                          T.C. Memo. 1996-505



                        UNITED STATES TAX COURT



                AFFILIATED FOODS, INC., Petitioner v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



       Docket No. 25703-93.              Filed November 7, 1996.



       William A. Hoy, for petitioner.

       George E. Gasper, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION

       PARR, Judge:   Respondent determined deficiencies in

petitioner's Federal income tax for taxable years 1989 and 1990

of $171,985.68 and $183,196.30, respectively.     The issues for

decision are:    (1) Whether certain payments made by vendors to

petitioner are includable in petitioner's income.     We hold they

are.    (2) Whether cash which petitioner supplied to vendors for
                                 - 2 -

distribution to petitioner's member stores at petitioner's food

shows is includable in petitioner's income.     We hold it is.    (3)

Whether petitioner is entitled to a deduction under section 162

for certain amounts received from Western Family Foods (Western)

and distributed to its member stores at its 1989 and 1990 food

shows.   We hold it is.1

      All subchapter and section references are to the Internal

Revenue Code in effect for the taxable years in issue, and all

Rule references are to the Tax Court Rules of Practice and

Procedure, unless otherwise indicated.    All dollar amounts are

rounded to the nearest dollar.

                           FINDINGS OF FACT

      Some of the facts have been stipulated.    The stipulated

facts and the accompanying exhibits are incorporated into our

findings by this reference.    At the time the petition in this

case was filed, petitioner's principal place of business was

located in Amarillo, Texas.    Petitioner keeps its books and

records on the accrual method of accounting, and it files its

Federal income tax return using a fiscal year ending September

30.

      Petitioner is a wholesale food purchasing cooperative that

supplies food and other consumer products to retail grocery


1
     Respondent also determined that petitioner was entitled to
an increased environmental tax deduction for 1990. This is a
mathematical adjustment.
                                 - 3 -

stores owned by its shareholders.    Petitioner also conducts a

small amount of business with stores not owned by shareholders.

Petitioner has 210 shareholders, and these shareholders operate

approximately 640 retail grocery stores (member stores).2      For

Federal tax purposes, petitioner is a nonexempt cooperative that

computes its taxable income under the provisions of Part I of

subchapter T (secs. 1381 to 1383, inclusive).

     Member stores purchase food and other consumer products from

petitioner.   Petitioner purchases these goods from more than

2,000 manufacturers and suppliers.       Petitioner purchases directly

from sales representatives of some manufacturers, such as Proctor

& Gamble (P&G) and Colgate-Palmolive (Colgate), and it purchases

other manufacturers' products from independent brokers, such as

Dejarnett Sales.   Brokers typically represented a variety of

manufacturers or distributors.    Unless otherwise specified, we

will use the term "vendor" to refer to manufacturers' sales

representatives and brokers.

     Petitioner maintains a single bank account with Amarillo

National Bank, which it uses as its general operating account

(Amarillo account).   Petitioner makes all of its deposits into

the Amarillo account, and it makes all of its payments from the

Amarillo account, including payroll expenditures.



2
     Petitioner does not own any interest in any member store.
                                - 4 -

Promotional Accounts

     During the years at issue, manufacturers provided vendors

with promotional funds, which were sometimes referred to as

"street money".   These promotional funds were to be used by the

vendors to increase retail sales.    Many vendors deposited their

promotional funds with petitioner.      Petitioner then deposited

these funds into its Amarillo account.      Petitioner did not

maintain separate accounts for the promotional funds; the

promotional funds were commingled with its general operating

funds.

     Although petitioner commingled the promotional funds with

its general operating funds, petitioner maintained promotional

fund accounting records.    Petitioner furnished each vendor with a

statement regarding its receipts and disbursements of promotional

funds.   Petitioner did not charge vendors a fee for maintaining

these accounting records.   We shall refer to these promotional

funds and the associated accounting records as vendor promotional

accounts.3



3
     Although these promotional funds and associated accounting
records are variously defined in the record as "record funds",
"promotional allowance accounts", etc., we will use the term
"promotional accounts". We use this term and any reference to
payments, deposits, receipts, or deductions related to the
promotional accounts for convenience only. The substantive
Federal tax characterization of these accounts and the
transactions related to these accounts are legal issues that we
address in the Opinion section of this case.
                                - 5 -

     Only P&G and Colgate had written promotional account

agreements with petitioner.    The remaining vendors had oral

agreements with respect to the promotional accounts.

     P&G and Colgate had the following written promotional

account agreements with petitioner:     Flexible Marketing Agreement

between petitioner and P&G; Cooperative Merchandising Agreement

between petitioner and P&G; Category Marketing Agreement between

petitioner and P&G; Ajax Line Special Event Merchandising

Contract between petitioner and Colgate; and Special Event

Merchandising Contract between petitioner and Colgate.     The funds

that were the subject of these written promotional account

agreements were maintained by petitioner.4

     Under the Flexible Marketing Agreement (FMA) with P&G, P&G

created a promotional account for each category of brand-name

products listed in the FMA; e.g., coffee/tea products, chilled

beverages, and baking mixes.    The amount paid into the

promotional account for each quarter was determined by

multiplying a specified rate by the number of cases of the

specified brands shipped to petitioner during the "base period".

The base period was the same quarter in the previous year.      The



4
     The written agreements are inconsistent on whether
petitioner or the manufacturer would maintain possession of the
promotional funds. However, the parties have stipulated that
petitioner maintained possession of the promotional funds, and
the testimony at trial supports the stipulation.
                               - 6 -

FMA indicated that petitioner could earn promotional funds by:

putting a price reduction into effect during the previous 30

days; making a special distribution of cases to retail outlets;

or making a special purchase (direct or indirect).

     Under the Cooperative Merchandising Agreement (CMA) with

P&G, P&G created a promotional account for each brand listed in

the agreement; e.g., Ivory bar soap, Top Job, Spic & Span, and

Bounce.   The amount paid into the promotional account for each

quarter was determined by multiplying 34 cents by the number of

cases of the specified brands shipped to petitioner during the

base period, which was defined as the same quarter during the

previous year.   Petitioner could use the entire amount in the

promotional account, under payment terms set forth in the CMA,

for print, broadcast, display, or outdoor billboard advertising.

The payment terms varied.   For example, if petitioner performed

in print media, petitioner would be entitled to "cost plus 50%

for advertising overhead expense," or, as an alternative, it

could "elect to be paid at the rate of $1.00 per physical case

distributed to stores in support of a feature on the Brands in

the Merchandiser's best print medium used for any item during the

period of the sale."   In addition, petitioner was entitled to use

up to 20 percent of the promotional account for other activities

in the amounts specified in the CMA; for example, petitioner
                               - 7 -

could be paid reasonable and customary costs for sponsoring an

in-store sampling program at one of its shareholder's stores.

     Under the Category Marketing Fund Agreement (CMFA) with P&G,

P&G created a promotional account for each brand listed in the

agreement; e.g, Bold, Dawn, and Downy.   The amount paid into the

promotional account for each period was determined by multiplying

the stated funding rate by the number of cases of the specified

brands shipped to petitioner during the base period, with the

base period being the same period during the previous year.

Petitioner was entitled to payment from the promotional account

at a stated rate per case for various advertising and price

reduction activities; e.g., print media, broadcast media, and

price reduction on sales to retail outlets.   Furthermore, P&G

authorized payment of petitioner's actual cost of various

activities from the promotional account, e.g., petitioner could

be paid reasonable and customary costs for sponsoring an in-store

sampling program at one of its shareholder's stores.

     As indicated, the three written agreements between P&G and

petitioner provided that petitioner could withdraw from the

promotional accounts certain amounts for performing certain

enumerated activities.   This was not, however, the entire

arrangement between petitioner and P&G's representative, Mr.

Davis.   Instead, petitioner withdrew funds from the promotional

accounts if it performed under the terms of oral agreements it
                               - 8 -

had with Mr. Davis, whether or not the activities giving rise to

payment were covered by the written agreements.   Mr. Davis

determined how petitioner could use the funds to best promote P&G

products, and petitioner decided if it would accept the terms of

Mr. Davis' offer.

     With respect to advertising activities petitioner could

perform to become entitled to withdraw funds from the promotional

accounts, Mr. Davis would inform petitioner that he was offering

an advertising program to promote certain P&G products and the

terms of the offer.   After providing the advertising, petitioner

would then deduct the moneys to which it was entitled under the

terms of Mr. Davis' offer from the P&G promotional accounts.      To

validate the deduction from the P&G promotional accounts,

petitioner provided Mr. Davis with proof of performance, e.g., a

copy of an advertisement.   Mr. Davis also used promotional

account funds to make cash payments to petitioner's member stores

at petitioner's annual food show.

     Under the Ajax Line Special Event Merchandising Contract and

the Special Event Merchandising Contract with Colgate (Colgate

agreements), Colgate agreed to create a promotional account for

special event promotional services.    The promotional account was

infused with capital every 6 months, and the amount contributed

was based on a fixed price per case of specified products shipped

to petitioner during the same period for the prior year.    The
                                - 9 -

moneys in the promotional account could be withdrawn when

petitioner rendered special event promotions, such as television

or radio advertising.    Colgate agreed to pay petitioner the cost

of performance, provided the total payment did not exceed the

amount in the fund for the 6-month period.    Furthermore, the

Colgate agreements provide that "Monies available for any one

promotional period must be earned by the dealer during that

period."   In terms of payment, the Colgate agreements provide:

     Payment will be made to the DEALER upon receipt of the
     Certificate of Performance which must indicate in the
     "Remarks" section the Jobber's invoice number(s) if invoiced
     by Jobber; a copy of the applicable short term agreement
     which indicates the number of cases shipped in support of
     the COLGATE sponsored short term promotion(s); and
     documentary proof (script/story/board, tear sheet of
     rotogravure, and any other appropriate proof of performance
     as may be required) satisfactory to COLGATE that the
     "SPECIAL EVENT" performance was rendered as required under
     the Terms and Conditions of this agreement. Such payments
     may not be used to reduce, or as set off against, the sale
     price of any COLGATE product, nor is any amount claimed to
     be due hereunder to be deducted by the DEALER from any
     invoice or bill for COLGATE products. In no event shall
     COLGATE have any liability to make payment unless proof of
     performance is submitted within 30 days after the
     termination of the performance period.

     In contrast to the foregoing, most of the vendors that

maintained promotional accounts with petitioner had only oral

agreements.    The vendors who had oral promotional account

agreements used the promotional funds to pay for product

advertising.    They also used the funds to make cash payments to

petitioner's member stores at petitioner's annual food show.
                                - 10 -

     Almost all of the promotional accounts had a credit balance

at yearend.   In fact, petitioner did not use any of the money in

several promotional accounts during the years at issue, e.g.,

Conagra Banquet Food/Pritchard, American Home Food Products,

Tropicana, Ragu Foods, Inc., Quaker/Gordon-Murdock, and Gortons

of Gloucester/Pritchard.

     Mr. Terry Sheldon, a C.P.A., was petitioner's accountant

during the years at issue.    Around mid-1988, petitioner's

management asked Mr. Sheldon to audit petitioner's advertising

department, because the department showed a large fluctuation in

income.   Upon audit, Mr. Sheldon discovered that petitioner had

started the promotional accounts sometime during 1988.    At that

time, petitioner was treating the promotional fund payments as

income when received and deducting expenses when incurred.      This

accounting treatment was applied for both financial reporting

purposes and tax purposes.    Beginning in 1989, petitioner stopped

treating promotional account payments as income on receipt.

Rather, petitioner treated promotional account receipts as

liabilities to the vendors.    Petitioner then reduced the

liability to each vendor as it incurred expenses that were paid

from the promotional account.    Most of the offsetting costs

incurred by petitioner were related to advertising costs.

     During 1989, petitioner had "art and printing department"

expenses of $1,712,656 and income of $1,562,855, resulting in a
                               - 11 -

loss of $149,801.    During 1990, petitioner had "art and printing

department" expenses of $1,817,957 and income of $1,810,992,

resulting in a loss of $6,965.    During 1989, petitioner had

"advertising department" expenses of $1,400,535 and income of

$966,654, resulting in a loss of $433,881.      During 1990,

petitioner had "advertising department" expenses of $1,050,053

and income of $918,231, resulting in a loss of $131,822.

     In petitioner's accounting records, the income reflected in

the art and printing department account and the advertising

department account included revenue from the vendor promotional

accounts.   However, the promotional accounts were not the only

source of revenue for these accounts.

     Petitioner's art and printing department had a staff of 24

professional artists and printers.      They produced printed

advertising material for member stores, including full color

circulars, handbills, shelf and stack signs, and newspaper

layouts.    The advertising department provided member stores with

advertising and promotional programs, and coordinated a 23-week

television campaign during the years at issue.      It also planned

for grand openings, anniversary sales, and other special events

for member stores.

     On its financial statements for the years at issue,

petitioner reported the unspent promotional account funds as
                               - 12 -

current liabilities.   At the end of 1989, that total liability

was $343,470, and, at the end of 1990, it was $624,880.

The Food Shows

     In 1989 and 1990, petitioner conducted its annual food shows

in Amarillo, Texas.    These shows were not open to the public.

Each vendor entered into an agreement with petitioner governing

the vendor's participation in the food show.    The food-show

"agreement to participate" generally provided that:    (1) The

vendor would pay $450 as a booth and participation fee; (2) the

vendor would properly decorate its booth and provide merchandise

samples; and (3) the vendor would offer approved special

promotions, allowances, and/or special buys on products, with the

condition that all offers must be a "real show special".

Furthermore, vendors had to agree to submit a recommended list of

show sale items to petitioner, which retained the right of

approval or rejection on all of the individual items.    Petitioner

recovered the expense it incurred in sponsoring the food show

through the sale of space.

     In preparation for each food show, petitioner asked the

participating vendors to complete order forms.    These forms had

spaces to identify the vendor, the product being promoted, and

the per-unit promotional allowance offered for each product.      The

vendors completed the order forms and returned them to
                              - 13 -

petitioner, and, if approved, the forms were bound into a "food-

show book".

     Each member store attending the show received a food-show

book.   Each page related to one vendor, and had a tear-off strip

on the right-hand side, which indicated the amount being ordered

and the product promotional allowance arising therefrom.

Generally, the product promotional allowance was paid in cash at

the food show when the order was placed.     Not all product

allowances, however, were paid in cash.

     The cash used by the vendors to make these payments at the

food show came from three sources:     (1) Promotional accounts;

(2) check transactions--a vendor would give petitioner a check,

and petitioner would cash the check and provide cash to the

vendor at the food show (check transaction); and (3) cash brought

to the food show by the vendor.

     In connection with the 1989 food show, vendors collectively

instructed petitioner to transfer a total of $74,700 in cash to

them out of the promotional accounts.     In connection with the

1990 food show, vendors collectively instructed petitioner to

transfer a total of $112,025 in cash to them out of the

promotional accounts.

     When funds used by vendors at the food show came from a

promotional account or check transaction, the vendors would

provide petitioner with written instructions indicating the
                              - 14 -

amount of cash they wanted and the denominations thereof.     Based

upon these written instructions, petitioner obtained cash from

the Amarillo National Bank.   Petitioner placed the cash requested

by each vendor in a separate bank bag supplied by the Amarillo

National Bank.   The bank bags were identified by a number

assigned to the individual vendors.     Immediately before the shows

began, petitioner made the bank bags available to the vendors at

a central location.   Each vendor was required to sign for the

bank bag at the time it obtained its requested cash.     At the

conclusion of the food shows, the vendors returned to petitioner

the bank bags and any unused cash.     Petitioner maintained a

record of the amount of cash given to each vendor, the source of

that cash, and the amount of any cash returned to petitioner at

the conclusion of the food show.

     As indicated above, each page in the food-show book had a

perforated tear strip.   At the food show, representatives of the

member stores placed their merchandise orders on the tear strip

and turned them into the vendors.    The vendor made the product

promotional payments, then gave the tear slip to petitioner.

Subsequently, petitioner would order the merchandise, deliver it

to the member stores, and bill the member stores.     The tear

strips had the amount of the product promotional allowance on

them.   However, petitioner destroyed these records.
                               - 15 -

     Mr. Davis participated in the 1989 and 1990 food shows on

behalf of P&G.   He requested a cash disbursement from the P&G

promotional account to use at the food show.    Then he distributed

the cash product promotional allowances at the food show as an

incentive to buy P&G food brands.    The product promotional

allowances available were set forth in the food-show book.      The

food show sales represented a significant portion of Mr. Davis'

annual sales; for example, he sold over 60 percent of his annual

volume of Pringle's Potato Chips at the food show.    If Mr. Davis

did not pass out the entire amount of the cash disbursed to him

for the food show, he returned the remainder to petitioner.

Western/Clawson Transactions

     Western is a corporation which buys and markets private

label products for the grocery industry.    It is called a

"sourcing company", because it does not produce goods; rather, it

contracts with manufacturers to produce the goods it sells under

its private label.   Petitioner purchases Western's private-label

goods.   These goods are then shipped from Western to petitioner,

and petitioner sells them to its member stores.

     Petitioner owns approximately 7 percent of Western's stock.

In 1989 and 1990, Western made payments to petitioner of $60,000

and $100,000, respectively.    Petitioner did not include the

$60,000 and $100,000 distributions in its income, but now
                               - 16 -

concedes that the payments should have been included in income

during 1989 and 1990, respectively.

     Petitioner deposited the $60,000 and $100,000 into its

Amarillo account in 1989 and 1990, respectively, withdrew cash in

the amounts deposited, and gave the cash to Mr. Val Clawson.

Mr. Clawson is an employee of Dejarnett Sales, which is a food

broker for Western.   Mr. Clawson was told to distribute this cash

to the member stores at the food shows.

     Western does not provide any currency to be passed out at

the food show on its behalf.   However, using the money given to

him by petitioner, Mr. Clawson offered allowances on Western

products purchased at the show.   For example, if a Western

product had a show allowance of a dollar a case and the member

store bought 100 cases, then he would give the store $100 cash.

He also offered payments by check; the decision on whether to

accept currency or a check was made by the member store.     Based

on the tear strips, the amount of cash given to Mr. Clawson could

be reconciled back to the amount of cash that he returned to

petitioner at the end of the show.      Thus, petitioner knew exactly

what was done with the money, how many cases were sold, and the

cash allowances distributed at the food show.

     According to petitioner's bookkeeping entries, Mr. Clawson

distributed $35,616 and $82,958 to representatives of the member

stores at the 1989 and 1990 food shows, respectively.     Although
                                 - 17 -

records existed at one time showing who received the funds from

Mr. Clawson, petitioner destroyed these records.

                                 OPINION

     Respondent determined that petitioner had increased

advertising and food-show income in 1989 of $343,470 and

$162,370, respectively, and increased advertising and food-show

income in 1990 of $281,409 and $255,509, respectively.

Issue 1.    Advertising Income

     In regard to respondent's 1989 and 1990 advertising income

determinations, the $343,470 and the $281,410 represent the

balance of the promotional accounts at the end of each year in

issue.5    By including only the balance of the promotional account

in petitioner's income, respondent in effect determined that the

promotional account payments constituted gross income and the

promotional account disbursements were allowable deductions.

Petitioner asserts that it held the promotional account funds as

a nontaxable intermediary between the vendors and the member

stores, and therefore no amount of the promotional account funds

should be includable in its income for either 1989 or 1990.6


5
     For 1990, petitioner's yearend balance in the promotional
accounts was $624,880; however, in her determination, respondent
treated the excess of the yearend balance less the prior yearend
balance ($343,470) as taxable income of $281,410.
6
     Since vendors withdrew $74,700 and $112,025 from the
promotional accounts for the 1989 and 1990 food shows,
                                                   (continued...)
                               - 18 -

Petitioner bears the burden of proof on this issue.    Rule 142(a);

Welch v. Helvering, 290 U.S. 111 (1933).

     Petitioner's contention that it held the promotional account

funds as a nontaxable intermediary rests upon a number of

decisions of this and other courts.     See, e.g., Ford Dealers

Advertising Fund, Inc. v. Commissioner, 55 T.C. 761 (1971), affd.

per curiam 456 F.2d 255 (5th Cir. 1972); Angelus Funeral Home v.

Commissioner, 47 T.C. 391 (1967), affd. 407 F.2d 210 (9th Cir.

1969); Seven-Up Co. v. Commissioner, 14 T.C. 965 (1950).

     In Seven-Up Co. v. Commissioner, supra, Seven-Up Co. (7-Up)

manufactured and sold extract for a soft drink to various

franchised bottlers.   Each bottler was granted an exclusive sales

territory by 7-Up and controlled its own sales promotion and

local advertising within that territory with the aid of 7-Up.

Certain bottlers decided that it would be more efficient to

conduct promotion and advertising of the beverage on a national

level.   In order to fund the national advertising campaign,

participating bottlers were required to pay 7-Up $17.50 per

gallon of extract purchased.   The funds were administered by 7-Up

and were to be spent solely for advertising purposes.    The funds




6
 (...continued)
respectively, these amounts are not part of the promotional
account yearend balances.
                              - 19 -

were accounted for separately on the company's books, but were

not placed in a separate bank account.

     In Seven-Up Co., the Commissioner contended that the excess

of the amounts received by 7-Up over the advertising expenses

incurred and paid constituted taxable income.   In holding that

the excess was not taxable, we stated:

     The payments made by the participating bottlers were not for
     services rendered or to be rendered by petitioner. Neither
     were they part of the purchase price of the extract. They
     did not, therefore, constitute earnings received by
     petitioner under a claim of right and without restriction as
     to disposition, which petitioner would have had to include
     in its gross income under the rule laid down in North
     American Oil Consolidated v. Burnet, 286 U.S. 417. While
     petitioner had the right to receive the bottlers'
     contributions under its agreements with them, all the facts
     and circumstances surrounding the transaction clearly
     indicate that it was the intention of all of the parties
     concerned that these contributions were to be used to
     acquire national advertising for the 7-Up bottled beverage
     and for that purpose only, and that petitioner was to be a
     conduit for passing on the funds contributed to the
     advertising agency which was to arrange for and supply the
     national advertising. * * * Although the funds were not all
     expended in the year received, for reasons set forth in our
     findings, petitioner did expend them for national
     advertising, did not use them for general corporate
     purposes, treated the amounts on hand in the fund on its
     books as a liability to the bottlers, and considered itself,
     as evidenced by its letter of May 2, 1944, to one of the
     participating bottlers, merely as a trustee, handling the
     bottlers' money. [Seven-Up Co. v. Commissioner, 14 T.C. at
     977-978.]

     In Ford Dealers Advertising Fund, Inc. v. Commissioner,

supra, the taxpayer received funds from franchised Ford Dealers

in the Jacksonville, Florida, area to be expended for advertising

and promotion.   The advertising fund also operated a "car-locator
                               - 20 -

service" within the territory.    In Ford Dealers, we stated that

"when a taxpayer receives trust funds, which he is obligated to

expend in entirety for a specified purpose and no profit, gain or

other benefit is to be received by him in so doing, the funds are

not includable in gross income."    Id.    Focusing on the restricted

use of the funds in question, the Court held that such funds were

received in trust and did not represent gross income.       Id. at

772.

       In contrast, in Krim-Ko Corp. v. Commissioner, 16 T.C. 31

(1951), we found that the amounts received were not restricted as

to use or disposition, but rather were paid in consideration for

the taxpayer's promise to furnish designated advertising material

and services; thus, we held that such amounts constituted gross

income to the taxpayer.    Id. at 39-40.   In so holding, we noted

that the agreements placed no restrictions upon the use of the

funds, nor did they indicate that the recipient was to act "as a

depository, conduit, trustee, or agent with respect to * * * [the

funds]".    Id. at 39.

       To determine whether petitioner was a nontaxable

intermediary, we must determine the agreement between the vendors

and petitioner.    Ford Dealers Advertising Fund, Inc. v.

Commissioner, supra at 771; Seven-Up Co. v. Commissioner, supra

at 977.    This is a question of fact to be determined by examining

all the facts and circumstances presented.      Angelus Funeral Home
                                - 21 -

v. Commissioner, 47 T.C. 391, 395 (1967); Seven-Up Co. v.

Commissioner, supra at 977.

     To establish the terms of the promotional account

agreements, petitioner presented several witnesses, including its

chairman, two of its officers, two current employees, and a

former employee.    Each of these individuals testified that

petitioner did not own the promotional account funds.7    But none

of these individuals clearly articulated the terms of the

agreements between the vendors and petitioner with respect to the

promotional accounts.    Due to the relationship between petitioner

and these individuals and the imprecise nature of their testimony

with respect to the promotional account agreements, these

witnesses did not aid petitioner in establishing that it was a

nontaxable intermediary with respect to the promotional accounts.

     In addition to the testimonial evidence, petitioner

submitted two written promotional account agreements between

petitioner and Colgate.    These agreements indicate that Colgate

will reimburse petitioner for its cost of rendering special event

promotions, provided petitioner substantiates such expenditures

through a "Certificate of Performance" and other supporting

documentation.     The Colgate agreements do not, however, indicate

that funds from the promotional accounts can be used to make cash


7
     We note that such testimony appears inconsistent with
petitioner's treatment of these accounts on its 1988 books.
                               - 22 -

disbursements at petitioner's annual food show.    Furthermore,

although the Colgate agreements indicate that the promotional

funds available for a particular period must be earned during

that period, petitioner carried a balance in its Colgate

promotional accounts from one period to the next.

     Petitioner also submitted three promotional account

agreements between petitioner and P&G.    The three written

agreements between petitioner and P&G indicate that petitioner

can withdraw funds from P&G's promotional accounts for performing

certain enumerated activities.   However, petitioner was

reimbursed for performing promotional activities that P&G's

representative offered to petitioner, even if such activities

were not specifically addressed in the agreements.

     Both the Colgate and the P&G agreements are helpful in

determining the substance of the agreements between petitioner

and these two vendors.   However, the facts and circumstances of

the case indicate that these agreements did not address the

entire arrangement between the parties.    Rather, the facts and

circumstances indicate that the vendors could authorize payment

from the promotional accounts for promotional activities not

addressed by the agreements.   For example, funds were withdrawn

from the promotional accounts to make cash payments at

petitioner's annual food show, even though the agreements did not

specifically address such payments.
                               - 23 -

     Although the overall evidence of the agreements between

petitioner and the vendors with respect to the promotional

accounts is sparse, particularly with respect to the oral

agreements, we believe the best evidence of the substance of such

agreements was the agreement with P&G, as there was both written

and testimonial evidence concerning that agreement.

     Based on all the facts and circumstances, we find that a

vendor would inform petitioner that it was offering an

advertising program to promote its product.    The amount offered

for performing was not only petitioner's actual cost, but its

cost plus an allowance.   Also, if the advertising was done in

connection with a product price promotion, the amount offered for

advertising was determined by multiplying a specified rate by the

volume of the product sold.    If petitioner accepted the proposal

and performed the advertising, it would deduct the corresponding

allowance from the vendor's promotional account and provide the

vendor with documentation validating the deduction.

     The majority of the withdrawals from the promotional

accounts were related advertising promotions.    By conducting

advertising activity for the vendors, petitioner generated

substantial amounts of revenue for its art and printing

department and its advertising department.    These departments

were an important part of petitioner's business, as indicated by

petitioner's annual reports.
                               - 24 -

     Although vendors designated a number of advertising

activities that petitioner could engage in to make withdrawals

from the promotional accounts, petitioner could elect which of

those activities to conduct.   This fact, coupled with the fact

that petitioner rarely, if ever, made refunds of promotional

account funds, enabled petitioner to perform only those

advertising activities that were profitable.   Petitioner could

pass on an unfavorable advertising offer and still earn the funds

allocated to the promotional accounts on a future date.

Essentially, petitioner could carry a balance in a promotional

account until it wanted to perform a proposed advertising

activity.

     The majority of the funds withdrawn from the promotional

accounts were treated as art and printing department and

advertising department revenue.   Petitioner was not merely a

conduit with respect to these funds; these funds were substantial

revenue for a large scale advertising activity.8   Petitioner

received these payments for materials and services rendered.

Petitioner advertised for the vendors, and it was paid for this

work.   Consequently, these amounts are earnings to petitioner,



8
     Petitioner's art and printing department alone had a staff
of 24 professional artists and printers. This department had
expenditures of almost $2 million a year for 1989 and 1990.
Furthermore, petitioner's advertising department had expenditures
of over $1 million a year for both 1989 and 1990.
                               - 25 -

not funds held in trust.    Ford Dealers Advertising Fund, Inc. v.

Commissioner, 55 T.C. at 773-774; Krim-Ko Corp. v. Commissioner,

16 T.C. at 39-40; Seven-Up Co. v. Commissioner, 14 T.C. at 977-

978.

       Vendors also offered product price reduction promotions to

petitioner, whereby petitioner could withdraw funds from the

promotional accounts to pay the member stores if the member

stores purchased a specified amount of a given product.      These

promotions were often associated with the aforementioned

advertising promotions.    The record is skimpy regarding these

product price reduction payments.    There is no evidence as to

whether the invoices received by the member stores reflected

these product allowances, nor how the member stores generally

treated them.    Furthermore, petitioner has not attempted to

substantiate the portion of the promotional accounts' balance

that was allocable to these promotions.    Overall, the record is

inadequate to establish whether these amounts were paid as a

rebate, a return of cooperative profits, or some other payment.

       Unlike the taxpayers in Seven-Up Co. v. Commissioner, 14

T.C. 965 (1950) and Ford Dealers Advertising Fund, Inc. v.

Commissioner, 55 T.C. 761 (1971), petitioner did not act as a

mere intermediary, passing the advertising funds along to an

advertising agency.    Rather, the facts and circumstances

surrounding the promotional accounts indicate that the
                                - 26 -

promotional account funds were to be used by petitioner as

payment for advertising materials and services provided by

petitioner's art and printing and advertising departments.     The

promotional account funds are income when received; of course,

petitioner will be entitled to claim its advertising expenses as

they are incurred.   By including only the balance of the

promotion accounts in petitioner's income, respondent in effect

determined that the promotional fund contributions constituted

gross income and the promotional fund disbursements were

allowable deductions.   Accordingly, we sustain respondent's

determination.

Issue 2.   Food-Show Currency

     Respondent determined that petitioner's income should be

increased by $162,370 and $255,509 for 1989 and 1990,

respectively, for the amount of currency distributed by the

vendors to the member stores at the 1989 and 1990 food shows from

vendor promotional accounts and vendor check transactions. Seven-

Up Co. v. Commissioner, supra at 977;9 petitioner asserts that

the cash it delivered to the vendors from the promotional

accounts and check transactions at the 1989 and 1990 food shows



9
   Although this determination includes amounts distributed from
vendor promotional accounts, these amounts were determined to be
included in income only once, as respondent included only the
yearend balances in the promotional account (advertising) income
determination. See supra note 6.
                              - 27 -

should not be included in its income.   Petitioner bears the

burden of proof on this issue.   Rule 142(a); Welch v. Helvering,

290 U.S. 111 (1933).

     To resolve this issue, we must examine the taxation of

nonexempt cooperatives.   A complete overview of the regime under

which nonexempt cooperatives are taxed is set forth in Buckeye

Countrymark, Inc. v. Commissioner, 103 T.C. 547, 554-555 (1994).

Consequently, we shall discuss only those cooperative concepts

that are necessary to resolve the issue involved herein.

     Cooperatives initially determine gross income without making

any adjustments for allocations or distributions made to patrons

from net earnings from business with or for patrons.   Sec.

1382(a).   After determining gross income in this manner, section

1382(b) permits cooperatives to compute taxable income by

allowing deductions for, inter alia, "patronage dividends",

defined in section 1388(a).   Gold Kist Inc. v. Commissioner, 104

T.C. 696, 708 (1995).   A "patronage dividend", generally, is an

amount that is allocated or paid to a patron out of the net

earnings of the cooperative from business done with or for its

patrons and that is based upon the quantity or value of business

done with or for the patron, under a preexisting obligation to

pay such amount.   Sec. 1388(a); Buckeye Countrymark, Inc. v.

Commissioner, supra at 555.
                               - 28 -

       Although patronage dividends are deductible by the

cooperative, the patron must include the amount of any patronage

dividend in income.    Sec. 1385(a)(1).   Accordingly, when income

from the cooperative's business is distributed as a patronage

dividend, the cooperative and its patrons pay only "a single

current tax with respect to the income of the cooperative, either

at the level of the cooperative or at the level of the patron."

S. Rept. 1881, 87th Cong., 2d Sess. 111 (1962), 1962-3 C.B. 707,

822.

       However, nonexempt cooperatives, such as petitioner, are

taxed like ordinary C corporations on business not conducted with

patrons.    Gold Kist Inc. v. Commissioner, supra at 708.

"Consequently, income from nonpatronage business is taxed to the

cooperative, and, if the balance is distributed to patrons, the

income is taxed again to the patrons."     Id.

       Petitioner purchases products from vendors and resells the

products to member and nonmember stores.    Petitioner profits from

its sales.    The profit from sales to nonmember stores is

allocated to petitioner's retained earnings.     However, profit

from business conducted with patrons is treated differently.

       As a cooperative, petitioner can distribute the profit it

earns from patronage business to the shareholders who own the

member stores and claim a deduction for this amount.     Sec.

1382(b).    Thus, income from cooperative activities will be
                                - 29 -

subject to a single level of tax, assuming the shareholders

include the patronage distributions in income.     Gold Kist Inc. v.

Commissioner, supra at 714.    Petitioner purchased products from

vendors and Western and resold them to member and nonmember

stores for a profit.    Ordinarily, petitioner would distribute the

patronage income to the shareholders who own member stores and

retain the nonpatronage income.

     Petitioner asserts that the cash it provided to the vendors

at the annual food show from check transactions and promotional

accounts should not be included in its income because it held

these funds as a nontaxable intermediary.    Respondent argues that

this cash was income to petitioner, and that the food show cash

payments to members were merely part of a scheme to bypass the

patronage dividend rules by way of the vendors.    To resolve this

issue, we must examine the facts and circumstances of the case.

Angelus Funeral Home v. Commissioner, 47 T.C. at 395; Seven-Up

Co. v. Commissioner, supra at 977;

     The economic substance of a transaction, rather than the

form in which it is cast, is controlling for Federal income tax

purposes; thus, courts may pierce the form of a transaction and

tax the substance.     Griffiths v. Helvering, 308 U.S. 355, 356-357

(1939); Gregory v. Helvering, 293 U.S. 465, 469 (1935).    The

underlying philosophy of the "substance over form" doctrine is to

prevent taxpayers from attempting to subvert the taxing statutes
                                - 30 -

by relying upon mere legal formality.     Mississippi Valley

Portland Cement Co. v. United States, 408 F.2d 827, 833 (5th Cir.

1969); Major v. Commissioner, 76 T.C. 239, 246 (1981).

     Petitioner claims nontaxable intermediary status, noting

that it had no part in determining the amount of cash vendors

distributed at the food shows.     We disagree.   Petitioner arranged

the food shows and compiled the food show book.     The food-show

book set forth the product price promotions available at the

show.    Vendors submitted their proposed product price promotions

to petitioner, and petitioner determined whether the product

would be included in the show.     There was an incentive to make

the promotions attractive, because the promotions were either

accepted or declined by petitioner; there was no negotiating

after the proposal was submitted.     The control petitioner

maintained over which products would be available at the show,

combined with the vendors' need to sell at the food show, ensured

that the product price promotion would be economically

attractive.    Thus, petitioner played a significant role in

determining the promotional allowances provided at the food

shows.

     With respect to the check transactions, petitioner claims it

merely provided a check-cashing service, receiving vendors'

checks, cashing the checks, and returning the checks to the

vendors.    We disagree.   Vendors made the checks payable to
                              - 31 -

petitioner.   Petitioner cashed these checks at its bank, and it

returned the cash to the vendors for distribution to the member

stores at the food show.   Petitioner also provided the vendors

with cash from the promotional accounts.   In both instances,

petitioner required the vendors to sign for the cash received,

and, most importantly, it also required any unused cash to be

returned to it at the end of the food show.    This was not a

check-cashing service.   Unlike a check-cashing service,

petitioner ensured that the check proceeds were either paid to

its shareholders or returned to it.

     Through the food-show book tear strips, petitioner knew the

exact amount of product price promotion distributed at the show,

as the tear strips indicated the product sold and the product

price promotion given by the vendor.   Petitioner destroyed these

records.

     Petitioner concedes that the $60,000 and the $100,000 checks

it received from Western are gross income.    Petitioner converted

these Western checks into cash and gave the cash to Mr. Clawson

to distribute to the member stores at the food show.    Although

petitioner kept records showing who received funds from Mr.

Clawson, petitioner destroyed these records.

     Mr. Clawson distributed the Western cash in the same manner

that the other vendors distributed their food-show cash--he

provided product promotion cash allowances.    For example, if a
                              - 32 -

Western product had a show allowance of a dollar a case, and the

member store bought 100 cases, then he would give the member

store $100.

     Petitioner's actions with respect to the Western money

reveal the substance of the food-show cash disbursements.

Petitioner was distributing its money to its member stores, and

hence its shareholders, and the distributions were based on the

amount of product purchased, or business done, by the

shareholder.   This is the essence of a patronage dividend.

However, rather than treat these distributions as patronage

dividends, where deductibility would be conditioned on the

distributions' meeting certain statutory requirements, petitioner

merely excluded the amounts from income, achieving the same tax

effect as a patronage dividend (provided the shareholders

included the cash in their income).    Moreover, the use of cash

and destruction of records invite suspicion that there was no

intent that the income be reported on any level.

     The vendors, not petitioner, were conduits with respect to

the food show cash transactions.   Petitioner was not a nontaxable

intermediary with respect to the food show cash disbursements

arising from the promotional accounts.    Ford Dealers Advertising

Fund, Inc. v. Commissioner, 55 T.C. 761 (1971).    Similarly, as

for the food show cash disbursements arising from the check-

cashing transactions, petitioner exercised dominion and control
                                - 33 -

over these funds, as evidenced by the return of any "unused"

cash.   Thus, these amounts must also be included in petitioner's

income.     See, e.g., North Am. Oil Consol. v. Burnet, 286 U.S.

417, 424 (1932); Ford Dealers Advertising Fund, Inc. v.

Commissioner, supra; Latimer v. Commissioner, 55 T.C. 515, 520

(1970).10    Accordingly, we sustain respondent's determination.

Issue 3. Section 162 Deduction

     Petitioner argues that, if the amounts distributed to the

shareholders at the 1989 and 1990 food shows from the promotional

accounts and check-cashing transactions are includable in its

income, the difference between the funds received from Western,

which petitioner concedes are income, and those returned by Mr.

Clawson at the end of the respective food shows are deductible

business expenses incurred by petitioner.    Petitioner asserts

that these amounts were paid for the purpose of promoting the

success of the food shows, and therefore are deductible under

section 162.    Respondent argues that such a deduction is not

allowable.    Petitioner bears the burden of proof on this issue.

Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84

(1992).



10
     Petitioner cannot substantiate a patronage dividend
deduction for the amounts distributed at the food show, because
it has destroyed the records that documented the products
purchased, the payments made, and the shareholders who received
the payments. Sec. 1388.
                              - 34 -

     In pertinent part, section 162(a) provides:   "There shall be

allowed as a deduction all the ordinary and necessary expenses

paid or incurred during the taxable year in carrying on any trade

or business".   To qualify for deduction under section 162(a), an

item must (1) be paid or incurred during the taxable year, (2) be

for carrying on any trade or business, (3) be an expense, (4) be

a necessary expense, and (5) be an ordinary expense.   INDOPCO,

Inc. v. Commissioner, supra at 85.

     Mr. Clawson received $60,000 and $100,000 from petitioner to

distribute on petitioner's behalf at the 1989 and 1990 food

shows, respectively.   Petitioner provided bookkeeping entries

that indicate that Mr. Clawson distributed $35,616 and $82,958 to

representatives of the member stores at the 1989 and 1990 food

shows, respectively.   In addition, Mr. Clawson testified that he

distributed such money to the shareholders of the member stores.

Mr. Clawson indicated that he made the cash payments to encourage

petitioner's shareholders to purchase Western products from

petitioner.   We hold that petitioner has substantiated its

entitlement to a deduction for the amounts distributed by Mr.

Clawson at the 1989 and 1990 food shows.   Associated Milk

Producers, Inc. v. Commissioner, 68 T.C. 729 (1977); sec. 1.162-

1(a), Income Tax Regs.11


11
     On brief petitioner did not argue that food show cash
                                                   (continued...)
                             - 35 -

     Since we sustained respondent's income determination with

respect to the promotional accounts and the food show

disbursements, we do not need to address her remaining argument.

     To reflect the foregoing,

                                      Decision will be entered

                                 under Rule 155.




11
 (...continued)
payments made by vendors other than Mr. Clawson were deductible;
accordingly, petitioner has conceded this issue. Cluck v.
Commissioner, 105 T.C. 324, 325 n.1 (1995); Money v.
Commissioner, 89 T.C. 46, 48 (1987). In any event, we would find
that petitioner has not substantiated its entitlement to such a
deduction, because it destroyed the records associated with such
disbursements and provided no other credible evidence
demonstrating its entitlement to deduct such amounts. Sec. 6001;
sec. 1.6001-1(a), Income Tax Regs.
