Wentworth Military, Scientific & Literary Educational Co. v. Commissioner

Wentworth Military, Scientific and Literary Educational Company, Petitioner, v. Commissioner of Internal Revenue, Respondent Wentworth Military, Scientific & Literary Educational Co. v. Commissioner Docket Nos. 29701, 31608 United States Tax Court 22 T.C. 721; 1954 U.S. Tax Ct. LEXIS 151; June 30, 1954, Filed June 30, 1954, Filed *151 Decisions will be entered for the respondent. Petitioner operates a military school for boys. It filed claims for relief under section 722 of the Internal Revenue Code for the years ended June 30, 1943, to June 30, 1946, inclusive. Held, petitioner is not entitled to relief under section 722 (a) and (b) (4) of the Code. Elmer B. Hodges, Esq., for the petitioner. David Karsted, Esq., for the respondent. LeMire, Judge. LEMIRE *721 These consolidated proceedings involve claims for refund of excess profits taxes under section 722 for the fiscal years ended June 30, 1943, to June 30, 1946, inclusive. The respondent denied all applications. *722 The issue is whether the petitioner is entitled to such relief by reason of an alleged change in management within the meaning of section 722 (b) (4) of the Internal*152 Revenue Code. FINDINGS OF FACT. The stipulated facts are found accordingly. The petitioner is a Missouri corporation organized in 1909, having its principal office and place of business in Lexington, Missouri. The petitioner reported its income on an accrual basis for the fiscal years ended June 30. Its tax returns for the periods involved were filed with the collector of internal revenue for the sixth district of Missouri. The petitioner is entitled to use the excess profits credit based on income. Its excess profits net income for each of the taxable years in the base period was as follows: Year ended Excess profits June 30 net income [1937] $ 4,449.50 [1938] 3,079.22 [1939] 8,133.38 [1940] 27,389.33 The average base period excess profits net income was $ 10,762.86 and the average computed under section 713 (f) was $ 23,556.19. The excess profits credit was $ 22,378.38. The petitioner's excess profits net income for the fiscal years ended June 30, 1941, to June 30, 1946, inclusive, was as follows: Excess profits Year net income [1941] $ 39,604.27 [1942] 25,176.04 [1943] 68,977.86 [1944] $ 81,375.47 [1945] 60,008.92 [1946] 38,701.05 The petitioner operates a school*153 for boys offering both high school and junior college courses. The academy was founded in about 1880 by Stephen G. Wentworth. For many years its president and active head was Colonel Sandford Sellers, Sr., hereinafter referred to as Colonel Sellers. After World War I, Colonel Sellers' three sons, Ovid, Sandford, Jr., and J. M., became active in the operation of the school, but shortly thereafter Ovid left the school. During the twenties and early thirties Colonel Sellers, due to his advanced age, became less active and while he retained the office of president he acted mainly in an advisory capacity. During those years Sandford, Jr., held the position of superintendent, and J. M. was commandant and, later, an executive officer. During the period June 30, 1923, to June 30, 1936, inclusive, the school suffered a loss in each year, except for the year ended June 30, 1926, when it had a net profit in the nominal amount of $ 606.57. In the midthirties the school had reached a critical financial condition. *723 Current bills of $ 35,000 to $ 40,000 had accumulated and credit was cut off by the local lending institutions. There was serious doubt whether the school would be able*154 to continue. At that time the stock of the petitioner was owned by Colonel Sellers, Sandford, Jr., and J. M., each owning a one-third interest. Because of the serious financial condition J. M. offered to sell his stock interest to his brother, Sandford, Jr., or to purchase Sandford, Jr.'s interest, with the result that J. M. acquired his brother's interest in 1934 and the latter left the military academy. At that time J. M. became superintendent. About three months after J. M. acquired the stock interest of his brother, L. B. Wikoff, who had been in the employ of the academy in various capacities since 1915, was named business manager. In 1935 Wikoff acquired the stock interest of Colonel Sellers and became secretary and treasurer of the petitioner, which offices he has held since that time. Immediate steps were taken to solve the petitioner's financial condition. Wikoff sent letters to creditors informing them that the company was making some business changes and asking for their consideration until the management knew where it was headed, since there was no money available to pay bills. Cooperative letters were received from practically all of the creditors. A meeting of local*155 business men and some of the creditors was called to discuss what could be done to raise money and determine whether the school should take bankruptcy or close. Those assembled did not want the school to close, but they could make no concrete suggestions as to what to do. Wikoff requested that he be permitted to select a committee of local citizens to endeavor to sell preferred stock to take care of current liabilities and provide some working capital. The committee selected consisted of the head of the local mining industry, a vice president of a local bank, the secretary of the local chamber of commerce, and Wikoff. The committee called upon creditors, persuading them to accept preferred stock for their indebtedness, and induced others to purchase preferred stock. Between $ 42,000 and $ 43,000 of preferred stock was disposed of in that manner. It was agreed that the individuals taking preferred stock should name three of the five directors of the company. The new board became very active and held meetings at least once a month and, frequently, special meetings. The three directors selected were J. L. Mann, president of the Lexington Savings Trust Company; B. M. Little, vice*156 president of the Commercial Bank; and Harry Booth, owner and publisher of the Lexington Advertiser, a local newspaper. The board of directors demanded that a budget be instituted although, presumably, some form of a budget had been in use prior thereto. The directors examined the operating statements *724 at least monthly and discussed them in detail. The budget estimates were closely followed, except for an occasional emergency. Officers' and instructors' salaries were reduced and all expenses were closely watched. A new policy was adopted regarding the holding of meetings of department heads and members of the faculty. Regular meetings were held, whereas the prior practice was to call faculty meetings only for some special reason. Prior to the institution of the new budget system there was no provision for central purchasing, and even subordinate employees were making purchases which they deemed necessary. This practice was changed; and, under the new budget, estimates of what each department would cost were planned in advance and in considerable detail. Prior to 1935 the school faculty had been selected on the basis of ability in the classroom, with the result that more*157 attention was given to the superior student. This was due to the influence of the dean of the faculty who placed emphasis on scholastic attainment and was unsympathetic with the type of teacher who would be able to go on the road during the summer period and sell the school to prospective students. His attitude had resulted in a situation where the school had practically no sales force. An effort was made to have the dean change his policies. When those efforts were unsuccessful he was removed. Under the successor dean the change in the type of faculty was accomplished and the new faculty members were selected with emphasis on practical value, such as the ability to coach in athletics, live with the students, and understand them. A change was also made in the uniform of the school. To the uniform, which had been entirely an olive drab, a red sweater, a blue dress uniform, and a red raincoat were added. This change resulted in an improved morale and stimulated the recruiting of new students. Prior to 1935 the military man had frequently served as commandant with the result that there were frequent changes in that position. Under the new policy a permanent commandant was employed. *158 Such change was important because the commandant is in charge of discipline in the school. A new policy was inaugurated placing more emphasis on hobbies and social interests of the students. A hostess was retained, who conducted classes in etiquette and organized parties and dances. These changes were designed to make the life of the student more pleasant. In 1935 a recreation room was set up and equipped with pool and ping-pong tables. Since 1923 the academy has put out a school paper called The Trumpeter. After 1935 one of the faculty members was put in charge of publishing the paper. He instituted the plan of sending news *725 items concerning the students to their local hometown papers and thus stimulating interest in the school. The petitioner has always spent considerable sums of money in advertising and promotional work, which included the instructors' traveling during the summer months contacting the parents of prospective students. The petitioner draws its students largely from Missouri, Iowa, Nebraska, Kansas, and Oklahoma. Its students are primarily boarding students. It has a small number of students from Lexington who do not board at the academy and are referred*159 to as day students. The petitioner's total student enrollment, including day students, for each of the periods 1930-1931 to 1939-1940, inclusive, was as follows: Number of Year students 1930-1931 [241] 1931-1932 [189] 1932-1933 [140] 1933-1934 [144] 1934-1935 [149] 1935-1936 [176] 1936-1937 [200] 1937-1938 [184] 1938-1939 [225] 1939-1940 [263] The petitioner's capacity for boarding students during the base period years was 284. The petitioner changed the character of its business during its base period. The petitioner has failed to establish that its average base period net income was an inadequate standard of normal earnings because of a change in the character of its business, and that a fair and just amount to represent its average normal earnings would exceed the average base period net income under the growth formula. OPINION. The question presented is whether the petitioner is entitled to any relief from excess profits taxes for the fiscal years ended June 30, 1943, to June 30, 1946, inclusive, under the provisions of section 722 of the Internal Revenue Code. We are convinced that the record establishes that the petitioner changed the character of its business during the*160 base period years within the meaning of section 722 (a) and (b) (4) of the Code. The essential nature of the changes was the institution of new key managing personnel and the adoption of new basic management policies in the operation of the business. The Wentworth Military Academy was founded in about 1880. In about 1909 it was incorporated and since that time has operated a school for boys, offering both high school and junior college courses. For many years Colonel Sandford Sellers, Sr., was the active head of *726 the academy and supervised its operation. After the end of World War I his three sons joined with him. One son soon left and the other two sons continued at the school. Sandford Sellers, Jr., and J. M. Sellers, together with their father, owned the stock of the corporation in equal portions. During the period 1922-1923 down to the commencement of the base period the academy suffered substantial and continuous losses annually, except in the school year 1925-1926, when the net profit was $ 606.57. Because of the serious losses, J. M. proposed to his brother, Sandford, Jr., a purchase or sale of their respective interests, thus placing control in one of them. *161 In 1934 J. M. acquired the interest of Sandford, Jr., who thereupon left the academy. By 1935 the petitioner's current obligations rose to between $ 35,000 and $ 40,000, its bank credit was cut off, and the problem as to whether the school could continue became acute. Upon acquiring the controlling interest J. M. became superintendent and turned over the business management to L. B. Wikoff, who had been associated with the school in various capacities since 1915. Wikoff took immediate steps to endeavor to rehabilitate the financial condition of the academy. He called into conference leading business men of the community and some creditors to discuss the situation and a committee was selected to undertake the sale of preferred stock. The committee persuaded certain creditors to accept preferred stock for their indebtedness and induced other men in Lexington to purchase preferred shares. In connection with the issuance of preferred stock it was agreed that three of the five directors were to be selected by the holders of the preferred stock. Two local bankers and the owner and publisher of a local newspaper were elected to the board of directors. The new board took a very active*162 interest in the operation of the academy. It demanded the institution of a more scientific budget and discussed in detail the monthly financial statements to see that the budget estimates were adhered to. In the latter part of 1935, Wikoff acquired the one-third interest in the common stock held by Colonel Sellers and was elected secretary and treasurer of the petitioner. The new management changed its existing policy regarding the selection of its faculty members. Prior thereto the dean of the faculty had selected faculty members entirely on the basis of ability in the classroom and was unsympathetic with the type of instructor who was able to go on the road in the summer months and sell the school to prospective students. The new management unsuccessfully sought to have the dean alter his policies and replaced him. A change in the *727 type of faculty members was put in effect and teachers were selected with emphasis placed on practical value rather than scholastic ability. The prior policy of the academy was to have the military man serve as commandant, with a result that there were frequent changes in that position. As the commandant was in charge of discipline it was*163 felt that more permanency would improve morale and a new commandant was employed who has been permanent in that position. Other changes inaugurated by the new management, although of lesser importance perhaps, were the adoption of a new uniform of brighter hue, the employment of a hostess who conducted classes in etiquette and arranged for parties and other entertainment, the institution of a hobby period, and the placing of more emphasis on the social interests of the student body. While all of these changes were not new in the sense that they were nonexistent under the old management, it was felt that the changes would make for a more pleasant student life, improve morale, and stimulate recruiting. While these last mentioned changes are not in themselves of too much significance, we think that in viewing the whole picture they are not to be ignored, although their ultimate effect on increased student enrollment is difficult to appraise. The facts that the petitioner for a dozen years or more prior to 1935 had suffered continuous net losses and that during its base period the student enrollment and net income steadily increased persuade us to believe that the ensuing improvement*164 in the petitioner's business stemmed from the change in its management and policies within its base period and qualifies it for relief within the purview of section 722 (b) (4) of the Code. Notwithstanding the establishment of a qualifying factor, the petitioner has the burden of proving that its average base period net income is an inadequate standard of normal earnings because of such factor and also what would be a fair and just amount representing normal earnings. Sec. 722 (a), I. R. C.; Green Spring Dairy, Inc., 18 T. C. 217; Irwin B. Schwabe Co., 12 T. C. 606; Powell-Hackney Grocery Co., 17 T. C. 1484. The petitioner contends that due to the character of its business the improvements in earnings would be reflected only after a considerable time lag, and that by the end of the base period it did not reach the level of normal earnings it would have reached if the change in the character of its business had been made two years before. Petitioner claims a constructive average base period net income for the taxable years in question in the amount of $ 53,098.58. The normal *728 net*165 income for the base period without the benefit of section 722 is $ 10,762.86, and computed under the growth formula is $ 23,556.19. The petitioner's reconstruction of its base period net income is not acceptable. It has erroneously applied the 2-year push-back rule. The purpose of the 2-year push-back rule is to establish a figure which is assumed to be the maximum amount which would have been earned in its last base period year if it had made the change 2 years before it did. Such assumed figure is then used as a point of departure in reconstructing the average base period net income, using appropriate indices. Suburban Transportation System, 14 T. C. 823; Del Mar Turf Club, 16 T. C. 749, 766. Furthermore, the petitioner bases its computation on data subsequent to January 1, 1940, although it makes no claim of any commitment in its base period. The respondent contends that the petitioner does not qualify for relief and, furthermore, that the petitioner has not shown that a fair amount representing normal earnings would be in excess of its average base period net income computed under the growth formula. On the basis*166 of this record, we think the evidence is insufficient to show that a fair and just amount to represent petitioner's normal earnings would exceed its average base period net income as computed under section 713 (f) of the Internal Revenue Code and allowed by the respondent under the growth formula. Therefore, we hold that petitioner is not entitled to any relief under section 722 of the Code. Reviewed by the Special Division. Decisions will be entered for the respondent.