Opinion
Docket No. 5730.
1947-06-17
LION CLOTHING COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
John M. Cranston, Esq., and Raymond M. Wansley, C.P.A., for the petitioner. R. E. Maiden, Jr., Esq., for the respondent.
Petitioner is engaged in the retail clothing business in San Diego, California. It was founded in 1886 and operated as a sole proprietorship until 1912, when it was incorporated. It has grown from a small beginning to a very large business, with needs for considerable amounts of working capital. In the taxable years 1940, 1941, and 1942 it had substantial net profits, out of which it paid large income and excess profits taxes to the Federal Government, substantial cash dividends to its stockholders, and added reasonable amounts to its earned surplus. The Commissioner has determined that petitioner accumulated its earnings and profits beyond the reasonable needs of its business and was availed of in each of the taxable years for the purpose of preventing the imposition of surtax upon its stockholders. Held, the amounts which petitioner added to its earned surplus in each of the taxable years were not unreasonable in amount in view of the needs of the business, and petitioner was not availed of in either of the taxable years for the purpose of preventing the imposition of surtax upon its stockholders. John M. Cranston, Esq., and Raymond M. Wansley, C.P.A., for the petitioner. R. E. Maiden, Jr., Esq., for the respondent.
The respondent determined deficiencies for the calendar years 1940, 1941, and 1942 as follows:
+-------------------------------------------+ ¦ ¦ ¦Declared ¦ ¦ +----+----------+------------+--------------¦ ¦ ¦ ¦value excess¦Excess profits¦ +----+----------+------------+--------------¦ ¦Year¦Income tax¦profits tax ¦tax ¦ +----+----------+------------+--------------¦ ¦1940¦$9,792.97 ¦None ¦None ¦ +----+----------+------------+--------------¦ ¦1941¦16,819.45 ¦None ¦$249.12 ¦ +----+----------+------------+--------------¦ ¦1942¦8,684.70 ¦$324.60 ¦5,692.34 ¦ +-------------------------------------------+
The Commissioner, in his determination of the deficiencies, made several adjustments for the respective taxable years. One of these adjustments, which was common to each of the taxable years, was the disallowance of $5,245.25 of the depreciation claimed by petitioner on its returns. However, the main adjustment which the Commissioner made and the one which is responsible for the greater amounts of the deficiencies, was to determine that petitioner was liable for the surtax provided by section 102 of the Internal Revenue Code.
In a statement attached to the deficiency notice the respondent, among other things, advised petitioner as follows:
It is held that you permitted your earnings or profits of the taxable years 1940, 1941 and 1942 to accumulate beyond the reasonable needs of your business instead of being distributed and that you were availed of in said years for the purpose of preventing the imposition of surtax upon your shareholders. It is therefore further held that surtax under the provisions of section 102 of the Internal Revenue Code should be imposed upon your net income for each of said taxable years 1940, 1941 and 1942.
Petitioner, by an appropriate assignment of error, contests the above holding by the respondent and also assigns as error the respondent's action ‘in reducing petitioner's invested capital as at January 1, 1941 by the amount of $9,792.97 and in reducing petitioner's invested capital at January 1, 1942 in the amount of $26,689.65, such reductions being the amount of Section 102 taxes for the year 1940 and for the years 1940 and 1941 respectively as erroneously determined by the Commissioner.‘ Petitioner does not contest the other adjustments made by the Commissioner in his determination of the deficiencies.
FINDINGS OF FACT.
Petitioner is a corporation, with its principal office in San Diego, California. The returns for the calendar years 1940, 1941, and 1942 were filed with the collector for the sixth district of California.
Petitioner was incorporated in 1912 under the laws of the State of California. Its business is that of retail clothing. The firm is the third oldest mercantile firm in San Diego. The business was founded in 1886 by Samuel I. Fox, and prior to 1912 it was operated as a sole proprietorship. Samuel I. Fox was president of petitioner until 1939, when he died. Upon his death his son, John H. Fox, became president. John began working part time for petitioner about 1916 at the age of 12. Upon graduation from college in 1927 he began working full time for petitioner as secretary and assistant to his father. In 1933 he was made general manager, and he has continued as president of petitioner since his father's death.
The first store in 1886 was small, about 25 by 50 feet, at the corner of Fifth and E Streets in San Diego. In 1893 the business was moved to larger premises on the corner of Fifth and G. In 1904 the business was moved back to Fifth and E in a two-story building. In 1929 it was moved to its present location at Sixth and Broadway, in a building much larger, about 100 by 100 feet, with four floors and a basement.
When John became general manager in 1933 he felt it was a heavy responsibility, for petitioner had just passed through the three depression years of 1930, 1931, and 1932, during which it suffered losses of $25,334.46, $17,114.75, and $21,115.20, respectively. On December 31, 1928, petitioner owed the banks nothing. In 1929, when it moved into its new building, it borrowed $95,000 to buy fixtures and additional merchandise. On December 31, 1930, its indebtedness to the banks amounted to $123,000. The banks were pressing petitioner for repayment and petitioner was forced to reduce its inventory from $251,547.66 on December 31, 1930, to $159,008.19 on December 31, 1931; to $133,156.55 on December 31, 1932; and to $79,593.90 on December 31, 1934, at which time the bank indebtedness had been paid in full. Also on December 31, 1930, petitioner was indebted to Samuel I. Fox in the amount of $31,418.62. Fox forgave this indebtedness in 1931 upon the suggestion of the bankers, and petitioner credited this amount to its earned surplus account. These experiences with the banks and the depression losses made a deep impression upon John H. Fox. He made up his mind that, if possible, he would not let the business get into such a bad financial position again. He decided, as manager, to try and build up some cash reserves. He figures that if petitioner had had a cash reserve in 1929 of about $200,000 it would not have become so dependent on the banks as it was during the following five-year period.
Prior to 1937 petitioner's capital stock consisted of 1,000 shares of the par value of $100 per share. During 1937 it was increased to 2,000 shares of the same par value. During the years 1931 to 1942, inclusive, this stock was owned as follows:
+-----------------------------------------------------------------------------+ ¦Year¦Samuel I. ¦John H ¦Pauline ¦Lillian ¦Arthur F ¦Calvin ¦Total ¦ ¦ ¦Fox ¦Fox ¦Fox ¦Gaynes ¦Gaynes ¦Hass ¦shares ¦ +----+----------+--------+--------+-----------+------------+--------+---------¦ ¦1931¦259 ¦225 ¦256 ¦225 ¦10 ¦25 ¦1,000 ¦ +----+----------+--------+--------+-----------+------------+--------+---------¦ ¦1932¦259 ¦225 ¦256 ¦225 ¦10 ¦25 ¦1,000 ¦ +----+----------+--------+--------+-----------+------------+--------+---------¦ ¦1933¦259 ¦225 ¦256 ¦225 ¦10 ¦25 ¦1,000 ¦ +----+----------+--------+--------+-----------+------------+--------+---------¦ ¦1934¦259 ¦250 ¦256 ¦225 ¦10 ¦ ¦1,000 ¦ +----+----------+--------+--------+-----------+------------+--------+---------¦ ¦1935¦259 ¦250 ¦256 ¦225 ¦10 ¦ ¦1,000 ¦ +----+----------+--------+--------+-----------+------------+--------+---------¦ ¦1936¦259 ¦250 ¦256 ¦225 ¦10 ¦ ¦1,000 ¦ +----+----------+--------+--------+-----------+------------+--------+---------¦ ¦1937¦465 ¦823 ¦ ¦697 ¦15 ¦ ¦2,000 ¦ +----+----------+--------+--------+-----------+------------+--------+---------¦ ¦1938¦465 ¦823 ¦ ¦697 ¦15 ¦ ¦2,000 ¦ +----+----------+--------+--------+-----------+------------+--------+---------¦ ¦1939¦465 ¦823 ¦ ¦697 ¦15 ¦ ¦2,000 ¦ +----+----------+--------+--------+-----------+------------+--------+---------¦ ¦1940¦ ¦1055 1/2¦ ¦929 1/2 ¦15 ¦ ¦2,000 ¦ +----+----------+--------+--------+-----------+------------+--------+---------¦ ¦1941¦ ¦1055 1/2¦ ¦929 1/2 ¦15 ¦ ¦2,000 ¦ +----+----------+--------+--------+-----------+------------+--------+---------¦ ¦1942¦ ¦1055 1/2¦ ¦929 1/2 ¦15 ¦ ¦2,000 ¦ +-----------------------------------------------------------------------------+
Arthur F. Gaynes and Lillian Gaynes are husband and wife. The latter is a sister of John H. Fox and a daughter of Samuel I. Fox. She was also on petitioner's board of directors. Arthur F. Gaynes was vice president of petitioner during the taxable years in question.
Prior to 1937 the building in which petitioner did business was owned by the Fox-Gaynes Realty Co. The stockholders of this company and petitioner were approximately the same. During 1937 petitioner took over all of the assets and liabilities of the Fox-Gaynes Realty Co. and the two corporations were merged. At the time of the merger there was an outstanding mortgage on the building of $205,000, which petitioner assumed. The mortgage called for an annual payment of $10,000 with the privilege of paying an additional $10,000 if petitioner elected to do so.
Among the assets taken over by petitioner from the Fox-Gaynes Realty Co. in the 1937 merger were some miscellaneous pieces of real estate which petitioner set up on its books at $92,831.67 under the caption ‘Union Trust Company Account.‘ The Union Trust Co. sold these miscellaneous pieces of real estate over a period of about seven years for cash and notes. Petitioner permitted the cash to remain with the Union Trust Co. until in 1944, when it was used to pay off the balance of the above mentioned $205,000 mortgage.
During the years 1933 to 1937, inclusive, petitioner had a net profit of $61,818.67 before income taxes. On this profit it paid income taxes of $7,462.50. It also paid dividends of $22,500 and credited the balance of $31,856.17 (51.53 per cent of $61,818.67) to earned surplus.
On May 28, 1938, a special meeting of the directors of petitioner was held. The minutes of this meeting are as follows:
Meeting called to order by S. I. Fox, president. All directors present. Motion made by J. H. Fox, seconded by A. F. Gaynes that in regard to future earnings of the company that a definite policy should be followed.
First, due to the fact that the company is obligated to pay out $20,000 per year on the mortgage to the New York Life Insurance Company, that that money be paid or set aside before any dividends are declared.
Second, the company has a bonus policy with its officers, and that this bonus be paid or set aside before any dividends are declared.
Third, of any remaining money that the company earns at least 50 per cent should go into surplus, so that the company have funds for expansion or any unseen business depression that might occur. Motion was passed.
There being nothing further to come before the special meeting of the Board, the president declared the meeting adjourned. Signed J. H. Fox, Secretary. S. I. Fox, President.
The above minutes are the only minutes of petitioner with regard to the accumulation of surplus.
In 1929 petitioner granted a concession under a ten-year lease to D. Goldering to operate within its premises a women's ready-to-wear department. Later, two other concessions were granted, one to Al Levy Co., to operate a women's millinery, and one to A.E. Nettleton Co., to sell men's shoes.
In 1934 petitioner and two Hafter brothers organized a corporation called the Hafter Co. The stock of this corporation consisted of 150 shares and was issued as follows: 73 shares to petitioner; 1 share to John H. Fox, who was elected secretary of the new company; 1 share to Arthur F. Gaynes; and 75 shares to the two Hafter brothers. The Hafter Co. purchased the women's ready-to-wear concession and lease from Goldering. It obtained a new ten-year lease from petitioner in 1939 and continued to operate this department until March 31, 1946, at which time petitioner bought the 75 shares of stock from the Hafter brothers for a consideration of $127,000.
For many years prior to the taxable years here involved John H. Fox had felt that petitioner should buy out the concessions and take them over as soon as petitioner was out of debt and had built up a reserve. At the end of 1942 Fox estimated that it would require about $100,000 to buy out the stock interest of the Hafter brothers in the Hafter Co. Petitioner has not yet taken over the concessions that were granted to Al Levy Co. and A.E. Nettleton Co.
The concessions were operated in substantially the following manner. Petitioner would give the concessionaires credit for the sales made through the store, deduct the rent and expenses such as advertising, salaries, and miscellaneous expenses, and remit the balance to the concessionaires before the 10th of each month.
Petitioner's balance sheets as of December 31, 1939, 1940, 1941, and 1942, were as follows:
+-----------------------------------------------------------------------------+ ¦ ¦Dec. 31, ¦Dec. 31, ¦Dec. 31, ¦Dec. 31, ¦ ¦ ¦1939 ¦1940 ¦1941 ¦1942 ¦ +-------------------------+------------+------------+------------+------------¦ ¦ASSETS ¦ ¦ ¦ ¦ ¦ +-------------------------+------------+------------+------------+------------¦ ¦Cash ¦$124,109.16 ¦$188,974.03 ¦$218,143.98 ¦$429,300.29 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Accounts receivable ¦100,431.63 ¦109,046.86 ¦114,705.02 ¦75,105.16 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Inventory ¦54,117.01 ¦35,983.98 ¦47,702.67 ¦48,908.34 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Bonds, U.S ¦9,000.00 ¦12,185.00 ¦34,545.00 ¦35,000.00 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Land ¦394,500.00 ¦394,500.00 ¦394,500.00 ¦394,500.00 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Building ¦304,272.99 ¦304,272.99 ¦304,272.99 ¦304,272.99 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Building equipment ¦51,352.89 ¦51,352.89 ¦51,352.89 ¦51,352.89 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Furniture and fixtures ¦90,494.01 ¦90,494.01 ¦90,494.01 ¦90,494.01 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Stock of Hafter Co ¦7,763.38 ¦7,763.38 ¦7,763.38 ¦7,763.38 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Cash surrender value of ¦10,554.25 ¦11,467.75 ¦12,416.25 ¦13,399.75 ¦ ¦life insurance ¦ ¦ ¦ ¦ ¦ +-------------------------+------------+------------+------------+------------¦ ¦Postwar refund ¦ ¦ ¦ ¦8,540.12 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Union Trust Co. account ¦89,092.98 ¦ ¦ ¦ ¦ +-------------------------+------------+------------+------------+------------¦ ¦Cash ¦ ¦8,215.60 ¦13,073.62 ¦22,846.02 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Notes receivable ¦ ¦8,932.09 ¦12,231.15 ¦13,438.06 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Real estate ¦ ¦55,185.59 ¦46,191.67 ¦37,472.22 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Total assets ¦1,235,688.30¦1,278,372.17¦1,347,392.63¦1,532,393.23¦ +-----------------------------------------------------------------------------+
LIABILITIES Accounts payable 1,986.92 9,918.44 17,344.92 Due concessionaires: Hafter Co 42,670.45 55,940.41 62,193.24 100,951.30 Others 3,666.05 4,033.79 5,058.78 2,315.77 Income taxes payable 5,496.66 12,742.88 38,507.05 123,998.15 Accrued miscellaneous taxes 4,143.82 4,305.91 5,386.98 6,444.91 Due stockholders 66,260.68 53,509.01 55,051.04 55,857.99 Mortgage payable 165,000.00 145,000.00 125,000.00 105,000.00 Reserves for depreciation: Building 86,565.61 92,008.29 97,450.97 102,893.65 Building equipment 56,870.55 59,438.19 62,005.83 64,573.47 Furniture and fixtures 29,649.63 32,614.59 35,579.55 38,544.51 Total liabilities 462,310.37 469,511.51 486,233.44 617,924.67 Capital 200,000.00 200,000.00 200,000.00 200,000.00 Paid-in surplus 409,443.08 409,443.08 409,443.08 409,443.08 Earned surplus 163,934.85 199,419.58 251,716.11 305,025.48 Total net worth 773,377.93 808,862.66 861,159.19 914,468.56 Total liabilities and net worth 1,235,688.30 1,278,374.17 1,347,392.63 1,532,393.23
The liabilities shown in the above balance sheets for income taxes do not include the proposed deficiencies here in question. The paid-in surplus of $409,443.08 occurred in 1937, when petitioner and the Fox-Gaynes Realty Co. were merged. The earned surplus shown in the above balance sheets includes the $31,418.62 which Samuel I. Fox donated to petitioner during 1931.
During the taxable years here involved salaries were paid by petitioner to its officers in the following amounts:
+-----------------------------------+ ¦Year¦John H. Fox,¦Arthur F. Gaynes,¦ +----+------------+-----------------¦ ¦ ¦president ¦vice president ¦ +----+------------+-----------------¦ ¦1940¦$15,000 ¦$12,000 ¦ +----+------------+-----------------¦ ¦1941¦20,000 ¦15,000 ¦ +----+------------+-----------------¦ ¦1942¦20,400 ¦15,600 ¦ +-----------------------------------+
During the years 1927 to 1945, inclusive, petitioner's net profit or (loss) (stipulated for the purposes of this case only), its income and excess profits taxes (except the deficiencies here in question) payable with respect thereto, the amounts of dividends paid, the increase or (decrease) of its earned surplus account, and the amounts paid on debt retirement were as follows:
+-----------------------------------------------------------------------------+ ¦Year¦Net profit or ¦Income and excess ¦Dividends ¦Net to ¦Debt ¦ ¦ ¦(loss) ¦profits taxes ¦paid ¦surplus ¦retirement ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1927¦$25,658.17 ¦$3,463.85 ¦$19,940 ¦$2,254.32 ¦ ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1928¦24,368.30 ¦2,924.20 ¦19,940 ¦1,504.10 ¦ ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1929¦4,264.47 ¦511.74 ¦ ¦3,752.73 ¦ ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1930¦(25,334.46) ¦ ¦ ¦(25,334.46)¦ ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1931¦(17,114.75) ¦ ¦ ¦(17,114.75)¦ ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1932¦(21,115.20) ¦ ¦ ¦(21,115.20)¦ ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1933¦147.16 ¦20.23 ¦ ¦126.93 ¦ ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1934¦2,466.17 ¦328.99 ¦ ¦2,137.18 ¦ ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1935¦24,158.73 ¦3,400.65 ¦ ¦20,758.08 ¦ ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1936¦13,909.97 ¦1,512.56 ¦7,500 ¦4,897.41 ¦ ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1937¦21,136.64 ¦2,500.07 ¦15,000 ¦3,936.57 ¦ ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1938¦43,337.96 ¦6,972.30 ¦10,000 ¦26,365.66 ¦$20,000 ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1939¦35,602.79 ¦5,496.66 ¦ ¦30,106.13 ¦20,000 ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1940¦59,353.69 ¦12,742.88 ¦11,000 ¦35,610.81 ¦20,000 ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1941¦104,716.15 ¦37,248.19 ¦15,000 ¦52,467.96 ¦20,000 ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1942¦182,725.74 ¦116,733.44 ¦20,000 ¦45,992.30 ¦20,000 ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1943¦183,416.01 ¦107,937.17 ¦25,000 ¦50,478.84 ¦25,000 ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1944¦215,386.25 ¦136,052.63 ¦35,000 ¦44,333.62 ¦80,000 ¦ +----+--------------+----------------------+----------+-----------+-----------¦ ¦1945¦184,386.44 ¦107,126.92 ¦40,000 ¦37,259.52 ¦ ¦ +-----------------------------------------------------------------------------+
The following schedule shows the additional tax that would have been paid by each of the stockholders of the petitioner in the years 1940, 1941, and 1942 if all of the profits of the petitioner for those years, after the payment of corporation taxes, had been distributed as dividends in said years to the stockholders (the taxes for the year 1942 have been computed under the Revenue Act of 1942 and no consideration has been given to any of the provisions of the Current Tax Payment Act of 1943):
+----------------------------------------------------------+ ¦Year¦John H. Fox¦Lillian Gaynes¦Arthur F. Gaynes¦Total ¦ +----+-----------+--------------+----------------+---------¦ ¦1940¦$5,574.15 ¦$4,092.85 ¦$22.33 ¦$9,689.33¦ +----+-----------+--------------+----------------+---------¦ ¦1941¦16,891.01 ¦13,568.63 ¦95.08 ¦30,554.72¦ +----+-----------+--------------+----------------+---------¦ ¦1942¦10,655.78 ¦8,936.80 ¦76.36 ¦19,668.94¦ +----+-----------+--------------+----------------+---------¦ ¦ ¦33,120.94 ¦26,598.28 ¦193.77 ¦59,912.99¦ +----------------------------------------------------------+
The population of the city of San Diego on January 1, 1930, was approximately 147,995; on April 1, 1940, 203,341; on January 1, 1943, 385,000; and on February 21, 1946, 361,942.
The building which petitioner moved into in 1929 lacked a freight elevator. Petitioner needed a freight elevator very badly, but had decided not to put one in until it had paid off its debts and built up a reserve. The estimated cost of installing a freight elevator was about $40,000.
During the taxable years here involved petitioner also needed new fixtures for the store, new lighting equipment, and new frontals. The estimated cost of these necessities was about $50,000. Petitioner had delayed making these improvements for the same reason it had delayed the installation of a freight elevator.
Petitioner usually declared its dividends around December 15 of each year in which dividends were declared. In 1941 war was declared before that date and petitioner's officers became very much concerned as to the effect the war would have on petitioner's business. San Diego was blacked out. Business people in San Diego were sending their records elsewhere on account of the fear of bombings. Merchandise was very hard to get in the fall of 1941, and at that time it looked as if the situation would grow worse as the war progressed. The subsequent large increase in population in San Diego was due principally to the war and it was the expectation of petitioner's president that after the war San Diego would experience another depression. In 1942 there was talk of rationing clothes. Petitioner believed that if clothes rationing had been put into effect it would have considerably slowed down petitioner's sales. The Federal Reserve Board did place restrictions upon the amount of credit petitioner could extend to its customers. This had the effect of reducing the accounts receivable and of building up the cash account. Petitioner believed that the removal of such restrictions would have an opposite effect and that an additional amount of cash of approximately $50,000 would be needed after the war to carry accounts receivable. Petitioner also estimated that it would cost twice as much after the war was over to replace petitioner's inventory to what it was before the shortages occurred. Petitioner estimated that approximately $100,000 would be required to expand inventories when goods should be again plentiful and available for purchase.
Petitioner's gross sales in 1940 were $363,962.69; in 1941, $449,172.22 and in 1942, $553,012.82.
During the taxable years here involved petitioner was not a mere holding or investment company.
Petitioner did not during the taxable years here in question permit its earnings or profits to accumulate beyond the reasonable needs of its business.
During the taxable years here involved petitioner was not availed of for the purpose of preventing the imposition of the surtax upon its shareholders or the shareholders of any other corporation through the medium of permitting its earnings or profits to accumulate instead of being divided or distributed.
The stipulation of facts is incorporated herein by reference.
OPINION.
BLACK, Judge:
The principal question in this proceeding is whether petitioner is subject to the surtax on corporations imposed by section 102 of the Internal Revenue Code, as amended, for the calendar years 1940, 1941, and 1942. A subsidiary question, depending upon the outcome of the principal question, is whether the respondent erred in reducing petitioner's invested capital by the amount of the tax computed under section 102. The material provisions of section 102, except for the rates involved, are identical for each of the years here involved and are set forth in the margin.
SEC. 102. SURTAX ON CORPORATIONS IMPROPERLY ACCUMULATING SURPLUS.(a) IMPOSITION OF TAX.— There shall be levied, collected, and paid for each taxable year (in addition to other taxes imposed by this chapter) upon the net income of every corporation (other than a personal holding company as defined in section 501 or a foreign personal holding company as defined in Supplement P) if such corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders or the shareholders of any other corporation, through the medium of permitting earnings or profits to accumulate instead of being divided or distributed, a surtax equal to the sum of the following:(b) PRIMA FACIE EVIDENCE.— The fact that any corporation is a mere holding or investment company shall be prima facie evidence of a purpose to avoid surtax upon shareholders.(c) EVIDENCE DETERMINATIVE OF PURPOSE.— The fact that the earnings or profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid surtax upon shareholders unless the corporation by the clear preponderance of the evidence shall prove to the contrary.
The respondent did not determine, and he does not contend, that petitioner was ‘formed‘ for the prohibited purpose. He did determine and he does contend that petitioner was ‘availed of‘ for that purpose. It may also be noted at the start that the respondent did not determine, nor does he contend, that petitioner was ‘a mere holding or investment company‘ as that term is used in section 102(b). It is clear, of course, that petitioner is not a mere holding or investment company, but is a very active business enterprise, with a large volume of business, a considerable number of employees, and, evidently, a very large number of customers. Petitioner was formed for the purpose of engaging in the retail sale of clothing, and during the taxable years here involved it was engaged in that business and was quite successful in its operations.
The respondent did determine and he contends that during the taxable years here in question petitioner permitted its earnings or profits ‘to accumulate beyond the reasonable needs of the business,‘ as that phrase is used in section 102(c) of the code. By virtue of section 102(c) the accumulation of earnings or profits beyond reasonable needs is determinative of a purpose to prevent the imposition of the surtax upon the shareholders, unless the corporation by a clear preponderance of evidence proves to the contrary. See Whitney Chain & Mfg. Co., 3 T.C. 1109; affd., 149 Fed.(2d) 936.
The determination of whether petitioner during the taxable years here in question permitted its earnings or profits ‘to accumulate beyond the reasonable needs of the business‘ or whether petitioner was ‘availed of‘ for the prohibited purpose are questions of fact, to be determined from all the evidence. See secs. 19.102-2 and 19.102-3 of Regulations 103 and the identical provisions of secs. 29.102-2 and 29.102-3 of Regulations 111. See also Helvering v. National Grocery Co., 304 U.S. 282; Helvering v. Chicago Stock Yards Co., 318 U.S. 693; Cecil B. DeMille, 31 B.T.A. 1161; affd., 90 Fed.(2d) 12; certiorari denied, 302 U.S. 713.
We think petitioner has met its burden of proof. Upon the evidence received at the hearing, we have found as ultimate facts that during the taxable years in question petitioner did not permit its earnings or profits to accumulate beyond the reasonable needs of its business and that it was not availed of for the prohibited purpose. The reason we think that earnings and profits of petitioner were not accumulated beyond the reasonable needs of its business is because petitioner has proved by evidence which seems convincing to us that in the year 1938 it adopted by appropriate corporate action a policy of accumulating a part of its net profits each year to be added to surplus ‘so that the company have funds for expansion or any unseen depression that might occur,‘ and that this policy under all the circumstances of the case was a reasonable one and has been carried out, including the taxable years which we have before us. We do not think it can be said that a taxpayer's earnings were accumulated beyond the reasonable needs of the business where it is shown that the purpose of their accumulation is to retire mortgage indebtedness, to make improvements which will add to the convenience and efficiency of operation of the business, to expand operations by purchasing the interests of concessionaires, to accumulate some cash reserves as a bulwark against future depressions, and to meet unknown risks of the war and post-war period. All these things we think petitioner has proved with reasonable clarity. The facts with respect thereto are set forth in our findings of fact and need not be repeated in detail here. The following table taken from petitioner's balance sheets will show what might be termed its net quick assets and current liabilities in each of the taxable years:
+----------------------------------------------------------------------+ ¦Quick net asset resources ¦Dec. 31, 1940¦Dec. 31, 1941¦Dec. 31, 1942¦ +----------------------------+-------------+-------------+-------------¦ ¦Quick gross asset resources:¦ ¦ ¦ ¦ +----------------------------+-------------+-------------+-------------¦ ¦Cash ¦$188,974.03 ¦$218,143.98 ¦$429,300.29 ¦ +----------------------------+-------------+-------------+-------------¦ ¦United States bonds ¦12,185.00 ¦34,545.00 ¦35,000.00 ¦ +----------------------------+-------------+-------------+-------------¦ ¦Union Trust Co. account: ¦ ¦ ¦ ¦ +----------------------------+-------------+-------------+-------------¦ ¦Cash ¦8,215.60 ¦13,073.62 ¦22,846.02 ¦ +----------------------------+-------------+-------------+-------------¦ ¦Notes receivable ¦8,932.09 ¦12,231.15 ¦13,438.06 ¦ +----------------------------+-------------+-------------+-------------¦ ¦Total ¦218,306.72 ¦277,993.75 ¦500,584.37 ¦ +----------------------------+-------------+-------------+-------------¦ ¦Deduct current liabilities: ¦ ¦ ¦ ¦ +----------------------------+-------------+-------------+-------------¦ ¦Due concessionaires ¦59,974.20 ¦67,252.02 ¦103,267.07 ¦ +----------------------------+-------------+-------------+-------------¦ ¦Accrued taxes ¦17,048.79 ¦44,106.40 ¦132,673.69 ¦ +----------------------------+-------------+-------------+-------------¦ ¦Mortgage payment ¦20,000.00 ¦20,000.00 ¦20,000.00 ¦ +----------------------------+-------------+-------------+-------------¦ ¦Due stockholders on demand ¦53,509.01 ¦55,051.04 ¦55,857.99 ¦ +----------------------------+-------------+-------------+-------------¦ ¦Total ¦150,532.00 ¦186,409.46 ¦311,798.75 ¦ +----------------------------+-------------+-------------+-------------¦ ¦Quick net asset resources ¦67,774.72 ¦91,584.29 ¦188,785.62 ¦ +----------------------------------------------------------------------+
We think petitioner has established by satisfactory evidence that in each of the taxable years it was reasonable to add accumulations to its surplus so that it would have ample funds on hand without borrowing from banks to finance the following reasonable business requirements:
+----------------------------------------------------------------------+ ¦ ¦Dec. 31, 1940¦Dec. 31, 1941¦Dec. 31, 1942¦ +----------------------------+-------------+-------------+-------------¦ ¦Installation of new elevator¦$40,000.00 ¦$40,000.00 ¦$40,000.00 ¦ +----------------------------+-------------+-------------+-------------¦ ¦Installation of new fixtures¦50,000.00 ¦50,000.00 ¦50,000.00 ¦ +----------------------------+-------------+-------------+-------------¦ ¦Purchase of Hafter interest ¦100,000.00 ¦100,000.00 ¦100,000.00 ¦ +----------------------------+-------------+-------------+-------------¦ ¦ ¦190,000.00 ¦190,000.00 ¦190,000.00 ¦ +----------------------------------------------------------------------+
In addition to the above, we think petitioner has established that if and when, after the taxable years in question, clothing become more plentiful in supply it will be necessary to increase the size of its inventories. Petitioner estimates that $100,000 will be needed for this purpose. We have no reason to doubt the bona fides of the estimate, considering the very large annual volume of petitioner's business. Also, when reductions on credit are removed it will be necessary to increase the size of its accounts receivable. Petitioner estimates that $50,000 will be required for this purpose. Thus it will be seen that substantial amounts of cash will be necessary for these purposes, even though it may turn out that petitioner has overestimated them. When all these facts are taken into consideration, we think they are sufficient to show that in none of the taxable years did petitioner accumulate its earnings beyond the reasonable needs of the business. In 1940, the first taxable year which we have before us, petitioner's net profits before taxes were $59,353.69. Of this amount, it paid $12,742.88 to the Federal Government in income and excess profits taxes, distributed $11,000 to its stockholders as dividends, and added $35,610.81 to earned surplus. In 1941 petitioner's net profits before taxes were $104,716.15. Of this amount, $37,248.19 was paid to the Federal Government in income and excess profits taxes, $15,000 was distributed to stockholders as dividends, and $52,467.96 was added to earned surplus. In 1942, the last of the taxable years which we have before us, petitioner's net profits were $182,725.74. Of this amount, petitioner paid $116,733.44 to the Federal Government in income and excess profits taxes, disbursed $20,000 to stockholders in dividends, and added $45,992.30 to earned surplus.
Thus we see from the foregoing facts that, while petitioner in the taxable years before us had large earnings, it paid large taxes to the Federal Government, disbursed substantial cash dividends to its stockholders, and added substantial amounts to its earned surplus. In the light of the facts recited in our findings of fact, we think the additions which petitioner made in each of the taxable years to its earned surplus were reasonable in amount and were accumulated to meet the legitimate needs of the business and not to prevent the imposition of the surtax on its stockholders.
One of the cases which respondent cites and relies upon is Whitney Chain & Mfg. Co., supra. We think the facts of that case are very unlike those present in the instant case, and, therefore, it is clearly distinguishable. In the Whitney Chain & Mfg. Co. case the taxpayer had loans outstanding to its stockholders in the amount of $347,800 and an investment in an unrelated corporation in the amount of $382,800. Largely because of these facts, we held that the taxpayer corporation was availed of in the taxable year for the purpose of preventing imposition of the surtax upon its stockholders through the medium of permitting its earnings or profits to accumulate instead of being distributed.
In the instant case petitioner had no outstanding loans to stockholders. On the contrary, petitioner was indebted to its stockholders in the respective taxable years in the following sums: 1940, $53,509.01; 1941, $55,051.04; and 1942, $55,857.99. These amounts were payable to stockholders on demand. Also petitioner, unlike Whitney Chain & Mfg. Co., supra, had no investments in unrelated corporations. It is true that in the taxable years it owned some stock in the Hafter Co. which operated in petitioner's place of business a women's ready-to-wear department, but this was a closely related business. Petitioner had $7,763.38 invested in this Hafter Co. stock which it had acquired in 1934. The evidence shows that this women's ready-to-wear department operated by the Hafter Co. had grown to be quite profitable and the acquirement of the remainder of this Hafter Co. stock was one of the expansion plans which petitioner had in view in accumulating some of its profits each year and adding them to surplus. Petitioner estimated at the end of 1942 that $100,000 would be required to buy out the stock interest of the Hafter brothers in the Hafter Co. It turned out that more than this amount was required, for in 1946 petitioner bought the 75 shares of Hafter Co. stock from the Hafter brothers for $127,000.
More like the instant case than Whitney Chain & Mfg. Co., supra, is General Smelting Co., 4 T.C. 313, in which we held in favor of the taxpayer on an issue similar to the one we have here, on the ground that the taxpayer's business was highly competitive and that in 1938 it decided upon a plan of modernization of its plant which was to and did extend over a period of several years. See also Dill Manufacturing Co., 39 B.T.A. 1023.
We hold that respondent erred in determining that the surtax under the provisions of section 102 of the code should be imposed upon petitioner's net income for each of the taxable years 1940, 1941, and 1942. Needless to say, our decision in petitioner's favor covering the taxable years before us is based upon the evidence as to those years and is no indication as to what might be the decision covering future years. Any decision for a future year would, of course, depend upon its own facts.
Having held in petitioner's favor on the main issue, it naturally follows that respondent erred in reducing petitioner's invested capital by the amount of the tax computed under section 102. We so hold.
As we stated at the outset, there were some adjustments made by the Commissioner in his determination of the deficiencies which are not contested, and effect will be given to them under Rule 50.
Decision will be entered under Rule 50.