Opinion
Docket No. 21156.
1956-12-11
Scott P. Crampton, Esq., Dewey R. Roark, Jr., Esq., and Paul E. Schaub, C.P.A., for the petitioner. Edward E. Pigg, Esq., and William T. Holloran, Esq., for the respondent.
Scott P. Crampton, Esq., Dewey R. Roark, Jr., Esq., and Paul E. Schaub, C.P.A., for the petitioner. Edward E. Pigg, Esq., and William T. Holloran, Esq., for the respondent.
The evidence does not justify a constructive average base period net income in excess of the determination of the respondent under the provisions of section 713(f), I.R.C. 1939.
Petitioner seeks relief under section 722(b)(4) of the Internal Revenue Code of 1939 because of a change in its capacity for production or operation consummated during and after the base period.
FINDINGS OF FACT.
The stipulations of the parties, oral and written, together with the exhibits attached to and made a part of the written stipulations, are incorporated herein and made a part hereof by this reference.
The petitioner is a corporation organized May 29, 1931, under the laws of the State of Tennessee. During the base period years it was engaged principally in the manufacture and sale of plastic buttons. Its principal place of business is at Knoxville, Tennessee.
Petitioner keeps its books and files its income and excess profits tax returns on the accrual basis of accounting and by calendar years. Its tax returns for all years involved herein were filed with the then collector of internal revenue for the district of Tennessee.
For the taxable years 1941, 1942, 1943, and 1945, petitioner paid excess profits taxes as follows:
+----------------------------+ ¦Year ¦Excess profits tax ¦ +------+---------------------¦ ¦1941 ¦$35,527.72 ¦ +------+---------------------¦ ¦1942 ¦60,695.40 ¦ +------+---------------------¦ ¦1943 ¦87,157.35 ¦ +------+---------------------¦ ¦1945 ¦85,333.32 ¦ +----------------------------+
The excess profits tax paid for such taxable years was based upon petitioner's excess profits net income for each of the years 1940 to 1945, inclusive, as follows:
+------------------------+ ¦ ¦Excess profits ¦ +------+-----------------¦ ¦Year ¦net income ¦ +------+-----------------¦ ¦1940 ¦1 $76,957.64 ¦ +------+-----------------¦ ¦1941 ¦211,855.55 ¦ +------+-----------------¦ ¦1942 ¦177,262.12 ¦ +------+-----------------¦ ¦1943 ¦199,171.03 ¦ +------+-----------------¦ ¦1944 ¦102,086.76 ¦ +------+-----------------¦ ¦1945 ¦212,534.92 ¦ +------+-----------------¦ ¦ ¦ ¦ +------------------------+ FN1 Computed under Revenue Act of 1941.
In determining its excess profits tax liability for the years 1940 to 1945, inclusive, petitioner used and respondent allowed an excess profits credit of $97,329.53, which was computed under the earned income methods as follows:
+----------------------------------------+ ¦ ¦Excess profits ¦ +-----------------------+----------------¦ ¦Base period years ¦net income ¦ +-----------------------+----------------¦ ¦1936 ¦$24,493.08 ¦ +-----------------------+----------------¦ ¦1937 ¦51,319.10 ¦ +-----------------------+----------------¦ ¦1938 ¦80,820.57 ¦ +-----------------------+----------------¦ ¦1939 ¦102,452.14 ¦ +-----------------------+----------------¦ ¦Total ¦$259,084.89 ¦ +-----------------------+----------------¦ ¦Actual average ¦64,771.22 ¦ +-----------------------+----------------¦ ¦Section 713 (f) average¦102,452.14 ¦ +-----------------------+----------------¦ ¦95 per cent thereof ¦97,329.53 ¦ +----------------------------------------+
The annual gross sales, net income, and excess profits net income of petitioner for 1935 through 1939 were as follows:
+------------------------------------------+ ¦Year¦Gross sales¦Net income¦Excess profits¦ +----+-----------+----------+--------------¦ ¦ ¦ ¦ ¦net income ¦ +----+-----------+----------+--------------¦ ¦1935¦$56,330.33 ¦$4,867.08 ¦ ¦ +----+-----------+----------+--------------¦ ¦1936¦132,795.30 ¦24,773.50 ¦$24,493.08 ¦ +----+-----------+----------+--------------¦ ¦1937¦216,609.28 ¦54,468.77 ¦51,319.10 ¦ +----+-----------+----------+--------------¦ ¦1938¦349,360.36 ¦81,185.72 ¦80,820.57 ¦ +----+-----------+----------+--------------¦ ¦1939¦630,638.07 ¦102,452.14¦102,452.14 ¦ +------------------------------------------+
For the years 1941, 1942, 1943, and 1945, petitioner filed with the respondent timely applications for relief from excess profits taxes under section 722, Internal Revenue Code of 1939. The years 1940 and 1944 are involved because of the carryover and carryback provisions of the Code. Petitioner's original and supplemental applications for relief were all considered by respondent on their merits before issuance of the statutory notice of disallowance of relief under section 722.
In its applications for relief, petitioner claimed qualification under several subsections of section 722. At the hearing, petitioner waived all claims to qualification except under subsection 722(b)(4).
Petitioner is entitled to use the excess profits credit based on income pursuant to section 713. In its applications for relief petitioner claimed an excess profits credit of $127,660.09, based on a constructive average base period net income of $134,379.04, because of an alleged change in capacity for production or operation consummated during the base period as well as after December 31, 1939.
The original paid-in capital of the petitioner was $5,000 cash. Subsequent increases in petitioner's capital were by the sale of additional stock for cash. In October 1933, the capital was increased to $25,000. In December 1936, capital was increased to $45,000, and in March 1937, to $50,000, at which amount it remained during the other years involved herein.
During the base period years, the Patent Button Company of Waterbury, Connecticut, hereinafter referred to as Connecticut, owned over 70 per cent of petitioner's capital stock and was petitioner's exclusive sales agent. The other principal stockholder during the base period years was Alex A. Scott, Jr., of Knoxville, petitioner's general manager, one of its founders, and owner of approximately 24 per cent of its capital stock.
Prior to the base period, petitioner was located in Townsend, Tennessee. On September 8, 1936, petitioner purchased a 3-story brick building in Knoxville, and thereafter transferred its operations from Townsend to Knoxville. On September 24, 1938, petitioner purchased, and added to its Knoxville plant, a 2-story brick building, which had a large floor area and could be connected with the 3-story building by a passageway. The 2-story building needed repairing and reconditioning which took most of 1939.
The number of plastic button presses which petitioner had at the beginning of the base period, the presses added or ordered during such period, together with their pressure capacity and cost, were as follows:
+--------------------------------------------+ ¦ ¦ ¦Reserve ¦Cost (per¦ +------+-----------------+---------+---------¦ ¦Number¦Date acquired ¦capacity ¦press) ¦ +------+-----------------+---------+---------¦ ¦ ¦ ¦(in tons)¦ ¦ +------+-----------------+---------+---------¦ ¦3 ¦Prior to 1936 ¦75 ¦ ¦ +------+-----------------+---------+---------¦ ¦1 ¦May 18, 1936 ¦75 ¦$1,525.00¦ +------+-----------------+---------+---------¦ ¦2 ¦Dec. 28, 1936 ¦100 ¦2,055.00 ¦ +------+-----------------+---------+---------¦ ¦2 ¦Apr. 1, 1937 ¦100 ¦2,040.00 ¦ +------+-----------------+---------+---------¦ ¦2 ¦July 10, 1937 ¦100 ¦2,296.00 ¦ +------+-----------------+---------+---------¦ ¦2 ¦Nov. 4, 1938 ¦100 ¦3,110.00 ¦ +------+-----------------+---------+---------¦ ¦2 ¦Nov. 30, 1938 ¦100 ¦3,110.00 ¦ +------+-----------------+---------+---------¦ ¦2 ¦July 31, 1939 ¦100 ¦2,832.50 ¦ +------+-----------------+---------+---------¦ ¦2 ¦Jan. 18, 1940 1 ¦100 ¦2,832.50 ¦ +------+-----------------+---------+---------¦ ¦4 ¦Apr. 29, 1940 2 ¦100 ¦2,832.50 ¦ +--------------------------------------------+ FN1 Ordered Sept. 13, 1939.FN2 Ordered Nov. 7, 1939.
The 16 plastic button presses operated by petitioner during the latter part of 1939 were installed in the 3-story building. There was no room in this building for additional presses and the weight of the 16 overtaxed the building's construction. The 6 presses ordered in September and November 1939 were installed in the 2-story building after their acquisition in January and April 1940. The dates on which these 6 presses began operating are undisclosed.
During 1937, 1938, and 1939, petitioner operated its button molding department, generally, 24 hours a day, 7 days a week, with minor exceptions. During most of this period petitioner operated three 8-hour shifts per day, but during a portion thereof it operated four 6-hour shifts. Petitioner tried to keep all its presses in operation.
Plastic buttons have two general classifications, the thermosetting type of button and the thermoplastic type. Petitioner manufactured the thermosetting button which was a very good button on clothing that was washed, ironed, or pressed. The thermosetting type of button was manufactured from a molding material such as urea formaldehyde compound or phenol formaldehyde compound, commonly called Plaskon and Bakelite, respectively. Bakelite was cheaper but only dark colors could be obtained with it; on the other hand, Plaskon was capable of making light and pastel shades as well as white.
In manufacturing buttons petitioner sent its molding compound through a pre-forming process in a rotary machine exactly the same as that used in making aspirin tablets. The performs, pills, or tablets were made by pressure without molding or heating. The pills or tablets were then placed in button molds, the number of cavities in which varied with the size of the press (75-ton or 100-ton) and the size of the button. The smaller presses had 225 cavity molds and the larger 152, to 304, depending on the size of the button. When the press machines were operated, heat and pressure were applied to form the button. The curing time was 45 to 75 seconds depending on the size of the button. A complete cycle for loading, curing, and unloading a mold of buttons took from a minute to 2 minutes depending on the size of the button. The majority of petitioner's buttons were of the smaller sizes. The estimated daily production of a button press operating a full day without interruption was 150 great gross, a great gross being 12 single gross, or 1,728 buttons.
Petitioner manufactured ‘utility’ buttons as distinguished from ‘fashion’ buttons. Fashion buttons were used by manufacturers of ladies' wearing apparel which trade petitioner did not cover, but which was the largest segment of the apparel industry. Utility buttons were used on trousers, work shirts, furnishings, and sport garments, which constituted a small segment of the apparel industry. Utility buttons changed very little in size or design from season to season, but fashion buttons varied seasonably, both in size and design, with changes in ladies' wearing apparel. Petitioner had practically no style or fashion problem with respect to its buttons but it did encounter demands for changes in colors.
Prior to September 1936, petitioner manufactured only trouser buttons and only in two sizes and designs, Pilot 1, sizes 22 and 27, and Pilot B, sizes 22 and 27. In September 1936 and May 1937, petitioner added work-shirt buttons to its line, and from time to time thereafter, other new buttons in sizes, colors, designs, and use were added to its line. The buttons manufactured by petitioner during the base period, with the additions thereto, were as follows:
+----------------------------+ ¦Date ¦Name ¦Size¦ +-------------+---------+----¦ ¦ ¦( Pilot 1¦22 ¦ +-------------+---------+----¦ ¦ ¦( Pilot 1¦27 ¦ +-------------+---------+----¦ ¦Jan. 1, 1936 ¦( Pilot B¦22 ¦ +-------------+---------+----¦ ¦ ¦( Pilot B¦27 ¦ +-------------+---------+----¦ ¦Sept. 1936 ¦Hylite ¦22 ¦ +-------------+---------+----¦ ¦May 1937 ¦Knoxite ¦20 ¦ +-------------+---------+----¦ ¦ ¦( Dixie ¦18 ¦ +-------------+---------+----¦ ¦Sept. 1937 ¦( Dixie ¦20 ¦ +-------------+---------+----¦ ¦ ¦( Dixie ¦22 ¦ +-------------+---------+----¦ ¦ ¦( Fisheye¦18 ¦ +-------------+---------+----¦ ¦Sept. 1937 ¦( Fisheye¦20 ¦ +-------------+---------+----¦ ¦ ¦( Fisheye¦22 ¦ +-------------+---------+----¦ ¦May 1938 ¦Knoxite ¦22 ¦ +-------------+---------+----¦ ¦May 1938 ¦Roman ¦22 ¦ +-------------+---------+----¦ ¦May 1938 ¦Roman ¦30 ¦ +-------------+---------+----¦ ¦Oct. 1939 ¦Vulcan ¦18 ¦ +-------------+---------+----¦ ¦Oct. 1939 ¦Vulcan ¦24 ¦ +----------------------------+
By the end of the base period, petitioner had a reasonably complete line of buttons and was covering the field it wanted to cover.
Petitioner's sales increased as the production of the wash clothing manufacturers increased, which occurred during the fall and the early months of the year. Petitioner maintained an inventory of buttons to meet these seasonal increases and to fill other anticipated orders. Seasonal color changes increased petitioner's inventory and production problems, particularly in the pastel shades. At the end of the base period petitioner was manufacturing buttons in about 17 styles or sizes and 30 or more colors.
In 1938, petitioner maintained a machine shop on the first floor of its building in which it machined its button molds. The hardening was done by other concerns, as petitioner had no hardening facilities. About the middle of 1939, petitioner purchased a hardening furnace which saved it about 30 days in the production of button molds.
During the base period, petitioner's exclusive sales agent, Connecticut, sold other items beside plastic buttons, namely, zippers, two types of metal buttons, overall hardware, and a few leather buttons. In addition to petitioner's buttons, Connecticut purchased plastic buttons for resale to its trade from the Colt Patent Firearms Company, hereinafter referred to as Colt. The Colt buttons were also thermosetting plastic buttons and Connecticut used the Colt line to supplement petitioner's line so that it could offer the trade a complete line of buttons. Connecticut had no exclusive sales contract with Colt, and consequently it sold the Colt buttons to the trade in direct competition with other concerns selling the Colt buttons. As petitioner added new styles and sizes of buttons to its line, Connecticut sold petitioner's buttons in preference to the Colt buttons.
Late in 1937, Connecticut and Colt had a disagreement, and thereafter Connecticut secured only limited cooperation from Colt in supplying buttons. Connecticut was unable to meet the button requirements of its customers with the partial line of buttons provided by petitioner and lost some customers. There were not other manufacturers of quality buttons from which Connecticut could obtain the additional buttons needed to offer the trade a complete line. After 1938, Connecticut ceased handling the Colt line of buttons.
During the years 1935 through 1939, Connecticut purchased plastic buttons from Colt in the following total amounts:
+-------------------+ ¦Year ¦Purchases ¦ +------+------------¦ ¦1935 ¦$75,996.58 ¦ +------+------------¦ ¦1936 ¦122,224.06 ¦ +------+------------¦ ¦1937 ¦167,128.32 ¦ +------+------------¦ ¦1938 ¦11,422.51 ¦ +------+------------¦ ¦1939 ¦None ¦ +-------------------+
During the base period years, Connecticut operated two plastic button presses at Waterbury, Connecticut, which it used for experimenting and to supplement petitioner's production. The following table shows orders received for buttons manufactured by petitioner and Connecticut, in great gross (GG), with an approximation of the orders filled by each:
+------------------------------------------------------------------+ ¦ ¦ ¦Work ¦ ¦Approximate orders ¦ +--------------+--------+-----------+-------+----------------------¦ ¦ ¦ ¦shirts, ¦Total ¦filled ¦ +--------------+--------+-----------+-------+----------------------¦ ¦Period or year¦Trousers¦playsuits, ¦orders ¦ ¦ +--------------+--------+-----------+-------+----------------------¦ ¦ ¦(GG) ¦underwear, ¦(GG) ¦ ¦ ¦ +--------------+--------+-----------+-------+-----------+----------¦ ¦ ¦ ¦and pajamas¦ ¦Connecticut¦Petitioner¦ +--------------+--------+-----------+-------+-----------+----------¦ ¦ ¦ ¦(GG) ¦ ¦(GG) ¦(GG) ¦ +--------------+--------+-----------+-------+-----------+----------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+--------+-----------+-------+-----------+----------¦ ¦1936 1 ¦46,152 ¦3,890 ¦50,042 ¦ ¦50,042 ¦ +--------------+--------+-----------+-------+-----------+----------¦ ¦1937 ¦94,306 ¦30,671 ¦124,977¦22,500 ¦102,477 ¦ +--------------+--------+-----------+-------+-----------+----------¦ ¦1938 ¦115,241 ¦171,502 ¦286,743¦15,000 ¦271,743 ¦ +--------------+--------+-----------+-------+-----------+----------¦ ¦1939 ¦188,775 ¦349,316 ¦538,091¦28,500 ¦509,591 ¦ +--------------+--------+-----------+-------+-----------+----------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------------------------------------------------------------+ FN1 Aug. 14, through Dec. 31.
For each of the base period years, petitioner's plastic button presses showed a net profit per press as follows. The number of presses in operation are averaged for each year.
+--------------------------------------+ ¦Year¦Presses¦Net profit ¦Profit per¦ +----+-------+--------------+----------¦ ¦ ¦ ¦ ¦press ¦ +----+-------+--------------+----------¦ ¦ ¦ ¦ ¦ ¦ +----+-------+--------------+----------¦ ¦1936¦3.58 ¦$24,773.50 ¦$6,919.97 ¦ +----+-------+--------------+----------¦ ¦1937¦8.50 ¦54,468.77 ¦6,408.09 ¦ +----+-------+--------------+----------¦ ¦1938¦10.50 ¦81,185.72 ¦7,731.97 ¦ +----+-------+--------------+----------¦ ¦1939¦14.83 ¦1 101,339.72¦6,833.43 ¦ +----+-------+--------------+----------¦ ¦ ¦ ¦ ¦ ¦ +--------------------------------------+ FN1 Stipulated figure adjusted by $1,112.42, which represented profits from custom molding division.
During 1939 petitioner produced 497,473 great gross of buttons or a weekly average of 9,566.8 great gross. Its shipments for 1939 total 505,353 great gross or a weekly average of 9,718.3 great gross. Petitioner operated 14 plastic button presses prior to July 31, 1939, and its average weekly production and shipments during the 30 weeks ending July 28, 1938, were 8,857.6 and 8,985.6 great gross, respectively. At some undisclosed date after July 31, 1939, petitioner operated 16 presses and its average weekly production and shipments for the remaining 22 weeks of 1939 were 10,533.8 and 10,717.5 great gross, respectively. The highest weekly production during the 30-week and the 22-week periods was 11,292 great gross for the week ending June 23, 1939, and 13,895 great gross for the week ending September 29, 1939. For the first 20 weeks of 1939, petitioner maintained an average weekly inventory of 40,815 great gross of buttons. No records are available as to petitioner's weekly inventory for the remainder of 1939.
The ratio of petitioner's net income to net worth and the percentage of net income to sales during the base period were as follows:
+-------------------------------------------------+ ¦ ¦ ¦ ¦Ratio ¦Percentage,¦ +----+----------+----------+----------+-----------¦ ¦Year¦Net income¦Net worth ¦(per cent)¦net income ¦ +----+----------+----------+----------+-----------¦ ¦ ¦ ¦ ¦ ¦to sales ¦ +----+----------+----------+----------+-----------¦ ¦ ¦ ¦ ¦ ¦ ¦ +----+----------+----------+----------+-----------¦ ¦1936¦$24,773.50¦$44,753.00¦55.4 ¦18.7 ¦ +----+----------+----------+----------+-----------¦ ¦1937¦54,468.77 ¦52,152.57 ¦104.4 ¦25.1 ¦ +----+----------+----------+----------+-----------¦ ¦1938¦81,185.72 ¦110,268.77¦73.6 ¦23.2 ¦ +----+----------+----------+----------+-----------¦ ¦1939¦102,452.14¦183,654.06¦55.8 ¦16.2 ¦ +----+----------+----------+----------+-----------¦ ¦ ¦ ¦ ¦ ¦ ¦ +-------------------------------------------------+
If petitioner had acquired its additional presses, molds, and plant facilities 2 years prior to the time it did acquire them, there would have been a market for any increased production resulting therefrom to the extent of the amount of buttons purchased by Connecticut from Colt for resale to the trade.
OPINION.
VAN FOSSAN, Judge:
In this case petitioner seeks relief under section consummated during and after the base period. The taxable years are 1941, 1942, 1943, and 1945, the years 1940 and 1944 being involved only by reason of petitioner's claim of unused excess profits credit carryovers and carrybacks.
Petitioner's actual average base period net income was approximately $64,000. In determining petitioner's excess profits tax liability for the taxable years, respondent used an average base period net income of approximately $102,000, computed under the ‘growth formula’ in section 713(f).
In its applications for relief, petitioner claimed a constructive average base period net income of approximately $134,000. In its proposed findings and brief, petitioner contends for a figure of approximately $148,000
The evidence establishes that petitioner changed its capacity for production or operation during the base period, within the meaning of section 722(b)(4). Petitioner increased its button presses from 3 at January 1, 1936, to 16 at December 31, 1939, and had 6 additional presses on order at the latter date. During the base period petitioner also acquired a 3-story building in 1936 and a 2-story building in 1938, thus substantially increasing the size of its plant during such period. On these facts we are of the opinion that petitioner has established a qualifying factor.
In its quest for relief, petitioner's chief burden is the establishment of a fair and just amount that can be used as a constructive average base period net income, in excess of the average base period net income computed by respondent under section 713(f). Petitioner's basic contention here is that it is entitled to apply the push-back rule. As a first step, it seeks to establish the net income it would have realized in 1939 if it had been operating 22 button presses (16 plus 6 on order at December 31, 1939) 2 years before. Pointing to the net profit per press of $6,833 realized in 1939 on the average number of presses operated in that year, petitioner contends that, if it had been operating 22 presses in 1939, it would have realized a net income of approximately $150,000 ($6,882 x 22). Petitioner then backcast this net income using indices computed from wholesale sales of the wearing apparel industry, postulating that 1939 sales equal 100.
The fallacy in petitioner's reconstruction is twofold. The parallelism of the wearing apparel industry is not proved. Nor has satisfactory evidence been adduced that the increased production from its increased capacity could have been sold. In other words, it does not appear in the record that there was an existing demand in the market for such an increase in buttons, or that a demand could have been created which would have absorbed such increased production.
The evidence establishes an existing demand for a part of petitioner's increased capacity, that part being represented by the purchases and sales of Colt buttons. Had Connecticut purchased all its buttons from petitioner instead of a part thereof from Colt during 1936, 1937, and 1938, petitioner's aggregate gross sales for such years would have increased approximately $300,000, and its average excess profits net income for the base period would have increased about $16,000. Adding the assumed $16,000 increase over actual average base period net income of $64,000 with the resulting figure of $80,000, is no help to petitioner in securing relief under section 722. It is still less than average base period net income computed by the Commissioner under section 713(f).
There is opinion evidence in the record to the effect that petitioner could have sold some additional buttons (over and above Colt purchases), if it had been able to supply Connecticut with a complete line of buttons, but no persuasive estimate of the amount of this demand is to be found in the record. Assuming, arguendo, that such additional demand would result in additional sales during the base period of another $300,000, with the further increase in average excess profits net income for the base period of another $16,000, nevertheless, petitioner would derive no benefit under section 722 because the reconstruction of earnings at $96,000 is still less than the $102,000 computed by respondent under section 713(f).
It is our opinion, therefore, that any reconstruction justified by this record will fall short of the average base period net income computed by respondent under the provisions of section 713(f).
Respondent is sustained.
Reviewed by the Special Division.
Decision will be entered for the respondent. 1. Computed under Revenue Act of 1941.