L. R. Teeple Co. v. Commissioner

L. R. TEEPLE COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. L. R. Teeple Co. v. Commissioner Docket Nos. 105051, 107676, 107895. United States Board of Tax Appeals 47 B.T.A. 270; 1942 BTA LEXIS 708; July 7, 1942, Promulgated *708 From 1924 through 1939 the petitioner sold under oral agreements made from year to year and on a competitive basis practically all of its output to a single customer. Particularly in the later years the competition was becoming keener and to meet this competition the petitioner was faced with possibilities of moving its plants from Portland, Oregon, to some location in an eastern state and, in the event of loss of its one customer, with the expense of an extended campaign, advertising and otherwise, to replace the lost business. To meet its needs in case of the happening of such contingencies, the petitioner accumulated annually a portion of its earnings and profits. On the facts here the earnings and profits accumulated during the years 1937, 1938, and 1939 were not beyond the reasonable needs of the petitioner's business. Held, that the petitioner was not availed of during those years for the purpose of permitting its stockholders to escape surtax. S. J. Bischoff, Esq., and Robert T. Jacob, Esq., for the petitioner. T. M. Mather, Esq., for the respondent. TURNER *270 The Commissioner determined deficiencies in the petitioner's*709 income tax as follows: Docket No. Year Deficiency 105051 [1938] $15,558.02 107676 [1937] 7,696.47 107895 [1939] 9,166.60 *271 The only question presented is whether the petitioner was subject to the surtax imposed by section 102 of the Revenue Acts of 1936 and 1938 and corporations improperly accumulating surplus. FINDINGS OF FACT. The petitioner is an Oregon corporation which filed its income tax returns for 1937, 1938, and 1939 with the collector of internal revenue for the district of Oregon. It was incorporated on September 28, 1921, under the name of "Tepco Manufacturing Company" and with an authorized capital stock of $5,000, divided into 50 shares of common stock of a par value of $100 each. In October 1926 the name was changed to "L. R. Teeple Company." In the latter part of 1934 and pursuant to the declaration of a stock dividend of $145,000, the capital stock was increased to $150,000 consisting of 1,500 shares of a par value of $100 each. Upon organization of the petitioner L. R. Teeple acquired 51 percent of its stock in payment for certain patents. A few years later he acquired from the other stockholders the remainder of the*710 stock. Since that time he and the members of his family have been the owners of all of petitioner's capital stock. The stock was held as follows at the end of 1939: L. R. Teeple 970 shares A. L. Teeple (wife) 370 shares L. R. Teeple, Jr. (son) 80 shares Mary Ann Teeple (daughter) 80 shares With the possible exception of gifts totaling 30 shares made by L. R. Teeple to his son and daughter during the years 1937 through 1939 the holdings at the end of 1937 and 1938 were the same as at the end of 1939. The petitioner was organized to engage in the business of manufacturing and selling devices for controlling, regulating, and indicating temperature and since its formation has been engaged in that business. The devices manufactured are generally denominated as thermostats, regulators, and pressure gauges. The petitioner manufactures all of the parts of its product except some small items which can be purchased from others cheaper than it can manufacture them. The manufacturing plant and office are in Portland, Oregon. Its operations were originally conducted in rented quarters, but for many years it has owned its own plants, at least three additions having*711 been made to the first unit constructed. L. R. Teeple has been president and manager of the petitioner since its formation. Prior to coming to Portland about 1920 or 1921 he was in the employ of the General Electric Co. at a plant in Fort Wayne, Indiana, and was engaged in developing patents and doing experimental work in the engineering department. As president *272 and manager of petitioner he devotes practically all of his working time to supervising production, making final decisions respecting inventions created in the plant, and otherwise managing the business. Following its organization the petitioner sold the products of another corporation on a commission basis. It also manufactured a few small control devices and made certain radio equipment. About 1923 or 1924 a corporation known as the Portland Wire & Iron Co. was formed for manufacturing and selling a combustion coal stoker. The corporation's name was later changed to Iron Fireman Manufacturing Co.The corporation had its office and plant at Portland. The petitioner, through L. R. Teeple, started working in cooperation with that corporation, sometimes hereinafter referred to as Iron Fireman, to develop*712 a full thermostatic control for the coal stoker. Its efforts were successful, and since the fall of 1924 the petitioner has furnished Iron Fireman with the control equipment used on the stokers which it has manufactured and sold. In recent years Iron Fireman has gone into the manufacture of oil burners and petitioner has furnished the control equipment for them. Since 1924, 98 or 99 percent of the products manufactured by the petitioner have been sold to Iron Fireman. Substantially all of the remainder of the products manufactured by the petitioner have been sold to another concern is Portland that manufactures hot water tanks. By 1927 the business of Iron Fireman was such that the acquisition of an additional manufacturing plant was decided upon and about that time a plant was acquired in Cleveland, Ohio. Since then a number of additions have been made to the Cleveland plant, one as late as 1938. Iron Fireman has a Canadian subsidiary in Toronto, Ontario, which does not use petitioner's products but supplies its needs from manufacturers there. During the past three or four years, Iron Fireman has had large branch offices in New York, Cleveland, Chicago, and St. Louis. *713 Most of its manufacturing is done at the Cleveland plant and the greater portion of its output is sold in the eastern part of the United States. It still maintains its home office and a plant in Portland, where its principal stockholders and managerial officers live. The business of Iron Fireman is placed with petitioner by an annual oral agreement which covers desired model changes, price per unit, and the time of delivery. At the time the annual agreement is made, Iron Fireman ordinarily gives petitioner an order to cover its requirements for a period of about three months and before that order has been delivered it gives petitioner another order for a similar period. Iron Fireman advises petitioner of its prospective sales program for the comming year. On this information and its past *273 experience, petitioner arranges its manufacturing schedule so as to supply the requirements of Iron Fireman for the year. It does most of its manufacturing during the months of June, July, August, and September, the peak being reached during August. During the last two or three months of the year it does not do much manufacturing and it is during that period that model changes*714 are worked out and research work is done. Normally petitioner has disposed of most of its products by December, and its inventory at the end of the year consists mainly of materials and supplies. While the stoker controls manufactured by petitioner are made specifically for the stokers manufactured by Iron Fireman, they are adaptable in many respects to the stokers made by many other manufacturers and portions of such controls will work on gas furnaces. Petitioner has never attempted, however, to obtain business from any of the manufacturers of other heating devices, the reason being that it has had a tacit understanding with Iron Fireman that so long as it purchases petitioner's controls petitioner will not solicit the business of other manufacturers of heating devices in the United States and Canada. Under the arrangement between the petitioner and Iron Fireman the petitioner is not permitted to put its name on the outside of the products sold by it to Iron Fireman. It is permitted, because of the inspection requirements of underwriters, to place its name on the inside of the device but not in such a way as to constitute a trade mark. Iron Fireman in advertising its products*715 does not advertise the fact that the controls or similar appliances attached thereto are manufactured by petitioner or that it uses petitioner's products. The petitioner owns 1,650 shares of Iron Fireman stock, being slightly less than one-half of 1 percent of the Iron Fireman stock outstanding. This stock was purchased on the open market at the request of officials of Iron Fireman and for the purpose of showing petitioner's interest in that company. Neither Iron Fireman nor any of its officers own any stock in the petitioner, nor are there any of the officers or directors of that company who are officers or directors of petitioner. There is no intercompany connection between Iron Fireman and petitioner which would cause that company to patronize petitioner in preference to other companies manufacturing devices of the same character. There are from one hundred to one hundred fifty firms in the United States engaged in the manufacturing of devices of the same general character as those manufactured by petitioner and of that number fifteen or twenty are manufacturing devices which could be used by Iron Fireman. In obtaining the business of Iron Fireman from year to year, petitioner*716 has had to meet the competition from such firms, which to some extent accounts for the *274 fact that for the years 1935 through 1939 the increase in cost of sales has been proportionately greater than any increase in the amount of sales. As early as 1929 L. R. Teeple, petitioner's president, considered the advisability of establishing a service station or service office adjacent to Iron Fireman's plant in Cleveland, but no such move has ever actually been made. At various times Teeple and other officers of petitioner have considered other steps such as putting on a national advertising campaign and manufacturing for others besides Iron Fireman; selling petitioner's products in the open market to the general public; or going into production of new products and setting up a factory and sales agency in the East, possibly at Cleveland. The minutes of the meeting of the stockholders of the petitioner held on November 3, 1934, contain the following: WHEREAS, the Company's production is now practically all confined to sales to the Iron Fireman Company at Portlan, Oregon, and Cleveland, Ohio, under a sales restriction forbidding the sale to others of all devices now being manufactured*717 by us and used in connection with the equipment they sell, and * * * WHEREAS, if the Iron Fireman Co. business was lost, it would necessitate a capital outlay for a period of ten years at least of $100,000.00 in local and national advertising and at least $25,000.00 in experimental and developing work, to get a volume of business sufficient to maintain present plant and organization, and therefore, it should be the policy of the Company to accumulate $125,000.00 or more in liquid resources, if possible, in addition to the $130,000.00 capital now employed in the business, * * * At the meeting of the petitioner's directors held on November 28, 1936, Teeple expressed the conviction that it would be necessary for the petitioner to open a plant in Cleveland in the near future to meet the service demands of Iron Fireman. He stated that petitioner had attempted to meet that company's demands for service by keeping an employee in the East at an expense of approximately $5,000 a year, but that the cost of freight and express on products shipped and Iron Fireman's demand for a larger stock to draw from were factors that might compel petitioner to open a Cleveland plant; that in view of*718 the prevailing prices for building materials and machinery the cost of such a plant would be not less than $150,000; that the petitioner could and would make this additional investment if competition required it or Iron Fireman demanded it, since petitioner had no other market for its products and it would be cheaper to make this investment than attempt to create another market, but that as a prerequisite to the making of such investment petitioner should demand a contract from Iron Fireman whereby it would purchase all production of the new plant for a period of five years; that under the existing arrangement with Iron Fireman petitioner should preserve its surplus in liquid assets and be prepared to go into the open market for business or to build a new plant as required. *275 At the meeting of the petitioner's directors held on December 24, 1937, Teeple stated that eventually, if not soon, the petitioner would be compelled to go into other lines of business; that if the business of Iron Fireman should be lost petitioner would carry on some line of manufacturing and, if possible, provide employment for its older employees; that to maintain production and find a national market*719 would require considerable capital and therefore petitioner's past policy of accumulating capital for such a purpose should be continued. The minutes of the meeting of the petitioner's directors held on December 24, 1938, contain the following: It was brought out that the position of the Company was becoming increasingly difficult because of reduced sales prices. It was agreed that better relations and a more economical arrangement would result if the L. R. Teeple Co. would open another manufacturing plant in Cleveland, so as to be close to the main plant of Iron Fireman. This would be a costly and difficult thing to do but should be deferred until Iron Fireman insisted upon the move; in the meantime plans should be made and funds conserved so as to make the move possible when necessity arose. The matter of selling our products on the open market to the general public was discussed and it was agreed that this could not be done until a new Plant was established in the East, a Sales Department organized and considerable national advertising undertaken. This would require the expenditure of considerable funds and it was remarked that this policy of the Company was a sound one*720 in conserving earnings for use in future plans of development and contingency. A Resolution was adopted that a 10% cash dividend be declared and that the balance of earnings be invested in liquid securities that could quickly be converted into cash for use in an emergency of manufacture or a change of business policy. At a meeting of the directors on December 18, 1939, L. R. Teeple commented on the fact that the petitioner's profits for the year would be considerably less than in 1938 and stated that it was becoming more difficult each year to procure Iron Fireman's business. At a directors' meeting on February 11, 1940, he stated that a tentative agreement had been entered into with an oil gauge company to manufacture and sell oil tank gauges, which would create a distinct field with the oil burner trade for some of the products then made and sold exclusively to Iron Fireman for use on coal stokers. The service department of Iron Fireman has asked that petitioner move its plant to Cleveland where the principal portion of Iron Fireman's manufacturing is done, and the president of Iron Fireman has mentioned the matter to L. R. Teeple. From 1921 to 1927 the salary paid by*721 petitioner to L. R. Teeple ranged from $1,680 to $6,000 per annum. His salary was $15,000 in 1927, $50,000 in 1928, and $65,000 in 1929 and 1930. A controversy arose between the petitioner and the Bureau of Internal Revenue as to the reasonableness of the salaries paid in 1928 and 1929 and the matter was disposed of by an agreement that $40,000 per annum was *276 a reasonable salary. During the years 1931 through 1939 Teeple was paid an annual salary of $40,000. From its inception through 1939 the petitioner paid dividends as follows: Stock dividend Cash dividend Per centum rate of cash dividend [1934] $145,000 $9,000 [1935] 15,000 [1936] 1 30,000 [1937] 15,000 [1938] 15,000 [1939] 15,000 [10] *722 Aside from the abovementioned withdrawal from the petitioner by Teeple neither he nor any member of his family has made any withdrawals from it. Nor has he or any of them made any loans to it or transferred any property to it, except the patents transferred by Teeple at the time of organization. Nor has the petitioner transferred any property to Teeple or any member of his family. The following is a comparative balance sheet as of December 31 for the indicated years, as shown by petitioner's income tax returns for those years: (Table omitted) *277 The notes receivable at the end of 1936 represented the amount due petitioner on a cash loan made to a local stockbroker. This loan was secured by collateral consisting of stocks and bonds. The notes receivable at the end of the years 1937 through 1939 represented the amount due petitioner on a cash loan made to an employee of Iron Fireman who had purchased such a large amount of stock in Iron Fireman that he became financially involved. Neither of the loans had any connection with the petitioner's manufacturing business. The only corporate stock owned by the petitioner during the years 1936 through 1939 was 1,650 shares*723 of stock in Iron Fireman. At the end of August (the peak month of the petitioner's business) of each of the years 1937, 1938, and 1939 the cash on hand ranged from about $260,000 in 1937 to approximately $214,000 in 1939. The accounts receivable ranged from approximately $100,000 in 1938 to about $79,000 in 1939. The inventory ranged from approximately $46,000 in 1937 to approximately $31,000 in 1939. The total liabilities, excepting capital stock but including accounts payable, ranged from approximately $79,000 in 1937 to approximately $35,000 in 1939. The following is a comparative statement of the petitioner's income and deductions for the indicated years as reported on its income tax returns for said years: (Table omitted) The accumulations of petitioner's earnings or profits during the years 1937 through 1939 were not beyond the reasonable needs of its business. OPINION. TURNER: The respondent has determined deficiencies against the petitioner for the years 1937, 1938, and 1939 under section 102 of the Revenue Acts of 1936 and 1938. These deficiencies were based on findings and a determination that during the years in question the petitioner's earnings or profits*724 were permitted to accumulate beyond the reasonable needs of its business and that it was availed of for the *278 purpose of preventing the imposition of surtax on its shareholders. The petitioner denies that its earnings or profits were permitted to accumulate beyond the reasonable needs of its business or that it was availed of for the purpose of preventing the imposition of surtax on its shareholders. Since its organization in 1921 the petitioner has enjoyed a very profitable and growing business. Its business is that of manufacturing automatic devices and controls and, since 1924, 98 or 99 percent of its entire output has been sold to the Iron Fireman Manufacturing Co. which is engaged in the manufacture and sale of combustion coal stokers. The relationship between the petitioner and Iron Fireman is solely that of manufacturer and customer and the business between them is conducted by oral agreement and on a year to year basis. The requirements of Iron Fireman are generally determined and arrived at through conferences at the beginning of the business year. The petitioner up to the date of the hearing has been able to retain the Iron Fireman's business and to realize*725 thereon a very large and satisfactory profit. In so doing, however, it has been required to meet substantial and aggressive competition and in recent years the margin of profit on its devices has noticeably failed to keep pace with its costs. Over the period of its existence the petitioner has accumulated a substantial surplus, ranging from $346,433.61 at January 1, 1937, to $456,070.09 at December 31, 1939. The major portion of this surplus has not been required or used in the operations actually carried on. The facts show, however, that the market and principal manufacturing plants of Iron Fireman are located in the eastern part of the United States, while petitioner's manufacturing is all done in Portland, Oregon, and, further, that the competition in petitioner's field has been growing from year to year, with the competitors much more advantageously located than petitioner. By reason of these facts and circumstances there is and has been present for a number of years the possibility that petitioner might lose its only customer, and it is the claim of petitioner that the surplus in question has been accumulated to meet that contingency and that it is not excessive in amount*726 nor beyond the reasonable needs of the business. We thus have a situation where a taxpayer has a substantial surplus which is not used and is not required in the business as it has been operated from year to year and will not be needed or required so long as the business continues in its present state. It its the claim of the respondent that, since the contingency did not happen in any of the taxable years and has not since happened, it must be regarded as too remote to take the petitioner outside the provisions of section 102, supra, so as to relieve it of liability for the deficiencies determined. While much of petitioner's brief is devoted to matter which *279 would be pertinent only in support of a motion for rehearing and to other matter of no importance here, it does advance the proposition that, even though the facts as to the current use of the accumulated surplus are generally true as stated and the business is still profitable, the dependency of the business upon the good will and continued patronage of one customer over which petitioner has no control the disadvantageous location of petitioner's plant in meeting the requirements of that one customer, and*727 the growing competition from competitors in better locations constitute an ever present danger and existing threat to its business. It is argued that sound business policy required the accumulation of a surplus sufficient to meet the happening of such contingencies and that meeting of those contingencies would require petitioner to go into the open market for customers, to enter fields in which it now has no good will or standing, and most likely to remove its plant to the eastern part of the United States, whether it be for the purpose of retaining the business of its present customer or supplying the needs of new customers. It is further argued and contended that the surplus accumulated and existing during the taxable years was not in excess of that reasonably required, due regard being given to the contingencies outlined. It is our opinion that the record adequately shows the need of some reserve or surplus, as the petitioner contends. While it is true that petitioner has continuously and profitably operated and has succeeded in retaining its one customer, and there is no indication that it intends voluntarily to make any change in its business, it is also true that the contingencies*728 in question are real, they are and have been continuously present, and the exercise of sound business judgment would not permit their being ignored. They are not remote and unproven as in the case of ; affd., , and . Neither, as in those cases, has the conduct of the petitioner or its stockholders furnished any basis for the conclustion that the real purpose for the accumulation was in any way different from that now claimed. See and compare ; ; and . To the contrary, we have here a situation comparable to that dealt with in ; affd., , and ; affd., . It is our opinion, and we so conclude, that a reasonable business need did exist for the accumulation of a reserve to meet the*729 contingencies outlined. As to the reasonableness of the amount of surplus accumulated, the record is not so clear. A number of witnesses were called by the *280 petitioner to give opinion testimony, and, while opinion testimony at its best is not too impressive, the witnesses were all in accord in the opinion that the accumulations during the taxable years were not excessive when the facts outlined herein are considered. The respondent relied on his cross-examination of the petitioner's witnesses and the testimony of the revenue agent. After careful consideration of the testimony offered, we conclude that the surplus accumulated during the years 1937, 1938, and 1939 was not beyond the reasonable needs of the petitioner's business and hold that the petitioner was not availed of for the purpose of preventing the imposition of the surtax upon its stockholders within the meaning of section 102 of the statute. Decisions will be entered under Rule 50. Footnotes 1. About 1932 L. R. Teeple built a new home for himself and withdrew from the petitioner $15,000 in excess of the balance owing to him by it. The amount was afterwards carried on the petitioner's books as an overdraft by Teeple. During the course of an examination of petitioner's books by a revenue agent in 1936 some question arose as to the matter and the petitioner at that time debited its surplus account and credited Teeple's account with the amount, which was thereafter regarded as a dividend paid to Teeple in that year. The remainder of the $30,000 represents a cash dividend of 10 percent declared in 1936. ↩