Hall Lithographing Co. v. Commissioner

The Hall Lithographing Company, Petitioner, v. Commissioner of Internal Revenue, Respondent Hall Lithographing Co. v. Commissioner Docket No. 32372 United States Tax Court 26 T.C. 1141; 1956 U.S. Tax Ct. LEXIS 83; September 21, 1956, Filed *83 Decision will be entered for the respondent. Petitioner seeks relief under section 722 (a) and (b) (4), Internal Revenue Code of 1939, upon the ground that it changed the character of its business during the base period years because of (1) a change in management, and (2) the acquisition of the business of a competitor. Held, petitioner has failed to establish its right to relief under such section. H. R. Schroeder, Esq., for the petitioner. Ray H. Garrison, Esq., for the respondent. Mulroney, Judge. MULRONEY *1141 The issue presented is whether petitioner is entitled to relief from excess profits taxes for the taxable years 1941 to 1945, inclusive, under section 722, Internal Revenue Code of 1939. FINDINGS OF FACT. The petitioner was incorporated in Kansas under the name of Hall and O'Donald Lithographing Company*84 in 1889, after operating for 2 years as the partnership of Hall & O'Donald. In 1896 the corporate name was changed to the Hall Lithographing Company. Under its charter, petitioner's authorized capital stock was 1,000 shares of common, par value $ 100 per share. The net assets of the partnership of Hall and O'Donald were transferred to petitioner in March 1890 in exchange for 567 shares of petitioner's stock. In 1938, petitioner's authorized capital was increased to 1,100 shares of common stock, par value $ 100 per share. In July 1938, petitioner issued 69 shares of common stock to Crane and Company of Topeka, Kansas, as a part payment of the purchase price of the printing business *1142 purchased from Crane and Company by the petitioner, as hereinafter related. During the base period years, petitioner operated a letterpress, lithographing, and embossing business, and also maintained a stationery department which handled a complete line of general office supplies and legal forms. In addition petitioner had a wholly owned subsidiary, the Hall Stationery Company of Topeka, Kansas, acquired April 18, 1919. The subsidiary operated a retail store, the principal merchandise handled*85 being stationery, office furniture, books, school supplies, photographic equipment, and greeting cards. Petitioner's business operations were carried on principally within two departments, the factory department and the stationery department. The factory department performed letterpress, lithographing, and embossing work. Its production was primarily on a job order basis. The principal products produced during the base period years and the process used to produce them were as follows: Lithography Car record books Color broadsides Calendars U. S. Government forms Lubrication charts and booklets Bank checks Greeting cards Advertising display posters Letterpress Freight bills Ruled record sheets Time tables Operating manuals Train sheets County record sheets Lithography and/or Letterpress General operating forms Letterheads Envelopes Annual passes Trip passes Waybills Car switch lists Paychecks Rule and instruction books Advertising material Building and loan operating Bank statements and ledger forms sheets Color booklets Accountant's and abstractor's Municipal and county forms forms The products furnished or produced by petitioner during the period *86 1909 to 1924 were the same as the products furnished or produced during the base period years. Various members of the Willard N. Hall family served as petitioner's principal officers from the time of its organization through the base period years. Willard N. Hall was petitioner's president from 1890 until his death on March 11, 1920. Richard N. Hall succeeded his father as president, serving until July 25, 1933. Guy A. Morse, who succeeded Richard, died on or about November 23, 1933, *1143 and was followed by Richard's mother, Mrs. Willard N. (Luella R.) Hall, who served as president until July 10, 1937. From the latter date until December 31, 1939, Richard N. Hall served as president. The chairman of petitioner's board of directors from April 22, 1936, through the remainder of the base period years was Luella R. Hall. Petitioner's vice presidents from 1920 through 1939 were: Richard N. Hall, January 1 to April 8, 1920; Guy A. Morse, April 8, 1920, to July 25, 1933; Richard N. Hall, July 25, 1933, to July 10, 1937; Mrs. John D. M. (Laura Hall) Hamilton, Richard's sister, July 10, 1937, to December 31, 1939. Petitioner's secretaries from 1920 through 1939 were: Guy A. Morse, *87 January 1 to April 8, 1920; Clement W. Seely, April 8, 1920, to January 1, 1925; Guy A. Morse, January 13, 1925, to September 22, 1927; Clyde A. Rowe, September 22, 1927, to August 31, 1936; Merl Tabor, September 14, 1936, to December 31, 1939. From January 1, 1920, to April 22, 1936, petitioner's president also served as its treasurer. On the latter date, Clarence A. Severin was named petitioner's treasurer and its general manager and served in both capacities during the remainder of the base period. Severin was selected and nominated to be petitioner's treasurer and general manager by Luella R. Hall. The Hall family controlled petitioner's board of directors from 1920 through the base period. The board of directors on April 8, 1920, January 1, 1936, and December 31, 1939, consisted of the following, the directors being increased from 5 to 6 on May 19, 1938: Apr. 8, 1920 Jan. 1, 1936 Dec. 31, 1939 Luella R. Hall Luella R. Hall Luella R. Hall Richard N. Hall Laura Hall Hamilton Richard N. Hall Laura Hall Hamilton 1 John D. M. Hamilton 1 Laura Hall Hamilton Guy A. Morse Clyde A. Rowe 1 Merl Tabor 1 C. W. Seely 1 James M. Lippett 1 Clarence A. Severin 1 Frank S. Crane *88 Severin became a director on April 22, 1936, Tabor on or about August 31, 1936, and Crane on July 5, 1938. Each of these 3 directors served continuously during the base period after their original election to petitioner's board of directors. Luella R. Hall and Laura Hall Hamilton were directors throughout the period April 8, 1920, to December 31, 1939. Richard N. Hall was a director throughout such period except for the period July 25, 1933, to May 9, 1936, when his brother-in-law, John D. M. Hamilton, served. During the period December 31, 1920, to December 31, 1939, Luella R. Hall owned or held, as an assignee for others, not less than 325 shares of the 567 shares of petitioner's capital stock, outstanding until 1938, and not less than 325 shares of the 636 shares outstanding in *1144 1938 and 1939. During such period Richard N. Hall owned 97 1/4 shares. During the years 1934 to 1939, inclusive, Laura Hall Hamilton owned 97 1/4 shares of petitioner's outstanding stock. During the 19-year period aforementioned, 47 1/4 shares were owned by Guy A. Morse (so stipulated; no change of ownership shown as a result of the *89 death of Guy A. Morse in November 1933). In 1938 and 1939 Crane and Company owned 69 shares of petitioner's outstanding stock. During the period January 13, 1925, to April 22, 1936, petitioner's executive officers managed its business without employing a general manager. Petitioner sustained losses in each calendar year of this period as hereinafter set forth. The employment of Clarence A. Severin as general manager was in accordance with the recommendation of Laird Dean, president of the Merchants National Bank of Topeka, Kansas. The petitioner, the estate of Willard N. Hall, and the members of the Hall family maintained bank accounts at Dean's bank and consulted him about business and financial matters. Dean was convinced that petitioner needed good business management more than anything else to halt its continuous losses. He so advised petitioner's officers and stockholders and recommended Severin to Luella R. Hall because, in his opinion, Severin possessed the qualities necessary to put petitioner's operations on a profitable basis. Prior to becoming petitioner's general manager, Severin had had more than 7 years of experience in the banking and investment business. Prior*90 to 1928 he worked in minor capacities in a couple of small country banks in Kansas. From about 1928 to 1933, he sold investment securities for a Topeka firm and a New York City firm. From 1933 to April 1936, he operated his own business as an investment counselor. One of his customers during this latter period was the estate of Willard N. Hall, which employed Severin as its investment manager. In such capacity he had access to general information about the petitioner. Upon being employed by petitioner, Severin had an understanding that he, as general manager, would make the decisions with respect to petitioner's operations but he agreed to inform petitioner's president, Luella R. Hall, about any major change before such change was undertaken. Severin had no previous experience, knowledge, or training in the printing business which he could use to assist him in the discharge of his duties as general manager. In order to acquaint himself with the printing business, Severin literally lived with it. During his first year he averaged approximately 18 hours a day in the business, spending the daytime in the plant learning the mechanical end of the business, and the nighttime in the*91 office. He informed the employees about petitioner's financial condition, that he intended to put the business on a profitable basis or lock the doors, and urged them to *1145 work together as a cohesive unit so that the firm could show a profit. From time to time, after he became general manager, and during the base period years, Severin found objectionable business practices, which he changed, and a failure to use other business practices which he considered beneficial, and which he installed. The principal changes made by Severin in petitioner's operations during the base period years were the changes hereinafter listed. Prior to April 22, 1936, petitioner's employees took inventory without any supervision from management and priced out the inventory when they got around to it. On April 22, 1936, the inventory as of December 31, 1935, had not been priced out. Severin changed the practice of taking inventory without management's supervision, and arranged with a disinterested outside printer to take an inventory on July 1, 1936, and to comment thereon. As a result of such inventory and comments, petitioner discarded about 30 tons of worthless inventory and sold or junked*92 merchandise on hand from discontinued lines. At April 22, 1936, petitioner's business lacked cooperation between its office and factory employees. Severin sought to eliminate this unhealthy condition with meetings between key office and factory personnel where the need for cooperation was stressed. Severin also established a policy of meetings of factory foremen at which jobs completed, in process, and to be bid on, were discussed. Operating economies were major items of discussion at these meetings. Prior to April 22, 1936, petitioner had no records from which the cost of a job could be determined. Severin introduced the practice of computing the cost of each job. Definite percentages were fixed which were to be added to the cost of materials entering into a job. Selling rates were fixed for each operation required to produce the job, including factory costs, overhead, selling expense, and profit. The total of these items represented the selling price for the job. Severin introduced the practice of keeping a record of each employee's chargeable time. These records, furnished daily, kept management informed as to where it had too much help and where it needed more help. On*93 April 22, 1936, petitioner employed 4 or 5 salesmen who worked without the direction or supervision of a sales manager. It was their practice to write up a job, buy the materials therefor, arrange for any needed outside purchases, order any cuts that were to be used on the job or have some one in the office do so for them, all without any checking by or supervision of management. Severin changed this practice. He held meetings with the salesmen at which key personnel from the office and factory and salesmen from paper mills explained the specifications needed to do the job and the kind of paper best *1146 suited for the job to be done. Severin tried to instill into the salesmen that they were selling a service and not just a job of printing. In August 1938, Severin appointed a sales manager, Merl Tabor, who issued sales bulletins periodically to inform petitioner's personnel of results achieved and new accounts acquired. Tabor had complete charge of the salesmen and the commercial selling except for the Santa Fe Railroad account and other railroad accounts which Severin retained and handled personally. As of April 22, 1936, petitioner's trade territory consisted of all *94 of Kansas, the first tier of counties on the west side of Missouri, and the aforementioned Santa Fe Railroad account. Severin expanded the territory served by petitioner so that, as of December 31, 1939, its trade territory consisted of Kansas, Oklahoma, Iowa, the west half of Missouri, the City of St. Louis, the river towns in Illinois, plus Chicago, Lincoln and Omaha, Nebraska, and Minneapolis, Minnesota. In addition, Severin expanded petitioner's railroad business from one account in 1936 to 15 or 18, as of December 31, 1939. Severin sold the railroad on exactly the same basis as petitioner's commercial accounts were sold, except that, in computing the selling price to the railroads no selling costs or commissions were included for the reason that Severin personally sold the railroad accounts. Prior to April 22, 1936, various people in petitioner's organization made purchases for it. Severin abolished this practice and appointed a purchasing agent who did all the buying. The previous practice of purchasing from a few suppliers was changed. The market was checked and quotations were obtained from as many suppliers as possible. A perpetual inventory of large-usage items was*95 set up which was gradually extended to include everything purchased by petitioner. The petitioner had made no use of bank credit in purchasing raw materials prior to the time that Severin became general manager. Severin arranged for and secured such bank credit in order to take advantage of the discounts offered by suppliers. He also obtained longer discount periods from some suppliers. Where possible, supplies were purchased in larger quantities to take advantage of the lowering price per unit as the quantity purchased increased. In the printing business there are losses from spoilage. Such losses occur when a job has to be done over again because it was wrong as originally produced. Prior to Severin's employment, petitioner had no method of determining the responsibility for spoilage losses, which were blamed largely on the factory employees. Severin instituted a policy of fixing the responsibility for spoilage losses, and it was ascertained that many losses blamed on the factory were due to faulty and incomplete specifications in writing up the job. *1147 In or about 1935, petitioner discontinued producing color work. After he became general manager, Severin negotiated*96 with Hall Brothers of Kansas City, Missouri (no relation to petitioner), relative to doing color work for them. The negotiations were successful, and in 1937 petitioner began to get color work from Hall Brothers. By the end of the base period the volume of petitioner's color work was increasing substantially, and it was profitable work. On January 1, 1938, Severin appointed a factory superintendent who had complete charge of the mechanical end of the business. He had the right to hire and fire factory foremen. From time to time, he met with his foremen to discuss operational procedures, quotations on major jobs, and the time estimates for doing the job. All jobs were routed through him and he had the authority to reject any job which, in his estimation, the factory could not produce within the time specified by the salesman or office worker who wrote the job specifications. Prior to the acquisition of the printing business of Crane and Company in 1938, petitioner had a small amount of mail order business consisting mostly of bank checks and building and loan forms. With the acquisition of such business, the volume of petitioner's mail order business for printed and ruled forms, *97 record books, and general printing increased substantially. During 1939, Severin negotiated with A. B. Dick Company to secure the distributorship for petitioner of that company's products. The negotiations were successful and an agreement with respect thereto was entered into between the parties on December 14, 1939. No sales were made under this agreement prior to December 31, 1939. Petitioner estimated that its annual sales from this distributorship would be about $ 60,000. During the base period years, Severin was also treasurer of the Hall Stationery Company, petitioner's wholly owned subsidiary. He devoted about 5 per cent of his time to the subsidiary's business and 95 per cent of his time to petitioner. During these years the only salary received by Severin from petitioner was $ 1,600 in 1939. The rest of his salary during the base period was paid by the Hall Stationery Company. Severin's salary for such years was as follows: 1936, $ 2,500; 1937, $ 3,600; 1938, $ 3,600; 1939, $ 5,000. Salaries paid to petitioner's other officers during the same years aggregated the following amounts: 1936, $ 3,380; 1937, $ 8,616; 1938, $ 9,216; 1939, $ 9,190. On or about January 11, *98 1938, petitioner's board of directors authorized the granting of an option to Severin and Merl Tabor to purchase its unissued capital stock, 216 1/2 shares each or a part thereof, at $ 100 per share, the option to expire in any event by December 31, *1148 1943. Such an option was granted, but at December 31, 1939, was outstanding and unexercised. Prior to May 30, 1938, Crane and Company, an Arizona corporation, with its principal office and plant in Topeka, Kansas, was engaged in the printing and binding business and also sold lithographic products and stationery. On the latter date, petitioner acquired the printing, binding, and lithographing business of Crane and Company, which thereafter engaged only in the stationery business. Petitioner's primary purpose in purchasing such business and assets was to acquire a substantial volume of business and eliminate a competitor. The negotiations between petitioner and Crane and Company were initiated by Frank S. Crane, president of the latter, who contacted petitioner's general manager, Clarence A. Severin. Petitioner's directors appointed Richard N. Hall and Severin to negotiate with Crane. Severin conducted most of the negotiations*99 which culminated in the purchase agreement of May 30, 1938. Petitioner paid cash and stock for the property acquired and the seller's covenant not to compete for a period of 10 years. After its acquisition of the business and assets, petitioner employed two of the key personnel of Crane and Company. One was the top salesman, and the other handled the printing and did estimating. Certain other employees of Crane and Company were also employed by the petitioner. The annual sales of that portion of the Crane and Company business acquired by the petitioner under the aforesaid agreement, were as follows: Year ended January 31 Annual sales [1935] $ 138,396.98 [1936] 110,807.50 [1937] 116,110.79 [1938] 106,788.90 1938 1 51,463.96 Between April 1936 and December 31, 1939, petitioner acquired 5 major items of equipment at a total cost of $ 38,600. Such equipment consisted of 3 letterpresses, 1 offset litho press, and 1 automatic spacer cutting machine. As of December 31, 1939, petitioner had 7 cylinder presses with total rated capacity of 16,900 impressions per hour, 5 platen presses with total rated capacity of 12,400 impressions per hour, and 2 litho*100 presses with total rated capacity of 10,000 impressions per hour. A table, compiled from petitioner's monthly payroll and machine *1149 records, shows the following facts with respect to operations in petitioner's factory department during the base period years: Year ended December 31 [1939] Total payroll man-hours -- factory 77,832.9 80,855.7 93,137.6 108,263.1 Ratio to 1939 71.89% 74.68% 86.02% 100.0% Total number of employees during year -- factory [708] Total chargeable hours, presses, machine hours 11,417.3 11,965.9 16,546.0 20,171.2 Ratio to 1939 56.60% 59.32% 82.03% 100.0% Total chargeable hours, all other machines, machine hours 4,161.3 4,860.5 4,689.5 4,651.3 Ratio to 1939 89.46% 104.4% 100.82% 100.0% Total hours run -- presses 7,151.5 7,591.2 10,005.2 12,356.8 Ratio to 1939 57.88% 61.43% 80.97% 100.0% Total number of presses in use during year [14] Total press impressions 12,876,460 15,769,067 21,558,559 27,301,186 Ratio to 1939 47.16% 57.76% 78.97% 100.0% Average impressions per hour run 1,801 2,077 2,155 2,209 Average impressions per press 643,823 985,567 1,347,410 1,950,085 *101 Petitioner's net sales, net income (or loss) before taxes, and per cent of net income to sales for the calendar years 1914 to 1935, inclusive, were as follows: Net income Per cent Year Net sales before taxes net income to sales [1914] $ 266,502.93 $ 42,833.70 16.07 [1915] 273,628.02 44,477.53 16.25 [1916] 323,699.27 78,902.98 24.37 [1917] 386,502.39 91,802.15 23.75 [1918] 367,529.83 58,056.60 15.79 [1919] 398,730.73 75,673.57 18.97 [1920] 569,245.69 117,377.59 20.61 [1921] 371,790.68 17,963.49 4.83 [1922] 381,120.48 12,304.50 3.22 [1923] 423,879.08 49,682.84 11.72 [1924] 377,097.44 24,055.12 6.37 [1925] 353,369.59 (2,464.85) [1926] 371,796.13 (17,884.68) [1927] 364,913.44 (19,998.36) [1928] 393,896.08 (427.69) [1929] 393,842.93 (24,341.38) [1930] 377,827.69 (8,012.85) [1931] 285,653.72 (53,727.62) [1932] 196,527.66 (37,703.04) [1933] 167,808.22 (29,887.09) [1934] 214,190.66 (3,026.32) [1935] 218,664.95 (23,330.59) Petitioner's summarized income statements with percentage analysis for the base period years were as follows: *1150 Year ended December 31 -- [1939] Sales (net) $ 190,398.24 $ 200,738.95 $ 246,980.50 $ 283,613.91 Cost of sales 152,401.19 141,313.72 166,768.15 205,086.63 Gross profit on sales $ 37,997.05 $ 59,425.23 $ 80,212.35 $ 78,527.28 Selling expenses $ 32,788.87 $ 28,044.80 $ 40,239.91 $ 36,132.66 Administrative expense 30,124.78 28,429.81 30,118.41 38,544.65 $ 62,913.65 $ 56,474.61 $ 70,358.32 $ 74,677.31 Net operating profit ($ 24,916.60) $ 2,950.62 $ 9,854.03 $ 3,849.97 Other income and expense (net) (1,970.09) (27.61) (2,504.71) (2,876.71) Net profit ($ 26,886.69) $ 2,923.01 $ 7,349.32 $ 973.26 Percentage analysis: Per cent Sales 100.00 100.00 100.00 100.00 Cost of sales 80.04 70.40 67.52 72.31 Gross profit 19.96 29.60 32.48 27.69 Selling expense 17.22 13.97 16.29 12.74 Administrative expense 15.82 14.16 12.20 13.59 33.04 28.13 28.49 26.33 Net operating profit (13.08) 1.47 3.99 1.36 Other income and expense (net) (1.03) (.01) (1.01) (1.02) Net profit (14.11) 1.46 2.98 .34 *102 The petitioner's sales, net profit, and ratio of net profits to sales during the base period years were as follows: Total net Factory Stationery Net profit Year sales net sales net sales Net profit to total sales [1936] $ 190,398.24 $ 153,523.37 $ 36,874.87 ($ 26,886.09) (14.12) [1937] 200,738.95 165,684.41 35,054.54 1 2,923.01 2 1.45 [1938] 246,980.50 209,962.08 37,018.42 7,349.32 2.98 [1939] 283,613.91 250,079.50 33,534.41 973.26 .34 For the base period year 1939, petitioner's net income dropped to $ 973.26 from $ 7,349.32 for 1938. Factors contributing to this decrease in net income were: (a) A pay increase granted to factory employees, office employees, and the general manager amounting to approximately $ 6,500; (b) unusual spoilage amounting to approximately $ 2,600 in the litho-plate department; (c) rearrangement of equipment at a cost of approximately $ 1,300 as a result*103 of a job-travel study; and (d) inventory items of approximately $ 3,000 acquired from Crane and Company were discarded as obsolete and of no value. The ratio of petitioner's cost of goods sold to sales during the base period years was as follows: *1151 Year Total Factory Stationery [1936] 80.04 72.24 112.53 [1937] 1 70.39 72.02 62.74 [1938] 67.52 67.62 67.00 [1939] 72.31 70.42 86.43 The ratio of petitioner's salesmen's compensation and expense to net sales during the base period years, was as follows: Salesmen's compensation and expense to Year net sales [1936] 9.67 [1937] 8.60 [1938] 11.28 [1939] 10.13 The Printing Industry of America (formerly known as the United Typothetae of America) is a trade association which collects statistics on sales, expenses, and profits in the industry. After compilation, these data are published by the association in its annual publication known as "Ratios for Printing Management." The cost analyses by the association during the base period years are generally comparable to those prepared by petitioner, and in fact were devised by a former official*104 of the petitioner. The ratios of net profit to sales for all members of the association and for those members most comparable in size to petitioner for the base period years were as follows: Ratios of net profits to sales Year Composite Class E sales Class F sales all members $ 150,000 to $ 300,000 to $ 300,000 $ 500,000 [1936] 3.91 2.42 2.64 [1937] 3.66 2.75 2.41 [1938] 2.81 1.23 2.00 [1939] 3.31 1.39 3.55 Corporate commercial printers filed 2,274 Federal income tax returns for 1938 and 2,015 such returns for 1939. Some of these returns reported net incomes and some deficits. The total net income reported for 1938 exceeded the total deficit reported for such year by $ 6,539,000. For 1939 the excess of net income over deficits was $ 9,523,000. On Federal income tax returns filed for all United States corporations in printing, publishing, and allied industries, corporate net incomes exceeded deficits for the base period years, as follows: *1152 Total Net Index Year returns income in 1939 = 100 thousands [1936] 12,735 $ 160,000 124.5 [1937] 12,667 147,045 114.4 [1938] 11,950 82,383 64.1 [1939] 11,690 128,545 100.0 *105 The following table, compiled from "Statistics of Income for 1940," a publication of the Bureau of Internal Revenue, shows a composite figure of net profit less tax-exempt income, plus interest paid, in millions of dollars, for all United States corporations filing Federal income tax returns during the base period years, together with an index 1939 = 100: Year Net profit Index in millions 1939 = 100 [1936] $ 7,450 102.0 [1937] 7,410 101.4 [1938] 4,479 61.3 [1939] 7,306 100.0 The following table, compiled from "Statistics of Income for 1940," shows composite net incomes reported by corporations in petitioner's trade territory on their Federal income tax returns for the base period years, together with an index 1939 = 100: Corporate net income (000 omitted) States in trade area [1939] Illinois $ 590,814 $ 573,428 $ 240,957 $ 529,071 Iowa 31,579 25,025 19,173 30,479 Kansas 30,561 18,297 13,821 16,659 Minnesota 81,382 56,587 25,056 69,468 Missouri 152,418 122,993 92,200 170,822 Nebraska 21,918 15,553 13,883 14,529 Oklahoma 49,309 73,784 31,118 40,989 Total $ 957,981 $ 885,667 $ 436,208 $ 872,017 Index 1939 = 100 109.9 101.6 50.0 100.0 *106 Prior to and during the excess profits tax taxable years, petitioner kept its books and reported its income on the accrual method of accounting. Its income and excess profits tax returns for the calendar years 1941 to 1945, inclusive, were filed with the collector of internal revenue for the district of Kansas. Petitioner's excess profits tax net income (after adjustments under section 711 (a) (1) income method and 711 (a) (2) invested capital method) for the taxable years 1941 to 1945, inclusive, was as follows: *1153 Calendar year Income Invested method capital method [1941] $ 21,328.20 $ 23,638.00 [1942] 37,338.68 39,530.34 [1943] 35,439.30 37,438.17 [1944] 35,437.89 36,416.04 [1945] 46,232.85 46,482.85 For the taxable years, petitioner's actual excess profits credit under the invested capital method, the excess profits tax paid by petitioner, and the refunds claimed by it under sections 722 and 322, Internal Revenue Code of 1939, were as follows: Excess profits Calendar year credit invested Excess profits Refund capital tax paid claimed method [1941] $ 13,779.43 $ 1,504.72 $ 1,504.72 [1942] 14,547.87 16,185.80 16,185.80 [1943] 15,267.46 13,908.28 13,908.28 [1944] 16,547.00 8,438.03 8,438.03 [1945] 19,883.12 14,235.52 14,235.52 *107 For the base period years petitioner's excess profits net income was as follows: Excess profits Year net income [1936] ($ 26,886.69) [1937] 1 2,715.00 [1938] 7,539.37 [1939] 356.73 Petitioner's actual average base period net income determined without the application of section 722, Internal Revenue Code of 1939, was $ 2,652.87. 1 Its average base period net income computed under section 713 (f), Internal Revenue Code of 1939, was $ 7,539.37. Applications for relief under section 722, Internal Revenue Code of 1939 (Form 991), were duly filed by petitioner for the taxable years 1941 to 1945, inclusive. For the taxable years 1942 to 1944, inclusive, petitioner filed refund claims (Form 843) as supplements to its applications for relief. In its applications*108 for relief and in its petition the petitioner claimed that it was entitled to relief under section 722 (b) (4) of the 1939 Code because there was a change in the character of its business during the base period by reason of (a) a change in management, and (b) the acquisition of the business of a competitor. Petitioner failed to establish a constructive average base period net income sufficient to give it a credit for the taxable years 1941 to *1154 1945 in excess of the credit to which it is entitled under the invested capital method. The stipulated facts are so found and are incorporated herein by reference. OPINION. Petitioner seeks relief under section 722 (a) and (b) (4), Internal Revenue Code of 1939. The pertinent provisions of the Code appear below. 2 Sectional references are to the 1939 Code unless otherwise stated. *109 In determining its excess profits tax liability for the taxable years 1941-1945, inclusive, petitioner used the invested capital method to compute its excess profits credit. Under the invested capital method, petitioner's excess profits credit for each taxable year ranged upward from $ 13,779.43 for 1941 to $ 19,883.12 for 1945. Such credits resulted in a lesser tax liability for the taxable years than would have been imposed if petitioner's excess profits credit had been computed under the income method because the credits under the latter method would have been computed upon an actual average base period net income of $ 2,652.87, and an average computed under the growth formula (sec. 713 (f)) of $ 7,539.37. *1155 Petitioner seeks relief under section 722 (b) (4) claiming that it is entitled to constructively increase its base period level of earnings because it changed the character of its business during such period. The (b) (4) factors upon which it relies are: (1) A change in management, and (2) the acquisition of the business of a competitor. Petitioner contends that, because of such change in character, its business did not reach the earning level by the end of the*110 base period that it would have reached if such change had occurred 2 years earlier, and that, had such change occurred 2 years earlier, a fair and just amount representing normal earnings would be $ 22,932.66 for 1941 and $ 35,822.90 for 1942-1945, inclusive. Among other cases, petitioner relies upon Royal Crown Bottling Co. of Knoxville, 22 T. C. 688 (1954), and Wentworth Military, Scientific, Etc. Co., 22 T. C. 721 (1954). Respondent contends that the Hall family continued their control of the petitioner, that the employment of a general manager did not constitute a change in management, and that no significant change in basic management policies resulted therefrom. Respondent also contends that such changes as were made during the base period were routine and normal changes which occur during the ordinary course of any well run business; that there was no substantial departure from normally expected changes; and that petitioner has failed to show that a higher level of normal earnings was directly attributable to such changes as were made. Respondent cites Toledo Stove & Range Co., 16 T. C. 1125 (1951),*111 as the leading case for his position. With respect to the acquisition of the printing, binding, and lithographing business of Crane and Company, respondent contends that no change in the character of petitioner's business occurred for the reason that its operations remained substantially unchanged after such acquisition. Respondent contends further that petitioner has failed to establish that its level of normal earnings increased materially as a direct result of such acquisition, and that, even if such acquisition be deemed a change in character of the business, petitioner has failed to show that, as a result thereof, its average base period net income, computed under section 713 (f), is an inadequate standard of normal earnings, Irwin B. Schwabe Co., 12 T. C. 606, 613 (1949), or to establish what would be a fair and just amount representing normal earnings. Kentucky Whip & Collar Co., 19 T. C. 743 (1953). Petitioner argues its evidence establishes a "change in the character of the business" within the definition of section 722 (b) (4) in that there was during the base period "a change in the operation or management *112 of the business" and "the acquisition before January 1, 1940, of all or a part of the assets of a competitor, with the result that the competition of such competitor was eliminated." Petitioner also had *1156 the burden of showing "that as a direct result thereof [of the change in the character of the business] there were increased earnings." Granite Construction Co., 19 T. C. 163, 171. Petitioner points to the evidence showing the earnings for a period after the change are greater than earnings for a period prior to the change. Such evidence would not be conclusive that the increased earnings were directly attributable to the change. Granite Construction Co., supra. We think petitioner, under the facts of this case, had a third burden with respect to establishing the amount of a constructive average base period net income. It will be remembered petitioner received heavy credits under the invested capital method. Before it shows itself entitled to any relief under section 722, petitioner would have to establish a constructive average base period net income sufficient to give it a credit for the taxable years*113 1941 to 1945 in excess of the credit to which it is entitled under the invested capital method. In Mokry & Tesmer Machine Co., 23 T. C. 12, 18, we said: petitioner, to be entitled to relief under section 722, must show not only that its average base period net income is an inadequate standard of normal earnings, but must establish what would be a fair and just amount representing normal earnings, and there is still no relief under section 722 unless the excess profits credit, based upon the constructive average base period net income which is established, is greater than the excess profits credit computed without the benefit of section 722. Green Spring Dairy, Inc., 18 T. C. 217, 237; Lamport Co., 17 T. C. 1079, 1084, 1085; General Metalware Co., 17 T. C. 286, 292; and Trunz, Inc., 15 T. C. 99, 105. We can assume there was the change in the character of the business in the base years and some increased earnings occurred as a direct result of the change. As shown in our Findings of Fact, the actual average base period net income, *114 computed without the application of section 722, would be $ 2,652.87 and its average base period net income computed under section 713 (f) would be $ 7,539.37. The question is whether, under the record presented, the additional earnings caused by the changes in the character of the business could have produced an average for the base period sufficient to produce a credit in excess of the credits allowed and used by petitioner under the invested capital method. The invested capital credits were as follows: Excess profits Calendar credit invested year capital method [1941] $ 13,779.43 [1942] 14,547.87 [1943] 15,267.46 [1944] 16,547.00 [1945] 19,883.12 From the above it will be seen the invested capital credit is about twice the section 713 (f) credit and many times the actual average base period net income credit. *1157 We realize that the changes made by Severin were intangible in their effect on petitioner's earnings. Petitioner lists those we have set forth in our Findings of Fact and states with respect thereto, "It is difficult to place a dollar sign on these changes, yet it seems fair to conclude that such factors would result in increased earnings." The*115 record furnishes no basis for determining whether the increased volume of petitioner's mail order business, record books, and general printing was profitable or resulted in losses. We do not know whether the average annual sales of Crane and Company for the 4 years prior to petitioner's acquisition, which amounted to $ 118,026, was profitable. We do not know whether petitioner was able to maintain such average annual volume. If petitioner's own sales continued to increase in 1938 over its 1937 sales of $ 200,738, then the volume of sales from the Crane and Company acquisition amounted to very little, for petitioner's 1938 sales were only $ 246,980. On the other hand, if petitioner maintained the Crane and Company average for 1938 and 1939 of $ 118,026, then petitioner's volume of sales from its own business was less than its 1936 or its 1937 sales. The only certain fact with respect to petitioner's earnings or losses from its acquisition of a portion of the Crane and Company business and assets is that the results of operating the enlarged business for the 19 months of 1938 and 1939 are reflected in petitioner's net profit of $ 7,349.32 for 1938 and $ 973.26 for 1939, and we *116 have been provided with no information as to how such figures can be allocated between the business and assets acquired and the business petitioner had at the date of acquisition. The evidence will not establish a fair and just amount that can be used as a constructive average base period net income which would result in a credit in excess of the credit already allowed under the invested capital method. No witness for petitioner was asked to express any opinion as to the amount of a constructive average base period net income. We can see no basis in this record for applying the 2-year push-back rule set forth in section 722 (b) (4). The purpose of that rule, as stated in Del Mar Turf Club, 16 T. C. 749, 766 (1951), "is to establish a figure which is assumed to be the maximum amount which would have been earned by the taxpayer in its last base period year," if it had changed the character of its business 2 years before it did. Petitioner has offered no proof of what such maximum amount would be under the facts of record. We appreciate the difficulty of proof to show increased earnings would result from changes in method of doing business but one could*117 conclude the changes inaugurated by Severin and the acquisition of Crane and Company could have resulted in 6 to 9 times the average net income and still it would be insufficient to produce a credit equal even to the *1158 lowest credit allowed under the invested capital method. We think the evidence falls far short of establishing such facts. In its brief petitioner contended that a fair and just amount representing normal earnings to be used as a constructive average base period net income is $ 22,932.66 for 1941, and $ 35,822.90 for 1942 to 1945, inclusive. These amounts were based upon, with immaterial minor adjustments, estimated sales of $ 447,000 for 1939. This amount is an arbitrary figure, set forth in petitioner's application for relief, which is unsupported by any evidence of record. In fact, none of petitioner's witnesses were asked to express an opinion as to petitioner's reconstructed sales. In reconstructing its sales for 1939, petitioner, in its brief, projected sales for 2 years under three methods, namely, (1) geometric straight line, (2) straight line sum of the least squares, and (3) second degree parabola. The average of these three methods, plus expected*118 sales of A. B. Dick products, resulted in constructed sales of $ 460,312.80 as compared with the $ 447,000 sales estimate used in its application for relief. Using the latter sales figure, an index which is not in the record, and estimated percentages for cost of sales, selling and administrative expense, a net operating profit to sales, petitioner has backcast to arrive at reconstructed figures for the base period years. Its computations result in reconstructed net income for each of the base period years in excess of $ 33,000. We can find no justification in the record for the constructive sales for 1939, for the index used in backcasting, or for the percentages used, which are at variance with the percentage analysis shown in our Findings of Fact. No evidence whatever was offered that petitioner might achieve a level of sales of $ 447,000 in 1939, that the index was proper, or that the percentages were accurate. We hold, therefore, that petitioner has failed to establish a fair and just amount to be used as a constructive average base period net income which would give to the petitioner an excess profits credit in the years 1941 through 1945 greater than the excess profits*119 credit computed under the invested capital method to which petitioner is already entitled. Petitioner, in short, has failed to establish the inadequacy of the alternative excess profits credits available to it under sections 713 and 714 of the Internal Revenue Code of 1939. We have carefully examined the Royal Crown Bottling Co. case, supra, cited by petitioner, but find it distinguishable on its facts from the instant case. Petitioner is not entitled to relief under section 722. Reviewed by the Special Division. Decision will be entered for the respondent. Footnotes 1. Qualifying shares assigned to Luella R. Hall.↩ 1. February 1 to June 30.↩ 1. Includes $ 1,200 income received in form of dividends from subsidiary, the Hall Stationery Company.↩ 2. So stipulated; mathematically this ratio is 1.4561, or 1.46; see table herein showing percentage analysis of petitioner's income statements.↩ 1. So stipulated; mathematically this ratio is 70.3967, or 70.40.↩ 1. Stipulated figure; but see footnote 1, infra↩. 1. Stipulated figure; this amount is correct, mathematically, if petitioner's excess profits net income for 1937 is $ 2,715.40, as it appears elsewhere in the record, rather than amount stipulated.↩ 2. SEC. 722. GENERAL RELIEF -- CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME. (a) General Rule. -- In any case in which the taxpayer establishes that the tax computed under this subchapter (without the benefit of this section) results in an excessive and discriminatory tax and 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. In determining such constructive average base period net income, no regard shall be had to events or conditions affecting the taxpayer, the industry of which it is a member, or taxpayers generally occurring or existing after December 31, 1939, * * * (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. * * *↩