Schneider's Modern Bakery, Inc. v. Commissioner

Schneider's Modern Bakery, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent Schneider's Modern Bakery, Inc. v. Commissioner Docket No. 27589 United States Tax Court 19 T.C. 763; 1953 U.S. Tax Ct. LEXIS 245; January 28, 1953, Promulgated *245 Decision will be entered under Rule 50. 1. Petitioner is a bakery seeking relief from excess profits taxes under section 722 for the years 1942, 1943, and 1944. At the beginning of the base period, petitioner had a small amount of mechanical equipment. During the base period years 1936 to 1938, petitioner made substantial purchases of machinery and enlarged its building. This mechanization program changed petitioner's method of operation principally by the reduction of ingredient cost per unit of product. Held, that petitioner qualifies for relief under section 722 (b) (4), and a constructive average base period net income is determined. 2. In 1936, petitioner had a strike of its bakers which lasted for three months. Petitioner replaced the striking employees with higher paid but less experienced labor, some of which was imported from out of the city. Other increased expenses were incurred. By these means production was substantially kept up to normal, but at an increased expense. Held, petitioner has established its right to relief under section 722 (b) (1), and the amount of relief is determined. Lewis R. Donelson, III, Esq., and W. Stuart McCloy, Esq., for the petitioner. Joseph L. Spilman, Jr., Esq., and Robert M. Willan, Esq., for the respondent. Black, Judge. BLACK *763 The respondent disallowed in entirety petitioner's claims for refunds of excess profits taxes under section 722, Internal Revenue Code, as follows: Calendar year Refund claim [1942] $ 3,232.97 [1943] 17,084.53 [1944] 10,838.97 The petitioner assigns errors as to this action of the Commissioner in denying its applications for relief and states its allegations of error as follows: (d) The Commissioner erred in failing to find that the petitioner's average base period net income is an inadequate standard of normal earnings because 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*247 during the base period, of events unusual and peculiar in the experience of the petitioner. (e) The Commissioner erred in failing to find that the petitioner either during or immediately prior to the base period, changed the character of the business and the average base period net income does not reflect the normal operation for the entire base period of the business. (f) The Commissioner erred in failing to find that petitioner is entitled to an excess profits credit of not less than $ 10,000.00 based on income and that the petitioner is entitled to relief on the basis of said credit for the year 1942 in the sum of $ 3,292.97; for the year 1943 in the sum of $ 6,500.00; and, for the year 1944 in the sum of $ 6,500.00. *764 Respondent determined deficiencies and an overassessment, which are not contested by petitioner, as follows: Calendar year Kind of taxes Deficiencies [1942] Income taxes $ 409.22 [1942] Declared value excess-profits tax 695.75 [1943] Declared value excess-profits tax 223.18 [1942] Excess profits tax 3,116.30 [1943] Excess profits tax 9,315.64 [1944] Excess profits tax 7,418.30 Total deficiencies 21,178.39 Overassessment [1944] Income tax $ 20.00 *248 Petitioner's excess profits taxes for the years in question, including those previously assessed and the deficiencies herein, are as follows: Year Amount [1942] $ 6,349.27 [1943] 26,820.28 [1944] 17,286.30 FINDINGS OF FACT. Some of the facts have been stipulated and are found accordingly. Petitioner Schneider's Modern Bakery, Inc., is a Tennessee corporation, organized February 6, 1924, with a capital of $ 10,000. Actually the business had been operating since 1900. Petitioner was operating a small bakery in Memphis engaged in the making of some 25 types of breads, rolls, and cakes, which were sold at wholesale to restaurants and at retail. It was a family owned corporation of which the two principal officers, Joe Schneider, president, and Sam Schneider, secretary-treasurer, owned all of the stock. No corporate minutes were in existence for the period 1924 through 1945. Petitioner kept its books and records on an accrual basis and filed its income and excess profits tax returns with the collector of internal revenue in Nashville, Tennessee. Petitioner duly filed with the Commissioner, within the time prescribed by law, applications for relief under section 722, I. R. C., *249 on Treasury Form 991 in the amounts of $ 3,232.97 for the year 1942, $ 17,084.53 for the year 1943, and $ 10,838.97 for the year 1944. Petitioner has preserved no books or records for the years 1936 and 1937, and the statements and figures for those years have been compiled from petitioner's income tax returns. The figures for the years 1938, 1939, 1940, and 1941, are taken from petitioner's books and records and are in conformance therewith. *765 Facts -- Change in Method of Operation. In 1930 petitioner engaged the services of R. L. Allan who had formerly been employed by the Continental Baking Company and was experienced in the operation of a machine bakery shop. Allan immediately began to urge petitioner to change its method of operation. Petitioner at that time had only one piece of mechanical equipment, an antiquated Peerless Dough Mixer which had no automatic feeding unit or cooling system. The rest of petitioner's baking operation was done completely by hand, including the measuring of the dough for mixing, the molding, grouping, cutting, and measuring of bread. Petitioner had a nonautomatic proofing box and two brick ovens which were completely hand operated*250 by the ancient method of sticking the bread into the oven on long poles and it was cooked by the eye and experience of the baker. Allan, after complete examination and appraisal of petitioner's operations, urged the adoption of mechanical baking methods and accordingly, in 1935 petitioner purchased a Century Make Up Group. This equipment included a guider, rounder, and proofer, which replaced the former bench hands who molded, measured, and cut the bread. This equipment, however, proved unsatisfactory since the manufacturer was new in the business and the equipment was not suited to the type and size of the bread being made by the petitioner. In October 1936 petitioner purchased a Haller automatic oven at a cost of $ 9,000. This oven was completely automatic, containing trays automatically rotated, a timing device, and temperature control. It was only necessary to load and unload and reload the oven. Petitioner's former hand bakers were completely replaced. In December 1936 petitioner purchased a Day Dough Developer at a price of $ 4,435, less an approximate allowance of $ 600. This represented the first automatic mixer and developer which petitioner had owned and replaced the*251 old Peerless Dough Mixer. It produced a much larger dough, had attached automatic feeding gauges measuring the materials going into the flour mix, and contained an automatic cooling jacket insuring more satisfactory dough mixing and less failures. In April 1938 petitioner purchased a Day Molder and attachments at a cost of $ 7,888.25 to replace the Century equipment which had proved unsatisfactory. This gave petitioner a Day Developer and Molder which provided for the automatic mixing, developing, molding, measuring, and cutting of the bread and a conveyer belt attachment. About this time petitioner purchased and installed a proofing box with automatic controls to determine the amount of moisture and *766 heat, insuring a more even and satisfactory rise in the bread. In this process, petitioner doubled the size of its physical plant. This addition cost approximately $ 6,000. In the latter part of 1938 petitioner completed its mechanization and enlargement program. It now had a new mixer with automatic load and measurement controls; a cooling jacket with control temperature; an automatic molder with conveyer belt, eliminating hand make up, cutting and measuring; an automatic*252 proofing box; and an automatic oven, eliminating hand bakers. Before 1935 petitioner's investment in mechanical equipment was small. During the period from 1935 until the end of 1938, taxpayer expended $ 22,214 on new equipment and $ 6,000 on an enlargement of its building. After the installation of the new equipment petitioner experienced some difficulty in working out a satisfactory formula for bread, and after considerable experimentation changed the type of wheat which it used and arrived at an entirely new formula. Petitioner also experienced difficulty acquainting its employees with the operation of the new equipment. By the end of 1939, petitioner had greatly increased its productive capacity, reduced the waste in the preparation of its dough, reduced failures in the preparation of dough, and improved its methods of proofing and baking so as to reduce the number of culls. Petitioner was now able to produce a superior product at less cost with less materials. Production per man hour increased significantly. Petitioner obtained normal operations and results from the new method of operation during the year 1939. Therefore, the year 1939 will be the basis for determining *253 adjustments to actual earnings for the change in method of operation in computing the constructive average base period net income, sometimes hereafter called CABPNI. The principal result of petitioner's changing the character of its business from a hand bakery to a machine operated bakery was, as we have already found, to substantially reduce the ratio of ingredients used per unit of product by the elimination of waste, dough failures, culls, and discards. Petitioner's mechanization program resulting in the modernization of its bakery plant constituted a change in the method of operation of its business which was a fundamental change in the character of its business. As a result, its average base period net income is an inadequate standard of normal earnings, and its excess profits taxes without the benefit of section 722 are excessive and discriminatory. Having considered the increased efficiency and also the resulting increase in expenses, we find that in a reconstruction of petitioner's average base period net income to arrive at a CABPNI, there should *767 be added the following amounts which take into account the increase in efficiency and expenses above: Year Amount [1936] $ 8,555.99 [1937] 5,144.61 [1938] 6,037.21 *254 Facts -- The Strike. In the summer of 1936 petitioner's bakers went on strike to obtain union recognition. Of approximately 15 to 18 employees, at least 80 per cent were on strike. The strike continued for about three months during which time petitioner continued operations. Petitioner replaced the striking employees with higher paid but less experienced labor, some of which was imported from out of the city, and by the officer-stockholders, Sam and Joe Schneider. Two night watchmen and special deputies were hired to protect the plant for about two months. Petitioner provided sleeping quarters for out-of-town employees and food for employees and guards. Petitioner was able thereby to maintain a normal rate of production at an increased cost. The strike was entirely unsuccessful. At the conclusion of the strike, the petitioner hired back some of the employees who had been out on strike. This was the only strike in petitioner's history. Petitioner's excess profits net income for 1936 as adjusted by the Commissioner showed a loss of $ 1,847.35. In determining a fair and just amount representing normal earnings for 1936, an adjustment should be made to the foregoing $ 1,847.35*255 loss determined by the Commissioner by adding $ 3,000 for extra expenses incurred in 1936 by petitioner by reason of the strike. When such adjustment is made, petitioner's excess profits net income for 1936 will be $ 1,152.65, instead of a loss of $ 1,847.35 which the Commissioner has determined. This figure of $ 1,152.65 should be used for 1936 in determining petitioner's CABPNI to effect adjustment for the strike. No adjustment for any of the other base period years is in order by reason of the strike. Facts -- Change in Method of Distribution. Petitioner, at the commencement of the base period, was selling part of its products through retail route salesmen who received 20 per cent commissions. Petitioner furnished and maintained trucks and supervised and took the risk of collecting accounts receivable. Towards the end of 1937 petitioner concluded that these routes could not be profitably operated because of the high cost of truck maintenance and large bad debt losses and collection expense on credit sales. *768 All salesmen were placed on an independent basis, operating their own trucks and purchasing the bread, etc., from petitioner for cash at a discount of 25 per*256 cent off wholesale, and handling their own collections of credit accounts. At that time, a substantial charge-off of bad debts for uncollectible accounts of retail route salesmen was made. An adjustment for the abnormal bad debt expenses of $ 2,862.03 in 1937 was recognized and disallowed by the Commissioner in determining petitioner's excess profits net income for 1937. No further adjustment is in order on the ground of this change in petitioner's method of distribution. Facts -- Computation of Petitioner's Average Base Period Net Income as Allowed by the Revenue Agent and Approved by the Commissioner. The parties have stipulated that the computation of petitioner's average base period net income as allowed by the revenue agent was as follows: [1939] Net income per returns (Same as Exhibit 1) ($ 2,247.35) ($ 3,875.44) ($ 994.46) $ 2,738.59 ADJUSTMENTS Overstatement of deductions 400.00 Unjust enrichment tax eliminated 3,831.66 3,831.66 Sect. 711 (b) (1) (J) adjustments Interest expenses 280.45 803.19 250.33 Bad debts 2,862.03 Total adjustments 400.00 6,974.14 4,634.85 250.33 EXCESS PROFITS NET INCOME Used for base period years (1,847.35) 3,098.70 3,640.39 2,988.92 1936-1939 Average $ 1,970.17 Average base period net income allowed for each of the years 1942, 1943, and 1944, under section 713 (f), "Growth Formula" (Same as 1938 earnings as adjusted above) $ 3,640.39 *257 The following is a summary of petitioner's excess profits tax liability determined by the Commissioner, including assessments and payments: [1942] Excess profits tax liability prior to post-war credit (sect. 784) $ 6,349.27 Less: Post-war credit allowable (sect. 784) Excess profits tax liability per statement attached to deficiency notice, dated January 18, 1950 6,349.27 Excess profits tax previously assessed April, 1943 3,232.97 June, 1944 April, 1945 Post-war credit allowed, sect. 784 Net excess profits tax previously assessed 3,232.97 Deficiency per deficiency notice dated January 18, 1950 3,116.30 [1943] Excess profits tax liability prior to post-war credit (sect. 784) $ 26,820.28 Less: Post-war credit allowable (sect. 784) Excess profits tax liability per statement attached to deficiency notice, dated January 18, 1950 26,820.28 Excess profits tax previously assessed April, 1943 June, 1944 17,504.64 April, 1945 Post-war credit allowed, sect. 784 Net excess profits tax previously assessed 17,504.64 Deficiency per deficiency notice dated January 18, 1950 9,315.64 [1944] Excess profits tax liability prior to post-war credit (sect. 784) $ 19,207.00 Less: Post-war credit allowable (sect. 784) 1,920.70 Excess profits tax liability per statement attached to deficiency notice, dated January 18, 1950 17,286.30 Excess profits tax previously assessed April, 1943 June, 1944 April, 1945 10,964,45 Post-war credit allowed, sect. 784 (1,096.45) Net excess profits tax previously assessed 9,868.00 Deficiency per deficiency notice dated January 18, 1950 7,418,30 *258 *769 Excess Profits Tax Payments Amounts Date paid [1944] Mar. 15, 1943 $ 3,232.97 June 16, 1944 $ 5,000.00 Sept. 12, 1944 6,252.32 June 16, 1944 1,288.64 Dec. 13, 1944 4,963.68 Mar. 15, 1945 $ 2,741.11 June 19, 1945 2,741.11 Sept. 21, 1945 2,192.88 Dec. 18, 1945 1,544.68 Jan. 24, 1946 648.22 Total excess profits payments $ 3,232.97 $ 17,504.64 $ 9,868.00 Note: In addition to the above listed payments, the petitioner has made a remittance of $ 19,994.23 on March 9, 1950, which has been deposited in a suspense account by the collector of internal revenue, district of Tennessee. Petitioner's total adjusted earnings for the base period years after giving effect to the 722 (b) (1) and 722 (b) (4) factors is $ 30,618.47; the constructive average base period net income, CABPNI, is $ 7,654.62. OPINION. To be entitled to general relief from excess profits taxes petitioner must satisfy two requirements which appear in section 722 (a) of the Code, as follows: In any case in which the taxpayer [1] establishes that the tax computed under this subchapter (without the benefit of this section) results in an*259 excessive and discriminatory tax and [2] establishes what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income for the purposes of an excess profits tax based upon a comparison of normal earnings and earnings during an excess profits tax period, the tax shall be determined by using such constructive average base period net income in lieu of the average base period net income otherwise determined under this subchapter. Petitioner contends that it satisfies the first requirement that the taxes are excessive and discriminatory, which is further defined in subsections 722 (b) and (c), because of the following three factors: installing new equipment which changed the method of operation and increased productive capacity (section 722 (b) (4)), converting the sales organization from commission salesmen to independent contractors (section 722 (b) (4)), and a strike in 1936 (section 722 (b) (1)). Immediately prior to the base period years, petitioner was predominantly a hand baking shop with little mechanical equipment. Over a four year period commencing in 1934, machinery was installed in place of hand operations in virtually*260 every phase of the baking process. By the beginning of 1936 machinery investment was $ 14,070. By 1938 this had increased to more than $ 22,000, in addition to a *770 $ 6,000 improvement which doubled the size of its plant. At the completion of this program every process was performed by machinery. Material waste, dough failure, poor baking, and culls were reduced significantly. The earning level has thus been substantially increased by a reduction of ingredient cost. This mechanization program was a change in operation which constituted a "change in the character of the business" within the scope of section 722 (b) (4). 7- Up Fort Worth Co., 8 T. C. 52. The applicable statute is printed in the margin. 1 We have found that this change results in petitioner's taxes being excessive and discriminatory, meeting the first requirement of section 722 (a). Rand Beverage Co., 18 T. C. 275; East Texas Motor Freight Lines, 7 T. C. 579. Respondent contends that the change in method of operation is not a 722 (b) (4) qualifying factor because the mechanization program merely modernized an obsolete*261 plant and represented normal modernization without placing petitioner's plant in a position superior to the industry. There is no precedent either in the statute or the cases under 722 (b) (4) which requires a taxpayer to show relative superiority in the industry. It is clear that during the base period years petitioner completed the modernization of its plant which had been begun immediately prior to the base period years. When all the facts attendant upon the change and resulting from it are considered, we think this was a change in petitioner's business which qualifies it for relief under section 722 (b) (4). *262 We next come to the second requirement of section 722 relief which is for petitioner to establish a fair and just amount representing normal earnings of the petitioner to be used as the CABPNI. In our Findings of Fact it is disclosed that the Commissioner, after making *771 certain adjustments to petitioner's excess profits net income for each of the base period years, arrived at a determination that petitioner's actual average base period excess profits net income was $ 1,970.17. In arriving at this determination the Commissioner determined that for the year 1938 petitioner's excess profits net income was $ 3,640.70. The Commissioner then applied the "Growth Formula" provided in section 713 (f) of the Code and determined that petitioner's average excess profits net income to be used in the computation of its excess profits tax liability for the taxable years was $ 3,640.70. In order to secure relief under section 722 petitioner must prove a CABPNI greater than the average base period excess profits net income which the Commissioner has allowed under section 713 (f). In proving this greater CABPNI, it must be done without the application of the growth formula provided by*263 section 713 (f). See Homer Laughlin China Co., 7 T. C. 1325. In arriving at our finding of $ 7,654.62 as the CABPNI to be used, we have observed the rule of the Laughlin China Co. case. At the conclusion of its brief petitioner contends that its CABPNI should be $ 26,542.90, while respondent questions the reconstruction in entirety because of alleged failure of proof. Petitioner did not maintain any books or records for 1936 and 1937, but submitted profit and loss statements from its Federal tax returns. For 1938 and 1939 petitioner submitted its records of profit and loss from its books which were not broken down in great detail. Petitioner is a relatively small business, and is not precluded from section 722 relief because it did not maintain and preserve intricate cost accounting records. Of course, to the extent relevant proof is missing, it will be construed against petitioner who has the burden of proof. Reconstruction -- Change in Method of Operation. We have found as a fact that in the year 1939 petitioner experienced normal operations from the introduction of the new machinery. We have found that the primary economy resulting from*264 the new machinery was the reduction of the cost of ingredients used per unit of product. Adjustments were made to the figures for sales and ingredient costs for the base period years so that the figures would be economically comparable to reflect the increase in efficiency of operation methods. A comparison of the ratio between sales and ingredient costs shows a considerably smaller relative ingredient cost for 1939 than the earlier years. We think the evidence establishes that this substantial difference in cost of ingredients per unit of product is to be attributed to an increase in the efficiency of the change in method of operations. We have made an adjustment to actual earnings for this factor in the Findings of Fact. *772 The machinery which brought about the increase in efficient operation also was directly responsible for increased expenses. Adjustments have been made for these increased expenses in the facts, Rand Beverage Co., supra, p. 289. All of this is shown in our Findings of Fact and need not be repeated here. Reconstruction -- The Strike. Petitioner's bakers were on strike for approximately three months during the spring*265 of 1936, which was the only strike in its history. The petitioner was able to replace the striking bakers with the result that production was not substantially curtailed, but this result was achieved only at considerable extra cost for salaries, room, board, and protection. The strike in 1936 was an unusual and peculiar event in the experience of petitioner and qualifies petitioner for relief under section 722 (b) (1) printed in the margin. 2 Section 35.722-3, Regulations 112, says, among other things: Unusual and peculiar events contemplated in section 722 (b) (1) consist primarily of physical rather than economic events or circumstances. Except as otherwise described in this paragraph, such events would include floods, fires, explosions, strikes, and other such exceptional and uncommon circumstances hindering production, output, or operation; * * * *266 Petitioner contends that its 1936 costs of production were increased $ 8,775.17 because of the strike and that its income for that year would have been that much greater if it had not been for the strike. Respondent concedes that the strike was an unusual and peculiar event in the experience of petitioner and comes within the provisions of section 722 (b) (1), but contends petitioner has failed in its proof to establish any increased costs. It is clear from the record that additional costs were incurred but that petitioner has not maintained precise records for those costs. Where an expenditure is certain but its precise amount unclear, we make an estimate bearing hard upon the petitioner who has the burden of proof. National Grinding Wheel Co., 8 T. C. 1278, 1286; Jefferson Amusement Co., 18 T. C. 44, 62. We have found those abnormal strike costs to be $ 3,000 and have adjusted actual earnings accordingly, as shown in our Findings of Fact. *773 Reconstruction -- New Method of Distribution. In our Findings of Fact we have held against petitioner as to this alleged ground for relief, except to the extent that*267 an adjustment of $ 2,862.03 in 1937 has been made by the Commissioner by reason of an abnormal bad debt deduction of petitioner in that year attributable to the change-over in method of distribution. In view of our Findings of Fact relating to this alleged ground for relief, it requires no further discussion. Reconstruction -- Change in Capacity. Petitioner's mechanization program was accompanied by an increase in the size of its building. We have already found that under its mechanization program petitioner reached its normal level of earnings in 1939. Petitioner has not shown that any increased capacity arising from increasing the size of its building would have resulted in increased sales in 1936, 1937, and 1938. Petitioner has not shown that its sales were limited by any lack of capacity in those years. We, therefore, find no adjustment is in order because of petitioner's increased capacity in computing its CABPNI. See National Grinding Wheel Co., 8 T. C. 1278; Green Spring Dairy, Inc., 18 T. C. 217. For reasons hereinbefore stated, we hold that a CABPNI of $ 7,654.62 should be used in determining petitioner's*268 relief from excess profits taxes instead of the $ 3,640.39 which the Commissioner has used under the growth formula. Reviewed by the Special Division. Decision will be entered under Rule 50. 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 -- * * * * (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 reflect the normal operation for the entire base period of the business. If the business of the taxpayer did not reach, by the end of the base period, the earning level which it would have reached if the taxpayer had commenced business or made the change in the character of the business two years before it did so, it shall be deemed to have commenced the business or made the change at such earlier time. 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, a difference in the products or services furnished, a difference in the capacity for production or operation, a difference in the ratio of nonborrowed capital to total capital, and the acquisition before January 1, 1940, of all or part of the assets of a competitor, with the result that the competition of such competitor was eliminated or diminished.↩ 2. 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, * * *↩