Sweet Candy Co. v. Commissioner

SWEET CANDY COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Sweet Candy Co. v. Commissioner Docket No. 32124. United States Board of Tax Appeals 26 B.T.A. 36; 1932 BTA LEXIS 1375; May 11, 1932, Promulgated *1375 B. H. Saunders, Esq., and Charles D. Hamel, Esq., for the petitioner. J. L. Backstrom, Esq., for the respondent. MATTHEWS *36 This is a proceeding for the redetermination of a deficiency in income and profits taxes for the calendar year 1920 in the amount of $456.18. It is alleged, first, that the respondent erred in failing to include in the petitioner's invested capital for 1920 the sum of $90,172.46 representing capital expenditures which had been erroneously charged to expense in prior years and also representing good will acquired by the petitioner corporation for cash. The second allegation of error is that the respondent refused to compute the petitioner's profits taxes for the year 1920 under the *37 provisions of sections 327 and 328 of the Revenue Act of 1918. the respondent affirmatively alleged in his answer that if the Board should find that amounts expended for advertising and charged to expense in prior years should be restored to invested capital, then the respondent erred in allowing the sum of $86,060.66, representing amounts expended for advertising, to be deducted as an expense in 1920, and that that amount should*1376 be restored to petitioner's gross income. The petitioner in answer to this averment in the answer denied that the respondent had erred in allowing such amount as an expense. The hearing in this proceeding was limited to the issues defined in subdivisions (a) and (b) of Rule 62 of the Board's rules of practice. FINDINGS OF FACT. The petitioner, formerly the Salt Lake Candy Company, is a corporation organized in May, 1900, under the laws of the State of Utah, by Louis Saroni. Shortly afterwards, Leon Sweet became interested in the company and a stockholder therein. Prior to the time of incorporation of the petitioner, Saroni was engaged in the candy business. He had organized various companies in San Francisco, Sacramento, Los Angeles, Portland and Seattle, the company in Portland being called the Sweet Candy Company. In 1899 he sold out his interests in these companies to the Pacific Coast Biscuit Company, in which one Wittenberg was the principal stockholder, and agreed not to use the name "Sweet Candy Company" or to engage in the candy business for twenty years. In 1900, when the petitioner was organized, under the name of the Salt Lake Candy Company, Wittenberg, *1377 representing the Pacific Coast Biscuit Company, agreed to allow Saroni to engage in the candy business in Salt Lake City and vicinity in consideration of receiving one-third of the profits of the petitioner. In 1904 Saroni paid Wittenberg or the Pacific Coast Biscuit Company $30,000 for the abrogation of this agreement, for the right to use the name Sweet Candy Company, and the right to engage in the candy business on the entire Pacific Coast. Leon Sweet contributed $4,000 of this amount. At that time Saroni and Leon Sweet each owned one-half of the stock of the petitioner. The name of the petitioner was then changed to "sweet Candy Company." When the petitioner was organized it took over the business of two candy companies then operating in Salt Lake City owned by Robert Eite and M. Kopp. The agreement with Eite provided that in consideration of the cancellation of a note for $450 executed by Eite to Louis Saroni & Company, and the sum of $4,198.75, Eite would convey to the petitioner all of his good will, merchandise, tools, machinery, *38 etc., that Eite should be employed by the petitioner as a salesman, and that for a period of five years, and while in the employ*1378 of petitioner thereafter, he would not engage in any other candy business. The bill of sale contained an itemized list of the tangible assets, amounting to $4,198.75. The contract with Kopp provided for the sale of merchandise, tools, good will, accounts receivable, etc., for the sum of $23,591.15, of which $7,008.68 represented accounts receivable. In 1904 the petitioner and J. G. McDonald Candy Company purchased the assets of W. R. Servis Candy Company, Inc., a candy business conducted by W. R. Servis. The contract with Servis provided for the purchase of good will, merchandise, machinery, Fixtures, etc., for $4,945.48 and the payment of $3,000 to Servis as an individual in consideration of his agreement not to compete in the candy business in the States of Utah or Idaho for five years. This amount of $3,000 was payable in installments of $600 a year. The petitioner paid the amount of $4,945.48 and took over the stock of merchandise and equipment, and also paid one-half of the $3,000. The petitioner was not able to use all of the merchandise and supplies taken over from these three companies, but was forced to discard and junk a part of the assets. None of these three*1379 companies was operating profitably at the time they were taken over by the petitioner. In 1915 the petitioner and several other candy manufacturers bought out the Merchants Candy Company for approximately $10,000. The cost to the petitioner of the assets taken over from this company was about $2,500. Most of these assets were discarded as worthless. The Merchants Candy Company had failed and discontinued operations prior to the time it was taken over and it was purchased to keep down competition. None of the amounts spent in the acquisition of these four companies was ever capitalized on the books of the petitioner. The officers of the petitioner, soon after it was organized, decided to develop a line of package specialties rather than to confine themselves to selling candy in bulk. About 1903 they began to develop these special lines. The first brand introduced was "The Carnation," which was followed later by "Italian," "Ideal," "Golden West," "Pink Lady," "Ethel Barrymore," "Maxine Elliott," "Julia Marlowe," "Aristocratic" and "DeLuxe." Some of the brands, including the "Carnation" and "Pink Lady," were trade-marked and others were copyrighted. From 1912 to 1916 a compaign*1380 was carried on to introduce the "Pink Lady," "Maxine Elliott," "Julia Marlowe" and "Ethel Barrymore" brands. Markets were being opened in California, Oregon, Washington, Montana, Colorado, Alaska, Hawaii, Australia, New Zealand, South America, China, India and France. The petitioner, in advertising these special brands, incurred *39 expenses for special demonstrators, window displays in stores, exhibits in fairs and newspaper advertising. From 1903 to 1916 it expended at least $24,173.43 for special demonstrators. These demonstrators contacted dealers, put in window and interior displays and distributed samples. Occasionally they made sales, but were not paid any commissions thereon. The petitioner had salesmen covering the same territories. The petitioner expended during the same period $2,216.38 for interior advertising; $1,026.24 for special exhibits; and paid the Utah Bill Posting Company $15,000 for outdoor advertising. During 1915 and 1916 it expended $5,433.97 for samples. It had made expenditures for samples in prior years which had been charged to the general merchandise account and the amount thereof could not be determined from its books. There were no samples*1381 of bulk goods distributed. All of the above expenditures, in the amount of $47,850.02, were for the purpose of developing its special lines of brand goods. Only $19,000 of this amount was charged to the advertising account. None of these amounts was ever capitalized on the books of the petitioner, but they were charged either to advertising, salaries, or merchandise. Some of the petitioner's records, including the cash books and most of the journals, were destroyed in 1920, but the general ledgers and some of the journals are still in existence. The petitioner expended other amounts in addition to those listed in the preceding paragraph in connection with advertising its special brand goods, but due to the loss of its records the amount thereof could not be determined from its books. In addition to this special campaign, the object of which was to acquaint dealers with the brand goods, the petitioner did general advertising, the object of which was to promote consumers' demands. The petitioner's books show an amount of $84,243.72 charged to advertising from 1902 to 1916, of which approximately $19,000, as stated above, represents special advertising and the balance represents*1382 general advertising. In 1917 petitioner discontinued its special advertising campaign, due to the restrictions on the use of sugar and other conditions arising out of the entry of the United States into the World War. In its income-tax return for 1920 the petitioner deducted $86,060.66 for advertising expenses. This deduction was allowed by the respondent. In 1920 a few shares of the petitioner's stock were owned by some employees and the remaining shares were owned by Arthur Sweet, Saroni, and Leon Sweet, Arthur Sweet owning approximately 20 per cent and Saroni and Leon Sweet owning approximately 40 per cent each. Saroni was president of the company, Arthur Sweet was *40 vice president and Leon Sweet was secretary-treasurer and general manager. Saroni did not receive any salary from the petitioner in 1920. Arthur Sweet and Leon Sweet both received a salary of $9,600 in that year, and devoted all their time to the business of the company. Arthur Sweet was the salesmanager and had charge of the records. He also handled the advertising in connection with the sales. Leon Sweet was the general manager and had charge of the factory and of financial matters. There were*1383 no cash dividends paid in 1920, but a stock dividend in the amount of $298,000 was declared and paid. In 1920 Saroni was living in San Francisco, but made frequent trips to Salt Lake City at his own expense to consult with officers of the petitioner. He did the buying for the petitioner in San Francisco and foreign markets and handled its export business. Saroni gave a great deal of his time in 1920 to the management of the Sweet Candy Company of California, a subsidiary of the petitioner. Both it and the petitioner used Saroni's warehouse at times at no cost. Saroni was interested in a number of other business in 1920, to which he devoted a considerable part of his time. The petitioner in 1920 owned a plant which, including the machinery and equipment, had been moved to its present location in 1910. At that time the machinery was thoroughly overhauled and put in first-class condition. It was always kept in like condition. The depreciated cost of this plant, machinery and equipment as shown on the books of the petitioner was $61,022.31 on March 1, 1913. The respondent used this amount plus cost of additions from January 1, 1913, to January 1, 1920, as a basis for the*1384 depreciation deduction for 1920 at the rate of 10 per cent. The petitioner in its return for 1920 reported an invested capital of $776,945.69. In a supplemental brief and exhibit submitted by the petitioner to the Commissioner of Internal Revenue in support of its claim for refund, invested capital as shown by the books in the amount of $747,848.03 was claimed. The respondent in determining the deficiency herein allowed an invested capital of $749,423.10. The amount of net income for 1920 as determined by the respondent was $239,306.95 and the total tax determined was $71,570.27. OPINION. MATTHEWS: The first contention of the petitioner is that it is entitled to have $90,172.46 restored to invested capital. Of this amount, it claims that $30,000 represents cash payments made to Wittenberg; $10,000, good will of Servis, Kopp, Eite and the Merchants Candy Company; and $50,172.46, amounts expended for special advertising campaigns and exhibits. As set forth in our findings of fact, the *41 petitioner definitely established that it expended, from 1909 to 1916, $47,850.02 for special demonstrators, window displays, exhibits, samples, and other advertising, for the purpose*1385 of introducing its special brands, and that no part of this amount was ever capitalized. Other amounts were expended for this purpose, but the exact amount can not be determined, due to loss of records. The petitioner contends that these were capital expenditures and, though charged to expense, should now be restored to invested capital. We can not agree with this contention of the petitioner. It is true that the amount established by the evidence, and probably more, was expended to advertise its trade-marked and special brand goods but this alone does not establish that such amounts were of a capital nature. As the expenses were incurred they were charged to advertising or other expense accounts. The special campaign resulted not only in building up a market for the trade-marked goods, but also increased the sales of these and the petitioner's other goods. A table admitted in evidence shows that the gross sales increased from approximately $435,000 in 1909 to over $2,000,000 in 1920. We do not know what proportion of the sales for any of these years was of trade-marked goods as, prior to 1921, there was no separate record kept of the sales of the trade-marked goods. The*1386 petitioner has thus failed to establish how much of the increase in sales was attributable to the advertising of its trade-marked goods. In such a situation, we can not say that the amounts so expended all resulted in the development of its special lines and were of a capital nature. Although there may be a few instances in which advertising expenses have been held to constitute capital expenditures, they are primarily in the nature of current expenditures, resulting in immediate increase of sales. In the instant proceeding there is no evidence upon which we can determine or even make an estimate as to how much of the amount of $47,850.02 constituted capital expenditures. In such a situation the petitioner is not entitled to have any part of such amount restored to its invested capital. See ; ; ; , affd., ; certiorari denied, ; *1387 ; . As to the good will, the petitioner is claiming that it paid $7,500 in cash for good will acquired from Eite, Kopp and Servis; $30,000 for good will acquired from Wittenberg, and $2,500 for good will acquired from the Merchants Candy Company. The petitioner contends that the value of the assets received from Eite, Kopp and Servis and the Merchants Candy Company and junked represents the amount of the purchase price paid in each instance for good will. We can not see any merit in this contention; moreover, Saroni testified *42 that these companies had not been operating at a profit and that the good will was worth very little, if anything. As to the transaction with Wittenberg, it is doubtless true that there was some good will paid for in cash, but it was paid by Saroni and not by the petitioner; moreover the payment of $30,000 was not only for the use of the name "Sweet Candy Company," but also for the abrogation of the agreement whereby Wittenberg was to receive one-third of the profits of the petitioner. There is no basis upon which*1388 an allocation can be made between these two items. We are, therefore, of the opinion that the petitioner has not established that it is entitled to have any part of the amount of $90,172.46 restored to its invested capital. The petitioner's second allegation of error relates to the respondent's disallowance of relief under the provisions of section 327 of the Revenue Act of 1918. That section provides as follows: SEC. 327. That in the following cases the tax shall be determined as provided in section 328: (a) Where the Commissioner is unable to determine the invested capital as provided in section 326; * * * (d) Where upon application by the corporation the Commissioner finds and so declares of record that the tax if determined without benefit of this section would, owing to abnormal conditions affecting the capital or income of the corporation, work upon the corporation an exceptional hardship evidenced by gross disproportion between the tax computed without benefit of this section and the tax computed by reference to the representative corporations specified in section 328. This subdivision shall not apply to any case (1) in which the tax (computed without benefit*1389 of this section) is high merely because the corporation earned within the taxable year a high rate of profit upon a normal invested capital * * *. In some instances where a taxpayer has established that capital expenditures have been charged to expense and the exact amount can not be determined, we have held that "invested capital can not be determined" within the meaning of the statute and that relief should be granted under the provisions of section 327(a). In the case of , the petitioner, engaged in the coffee and tea business, had expended an aggregate amount of approximately $295,000 for route extensions, advertising special brands and creating new markets. The evidence in that case clearly showed that the petitioner's brand sales had increased from 66 per cent of its gross sales in 1909 to 84 per cent in 1921. We held that the exact amount attributable to capital could not be determined and granted special assessment, saying: The expenditures of the petitioner herein constituted to a substantial extent investments in capital assets which have not been and can not be included in invested capital, but which nevertheless*1390 contributed materially to the production *43 of the taxable income. This is strikingly shown by the rapid increase in the petitioner's brand sales, which in 1921 constituted 84 per cent of its gross sales. * * * In our opinion, therefore, the facts in the present case bring the petitioner within the scope of section 327(a) of the Revenue Act of 1921, supra, and entitle it to have its tax determined in accordance with the provisions of section 328 of said act, upon the ground that its invested capital can not be determined as provided in section 326. It should be noted in the Caswell case that the amounts expended for advertising were very substantial and there was no evidence in that case as to the invested capital allowed. In the instant case the respondent has allowed the petitioner an invested capital of $749,423.10 and the amount which the petitioner claims can not be determined is not substantial in relation to the total capital already allowed. The statute was not intended to cover cases where the respondent has allowed a considerable invested capital and it is clear that only an inconsiderable amount can not be determined. See *1391 . In the case of (affirmed by the Circuit Court of Appeals in ), we said: As to the remaining contention under subdivision (a), all we know is that "quite a substantial amount" of money was expended by the partnership and the petitioner for advertising. No attempt was made to show what proportion of the whole amount spent was expended to create future sales. It may be that some part of the unknown sum expended did result in establishing petitioner's produce in the minds of the public and thus create a capital asset, but it is also apparent that a portion was used to bring about current sales. Without more facts than those before us we can not say that any part of the amount spent should be capitalized, and, therefore, be considered in computing invested capital. In our opinion the petitioner has failed to show that its invested capital can not be determined. As stated, the respondent has determined an invested capital of $749,423.10, and only an inconsiderable amount, if any, can not be determined. We are, therefore, of the*1392 opinion that the petitioner is not entitled to special assessment under the provisions of subdivision (a) of section 327. With regard to the provisions of subdivision (d) of said paragraph, the petitioner contends that its capital is abnormal due to the fact that it owned valuable good will, trade names and trade brands which were not included in its invested capital; and that its income is abnormal, due to the fact that the respondent has allowed insufficient depreciation on its plant and machinery, that salaries paid to officers were inadequate, and that petitioner used Saroni's warehouse and office facilities in San Francisco at no cost. *44 The petitioner's claim as to abnormality of capital rests upon the theory that it had acquired assets of substantial value, none of which were ever capitalized; that these assets consisted of good will and valuable trade names and trade-marks, and that they were material income-producing factors. It is true that we have held in a number of cases that in such circumstances an abnormality exists and that special assessment should be granted. See *1393 ; ; and . In the Whitman case the asset excluded was the most substantial part of the taxpayer's capital and was the principal income-producing factor. In the instant proceeding the petitioner sought to establish that it has intangible assets of a value of at least $700,000. The proof, consisting of a table showing tangible assets and earnings over a limited period of years, is clearly insufficient to establish such a value and we do not consider it necessary to discuss it at any length. There is no evidence as to the value of such intangibles other than the fact that a part of amounts expended for advertising may have contributed to some extent in the building up of the trade-marks, but such amount is small in comparison with petitioner's total invested capital, and it is clear that these assets were not material income-producing factors. See . The petitioner's situation is not comparable with that of the taxpayer in the Whitman case. The petitioner probably*1394 did have a good will of some value, but so does almost any going concern. We have held that there is nothing abnormal in a situation where a taxpayer has by ordinary good business methods built up a valuable good will and have made a distinction between this situation and the one in the Whitman case, and others cited above. The situation herein is similar to that in the case of , in which we said: The second contention of the petitioner is that a good will of great value was built up during the years 1916 to 1919, inclusive, which was in no wise reflected in the invested capital of the petitioner for the years 1920 and 1921. Competent witnesses testified as to the value of the good will which had been built up by the large expenditures for advertising during the years 1916 to 1919. It is to be noted, however, that all of the payments for the advertising were treated as expenses upon the petitioner's books of account. In no case were they capitalized. The advertising was for the sale of merchandise then on the petitioner's shelves. Even though a good will resulted from that advertising, we think that did not create*1395 an abnormality in the invested capital. Many stores which conduct large advertising campaigns create a valuable good will which, under the provisions of the taxing statute, will not ordinarily be reflected in the invested capital determined under the provisions of the taxing acts. There is, however, nothing abnormal in this fact. A condition that *45 is common to many corporations does not create such an abnormality in invested capital as warrants the application of special assessment for the purpose of determining tax liability. The facts in this case appear to be simply that the petitioner through unique advertising had large profits in the years 1920 and 1921. The provision of the statute is that section 327(d) - * * * shall not apply to any case (1) in which the tax (computed without benefit of this section) is high merely because the corporation earned within the taxable year a high rate of profit upon a normal invested capital * * *. If there was any abnormality in the invested capital, it is such as results from the normal application of the statute. In our opinion it was not the intention of Congress that the special assessment provision should have application*1396 to such a case as is presented herein. There remains only the question of abnormality of income. The first ground upon which the petitioner is basing this claim is that it was allowed depreciation on its plant and equipment on the basis of depreciated cost, rather than on its March 1, 1913, value, which it claims was greatly in excess of such cost, thus resulting in an understatement of income for 1920. The evidence introduced by the petitioner tends to show that the March 1, 1913, value of the plant was in excess of the depreciated cost used by the respondent as the basis for depreciation deductions, but was not sufficient to show what that value is. Moreover, it should be noted that the petitioner's income for 1920 was $239,306.95 and the amount by which petitioner claims it was understated as a result of this item is only $5,900. Clearly, this is not sufficient to constitute an abnormality. As to the remaining contentions, the evidence does not establish that the salaries paid to Leon and Arthur Sweet were inadequate, that the services of Saroni were of any great monetary value, or that the use of the warehouse resulted in any abnormality. We are, therefore, of the opinion, *1397 upon consideration of all the evidence, that the petitioner has not established that there is an abnormal condition of either capital or income sufficient to entitle it to have its tax computed under the provisions of section 328. In view of our holding that the petitioner is not entitled to have amounts expended for advertising in prior years restored to invested capital, it is unnecessary to consider the respondent's allegation that he erred in allowing a deduction in 1920 for amounts expended for advertising. Reviewed by the Board. Judgment will be entered for the respondent. TRAMMELL and GOODRICH dissent.