                         T.C. Memo. 1996-539



                       UNITED STATES TAX COURT



      S. CLARK JENKINS AND MARY P. JENKINS, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 20718-94.              Filed December 12, 1996.



     Randolph G. Abood, for petitioners.

     Mary Ann Amodeo and Louis A. Ramunno, for respondent.




             MEMORANDUM FINDINGS OF FACT AND OPINION

     CLAPP, Judge:    Respondent determined deficiencies in

petitioners' Federal income taxes as follows:

               Year                  Deficiency

               1990                   $3,100
               1991                    9,329
                                   2

       After concessions by the parties, the issues for decision

are:

       (1) Whether payments made to North Carolina and Virginia

resulting from deficiencies in fertilizer products are deductible

ordinary and necessary business expenditures under section 162(a)

or nondeductible fines or penalties under section 162(f).        We

hold that the payments are deductible ordinary and necessary

business expenditures under section 162(a).

       (2)   Whether petitioners have substantiated amounts greater

than the amounts conceded by respondent.      We hold that they have

not.

       All section references are to the Internal Revenue Code in

effect for the years in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure, unless otherwise

indicated.

                           FINDINGS OF FACT

       Some of the facts are stipulated and are so found.   We

incorporate by reference the stipulation of facts and the

attached exhibits.

       Petitioners were residents of Tarboro, North Carolina, when

the petition was filed.    S. Clark Jenkins (petitioner) owned 50

percent of W.S. Clark & Sons, Inc. (WSC), an S corporation.        The

dispute in this case stems from amounts paid by WSC to North

Carolina and Virginia resulting from deficiencies in fertilizer

products and deducted as ordinary and necessary business
                                   3

expenditures.   The tax consequences passed through to petitioner

as a shareholder of WSC.

     WSC is engaged in the business of producing and supplying

fertilizers, agricultural chemicals, seeds, and other

agricultural products for use by farmers.       WSC distributes its

products to retail farm centers, wholesale distribution centers,

and independent commission agents.       The dispute in this case

relates to WSC's fertilizer operations.

     During the years at issue, WSC owned and operated fertilizer

production facilities in North Carolina and Virginia.         It

conducted most of its business in North Carolina.       WSC

distributes most of its fertilizer in bulk; i.e., by the

truckload.

     Fertilizer primarily consists of three active ingredients:

Nitrogen, phosphate, and potash.       Fertilizer also contains

smaller amounts of other nutrients known as micronutrients, as

well as inactive ingredients.   Farmers or other purchasers select

the concentration of the three fertilizer ingredients depending

on their particular needs.   Soil conditions, the type of crop

being planted, the expected weather conditions, and price may

each influence the farmer's selection of fertilizer.       For

example, a corn farmer may require fertilizer in the mixture of

5-15-30 (which is 5 percent nitrogen, 15 percent phosphate, and

30 percent potash); a soybean farmer may require fertilizer in

the mixture of 3-9-27.
                                  4

     WSC manufactures fertilizer using two methods:      A blending

method and an ammoniation method.     In the blending method, the

separate ingredients of fertilizer are purchased from large

mining companies and nitrogen producers.     The fertilizer

ingredients are poured in bulk form into a steel receptacle and

then blended through a circular mixing motion.     The farmer's

specifications determine the concentration of each fertilizer

ingredient in a particular blend.

     In the ammoniation method, the fertilizer ingredients are

mixed through a heat reaction involving ammonia, superphosphate,

and sulphuric and/or phosphoric acid.     The solution is heated to

a semiliquid.    As the solution is slowly cooled, the final

product forms as a pellet.    The pellets are removed from the

solution, dried, and packaged.

     A fertilizer is deficient when it contains less of a

particular ingredient than guaranteed by the manufacturer.

Fertilizer companies expect that some of their fertilizer will be

deficient in at least one category of the three primary

ingredients.    Segregation, the most common source of

deficiencies, affects both types of fertilizer manufacture.

     Segregation develops from particle-size differences among

the fertilizer ingredients.    The particle-size differences cause

the particles not to mix properly, and segregation results.       The

entire batch of fertilizer may have the proper percentages of the

three active ingredients, but a test sample taken from the batch
                                  5

may vary due to segregation.    Density differences among the

respective particles do not exacerbate segregation; particle size

is the determinative factor.    For this reason, a fertilizer

manufacturer will attempt to purchase and then blend ingredients

that have a similar particle size.

     Segregation can be reduced but not eliminated.    One method

used to reduce segregation is purchasing the separate fertilizer

ingredients on the basis of size guide number (SGN).    SGN is a

method of measuring the average size of the particles of the

particular fertilizer ingredient being purchased.     The same SGN

for each of the three primary fertilizer ingredients does not

assure a uniform particle size in each of the three primary

ingredients, since actual sizes among the three average sizes may

be significantly different.

     The North Carolina and Virginia legislatures have enacted

legislation to regulate commercial fertilizer manufacturers

operating in their States.    The North Carolina Commercial

Fertilizer Law of 1977, N.C. Gen. Stat. secs. 106-655 through

106-677, as amended through 1993, is substantially the same as

the law in effect in North Carolina during the taxable years in

issue.   N.C. Gen. Stat. sec. 106-656 provides that its purpose

"shall be to assure the manufacturer, distributor, and consumer

of the correct quality and quantity of all commercial fertilizer

sold in this State".   The Virginia Commercial Fertilizer Law, Va.
                                 6

Code Ann. sec. 3.1 (Michie 1994), is substantially the same as

the North Carolina fertilizer law for purposes of this case.

     In 1990 and 1991, WSC paid $43,809 and $44,876,

respectively, to the North Carolina Department of Agriculture

pursuant to the assessment of penalties for violation of N.C.

Gen. Stat. sec. 106-665.   In 1991, WSC paid $2,057 to the

Virginia Department of Agriculture pursuant to the assessment of

penalties for violation of an analogous provision of the Virginia

fertilizer law.

     The relevant portions of N.C. Gen. Stat. sec. 106-665 may be

summarized as follows:

     (a)   When making an administrative determination as to

whether a fertilizer is deficient in plant food, the commissioner

of agriculture (commissioner) shall be guided solely by the

official sample taken by an authorized agent and in the manner

prescribed by statute;

     (b)   if the analysis shows that any commercial fertilizer

falls short of the guaranteed nitrogen, phosphate, or potash,

then a penalty of three times the value of the deficiency shall

be assessed if the deficiency exceeds the investigational

allowance; and

     (c)   all penalties assessed under N.C. Gen. Stat. sec. 106-

665 shall be paid to the consumer of the lot of fertilizer; if

the consumer cannot be found, the amount of the penalty assessed

shall be paid to the commissioner, who shall deposit the same
                                  7

with the State treasurer as custodian for the department of

agriculture fund.   The sums that have been deposited with the

State treasurer payable to the consumer shall not be subject to

claim by the consumer after 12 months from the date of

assessment.

     The "investigational allowance" allows for variations in

fertilizer sampling, handling, and laboratory analysis.   If a

deficiency exceeds the investigational allowance, then the

penalty is assessed on the entire deficiency.

     The intent of the statute is to reimburse the consumer for

the cost of the deficient fertilizer ingredient, which the farmer

paid for but never received, and the lower crop production that

results from the deficiency in the fertilizer.

     Thus, under N.C. Gen. Stat. sec. 106-665, if a fertilizer is

deficient in one or more fertilizer ingredients from the amount

requested by, and guaranteed to, the customer/farmer, then a

penalty is imposed on the manufacturer.   The penalty under N.C.

Gen. Stat. sec. 106-665 is calculated on the amount and relative

value of the deficient product.   For example, for 25 tons (2,000

pounds per ton) of 10-10-10 fertilizer (10 percent nitrogen, 10

percent potash, and 10 percent phosphate) which contains only 8

percent nitrogen, the penalty is calculated as follows:   the

fertilizer is guaranteed to contain 200 pounds of nitrogen per

ton (i.e., 2,000 pounds x 10 percent), but it contains only 160

pounds of nitrogen (i.e., 2,000 pounds x 8 percent).   As a
                                  8

result, there is a deficiency of 40 pounds per ton (200 pounds

minus 160 pounds).   Assuming the relative value of nitrogen is 28

cents per pound, the penalty will equal 40 pounds x 28 cents x

3 = $33.60 per ton x 25 tons = $840.    The fertilizer commissioner

determines and publishes annually the values per pound of each of

the primary ingredients of fertilizer.

     Fertilizer inspectors from the departments of agriculture of

North Carolina and Virginia typically visit a fertilizer

manufacturer unannounced to obtain samples of fertilizer for

testing.   Once on the site, they randomly collect official

samples of fertilizer.   The inspectors collect samples of the end

product only; i.e., the mixed fertilizer; they do not take

samples of the separate ingredients of the mixed fertilizer.    The

inspectors place the samples in containers that are marked and

registered, and they maintain a chain of evidence with all

official samples.    The official samples are taken to a testing

facility, where they are tested for conformity with the

percentages guaranteed by the fertilizer manufacturer.    The

testing facility reports the test results to the fertilizer

administrator, and copies of the results are sent to the

fertilizer manufacturer.    The fertilizer manufacturer is allowed

2 weeks to comment on the test results.    If a deficiency exists

that gives rise to a penalty, then an assessment letter is mailed

to the manufacturer at the end of 2 weeks.    The assessment letter

contains the amount of the penalty imposed for a violation.     If
                                   9

the ultimate consumer of the deficient fertilizer can be

identified, the penalty is paid to the consumer.

     If the ultimate consumer cannot be identified, the penalties

are paid to the State department of agriculture.     Often the

ultimate consumer cannot be identified because most fertilizer

samples are taken from dealer storage, and the dealers do not

record who purchased a particular batch of stored fertilizer.

Thus, most penalties are paid to the State department of

agriculture.

     The departments of agriculture in North Carolina and

Virginia test approximately 10 percent of the fertilizer sold by

each fertilizer manufacturer.     However, if a fertilizer

manufacturer is consistently below standard, the department of

agriculture will test a greater percentage of that manufacturer's

fertilizer.

                                OPINION

     Section 162(a) provides that taxpayers may deduct all

ordinary and necessary trade or business expenses.    Subject to

section 162(f), respondent concedes that the payments at issue

meet the requirements of section 162(a) as deductible business

expenses.   The payments were normal, usual, and customary, and

they stem from an activity ordinarily to be expected from WSC and

other fertilizer manufacturers.     Commissioner v. Heininger, 320

U.S. 467, 471 (1943); Deputy v. Dupont, 308 U.S. 488, 495 (1940).

The payments were appropriate and helpful also for the
                                 10

development of WSC's business.   Commissioner v. Tellier, 383 U.S.

687, 689 (1966).

     The real dispute in this case centers on section 162(f),

which provides that no deduction shall be allowed under section

162(a) for any "fine or similar penalty paid to a government for

the violation of any law."   The regulations provide that, for

purposes of section 162(f), a "fine or similar penalty" includes

an amount paid as a civil penalty imposed by a Federal, State, or

local law.   Sec. 1.162-21(b)(1)(ii), Income Tax Regs.

     Section 162(f) disallows deduction of civil penalties

"'imposed for purposes of enforcing the law and as punishment for

the violation thereof'", and yet some payments, although labeled

"penalties", remain deductible if "'imposed to encourage prompt

compliance with a requirement of the law, or as a remedial

measure to compensate another party'".    Huff v. Commissioner, 80

T.C. 804, 824 (1983) (quoting Southern Pac. Transp. Co. v.

Commissioner, 75 T.C. 497, 652 (1980)).   Where the law serves

both a remedial and a punitive purpose, then we must determine

which purpose the payments in question were designed to serve.

S & B Restaurant, Inc. v. Commissioner, 73 T.C. 1226, 1232

(1980).

     The proper inquiry is the purpose which the statutory

penalty is to serve, as opposed to the type of conduct which

gives rise to the violation resulting in the penalty.    Southern

Pac. Transp. Co. v. Commissioner, supra at 653.
                                 11

     The characterization of a payment for purposes of section

162(f) depends on the origin of the liability giving rise to it.

Bailey v. Commissioner, 756 F.2d 44, 47 (6th Cir. 1985); Middle

Atl. Distribs. v. Commissioner, 72 T.C. 1136, 1144-1145 (1979).

     Each party provided an expert witness to assist the Court in

understanding the workings of the North Carolina Department of

Agriculture and the administration of the North Carolina

commercial fertilizer law.

     Petitioner's expert witness, James R. Stevens (Stevens),

developed his expertise during his 41 years of service with the

North Carolina Department of Agriculture.    He began his career in

1950 as a temporary fertilizer inspector.    He was promoted to

chief fertilizer inspector in 1955 and promoted to feed,

fertilizer, and pesticide inspector supervisor in 1965.    In 1974,

Stevens was promoted to fertilizer administrator, and he remained

in that position until his retirement in December 1991.    Stevens

currently works as a consultant to the fertilizer industry.

     Respondent's expert witness, Peter T. Hight (Hight),

received a bachelor of science degree in horticulture in 1979 and

a master's degree in crop science in 1986, both from North

Carolina State University.    Hight has worked in an agriculture-

related field since 1980.    From March 1980 through 1987, Hight

served as an agriculture extension agent, conducting numerous

field investigations on plant disease and plant nutritional and

insect problems.   From January 1988 through October 1991, Hight
                                12

served as an agronomist for the North Carolina Department of

Agriculture.   In November 1991, Hight succeeded Stevens as

fertilizer administrator for the North Carolina Department of

Agriculture, a position he held until October 1994.

     Both experts were credible and helpful witnesses.    They gave

parallel testimony regarding the fertilizer industry and

administration of the fertilizer laws.    They agreed in nearly

every material aspect of this case except the legislative purpose

for the penalty payments at issue.

     Both experts agreed that segregation is the primary factor

leading to deficient fertilizer, and they also agreed that

deficiencies can be reduced but not eliminated.    The experts

agreed that there are two losses to a farmer when the farmer

purchases a deficient fertilizer that is applied to the farmer's

crop.   The first loss to the farmer is the cost of the deficient

fertilizer ingredient, which the farmer paid for but never

received.   The second loss is the farmer's reduced yield at

harvest caused by the deficient fertilizer.    They agreed that the

second loss, reduced yield at harvest, is nearly impossible to

measure, since crop yield is dependent on numerous factors.

     The experts' opinions diverge when it comes to the purpose

of the penalty payments at issue.    Stevens opined that the

purpose of the penalty for deficient fertilizers is to compensate

the user for any loss the deficient fertilizer has caused.     Hight

opined that the purpose of the penalty for deficient fertilizers
                                13

is to punish and deter fertilizer manufacturers who fail to

comply with the fertilizer laws.

     We are not bound by the opinion of an expert witness.     We

will accept or reject expert testimony when, based on the record,

it is appropriate to do so.   Estate of Newhouse v. Commissioner,

94 T.C. 193, 217 (1990).   We may choose to accept the opinion of

one expert in its entirety, Buffalo Tool & Die Manufacturing Co.

v. Commissioner, 74 T.C. 441, 452 (1980), or we may be selective

in the use of any portion of that opinion; Seagate Technology,

Inc. & Consol. Subs. v. Commissioner, 102 T.C. 149, 186 (1994).

     We are satisfied that the payments at issue were designed to

compensate the consumer of the deficient fertilizer.    The North

Carolina fertilizer law provides:    "All penalties assessed under

this section shall be paid to the consumer of the lot of

fertilizer represented by the sample".    N.C. Gen. Stat. sec. 106-

665(c).   The Virginia fertilizer law provides:   "If the analysis

shows that the fertilizer is deficient * * * then an assessment

* * * shall be paid to the consumer by the guarantor."    Va. Code

Ann. sec. 3.1-106.13.A (Michie 1994).    The quoted language

indicates that the respective State legislatures intended to

compensate the consumer of the deficient fertilizer.

     The two-step method used to calculate the penalty also

supports the conclusion that the payment to the consumer is

remedial.   Each step of the calculation accounts for a separate

loss to the consumer.   First, the value of the deficient
                                 14

fertilizer ingredient is calculated.   This calculation accounts

for the amount of fertilizer ingredient paid for but never

received by the consumer.   Second, the value of the deficient

fertilizer ingredient is multiplied by a factor of 3 (2 in

Virginia).   We conclude that the legislatures intended this

calculation to account for the reduced crop yield to the

consumer, despite the fact that reduced crop yield may be

difficult, if not impossible, to measure.   In so doing, the

respective legislatures were attempting to compensate for the

consumer's actual loss.   See Middle Atl. Distribs. v.

Commissioner, 72 T.C. at 1145.

     Respondent argues that the payments at issue had no, or a

negligible, compensatory element because the vast majority of the

payments were made to the respective States and not the consumer.

We do not find respondent's argument persuasive.   The inability

of the departments of agriculture to identify the consumer of the

deficient fertilizer and the difficulty in effectuating the

legislation does not alter the legislative intent.

     Respondent relies on specific provisions of the fertilizer

law to argue that the payments in question were designed to

enforce the law and to punish its violation.   Respondent cites

the North Carolina legislature's statement that "it is in the

public interest that the State regulate activities" of commercial

fertilizer companies.   N.C. Gen. Stat. sec. 106-672 (1993).

Respondent also highlights the commissioner of agriculture's
                                15

authority under various other sections of the fertilizer law in

an attempt to show a law enforcement purpose.    However, the

payments at issue in this case stem from N.C. Gen. Stat. sec.

106-665 and Va. Code Ann. Sec. 3.1-106.13 (Michie 1994).    We need

not, and do not, decide the purposes of any other sections of the

fertilizer laws.

     Respondent argues that the legislature contemplated that a

separate civil action for damages would be the compensatory

remedy for the consumers of deleterious fertilizers.    Respondent

reasons that since this compensatory remedy exists, the payments

at issue are not designed to compensate the consumer of the

deficient fertilizer.   We do not agree.   N.C. Gen. Stat. sec.

106-665 applies to the sales of large and small quantities of

fertilizer.   The experts in this case testified that the reduced

crop yield from a deficient fertilizer is difficult to establish.

We consider it likely that this difficulty also would hamper a

plaintiff's ability to prove damages in a civil case.    Thus, we

do not agree that a civil action for damages is "the primary

compensatory or remedial mechanism" in the fertilizer law.      See

True v. United States, 894 F.2d 1197, 1205-1206 (10th Cir. 1990)

(stating that provision in the Federal Water Pollution Control

Act authorizing Government to recoup oil cleanup costs was

primary compensatory mechanism).     If the legislature considered a

civil action for damages to be the primary compensatory remedy,

then we would see no purpose for the legislative edict that the
                                16

payments pursuant to N.C. Gen. Stat. sec. 166-665 be made to the

consumer.   The legislature likely anticipated that the payments

pursuant to N.C. Gen. Stat. sec. 166-665 would provide the

consumer a modicum of relief in circumstances where the amounts

involved would not justify the cost of a civil action for

damages.

      Respondent attempted to discredit Stevens using the

fertilizer inspectors manual (inspectors manual) published by the

Association of American Plant Food Control Officials (AAPFCO).

North Carolina and Virginia are members of AAPFCO.    Stevens

edited the inspectors manual, and he authored a large portion of

it.   The inspectors manual instructs inspectors to treat the

official fertilizer samples as evidence in a crime.     Respondent

seems to argue that since the inspectors are told to treat the

fertilizer samples as evidence in a crime, then the fertilizer

inspectors must be investigating a crime.   Respondent reasons

that the payments at issue are punishment for a criminal act.

Respondent overlooks the several categories of conduct dealt with

in the fertilizer laws.   Some acts are punishable as

misdemeanors.   See N.C. Gen. Stat. sec. 106-668.   Thus,

instructing the fertilizer inspectors to treat every sample as

evidence in a crime seems logical since, at the time the sample

is taken, the inspector is unaware of which, if any, provision of

the fertilizer law has been violated.
                                 17

     Petitioners have offered no evidence to support their

argument that WSC paid amounts greater than those conceded by

respondent.   We will not guess as to any additional amount that

WSC could have deducted.   See Lerch v. Commissioner, 877 F.2d

624, 628 (7th Cir. 1989), affg. T.C. Memo. 1987-295.

     To reflect the foregoing,

                                           Decision will be entered

                                      under Rule 155.
