J. E. Mergott Co. v. Commissioner

O’CONNELL, Circuit Judge. Petitioner (“Mergott”), a Delaware corporation on the accrual tax basis, seeks review of a decision of the Tax Court holding that there are deficiencies in its declared value excess-profits tax for the year 1943 and in its excess profits tax for the year 1944. Whether or not there was a tax deficiency in those years is dependent upon the propriety of a 1943 deduction of $17,068.68, that sum purportedly representing a loss resulting from the scrapping of 103 tumbling barrels and 58 tanks by Mergott in that year. The facts are substantially as follows: For at least several years prior to 1930 and up to 1943, Mergott had been manufacturing metal handbag frames and other metal specialties, in the process of which fabrication Mergott used patented wooden barrels for a polishing operation.1 The oak used for the barrels was specially selected, milled to Mergott specifications, and stored in a particular manner on Mergott property. The barrels all were constructed under Mergott supervision by two Mergott carpenters continuously on the Mergott payroll. The production rate on the barrels was between 52 and 78 per year. The useful life of the barrels was six months to two years, the average being one year. As the Tax Court said, “Each year petitioner abandoned, as worn out, approximately the same number of barrels and tanks as it built during the year.”2 In 1943, war material work by Mergott forced discontinuance of its civilian products and, since the tanks and barrels then on hand were no longer useful, they were scrapped.3 Such was the function, and the history, of the tumbling barrels. The accounting treatment which Mergott accorded them requires some detailed explanation. Prior to 1931, the value of the barrels was included in the merchandise inventory account. At t'he suggestion of a Mergott accountant, in 1931 the $18,980 item representing the value of the barrels was subtracted from opening inventory and added to the machinery and equipment account, “purely for balance sheet purposes.” 4 This amount was adjusted to reflect the actual value of barrels on hand as of the close of the years, 1932, 1933, 1934, 1935, and 1936 ;5 [862] subsequent to December 31, 1936, the practice was discontinued and the value as of that date, viz., $17,068.68, was carried unaltered through the years 1937 to 1943. Mergott, nevertheless, continued to charge directly to operating expenses the labor and material costs incurred in the production of replacement barrels. When the barrels were scrapped in 1943, Mergott charged to profit and loss the item of $17,068.68 carried since 1936. The Tax Court held that, since Mergott (had taken a deduction for the full amount expended by Mergott in labor And materials in the manufacture of the barrels on hand in 1943, an allowance of the deduction of $17,068.68 would be granting Mergott a double deduction; and therefore upheld the deficiency determination of the Commissioner. 1948, 11 T.C. 47. ’ The case before us is not one in which the law is disputed. 'All members of this Court agree that “bookkeeping entries, though in some circumstances of evidential value, are not determinative of tax liability”, Helvering v. Midland Ins. Co., 1937, 300 U.S. 216, 223, 57 S.Ct. 423, 426, 81 L.Ed. 612;108 A.L.R. 436. The sole question before the Tax Court, as well as before us, is factual: When did Mergott suffer the loss for which it now seeks to claim credit? The difficulty stems from the vacillating accounting practice adopted by Mergott,6 which has created problems entirely of its own making. Even if we were to assume arguendo that, by virtue of section 36, P.L. 773, 80th Congress, 26 U.S.C.A. § 1141(a), this Court may substitute its concept of proper accounting practice for that prescribed by the expert .tribunal, the Tax Court, we are not prepared to say that the instant Tax Court decision is without suth stantial foundation in the evidence. The item of $17,068.68 represented the value of the barrels on 'hand on December 31, 1936. Those barrels, presumably, had long since been consumed and discarded by 1943. Consequently, it could not be the 1936 barrels, but barrels constructed thereafter, for which Mergott attempted to deduct in 1943. As to any barrels built subsequent to December 31, 1936, the Tax Court has found that “Labor and material costs for their construction were treated in the same manner as were the costs incident to the creation of the products it sold,” that “the cost of producing the barrels was in all instances deducted as a current expense,” and that “For each [barrel abandoned in 1943] petitioner was given a simultaneous deduction for the full amount expended in labor and materials.” While the Mergott accountant did present testimony indicating that the effect of what was done amounted to setting off the material and labor cost in producing the barrels against the cost of the discarded barrels, we know of no reason why the Tax Court had to be bound by his testimony. The fact that the figure representing the value of the barrels on hand remained absolutely constant for more than 6 years, between 1936 and 1943, a period when the national economy was undergoing radical [863] changes,7 plus the obvious fact that at least in 1943, under its own theory, Mergott would have been deducting the 1943 operating expenses of making the barrels as well as writing off the same barrels, certainly permitted the Tax Court to draw the conclusion that, whatever may have been intended by the Mergott officials, what they actually accomplished was to charge to current expenses the cost of the barrels on hand.8 It requires no citation to state that the cost of the barrels actually on hand in the ■year 1943, having been charged to the cost of operations with the commensurate tax advantages, cannot again be charged off simply because they are on hand. See David Hanover v. Com’r, 1949, 12 T.C. 342, referring to the instant Tax Court decision. Somewhere in prior years, petitioner probábly should have charged off to expense the item of $17,068.68. This was not done; why, we can only speculate. It may well be that such an action would not have been profitable taxwise. Whatever the reason of taxpayer may have been, the principle has long been established that, for tax purposes, expenses attributable to one year may not be charged off in a subsequent year. Sec. 29.43-2 Treasury Regulations 111, 492 C. C. H. Standard Fed. Tax Rep. Par. 409. The decision of the Tax Court will be affirmed. Footnotes [1] In the polishing operation, the barrels of which we speak were placed in tanks made of live cypress. The question of the deductibility of the value Mergott assigned to the tanks is in all material respects identical with that concerning the barrels. Consequently, for convenience, we shall refer henceforth only to the barrels. [2] We note in passing that the vice president of Mergott also testified that Mergott had never had a stockpile of barrels. The record does not explain, however, why 103 were scrapped when the annual production was between half and three-quarters of that figure, and when the average life was one year. [3] Half were destroyed in the earlier part, and half in the autumn, of 1943. Barrels had been made almost until the scrapping was begun. Although the metal was sold for scrap, the officer of Mergott testified that “It hardly paid to recover [the metal].” [4] The quoted characterization is from the testimony of the Mergott accountant. [5] The amounts were as follows: 1932, $18,960; 1933, $16,560; 1934, $16,560; [862] 1935, $15,280; 1936, $17,088.68. The figures prior to 1935 apparently include barrels other than the tumbling barrels here involved. [6] If the intent of the Mergott accountants was to include the barrels in inventory throughout, they were ignoring section 29.22 (c)-1 of Treasury Regulations 111, 491 C.C.I-I. Standard Tax Rep. Par. 116, which provides in part, “ * * * The inventory should include all finished or partly finished goods and, in the case of raw materials and supplies, only those which have been acquired for sale or which will physically become a part of merchandise intended for sale. * * * ” The rule prior to 1933 had “allowed the taxpayer to inventory ‘supplies on hand that have been acquired for’ * * * use in productive processes * * II Montgomery, Federal Taxes Corporations and Partnerships, 1948-1949, ch. 14, page 421. It goes without saying, of course, that even under that rule it was incumbent upon Mergott to inventory its barrels annually, with which requirement Mergott complied until 1936. The distinction between these barrels and goods accompanying merchandise for sale is that which renders inapplicable here the ruling as to bread wrappers in Liberty Baking Co. v. Heiner, 3 Cir., 1930, 37 F.2d 703, on which ease Mergott has placed some reliance. [7] The vice president of Mergott testified: “I know that the cost of our factory increased double during that period.” [8] What Mergott professed to have effectually done in its bookkeeping entries, of course, was contrary to section 29.22 (c)-l, Treasury Regulations 111, quoted in the pertinent part in footnote 6, supra, because the barrels were not supplies acquired for sale or physically a part of merchandise intended for sale.