Opinion
Docket No. 31911.
Filed January 13, 1956.
Petitioner held entitled to relief under section 722 (b) (4) of the Internal Revenue Code of 1939, and a constructive average base period net income determined.
Alex M. Hamburg, Esq., for the petitioner.
Martin D. Cohen, Esq., for the respondent.
This proceeding involves claims for excess profits tax relief under section 722, Internal Revenue Code of 1939, for the years 1942, 1943, and 1944 in the respective amounts of $35,584.55, $53,433.60, and $60,000. Petitioner's claims are based on section 722 (b) (4) of the Internal Revenue Code.
As our findings of fact we adopt, in substance, the proposed findings submitted by the hearing commissioner who took the evidence in the case.
FINDINGS OF FACT.
Petitioner is a corporation with its principal office and place of business located in Brooklyn, New York. Its returns for the years involved were filed with the collector of internal revenue for the first district of New York.
Petitioner is engaged in the business of manufacturing folding paper box containers and sundries, such as wrapping paper and twine, which it sells to jobbers and others. It was organized in 1919 to take over a business that had been in operation since 1905.
At all times here material, petitioner was owned and controlled by a family group. The 750 shares of outstanding capital stock were held during 1936, 1937, and until July 30, 1938, as follows:
Name Number of shares
Aaron Blum, president and secretary ......... 411 Morris Blum, a brother, vice president ...... 55 Thomas B. Blum, a brother ................... 54 Barney Raftenberg, brother-in-law ........... 100 Carl Blum, son of Thomas B. Blum ............ 55 Julius K. Funston, son-in-law of Barney Raftenberg ........................... 75
On July 30, 1938, Morris and Aaron Blum, under circumstances hereinafter more fully described, transferred all of their shares to others within their family group.
For many years, petitioner's business consisted principally of manufacturing folding cardboard boxes which were used by laundries and by merchants for packing suits, dresses, and other such commodities, as well as certain foods. Some of these boxes were made to customers' specifications and were referred to as specials. Later, specials came to mean boxes containing colors and printed matter, to be used for merchandising purposes. The boxes were all cut from sheets of paperboard and creased for folding on machines described as converted presses.
During and for some time prior to the base period, there was a growing demand in the folding paper box trade for specials designed for displaying merchandise in retail stores. These specials were of various sizes and shapes. Some were in two or more colors and contained printing of many different types. They sold for much higher prices than the stock boxes. The younger, more progressive faction of petitioner's stockholders wanted to expand petitioner's line of specials and modernize the plant, while the elder Blums, Aaron and Morris, opposed them. The manufacture of specials of this kind on a large scale required precision cutting, coloring, and printing, for which petitioner was not then equipped.
The dissension among the stockholders and officers continued until finally Aaron and Morris Blum agreed to withdraw from the business, and on July 30, 1938, as mentioned above, they transferred their stockholdings to others. From that date and throughout the remainder of 1938 and 1939, petitioner's stock was held as follows:
Name and title (if any) Number of shares
Thomas B. Blum (Theodore Blum), president ...... 112 1/2 Barney Raftenberg, treasurer ................... 112 1/2 Julius K. Funston, assistant secretary ......... 75 Carl Blum, vice president ...................... 150 Matthew M. Raften, secretary ................... 150 Maurice Blum, assistant treasurer .............. 112 1/2 Harry H. Blum .................................. 18 3/4 Martin Blum .................................... 18 3/4
Under the new management petitioner set about to expand and modernize its plant with the idea of increasing the proportion of specials to stock boxes manufactured, as well as the over-all production. It notified its agents and machinery dealers to be on the lookout for used machines of the types needed. It was petitioner's practice to buy good, used equipment whenever it could be found. In September 1938, petitioner set up an art department to design specials, and hired a full-time artist. It began negotiations for additional plant space, and on September 1, 1939, obtained occupancy under a 5-year lease of the entire basement of an adjoining building containing 23,500 square feet of floor space, at a rental of $4,800 a year. Petitioner's floor space up to that time was 43,000 square feet. The total rents paid by the petitioner amounted to $11,145.00 in 1936, $12,307.47 in 1937, $13,288.92 in 1938, and $15,926.01 in 1939.
With the additional floor space, petitioner rearranged its equipment for more efficient operation. It replaced some of its worn-out or obsolete machines with newer ones and acquired some additional equipment. The die department was enlarged and equipped with precision tools suitable for manufacturing dies for various types of specials. The following is a list of the major items of machinery acquired by petitioner and the cost in 1939 of each:
Type of machine Date acquired Cost
International folding and September 1939 ............ $4,417.50 gluing machine. Two-color Miehle Duplex November 1939 ............ } 10,000.00 cylinder printing press. } Miehle 5° special press September 1939 ............ } Following are the total amounts expended for machinery and production equipment by petitioner in each of the years 1936 to 1939, inclusive:Year Amount
1936 ............................... $2,700.00 1937 ............................... 8,191.99 1938 ............................... 3,752.78 1939 ............................... 17,085.47
An appraisal made of petitioner's plant equipment by Standard Appraisal Company, dated December 8, 1939, shows machinery and equipment of a total replacement value of $195,974 and a "sound value" — after depreciation — of $127,341, exclusive of cutting and creasing dies.
Petitioner's gross sales of boxes for the calendar year 1939 amounted to $507,469 of which $342,054 were special boxes. The other non-specials included boxes for clothing $106,957, laundry $15,605, cake $7,348, and shirt envelopes $35,504.
Petitioner's total net sales, gross profits, and net income (per revenue agents' reports) for the years 1922 to 1939, inclusive, and the compensation paid to its officers for the years 1936 to 1939, inclusive, were as follows:
Exclusive of reduction for prior year's loss.
The following tables show the percentage of the sales of specials to total sales, exclusive of sundries, for the month of March in each of the years 1938 and 1939, and a month-by-month comparison of specials to total sales in 1939:
Percentage of special Month of March box sales to total sales
1938 ...................................... 54.45 1939 ...................................... 66.57 per cent
Proportion 1939 (A) (B) of specials to Total sales Sales of total sales specials (B) ÷ (A) January ................ 35,034 24,530 70.02 February ............... 36,400 25,963 71.33 March .................. 39,277 26,146 66.57 April .................. 43,204 28,510 65.99 May .................... 35,970 24,331 67.64 June ................... 37,096 22,378 60.32 July ................... 34,538 24,487 70.90 August ................. 30,937 22,112 71.47 September .............. 51,428 35,203 68.45 October ................ 65,628 41,817 68.72 November ............... 52,787 35,323 66.92 December ............... 45,170 31,254 69.19 Petitioner's operating profits, or losses, after adjustments for capital gains and losses, were profits of $901.52 in 1936 and $3,283.43, in 1938, and losses for 1937 and 1939 in the respective amounts of $1,406.16 and $90.02.The following table shows petitioner's excess profits net income, excess profits credits based on invested capital, and excess profits tax liability, for the taxable years 1942, 1943, and 1944:
Year Excess profits Excess profits Excess profits net income credits liability 1942 .................... $62,368,47 $12,177.84 $40,671.57 1943 .................... 84,334,51 13,110.80 55,601.34 1944 .................... 97,493.44 14,825.49 62,131.09 Petitioner's average base period net income is an inadequate standard of normal earnings because of changes in management and productive capacity which occurred during the base period.A fair and just amount representing normal earnings to be used as a constructive average base period net income is $22,500.
The stipulated facts not specifically set out above are incorporated herein by this reference.
OPINION.
Petitioner seeks excess profits tax relief under section 722 (b) (4), Internal Revenue Code of 1939, for the years 1942, 1943, and 1944. It claims that its average base period net income is an inadequate standard of normal earnings because of changes which took place during the base period in its management, its products, and its capacity for production.
The facts, we think, clearly establish petitioner's qualification for relief under subsection (b) (4), both by reason of a change in management and a change in capacity for production. Whether there was also a sufficient change in the products manufactured by petitioner, that is, a change from the standard or stock boxes to specials, to afford independent grounds for relief, we need not decide. These changes were all so closely interrelated that they must be considered together in any reconstruction of normal base period earnings. See Victory Glass, Inc., 17 T.C. 381, and Bardons Oliver, Inc., 25 T.C. 504.
The change in management came about when Aaron and Morris Blum withdrew from the business and a new slate of officers and directors was installed to operate the business. The new management took over about the end of July 1938, and immediately set about to modernize and expand the business. Their principal aim was to increase the production of specials to meet the growing demand for boxes of that type. This required additional floor space and equipment. The old management had been opposed to this change. As a consequence of the change, there was a steady increase in the percentage production of specials over several years. The figures for the month of March, which were selected as representative of the full year's operations for comparative purposes, show an increase of specials from 54.45 per cent of total production in 1938 to 69.79 per cent in 1941. The production of specials requires the services of a full-time artist to design the boxes, more and better machinery for cutting and printing (particularly for the color printing), and more skilled labor than had been employed theretofore.
Petitioner's capacity for production was substantially increased by the expansion and modernization of its plant. In September 1939, it enlarged its floor space approximately 55 per cent, and in each of the years 1939 and 1940 it purchased additional production equipment at a cost of over $17,000. Its average yearly purchases of equipment for the 3 next preceding years was less than $5,000. Compare in this respect Farmers Creamery Co. of Fredericksburg, Va., 18 T.C. 241.
We do not consider it detrimental to petitioner's claims, as respondent argues, that it may have been required to make the changes which it made in order to maintain its competitive position in the industry. The statute imposes no conditions as to the underlying causes for the qualifying changes. It is the importance of the changes and their effect upon the taxpayer's independent business with which the statute is concerned.
The full effect of petitioner's base period changes, and particularly of the increase in plant capacity, was not realized by the end of the base period, so that the application of the push-back rule is required.
While, as we have said, petitioner's qualifications for relief because of base period changes have been established to our satisfaction, the evidence leaves considerable uncertainty as to what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income.
Petitioner contends that $50,492 is a fair and just amount representing normal base period earnings. To arrive at this figure petitioner increased its net sales for 1939 by approximately 20 per cent over actual 1939 net sales, under the 2-year push-back rule, and reconstructed its expenses for that year so as to yield a profit of approximately 7.88 per cent on such sales. The reconstructed 1939 profit is then adopted as the constructive average base period net income. Petitioner's actual average base period net income is $7,406.77. Its excess profits credits, computed under the invested capital method, are $12,177.84 for 1942, $13,110.30 for 1943, and $14,825.49 for 1944.
It is true, as respondent points out, that both the increase in net sales and the reconstructed expenses proposed by the petitioner, are based largely on conjecture. But as we have said, the statute calls for "a prediction and an estimate of what earnings would have been under assumed circumstances, an approximation when an absolute is not available and not expected." Victory Glass, Inc., supra.
The petitioner, in our opinion, has considerably overestimated its constructive base period earnings. After a careful evaluation of the evidence before us we have determined that $22,500 is a fair and just amount representing normal earnings to be used as a constructive average base period net income. While this amount is considerably greater than petitioner's profits for any of the prior years of its operations, we think that it is a conservative estimate of what might have been expected with a 2-year development of the base period changes.
There is no merit in respondent's argument that because petitioner's average base period net income was greater than its average for the preceding 18-year period, or for any interim period, it cannot claim that its business was depressed during the base period. Relief under subsection (b) (4) of section 722 is not predicated on a "depressed" base period income. That term is used only in subsections (2) and (3). Under subsection (b) (4), a taxpayer has first to meet the general requirements of subsection (a), that is, a taxpayer must show that the excess profits tax computed without the benefits of the relief provisions is "excessive and discriminatory." A taxpayer must show further that, as the result of having commenced business or changed the character of its business during or immediately prior to the base period, its average base period net income does not reflect the normal operation of the entire base period and is, therefore, an "inadequate standard" of normal earnings. It must show further what would be a fair and just amount representing normal base period earnings. We conclude that the facts adequately demonstrate that petitioner qualifies for relief.
Reviewed by the Special Division.
Decision will be entered under Rule 50.