Pechtel v. United States

Victor Pechtel, Charles Pechtel and Dwight H. Chester, Co-Partners Doing Business Under the Name and Style of Island Machine Tool Company, Petitioners, v. United States of America, Respondent Pechtel v. United States Docket No. 750-R United States Tax Court 18 T.C. 851; 1952 U.S. Tax Ct. LEXIS 125; August 7, 1952, Promulgated *125 1. Held, the petitioners' partnership and a corporation, which was owned and operated by two of the partners, were under common control and since both enterprises were subcontractors during the fiscal year here involved and since their combined renegotiable sales exceeded $ 500,000, petitioners' partnership profits are subject to renegotiation. 2. Held, that on the basis of the facts presented petitioners received excessive profits from the partnership in the amount herein determined. Meyer Bernstein, Esq., for the petitioners. John F. Wolf, Esq., and James D. Lynch, Esq., for the respondent. Hill, Judge. HILL *852 During the period May 1, 1944, through April 30, 1945, the three petitioners herein were general and equal partners in a business known as the Island Machine Tool Company, a subcontractor within the meaning of the Renegotiation Act. The respondent unilaterally determined that for the fiscal year ended April 30, 1945, the partnership's profits were excessive to the extent of $ 110,000 and that, after proper adjustment on account of taxes, other than Federal taxes, measured by income, the amount of excessive profits which should be eliminated was $ 108,267. Two issues are presented. The first issue concerns the question whether within the meaning of section 403 (c) (6) of the Renegotiation Act the partnership, the Island Machine Tool Company, and the Island Stamping Company, Inc., a corporation, were under common control. The other issue concerns the question of the amount, if any, of excessive profits *127 realized by the partnership during the fiscal period ended April 30, 1945. FINDINGS OF FACT. Part of the facts have been stipulated and they are so found. During the fiscal year here involved, May 1, 1944, through April 30, 1945, petitioners herein, Victor Pechtel, Charles Pechtel and Dwight H. Chester, were general and equal partners doing business under the firm name of Island Machine Tool Company, hereinafter referred to as the partnership. All of the partnership's activities were carried on in a two-story brick and frame building located at 132-6 Front Street, Farmingdale, New York. These premises, as well as a garage used for storage purposes, were rented by the partnership. During the period here involved the partnership was engaged in the business of machining tools and parts for aircraft. Most of its work was performed on castings and forgings supplied by outside companies. All of the products it sold during the period were for war-end use and it was a subcontractor within the meaning of the Renegotiation Act. The fiscal year here involved was the first year of the partnership's operations. The partnership agreement was entered into on April 30, 1944, and the partnership*128 commenced operations on May 1, 1944. The three individuals who made up the membership of the partnership were all closely related. Victor Pechtel was the father of Charles Pechtel and the father-in-law of Dwight H. Chester. The partnership agreement provided, among other things, that the three members were to be general and equal partners and that the partnership was to continue for the duration of the war (World War *853 II), plus 6 months thereafter, and/or until all obligations of the partners each to the other, if any, were paid. The functions of each partner were set out in the fifth paragraph of the agreement, which reads as follows: 5. That the parties hereto agree that the party of the first part [Victor Pechtel] shall be employed on a weekly salary basis at a sum to be agreed upon by the parties hereto in exchange for which the party of the first part shall advise, consult and shall have the general managerial duties of the partnership business and the parties hereto further agree that the party of the second part [Dwight H. Chester] and the party of the third part [Charles Pechtel] shall likewise be employed on a weekly salary basis at a sum to be agreed upon by *129 the parties hereto in exchange for which the party of the second part shall have the general duties of salesman and consulting engineer for the partnership business, and the party of the third part shall have the duties of production manager for said partnership business. This division of authority and of functions was, in fact, followed in the operation of the business. Victor Pechtel was in over-all charge of operations, and during the fiscal year ended April 30, 1945, he was the only person authorized to sign checks for the partnership. The capital of the partnership amounted to $ 45,000, consisting of machinery set up on the books of the partnership at a value of $ 30,000 and the intangible asset of good will in the amount of $ 15,000. The machinery was that formerly used by Victor Pechtel in his business operated as a sole proprietorship. No cash was invested. The partnership obtained working capital in the early weeks of its operations through advances or loans made to it by Victor Pechtel. The capital contributions of Charles Pechtel and Dwight Chester were in fact furnished by Victor Pechtel, and during the period here involved Charles Pechtel and Dwight Chester each*130 paid to Victor Pechtel $ 15,000 from their share of the profits of the partnership. For the fiscal year here involved the partnership's net profit from operations amounted to $ 175,569.39, and the profit for the year before any allowance for partners' salaries and Federal income taxes was $ 175,194.27. The partnership's total sales per its books for the fiscal year ended April 30, 1945, were as follows: Eastern Aircraft $ 355,063.78 Tennessee Aircraft, Inc 11,610.98 Measurements Corp 17,485.85 Glen Cove Welding Works 277.24 S. Pulitzer 300.00 Roof Structures 3.50 Island Stamping Co 111.28 Long Island Can Co 83.00 Glenn L. Martin Co 16.25 $ 384,951.88 Discount on sales $ 4,339.76 Total sales per books $ 380,612.12 *854 The sales made to the Eastern Aircraft Division of the General Motors Corporation (hereinafter referred to as Eastern Aircraft), in the amount of $ 355,063.78, as shown by the books of the partnership, was understated by an amount of $ 93,588.74 due to an error in bookkeeping; however, due to the partnership's method of keeping its books, this error did not affect the amount of its profit on sales. Following is a summary of the partnership*131 accounts for the fiscal year ended April 30, 1945: Dwight H. Victor Pechtel Charles Pechtel Chester Opening balance, per books $ 15,000.00 $ 15,000.00 $ 15,000.00 Checks charged to partners' accounts during year ended 4/30/45 13,000.00 13,000.00 13,000.00 Balance $ 2,000.00 $ 2,000.00 $ 2,000.00 Profit share for year ended 4/30/45 68,759.12 49,109.11 50,419.11 Total $ 70,759.12 $ 51,109.11 $ 52,419.11 Less Transfer from labor accounts: Management 26,200.00 Superintendence 6,550.00 Engineering 7,860,00 Balance 4/30/45 $ 44,559.12 $ 44,559.11 $ 44,559.11 Salaries other than those of the partners wre as follows: Direct labor $ 90,441.43 Indirect labor 20,508.77 Office and engineering payroll 7,751.63 Total $ 118,701.83 The partnership employed an average of 50 men. Drawings for the fiscal year, which were designated as salaries on the partnership's books, amounted to $ 40,610, made up as follows: Victor Pechtel $ 26,200 Charles Pechtel 6,550 Dwight Chester 7,860 Total $ 40,610 During the year here involved none of the partnership's investment was covered by a certificate of*132 necessity, and increased production schedules were met with its own capital without such a certificate. The books and records of the partnership show that no capital equivalent or financial assistance of any kind was received by the partnership *855 from the Government or any source other than the individual partners. None of the partnership's sales were made under cost plus fixed fee contracts. All of its sales were made either by bid or negotiated contracts, and no accelerated depreciation was allowed which affected the partnership's assets. From time to time the partnership was called upon by its principal customer, Eastern Aircraft, to furnish parts in addition to the quantities called for by its regular orders when other suppliers had fallen down or were unable to meet their requirements. The partnership complied with such requests. The machine work performed by the partnership was basically the same as that performed by other suppliers of Eastern Aircraft but this work called for high tolerances and the partnership had a low rate of rejection on its parts. In its contract with Eastern Aircraft the partnership had an escalator clause to cover any possible rise in material*133 costs. All three partners were experienced and capable men. Victor Pechtel, who had experience in machine shops in Germany, came to the United States in 1914. He worked at various plants in the United States, including the American Can Company. He became a superintendent in that company after many years and was in charge of the tooling, stamping and hand press departments. Due to differences of opinion as to policy, he left this company about 1925 or 1926 and started a small machine shop. He operated his machine shop as a sole proprietorship until the partnership was formed. Charles Pechtel, the son of Victor Pechtel, was a shop man who had worked in various machine shops as tool maker and a foreman. He had worked with the American Can Company and Fairchild Aircraft. Just prior to World War II he conducted a small plumbing and steam fitting business. He had about 15 years' experience as foreman and machinist. He was in charge of production in his father's company prior to the time the partnership was formed. Dwight Chester, the third partner, had for many years worked as an engineer for various aircraft companies and had a reputation in his trade as an outstanding engineer. *134 Over a period of years he worked with many different aircraft companies in the capacity of an engineer, and also did some work with respect to the production and selling end of the business. During the fiscal year here involved, Victor Pechtel and Dwight Chester were engaged in a second business. This was a corporation known as the Island Stamping Company, Inc. It was incorporated in July 1943. The stock of this company was owned as follows: Victor Pechtel 60% Dwight Chester 20% Mrs. Dwight (Matilda) Chester 20% *856 Mrs. Dwight (Matilda) Chester was the daughter of Victor Pechtel, sister of Charles Pechtel, and wife of Dwight Chester. The Island Stamping Company, Inc., hereinafter referred to as the corporation, during the year involved (the 12-month period ended April 30, 1945) was engaged primarily in welding with incidental machine operations on the parts being welded and, like the partnership, was a subcontractor within the meaning of the Renegotiation Act. Its operations were carried on at 620 Fulton Street, Farmingdale, which location was approximately seven-tenths of a mile from the premises where the business of the partnership was carried on. Some of*135 the books of the corporation were kept at the partnership's office on Front Street. The corporation was organized as the direct result of a conversation between officials of Eastern Aircraft and Dwight Chester, during the course of which the officials of Eastern Aircraft stated that they desired additional subcontractors for the production of welded assemblies. Dwight Chester was the operating head of the corporation. He was its president and general manager. Victor Pechtel was the treasurer and the sole officer designated to disburse the corporation's funds. Charles Pechtel was not associated with the corporation in any capacity. During the 12-month period ended April 30, 1945, Dwight Chester devoted about 85 per cent of his time to the corporation's business. He solicited orders, contacted various customers, and did the greater portion of the engineering work with the help of hired personnel. During the 12-month period ended April 30, 1945, the partnership made loans and advances to the corporation totaling $ 21,043.17. As of the end of the same period the partnership had been paid on account $ 9,181.91, leaving a balance owing from the corporation in the amount of $ 11,861.26. *136 The only other intercompany transaction between the partnership and the corporation was an item of repair work performed by the partnership for the corporation in the amount of $ 111.28. This service was included in the total sales of the partnership set out above. During the 12-month period ended April 30, 1945, the corporation had sales subject to renegotiation within the meaning of the Renegotiation Act in an amount of not less than $ 400,000. The partnership and the corporation were not jointly operated; however, they were under common control of a single family unit. A reasonable salary allowance for the three partners for the 12-month period here involved is $ 45,000, and for the same period the petitioners, Victor Pechtel, Charles Pechtel and Dwight Chester, doing business as a partnership under the firm name of Island Machine Tool Company, had excessive profits within the meaning of the Renegotiation Act in the amount of $ 80,000. *857 OPINION. The first issue concerns the question whether some form of common control existed between the partnership, Island Machine Tool Company, and the corporation, Island Stamping Company, Inc., so that the sales of each (about $ 400,000*137 for each company) may be combined to equal sales in excess of $ 500,000, thereby subjecting the partnership to renegotiation. 1*138 The question whether or not any two or more business ventures are under common control is a question of fact which must be determined on the basis of all the evidence presented. 2 Petitioners contend that their partnership was not under common control with the corporation and that since its renegotiable sales were in fact less than $ 500,000, it is not subject to renegotiation for the year here involved. The evidence introduced indicates that while the partnership was engaged in machining tools for aircraft, the corporation was engaged in welding assemblies for aircraft; that the business of each was conducted in separate buildings seven-tenths *139 of a mile apart; that while Victor Pechtel was the head man of the partnership, Dwight Chester was in charge of the corporation; and that with the exception of a minor repair item neither company performed work for the other or subcontracted any work to the other. We believe that such evidence indicates that the two firms were not jointly operated; however, we are convinced by the evidence that they were under common control. The corporation was a close corporation, whose stock was held by three parties. The controlling interest, 60 per cent, was held by Victor *858 Pechtel. 3 Of the remaining 40 per cent of the stock, 20 per cent was held by Dwight Chester, the son-in-law of Victor Pechtel, and 20 per cent was held by Matilda Chester, the daughter of Victor Pechtel and the wife of Dwight Chester. Dwight Chester was the president and acted in the capacity of general manager of the corporation. He was in fact its operating head. However, Victor Pechtel was the treasurer and was in charge of the very important function of disbursing funds needed by the corporation. *140 The partnership was under the control of the same family. It consisted of three general and equal partners, Victor Pechtel, Charles Pechtel, the son of Victor, and Dwight Chester. Victor Pechtel was in fact the operating head of this venture. There were only four people involved in both ventures and two of the partners held 80 per cent of the stock in the corporation. In addition, the partnership made a substantial loan to the corporation in the amount of $ 21,043.17, and at the end of the period here involved the balance due on this loan amounted to $ 11,861.26. In view of the foregoing facts we have found that common control was exercised over both ventures. To find otherwise would require us to turn our backs on the reality of the situation. We hold that since the combined renegotiable sales of the partnership and the corporation exceeded the jurisdictional minimum of $ 500,000, the partnership is subject to renegotiation. The second and main issue concerns the amount, if any, of excessive profits realized by the partnership for the fiscal year ended April 30, 1945. Petitioners maintain that they had no excessive profits during this period. In support of this position the*141 argument was made that the respondent did not make adequate allowance in its computation for salaries of the three partners. Petitioners also argue generally that respondent did not properly take into consideration the factors mentioned in section 403 (a) (4) (A) of the Renegotiation Act 4 so far as they related to petitioners' business. *142 *859 In this proceeding the petitioners have the burden of proving their position that the partnership received no excessive profits. Cohen v. Secretary of War, 7 T. C. 1002. With respect to the question of reasonable salaries, section 403 (a) (4) (B) of the Renegotiation Act provides for recognition of deductions allowed for income tax purposes. Of course, a partnership is not allowed any deduction for income tax purposes on account of compensation of active partners; however, the renegotiating authorities have recognized, and we have held, that allowance should be made for reasonable compensation for services actually rendered by them. Larrabee v. Stimson, 17 T. C. 69; Beeley v. W. C. P. A. B., 12 T. C. 61; Grob Brothers v. Secretary of War, 9 T. C. 495; Stein Brothers Manufacturing Co v. Secretary of War, 7 T. C. 863. While the record does not indicate what allowance for such salaries was made by the respondent in its determination, it is apparent from the statement of counsel at the hearing and the*143 arguments on brief that the respondent considers the amount claimed as reasonable salaries for the partners as set out in the petition ($ 75,000) to be excessive and argues that a reasonable salary allowance is $ 25,000. At the hearing there was introduced evidence with respect to the ability, experience, training, and reputation of the three partners and the nature of the work they performed. A witness testified as to a reasonable amount of salary for the work performed. After due consideration of all the evidence, we have found that a reasonable amount of the salary allowance for the partners is $ 45,000. After consideration of all the evidence presented to us, including the total business done by the partnership, the amount of capital invested, the capital risk involved, the efficiency of the partnership work, its contribution to the war effort, its ability to carry on without Government aid, the extent to which the partnership's business was competitive, the extent of risk with respect to increased costs and the amount of a reasonable salary allowance, we have concluded, as is evidenced in our findings of fact, that during the fiscal year here involved the three petitioners, *144 doing business as a partnership under the firm name of Island Machine Tool Company, realized excessive profits in the amount of $ 80,000. An order will be issued in accordance herewith. Footnotes 1. Section 403 (c) (6) of the Renegotiation Act: Sec. 403 (c) (6). This subsection shall be applicable to all contracts and subcontracts, to the extent of amounts received or accrued thereunder in any fiscal year ending after June 30, 1943, whether such contracts or subcontracts were made on, prior to, or after the date of the enactment of the Revenue Act of 1943, and whether or not such contracts or subcontracts contain the provisions required under subsection (b), unless (A) the contract or subcontract provides otherwise pursuant to subsection (i), or is exempted under subsection (i), or (B) the aggregate of the amounts received or accrued in such fiscal year by the contractor or subcontractor and all persons under the control of or controlling or under common control with the contractor or subcontractor, under contracts with the Departments and subcontracts (including those described in clause (A), but excluding subcontracts described in subsection (a) (5) (B)) do not exceed $ 500,000 and under subcontracts described in subsection (a) (5) (B) do not exceed $ 25,000 for such fiscal year . If such fiscal year is a fractional part of twelve months, the $ 500,000 amount and the $ 25,000 amount shall be reduced to the same fractional part thereof for the purposes of this paragraph.↩ 2. With respect to the purpose of the common control clause, we stated in Moening v. W. C. P. A. B., 14 T. C. 589, that -- The purpose of the "common control" clause in question is at least in part to prevent contractors from establishing, either in corporate or partnership form, a series of ad hoc↩ business enterprises, each of which is to work on a phase of war contracts, in order to prevent the total receipts of the individual contractors derived from war contracts or subcontracts from reaching the jurisdictional minimum. See Senate Report No. 440, part 2, 80th Cong., 2d sess., p. 11. 3. The record does not indicate the extent of Victor Pechtel's investment in the corporation, but testimony indicated generally that he probably furnished at least a substantial portion of the capital for this venture.↩ 4. Sec 403 (a). For the purposes of this section -- * * * * (4) (A) The term "excessive profits" means the portion of the profits derived from contracts with the Departments and subcontracts which is determined in accordance with this section to be excessive. In determining excessive profits there shall be taken into consideration the following factors: (i) efficiency of contractor, with particular regard to attainment of quantity and quality production, reduction of costs and economy in the use of materials, facilities, and manpower; (ii) reasonableness of costs and profits, with particular regard to volume of production, normal pre-war earnings, and comparison of war and peacetime products; (iii) amount and source of public and private capital employed and net worth; (iv) extent of risk assumed, including the risk incident to reasonable pricing policies; (v) nature and extent of contribution to the war effort, including inventive and developmental contribution and cooperation with the Government and other contractors in supplying technical assistance; (vi) character of business, including complexity of manufacturing technique, character and extent of subcontracting, and rate of turn-over; (vii) such other factors the consideration of which the public interest and fair and equitable dealing may require, which factors shall be published in the regulations of the Board from time to time as adopted.↩