New England Foundry Corp. v. Commissioner

New England Foundry Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent New England Foundry Corp. v. Commissioner Docket No. 3535-63 United States Tax Court 44 T.C. 150; 1965 U.S. Tax Ct. LEXIS 91; May 5, 1965, Filed *91 Decision will be entered under Rule 50. Held, that petitioner has established by a clear preponderance of the evidence that the transfer of property made to it by another corporation shortly after petitioner's formation was not made with a major purpose of obtaining the surtax exemption provided for in section 11(c) of the Internal Revenue Code of 1954; and accordingly that respondent erred in denying to the petitioner, pursuant to section 1551 of the 1954 Code, the benefit of such exemption for its taxable years ending July 3, 1959, and July 2, 1960. Burton L. Williams, for the petitioner. Robert B. Dugan, for the respondent. Turner, Judge. TURNER *150 The respondent determined deficiencies in income tax against the petitioner of $ 16,385.08 for the taxable year ended July 3, 1959, and $ 6,254.12 for the taxable year ended July 2, 1960. The parties have stipulated that petitioner's taxable*93 income for the taxable year ended July 3, 1959, is increased in the amount of $ 14,362.79 as the result of a partial disallowance of a loss claimed on the sale of real estate rather than the amount of $ 19,284.66 shown in the notice of deficiency. It is further stipulated that petitioner's taxable income for each of the taxable years ended July 3, 1959, and July 2, 1960, is increased in the amounts of $ 1,012.14 and $ 774.93, respectively, as the result of the partial disallowance of depreciation claimed rather than the amounts of $ 1,637.14 and $ 1,321.80, shown respectively in the notice of deficiency. In view of the foregoing concessions of the parties, the only question for decision is whether a major purpose for the transfer in 1957 of property by Watts Regulator Corp. to the petitioner, New England Foundry Corp., was the securing of a surtax exemption. FINDINGS OF FACT Some of the facts have been stipulated and are found as stipulated. The petitioner is a corporation organized under the laws of Massachusetts on January 28, 1957. It is engaged in the business of operating a foundry. It keeps its books on an accrual basis and filed its *151 Federal income tax return for*94 its fiscal years ended July 3, 1959, and July 2, 1960, with the district director of internal revenue at Boston, Mass. Watts Regulator Co., hereinafter referred to as Watts, is a corporation engaged in the manufacture of valves and plumbing and heating systems. During the years in question, Watts had 38,000 shares of capital stock outstanding, which were held as follows: George B. Horne, hereinafter referred to as Horne, owned 23,000 shares; a trust created by Horne's father, Burchard Horne, owned 14,400 shares; and Horne's children owned 600 shares. The trust was created by an instrument executed on December 29, 1947, and the original corpus consisted of 144 shares of Watts' common stock. Horne and his mother were the primary beneficiaries of the trust, and it was provided in the trust instrument that the trustees were to vote any Watts' stock held thereunder as directed by Horne. At all times material hereto, Horne was the president and treasurer of Watts. From 1952 until August 1959, Cyrus Gates was vice president and general manager of Watts. Watts' factory is located in Lawrence, Mass. The principal customers of Watts are plumbing and heating wholesalers. Watts also sells*95 certain products to manufacturers who incorporate the products into boilers and other equipment. Until 1958, Watts operated a small foundry in its factory building to supply castings needed in its manufacturing operations. Out of a total of approximately 250 persons employed in the plant, approximately 30 to 35 were employed in the foundry. The small size of the foundry made it necessary to carry on many of its operations by hand, and its operations were generally not efficient. The foundry supplied Watts approximately 40 percent of the castings it needed and it was thus necessary for Watts to purchase substantial quantities from outside sources. The castings purchased by Watts from outside sources often turned out to be of unacceptable quality. Watts attempted at one time to operate an additional shift in its own foundry in order to increase its production and thus reduce its dependency on outside sources. Due to a shortage of supervisory personnel, however, the results were unsatisfactory and there was pilferage by some employees. The additional shift was terminated after several months. The employees of Watts, including the foundry employees, were represented by Federal Labor*96 Union No. 22451, AFL-CIO, in a single bargaining unit. The contract between Watts and the union was renegotiated annually with the exception of one instance when it covered a 2-year period. The union was dominated by the machinists, and the foundry employees were inadequately represented during the negotiations with Watts. There was usually only one foundry employee *152 on the bargaining committee, along with seven or eight employees from other departments. The union contract provided for seniority on a plant-wide basis, so that if a worker in another department was about to be laid off, he could "bump" or replace a foundry employee having less seniority. This procedure occurred quite frequently and resulted in persons having little, if any, foundry experience replacing experienced personnel in the foundry. Watts protested against this procedure in its bargaining with the union, but was unable to bring about a change. Webster Valve Co., hereinafter referred to as Webster, is a corporation which was organized in 1955 or 1956. Its capital stock has at all times been owned by Horne and his five children. Horne became president and treasurer of Webster and remained in these*97 capacities during the years in question here. In the beginning Webster made nothing but screw machine products. It later began the manufacture of valves for sale under its own trade name, not in competition with Watts but on a lower priced market. Its plant was located in Franklin, N.H., some 75-mile distance from Watts and New England Foundry. Prior to the organization of petitioner some castings used by Webster in its operations were supplied by the Watts foundry. On May 7, 1956, Horne acquired certain property from Pacific Mills Co., which property was located across the street from the Watts plant. The property consisted of approximately 156,769 square feet of land and four buildings or structures thereon, which had previously been used as a powerplant, turbine house, oil reservoir, and garage. The cost to Horne was $ 110,000, represented by $ 10,000 in cash and a mortgage of $ 100,000 to the Arlington Trust Co. of Lawrence. Consideration was given to the possibility of operating a foundry in the powerhouse building on the property thus acquired, and a firm of foundry engineering specialists was engaged to study the feasibility of such an operation. The engineering firm *98 concluded that a foundry could be operated in the building which could not only produce all the castings needed by Watts but could actually produce an excess. Efforts were made by Cyrus Gates to obtain customers for the excess castings which could be produced by the new foundry. Several companies indicated an interest in purchasing castings, provided Watts did not control the production of the foundry. If they placed an order with petitioner they wanted to be assured it would not be deferred for a later order from Watts. For some time Watts had done practically all of its banking with Arlington Trust Co. and it had a standing line of credit with that bank. Watts had at one time attempted to obtain a loan from a Boston bank, but it had found the conditions required by the Boston bank to *153 be too restrictive, and therefore continued to do business with Arlington Trust Co. In 1957, the lending limit of Arlington Trust Co. to any one borrower was $ 300,000. New equipment was to be acquired for the new foundry and the methods of molding and producing the castings were to be more modern and efficient than those used in the Watts foundry. The management of Watts, therefore, desired*99 to have a time-study analysis made of the operation of the new foundry and to set new base wage rates and incentive bonuses for the foundry employees, based upon the time study. Under the union contract, this could not be done in one department of Watts unless the same was done in all other departments. Watts had never sought to manufacture finished products for mail-order companies such as Sears, Roebuck & Co. or Montgomery Ward & Co., which marketed products under their own brand names. It was certain that if it did so it would lose business from its regular customers, who were competitors of the mail-order companies. Likewise, it feared that if a Watts foundry supplied castings for the manufacture of products for the mail-order companies, that practice would similarly have an adverse effect upon Watts' business with its regular customers. Horne, Gates, and Roland Sherman, attorney for Watts, discussed the advisability of organizing a separate corporation to conduct the foundry operation. The costs of operating the foundry as a separate entity were discussed, and it was decided that the petitioner would be organized. On January 28, 1957, the petitioner was organized for the *100 purpose of operating a foundry. Its authorized capital stock consisted of 1,000 shares of common stock of $ 1 par value. At the time of the organization, 600 shares were issued, 200 shares each to Horne, Gates, and Sherman. At the same time, Gates and Sherman gave Horne an option to purchase the stock owned by them at any time within 5 years thereafter at a price of $ 5 per share. Horne became the president and treasurer of the petitioner. On March 31, 1957, Watts borrowed $ 140,000 from Arlington Trust Co., and on the same date Watts loaned those funds to the petitioner. On April 30, 1957, Watts loaned an additional $ 25,000 to the petitioner. These transactions were recorded as notes receivable on the books of Watts. On June 7, 1957, Horne sold the Pacific Mills property to Watts for $ 200,000. In payment therefor, Watts gave Horne its note for $ 100,000 and assumed the $ 100,000 mortgage to the Arlington Trust Co. *154 On the same date, Watts sold a portion of the property, consisting of the powerplant and oil reservoir and approximately 93,047 square feet of land, to the petitioner for $ 150,000. In payment the petitioner gave Watts its note for $ 50,000 and assumed *101 the $ 100,000 mortgage to the Arlington Trust Co. On June 30, 1957, the petitioner borrowed $ 165,000 from Arlington Trust Co. and repaid to Watts the amounts it had borrowed on March 31, 1957, and April 30, 1957. In December 1957, the petitioner purchased from Watts various items of equipment, having a total adjusted basis to Watts of $ 4,477.11. The purchase was recorded on the petitioner's books by debiting $ 4,477.11 to "Equipment" and crediting a like amount to "Inter-Company Account." Watts obligated itself to purchase all of the castings it needed, other than ferrous castings, from the petitioner. In June 1958, the petitioner began production and Watts closed its foundry. Watts terminated its employment of the foundry employees and they were immediately hired by the petitioner. Separate labor contracts, each dated January 28, 1958, were executed by Watts and the petitioner, respectively, with the Federal Labor Union. Each of these contracts was separate and independent of the other and had to do only with the terms and conditions of employment by the one company and not the other. After operations had begun in the petitioner's foundry, a time-study analysis of the operations*102 was made by an outside firm of experts, in order to establish new base rates and incentives for the employees. Amendments to the petitioner's contract with the union were made on August 28, 1958, and October 22, 1958, to change the base rate and incentive provisions in accordance with the results of the time study. In July 1958, Robert Chaffee, who had been engaged in sales in the plumbing and heating industry since 1929, was hired by Horne to help expand the business of Watts, Webster, and the petitioner. His position with Watts was that of sales vice president. Among the customers to whom Chaffee had negotiated sales for his previous employer was Sears, Roebuck & Co. In August 1959, Cyrus Gates terminated his employment with Watts and joined another corporation operating a foundry. In the same month, Robert Chaffee became executive vice president of Watts, Webster, and the petitioner. During the taxable years in question, Robert Tesar was the manager of Watts Regulator Sales Co. at No. 6 Erie Street, Cambridge, Mass.The business of that company was that of selling products manufactured by Watts and others on a commission basis. Chaffee requested *155 that Tesar devote*103 a portion of his time to seeking orders for brass or bronze castings produced by the petitioner. In this regard, calling cards were printed for Tesar reading: "New England Foundry Corp., Robert J. Tesar, Sales Manager." Tesar made a number of calls over a period of several months, attempting to make sales of the castings, but was unsuccessful. In 1959, Webster began manufacturing valves for Sears, Roebuck & Co. and Montgomery Ward. The valves were marketed by Sears, Roebuck & Co. under its own brand name, "Homart." Sales to the mail-order companies and other companies for marketing under their own brand names have constituted a substantial part of Webster's business since that time. Webster also continued to manufacture products for sale under its own brand name. The majority of the castings used by Webster are purchased from the petitioner. During the taxable years, all of petitioner's sales were made to Watts and Webster although other accounts were solicited. Accounts were not solicited from the companies which had previously been approached by Gates. Gates had taken over another foundry and some of those companies had become his customers. Petitioner did procure an order *104 for valve castings from Jenkins Bros. Valve Co. of Bridgeport, Conn., but at or about the time production began the contract was canceled. Jenkins, which had a foundry of its own, suffered a reduction in business and needed the work for its foundry. They closed their order with petitioner through the payment of $ 1,500. Horne, Chaffee, and Gates, up to the termination of his employment in August of 1959, all performed services for the petitioner during the taxable years. They received compensation from Watts and Webster but received no salary from the petitioner. The services rendered were compensated for by way of adjustments between petitioner and Watts and between petitioner and Webster. During the taxable years, the petitioner's books and records were kept by Watts' bookkeeping department. Watts did not endorse or guarantee any notes of the petitioner, but Horne personally guaranteed certain of its notes. For its taxable year ended July 3, 1959, the petitioner had gross sales of $ 1,253,967.71 and taxable income of $ 125,893.51, as shown by its returns. For its taxable year ended July 2, 1960, the petitioner had gross sales of $ 984,421.93, and taxable income of $ 46,217.85, *105 as shown by its returns. The transfer of Watt's property to the petitioner was not made with a major purpose of securing an exemption from surtax for the petitioner. *156 OPINION Section 1551 of the 1954 Code, which is the governing statute in this case, provided as follows during the years in question: SEC. 1551. DISALLOWANCE OF SURTAX EXEMPTION AND ACCUMULATED EARNINGS CREDIT. If any corporation transfers, on or after January 1, 1951, all or part of its property (other than money) to another corporation which was created for the purpose of acquiring such property or which was not actively engaged in business at the time of such acquisition, and if after such transfer the transferor corporation or its stockholders, or both, are in control of such transferee corporation during any part of the taxable year of such transferee corporation, then such transferee corporation shall not for such taxable year (except as may be otherwise determined under section 269(b)) be allowed either the $ 25,000 exemption from surtax provided in section 11(c) or the $ 100,000 accumulated earnings credit provided in paragraph (2) or (3) of section 535(c), unless such transferee corporation shall *106 establish by the clear preponderance of the evidence that the securing of such exemption or credit was not a major purpose of such transfer. For purposes of this section, control means the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote or at least 80 percent of the total value of shares of all classes of stock of the corporation. In determining the ownership of stock for the purpose of this section, the ownership of stock shall be determined in accordance with the provisions of section 544, except that constructive ownership under section 544(a)(2) shall be determined only with respect to the individual's spouse and minor children. The provisions of section 269(b), and the authority of the Secretary under such section, shall, to the extent not inconsistent with the provisions of this section, be applicable to this section. Income Tax Regulations, sec. 1.1551-1(e), provides as follows: Sec. 1.1551-1 Disallowance of surtax exemption and accumulated earnings credit. (e) Purpose of transfer. In determining, for the purpose of section 1551, whether the securing of the exemption from surtax or the accumulated*107 earnings credit constituted "a major purpose" of the transfer, all circumstances relevant to the transfer shall be considered. For disallowance of the surtax exemption and accumulated earnings credit under section 1551, it is not necessary that the obtaining of either such credit or exemption or both have been the sole or principal purpose of the transfer of the property. It is sufficient if it appears, in the light of all the facts and circumstances, that the obtaining of such exemption or credit, or both, was one of the major considerations that prompted the transfer. Thus, the securing of the surtax exemption or the accumulated earnings credit may constitute "a major purpose" of the transfer, notwithstanding that such transfer was effected for a valid business purpose and qualified as a reorganization within the meaning of section 368. The taxpayer's burden of establishing by the clear preponderance of the evidence that the securing of either such exemption or credit or both was not "a major purpose" of the transfer may be met, for example, by a showing that the obtaining of such exemption, or credit, or both, was not a major factor in relationship to the other consideration*108 or considerations which prompted the transfer. *157 The facts show that the sale of property to the petitioner by Watts was motivated by a number of purposes. Among them were increased production and efficiency, the elimination of a difficult intraplant labor problem with which Watts had been plagued and which it had not been possible to resolve, the generation of sufficient local financial credit through the creation of a new borrower as a result of incorporation, and the solution of specialized marketing problems through the medium of a separate corporate entity. Not only do the facts fail to persuade us that the securing of an additional surtax exemption was a major purpose of the transfer, but to the contrary the evidence convinces us that it was not. We have so found. That the transaction here was a transaction dealt with in section 1551 is not disputed. Here there was a transfer of property to a transferee corporation which was formed to acquire said property and the transferee corporation was controlled by the shareholders of the transferor corporation. Nor is there any dispute in fact or law that the "sale" in the instant case is a "transfer" within the meaning of*109 the statute. Hiawatha Home Builders, Inc., 36 T.C. 491 (1961). Once the requirements of the statute have been met, the remaining issue is one of fact and the petitioner has the burden of showing by a clear preponderance of the evidence that the securing of an exemption was not a major purpose for the transfer in question. The facts show and respondent does not seriously dispute that Watts was in need of considerably more foundry production. In addition, it is clear from the facts that a serious labor problem stood in the way of efficient foundry operations so long as the foundry was owned and operated by Watts. Experience had established that this problem could not be resolved so long as Watts undertook to do its own casting and it and its foundry workers were required to deal with their work and employment problems through a single shopwide bargaining committee. A time-study program could not feasibly be instituted and the elimination of plantwide "bumping" could not be accomplished while the foundry workers were subject to a single plantwide labor contract. A separate, incorporated foundry with its own union contract was Watts' solution to these*110 problems. In view of the uncontroverted facts in the record, we think the incorporation of the new foundry and the resulting division of the existing union into two separate bargaining units by the creation of a separate employer for the foundry workers was a good commonsense solution to the problem. See Cronstroms Manufacturing, Inc., 36 T.C. 500 (1961). Respondent argues that arrangements for a separate bargaining unit other than the incorporation of petitioner were available at the end of the various contract periods but this is not sustained by the record. The uncontradicted testimony of witness Gates was that the machinists *158 dominated the union, that no contract distinction was drawn between the respective arts of machining and casting, and that Watts negotiated and renegotiated at the end of each contract period for effective operative changes under the contract but without success. Another moving purpose for the organization of petitioner was that of financing the new foundry. Watts had done practically all of its banking with Arlington Trust but its lending limit to any one borrower was $ 300,000, which in this instance would not*111 have permitted Watts to expand its borrowing to the extent necessary. Respondent seeks to discount the financing problem as a major purpose for organizing petitioner, arguing that it is far from clear that the possibilities of financing other than by organization of a separate corporation had been exhausted. He stresses Gates' testimony that only two local banks were contacted and Horne's testimony regarding what appears to be "general" financial nogotiations with a single Boston bank. The record shows that the Bay State Merchants Bank, the only other local bank in Lawrence at the time of the transaction, had been contacted. Furthermore, Watts was not a stranger to the difficulties attendant upon negotiations for outside financing. The record does not, it is true, supply the details of the negotiations with the Boston bank, but it does show that lengthy negotiations did take place and that they were abandoned because of the regulations and financial red tape involved. See and compare Bush Hog Manufacturing Co., 42 T.C. 713 (1964), wherein the credit limit of the bank to each borrower was $ 60,000. The record indicates that the valve industry is*112 involved with rather specialized problems and that its attendant market has some peculiar facets. For example, the uncontroverted testimony of record indicates that the relationship and lines of distribution between a supplier of the standing of Watts and its principal classes of customers might seriously be affected if it were known that the facility and know-how of Watts should be equally available to mail-order houses and the like. These latter groups marketed products under their own brand names which were in competition with the established customers of Watts, such as plumbing and heating wholesalers and original equipment manufacturers. This was a major purpose for the setting up of Webster Valve Corp. sometime in 1955 or 1956. Webster produces a rival but less expensive line of products than Watts and is utilized primarily as a vehicle for making sales to mail-order houses on a name-brand-account basis. Watts has never made any sales to mail-order houses and its company policy to this effect was engendered by the above-described competitive situation existing between the mail-order houses and its principal classes of customers. The record shows that at all times pertinent*113 Horne was the real party in interest to the transactions of concern here. And while Gates *159 and Sherman did participate in the discussions and planning which led to the organization of petitioner, it was Horne's approval which made the decisions final. It was his testimony that the procuring of a surtax exemption was not a moving factor in the decisions made and we are fully satisfied that such was the case. It is our opinion that petitioner has carried its burden of showing by a clear preponderance of the evidence that the securing of a surtax exemption was not a major purpose of the transfer at issue herein. We so conclude and hold. Decision will be entered under Rule 50.