Moses-Rosenthal Co. v. Commissioner , 17 B.T.A. 622 ( 1929 )

MOSES-ROSENTHAL CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Moses-Rosenthal Co. v. Commissioner

Docket No. 14297.

United States Board of Tax Appeals

17 B.T.A. 622; 1929 BTA LEXIS 2276;

September 27, 1929, Promulgated

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The fact that a corporation was enabled to carry on its business with less capital than would have been required had it not had the benefit of a favorable contract arrangement is no ground for special assessment when it appears that the capital as used in its business and recognized for statutory invested capital purposes is not other than normal for a business so carried on.

C. N. Goodwin, Esq., for the petitioner.

G. S. Herr, Esq., for the respondent.

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LITTLETON

This is a proceeding for the determination of a deficiency in income and profits tax for the fiscal year ended March 31, 1921, in the amount of $451.10. The error assigned is that the Commissioner refused to recognize the existence of abnormalities affecting petitioner's income and invested capital and, therefore, erroneously failed to compute its profits tax under the provisions of section 328 of the Revenue Acts of 1918 and 1921.

The hearing of the case was limited to the issues defined in subdivisions (a) and (b) of Rule 62.

FINDINGS OF FACT.

The petitioner is an Illinois corporation with principal office at Chicago.

From 1911 to 1917 H. S. Moses and Adolph M. Rosenthal were associated in the business of manufacturing women's dresses, accessories, etc., under the name of H. S. Moses & Co. During that time business relations were established with Carson, Pirie, Scott & Co.

In the year 1917 petitioner was formed and engaged in the business of manufacturing athletic style underwear. Moses was president and treasurer of the petitioner and attended to the manufacturing and selling of petitioner's products. Rosenthal was secretary and attended to the office and other details of the business. He was also engaged in the selling department of the business.

During the taxable year ended March 31, 1921, Moses owned 758 shares of stock of the petitioner and Rosenthal owned 642 shares. The remainder of the stock of petitioner, amounting to 100 shares, was owned by C. I. Pickerill and John R. Mason, employees of petitioner.

During 1920 Carson, Pirie, Scott & Co. wanted petitioner to furnish them with more merchandise than petitioner was able to manufacture with the capital which it then had. Moses suggested that petitioner increase its capital and that Carson, Pirie, Scott & Co. subscribe to the additional stock, giving petitioner the privilege of buying back such stock at the expiration of a period of time or whenever it was able to buy it back. Carson, Pirie, Scott & Co. suggested that instead of such an arrangement the petitioner use the credit of Carson, Pirie, Scott & Co. for the purchase of materials.

In accordance with this agreement, petitioner, in January, 1920, purchased in New York and had charged to the account of Carson, Pirie, Scott & Co. approximately $1,000,000 worth of merchandise. The petitioner on its own books showed that this amount of goods was purchased and billed to Carson, Pirie, Scott & Co. and was to be withdrawn as needed by the petitioner.

During the fiscal year ended March 31, 1921, petitioner withdrew from Carson, Pirie, Scott & Co.'s warehouse 414,617 pieces of goods, which consisted of madras, pajama checks, voiles, etc. When made up these goods represented about $800,000 worth of finished goods. The value of the raw material is about one-half the value of the finished product.

The goods withdrawn by the petitioner from the warehouse of Carson, Pirie, Scott & Co. were billed to petitioner on 70 days' credit. The manufacture of such raw material required from four to eight weeks. Delivery was then immediately made to Carson, Pirie, Scott & Co. and that company was billed on 10 days' credit. Petitioner was, therefore, able to deliver the goods to Carson, Pirie, Scott & Co. and receive credit for them before the bill for the goods came due. During the fiscal year ended March 31, 1921, about 90 per cent of the output of petitioner was taken by Carson, Pirie, Scott & Co.

Petitioner had been doing business with Carson, Pirie, Scott & Co. for a number of years and their business relations were upon the basis of mutual confidence. The petitioner was required to use the materials in question, which had been purchased for the account of Carson, Pirie, Scott & Co., in the manufacture of goods for delivery to that company and similarly Carson, Pirie, Scott & Co. were under obligation to take the goods manufactured by the petitioner from such materials. Prior to the petitioner's ordering raw materials, no written order was placed with petitioner by Carson, Pirie, Scott & Co. Written orders for specific quantities of goods were submitted later at such time as petitioner requested them.

Carson, Pirie, Scott & Co. charged petitioner the cost price of such raw materials until June, 1920, when there was a slump in the market, and thereafter petitioner was charged the market value of the raw materials. The finished goods were billed to Carson, Pirie, Scott & Co. on the basis of a normal profit on manufacturing.

Petitioner had no working capital other than a small amount of cash. Under the arrangement with Carson, Pirie, Scott & Co. about the only capital needed by petitioner was that necessary to cover the cost of machinery, labor, and trimmings. It could have borrowed between $30,000 and $50,000, and, at times other than the year in question, petitioner did borrow small amounts of money. If the petitioner had not had the arrangement with Carson, Pirie, Scott & Co. or some similar or equivalent arrangement, it would have taken approximately $300,000 additional capital to have carried on the business which it did in the year ended March 31, 1921, in a manner similar to that which its business had heretofore been carried on. During this year the mills would not hold merchandise for any account to be shipped later, and petitioner would have required more money than in normal years. Even in normal years a large outlay would have been necessary, since the petitioner's business is a seasonal business and all the manufacturing is done over a period of eight months, while the deliveries are made over a period of five or six months.

The balance sheets of the petitioner as submitted with its return for the fiscal year ended March 31, 1921, were as follows:

	Mar. 31, 1921		Mar. 31, 1920
ASSETS
Cash		$90,061.72		$12,322.72
Trade accounts receivable		65,398.66		101,648.93
Other accounts receivable:
H. S. Moses	$8,803.31		$3,268.22
Sundry	160.00
		8,963.31		3,268.22
Notes receivable		1,700.00
Inventories:
Raw material	14,540.04		95,545.82
Work in progress	15,385.67		52,540.65
Supplies			219.84
		29,925.71		148,306.31
Investments:
Liberty Loan bonds -
First issue			200.00
First issue converted to
second issue				100.00
Thired issue			2,000.00
Fourth issue			6,300.00
Victory Loan bonds			700.00
United States certificates of
indebtedness, 6 per cent		75,000.00		9,300.00
Prepaid insurance		374.50		560.65
Fixtures and machinery	44,348.25		41,610.75
Less reserve for depreciation	14,699.01		8,252.09
		29,649.24		33,358.66
		301,073.14		308,765.49
LIABILITIES
Trade accounts payable		29,750.06		131,185.15
Sundry accounts		5,160.14		6,390.00
A. M. Rosenthal		1,628.91		110.67
Accrued liabilities:
Pay roll and bonus	9,336.00		11,267.01
Vacation fund	2,476.00		2,816.00
		11,812.00		14,083.00
Capital stock		150,000.00		55,000.01
Surplus		102,722.03		101,987.60
		301,073.14		308,765.49

For the year ended March 31, 1921, Moses received $12,000 salary and Rosenthal received $10,000 salary. They performed all the services necessary for running the business. Each received in addition 2 1/2 per cent of sales as commission. The return for that year shows that they received commissions of $11,096.69 and $9,247.24, respectively. Some sales were made by Owen-Coogan, which concern also received 2 1/2 per cent of the sales.

Schedule "A" attached to petitioner's return for the fiscal year 1921 shows that Moses and Rosenthal received salaries of $9,000 and $7,500, respectively, for the fiscal year 1920. This schedule states that salaries for the fiscal year 1921 were increased in accordance with added duties and responsibilities incident to the growth of the business. This schedule also shows that they received commissions of $7,431.78 and $6,193.16, respectively. In its income and profits-tax return for the fiscal year ended March 31, 1921, petitioner showed that the total volume of sales was $973,639.41, and that the total net taxable income was $108,811.89. The total tax assessed for this year was $40,745.34.

OPINION.

LITTLETON: The question is whether there existed such abnormalities with respect to capital or income for the fiscal year ended March 31, 1921, which would bring the petitioner within the provisions of section 327 of the Revenue Acts of 1918 and 1921, and therefore entitle the petitioner to have its tax computed as provided in section 328 of the same Acts.

The basic reason which petitioner assigns for the benefit of section 327 is a favorable contract arrangement which it had with a concern to whom it sold more than 90 per cent of the product which it manufactured. We can agree that with the limited borrowing capacity at petitioner's command it would not have been possible for the petitioner to have carried on the business done without the arrangement in question or something similar or equivalent which would have enabled it to have secured the materials for the larger volume of business which it undertook after the contract in question was effected, but we are unable to see that it necessarily follows that there was an abnormality in capital or income which would permit the application of the special assessment provisions. The substance of the arrangement seems to have been that Carson, Pirie, Scott & Co. furnished materials to the petitioner which were used by the latter in the manufacture of finished goods for sale to the former on something in the nature of a cost-plus basis. The materials in question which were purchased by Carson, Pirie, Scott & Co. could be used only in the manufacture of goods to be sold to that company, and Carson, Pirie, Scott & Co. were under obligation to take the finished product. Of course, if the petitioner had been required to buy the materials in the amount and at the time they were purchased by Carson, Pirie, Scott & Co., capital would have been required, but this is not the kind of a venture in which the petitioner was engaged. The materials were purchased for the account of Carson, Pirie, Scott & Co., and that company was responsible as to the payment therefor. That Carson, Pirie, Scott & Co. billed the goods to the petitioner at cost or market, whichever was lower, would not seem to be very material, for the reason that the petitioner billed the finished goods to Carson, Pirie, Scott & Co. on the basis of a normal profit on manufacturing. The contract was, of course, advantageous to the petitioner in the sense that it gave to the petitioner a supply of materials without an outlay of capital, and also gave to it an almost certain profit without the risk incident to the purchase of materials on its own account. But there is nothing to indicate that the transaction was not likewise advantageous and desirable from the standpoint of Carson, Pirie, Scott & Co. The latter company desired the product which the petitioner had been manufacturing and by this arrangement or contract, it was enabled to insure, in a large measure, the necessary finished goods at what might be termed a maximum cost, taking the risk that there might be a drop in the price of the materials purchased. The credit arrangements between the two companies amounted to little more than that the petitioner would not ordinarily be called upon to pay for the piece goods prior to the time when it could expect payment for the finished product.

While the foregoing arrangement may be unusual as to the exact manner in which it was effected, and also unusual to the petitioner in that its business had heretofore been conducted in a different manner, it is not unusual for one concern to manufacture for, and supply to, another concern all or a designated part of its output. And we think it would be going far beyond the intendment of Congress to say that, because the manufacturing concern was not required to lay out capital for the purchase of materials required in its operations, there is an abnormality as to capital in that there is capital being furnished from another source which is not recognized in the manufacturing concern's statutory invested capital. Not only was this unrecognized capital not that of the petitioner, but also it was not required by it in its operations as carried on. Nor was it in any sense borrowed capital, since Carson, Pirie, Scott & Co. were responsible for the payment for the goods and not the petitioner. The evidence does not indicate other than that the recognized capital of petitioner for invested capital purposes was a normal invested capital for a business carried on in this manner. The fact that the income was high on such an invested capital is not material. In , where special assessment was denied in a case similar to the one now before us, the Board said:

The proximity of the petitioner's plant to that of Spang-Chalfant & Co. enabled it to secure its raw material upon very short notice, wherefore it was unnecessary for petitioner to carry any substantial inventory. It also purchased its supplies from Spang-Chalfant & Co. upon credit terms which enabled it to ship its finished product to its customers and receive the purchase price from them before it became liable to pay Spang-Chalfant & Co. The petitioner's witnesses estimate that if the petitioner had been situated farther from a source of supply of its raw materials and had been required to pay for its goods upon the usual credit terms, it would have required from $300,000 to $350,000 more capital. These favorable conditions may indicate good management and may have resulted in substantially larger income than could have been hoped for under less favorable conditions, but in our opinion they do not create abnormalities in either the capital or income. Section 327 of the Act expressly provides that it shall not apply to any case in which the tax is high merely because the corporation earns a high rate of profit upon a normal invested capital. The record leads us to believe that this was the situation of the petitioner. No two businesses can be alike in all their factors. Each is bound to have certain favorable or unfavorable conditions as compared with others. It was not to such things as these that Congress had reference in the use of the word abnormalities in section 327, but rather to those situations where by reason of some peculiarity in the corporate structure, invested capital was unusually small as compared with the total capital employed in the business or income was affected by some unusual circumstance. . Here none of such circumstances existed.

The further contention is made that special assessment should be allowed for the reason that the salaries paid the officers were low. One of the officers, who was also one of the two principal stockholders, testified that a reasonable salary for the two officers as to whom evidence was submitted would have been between $40,000 and $50,000. Their salary for the year before us was $22,000, and in addition they received commissions in the sale of goods amounting to $20,343.93, or a total of $42,343.93. The salary of the same two officers in the previous year was $16,500 which, when added to commissions paid to them in that year, made a total of salaries and commissions of $30,124.94. The schedule attached to the return and submitted in evidence states that the increases in salaries for 1921 over 1920 were made in accordance with added duties and responsibilities incident to the growth of the business. The evidence submitted as to salaries paid for similar services in the same industry is insufficient to show that the salaries paid to petitioner's officers were low as compared to those generally paid in the industry. Obviously, we are unable to say that grounds for the application of the special assessment provisions exist on account of such conditions. .

Reviewed by the Board.

Judgment will be entered for the respondent.

TRAMMELL dissents.