Harry Lang Mfg. Co. v. Commissioner , 19 T.C. 567 ( 1952 )

Harry Lang Manufacturing Company, Petitioner, et al., ^{Harry Lang Mfg. Co. v. Commissioner}

Docket Nos. 26689, 25640, 25641

United States Tax Court

19 T.C. 567; 1952 U.S. Tax Ct. LEXIS 6;

December 30, 1952, Promulgated

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Decisions will be entered for the respondent.

Petitioners were organized after December 31, 1939. During the taxable year they were engaged exclusively in the production of coveralls under Government contract for the armed forces. Petitioners filed claims for relief under section 722 (c) (1) and (3), I. R. C., for the taxable year ending June 30, 1944. Held, petitioners are not entitled to any relief under section 722 (c) because they have failed to establish a constructive average base period net income within the framework of section 722 (a).

Sidney Gelfand, for the petitioners.

Arthur B. White, Esq., for the respondent.

Harron, Judge.

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HARRON

The issue for decision is whether the Commissioner erred in disallowing the application of the petitioners for relief from excess profits tax for the fiscal year ended June 30, 1944, under the provisions of subsections (1) and (3) of section 722 (c) of the Code.

FINDINGS OF FACT.

The petitioners are Minnesota corporations. Their principal office is located in Minneapolis, Minnesota. Federal tax returns were filed with the collector for the district of Minnesota.

The petitioners were incorporated June 16, 1943, to take over the overall and coverall manufacturing operations, then being conducted by Harry Lang, individually (hereinafter referred to as Lang), under the name of H. Lang Company, at River Falls, Wisconsin, Des Moines, Iowa, and Minneapolis, Minnesota.

Lang had extensive experience, over a period of more than 20 years, in the manufacture of overalls and had organized and controlled several corporations for that purpose, prior to beginning operations as an individual. He organized H. Lang & Co., Inc., about 1927. From 1930, until the corporation went into receivership in early 1938, it manufactured overalls in a rented building at River Falls, Wisconsin. The machines and equipment used in the operation were owned by the corporation. During the period 1927 to 1938, H. Lang & Co., Inc., realized a profit in only four years, ^{*9 conducted their operations on a "complete garment" basis, i. e., they supplied all the material used in the making of the garments.}

In the latter part of 1940 or early 1941, Lang began securing U. S. Government contracts for the production of military coveralls for the armed forces. In order to increase his production capacity, Lang, during 1941, purchased additional machines for use in the River Falls building, and in December of 1941, purchased a building in Des Moines, Iowa, at a cost of $ 25,000 with a down payment of $ 250, and leased a vacant school building in Minneapolis, Minnesota. Lang sublet part of the school building in Minneapolis. After purchasing the necessary machines and equipment, he began producing overalls and coveralls at Des Moines and Minneapolis, in addition to his operations at River Falls.

Building space is easily adapted to the garment manufacturing operation conducted by Lang. The equipment used requires no major installation and consists principally of sewing, buttonhole, cutting and similar machines, usually installed on work tables.

The petitioners commenced business on July 5, 1943, with a taxable year ending June 30, 1944. Petitioner, Harry Lang Manufacturing Company, took over Lang's operations at River Falls, Wisconsin, assuming the leases of the building and equipment. Petitioner, Langwear, Inc., took over the operations at Des Moines, Iowa, and acquired the building there, purchased by Lang. Petitioner, Lang Industries, Inc., took over the operations at Minneapolis, Minnesota, assuming the lease of the building.

Lang received in exchange for the assets he transferred, all of the capital stock of each of the corporations, except qualifying shares. The assets transferred consisted principally of machines, equipment and inventories, and in the case of Langwear, Inc., a building which Lang had purchased in December, 1941, at a cost of $ 25,000, making a down payment of $ 250. Capital stock was issued on the basis of the market value of the properties transferred, or the net sound value based upon an appraisal. The capital stock issued, and the adjusted basis of the assets transferred to each corporation were as follows:

	Capital stock	Adjusted basis
	issued upon	of assets
	organization	transferred
Harry Lang Mfg. Co	$ 50,400	$ 34,691
Langwear, Inc	88,200	32,139
Lang Industries, Inc	39,000	24,365

Lang assumed the positions of president, treasurer and manager of each corporation. He continued to act individually, under the name of H. Lang Company, as a prime contractor, securing U. S. Government contracts and subletting the production of the garments to petitioners. In addition to his salary as an officer of each of the petitioners, Lang received income of $ 44,279 during the year 1944, as prime contractor on Government contracts.

From the date petitioners commenced business (July, 1943) and throughout the taxable year ending June 30, 1944, they were engaged exclusively in war work, producing one piece, herring-bone twill coveralls, under U. S. Government contract for the armed forces. The manufacturing process of petitioners consisted of cutting the material, sewing the garments and putting on the trim according to military specifications. All the material for the garments was furnished by the Government, with the exception of trim which consisted of thread, buttons and similar items.

Where the cloth is furnished by the customer, the process, performed by the fabricator, is a "cut, make and trim" operation, and is commonly referred to in the trade as "contract work". A producer on a "contract work" basis is primarily a contractor of labor.

All war contracts for the manufacture of military clothing were let on a "contract work" basis.

The petitioners employed in their operations during the taxable year a "straight line" method of production which was designed by Lang to secure maximum efficiency and production. The straight line system of production was not used in the base period years by either H. Lang & Co., Inc., or by Lang individually.

The Government contracts under which petitioners performed in the taxable year were not secured on the basis of competitive bidding but were negotiated.

The petitioners produced a total of 1,011,794 coveralls during the taxable year.

After renegotiation, the petitioners' sales, net income, excess profits credit and excess profits tax liability for the taxable year ending June 30, 1944, were as follows:

	Sales (receipts		Excess	Excess
	under	Normal tax	profits	profits
	contracts)	net income	credit	tax
Harry Lang Mfg. Co	$ 557,360	$ 57,509	$ 3,402	$ 36,730
Langwear, Inc	305,213	32,033	3,399	19,972
Lang Industries, Inc	305,813	30,076	2,360	13,672

In 1941, a shortage of available capacity for the production of military clothing existed. Many steps were taken at the time by the Government procurement authorities to develop additional sources of supply. Before commencing his operations at Des Moines and Minneapolis, Lang had been asked, by the procurement officers, to take what steps he could to increase his production of coveralls.

It was only after the occurrence of the war emergency that "contract work" in the garment industry subgroup in which petitioners' products fall, became available in any substantial volume, in the areas in which petitioners operated.

For the year 1939, the total dollar value of garment manufacturing performed on a "contract work" basis, as reported in the Census of Manufacturers -- 1939, in the garment industry subgroup into which petitioners' products fall, for the United States as a whole, and for the States of Iowa, Minnesota, and Wisconsin, was as follows: United StatesIowaMinnesotaWisconsin1939$ 3,383.241$ 21,550$ 5,151$ 7,278

During the base period years garment fabricators in the south enjoyed a competitive advantage over northern operators due principally to the prevailing difference in wage rates.

The "straight line" system of production employed by petitioners could only be profitably utilized in periods of high and continuous production, and the system could not offset the higher labor cost of the north so as to overcome the competitive advantage of the south.

The petitioners could not have secured any substantial volume of "contract work" in the base period years, from organizations with national outlets, such as Butler Brothers, Montgomery Ward & Co., Sears Roebuck & Co., and J. C. Penney Co. The companies mentioned were either not purchasing any garments of the kind in question on a "contract work" basis, or were purchasing the bulk of their requirements from southern firms which could produce profitably at a lower cost due to the prevailing difference in wage rates between the areas.

The petitioners' reconstruction of earnings is based on the assumption that they could have secured a volume of business equal to at least 75 per cent of that realized in the taxable year. Further assumptions, as to the amount of direct labor cost, and normal profit to be realized which is expressed as a percentage of direct labor cost or as a fixed rate per dozen garments produced, are then made. The petitioners' reconstructions are based on the actual production levels achieved during the taxable year.

Applications for relief, under the provisions of section 722 (c) (1) and (3), for the taxable year ending June 30, 1944, were duly filed by petitioners. Respondent disallowed in full the petitioners' applications for relief.

Petitioners are not entitled to any relief from their excess profits tax liabilities for the taxable year ending June 30, 1944, under any of the provisions of section 722 (c) of the Internal Revenue Code.

OPINION.

The petitioners were organized after December 31, 1939, and they are, therefore, required by section 712 (a) section 722 (c) (1) and (3) of the I. R. C.section 722 (c) (1), the extensive experience, production skill, contacts and established reputation in the trade, of their common president and principal stockholder, Harry Lang. Petitioners contend they qualify under section 722 (c) (3) because they secured plant buildings on unusually favorable terms, and acquired machinery that had a tax basis substantially less than market value on date of acquisition. Also, that petitioner, Harry Lang Manufacturing Company, leased some machinery used in its operations.

Respondent denies that petitioners qualify under section 722 (c) (1) or (3), and contends that, even if petitioners are held to qualify under section 722 (c), relief must be denied because petitioners have failed to establish a constructive average base period net income within the framework of section 722 (a).

In order to secure relief under section 722 (c), a taxpayer must not only prove that it is qualified for relief under one of the provisions of such subsection, but must also establish a fair and just amount representing normal earnings, for use as a constructive average base period net income, within the requirements of section 722 (a). Crowncraft, Inc., 16 T. C. 690, 695, 696; Tin Processing Corporation, 16 T. C. 713, 722; Danco Co., 14 T. C. 276, 282.

We need not decide the question of whether the petitioners qualify under section 722 (c) (1) or (3), for, even if we assume the existence of qualifying factors, the petitioners have failed to demonstrate that they are entitled to relief within the framework of section 722 (a).

Petitioners, throughout the taxable year, were engaged exclusively in war work producing military coveralls or fatigue uniforms under Government contracts. Petitioners performed what is called by the trade "contract work," a cut, make and trim operation, with the cloth furnished by the Government. Plants were located in Iowa, Minnesota, and Wisconsin.

Petitioners, in their reconstruction of normal earnings for the base period, make the assumption that they could have secured a volume of business in the base period years equal to at least 75 per cent of that realized in the taxable year 1944. They, then, make additional assumptions about the amount of direct labor cost, and normal profit to be realized, which is expressed as a percentage of direct labor cost, or as a rate per dozen of garments produced. The petitioners' reconstructions are based on the actual production levels achieved during the taxable year 1944 when the volume of production was the result of war time demand and production capacity was under the strain of war time contracts.

While any relief under section 722 must be based upon assumptions, due to the very nature of the relief afforded, it is incumbent upon the party seeking relief to establish some basis within the framework of section 722 (a) upon which the assumptions can be grounded. Crowncraft, Inc., supra, p. 696. In the instant case the petitioners have failed to show that they could have secured, in the base period, the volume of business necessary to support any reconstruction of earnings, even their proposed reconstruction, and that they could have operated at a profit.

A constructive average base period net income must be computed on the basis of an operation of the same type and character as that conducted in the taxable year. Tin Processing Corporation, supra, pp. 723, 724. In the taxable year 1944, the petitioners performed only "contract work," and they have offered no evidence showing the volume of "contract work" performed, or available, during the base period years in the garment industry subgroup in which their products fall. Census of Manufacturers -- 1939, indicate that, even considering a broader category of products, in the year 1939 for example, only a nominal amount of "contract work" was performed in the industry subgroup in which petitioners' products fall, in the United States as a whole, and that in the three states in which petitioners operate, the volume of "contract work" was negligible.

In contrast, net sales by the petitioners after renegotiation, for the taxable year ending June 30, 1944, were substantial, exceeding a million dollars.

It is apparent from the record that only after the occurrence of the war emergency, did "contract work" in any substantial volume become available in the areas in which petitioners operated, and this new demand was created by heavy Government buying. All of petitioners' sales in the taxable year were under Government contract.

Petitioners argue that because of the quality of their product, had they been in operation during the base period years, they could have secured a substantial volume of business from large chain or wholesale organizations with national outlets, citing specifically Butler Brothers, Montgomery Ward & Co., Sears Roebuck & Co., and J. C. Penney Co.

The evidence provides no foundation for petitioners' argument. In fact, the testimony of petitioners' witnesses serves to establish that, during the period 1936-39, the national chain companies mentioned above were either not purchasing any garments of the kind in question on a "contract work" basis, or were purchasing the bulk of their requirements from southern operators who could produce, profitably, at a lower cost than the northern firms, due principally to the prevailing differences in wage rates between the areas.

It is apparent that had petitioners been in operation during the base period they would have been at a competitive disadvantage with southern firms whose wage scales were lower. Lang admitted that the higher labor costs of the north could not be overcome by the use of the production methods employed by petitioners. This competitive disadvantage is significant in view of the fact that a manufacturer in the garment industry, operating on a "contract work" basis is primarily a contractor of labor. Petitioners have offered no evidence of the experience of other companies during the base period years. We have therefore no basis for assuming that, had petitioners been in operation during the base period, they would have been financially successful. In fact, the evidence all tends towards a contrary conclusion.

On the evidence before us, the petitioners have failed to establish what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income as required by section 722 (a). Cf. Danco Co., supra. Accordingly, the petitioners' claims for relief must be denied.

In view of the conclusion reached, it is not necessary for us to resolve other questions of law or fact raised by the parties.

Reviewed by the Special Division.

Decisions will be entered for the respondent.

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Footnotes

• 1. Proceedings of the following petitioners are consolidated herewith: Langwear, Inc., and Lang Industries, Inc.↩

• 2. 1927, $ 3,141.15; 1931, $ 2,676.95; 1933, $ 6,480.66; 1934, $ 522.92.↩

• 3. The industry subgroup, covered by Census of Manufacturers figures, includes not only coveralls and overalls, but other types of garments such as sport garments (except leather) and work pants.↩

• 4. SEC. 712. EXCESS PROFITS CREDIT -- ALLOWANCE

  (a) Domestic Corporations. -- In the case of a domestic corporation which was in existence before January 1, 1940, the excess profits credit for any taxable year shall be an amount computed under section 713 or section 714, whichever amount results in the lesser tax under this subchapter for the taxable year for which the tax under this subchapter is being computed. In the case of all other domestic corporations the excess profits credit for any taxable year shall be an amount computed under section 714. (For allowance of excess profits credit in case of certain reorganizations of corporations, see section 741.)↩

• 5. SEC. 722. GENERAL RELIEF -- CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME.

  * * * *

  (c) Invested Capital Corporations, Etc. -- The tax computed under this subchapter (without the benefit of this section) shall be considered to be excessive and discriminatory in the case of a taxpayer, not entitled to use the excess profits credit based on income pursuant to section 713, if the excess profits credit based on invested capital is an inadequate standard for determining excess profits, because --

  (1) the business of the taxpayer is of a class in which intangible assets not includible in invested capital under section 718 make important contributions to income.

  * * * *

  (3) the invested capital of the taxpayer is abnormally low. In such case for the purposes of this subchapter, such taxpayer shall be considered to be entitled to use the excess profits credit based on income, using the constructive average base period net income determined under subsection (a). For the purposes of section 713 (g) and section 743, the beginning of the taxpayer's first taxable year under this subchapter shall be considered to be that date after which capital additions and capital reductions were not taken into account for the purposes of this subsection.↩

• 6. SEC. 722. GENERAL RELIEF -- CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME.

  (a) General Rule. -- In any case in which the taxpayer establishes that the tax computed under this subchapter (without the benefit of this section) results in an excessive and discriminatory tax and establishes what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income for the purposes of an excess profits tax based upon a comparison of normal earnings and earnings during an excess profits tax period, the tax shall be determined by using such constructive average base period net income in lieu of the average base period net income otherwise determined under this subchapter. In determining such constructive average base period net income, no regard shall be had to events or conditions affecting the taxpayer, the industry of which it is a member, or taxpayers generally occurring or existing after December 31, 1939, except that, in the cases described in the last sentence of section 722 (b) (4) and in section 722 (c), regard shall be had to the change in the character of the business under section 722 (b) (4) or the nature of the taxpayer and the character of its business under section 722 (c)↩ to the extent necessary to establish the normal earnings to be used as the constructive average base period net income.

• 7. It would not help petitioners' case if they were permitted to reconstruct on the basis of a complete garment operation. Lang's companies in the base period, operating on a complete garment basis, failed to realize a profit.↩