Opinion
Docket No. 4424.
1947-04-24
HARRIS HARDWOOD COMPANY, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
H. F. Hinderer, C.P.A., for the petitioner. Edward L. Potter, Esq., for the respondent.
1. Petitioner expended $2,765.29 for grading and dirt fill in connection with 1940 flood damage and in erecting a levee to protect its plant from future floods. Held, no part of the expenditure is deductible as an ordinary and necessary business expense of 1941.
2. Held, petitioner has established its right to deduct a casualty loss in 1940 of $2,765.29.
3. Dividends under a group life insurance policy, issued in August 1934 and carried by petitioner for the benefit of its employees, were payable and received at the end of each policy year for the first nine years of the policy, except for the years 1935, 1936, 1939, 1942, and 1943. Held, the entire amount of the 1940 dividend is taxable for excess profits tax purposes in 1940 and petitioner is not entitled to apportion any part thereof to its 1939 taxable income; held, further, petitioner has failed to establish that any part thereof is attributable to prior or future years as required by section 721(b), I.R.C., and section 35.721-3, Regulations 112.
4. Certain deductions during the base period years for unemployment compensation payments, and dues and subscription expenses determined to be abnormal in amount and disallowed under section 711(b)(1)(J)(ii); interest deductions held not abnormal in amount.
Petitioner is entitled to an unused excess profits credit carryback from the year 1943. H. F. Hinderer, C.P.A., for the petitioner. Edward L. Potter, Esq., for the respondent.
Respondent determined deficiencies for the taxable years 1940 and 1941 as follows:
+--------------------------------------------------------+ ¦Nature of tax ¦1940 ¦1941 ¦ +---------------------------------+--------+-------------¦ ¦Income tax ¦$194.27 ¦* $2,230.67¦ +---------------------------------+--------+-------------¦ ¦Declared value excess profits tax¦58.69 ¦ ¦ +---------------------------------+--------+-------------¦ ¦Excess profits tax ¦1,148.80¦9,907.92 ¦ +--------------------------------------------------------+
FN* Overassessment.
The issues are (1) whether respondent erroneously treated as a capital expenditure the amount of $2,765.29 expended for grading and dirt full, which petitioner claims was an ordinary and necessary expense in 1941, or (2), in the alternative, whether 1940 income should be reduced by a casualty loss of equal amount from damages due to a flood; (3) whether respondent erroneously treated a group life insurance dividend in the amount of $1,483.56 as fully taxable for excess profits tax in 1940; (4) whether petitioner's base period net income should be adjusted under section 711(b)(1)(J)(ii) for abnormalities in (a) unemployment compensation taxes, (b) interest, and (c) dues and subscription expense; and (5) whether petitioner is entitled to an unused excess profits credit carry-back from the year 1943 of $22,271.21. Petitioner abandoned an allegation of error relating to group life insurance premiums.
FINDINGS OF FACT.
The petitioner is a Virginia corporation, organized in 1919. It is engaged in the business of manufacturing hardwood flooring, with its principal office in Roanoke, Virginia. Its income and excess profits tax returns were filed with the collector of internal revenue at Richmond, Virginia. The petitioner used the accrual method of accounting.
The manufacturing plant operated by petitioner consists of approximately 15 acres located at Roanoke, Virginia. The equipment and properties have a cost basis in excess of $200,000. The improvements consist of an extensive lumber yard, 6 dry kilns, a 2-story planing mill, warehouse, and office building, trackage, roads, and flooring machinery and equipment. The petitioner normally carries 3,000,000 to 5,000,000 feet of lumber in the yard, plus extensive warehouse inventories of finished stock. The plant has a frontage of approximately 2,700 feet on the banks of the Roanoke River.
On August 14, 1940, the Roanoke River flooded to a stage of 19 1/2 feet, compared with a normal stage of 3 feet at the company's plant. The flood put 8 feet of water into the dry kilns, more than 5 feet into the mill, and 4 feet into the boiler house. The flood currents washed out roads and trackage, damaged kilns, buildings, and machinery, floated away stacks of lumber up to several thousand feet, and damaged inventories extensively. Petitioner had no flood insurance.
Following the flood petitioner paid $2,765.29 for dirt and hauling costs. Of this amount approximately two-thirds was used to build a new river levee to prevent a repetition of the 1940 flood and the balance was used to replace washout damage to roads and trackage. The amount of $2,765.29 was charged on petitioner's books to 1940 expense and was taken as an expense deduction for income tax purposes in 1940. The inventory loss was absorbed into expense and is not in controversy. No other repair item is in controversy. Petitioner's 1940 and 1941 tax returns show deductions for repairs of $18,235.27 and $25,909.79, respectively.
In determining petitioner's 1941 tax liability respondent made six adjustments to its net income. The first adjustment was designated ‘(a) Capital expenditures $3,242.98.‘ This adjustment was explained as follows:
(a) Expenditures of this amount have been determined to be capital expenditures and not deductible from gross income. Section 19.24-2, Regulations 103.
Included in the disallowed expenditures is the amount of $2,765.29 expended in the construction of a levee to hold back flood water of the Roanoke River. The contention in your protest that this expenditures (sic) was a currently deductible expense and not a capital improvement has been denied.
Damage inflicted by the flood which was not repaired included settled piers and sagging roof and floor in the warehouse, crumbled retainer walls in kilns, garage floor which had to be replaced where flood waters had washed fill out from under it, and cracked wall in boiler house. The above damage did not prevent operation of the plant. The amount of the unrepaired flood damage at the end of 1940 was estimated to be at least $5,000. No deduction was claimed in the 1940 return for loss sustained from the flood. In 1940 petitioner sustained a casualty loss of $2,765.29 as a result of the flood.
During the taxable years and prior thereto petitioner carried a group life insurance policy, No. G-4628, with the Prudential Life Insurance Co. of America on the lives and for the benefit of its employees. This policy was issued on or about August 26, 1934. Petitioner paid all the premiums on the policy and was entitled to all dividends thereon in accordance with the following dividend provision of the policy:
Annually, during its continuance in force, the proportion of the divisible surplus accruing upon this policy shall be ascertained and apportioned by the Board of Directors and credited to this Policy at the end of the policy year as a dividend. Such dividend shall be (1) paid to the Employer in cash or (2) at the option of the Employer applied to the reduction of the premium then due, if any; or upon the written request of the Employer it may be (3) left to accumulate to the credit of the Policy with interest compounded annually at the rate of 3 1/2% plus such additional interest as the Company may declare on such funds and withdrawable at any time.
The only dividends received by petitioner to and including the year 1943 were $115.55 in the policy year ended 1937; $756.81 in the policy year 1938; $1,483.56 in the policy year 1940; and $621.01 in the policy year 1941. No dividends were received in 1935, 1936, 1939, 1942, or 1943.
The Federal Unemployment Compensation Act and the Virginia Unemployment Compensation Act became effective January 1, 1936. Without reflecting reductions in rates, due to state merit ratings, the Federal and the Virginia unemployment compensation rates were fixed at the following percentage rates applied to all compensation up to $3,000 per employee:
+------------------------------------------+ ¦Year ¦Virginia ¦Federal ¦Total ¦ +------------+---------+---------+---------¦ ¦ ¦Percent ¦Percent ¦Percent ¦ +------------+---------+---------+---------¦ ¦1936 ¦0.9 ¦0.1 ¦1.0 ¦ +------------+---------+---------+---------¦ ¦1937 ¦1.8 ¦.2 ¦2.0 ¦ +------------+---------+---------+---------¦ ¦1938 ¦2.7 ¦.3 ¦3.0 ¦ +------------+---------+---------+---------¦ ¦1939 to date¦2.0 ¦.3 ¦3.0 ¦ +------------------------------------------+
The unemployment compensation acts are administered by the several states, subject only to certain Federal restrictions and regulations. The Commonwealth of Virginia, in common with other states, established individual reserve accounts for each employer. Virginia followed a policy of charging against such reserves claims paid to unemployed persons who were former employees. Virginia established a merit-rating system granting lower rates to those employers whose reserves, by reason of steady employment and low labor turnover, reached certain standards. Petitioner qualified for the best merit rating in the first year that such rating applied. The ratings applied to petitioner during the years pertinent hereto were as follows:
+---------------------------------------------+ ¦Year ¦Virginia ¦Federal ¦Total ¦ +---------------+---------+---------+---------¦ ¦ ¦Percent ¦Percent ¦Percent ¦ +---------------+---------+---------+---------¦ ¦1936 ¦0.9 ¦0.1 ¦1.0 ¦ +---------------+---------+---------+---------¦ ¦1937 ¦1.8 ¦.2 ¦2.0 ¦ +---------------+---------+---------+---------¦ ¦1938-1940, incl¦2.7 ¦.3 ¦3.0 ¦ +---------------+---------+---------+---------¦ ¦1941 ¦1.0 ¦.3 ¦1.3 ¦ +---------------+---------+---------+---------¦ ¦1942 ¦1.0 ¦.3 ¦1.3 ¦ +---------------+---------+---------+---------¦ ¦1943 ¦1.0 ¦.3 ¦1.3 ¦ +---------------------------------------------+
Petitioner's unemployment compensation payments were substantially reduced by the merit-rating reduction rates. This reduction of rates resulted from reserves built up during the base period years, favorable labor relations, and low labor turnover. The favorable labor relations and low labor turnover continued unchanged through 1940, 1941, and 1942.
During the base period years and the taxable years petitioner's volume of business, gauged by lumber footage consumed, was as follows:
+------------------------------------------------------------+ ¦ ¦Feet ¦ ¦Feet ¦ +-------------------+----------+------------------+----------¦ ¦1936 ¦9,000,000 ¦1940 ¦10,000,000¦ +-------------------+----------+------------------+----------¦ ¦1937 ¦10,000,000¦1941 ¦15,000,000¦ +-------------------+----------+------------------+----------¦ ¦1938 ¦11,000,000¦1942 ¦11,000,000¦ +-------------------+----------+------------------+----------¦ ¦1939 ¦13,000,000¦ ¦_ ¦ +-------------------+----------+------------------+----------¦ ¦ ¦_ ¦Three year average¦12,000,000¦ +-------------------+----------+------------------+----------¦ ¦Base period average¦10,750,000¦ ¦ ¦ +------------------------------------------------------------+
The amounts of unemployment compensation tax paid (Federal and state) were as follows:
+--------------+ ¦1936¦$851.75 ¦ +----+---------¦ ¦1937¦2,463.00 ¦ +----+---------¦ ¦1938¦3,993.38 ¦ +----+---------¦ ¦1939¦4,541.03 ¦ +----+---------¦ ¦1940¦4,380.19 ¦ +----+---------¦ ¦1941¦2,497.52 ¦ +----+---------¦ ¦1942¦2,455.43 ¦ +----+---------¦ ¦1943¦2,473.34 ¦ +--------------+
The decrease in the amounts of unemployment compensation tax paid in 1941, 1942, and 1943 was due primarily to the reduction in rates.
The unemployment compensation payments were carried by the petitioner as a separate cost and expense classification in its accounting records and operating statements. Such payments were a new expense burden to every employer of eight or more persons throughout the United States. Payments into petitioner's reserve account from 1936 to 1940 at full statutory rates built up the reserve and created abnormal expenses in some of those years. Abnormal deductions for unemployment compensation payments under section 711(b)(1)(J)(ii), as limited by (K)(iii), are as follows:
+----------------------------------------------------------------+ ¦Excess profits taxable year¦ ¦ ¦ ¦ ¦ +---------------------------+------------------------------------¦ ¦Base period years ¦_ ¦ +---------------------------+------------------------------------¦ ¦ ¦1940 ¦1941 ¦1942 ¦1943 ¦ +---------------------------+-------+---------+--------+---------¦ ¦1936 ¦None ¦None ¦None ¦None ¦ +---------------------------+-------+---------+--------+---------¦ ¦1937 ¦None ¦None ¦$7.57 ¦None ¦ +---------------------------+-------+---------+--------+---------¦ ¦1938 ¦None ¦$1,498.86¦1,537.95¦$1,520.04¦ +---------------------------+-------+---------+--------+---------¦ ¦1939 ¦$160.84¦2,043.51 ¦2,085.60¦2,067.69 ¦ +----------------------------------------------------------------+
The abnormal deductions in the base period years were not a consequence of an increase in the gross income or a decrease in the amount of some other deduction during the base period years. The reduction in amount of the unemployment compensation payments was not a consequence of a change at any time in the type, manner of operation, size, or condition of the business engaged in by the taxpayer.
For the taxable years 1940 and 1941 petitioner reported deductions for taxes in the respective amounts of $10,099.49 and $10,635.47.
Petitioner's interest expense for the years 1932 to 1943, inclusive, was as follows:
+---------------+ ¦1932¦$2,731.06 ¦ +----+----------¦ ¦1933¦2,697.05 ¦ +----+----------¦ ¦1934¦1,903.47 ¦ +----+----------¦ ¦1935¦245.68 ¦ +----+----------¦ ¦1936¦391.30 ¦ +----+----------¦ ¦1937¦1,731.39 ¦ +----+----------¦ ¦1938¦2,096.80 ¦ +----+----------¦ ¦1939¦2,439.96 ¦ +----+----------¦ ¦1940¦1,758.73 ¦ +----+----------¦ ¦1941¦1,273.24 ¦ +----+----------¦ ¦1942¦874.92 ¦ +----+----------¦ ¦1943¦1,712.46 ¦ +---------------+
In 1935 petitioner retired all of its funded debt. All interest payments subsequent to 1935 were on amounts borrowed for carrying on the business. The reduction in interest expense after 1939 was due entirely to increases in working capital resulting from accumulated earnings left in the business. The reduction in interest expense was not the result of any decrease or change in any other expense classification. The decrease in interest expense was not a consequence of a change at any time in the type, manner of operation, size or condition of the business engaged in by the taxpayer.
Petitioner's expense for ‘dues and subscriptions‘ for the years 1932 to 1943, inclusive, was as follows:
+---------------+ ¦1932¦$1,452.80 ¦ +----+----------¦ ¦1933¦1,187.33 ¦ +----+----------¦ ¦1934¦940.03 ¦ +----+----------¦ ¦1935¦1,149.63 ¦ +----+----------¦ ¦1936¦819.16 ¦ +----+----------¦ ¦1937¦1,404.42 ¦ +----+----------¦ ¦1938¦1,627.33 ¦ +----+----------¦ ¦1939¦1,772.85 ¦ +----+----------¦ ¦1940¦816.13 ¦ +----+----------¦ ¦1941¦1,091.58 ¦ +----+----------¦ ¦1942¦862.76 ¦ +----+----------¦ ¦1943¦893.23 ¦ +---------------+
Approximately 90 per cent of petitioner's dues and subscriptions represented dues to the National Oak Flooring Manufacturers Association, computed on a variable rate per thousand of flooring shipments. Production and shipments were lower in the base period years than in the subsequent years. The National Oak Flooring Manufacturers Association is a service fund and not an advertising fund. The reduction in dues and subscription expense was due to a rate reduction; it was not a consequence of an increase in petitioner's gross income in the base period or a decrease in amount of some other deduction in its base period. The decrease in dues and subscription expense was not the result of any change in the type of business, manner of operation, size, or condition of the business. The abnormalities, under section 711(b)(1)(J)(ii), as limited by (K)(iii), in dues and subscription expense, are as follows:
+-----------------------------------------+ ¦Base year¦1940 ¦1941 ¦1942 ¦1943 ¦ +---------+-------+-------+-------+-------¦ ¦1936 ¦None ¦None ¦None ¦None ¦ +---------+-------+-------+-------+-------¦ ¦1937 ¦$124.37¦$124.37¦$124.37¦$124.37¦ +---------+-------+-------+-------+-------¦ ¦1938 ¦279.44 ¦279.44 ¦279.44 ¦279.44 ¦ +---------+-------+-------+-------+-------¦ ¦1939 ¦210.17 ¦210.17 ¦210.17 ¦210.17 ¦ +-----------------------------------------+
The petitioner's excess profits tax credit for 1943 was in excess of its taxable income. The amount of the carry-back credit from 1943 to 1941, as a result of that excess, is stipulated to be at least $15,748.79, plus whatever increase in the amount of the carry-back credit that may result from the determination of the issues here in controversy.
OPINION.
ARNOLD, Judge:
The first issue involves an expenditure of $2,765.29 which the respondent capitalized and which petitioner contends is a 1941 expense item. The testimony is specific that the $2,765.29 was charged as an expense item against 1940 income and deducted on petitioner's 1940 income tax return. Clearly petitioner is not entitled to deduct the expenditure in both taxable years as an expense item. The evidence does not convince us that petitioner is entitled to deduct any part of the $2,765.29 as an expense item chargeable against 1941 income.
The second issue is an alternative to the first.
It raises for the first time the question of whether petitioner is entitled to a loss deduction in 1940 under section 23(f) of the code. The pleadings, as shown in footnote 1, allege the amount of the loss sustained to be $2,765.29. There is no allegation that the loss was in excess of that amount. The petitioner contends in its brief that ‘ * * * damage existed in an amount greater than the first fill cost (i.e., $2,765.29) and the allowance of such damage would stand on its own basis and not as an alternative.‘ By this argument we understand petitioner to contend that, regardless of its allegation of error as to the amount of its 1940 flood damages, or lack of a proper allegation, it is entitled to deduct as a loss the amount of damages proved by the evidence adduced. Petitioner contends that it has proved damages to its permanent structures or improvements aggregating $5,300 or more. It offered the testimony of its superintendent at its Roanoke plant and its general superintendent, both of whom testified in detail with respect to the damages suffered by the various structures and improvements at petitioner's plant. The witnesses estimated that the aggregate cost of repairing and restoring the improvements to their former usefulness would be between $5,300 and $8,000. We have found from their testimony that the unrepaired flood damage to petitioner's plant at the end of 1940 was estimated to be at least $5,000. We are unable to find as a fact that petitioner sustained a loss by flood of $5,000.
Decision will be entered under Rule 50. The allegation in the petitioner reads as follows: ‘If said expenditure of $2,765.29 be not allowable as an ordinary and necessary expense of 1941, then 1940 income should be reduced by a casualty loss of equal amount by reason of the Roanoke River flood which occurred in that year and which made this expenditure necessary.‘
We are, however, convinced that petitioner sustained a loss from the flood and that no loss deduction has been claimed or allowed in determining its 1940 income tax liability. Our problem is to determine the amount of the loss. In determining the amount of the loss we must examine the evidence in the light of the limitation contained in the pleadings that the loss sustained was $2,765.29. We are convinced that at least this amount of loss was sustained. The testimony aforementioned and petitioner's 1940 tax return support this determination, the latter showing that petitioner's undepreciated cost of permanent structures was far in excess of the claimed loss. Considering all the facts and circumstances herein, we are of the opinion, and hold, that petitioner is entitled to a loss deduction in 1940 of at least $2,765.29. The identity in amount of the loss deduction with the expense deduction claimed in the first issue is a mere coincidence, due to the manner in which issues involving entirely different sections of the code were pleaded.
The next issue is whether in computing petitioner's excess profits tax for 1940 it is fully taxable on a group life insurance dividend in the amount of $1,483.56, or only a portion thereof. Petitioner would prorate the 1940 dividend between the taxable years 1939 and 1940. It points out that if the 1940 dividend is prorated mathematically to the policy years, which are different from the calendar years, the amount eliminated from 1940 excess profits tax net income would total $999.88. Petitioner's argument ignores the provision of its group life insurance policy providing for payment of dividends which is set forth in our findings. By the terms thereof the board of directors of the insurance company was required annually to ascertain and apportion the divisible surplus accruing upon the policy at the end of each policy year. The amount of the dividend so ascertained and apportioned by the insurance company to petitioner for 1940 was $1,483.56. As no dividends were received on the policy in 1939, it must be presumed that there was no divisible surplus accruing on the policy during that year. Under the specific terms of the insurance policy and the facts of record, we would not be justified in holding that part of the 1940 dividend could be apportioned to any other taxable year. On this point we sustain the respondent.
As an alternative to proration petitioner contends that $1,247.06 of the dividend should be eliminated upon the ground that it is abnormal in amount. Abnormalities in income for the taxable year 1940 are defined in section 721, Internal Revenue Code, as amended, the pertinent portions of which are set forth in the margin.
Our findings show that it was not abnormal for petitioner to receive income of this class. It had contracted therefor, and under the terms of the insurance policy it had derived income therefrom in 1937 and 1938. Clearly there was no abnormality with respect to the kind of income. The second portion of the definition of abnormal income relates to the amount of income in such class which is in excess of 125 per cent of the average amount for the four previous taxable years. This excess amount is specifically defined as abnormal income by section 721(a). Our findings show the income derived from dividends on the group policy for the four years previous to the taxable year 1940. By following the statutory formula the amount of abnormal income can be determined. Determination of the amount of abnormal income is of no benefit to petitioner, however, unless it can show that a part or all thereof is excluded from excess profits net income for the reason that it is attributable to years other than the year in which the excess profits tax is being computed. Sec. 35.721-3, Regulations 112,
SEC. 721. ABNORMALITIES IN INCOME IN TAXABLE PERIOD.(a) DEFINITIONS.— For the purposes of this section—(1) ABNORMAL INCOME.— The term ‘abnormal income‘ means income of any class includible in the gross income of the taxpayer for any taxable year under this subchapter if it is abnormal for the taxpayer to derive income of such class, or, if the taxpayer normally derives income of such class but the amount of such income of such class includible in the gross income of the taxable year is in excess of 125 per centum of the average amount of the gross income of the same class for the four previous taxable years, or, if the taxpayer was not in existence for four previous taxable years, the taxable years during which the taxpayer was in existence.(b) AMOUNT ATTRIBUTABLE TO OTHER YEARS.— The amount of the net abnormal income that is attributable to any previous or future taxable year or years shall be determined under regulations prescribed by the Commissioner with the approval of the Secretary. * * *
promulgated pursuant to the provisions of section 721(b) of the code. Since petitioner has not shown that any part of this abnormal income is attributable to prior years, we must affirm respondent's determination that no part of the dividend is excludible for excess profits tax purposes. Premier Products Co., 2 T.C. 445; E. T. Slider, Inc., 5 T.C. 263; cf. Arrow-Hart & Hegeman Electric Co., 7 T.C. 1350.
SEC. 35.721-3. AMOUNT ATTRIBUTABLE TO OTHER YEARS.— The mere fact that an item includible in gross income is of a class abnormal either in kind or in amount does not result in the exclusion of any part of such item from excess profits net income. It is necessary that the item be found attributable under these regulations in whole or in part to other taxable years. Only that portion of the item which is found to be attributable to other years may be excluded from the gross income of the taxpayer for the year for which the excess profits tax is being computed.
The next issue involves adjustments to petitioner's excess profits net income for base period years under section 711(b)(1)(J)(ii). Section 711 of the Internal Revenue Code relates to excess profits net income. Subsection 711(a) provides that for any taxable year beginning after December 31, 1939, the excess profits net income shall be the normal tax net income except for adjustments not here material. Subsection 711(b) relates to the taxable years in the base period, and paragraph (1) thereof states that for any taxable year subject to the Revenue Act of 1936 the excess profits net income shall be the normal tax net income. For any other taxable year beginning after December 31, 1937, and before January 1, 1940, the excess profits net income shall be the special class net income defined in section 14(a) of the Revenue Act of 1936. In either case adjustments are to be made as provided for in the several subparagraphs to section 711(b)(1). Subparagraph (J), relating to abnormal deductions; and subparagraph (K), which sets forth the rules for applying (J) and subparagraphs (H) and (I), are controlling here, and the pertinent portions thereof are set forth in the margin.
SEC. 711(b)(1)(J). Abnormal Deductions.— Under regulations provided by the Commissioner, with the approval of the Secretary, for the determination, for the purposes of this subparagraph, of the classification of deductions—(i) Deductions of any class shall not be allowed if deductions of such class were abnormal for the taxpayer, and(ii) If the class of deductions was normal for the taxpayer, but the deductions of such class were in excess of 125 per centum of the average amount of deductions of such class for the four previous taxable years, they shall be disallowed in an amount equal to such excess.(K) Rules for Application of Subparagraphs (H), (I) and (J).— For the purposes of subparagraphs (H), (I) and (J)—(ii) Deductions shall not be disallowed under such subparagraphs unless the taxpayer establishes that the abnormality or excess is not a consequence of an increase in the gross income of the taxpayer in its base period or a decrease in the amount of some other deduction in its base period, and is not a consequence of a change at any time in the type, manner of operation, size, or condition of the business engaged in by the taxpayer.(iii) The amount of deductions of any class to be disallowed under such subparagraphs with respect to any taxable year shall not exceed the amount by which the deductions of such class for such taxable year exceed the deductions of such class for the taxable year for which the tax under this subchapter is being computed.
Respondent does not object to the amounts claimed as excessive for the taxable years in the base period with respect to unemployment compensation payments and dues and subscription payments, or interest payments. He contends that petitioner's business was growing during the base period years and the taxable years, that the evidence does not show the excessiveness of the deductions was not the consequence of an increase in gross income, and that the petitioner has not established that the abnormal deductions were not the consequences of a change in the type, manner of operation, size, or condition of the business in which it was engaged. Respondent contends further with respect to the unemployment compensation payments that this item should be classified with other deductible taxes in determining a proper class of abnormal deductions under section 711(b)(1)(J) of the code and section 35.711(b)-2 of Regulations 112.
In making our findings of abnormalities in unemployment compensation payments and dues and subscription payments in the base period years we have carefully considered and weighed respondent's contentions. But we can not agree that the abnormal deductions found herein for certain of the base period years were ‘the consequence of one of the changes mentioned in the statute.‘ Wentworth Manufacturing Co., 6 T.C. 1201, 1207. The statute, section 711(b)(1)(J), provides for two types of abnormal deductions, namely, deductions of a class abnormal to the taxpayer, 711(b)(1)(J)(i), and deductions of the taxpayer abnormal in amount, 711(b)(1)(J)(ii). Our problem relates to deductions abnormal in amount, and as to this type of abnormal deduction the statute provides that the abnormality is that amount of the deduction in the base period year which is in excess of 125 per cent of the average amount of deductions of such class for the four previous taxable years.
Our findings show petitioner's deductions for four years prior to the first base period year with respect to dues and subscription payments, but the findings with respect to unemployment compensation payments start with 1936, as the effective date of the unemployment compensation act was January 1, 1936, and there were no payments for any year prior thereto. Determining the amount of the excess deductions for each of the base period years is a mathematical calculation, which we have checked for accuracy. The next step, after determining the amount of the excess, is to apply the limitation contained in section 711(b)(1)(K)(iii). This subparagraph bars the use of the excess in computing petitioner's excess profits credit, if the excess profits tax year deduction exceeds the deduction for the taxable year in the base period. /a/ And even though taxpayer's base period years deduction exceeds 125 per cent of the average of the four previous years, this excess can not be used as an abnormal deduction unless the deduction for the excess profits tax year is also less than 125 per cent of the average of the four previous taxable years. /b/ If the deduction for the excess profits tax year is more than 125 per cent of the average of the four previous tax years but less than the deduction for the taxable year, then the excess is limited to the difference between the taxable year deduction and the excess profits tax year deduction. /c/ In determining the amount of petitioner's abnormal deductions for the base period years with respect to the excess profits tax years 1940 through 1943 (the excess profits tax years 1942 and 1943 are involved here in virtue of the excess profits credit carry-back provisions) we have followed the method above outlined. For example:
+-----------------------------------------------------+ ¦Taxable year¦125% of average¦Excess ¦Excess ¦ +------------+---------------+-----------+------------¦ ¦in base ¦of 4 previous ¦profits tax¦amount to be¦ +------------+---------------+-----------+------------¦ ¦period ¦years ¦year ¦disallowed ¦ +------------+---------------+-----------+------------¦ ¦a $800 ¦$1,400 ¦$1,000 ¦None ¦ +------------+---------------+-----------+------------¦ ¦b 1,400 ¦1,000 ¦800 ¦$400 ¦ +------------+---------------+-----------+------------¦ ¦c 1,400 ¦800 ¦1,000 ¦400 ¦ +-----------------------------------------------------+
The amounts so determined are to be eliminated from petitioner's deductions for base period years in computing its credit for excess profits tax purposes in 1940 through 1943 unless petitioner has failed to meet the requirements set forth in section 711(b)(1)(K)(ii). This section requires petitioner to establish that the abnormality or excess must not be a consequence of an increase in its gross income in the base period or a decrease in the amount of some other deduction. In William Leveen Corporation, 3 T.C. 593, 595, we pointed out that perhaps the best method of establishing that the abnormal deduction was not a consequence of an increase in gross income was to prove affirmatively that the excess was a consequence of something other than an increase in gross income and could not be identified therewith. Petitioner here has established, and we have found as fact, that the abnormal deductions in the base period years with respect to unemployment compensation payments and dues and subscription payments were due to a reduction in rates subsequent to the base period. The inference we draw from the rate reductions and the other facts and circumstances is that the abnormal deductions can not be identified with any increase in petitioner's gross income during the base period.
Section 711(b)(1)(K)(ii) also requires petitioner to establish that the abnormal deduction is not a consequence of a decrease in the amount of some other deduction. Respondent argues in this case, as he has in other cases, that unemployment compensation payments should be classified with other deductible taxes and the excess, if any, disallowed only if the petitioner establishes that the excess tax deduction was not a consequence of the decrease in amount of some other deduction in the base period years. In Wentworth Manufacturing Co., supra, we considered unemployment compensation payments under the statutes of Illinois. We there held that the excessive deduction should be disallowed. The situation here is comparable to that existing in the Wentworth case and, upon the authority of that decision, we reject respondent's contention that unemployment compensation payments should be classified with other deductible taxes. In all other respects this record and the existing facts support the conclusion that the abnormal deductions were not a consequence of a decrease in any other deduction during the base period years.
Finally, section 711(b)(1)(K)(ii) requires petitioner to establish that the abnormal deductions are not a consequence of a change at any time in the type, manner of operation, size, or condition of the business engaged in by it. This record shows that petitioner continued throughout the base period to manufacture hardwood flooring. It absorbed no other companies. It made no departure from its customary method of operating. Its size did not vary. Its business, based on footage of lumber consumed, showed a gradual increase, but no phenomenal growth. In our opinion petitioner has sustained its burden and is entitled to disallow the excess deductions shown in our findings in computing its excess profits credit for the excess profits tax years involved herein.
Petitioner also claimed that it had established its right to disallow excess interest deductions in the base period years. The proof is not convincing, however, that the excess interest deductions were not a consequence of an increase in petitioner's gross income during the base period years. Petitioner's 1940 tax return shows normal tax income or special class income for each of the base period years, but it fails to show the gross income for any base period year. There is no affirmative proof here which shows the abnormal interest deductions were due to some cause other than an increase in gross income. William Leveen Corporation, supra. In the absence of proof establishing that the abnormal interest deductions were not a consequence of an increase in gross income during the base period years, we affirm respondent's determination with respect to the excess interest deductions.
The final issue is the amount of unused excess profits tax back petitioner is entitled to in computing its 1941 excess profits tax liability. The parties have stipulated that petitioner is entitled to a carry-back credit of at least $15,748.79, plus any increase that results from our determination of the other issues herein. Our decision as to the amount of petitioner's abnormal deductions during the base period years will affect the amount of petitioner's excess profits tax liability for the taxable years 1940 and 1941. And, since we have to determine the amount of petitioner's excess profits credit carry-back from 1943 to 1941, our decision as to abnormal deductions in the base period years will also affect the taxable years 1942 and 1943, which are involved herein only in so far as it is necessary to determine petitioner's excess profits credit carry-back.
After making the adjustments required by our holdings, the petitioner's excess profits carry-back credit for 1943 should be redetermined and the amount thereof used in determining petitioner's excess profits tax liability for 1941. Whether deficiencies or overpayments in income and excess profits taxes for 1940 and 1941 will result from our determination of the issues decided herein will have to await recomputation under Rule 50.