). In the instant case petitioner relied on the tax expertise of accountant Grauer. Since to our knowledge petitioner had not prior to 1954 had occasion to file returns for United States income, petitioner's reliance upon Grauer was both reasonable and prudent. Cf. Estate of Henry P. Lammerts, 54 T.C. 420 (1970). The mere fact that, according to the conclusions reached by us in this proceeding, Grauer was incorrect in concluding that petitioner would not have to pay tax in 1954, and that a declaration of estimated tax would, therefore, not be required, is not fatal to petitioner. Brooklyn Richmond Ferry Co., 9 T.C. 865, 877 (1947). Petitioner's good-faith disclosure to his accountant, who was in all respects well qualified, and who was aware of petitioner's reliance, was, in our judgment, all that was required. Compare Rene R. Bouche, 18 T.C. 144, 149 (1952) (reliance not sufficient where accountant not competent).
B. 1955-1958
The additions to tax, as determined by respondent, for underpayment of estimated taxes during the years 1955 through 1958 is governed by section 6654. As we said in Estate of Barney Ruben, 33 T.C. 1071, 1072 (1960), "This section has no provision relating to reasonable cause and lack of willful neglect. It is mandatory and extenuating circumstances are irrelevant." Only if petitioner shows that his case comes within one of the exceptions provided in subsection (d) can he be excused from payment of a penalty under section 6654. John P. Reaver, 42 T.C. 72 (1964). This he has not shown and (to the extent now applicable) respondent's determination may not, therefore, be overturned.
SEC. 6654. FAILURE BY INDIVIDUAL TO PAY ESTIMATED INCOME TAX.
(a) ADDITION TO THE TAX. — In the case of any underpayment of estimated tax by an individual, except as provided in subsection (d), there shall be added to the tax under chapter 1 for the taxable year an amount determined at the rate of 6 percent per annum upon the amount of the underpayment (determined under subsection (b)) for the period of the underpayment (determined under subsection (c)).
Issue 7. Denial of Election to File Joint Returns
On March 10, 1965, petitioner and his wife filed joint returns on Form 1040 for each of the years 1954 through 1958. The final question for our consideration is whether the election to file a joint return was proper in light of respondent's antecedent statutory notice in which individual rates were employed in determining petitioner's deficiency.
Though several cases have touched upon this issue and have held for respondent, the specific question presented has not been considered by this Court with regard to tax years covered by section 6013(b), or its progenitor, section 51(g) of the Internal Revenue Code of 1939 (applicable to years beginning after December 31, 1950).
See Max Dritz, T.C. Memo. 1969-175, presently on appeal, (joint rates not available where putative election made in pleadings, no returns having been filed); Joseph A. Mundy, T.C. Memo. 1965-270 (assertion of individual rates by respondent upheld where no returns filed).
In Estate of Samuel Grobart, T.C. Memo. 1961-128 (considered extensively by both parties), a case dealing with two pre-1951 years, we held that petitioner and his wife were not entitled to elect joint rates for the years 1948 and 1949 since their returns for these years had been filed subsequent to respondent's notice of deficiency in 1957, in which individual rates had been used to compute tax.
Section 6013(b), as originally contained in the Revenue Act of 1951, was enacted to remedy the dilemma which often befell married taxpayers who were required to make a binding election (regarding the type of return they would file) at a time when they lacked "informed tax knowledge not possessed by the average person." S. Rept. No. 781, 82d Cong., 1st Sess. (1951), 1951-2 C.B. 458, 492. Accordingly, with certain exceptions, section 6013(b) and its Revenue Act of 1951 analog permit married persons, who originally elect to file individual returns, to later change their election and file joint returns at any time within the 3-year period of the statute of limitations.
SEC. 6013. JOINT RETURNS OF INCOME TAX BY HUSBAND AND WIFE.
(b) JOINT RETURN AFTER FILING SEPARATE RETURN. —
(1) IN GENERAL. — Except as provided in paragraph (2), if an individual has filed a separate return for a taxable year for which a joint return could have been made by him and his spouse under subsection (a) and the time prescribed by law for filing the return for such taxable year has expired, such individual and his spouse may nevertheless make a joint return for such taxable year. A joint return filed by the husband and wife under this subsection shall constitute the return of the husband and wife for such taxable year, and all payments, credits, refunds, or other repayments made or allowed with respect to the separate return of either spouse for such taxable year shall be taken into account in determining the extent to which the tax based upon the joint return has been paid. * * *
(2) LIMITATIONS FOR MAKING OF ELECTION. — The election provided for in paragraph (1) may not be made —
* * * * * * *
(B) after the expiration of 3 years from the last date prescribed by law for filing the return for such taxable year (determined without regard to any extension of time granted to either spouse); * * *
In the instant case, petitioner and his wife did not file joint returns for the years 1954 through 1958 until March 10, 1965. Clearly, therefore, had they originally filed individual returns for these years, their election in 1965 to file joint returns would have been untimely. We see no reason why the same rule should not obtain where, as here, no returns were originally filed. However, we need not premise our decision on this fact alone since, in our estimation, the administrative considerations which accompany a system such as ours, where taxation is based upon voluntary disclosure, demand that where, "as the result of a failure to file a return, the Commissioner has been required to make an election for the taxpayers * * * that election may not thereafter be altered." Spanos v. United States, 212 F. Supp. 861, 864 (D. Md. 1963), reversed in part by 323 F.2d 108 (C.A. 4, 1963), but affirmed as to matters relevant to the language quoted. See also cases discussed therein. Accordingly, we believe this issue must be decided in favor of respondent.
Decision will be entered under Rule 50.