Benson Hotel Corp. v. Commissioner

Benson Hotel Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent Benson Hotel Corp. v. Commissioner Docket No. 42685 United States Tax Court 36 T.C. 997; 1961 U.S. Tax Ct. LEXIS 76; September 14, 1961, Filed *76 Decision will be entered under Rule 50. Petitioner is conceded by respondent to be qualified for relief under section 722(b)(4), I.R.C. 1939, from excess profits taxes because of a change in the character of its business resulting from the sale of a small hotel and purchase of a larger hotel during the base period. The relief granted by the Commissioner held to be inadequate and a constructive average base period net income was determined for each of petitioner's fiscal years ended May 31, 1942, through May 31, 1946. The variable credit rule is applied to determine a constructive average base period net income for petitioner's fiscal year ended May 31, 1941, for purposes of carryover credits. Bert B. Rand, Esq., and Hans A. Nathan, Esq., for the petitioner. John W. Holt, Esq., for the respondent. Kern, Judge. *77 KERN *998 The petitioner duly filed applications for relief under section 722 of the Internal Revenue Code of 19391 and related claims for refunds of excess profits taxes for its taxable fiscal years ended May 31, 1943, 1944, 1945, and 1946. In his statutory notice of deficiencies and partial disallowance of claims for relief and refund the respondent determined that the petitioner qualified for relief under section 722(b)(4) and based his partial allowance of petitioner's claims upon a constructive average base period net income of $ 14,000 for all the taxable years involved and also for the fiscal year ended May 31, 1942, for the purpose of carryover of unused constructive excess profits credit. Respondent disallowed in full the petitioner's claim for a constructive average base period net income for the fiscal year ended May 31, 1941, for the purpose of carryover of unused excess profits credit. Respondent also *78 determined deficiencies in income and excess profits taxes for the years 1943 through 1946. The respondent affirmatively alleges in his answer filed herein that in his notice of deficiencies and partial disallowance of claims for refund he erred in his computation of deficiencies in income and excess profits taxes by failing to properly apply the provisions of section 713(g) in each of the fiscal years ended May 31, 1944, 1945, and 1946, and through a mathematical error in his computation for the fiscal year ended May 31, 1944. Petitioner's reply denies all of respondent's affirmative allegations. Petitioner controverts the asserted deficiencies and alleges overpayments of excess profits taxes for the years and in the amounts as follows: Fiscal year Alleged overpayments of ended May 31 -- excess profits taxes [1943] $ 28,431.16 [1944] 21,479.87 [1945] 21,912.35 [1946] 16,079.89 Petitioner assigns as errors: (1) Respondent's failure to determine a constructive average base period net income under section 722 in excess of $ 14,000 for each of the fiscal years ended May 31, 1942, through May 31, 1946, and his disallowance of a constructive average *999 base period *79 net income for the fiscal year ended May 31, 1941, for purpose of a carryover and, further, his failure to determine a constructive average base period net income of $ 80,364 for all of those years; and (2) respondent's determination of petitioner's normal tax net income for each of the taxable years in controversy to be the amount determined by respondent under section 722 instead of pursuant to section 13(a)(2) without regard to the relief granted under section 722. FINDINGS OF FACT. Some of the facts and certain evidence have been stipulated by the parties. We find the facts to be as stipulated and incorporate the stipulation herein by this reference. The petitioner is a corporation organized under the laws of Indiana on May 24, 1933. During the years here involved its principal office was located at the Hotel Washington, Indianapolis, Indiana. Petitioner's books are maintained on an accrual basis, and its tax returns were filed on the basis of a fiscal year ending May 31. Petitioner's income and excess profits tax returns for all the years involved herein were filed with the then collector of internal revenue at Indianapolis, Indiana. Petitioner's base period was for 48 months*80 -- from June 1, 1936, to May 31, 1940. E. W. Benson, hereinafter referred to as Benson, has been the president and majority stockholder of petitioner since its incorporation. Benson has had almost 40 years' experience in the hotel business. The first 7 years of his career were spent at the Drake and Blackstone Hotels in Chicago, where he was employed in various capacities and gained a broad experience in hotel operations. Benson later joined Horwath & Horwath, a nationwide firm of auditors specializing in hotel accounting. Thereafter he became manager of the 300-room Oliver Hotel in South Bend, Indiana. On May 24, 1933, Benson joined with others to purchase the furniture and equipment and to lease the Frances Hotel in Kokomo, Indiana. The petitioner corporation was formed to operate the hotel with an authorized capital stock of 1,000 shares of no-par-value common stock. The Frances Hotel, hereinafter referred to as the Frances, had 106 rooms available for occupancy. Petitioner took over the Frances shortly after the end of the prohibition period and a new bar was installed in 1935. Its principal competitor -- the Courtland Hotel -- was unable to obtain a liquor license and*81 the Frances was the principal hotel in Kokomo where liquor was served. The earnings of the Frances were improved by application of a "formula" which called for the immediate improvement of the food and beverage facilities followed by an improvement of the rooms and *1000 other appointments. During the years the Frances was under Benson's management its operational results 2 were as follows: Benson Hotel Corporation of Indiana Hotel Frances Fiscal year ended May 31 -- [1936] Gross income $ 47,047.97 $ 59,082.04 $ 97,655.23 Less: Cost of sales 11,790.10 16,514.98 31,808.72 Payroll 12,175.35 14,680.53 22,073.39 Other expenses 15,799.89 16,729.64 25,292.49 Profit on operations $ 7,282.63 $ 11,156.89 $ 18,480.63 Less: Rent, taxes, insurance 5,745.01 6,565.67 9,322.15 Depreciation 1,588.83 2,045.73 2,962.96 Net income ($ 51.21) $ 2,545.49 $ 6,195.52 Hotel total sales trend (1929 = 100) [79] Benson Hotel Corporation of Indiana Hotel Frances Fiscal year ended May 31 -- [1938] Gross income $ 120,203.21 $ 122,052.24 Less: Cost of sales 38,540.63 33,914.10 Payroll 27,812.72 30,070.72 Other expenses 28,776.34 30,153.77 Profit on operations $ 25,073.52 $ 27,903.65 Less: Rent, taxes, insurance 11,395.80 12,499.72 Depreciation 5,305.39 5,483.46 Net income $ 8,372.33 $ 9,920.47 Hotel total sales trend (1929 = 100) [80] *82 On May 28, 1937, the State of Indiana approved a change in the petitioner's capital structure to include 2,000 shares of no-par-value common stock and 250 shares of $ 100-par-value preferred stock. Thereafter a preferred stock dividend was paid to the shareholders in the amount of $ 7,700. In 1937 Benson became interested in a rundown, transient hotel of 98 rooms, located in an area of Indianapolis situated over a mile away from the center of the city, known as the Hotel Riley, hereinafter referred to as the Riley, and on May 3, 1937, he acquired a 30-month lease with an option to purchase the hotel. The furniture, *83 fixtures, and equipment were purchased outright. Benson organized the Benson Riley Hotel Corporation to operate the hotel and served as its president. On June 10, 1937, the petitioner purchased 220 shares of $ 100-par-value preferred stock of the Benson Riley Hotel Corporation in lieu of a loan of $ 22,000 requested by the corporation. During the first year the Riley was operated by Benson a new coffeeshop and private dining rooms were installed. Certain retail stores in the building were moved out and replaced with a bar and cocktail lounge. These food and beverage facilities were planned and installed by the architectural engineering firm of Design, Inc., of St. Louis, Missouri. The Riley was successful in attracting customers to patronize its bar and dining room. Sales and profits at the Riley increased noticeably thereafter as shown by the following summary: *1001 Benson Riley Hotel Corporation Hotel Riley Fiscal year ended Apr. 30 -- [1940] Gross income $ 75,846.18 $ 128,749.05 $ 146,853.84 Less: Cost of sales 17,022.14 37,362.88 42,473.40 Payroll 18,353.83 32,349.80 41,878.21 Other expenses 20,663.43 31,961.80 31,996.85 Profit on operations $ 19,806.78 $ 27,074.57 $ 30,505.38 Less: Taxes, insurance 7,654.34 9,500.40 10,395.34 Depreciation 3,340.26 5,187.54 5,638.93 Net income $ 8,812.18 $ 12,386.63 $ 14,471.11 Hotel total sales trend (1929 = 100) [85] *84 The Riley derived some degree of steady business from a large hospital located across the street, and visitors and families of patients would stay at the Riley longer than guests ordinarily remain in commercial hotels. The Riley has since been sold to the hospital for use as a nurses' home. Benson first became interested in the Washington Hotel, hereinafter referred to as the Washington, in the fall of 1938. At that time the Washington was a transient hotel of about 240 rooms located in the heart of downtown Indianapolis, Indiana, adjacent to stores, courthouses, and office buildings. The Washington was badly rundown at the time. Benson obtained the services of Design, Inc., to survey the property. Thereafter Benson concluded that the property had an excellent potential and entered into negotiations to obtain the hotel, acquiring a lease on December 16, 1938. The lease provided for occupancy beginning on January 15, 1939. At a special meeting of petitioner's board of directors held on December 20, 1938, a resolution was adopted approving the sale of the Frances Hotel, together with all leases, inventories, and improvements, for the cash sum of $ 70,273.66. Another resolution*85 at the same meeting approved the acquisition of the Washington Hotel. The petitioner paid $ 15,000 for the Washington's equipment and $ 5,000 for the inventories. In addition an expenditure of $ 25,000 was authorized to reequip and refurnish the hotel. The improvements undertaken at the Washington were handled between petitioner and Design, Inc., on a conditional-sale-contract basis. The contract for the bar and cocktail lounge, subsequently known as the Bronze Room, was made in 1939, and the contract for the dining room or supper club, subsequently known as the Sapphire Room, was made prior to March 1940 pursuant to the general rehabilitation program planned before December 1938. A continental or French-style cafe or coffeeshop was also planned, but since the space *1002 was being used as a haberdashery by the brother of the former operator the completion of the coffeeshop was delayed until the tenant could be displaced. It would take several years for a facility like the Sapphire Room to reach a normal level of operations, and because the improvements to the hotel rooms were planned and carried out on a gradual basis it would take longer for the hotel as a whole to reach*86 a normal level of operations. Benson applied the same "formula" to the management of the Washington which had proved to be successful at the Frances and the Riley. He first improved the food and beverage facilities and, as circumstances permitted, gradually improved the rooms. The new bar and lounge, known as the Bronze Room, had a capacity of 85 persons. It was opened in May 1939 and beverage sales at the Washington tripled immediately after its opening and continued to increase thereafter. The hotel's dining and dancing facility, which opened in May 1940, was installed in place of a basement restaurant. It had a capacity of about 230 persons and was known as the Sapphire Room. The profit realized from the increased sales in the Sapphire Room was not proportionately as great as the increase in total sales because expenses for live entertainment reduced the profit figure somewhat, but it was the only supper club in downtown Indianapolis in 1940 and the first such facility to be successfully operated in downtown Indianapolis. The new coffeeshop was opened, a new lobby installed, and room improvements such as carpets and new furnishings to replace the brass beds previously used*87 in the hotel were added while the hotel was being used. The dining room had to be closed in order to complete its construction because the customers complained of sand being found in their food. The work on the rooms was slow as rooms were often needed by customers and labor and material became harder to get. The hotel staff did much of the work on the rooms. In the process of renovation a few of the rooms without baths were eliminated. The result was a slight reduction in the total number of rooms to 214, but those remaining were more easily rented and although the rates were not raised immediately the revenue from the rooms gradually increased. The greater part of the work on the rooms was completed by May 31, 1940. The full benefit from a program of room improvements would not be realized until about a year after the improvements were completed. During the 1920's and before the inroads made on the hotel business by the motels or motor hotels, the nation's hotels were doing an excellent tourist business. The years between 1924 and 1929 were years of relative prosperity and new construction of hotel buildings increased, but in 1930 the supply of available rooms surpassed *88 the demand. The effect of the depression of the early 1930's did not *1003 reach the hotel business until 1931. The period between 1931 and 1933 was one of depressed business activity for the hotel industry as a whole as well as in Indianapolis. The hotel business began to improve in 1935 but, in the meantime, about 85 percent of the nation's hotels were either bankrupt or in the hands of receivers. Hotels resorted to rate cutting during the depression in order to attract customers. From 1936 to 1939 the hotel business was neither good nor bad, and the success of a given hotel depended upon its management, the efficiency of its operation, and a favorable capital structure. During the war years the hotel business in Indianapolis benefited from an increased number of transient customers consisting of military personnel and their families from nearby military installations. The increased military activity in the Indianapolis area during World War II was noticeable in increased patronage to hotels in 1942 but it was most significant in 1943. There was also considerable economic and business growth in Indianapolis and the surrounding area during the years 1940 to 1945, inclusive, *89 which favorably affected the hotel business. The principal hotels competing for the transient business in downtown Indianapolis during all the years material to this proceeding were the Claypool, the Lincoln, the Severin, the Warren, the Washington, the Harrison, and the Antlers. Before the war the three larger or prestige hotels were the Claypool, the Lincoln, and the Severin, while the Washington, the Warren, the Harrison, and the Antlers were placed in a second category, but they were still rated above the smaller and less expensive hotels which also shared a portion of the transient trade. The Claypool and the Lincoln had the highest room rates, but the rates charged by the other principal hotels were not far behind, varying from $ 1 to $ 1.50 less. The Claypool Hotel had about 450 rooms, although a number of them were without baths. The Lincoln had 348 rooms, the Severin had about 300 rooms, and the Warren and the Antlers each had about 200 rooms. After the renovation program at the Washington was completed it had 214 rooms. The Claypool had the largest convention facilities, with the size of the convention facilities of the Lincoln, Severin, Antlers, and Washington following*90 in that order. All of the principal hotels had food and beverage facilities. The Washington's Sapphire Room offered entertainment to its customers, and in 1940 it was the only supper club in downtown Indianapolis. From time to time the other hotels had offered their customers the same type of entertainment without much success. Both the Severin and the Claypool abandoned their efforts to establish similar "supper clubs." *1004 During all the years material to this proceeding the managements of the Severin, Warren, and Harrison Hotels were "good" and the management of the Antlers was "average." The Claypool's management was "good" until the manager left to enter military service, after which time the Claypool's management was "below average." The Severin and the Warren were located on South Illinois Street, which was "rundown" and "sort of honky-tonk" during all of the years pertinent hereto, and were farther removed from the center of the city where petitioner was located. The Claypool Hotel's building was donated to the Roman Catholic Church by its former owners, and leased back to the present operators by the church. The building itself was not comparable to the Washington*91 because of its numerous connecting rooms, rooms without baths, a large "oversized" lobby difficult to heat, and numerous banquet or ballrooms. The rates charged by the Claypool and the Lincoln were substantially the same and were higher than the other Indianapolis hotels. The Claypool occupancy rates were higher than those of the Washington and the Lincoln. The hotel business in Indianapolis was quite competitive during all of the years involved herein. From 1936 to 1939, a period of relatively low occupancy, it was normal to rent the lower priced rooms first. After 1941 the trend was reversed. Occupancy rates were high and during periods of high occupancy the better rooms were rented first. Hotel profits are closely related to the rise and fall of occupancy, but the fixed expenses of a particular hotel can have a decisive influence on its profits. The rent paid for the building, the compensation paid to hotel officers, and the amount of rehabilitation and renovation undertaken during a given year vary from hotel to hotel and affect the profitability of their operations. In the years between 1936 and 1939 rehabilitation was more easily performed than during the subsequent years*92 when the procurement and the use of labor and materials were difficult or restricted. It is customary in the hotel business to modernize facilities regularly in order to keep abreast of the competition. Experience has shown that a completely new installation will give a bar or dining room an increased earning capacity. It is considered a good practice to redecorate hotel bars every 10 or 12 years and dining rooms every 12 or 15 years. However, a complete renovation is an unusual occurrence. Upon the completion of the renovation program at the Washington, the most validly comparable hotel in Indianapolis was the Lincoln Hotel. *1005 The Washington and Lincoln Hotels were of similar construction, located on the same street, and both (after the renovation program at the Washington) catered to the same type of clientele. The Lincoln was larger, having 348 rooms compared to 214 in the Washington. The Lincoln's room rates were higher than those of the Washington, but the Washington had larger food and beverage facilities. As petitioner refurnished and renovated the rooms at the Washington the rates were gradually raised. In 1942 the Office of Price Administration required the*93 petitioner to limit its room rates to those existing in June 1941. Thereafter the Washington was unable to charge rates commensurate with the quality of rooms it offered. The restrictions imposed by the Office of Price Administration were lessened in 1946 and removed altogether in 1947. The Lincoln was operated by the Lincoln Operating Company, as lessee of the Lincoln Building Company, both of which had substantially identical ownership. The Lincoln's profits were reduced by profit-sharing payments provided in its lease from the Lincoln Building Company. Petitioner leased the Washington from the Alabama & Ohio Realty Corporation, an Indiana corporation, and the lease provided that the Benson Hotel Corporation would pay a minimum rent as well as the taxes and insurance costs on the building, and, if the sales were sufficiently high, the rent would be increased to an amount equal to 25 percent of the gross room sales and 8 percent of the gross beverage sales. Due to differences in lease provisions of the two hotels, the amounts the Lincoln and Washington paid for rent, insurance, and taxes were not in the same proportion to the gross sales of the respective hotels. The lease *94 arrangement of the Washington was more favorable during the years involved herein than that of the Lincoln. The Lincoln also employed Design, Inc., to remodel its bar in 1939 and the result was an increase in profits in 1940. The clientele of the Lincoln's rooms was slightly better than that of the Washington, but the patrons of the food and beverage facilities of the two hotels were of the same general caliber. While the profits of a hotel generally depend upon its occupancy rates, it was possible for a hotel which specialized in food and beverages to show higher earnings notwithstanding a lower occupancy rate than a comparable hotel. Likewise, it is possible for a small hotel with lower fixed costs to show a better profit proportionately than a larger hotel. The Lincoln's operations during the years 1936 through 1945 are summarized as follows: *1006 Lincoln Operating Company Hotel Lincoln Taxable year ended Dec. 31 -- [1938] Gross income $ 608,348.19 $ 649,054.04 $ 615,181.52 Less: Cost of goods sold 109,479.58 117,961.89 96,006.73 Payroll 154,337.84 180,896.49 193,013.20 Other expenses 195,223.94 171,319.89 160,279.73 Profit on operations $ 149,306.83 $ 178,875.77 $ 165,881.86 Less: Rent, taxes, insurance 84,526.66 112,258.31 108,056.40 Interest 23,229.25 23,296.50 23,081.00 Depreciation 21,251.51 22,340.80 20,302.29 Net income $ 20,299.41 $ 20,980.16 $ 14,442.17 Hotel total sales trend (1929 = 100) [80] *95 Lincoln Operating Company Hotel Lincoln Taxable year ended Dec. 31 -- [1940] Gross income $ 624,897.27 $ 667,968.44 Less: Cost of goods sold 128,002.46 145,704.52 Payroll 202,332.98 209,825.86 Other expenses 143,643.87 143,708.54 Profit on operations $ 150,917.96 $ 168,729.52 Less: Rent, taxes, insurance 116,647.05 125,456.05 Interest 3,072.00 3,312.00 Depreciation 18,197.72 19,019.93 Net income $ 13,001.19 $ 20,941.54 Hotel total sales trend (1929 = 100) [85] Lincoln Operating Company Hotel Lincoln Taxable year ended Dec. 31 -- [1943] Gross income $ 726,191.91 $ 817,505.30 $ 1,019,995.28 Less: Cost of goods sold 158,805.20 189,286.14 249,466.62 Payroll 228,812.63 250,289.56 305,548.06 Other expenses 165,474.24 163,821.91 191,373.44 Profit on operations $ 173,099.84 $ 214,107.69 $ 273,607.16 Less: Rent, taxes, insurance 130,707.15 150,556.65 184,037.87 Interest 3,072.00 3,072.00 3,072.00 Depreciation 18,776.56 17,632.71 16,486.28 Net income $ 20,544.13 $ 42,846.33 $ 70,011.01 Hotel total sales trend (1929 = 100) [137] Lincoln Operating Company Hotel Lincoln Taxable year ended Dec. 31 -- [1945] Gross income $ 1,077,095.94 $ 1,130,196.67 Less: Cost of goods sold 285,030.63 289,891.97 Payroll 349,763.38 382,326.50 Other expenses 213,445.15 241,071.86 Profit on operations $ 228,856.78 $ 216,906.34 Less: Rent, taxes, insurance 163,074.25 159,628.53 Interest 3,072.00 3,072.00 Depreciation 15,609.55 13,261.37 Net income $ 47,100.98 $ 40,944.44 Hotel total sales trend (1929 = 100) [163] *96 In accordance with his policy of placing emphasis on food and beverage facilities Benson obtained the services of Arthur J. Weber to manage the Washington. Weber had specialized in food and beverage facilities in various hotel and club operations, some of which were located in Indianapolis. The emphasis on food and beverage facilities, together with the appearance of live entertainment in Benson's hotel, resulted in a disproportionate relationship between the sale of rooms and the sale of food and beverages. During petitioner's fiscal year ended May 31, 1939, a portion of its total sales was made at the Frances Hotel in Kokomo (sold around January 1, 1939) and the remaining sales were made at the Washington in Indianapolis. There was no combined audit report for that year among the numerous exhibits introduced as evidence at the trial, but based upon the figures reported on petitioner's tax return the combined sales or gross income of the two hotels amounted to $ 150,332.36 during fiscal 1939. The total cost of goods sold was $ 34,081.75, the payroll totaled $ 50,333.93, and other expenses amounted to $ 44,582.62. After deducting $ 22,321.89 for rent and taxes and $ 4,123.44 *97 for depreciation charges, the petitioner suffered an operating loss of $ 5,111.27 for its fiscal year 1939. These figures do not include the $ 29,871.48 capital gain realized on the sale of the Frances. *1007 The Washington's operations during the years 1939 through 1948 are summarized as follows: Benson Hotel Corporation of Indiana Hotel Washington Fiscal year ended May 31 -- Jan. 15- [1941] May 31, 1939 Gross income $ 75,446.44 $ 316,137.82 $ 444,525.02 Less: Cost of goods sold 17,709.40 79,062.71 115,925.10 Payroll 25,976.65 87,426.15 115,243.17 Other expenses 26,652.50 86,733.91 127,555.50 Profit on operations $ 5,107.89 $ 62,915.05 $ 85,801.25 Less: Rent, taxes, insurance 15,031.65 43,693.05 57,697.91 Interest Depreciation 892.86 6,285.86 10,919.96 Net income ($ 10,816.62) $ 12,936.14 $ 17,183.38 Hotel total sales trend (1929 = 100) [93] Benson Hotel Corporation of Indiana Hotel Washington Fiscal year ended May 31 -- [1943] Gross income $ 451,596.75 $ 606,296.47 Less: Cost of goods sold 115,401.06 140,139.75 Payroll 142,590.41 177,775.40 Other expenses 109,013.79 140,224.66 Profit on operations $ 84,591.49 $ 148,156.66 Less: Rent, taxes, insurance 60,108.34 73,223.14 Interest Depreciation 12,103.59 14,035.33 Net income $ 12,379.56 $ 60,898.19 Hotel total sales trend (1929 = 100) [137] *98 Benson Hotel Corporation of Indiana Hotel Washington [1946] Gross income $ 693,683.29 $ 732,429.58 $ 855,485.29 Less: Cost of goods sold 169,280.27 182,722.33 218,442.52 Payroll 189,949.30 206,353.64 245,368.56 Other expenses 197,937.08 206,020.73 235,435.63 Profit on operations $ 136,516.64 $ 137,332.88 $ 156,238.58 Less: Rent, taxes, insurance 67,180.35 69,640.40 74,488.77 Interest 1,991.26 1,343.72 980.84 Depreciation 17,374.62 18,068.96 21,620.27 Net income $ 49,970.41 $ 48,279.80 $ 59,148.70 Hotel total sales trend (1929 = 100) [181] Benson Hotel Corporation of Indiana Hotel Washington [1948] Gross income $ 867,545.86 $ 857,017.80 Less: Cost of goods sold 215,972.37 216,900.16 Payroll 268,430.88 262,426.57 Other expenses 180,556.50 174,240.97 Profit on operations $ 202,586.11 $ 203,450.10 Less: Rent, taxes, insurance 81,064.54 85,586.55 Interest 492.91 Depreciation 23,005.79 26,101.20 Net income $ 98,022.87 $ 91,762.35 Hotel total sales trend (1929 = 100) [194] The average rate of occupied rooms in the Washington and the Lincoln reflects*99 the same trend, although the Lincoln occupancy rate was higher than that of the Washington. The Lincoln had more parlor suites which produced a slightly higher average rate per room. The break-even point, or point at which income and expenses are balanced, is an occupancy figure of about 68 percent although the figures will vary from hotel to hotel. The percentage-of-occupancy figures of Lincoln, Washington, and Riley Hotels compare as follows: Year Lincoln Washington Riley [1936] 73.80 [1937] 76.61 [1938] 71.37 66.28 [1939] 71.48 57.60 78.01 [1940] 70.80 58.76 82.73 [1941] 74.99 67.42 87.18 [1942] 77.52 71.89 87.28 [1943] 86.87 78.96 91.09 [1944] 87.90 80.20 91.96 [1945] 91.86 87.58 92.90 *1008 After World War II occupancy tended to level off or drop from the peak figures of the war years. In the petitioner's fiscal year 1940 food sales at the Washington were divided among four separate facilities. The Cafe George (predecessor of the Sapphire Room) attained a business peak in December 1939 when sales totaled $ 4,995.05, and reached a low point in July 1939 when sales totaled $ 3,581.45. The Cafe George was replaced as the hotel's food facility by the*100 newly opened coffeeshop in April or May 1940 while construction proceeded on the Sapphire Room. The Bronze Room was primarily a cocktail lounge but some food was sold there, the sales ranging in amounts from a high of $ 260.75 in September 1939 to a low of $ 120.30 in May 1940. Food sales at banquets and parties were highest during the winter months and lowest during the summer, usually averaging around $ 1,500 per month and varying from $ 779.90 in August 1939 to $ 2,182.10 in December 1939. The Sapphire Room was opened in May 1940, the last month of petitioner's fiscal year and also the last month of the petitioner's base period. Food sales in the Sapphire Room totaled $ 10,256 in May 1940, which was a somewhat higher figure than was subsequently found to be normal for that facility. Beverage sales were not broken down among the various facilities during petitioner's fiscal year 1940, but such sales generally averaged around $ 7,500 a month, although the December 1939 figure was $ 9,414.80. In May 1940 (the month the Sapphire Room opened) beverage sales more than doubled, and the total beverage sales for that month amounted to $ 16,043.15. The total food and beverage sales*101 for the entire fiscal year 1940 amounted to $ 186,606.65. During petitioner's fiscal year 1941 the coffeeshop almost maintained the sales level established by the Cafe George in fiscal 1940. The highest monthly sales figure during the fiscal year 1941 was $ 3,773.25 and the lowest was $ 2,953.91. Food sales in the Bronze Room and at banquets and parties were more or less maintained at the same level during the fiscal year 1941, with no significant variations or trends. The food sales in the Sapphire Room declined from the initial success of May 1940 to a low point of $ 5,260.50 in April 1941, but all food sales in this room represented an increase beyond the previous year when the facility was nonexistent. The drop from the high of May 1940 was gradual and not abrupt, and food sales in the Sapphire Room leveled out and continued to rise thereafter, attaining an average of about $ 6,500 a month over the entire fiscal year. Beverage sales were apportioned between the Bronze Room and the Sapphire Room during the fiscal year 1941. In the Bronze Room beverage sales held to the level of the previous year, but the sales in the Sapphire Room added to the total beverage sales of the *102 hotel an amount that varied from $ 6,463.35 in September 1940 to $ 4,440.50 in *1009 April 1941. The total food and beverage sales at the Washington during the fiscal year 1941 amounted to $ 296,182.73, an increase of almost $ 110,000 over the previous fiscal year. That level was maintained the following year when total sales of food and beverages amounted to $ 290,763.13. The Riley Hotel differed physically from the Washington, but is comparable as an indication of the experience of the individual operator and the effectiveness of his managerial policies on earnings and profits. Benson had an excellent reputation as a hotel operator. He is a successful hotel man who is rated above average by his competitors. His corporation took over the Washington following a period of decline in the years between 1936 and 1939. The building and equipment were rundown, the hotel was bankrupt, and the previous operator was well along in years and exercised diminishing control over his faculties. Benson would have operated the hotel more profitably than it was being operated and he would have done a more efficient job than almost any other hotel man would have done. A fair and just amount*103 representing normal earnings to be used as a constructive average base period net income for the purpose of computing petitioner's excess profits credit is the sum of $ 20,000 for each of the years involved except for the fiscal year ended May 31, 1941, for which it is $ 18,000. The petitioner retired its preferred stock in the amount of $ 25,000 on September 30, 1943. The petitioner properly treated this retirement of its stock as a capital reduction within the meaning of section 713(g) on its excess profits tax returns for its taxable years 1944, 1945, and 1946, effective for those years. OPINION. The respondent has determined that the petitioner is eligible for relief under section 722(b)(4)3 as a result of a change in *1010 the character of petitioner's business during its base period, which began on June 1, 1936, and ended on May 31, 1940. From 1933 to 1938 the petitioner operated a small hotel of approximately 100 rooms in Kokomo, Indiana. During January 1939 the petitioner acquired the Washington, a hotel of about 240 rooms, in Indianapolis, Indiana, and disposed of the hotel in Kokomo. At the same time the petitioner planned and began to carry out a program of improvements*104 designed to upgrade the Washington in order to compete with the first-class hotels of Indianapolis. Not all of these improvements were completed during the base period, nor had the petitioner attained its normal operating level by May 31, 1940. *105 As petitioner did not reach its normal level of earnings during the base period it is entitled, under section 722(b)(4), to establish what the normal level of earnings would have been had the changes been made 2 years earlier. The respondent has allowed a constructive average base period net income of $ 14,000, and petitioner must show that the respondent's allowance is inadequate and the excess profits taxes computed pursuant thereto are excessive and discriminatory. We have carefully considered all of the evidence in this case and have concluded that the constructive average base period net income allowed by the respondent is inadequate and does not reflect the level of earnings petitioner would have reached had it changed the character of its business on May 31, 1938. But we are not convinced from the evidence presented herein that the petitioner is entitled to the constructive average base period net income for which it contends. We are again in the position of being unable to accept the constructive average base period net income figures proposed by either party. In such a situation this Court may make its own determination of the taxpayer's constructive average base period*106 net income. Lily Mills Co., 21 T.C. 900; Superior Valve & Fittings Co., 18 T.C. 931; Radio Shack Corporation, 19 T.C. 756. We have exercised our own best judgment and have determined that a fair and just amount representing normal earnings to be used as a constructive average base period net income for the purpose of computing petitioner's excess profits credit is $ 20,000 for each of the years involved herein, except for the fiscal year ended May 31, 1941, which is involved herein only for the purpose of carryover credits. The petitioner did not attain the normal level of operations during 1941 that it would have reached had it made the change in character of its business 2 years earlier. Accordingly, the so-called variable credit rule (Reg. 112, sec. 35.722-3(d), as amplified by Bulletin on Section 722, pp. 120-123) is applicable. See Nutrena Mills, Inc., 26 T.C. 1096, 1113, and the cases cited therein. Pursuant thereto we have determined that the constructive average base period net income for the fiscal year ended May 31, 1941, is $ 18,000. *1011 *107 Any mathematical error in the respondent's computation may be corrected as a part of the Rule 50 computation. The issue apparently raised by petitioner relating to the determination of its normal-tax net income under section 13(a)(2) is not only vague but it is also ignored by both parties on briefs and at the trial. Under the circumstances we are unable to determine the nature of the controversy, and we deem it to have been abandoned. The petitioner in its taxable year 1943 reduced its capital through retirement of its preferred stock in the amount of $ 25,000, and the respondent correctly applied the provisions of section 713(g) in his computation as set forth in his amended answer. Reviewed by the Special Division. Decision will be entered under Rule 50. Footnotes 1. All references to Code sections in this report refer to the Internal Revenue Code of 1939.↩ 2. As a basis for comparing the gross income of the various hotels mentioned herein we have added to these operational summaries an index referred to as "Hotel Total Sales Trend," which was computed by Horwath & Horwath and published on page 26 of that firm's "25th Annual Study" submitted as petitioner's Exhibit No. 31. The index used herein closely parallels the general business index for the same period.↩ 3. 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 * * * 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 * * * made the change in the character of the business two years before it did so, it shall be deemed to have * * * made the change at such earlier time. For the purpose 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 * * *↩