E. W. Williams Publications, Inc. v. Commissioner

E. W. Williams Publications, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent E. W. Williams Publications, Inc. v. Commissioner Docket No. 48672 United States Tax Court 25 T.C. 282; 1955 U.S. Tax Ct. LEXIS 43; November 25, 1955, Filed *43 Decision will be entered for the respondent. Petitioner commenced publishing a new trade magazine in 1938 from which it derives advertising and subscription income. Its advertising income for 1945 was abnormal in amount. It claimed relief from excess profits tax under section 721(a)(2)(C), Internal Revenue Code of 1939, on the ground that its advertising income was a separate class of income resulting from research and development of tangible property. Held: Assuming that petitioner had a class of income as described in section 721(a)(2)(C) and that petitioner established the amount of net abnormal income derived therefrom, petitioner is not entitled to relief. Petitioner has failed to show that any part of the assumed net abnormal income is, under section 721(b), attributable to prior years and not to improved business conditions in the taxable year. Claude A. Hope, Esq., and Richard T. Scully, Esq., for the petitioner. William G. O'Neill, Esq., for the respondent. Arundell, Judge. ARUNDELL *283 The Commissioner determined deficiencies in declared value excess-profits tax and excess profits tax for the year 1945 in the amounts of $ 372.81 and $ 24,909, respectively. Petitioner, in its amended petition, claims an overpayment of excess profits tax for 1945 in the amount of approximately $ 2,700. Petitioner's application for relief from excess profits tax for 1945 under section 721, Internal Revenue Code of 1939, was rejected by respondent. The only issue presented is whether the petitioner had net abnormal income in 1945 from the development of tangible property within the meaning of section 721 (a) which is attributable to previous taxable years as provided in section 721 (b), Internal Revenue Code of 1939. *45 FINDINGS OF FACT. Petitioner was incorporated in New York on November 20, 1934, under the name of Butchers' Advocate, Inc. Its name was changed to E. W. Williams Publications, Inc., on October 30, 1943. Petitioner has been engaged in the business of publishing trade magazines since its organization. Its books are kept and its returns are filed on an accrual calendar year basis. The petitioner filed income and declared value excess-profits tax and excess profits tax returns for 1945 with the collector of internal revenue for the third district of New York. Upon incorporation in 1934, the petitioner acquired and commenced the publication of an established weekly trade magazine, Butchers' Advocate, which served the wholesale and retail meat trade. Butchers' Advocate was published by the petitioner through December 1943. On December 23, 1943, the petitioner sold the Butchers' Advocate magazine to a former employee, effective as of January 1, 1944. In August 1938, the petitioner published the first issue of a new trade magazine, Quick Frozen Foods, which was designed to serve the packers and distributors of frozen foods. It has published Quick Frozen Foods, monthly, since the first*46 issue. Since 1942, the petitioner has published a news letter, Quick Frozen Foods News Letter, which is sold separately from the magazine and, since 1945, petitioner has published two trade directories, Quick Frozen Foods Directory of Frozen Foods Processors, and Quick Frozen Foods Directory of Wholesale Distributors of Frozen Foods. *284 E. W. Williams has been president of the petitioner and publisher of its trade publications since its organization. The pre-publication work on the magazine Quick Frozen Foods was started by the petitioner in 1935, at which time its regular publication was Butchers' Advocate. Frozen foods was a relatively new business in 1935. The industry at that time did not have either a trade publication or a national trade organization. Petitioner's editorial staff did not have any experience in the field of frozen foods. Prior to publication of the first issue of Quick Frozen Foods in August 1938, petitioner's employees had to acquire a knowledge of the industry and its problems, gather material for articles, establish contacts in the trade, obtain subscribers and advertisers and prepare a format for the magazine. From 1935 until August 1938, Williams*47 and three of the petitioner's regular employees, Roy Cohen, Jerome Gordon, and Margaret Stokes, devoted a part of their time to pre-publication work on the frozen foods magazine. Also, in 1937, petitioner employed George Treat as editor of the magazine. He devoted his full time to the pre-publication work. The following activities are illustrative of the pre-publication work in connection with the magazine Quick Frozen Foods: Petitioner subscribed to press clipping services in order to obtain current information on frozen foods, and it purchased books and periodicals which contained material on frozen foods. Williams and the aforementioned employees gathered and studied facts and information on the industry from all available sources. They visited companies engaged in packaging and distributing frozen foods, among them Birds Eye Division of General Foods, Seabrook, and Dulany. They also visited experimental stations and research centers where work on various aspects of frozen foods was being conducted such as the University of Tennessee and the Ferry-Morse Seed Company. Companies engaged in manufacturing items used in the industry, such as refrigeration equipment and packaging*48 materials, were also visited. Consumers were interviewed in retail markets in order to obtain a sampling of consumer opinion on frozen foods. Lists of potential subscribers and advertisers for the magazine were prepared and subscribers and advertisers were solicited. The purpose of the aforementioned and other pre-publication activities was to familiarize the petitioner's staff with the industry and its problems, to obtain material for articles for the magazine, and to promote circulation and advertising for the magazine. In January 1938, the petitioner began to insert articles on frozen foods in its regular publication, Butchers' Advocate, and in March 1938 it began to run a column on frozen foods in Butchers' Advocate. A dummy copy of the magazine Quick Frozen Foods was published *285 by petitioner in July 1938. The first regular issue of Quick Frozen Foods was published in August 1938. After petitioner commenced the publication of Quick Frozen Foods, it continued its efforts to promote circulation and advertising for the magazine and to secure its acceptance by the frozen food industry. During the period from August 1938 through December 1943, petitioner, among other*49 things, compiled trade directories for the industry; published market reports; compiled a glossary of frozen food terms; assisted the Government in developing standards and grades for frozen foods; solicited articles, both paid and gratuitous, from members of the industry and from persons engaged in research on frozen foods; and in 1940 and 1941 petitioner ran the first national conventions held by the frozen food industry. The magazine Quick Frozen Foods has been registered as a copyright with the United States Patent Office since the issue of November 1938. The contents of each issue of the magazine have been copyrighted since the issue of May 1940. The annual subscription rate for the Quick Frozen Foods magazine from January 1941 through February 1943 was $ 3; from March 1943 through December 1945, the rate was $ 3.50. The total circulation of Quick Frozen Foods magazine during the years 1938 to 1945 was as follows: [1938] 4,200 [1939] 5,200 [1940] 6,200 [1941] 6,700 [1942] 7,150 [1943] 7,200 [1944] 7,400 [1945] 8,000 Petitioner's income from the Quick Frozen Foods magazine was derived principally from advertising. Approximately 50 per cent of the advertising in the magazine was food*50 advertising; the other 50 per cent was advertising by companies producing equipment or supplies or providing services for the frozen food industry. Petitioner's general advertising rates for one-page, one-half-page, and one-quarter-page ads in the frozen foods magazine during the period 1941-1944 are set forth below. In arriving at the rates shown, the rates for 1, 6, and 12 issues have been averaged; rates for less than one-quarter of a page are not included: Rates Period 1 page 1/2 page 1/4 page 1/1/41-12/31/41 $ 130.00 $ 65.00 $ 32.50 1/1/42-11/30/43 165.00 90.00 50.00 12/1/43-12/31/44 181.66 100.00 55.00 *286 The average general advertising rates for the 4-year period 1941-1944 were as follows: Average rates -- 1941-1944 1 page 1/2 page 1/4 page $ 160.76 $ 86.45 $ 46.98 Petitioner's general advertising rates for the year 1945 were as follows: Advertising rates -- 1945 1 page 1/2 page 1/4 page $ 181.66 $ 100 $ 55 The advertising rates in effect during 1945 represent an average increase of 15.2 per cent over the rates in effect during the years 1941-1944 as set forth below: Space 1945 rates Average rates Percentage of 1941-1944 increase per cent 1 page $ 181.66 $ 160.76 [13] 1/2 page 100.00 86.45 15.6 1/4 page 55.00 46.98 [17] *51 The total number of pages in the frozen foods magazine, and the number of pages which were devoted to advertising in each of the years 1941-1944 were as follows: Advertising Year Total pages pages [1944] 1,022 [589] The average number of pages devoted to advertising during the 4-year period 1941-1944 was 340. The total number of pages in the frozen foods magazine for the year 1945 was 1,516, and the number of pages devoted to advertising was 958. Petitioner's gross income from the sale of advertising space in the frozen foods magazine (after discounts and allowances) for each of the years 1941 to 1944, inclusive, was as follows: Gross income -- Year advertising [1941] $ 29,506 [1942] 31,474 [1943] 50,817 [1944] 103,934 Petitioner's average gross income from the sale of advertising space in the frozen foods magazine for the 4-year period 1941-1944 was $ 53,933. Petitioner's gross income from advertising for the year 1945 was $ 176,394. *287 Petitioner has received advertising income from the frozen foods magazine since 1938, the first year of publication. Its gross income from advertising for the years 1938, *52 1939, and 1940 was $ 7,085, $ 20,432, and $ 26,046, respectively. The growth and financial success of petitioner's trade magazine was related to the growth and expansion of the frozen foods industry which it served. The following schedule shows the production figures of commercial frozen food packs in millions of pounds for the years 1938-1945: Production Year (millions of pounds) [1942] 647.5 [1945] 1,028 The frozen food industry and the petitioner's trade magazine were affected by the occurrence of World War II. The industry was designated as essential to the war effort by the Government. Ceiling prices were placed on frozen foods by the Office of Price Administration. The Armed Forces requested a large percentage of the total production of the industry, thereby reducing the supply available for domestic markets. The Armed Forces requested about 40 per cent of the industry's 1943 and 1944 packs. The expansion of the industry was hampered by wartime controls and restrictions on materials and transportation. The first wartime restrictions which affected the industry were imposed early*53 in 1942 when an order of the War Production Board limited the supply of cabinets available to the industry. Petitioner's frozen food magazine was directly affected by wartime restrictions on paper and magazine content. Also, during the period from 1941 until about the middle of 1944, it was more difficult for the petitioner to obtain advertising and, in many instances, it lost advertisers, particularly companies which manufactured equipment for the industry. During the war years, the demand for frozen foods exceeded the available supplies. Consumer demand for frozen foods was stimulated by the war. A general feeling prevailed in the industry that, once wartime controls and restrictions were removed, the industry would expand. In March 1944, frozen foods were removed from the ration list. This action gave further impetus to the increasing consumer demand. Other wartime restrictions which affected the industry were eased *288 during the latter part of 1944 and early 1945. In August 1945, all wartime controls affecting the industry were removed. Petitioner's profit and loss statements for 1938 and 1939 show net losses from the publication of Quick Frozen Foods in the amounts*54 of $ 5,028 and $ 3,804, respectively. For the year 1940, petitioner reported net income of $ 653; the tax return does not contain a breakdown of the reported net income as between Butchers' Advocate and Quick Frozen Foods, and petitioner's profit and loss statement for 1940 is not available. A summary of the petitioner's profit and loss statements for the years 1941, 1942, and 1943 is set forth below. The income and expenses of Butchers' Advocate and Quick Frozen Foods are shown separately; the year 1943 was the last year in which petitioner published Butchers' Advocate: Butchers' Quick Frozen Total Advocate Foods [1941] Gross receipts: Advertisements (net) $ 48,722 $ 29,506 $ 78,228 Subscriptions 9,968 4,118 14,086 Total gross receipts $ 58,690 $ 33,624 $ 92,314 Publication and circulation costs 39,125 17,966 57,091 Gross profit $ 19,565 $ 15,658 $ 35,223 General and adm. exp 14,682 13,662 28,344 Net operating profit $ 4,883 $ 1,996 $ 6,879 Convention income [141] Net profit $ 4,954 $ 2,066 $ 7,020 [1942] Gross receipts: Advertisements (net) $ 43,279 $ 31,474 $ 74,753 Subscriptions 11,545 7,466 19,011 Total gross receipts $ 54,824 $ 38,940 $ 93,764 Publication and circulation costs 40,873 19,014 59,887 Gross profit $ 13,951 $ 19,926 $ 33,877 General and adm. exp 15,841 15,555 31,396 Net profit or loss ($ 1,890) $ 4,371 $ 2,481 [1943] Gross receipts: Advertisements (net) $ 38,094 $ 50,817 $ 88,911 Subscriptions 5,263 9,537 14,800 Total gross receipts $ 43,357 $ 60,354 $ 103,711 Publication and circulation costs 32,324 30,850 63,174 Gross profit $ 11,033 $ 29,504 $ 40,537 General and adm. exp 14,493 19,522 34,015 Net profit (or loss) ($ 3,460) $ 9,982 $ 6,522 *55 The following schedule is a summary of the petitioner's profit and loss statements for 1944 and 1945 during which years it published only the frozen foods publications: *289 Gross receipts: [1945] Advertisements (net after discounts) $ 103,934 $ 176,394 Subscriptions (net after provision for unexpired subscriptions) 13,364 47,512 Total gross receipts $ 117,298 $ 223,906 Publication and circulation costs 61,744 117,305 Gross profit $ 55,554 $ 106,601 General and administrative expense 45,190 61,769 Net operating profit $ 10,364 $ 44,832 Other income 2,475 4,880 Net profit $ 12,839 $ 49,712 Petitioner claimed the benefits of section 721 of the 1939 Code in its excess profits tax return for 1945. Petitioner attached to the return an application for relief, under section 721, based on the grounds that it had a class of abnormal income, namely, advertising income from the magazine Quick Frozen Foods, and net abnormal income derived therefrom which was attributable to prior taxable years. Respondent rejected the claim for relief and determined the deficiency in excess profits tax. Respondent, in determining the deficiency, *56 did not allow any deduction for abnormal income attributable to prior years. The increase in 1945 in the petitioner's advertising income was due to an improvement in business conditions. The increased income was the result of higher prices and an increased physical volume of sales due to increased demand for the type of product sold by the petitioner, namely, advertising space. OPINION. Petitioner seeks relief from excess profits tax for 1945 under the provisions of section 721 of the 1939 Code which relate to abnormalities in income in the taxable period. Section 721 is designed to afford relief to taxpayers who receive income in the taxable year which is inherently abnormal in character or in amount. W. B. Knight Machinery Co., 6 T. C. 519, 529. Abnormal income, as defined in section 721 (a) (1), means "income of any class includible in the gross income of the taxpayer for any taxable year * * * if it is abnormal for the taxpayer to derive income of such class, or, if the taxpayer normally derives income of such class but the amount of such income of such class includible in the gross income of the taxable year is in excess of 125 per centum of the*57 average amount of the gross income of the same class for the four previous taxable years * * *." Section 721 (a) (2) describes several separate classes of income and provides that the classification of income of any class not described therein shall be subject to regulations *290 prescribed by the Commissioner. Relief is provided only with respect to net abnormal income as defined in section 721 (a) (3), 1*58 and only with respect to that part thereof which, under regulations prescribed by the Commissioner, is properly attributable to other taxable years as provided in section 721 (b). 2 In order to obtain relief, the taxpayer must establish, within the framework of the statute and applicable regulations, (1) the class and amount of abnormal income in the taxable year; (2) the amount of net abnormal income derived therefrom; and (3) the portion of net abnormal income which is attributable to other taxable years. Producers Crop Improvement Association, 7 T. C. 562, Powell-Hackney Grocery Co., 17 T. C. 1489. A separate class of income is described in subparagraph (C) of section 721 (a) (2) as: Income resulting from exploration, discovery, prospecting, research, or development of tangible property, patents, formulae, or processes, or any combination of the foregoing, extending over a period of more than 12 months * *59 * * Petitioner claims that its entire advertising income from the frozen foods magazine is a separate class of income, abnormal in amount, resulting from research and development of tangible property -- the magazine -- within the purview of subparagraph (C) above, and that it had net abnormal income derived therefrom which is attributable to the prior taxable years 1935-1943, during which period it developed the magazine. Petitioner contends on brief that the amount of its abnormal income is $ 176,394, which sum represents the petitioner's gross advertising income for 1945, and that the amount of net abnormal income derived therefrom, before the application of any business improvement factor, is $ 63,796. It maintains that if an adjustment to net abnormal income to reflect business improvement in the taxable year is proper, the amount of net abnormal income after such adjustment is $ 42,138. Respondent denies that petitioner's advertising income is a separate class of income resulting from "research or development of tangible *291 property" within the intendment of the statute, and he argues that even if petitioner's advertising income is a separate class of income as described*60 in subparagraph (C) above, and even if petitioner established the amount of net abnormal income derived therefrom as required by section 721 (a) (3), petitioner would not be entitled to any relief since no part of the net abnormal income is attributable to other years under section 721 (b) and the applicable regulations. We question the validity of the petitioner's argument that its advertising income is a separate class of income as described in subparagraph (C) of the statute. We doubt whether the petitioner's activities in connection with the publication and promotion of the frozen foods magazine constitute "research or development of tangible property" within the intendment of the statute. Cf. Powell-Hackney Grocery Co., supra; Atlumor Manufacturing Co., 12 T. C. 949. However, we need not decide the question. We agree with the respondent that even if we were to assume, arguendo, that petitioner had net abnormal income under section 721 (a), petitioner is not entitled to relief since it has failed to show that any part thereof is, under the applicable regulations, properly attributable to prior taxable years. Section*61 721 (b) provides that the amount of net abnormal income that is attributable to other years shall be determined under regulations prescribed by the Commissioner. Treasury Regulations 112, section 35.721-3, provide, in part, as follows: To the extent that any items of net abnormal income in the taxable year are the result of high prices, low operating costs, or increased physical volume of sales due to increased demand for * * * the type of product sold by the taxpayer, such items shall not be attributed to other taxable years. Thus, no portion of an item is to be attributed to other years if such item is of a class of income which is in excess of 125 per cent of the average income of the same class for the four previous taxable years solely because of an improvement in business conditions. In attributing items of net abnormal income to other years, particular attention must be paid to changes in those years in the factors which determined the amount of such income, such as changes in prices, amount of production, and demand for the product. The respondent's regulations have been sustained as valid by this Court. Soabar Co., 7 T. C. 89. We are*62 satisfied from the record that any net abnormal income which petitioner had in 1945 was due solely to an improvement in business conditions. It was the result of higher prices, increased physical volume of sales due to increased demand for the type of product sold by petitioner (advertising space), and other factors present in the taxable year. Consequently, no part thereof is, under the regulations, properly attributable to other years so as to entitle the petitioner to relief. See Soabar Co., supra; Geyer, Cornell & Newell, Inc., 6 T. C. 96; Eitel-McCullough, Inc., 9 T. C. 1132; Ramsey Accessories Manufacturing Corporation, 10 T. C. 482; Atlumor Manufacturing Co., supra; *292 Powell-Hackney Grocery Co., supra; Dr. P. Phillips & Sons, Inc., 20 T. C. 435. Petitioner, in the first instance, erroneously assumes that the entire amount of its advertising income in 1945 and in the 4 previous years is class (C) income. It has not even attempted to show what part of the advertising*63 income is attributable to such factors as management, salesmanship, and goodwill. Income attributable to such factors is never a part of class (C) income. Ramsey Accessories Manufacturing Corporation, supra, p. 487. Primas Groves, Inc., 15 T. C. 396. Obviously some part of petitioner's advertising income is attributable to the aforementioned factors and not to the pre-publication and post-publication activities which petitioner characterizes as "research and development." Moreover, we are unable on the record before us to make any reasonable allocation of some part of petitioner's advertising income to such factors as management, salesmanship, and goodwill. A further, and in our opinion, fatal weakness in petitioner's case is its failure to prove that any part of any net abnormal income is attributable to prior years. The observation of the Court in Primas Groves, Inc., supra, page 400, is pertinent here: The basic weakness which underlies petitioner's theory, after indulging in the favorable assumptions, relates to the problem of the attribution of the income to other years. Petitioner*64 has not and apparently can not show what portion of its assumed net abnormal income * * * resulted from developmental activities antedating the year before us, and what portion resulted from activities and circumstances in the instant year. The evidence is persuasive that petitioner's assumed net abnormal income in 1945 was due, chiefly, to an increase in advertising rates and increased sales of advertising space. Petitioner admits that its increased advertising income in 1945 was accompanied by an increase in the amount of advertising space sold, and that the advertising rates in effect in 1945 were higher than the average of the rates in effect during the 4 previous years. It argues, however, that a factor of 1.514 when applied to net abnormal income adequately compensates for the improvement in business conditions in the taxable year. We cannot agree. The factor employed by petitioner to measure the improvement in business conditions in the taxable year, 1.514, represents the ratio of the production of commercial frozen food packs in 1945 (1,028 million pounds) to the average production for the years 1941-1944 (679.1 million pounds). Although the fortunes of petitioner's trade*65 magazine are related to those of the industry which it serves, it is apparent from the record that the production figures for the industry are grossly inadequate for the purpose of measuring the improvement in the petitioner's business conditions in the taxable year. *293 The evidence reveals that the advertising rates in effect in 1945 were approximately 15 per cent higher than the average of the rates in effect during the 4 previous years. In 1945 the number of magazine pages devoted to advertising was 958 whereas during the previous 4 years the average number of pages devoted to advertising was 340. These facts clearly establish that the increase in petitioner's advertising income, from an average of $ 53,933 in the test years to $ 176,394 in 1945, was due to improved business conditions in the taxable year. Without taking into account other deficiencies in petitioner's proof, they preclude the allocation of any part of petitioner's assumed net abnormal income for 1945 to prior years. We conclude that, even on the basis of assumptions favorable to petitioner, no part of the petitioner's assumed net abnormal income for 1945 is properly attributable to prior years under section*66 721 (b) so as to entitle petitioner to relief. The respondent's determination is sustained. Reviewed by the Special Division. Decision will be entered for the respondent. Footnotes 1. SEC. 721. ABNORMALITIES IN INCOME IN TAXABLE PERIOD. (a) Definitions. -- For the purposes of this section -- * * * * (3) Net abnormal income. -- The term "net abnormal income" means the amount of the abnormal income less, under regulations prescribed by the Commissioner with the approval of the Secretary, (A) 125 per centum of the average amount of the gross income of the same class determined under paragraph (1), and (B) an amount which bears the same ratio to the amount of any direct costs or expenses, deductible in determining the normal-tax net income of the taxable year, through the expenditure of which such abnormal income was in whole or in part derived as the excess of the amount of such abnormal income over 125 per centum of such average amount bears to the amount of such abnormal income.↩ 2. SEC. 721. ABNORMALITIES IN INCOME IN TAXABLE PERIOD. (b) Amount Attributable to Other Years. -- The amount of the net abnormal income that is attributable to any previous or future taxable year or years shall be determined under regulations prescribed by the Commissioner with the approval of the Secretary.↩