Lanzit Corrugated Box Co. v. Commissioner , 29 T.C. 330 ( 1957 )

Lanzit Corrugated Box Co., Petitioner, v. Commissioner of Internal Revenue, Respondent

Lanzit Corrugated Box Co. v. Commissioner

Docket No. 39085

United States Tax Court

29 T.C. 330; 1957 U.S. Tax Ct. LEXIS 39;

November 20, 1957, Filed

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">*39

Decision will be entered for the respondent.

Petitioner, a manufacturer of paper boxes, seeks relief under section 722 (b) (4), I. R. C. 1939, based upon a change in character resulting from an increase in its capacity for operation and production which occurred partly during the base period and to which it was partly committed during the base period. Held, petitioner has not shown a change in character within section 722 (b) (4) because it has failed to show that capacity for operation and production was a bottleneck; and it has failed to show that with increased capacity it would have captured additional business in its competitive area. It has also failed to show that with application of the push-back rule its labor savings resulting from its increased capacity would in turn have resulted in greater average base period net income than that with which it is credited by respondent under section 713 (f).

Morris W. Needlman, Esq., for the petitioner.

David H. Nelson, Esq., for the respondent.

Withey, Judge.

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WITHEY

">*330 The Commissioner has denied petitioner's timely application for relief and its claim for refund with respect to its excess profits tax for the years ended December 31, ">*40 1941 through 1945. The issue for our decision is whether petitioner's average base period net income is an inadequate measure of its normal earnings during that period because of a change in the character of its business within the meaning of section 722 (b) (4), I. R. C. 1939. Other issues raised by the pleadings have been abandoned by petitioner.

FINDINGS OF FACT.

Stipulated facts are found.

Petitioner was incorporated in Illinois in 1913 and its corporation income and excess profits tax returns for the years 1940 through 1945 were filed with the collector of internal revenue for the first district of Illinois.

Petitioner is entitled to compute its excess profits tax for the years at issue under section 713 of the 1939 Code.

">*331 Petitioner's excess profits net income for each of the taxable years 1941 through 1945, computed under section 711 of the 1939 Code, is as follows:

	Income method
Year	(sec. 711 (a) (1))
1941	$ 334,088.92
1942	301,157.15
1943	466,013.89
1944	412,086.08
1945	311,989.54

Petitioner's excess profits net income for each of the base period years, as finally determined by the Commissioner without the application of section 722 of the 1939 Code, is as follows:

1936	$ 158,108.91
1937	129,939.84
1938	139,315.94
1939	152,754.99
Arithmetic average	145,029.92

Petitioner's ">*41 average base period net income and excess profits credit (95 per cent of ABPNI), computed pursuant to the provisions of section 713 (f) of the 1939 Code for each of the taxable years 1941 through 1945 are $ 147,041.01 and $ 139,688.96, respectively.

Petitioner's excess profits tax liability for each of the taxable years 1941 through 1945, as finally determined by the Commissioner without the application of section 722 of the 1939 Code, is as follows:

1941	$ 76,176.70
1942	140,821.37
1943	289,192.44
1944	224,349.53
1945	138,766.99

The petitioner contends on brief that for the taxable years 1941 through 1945 it is entitled to a constructive average base period net income of $ 252,273.25 and a constructive excess profits credit of $ 239,659.59.

Since 1913 petitioner has been in the business of manufacturing corrugated paper boxes to its customers' specifications. The "heart and soul" of its manufacturing operation, to which all prior and subsequent steps in manufacture are dependent, is a corrugating machine. Two such machines are here involved, a machine capable of processing a sheet of paper 63 inches in width and another capable of processing a sheet 85 inches in width. A 63-inch corrugator was ">*42 the only such machine in operation in petitioner's plant during the base period. ^{29 T.C. 330">*332 During the base period it was committed to a course of action which resulted in 1940 in its acquisition and placing in operation of an 85-inch corrugator. During the base period and the years at issue petitioner sold over 75 per cent of its product to customers within an area comprised of the city of Chicago, the northern half of Illinois, and the industrial area bordering the southern shore of Lake Michigan. The area is known in petitioner's industry as zone 9.}

Petitioner's business has since its inception been seasonal, corresponding in its variation with that of its customers. Due to the inordinate space required for storage of its finished product, it is inefficient and uneconomical for petitioner to manufacture paper boxes for stock in advance of the orders of customers. Petitioner's monthly production of corrugated paper used in its product, expressed in thousands ">*43 (M) of square feet and the hours of running time of the 63-inch corrugator necessary to produce the same, was for the base period as follows:

	1936		1937		1938		1939
	M square	Hours	M square	Hours	M square	Hours	M square	Hours
	feet		feet		feet		feet
Jan	10,432	429	11,030	438	9,234	363	11,637	394
Feb	9,342	394	13,213	467	10,195	392	12,712	427
Mar	10,193	411	15,336	532	11,974	452	15,973	495
Apr	10,267	403	14,074	487	12,506	439	14,088	438
May	11,397	442	12,925	451	11,141	427	15,746	479
June	10,676	417	12,364	455	11,024	428	13,550	448
July	11,191	441	9,906	372	9,159	360	11,347	375
Aug	11,575	461	12,358	434	12,175	452	15,277	485
Sept	13,626	499	13,000	440	14,587	471	16,236	466
Oct	14,968	541	12,923	451	15,280	516	21,240	568
Nov	13,588	498	9,929	388	12,209	486	18,890	537
Dec	11,818	461	7,373	320	11,283	415	12,377	418
Total	139,073	5,397	144,431	5,235	140,767	5,201	179,073	5,530

Note: The foregoing includes production on petitioner's 63-inch double-face machine only since a 63-inch single-face unit accounted for such an insignificant part of the total output.

Petitioner, because its production was limited by orders, experienced no difficulty in disposing of its base period production to its customers. Its chief competitors were in zone 9 and consisted of 8 corrugated box plants operated by 6 separate companies or corporations. ">*44 It did not compete to a significant extent with other paper box manufacturers outside zone 9 for the reason that the bulk of its product made shipping costs to any but closely situated customers uneconomical. This is true throughout the industry.

In 1937 petitioner entered upon a course of action which, in July 1938, resulted in an increase in its productive capacity. It purchased, renovated, and put into use additional storage space for its raw materials which permitted the storage and use of rolls of paper of greater diameter, width, and therefore weight than it had theretofore ">*333 been able to store. The addition of an overhead crane and floor tracking permitted the mechanical transfer of larger rolls of paper fiber from stock to the corrugator, whereas prior thereto such transfer of stock had been done by hand. A new and larger steam boiler and the plumbing incidental thereto was installed, which permitted increased steam pressure to be used in the 63-inch corrugator and was sufficient to furnish adequate pressure also to an 85-inch corrugator when it should be installed. The increased steam pressure resulted, upon its being put into use in July 1938, in an increase in the capacity ">*45 of the 63-inch corrugator to produce corrugated board.

The additional storage space was provided when petitioner purchased certain land and buildings in 1937 which were adjacent to its manufacturing plant. It was sufficient to provide space for the installation of the 85-inch corrugator and the reinstallation of the 63-inch machine alongside, both of which installations were completed and put into operation in 1940. Prior to any alteration or repair of such land and buildings for manufacturing purposes, however, two of such buildings were renovated and repaired by petitioner during 1937 for rental to others. As soon as the repairs could be made, the buildings were rented during the base period at a total rental of about $ 30,000 per year. The repairs to the buildings which were rented were completed at a cost to petitioner of $ 109,745.06.

In the 2 taxable years immediately prior to and during the first 3 years of the base period, the petitioner distributed dividends to its stockholders as follows:

Dec. 27, 1934	$ 60,000 in cash
Dec. 27, 1934	440,000 in stock
Dec. 28, 1935 80,000 declared
Dec. 31, 1936	20,000 in cash
1937	80,000 in cash
1938	60,000 in cash

At approximately the ">*46 same time 1937 and 1938 dividends were paid, amounts in excess thereof were borrowed from petitioner's stockholders and its available cash was not depleted by those dividend payments.

In addition to land and buildings which it purchased in 1928, 1936, and 1937, petitioner also purchased various parcels of improved real estate in Chicago and vicinity in 1934 and 1935 at a cost of $ 209,687.63. In 1934 it purchased a mortgage on improved real estate in Forest Park, Illinois, for $ 12,682.74 to which it acquired full title by deed in 1939 by paying an additional $ 500. None of the aforementioned real estate was in any manner used in petitioner's manufacturing ">*334 operations but the properties consisted variously of a gasoline station and stores with apartments overhead and another group of apartment buildings. All of these properties were distributed to the shareholders in 1940 and 1941 as taxable dividends. Petitioner received gross rentals from its factory buildings not put to its own use between December 31, 1928, and January 1, 1940, in the amount of $ 168,634.08.

Petitioner's surplus account increased steadily from $ 188,298 as of December 31, 1935, to $ 417,010 at December 31, 1939. ">*47 From 1934 to and including 1938, petitioner paid cash dividends to shareholders aggregating $ 300,000.

In 1928 petitioner had purchased for its factory a parcel of real estate in Chicago, Illinois, comprising a portion of a square block, from National Malleable and Steel Castings Co. Although the rest of the square block was available, it was not then purchased by petitioner because the property purchased was considered to be adequate for petitioner's needs. A small adjoining building was purchased in 1936. As part of the consideration for the 1928 purchase, petitioner signed a mortgage on the property amounting to $ 173,743.37. Of this, the sum of $ 153,743.37 was due on December 26, 1938. An extension of this mortgage was obtained by petitioner prior to the due date or it was assured of such extension prior to that date.

On August 8, 1939, petitioner placed an order for the purchase of an 85-inch corrugator which was installed and placed in operation in April 1940. The installed cost of the corrugator, together with its auxiliary equipment, was about $ 89,000. Petitioner's financial position throughout the base period was such that, had it seen fit to do so, it could have acquired ">*48 the 85-inch corrugator and its incidental equipment at any time.

During the base period and until the trial herein the petitioner operated its plant in two shifts. During seasonal peaks in the base period it operated the 63-inch corrugator in fairly standard shifts of 10 hours each. However, on occasions the shifts were of 11 or 12 hours each. In times of off-peak demand during the base period the petitioner usually operated in 9-hour shifts.

Industry corrugated shipments during the years 1936 to August 1939 reached a high weekly average of 645,138 thousand square feet in the month of March 1937. This average was exceeded by the industry after July 1939, as follows:

Month	M square feet
August	662,908
September	731,377
October	828,231
November	705,369

">*335 The industry usually experiences a seasonal decline in the month of December.

Over a long period of time there was a trend in the industry toward the use of larger corrugating machines. This trend was to some extent influenced by changes in the width of the papermaking machines. The 85-inch machine made possible the manufacture of large boxes for packing large or bulky items from one sheet, whereas, when run on smaller corrugators, such boxes ">*49 sometimes had to be made from two sheets fastened together with a taped joint.

The following table shows petitioner's combined monthly ^{each of these machines for 1941:}

		1941
	1940	M square feet
	M square
	feet
		Total	63"	85"
Jan	14,909	20,330	5,807	14,523
Feb	16,647	20,058	5,555	14,503
Mar	14,924	22,594	6,533	16,061
Apr	15,576	27,084	10,691	16,393
May	17,219	25,430	10,051	15,379
June	15,792	25,785	10,089	15,696
July	15,183	26,571	10,364	16,207
Aug	18,829	25,980	8,998	16,982
Sept	19,855	28,363	11,451	16,912
Oct	23,738	30,652	13,816	16,836
Nov	21,489	25,716	10,312	15,404
Dec	22,265	28,621	12,816	15,805
Total	216,426	307,184	116,483	190,701

Petitioner's employees were not sufficiently trained in the use of the 85-inch corrugator to obtain its normal efficient output until the latter part of 1940, at which time its normal capacity reached 60 to 65 thousand square feet per hour.

For the years beginning January 1, 1936, through December 31, 1943, petitioner's gross monthly production of corrugated box material expressed in thousands (M) of square feet, its monthly cost of labor in connection with its "corrugation 1957 U.S. Tax Ct. LEXIS 39">*50 center," and its monthly labor cost per thousand (M) square feet of production was as follows: ">*336

	1936
			Corrugator
	Gross	Corrugator	center
	production M	center	labor cost
	square feet	labor cost	per M
			square feet
Jan	10,445	$ 1,136.26	$ 0.1088
Feb	9,345	1,056.82	.1131
Mar	10,196	1,078.33	.1058
Apr	10,267	1,099.52	.1071
May	11,401	1,153.14	.1011
June	10,683	1,136.16	.1063
July	11,193	1,220.36	.1090
Aug	11,582	1,280.18	.1105
Sept	13,627	1,383.44	.1043
Oct	14,983	1,537.59	.1026
Nov	13,592	1,496.28	.1101
Dec	11,821	1,441.93	.1220
Total	139,135	15,020.01
	1938
Jan	9,235	$ 1,182.01	$ 0.1280
Feb	10,196	1,250.87	.1227
Mar	11,976	1,430.05	.1194
Apr	12,509	1,388.32	.1110
May	11,148	1,359.84	.1220
June	11,027	1,356.17	.1230
July	9,159	1,123.46	.1227
Aug	12,176	1,428.50	.1173
Sept	14,589	1,565.99	.1073
Oct	15,281	1,662.67	.1088
Nov	12,210	1,399.96	.1146
Dec	11,287	1,295.61	.1148
Total	140,793	16,443.45	1 .1168
	1940
Jan	14,975	$ 2,172.32	$ 0.1451
Feb	16,699	2,301.33	.1378
Mar	14,992	2,342.85	.1563
Apr	15,619	2,428.73	.1555
May	17,223	2,237.41	.1300
June	15,799	2,055.08	.1301
July	15,211	1,793.85	.1179
Aug	18,864	1,873.84	.0993
Sept	19,903	1,905.58	.0957
Oct	23,945	2,184.66	.0912
Nov	21,489	1,911.86	.0890
Dec	22,317	2,000.72	.0896
Total	217,036	1, 2 .1161
	1942
Jan	28,324	$ 2,765.55	$ 0.0976
Feb	23,628	2,451.99	.1038
Mar	25,876	3,087.39	.1193
Apr	24,525	2,733.42	.1115
May	19,120	2,315.04	.1211
June	16,154	1,865.50	.1155
July	15,907	2,061.24	.1296
Aug	16,174	2,058.92	.1273
Sept	17,817	2,116.14	.1188
Oct	20,605	2,314.49	.1123
Nov	19,406	2,242.32	.1155
Dec	20,855	2,278.08	.1092
Total	248,391	28,290.08	1 .1139

">*51

	1937
			Corrugator
	Gross	Corrugator	center
	production M	center	labor cost
	square feet	labor cost	per M
			square feet
Jan	11,030	$ 1,339.19	$ 0.1214
Feb	13,214	1,412.91	.1069
Mar	15,336	1,676.09	.1093
Apr	14,075	1,570.04	.1115
May	13,290	1,447.83	.1089
June	12,671	1,572.65	.1241
July	9,968	1,228.77	.1233
Aug	12,390	1,395.59	.1126
Sept	13,001	1,421.26	.1093
Oct	12,925	1,442.52	.1116
Nov	9,932	1,241.48	.1250
Dec	7,378	1,038.35	.1407
Total	145,210	16,786.68	1 .1156
	1939
Jan	11,643	$ 1,195.97	$ 0.1027
Feb	12,714	1,320.23	.1038
Mar	15,974	1,444.91	.0904
Apr	14,093	1,408.52	.0999
May	15,749	1,492.78	.0948
June	13,553	1,428.08	.1054
July	11,351	1,187.09	.1046
Aug	15,278	1,517.49	.0993
Sept	16,370	1,477.26	.0902
Oct	21,300	1,940.41	.0911
Nov	19,004	1,897.75	.0999
Dec	12,524	1,411.32	.1127
Total	179,553	17,721.81	1 .0987
	1941
Jan	20,480	$ 1,921.24	$ 0.0938
Feb	20,227	1,804.99	.0892
Mar	22,751	1,974.22	.0868
Apr	27,301	2,570.64	.0942
May	25,527	2,443.82	.0957
June	25,813	2,554.59	.0990
July	26,606	2,413.89	.0907
Aug	26,045	2,620.45	.1006
Sept	28,411	2,821.56	.0993
Oct	30,676	2,918.93	.0952
Nov	25,786	2,431.25	.0943
Dec	28,715	2,771.41	.0965
Total	308,338	29,246.99	1 .0949
	1943
Jan	19,672	$ 2,184.80	$ 0.1111
Feb	20,470	2,261.71	.1105
Mar	22,621	2,658.23	.1175
Apr	22,387	2,648.10	.1183
May	20,312	2,366.29	.1165
June	22,504	2,399.14	.1066
July	21,884	2,866.60	.1310
Aug	21,114	2,638.21	.1250
Sept	23,083	2,693.05	.1167
Oct	22,739	2,540.95	.1117
Nov	21,813	2,547.48	.1168
Dec	23,163	2,663.45	.1150
Total	261,762	30,468.01	1 .1164

">*52

">*337 During the base period petitioner's income was not impaired by a lack of operating or productive capacity. As of December 31, 1939, it had reached its normal level of earnings for the base period.

Petitioner's actual average base period net income is an adequate standard of its normal base period earnings.

OPINION.

Petitioner claims qualification to reconstruct its base period net income for the purpose of determining its excess profits tax for the years at issue under section 722 (b) (4), I. R. C. 1939, because of a change in the character of its business during the base period. The claimed change in character, it contends, occurred because of an increase in its capacity for operation and production, part of which increase took place within the base period and to part of which it was committed during the base period resulting in an increase in capacity which, had it taken place 2 years prior, would in turn have resulted in increased average base period net income, thus affording it tax relief with respect to its excess profits ">*53 taxes here in issue. Respondent now concedes an increase in petitioner's capacity for production which took place and was put into operation in July 1938 and, further, that during the base period it was committed to a course of action which resulted in a further increase in capacity through the installation in 1940 of an 85-inch corrugating machine in its manufacturing plant. However, respondent insists that such increases in capacity even had they taken place 2 years prior to the date of the two installations would not have resulted in increased base period net income but instead would have resulted in decreased base period net income because of increased cost of such installations and depreciation and cost of operation thereof. In this connection he relies upon National Grinding Wheel Co., 8 T.C. 1278; Green Spring Dairy, Inc., 18 T.C. 217, affd. (C. A. 4, 1953) 208 F.2d 471; Farmers Creamery Co. of Fredericksburg, Va., 18 T.C. 241; and Schneider's Modern Bakery, Inc., 19 T.C. 763. In those cases this Court followed the principle that an increase in capacity for operation or production which did not or would not lead to increased base period net income is not a change in the ">*54 character of a taxpayer's business within the meaning of section 722 (b) (4) which would qualify it to reconstruct its base period net income. We think the cases have application here.

Petitioner's business was seasonal and there is no indication in the record but that its existing capacity during the base period before any increase thereof was sufficient, with slight exception, to meet the peak demands of its sales activities. In July 1938, it put into operation a new steam boiler and the necessary plumbing in connection therewith to attach it to its existing 63-inch corrugator. This installation ">*338 permitted an increase in its speed of production of corrugated board. However, even after the installation of the boiler, the increased capacity was used in less than half the remaining months of the base period. During such months as the production exceeded the peak production prior to such installation, such excess production was not sufficient in amount to render petitioner's actual base period experience an inadequate measure of normal production, particularly in view of the fact that its base period net income has been determined under section 713 (f). That section is designed to ">*55 give due consideration to the natural growth of the taxpayer and affords adequate relief from excess profits tax where mere technological growth has taken place as distinguished from a change in character. Petitioner's claimed change in character is in reality a technological growth.

In our view petitioner has failed in its proof with respect to its base period market. Even assuming that it did not arrive at its normal level of income which might be expected from the sale of its product in view of its increased capacity, it has failed to convince us that it would have been able at any time during the base period to capture from its competitors sufficient additional sales to have resulted in increased income attributable to such increased capacity. The proof petitioner has offered with respect to market conditions in its industry during the base period relates to the sales and production experience of some 21 paper box manufacturers, other than itself, located within an area in the United States roughly east of the Mississippi River. Six of the 21 companies referred to are within zone 9, which is the area within which petitioner made more than 75 per cent of its sales during the ">*56 base period. The area consists of the city of Chicago, the northern half of the State of Illinois, and the industrial area bordering the southern tip of Lake Michigan. Within that area the 6 companies or corporations, other than petitioner, operate 8 paper box factories. These 8 factories constitute petitioner's main competition. To all but an inconsequential extent, petitioner does not compete with the remaining 15 paper box manufacturers above referred to for the reason that the bulk of its product when shipped to customers any appreciable distance from its plant makes such shipments uneconomical because of the excessive freight rates involved. In fact this is true of its entire industry. Nowhere does it appear that with its existing capacity prior to July 1938 petitioner ever lost a customer because of inability to fulfill his order for paper boxes. It is significant too that had petitioner needed additional productive capacity in order to obtain any new customers during the base period it was financially able to acquire it. After July 1938, when the new and more powerful steam boiler had been attached to the 63-inch corrugator, there is no indication that such increased capacity ">*57 led to the acquisition of any new customers. ">*339 Indeed, during most of the remainder of the base period its plant was operated below its capacity existing prior to that time. The increase in petitioner's capacity permitted an increase in its base period income but did not cause such increase. Green Spring Dairy, Inc., supra.

Petitioner makes claim for increased average base period net income on the basis of a reduction in its labor cost. Due to the fact that with application of the push-back rule petitioner from April 1938 would have produced its actual square footage of paper box material with 15 employees in one-third the time actually required, it follows that its labor cost would have been reduced to an extent. However, we are unable to find from this record that such reduction in labor cost would have resulted in increased net income to an extent which would exceed the allowances already granted by respondent under section 713 (f). We are impressed too that if depreciation upon the new equipment is considered, its savings through reduction in labor cost would be considerably less although we are given no explicit evidence with respect to the depreciation actually taken by petitioner ">*58 upon its new equipment.

It follows that petitioner has failed to demonstrate that its increased capacity for operation and production during the base period even with the application of the push-back rule with respect to installation of the 85-inch corrugator would have resulted in increased base period net income. We therefore conclude that petitioner has failed to show that its actual average base period net income is an inadequate standard upon which to determine its excess profits taxes for the years 1941 through 1945.

Reviewed by the Special Division.

Decision will be entered for the respondent.

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Footnotes

• 1. The machine referred to is a "double-face" corrugator. Actually it was operated in conjunction with a "single-face" 63-inch corrugator but the production from the latter was comparatively so insignificant as to be of no moment here.↩

• 1. Paid in 1936.↩

• 2. Figures are not available for each of the machines separately in 1940.↩

• 1. Average.↩

• 2. Corrugator center labor costs for a portion of the year 1940 were not normal because of a breaking-in period required for the new 85-inch corrugator.↩