Kentucky Whip & Collar Co. v. Commissioner

Kentucky Whip & Collar Company, Petitioner, v. Commissioner of Internal Revenue, Respondent Kentucky Whip & Collar Co. v. Commissioner Docket No. 24419 United States Tax Court 19 T.C. 743; 1953 U.S. Tax Ct. LEXIS 250; January 27, 1953, Promulgated *250 Decision will be entered for the respondent. Petitioner having had losses in all of the base period years except one, in filing excess profits tax returns for its fiscal years ending April 30, 1943, 1944, and 1945, used excess profits credits based on invested capital. Petitioner filed applications for relief under section 722 of the Code based on 722 (b) (1) or (2) and (4). The Commissioner denied relief and petitioner has appealed from such denial. Held, petitioner has not established its grounds for relief under either 722 (b) (1) or (2) or (4) and the Commissioner's determination is sustained. Reber Boult, Esq., and T. M. McIntyre, C. P. A., for the petitioner. Robert M. Willan, Esq., and Joseph L. Spilman, Jr., Esq., for the respondent. Black, Judge. BLACK *743 Petitioner filed applications for*251 relief under section 722 of the Code claiming refunds in tax as follows: Fiscal year ended Tax refund claimed April 30, 1943 $ 13,110.86 April 30, 1944 4,465.60 April 30, 1945 10,310.68 Petitioner now appeals from the Commissioner's disallowance of its claims for relief and it alleges it is entitled to relief by virtue of one of the following: 722 (b) (1) or (b) (2) and 722 (b) (4) of the Code. Petitioner's excess profits credit based on invested capital for each of the taxable years was stipulated to be as follows: Fiscal year ended Excess profits credit April 30, 1943 $ 11,165.33 April 30, 1944 11,419.31 April 30, 1945 10,272.18 For each of the taxable years petitioner claims it is entitled to a constructive average base period net income of $ 27,423.77. Petitioner relies on two factors as qualifying it for relief. First, it contends that a smear campaign or sales tactics of its competitors during the base period qualifies it for relief under section 722 (b) (1) or (b) (2). Second, it contends that a change in management which occurred on September 1, 1939, qualifies it for relief under section 722 (b) (4). FINDINGS OF FACT. The facts which have been*252 stipulated are made a part of these findings and are incorporated herein by this reference. Petitioner's tax returns for the fiscal years 1943, 1944, and 1945 were filed with the collector of internal revenue for the district of Kentucky. *744 Petitioner was incorporated in July 1930, with an authorized capital stock of $ 100,000, consisting of 100 shares of no par value common stock and 500 shares of preferred stock of the par value of $ 100 per share. Petitioner was the successor of a partnership which had three partners, R. S. Mason, A. P. Day, and a Mr. Moser. The partnership business was organized in 1908 for the purpose of manufacturing horse collars and harness. In 1908, Mason purchased a horse collar factory operating in the Kentucky state penitentiary at Eddyville, Kentucky. Mason joined with Moser of the Moser Leather Company, New Albany, Indiana, to form the partnership to operate the factory at Eddyville. The partnership and its successor corporation, the petitioner, engaged in the manufacture of horse collars and harness in the penitentiary from 1908 until October 11, 1936, using convict labor. Petitioner is still in business but no longer uses convict labor*253 and no longer carries on its business of manufacturing in the penitentiary. From the very beginning of the partnership in 1908, Mason supervised the operation of the prison factory and the employees, including certain foremen whom he had been training in the business for 10 years. The foremen were left in charge of the factory while Mason traveled to the wholesale trade and obtained orders for between 50 per cent and 60 per cent of the partnership's total sales at that time. Beginning about 1914, the partnership engaged to handle their collars salesmen who were traveling for some other concern handling harness. In this way the partnership built up considerable trade. Mason continued to travel and sell throughout his association with the business, making his last trip for petitioner in the spring of 1939. By virtue of this long experience Mason became very familiar with the conditions and problems of the harness and horse collar industry. Day became a partner in the business during 1909. Prior to September 1939, Day served the business as secretary and treasurer, and as such, he was primarily in charge of the business office of petitioner. Sometime during the 1920's, the partnership*254 added the manufacture of harness to its operations. The decision to manufacture harness was made after consideration of the fact that leather piled all over Moser's tannery was beginning to deteriorate and rot. Petitioner purchased from Moser Leather Company the greater proportion of certain types of leather it used in manufacturing harness and collars. The partnership operated under written contracts with the State of Kentucky, which supplied the prison labor used in the business. The contract dated September 1, 1922, provided for the employment of 150 able-bodied convicts at a wage of $ 1 per day per man. Under the contract a prison building was also furnished the business without additional charge. The convicts were to work 9 hours a day *745 throughout the year, except Sundays and holidays. This contract was extended and was in force until another contract was executed under date of August 1, 1932, which provided for 50 men at a wage of 60 cents per day per man. The partnership developed a method of training its workers and breaking down its manufacturing process into steps similar to that used in many industries today. It was as follows: When a man came to work for*255 the first time he was taught to do just one thing and to do that well through repetition. The men would work in groups with one cutting the leather, another stitching, another stuffing the collars, another sewing by machine, and another finishing them. Each man had his own particular task. This system worked well with convict labor and when used later with free labor, after petitioner moved out of the penitentiary in October 1936, it worked well. Under this system of manufacturing petitioner found very little difference between the efficiency of convict labor and free labor. Using this system petitioner found that the economy of using prison labor depended upon its ability to keep a large proportion of the available convicts occupied throughout the year. During the period from 1930 to August 1, 1932, when the new contract became effective, petitioner's contract for 150 convicts was burdensome. Due to a decline in sales only half that number, or approximately 75, could be kept occupied. Between August 1, 1932, and October 1936, operating under a new contract, the business was able to utilize fully the convicts available to it. Prior to October 11, 1936, petitioner used convict*256 labor except for its salesmen, office workers, foremen, and officers. From that date until October 24, 1938, the effective date of the Fair Labor Standards Act, petitioner operated on a 6-day week of 48 hours and paid its laborers $ 1 per day. While the hourly rate of pay for free labor was higher, petitioner found that this increase in expense was offset largely by other factors affecting labor costs. During the year 1930, when petitioner was using convict labor, and again during 1938, when petitioner was using free labor, estimates were made of unit costs for certain of its products. The estimates of labor and other manufacturing costs of these items were only estimates made during those years by petitioner's management for pricing purposes and were subject to error as no reconciliation of unit costs was made at the end of the year with total costs for the particular year. Beginning shortly after 1909, the saddle and harness industry entered into a period of permanent decline. The trend continued after 1931; however, the industry decline was not so great after 1931. On January 19, 1929, the "Hawes-Cooper Act," 45 Stat. 1084, was enacted (effective January 19, 1934), which made*257 prison-made goods subject to state laws, even though shipped in original package in *746 interstate commerce. On July 24, 1935, the "Ashurst-Summers Act," 49 Stat. 494, was enacted, which made it unlawful to transport knowingly in interstate or foreign commerce goods made by convict labor into any state where the goods were intended to be received, processed or sold, or used in violation of its laws. Petitioner brought suit to restrain enforcement of this law on the grounds that such law was unconstitutional. See Kentucky Whip & Collar Co. v. Illinois Central Railroad Co., 12 F. Supp. 37. Petitioner was granted a preliminary injunction on August 28, 1935, pending a hearing on the merits. On January 4, 1937, the Supreme Court upheld the Ashurst-Summers Act. Kentucky Whip & Collar Co. v. Illinois Central Railroad Co., 299 U.S. 334. After the Hawes-Cooper Act became effective January 19, 1934, petitioner's competitors called the attention of petitioner's customers to the various state laws enacted under the Hawes-Cooper Act which made illegal the sale of petitioner's convict-made goods within their respective*258 borders and also called attention by various means to the increase in public sentiment against the sale of convict-made goods. As a result of these statutes and the efforts of petitioner's competitors, petitioner lost numerous customers and its sales were substantially decreased. The management of petitioner decided to move its business from the penitentiary and with this in mind petitioner in April 1936, acquired a building at Kuttawa, Kentucky. This building was destroyed by fire on July 31, 1936, before any manufacturing operations were begun there so that normal production of petitioner was not interrupted. Petitioner acquired in May 1936 a second building located between Eddyville and Kuttawa. Petitioner commenced manufacturing operations at this building in October 1936, and they were carried on there until December 1939, when this building was destroyed by fire. Normal production was not interrupted since petitioner was permitted to employ free labor in using the free facilities at the Eddyville penitentiary from December 1939 until May 1940. Prior to September 12, 1939, R. S. Mason owned five-eighths of the common stock of petitioner and A. P. Day owned three-eighths. *259 Also prior to September 12, 1939, R. S. Mason was president and general manager of petitioner. On that date, September 12, 1939, R. S. Mason tendered his resignation as president, director, and general manager of petitioner effective September 1, 1939. The salary of R. S. Mason at the time he resigned was $ 4,800 per annum. The vacancy occasioned by the resignation of Mason was not filled. At or about the same date, September 12, 1939, A. P. Day was elected president of petitioner, and his son Howard E. Day and his son's wife Vanetta M. Day were elected directors for the first time. *747 The following schedule shows the net sales, gross profit from sales, and net income (or loss) of the petitioner for each year from its incorporation in 1930 to the end of the base period: Gross profits Year Net sales from sales Net income July 1, 1930 to December 31, 1930 $ 87,202.61 $ 7,363.92 ($ 6,425.76) — 1931 — 196,017.07 32,701.39 (2,430.45) — 1932 — 153,930.22 24,003.83 (481.53) — 1933 — 219,371.16 67,025.16 15,015.32 — 1934 — 295,067.28 79,790.84 26,701.11 — 1935 — 331,414.53 90,040.89 30,912.38 — 1936 — 339,736.37 74,398.22 6,812.84 — 1937 — 263,005.14 54,282.55 (527.76) — 1938 — 145,079.00 16,311.86 (25,397.57) — 1939 — 137,683.75 (100.22) (48,073.45) *260 Petitioner's normal production, output, or operation was not interrupted or diminished during the base period because of the occurrence either prior to or during the base period of events unusual and peculiar in the experience of petitioner. Petitioner's business was not depressed in the base period because of temporary economic circumstances unusual in the case of petitioner or of the industry of which it was a member by reason of a "smear campaign" conducted against petitioner by its competitors after the passage of the Hawes-Cooper Act and the Ashurst-Summers Act which adversely affected petitioner's business and profits so as to qualify petitioner for relief under section 722 (b) (1) or (b) (2), I. R. C. Petitioner did not change the character of its business during the base period by a change in management, fiscal and operational policies on or about September 1, 1939, which would qualify petitioner for relief pursuant to section 722 (b) (4) of the Code. Petitioner's excess profits tax for each of the years involved was not excessive and discriminatory. Petitioner is not entitled to relief pursuant to section 722 of the Code for any of the years involved. OPINION. Petitioner's*261 average base period net income for its four base period years, 1936, 1937, 1938, and 1939 was a minus quantity. It had net income in only one of the base period years, namely, 1936 and its net income for that year was only $ 6,812.84. It had losses for the other three base period years and when all four of the years are averaged up, petitioner had an average loss of $ 16,796.48 during the base period years. Such being the case, it is to petitioner's advantage to use an excess profits credit based on invested capital. Those credits were $ 11,165.33 for the fiscal year 1943, $ 11,419.31 for the fiscal *748 year 1944, and $ 10,272.18 for the fiscal year 1945. These credits have been used in a computation of petitioner's excess profits liability for the respective fiscal years named and there is no dispute about them. Petitioner contends, however, that it is entitled to a constructive average base period net income, hereafter referred to as CABPNI, under section 722 of the Code which will yield it a larger excess profits credit than has been granted it, based on its invested capital. In making such a claim petitioner states three issues as having been raised by the pleadings, *262 as follows: (1) Was a "smear campaign" conducted against Petitioner by its competitors after the passage of the Hawes-Cooper Act and the Ashurst-Summers Act which adversely affected Petitioner's business and profits so as to qualify Petitioner for relief under Section 722 (b) (1) or (b) (2), above quoted? (2) Was there a change in the character of the business of Petitioner represented by a change in management, fiscal and operational policies on or about September 1, 1939 which would qualify Petitioner for relief for the preceding two years pursuant to Section 722 (b) (4), above quoted? (3) Has the Petitioner established a basis for finding a fair and just amount of normal earnings sufficient to warrant an excess profits credit in excess of the credit allowable under the invested capital method for each of the years under review? Petitioner contends that the facts proved at the hearing require an affirmative answer to all three of the foregoing questions and based upon that assumption petitioner argues that it has also sufficiently proved that it is entitled to a CABPNI of $ 27,423.77. Petitioner contends that in each of the taxable years its excess profits credit should be based*263 on this $ 27,423.77 CABPNI, instead of the credits which have been used based on invested capital. The first thing which we have to decide is whether petitioner has proved its ground for relief as provided in section 722. If it has not done so, then it follows as a matter of course that there is no basis for arriving at a CABPNI. After a careful consideration of all the evidence in the record we have concluded that petitioner has not proved either of the grounds upon which it relies for relief in its applications and its petition and we have made findings to that effect in our Findings of Fact. Ground 1, Smear Campaign Conducted by Petitioner's Competitors. As pointed out above, petitioner in raising this ground for relief relies upon section 722 (b) (1) or (b) (2). These provisions of the Code are printed in the margin. 1 *264 *749 We will first take up petitioner's contention that it has established ground for relief under 722 (b) (2) as that seems to be the ground most relied upon by petitioner. The essential elements of this subsection, as we understand them, are: (1) the business of the taxpayer (or the business of the industry of which it was a member) must be depressed, (2) the depression of business must be caused by temporary economic circumstances, and (3) such circumstances must be "unusual in the case of the taxpayer," or of the industry. After a careful reading of petitioner's brief we understand it to concede that the industry of which it was a member, the horse collar and harness industry, was depressed by causes which were permanent, namely, the declining use of horses and mules on the farm. But petitioner contends that its own particular business was depressed during the base period years not so much because of the declining industry of which it was a part, but because of the smear campaign or sales tactics conducted by its competitors during the base period years which petitioner alleges was temporary. We are not convinced by the evidence that petitioner's position is sound. We*265 think the real effective cause of petitioner's declining sales during the base period was due to the enactment by Congress of the Hawes-Cooper Act and the Ashurst-Summers Act plus the fact that petitioner was a member of a declining industry, and these causes were not temporary. An example given in Regulations 112, section 35.722-3 (b) seems to us analogous: An economic circumstance is temporary depending upon the character and nature of such circumstances rather than upon the mere length of time of its existence. Thus, the income of a declining business or industry which was depressed throughout the base period because of economic conditions of a chronic and continuing character which may be expected to depress the earnings of such business for an indefinite period is not an inadequate standard of normal earnings under section 722 (b) (2). For example, a traction company the earnings of which had been steadily reduced over a decade by increasing competition with motor trucks and by the use of private passenger vehicles might not be considered to suffer business depression by reason of temporary and unusual economic circumstances. Higher income resulting from increased patronage*266 due to wartime restrictions upon the use of alternative methods of transportation should reasonably be regarded as excess profits. Low earnings are entirely normal in the case of such a chronically depressed taxpayer and *750 are not rendered subnormal merely because an increased level of profits resulting from the effect of war conditions occurs during excess profits tax taxable years. Cf. Toledo Stove & Range Co., 16 T. C. 1125, in which we said, among other things, as follows: At the risk of unnecessarily extending the discussion of petitioner's claim under section 722 (b) (2), even if petitioner were held to have shown that its business was depressed within the meaning of the statute, it still would be incumbent on petitioner to show that the depression was caused by "temporary economic circumstances" in its own case or such events in the case of its industry. * * * We then went on to hold that the taxpayer in the Toledo Stove & Range Co. case had not made such a showing. We make the same sort of holding here. Petitioner in support of its contention that it has qualified itself for relief under 722 (b) (2) strongly relies*267 on Dyer Engineers, Inc., 10 T. C. 1265. We think that case is distinguishable on its facts and is not controlling here. As we have already said petitioner not only relies upon section 722 (b) (2) but it relies upon section 722 (b) (1) for relief. What we have said in denying petitioner's claim for relief under section 722 (b) (2), we think is largely applicable to petitioner's claim for relief under section 722 (b) (1). Under the facts which have been set out in our Findings of Fact, we do not think petitioner has proved right to relief under section 722 (b) (1). We so hold. 722 (b) (4) Ground. Did the reduction in the size of the management staff of petitioner by one individual following the retirement of petitioner's president in September 1939 constitute a change in management within the meaning of subsection (b) (4)? A taxpayer's average base period net income may be deemed to be an inadequate standard of normal earnings under subsection (b) (4) if: (4) the taxpayer, either during or immediately prior to the base period, commenced business or changed the character of the business and the average base period net income does not*268 reflect the normal operation for the entire base period of the business. * * * For the purposes of this subparagraph, the term "change in the character of the business" includes a change in the operation or management of the business, * * * The applicable regulations to the part of the statute which we have just quoted are printed in the margin. 2 *269 *751 The basis of petitioner's claim under subsection (b) (4) was set forth as follows in its applications for relief: Taxpayer also claims that there was a change in character of business during the base period as defined in Section 722 (b) (4). The specific change in character of the business upon which taxpayer relies is that portion of Section 722 (b) (4) which relates to "change in the operations or management of the business." Taxpayer corporation during that portion of the base period prior to September 1, 1939 was owned 5/8ths by R. S. Mason and 3/8ths by A. P. Day. R. S. Mason was president and general manager of the taxpayer corporation, and being the majority stockholder, controlled all corporation activities, including its sales policies, financial management, etc. in much the same manner as if it were his own individual business. As the taxpayer's comparative balance sheets will show, the company on September 1, 1939 was in a serious financial condition. It was on that date that A. P. Day, the owner of 3/8ths of the capital stock, purchased the 5/8ths interest of R. S. Mason, who then terminated his connection with the company. Upon acquiring the entire capital*270 stock of the corporation, A. P. Day assumed all of the duties formerly delegated to R. S. Mason without an increase in his own salary or employing anyone to perform the duties previously handled by R. S. Mason. It is contended by the taxpayer that had this change in management of the corporation occurred two years prior to September 1, 1939 the corporation would have saved the amount of salary paid to R. S. Mason during the two year period ended on that date. * * * We do not think the change upon which petitioner relies qualifies under 722 (b) (4) as a change in the "operation and management of the business." We call particular attention to that part of Regulations 112, section 35.722-3 (d) which says: * * * the hiring of new key managing personnel or the adoption of materially new basic management policies by the old management resulting in drastic changes from old policies would constitute a change in the operation or management of the business. However, * * * changes in operating or supervisory personnel normally experienced by business in general and having no effect upon basic business policies would not be considered a change in the operation or management of the business. *271 We hold against petitioner as to this particular alleged ground for relief in the change of the character and operation of its business. Doubtless it is true that in October 1936, when petitioner acquired a new building and moved out of the penitentiary and ceased to use convict labor and began the use of free labor, a change in the character *752 of its business occurred which would have qualified petitioner for relief under 722 (b) (4), but it is not every qualifying change which affords relief under 722. The taxpayer must show by adequate evidence that a CABPNI results from such change which will yield a larger excess profits credit than the taxpayer has been granted under the other provisions of the statute. Petitioner in this case has made no such showing. As a matter of fact, petitioner did not rely upon this particular change in its applications for relief, in its petition, nor does it do so in its brief. Therefore, such change from convict labor to free labor is without any significance in this proceeding. In our Findings of Fact we have omitted any reference to the figures which were embodied in the CABPNI which petitioner alleged it was entitled to use in lieu *272 of the excess profits credit that petitioner has been granted under the invested capital method. The reason we have omitted these figures from our Findings of Fact is because until a taxpayer has qualified itself for relief under section 722 such figures are irrelevant; they serve no useful purpose. Decision will be entered for the respondent. Footnotes 1. SEC. 722. GENERAL RELIEF -- CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME. * * * * (b) Taxpayers Using Average Earnings Method. -- The tax computed under this subchapter (without the benefit of this section) shall be considered to be excessive and discriminatory in the case of a taxpayer entitled to use the excess profits credit based on income pursuant to section 713, if its average base period net income is an inadequate standard of normal earnings because -- (1) in one or more taxable years in the base period normal production, output, or operation was interrupted or diminished because of the occurrence, either immediately prior to, or during the base period, of events unusual and peculiar in the experience of such taxpayer, (2) the business of the taxpayer was depressed in the base period because of temporary economic circumstances unusual in the case of such taxpayer or because of the fact that an industry of which such taxpayer was a member was depressed by reason of temporary economic events unusual in the case of such industry,↩ 2. Regulations 112, section 35.722-3 (d) provides in part as follows: A change in the character of the business for the purposes of section 722 (b) (4) must be substantial in that the nature of the operations of the business affected by the change is regarded as being essentially different after the change from the nature of such operations prior to the change. No change which businesses in general are accustomed to make in the course of usual or routine operations shall be considered a change in the character of the business for the purposes of section 722 (b) (4). * * * A change in the character of the business includes changes resulting from the following activities: (1) A change in the operation or management of the business, * * * the hiring of new key managing personnel or the adoption of materially new basic management policies by the old management resulting in drastic changes from old policies would constitute a change in the operation or management of the business. However, * * * changes in operating or supervisory personnel normally experienced by business in general and having no effect upon basic business policies would not be considered a change in the operation or management of the business.↩