1. A corporation, operating a bus line interstate and
intrastate, finding that in a particular State it could not
lawfully engage in the local business because it had not been there
incorporated, organized, pursuant to the laws of that State, a
wholly owned subsidiary which took over the parent company's
traffic from the state line and operated intrastate as well.
Pursuant to the contract between them, the parent corporation kept
the accounts of the subsidiary, managed its finances, paid its
bills, and absorbed all of its profits and deficits.
(1) That a payment made by the parent company to cover an
operating deficit of the subsidiary during a tax year was not
deductible by the parent company under § 23(a) of the Revenue Act
of 1936 from gross income as an ordinary and necessary business
expense of that company. P. 319 U. S.
(2) In the absence of proof allocating the deficit as between
the intrastate and interstate business of the subsidiary, the
entire deficit must be attributed to the intrastate business. P.
319 U. S.
(3) The mere fact that the expense was incurred under
contractual obligation did not sustain the deduction. P.
319 U. S.
Page 319 U. S. 591
2. An income tax deduction is by legislative grace, and the
burden of showing his right to the deduction is on the taxpayer. P.
319 U. S.
130 F.2d 136 affirmed.
Certiorari, 318 U.S. 751, to review the affirmance of a ruling
(44 B.T.A. 957) sustaining a deficiency assessment of income
MR. JUSTICE REED delivered the opinion of the Court.
This case involves a claim by the taxpayer to treatment of
itself and a subsidiary as a single taxable person. The writ of
certiorari was granted because of uncertainties in this area of
important federal tax law. See Moline Properties, Inc. v.
p. 319 U. S. 436
1. Petitioner Interstate Transit Lines, sought to deduct $28,100.66
as an ordinary and necessary business expense for the year 1936. §
23(a), Revenue Act of 1936. [Footnote 1
] This sum represented a credit to its
subsidiary Union Pacific Stages of California pursuant to a
contract by which petitioner was to be liable for all operating
deficits of the subsidiary. The claimed deduction was disallowed,
and a deficiency determined. The Board of Tax Appeals sustained the
Commissioner, and the Circuit Court of Appeals has affirmed the
Board. Interstate Transit Lines v. Commissioner,
957; 130 F.2d 136.
Page 319 U. S. 592
Petitioner, a Nebraska corporation, operated an interstate bus
transportation line between Illinois and California, and Missouri
and Wyoming, and did an intrastate business in most of the states
en route. Because of its foreign incorporation, petitioner was
barred, under the California Railroad Commission's interpretation
of California law, from obtaining a certificate of public
convenience to do intrastate business in California. To avoid this
situation, petitioner in 1930 organized Stages in California as its
wholly owned subsidiary to do the business it was unable to do. It
contracted with Stages that Stages was to operate solely for
petitioner's benefit and under petitioner's direction; all profits
were to be paid to petitioner, and it was to reimburse Stages for
any operating deficit. In addition to its own intrastate business,
Stages was to carry on all of petitioner's interstate business in
California, the agreement providing that, as each party's buses
crossed the state line, the other became its lessee. The lessee was
to pay the lessor five cents per mile operated by the bus in the
lessee's custody. All this resulted in no change and no added
expense in the business formerly done in respects other than
accounting except for the addition to the gross revenues of the
enterprise of the proceeds of intrastate California business.
Petitioner kept Stages' accounts, managed its finances, and paid
its bills and payroll. Each month, petitioner apportioned between
the two companies the revenues and expenses on the basis of
passenger and traffic mileage. On the books of each, a "clearing
account" with the other showed the absorption by petitioner of
Stages' annual deficit or profit. It is the 1936 operating deficit
of Stages, entered on the books of both on December 31 of that
year, which petitioner now seeks to deduct as its business expense.
Some years after 1936, by reason of a change in California law or
its interpretation, petitioner became able to conduct
Page 319 U. S. 593
business in California. Consequently, Stages was dissolved and
its assets and franchises transferred to petitioner. In 1932 and
1933, consolidated income tax returns were filed by petitioner
pursuant to § 141 of the Revenue Act of 1932, 47 Stat. 169,
Whether phrased as the payment of an expense in a business
conducted for a principal by an agent or as a case where equity and
reality require that the separate corporate identities be ignored
or as the incurring under contract of a necessary expense,
petitioner's argument for its success depends on the contention
that Stages' operating deficit is an expense of petitioner's
business. Without this keystone, the entire argument must fall. And
we examine the argument in the light of the now familiar rule that
an income tax deduction is a matter of legislative grace, and that
the burden of clearly showing the right to the claimed deduction is
on the taxpayer. New Colonial Ice Co. v. Helvering,
292 U. S. 435
292 U. S. 440
Deputy v. Du Pont, 308 U. S. 488
308 U. S. 493
The decision of the two courts below is that this burden has not
This is not the case of a mere branch or division of a business
conducted solely for convenience's sake under a separate corporate
form. Petitioner did an interstate bus business, and was a
corporation foreign to California. On the other hand, the business
of Stages in the tax year in question was both interstate and
intrastate. For petitioner to engage in intrastate business in
California was, on the findings, illegal. Thus, the businesses of
the two companies were distinct. Cf. Edwards v. Chile Copper
Co., 270 U. S. 452
270 U. S.
-456; Texas-Empire Pipe Line Co. v.
127 F.2d 220. Even assuming that the interstate
business of Stages could be the business of the petitioner,
] it follows that,
at most, only that part of
Page 319 U. S. 594
the deficit attributable to Stages' interstate business could be
an expense of petitioner's business, and petitioner could not
conceivably deduct as a business expense the cost of Stages'
intrastate business. There was no showing below as to the
allocation of the deductions sought as between Stages' intrastate
and interstate business. There is thus no record requiring a
further examination of petitioner's argument, since, in the absence
of affirmative proof to the contrary, we must assume that the
entire deficiency was found correctly by the Commissioner and that
the deficit is attributable to Stages' intrastate business.
It is no answer to this defect of proof that petitioner was
obligated by contract to assume Stages' deficit. The mere fact that
the expense was incurred under contractual obligation does not, of
course, make it the equivalent of a rightful deduction under §
23(a). That subsection limits permitted deductions to those paid or
incurred "in carrying on any trade or business." The origin and
nature, and not the legal form, of the expense sought to be
deducted determines the applicability of the words of § 23(a).
Deputy v. Du Pont, supra, 308 U. S. 494
It was not the business of the taxpayer to pay the costs of
operating an intrastate bus line in California. The carriage of
intrastate passengers did not increase the business of the
taxpayer. The profit earned on their carriage increased the
taxpayer's profit, but so would any other profitable activity
wholly disconnected from the taxpayer's own business. As the
Circuit Court pointed out, the assumption of the deficit was not
dependent upon a corresponding service or benefit rendered to the
petitioner by Stages in connection with petitioner's business. 130
F.2d 136, 139.
In view of these conclusions, it is unnecessary to characterize
the payment by petitioner as a capital expenditure or otherwise, or
to decide whether, if the record were complete, petitioner and
Stages should be treated as a
Page 319 U. S. 595
taxable entity for the claimed purpose. Cf. Moline
Properties, Inc. v. Commissioner, supra,
49 Stat. 1648:
"Sec. 23. Deductions from Gross Income."
"In computing net income there shall be allowed as
"(a) Expenses. -- All the ordinary and necessary expenses paid
or incurred during the taxable year in carrying on any trade or
business. . . ."
Cf. Moline Properties, Inc. v. Commissioner, ante,
319 U. S. 436
Higgins v. Smith, 308 U. S. 473
308 U. S. 477
MR. JUSTICE JACKSON, dissenting.
This taxpayer operated a bus system between Chicago and Los
Angeles. It could not pick up intrastate passengers in California,
as it did elsewhere, because the State denied foreign corporations
permission to do so. In order to obtain local traffic to help carry
the cost of operating the interstate buses, taxpayer organized a
wholly owned and dominated California subsidiary. This contented
the local authorities, and it was granted permission to carry local
business. It took over buses arriving at the state line, operated
them in California, thus performing a part of the taxpayer's
agreements of through carriage and benefiting from local traffic to
reduce the cost. It was a common sense business arrangement, for
the purpose of making its business profitable.
The taxpayer made a contract with the subsidiary by which the
subsidiary undertook the service; the parent company became
entitled to the profits and assumed the losses. The taxpayer agreed
to reimburse the subsidiary for any operating deficit. This, too,
was a common sense business arrangement. To pay its wholly owned
subsidiary more would be pointless, for it would only come back. To
pay it less would result in its bankruptcy to the injury of
creditors. So the taxpayer agreed that the operating deficits
should be the measure of its contractual obligation to the
There is no suggestion that this arrangement was for tax
avoidance, or, for that matter, that it did not actually reduce
taxpayer's costs, and thus increase its tax liability. The
Commissioner ruled, however, that the amount of operating deficit
paid by the taxpayer was not a business expense.
Page 319 U. S. 596
To require the Commissioner in all cases to allow a deduction so
fixed might be turned by the unscrupulous to tax evasion ends. It
could then, through its controlled subsidiary, make expenditures
not properly allowable as business expense, but get them allowed as
part of the deficit assumed by contract. Of course, the
Commissioner is not obliged to allow this, or any other
arrangement, when it is used as a cover for tax skullduggery.
Examination of the items is open to the Commissioner. But this
deduction has been denied not for such reasons, but upon a legal
theory which I think is erroneous.
The taxpayer took inconsistent positions: first, that the
corporate entity of the subsidiary should be disregarded and the
two companies taxed on a consolidated basis; second, that the
amount was a proper deduction under the contract, which, of course,
implies existence of two parties to contract. The Government, not
to be outdone in the matter of inconsistency, denied the separate
entity theory and also disregarded the contract, and argues to
"the contract of the taxpayer to make good Stages' operating
deficits is one pervaded by the stockholder-corporation relation.
Any contribution to Stages under this contract must therefore be
regarded as incident to the taxpayer's stockholder status."
So the Government says the payment was not a compensation for
services, which the contract provides that it was, but was a
"capital contribution," which the contract says it was not.
I think there is no merit in the taxpayer's theory that the
Commissioner must disregard the corporate entity of the subsidiary.
If a taxpayer itself creates and uses a corporation, he cannot
require the Commissioner to say it isn't there.
But, on the other hand, if the Commissioner says there are two
entities, it would seem that they would be able to contract with
each other, one to perform a service and the other to pay a price.
The service may be, and often is,
Page 319 U. S. 597
one that the taxpayer could not perform for itself, but, if it
is hired to build up its business, I see no reason why its proper
cost is not a business expense deduction. The price need not be a
fixed one, but may be determinable by costs or other contingencies;
but when fixed, its amount (barring use as a device to evade) is
the amount of the deduction. Cost or "cost plus" is one of the
Government's own methods of contracting. It is not an illicit
method for a taxpayer to employ.
But it is urged that, since the taxpayer could not itself pick
up local business under California law, it cannot be the business
of the taxpayer in a legal sense to have a subsidiary do so, and
disbursements to have local business brought in are legally foreign
to its business, although for its benefit. I do not suppose the
taxpayer corporation can itself legally practice law or medicine,
but, I would suppose, if it needed legal service for its business
or thought it good business to supply medical attention to injured
or ailing employees, the cost would be a business deduction even
though the agent was doing what the taxpayer could not legally do
for itself. The taxpayer may not be authorized to run a newspaper
or put up billboards, but if it contracted for services of those
who are, in order to fill vacant seats in its buses, I do not
suppose its cost would be disallowed for that reason.
This company has not violated the law, even of California.
Indeed, it went to this trouble to comply with it. The fact that it
used a subsidiary to benefit its business in areas where its own
competence was lacking can hardly invalidate the arrangement,
particularly since it is insisted that the subsidiary had separate
legal and tax existence. If states create dummies, businessmen may
utilize them, so long as they keep within the law, and the function
of the revenue laws is not to tell them how they shall manage
business, but to see that what they do has proper tax
Page 319 U. S. 598
Since the decision of this case, the Tax Court has held in a
very similar case that, where a wholly owned subsidiary exclusively
performs services essential to the business of the parent
corporation, advances made by the parent to meet the subsidiary's
operating deficit are deductible as a business expense. Texas
& Pacific Ry. Co. v. Commission,
No. 105730, March 25,
1943. I think this is a correct rule. Judge Harron there avoids the
force of this case only upon the ground that the parent corporation
here could not itself engage in the business done in its behalf by
the subsidiary. That distinction is good enough to get the Tax
Court away from a bad rule, but I see no reason why such a
deduction should be available in case of an unnecessary subsidiary
and be refused in the case of one needed to comply with state laws
in making a profitable enterprise. I would reverse.
THE CHIEF JUSTICE and MR. JUSTICE MURPHY join in this