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COASTAL EXPANDED METAL CO., INC., Petitioner
v. COMMISSIONER OF INTERNAL REVENUE, RespondentCoastal Expanded Metal Co. v. CommissionerDocket No. 16576-85.United States Tax Court T.C. Memo 1988-54; 1988 Tax Ct. Memo LEXIS 54; 55 T.C.M. 101; T.C.M. (RIA) 88054;February 18, 1988. Carolyn J. Woodruff Reed Johnston ,Alan I. Weinberg ,Frank C. McClanahan, III ,Paul G. Topolka ,KORNERMEMORANDUM FINDINGS OF FACT AND OPINION
KORNER,
Judge: In a timely statutory notice of deficiency, respondent determined a deficiency in petitioner's Federal income tax for taxable year of $ 59,333. Additionally, he determined that the underpayment of tax was due to fraud and determined an addition to tax of $ 29,667 (50 percent of the underpayment).After concessions, the issues for our consideration are: (1) Whether petitioner's December 31, 1981 inventory was understated; and (2) whether petitioner is liable for the addition to tax under
section 6653(b) section 6653(a) for negligence.1988 Tax Ct. Memo LEXIS 54">*56 FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of facts Background Findings
Petitioner was incorporated on March 13, 1970. Robert D. Battin was petitioner's president and sole shareholder during the years 1980, 1981, and 1982. Petitioner (hereinafter sometimes referred to as "CEMCO of North Carolina") is engaged in the business of manufacturing, fabricating and selling expanded metal. Mr. Battin has over 25 years of experience in the expanded metals industry.
Expanded metal is sheet metal which has been fabricated into an open mesh or weave pattern of various shapes and sizes. The process involves the use of an "expanded metal press" through which coils of carbon steel, galvanized steel, or1988 Tax Ct. Memo LEXIS 54">*57 aluminum are fed. The coil of raw material is mounted on a "decoiler" which spools out the metal to the press. The expanded metal press partially shears the material and simultaneously stretches it to form a diamond-shaped open mesh. The processing through the press causes the resulting sheets of expanded metal to be curved. To remove the curve and allow the sheets to lie flat, the material is passed through a series of offset rollers called a "level roller." Depending upon the use which will be made of the expanded metal, it may also be run through a flattening roller, or "flattener." As its name implies, the flattener flattens the expanded metal, removing the louvered surface created by the expanded metal press and in the process slightly reducing the thickness of the finished product. Approximately 80 percent of petitioner's products must be flattened.
There was, in the year in issue, no domestic manufacturer of the basic machinery used in the expanded metal process. Thus, the availability of equipment is one of the prime barriers to entering the expanded metal industry, or to expanding an existing business. There are currently only about a dozen manufacturers engaged1988 Tax Ct. Memo LEXIS 54">*58 in this business in the United States.
Mr. Battin has acquired machinery for petitioner in a variety of different ways over the years. Some pieces he acquired from bankrupt competitors. Others were adapted from similar machinery used in other industries. Although Mr. Battin has himself developed a high level of engineering skill and technical expertise over the years, he has worked closely with a business associate, Walter A. Minor, on many occasions in designing and rebuilding machinery to be used in petitioner's business.
CEMCO of Florida In the expanded metal industry, costs of shipping the finished product are a substantial production expense. In order to minimize this cost and improve petitioner's competitiveness, Mr. Battin envisioned the establishment of a number of regional manufacturing facilities across the country. To this end, Mr. Battin and Walter Minor entered into an agreement in 1978 to establish a facility near Mr. Minor's home in Pensacola, Florida, for the production of expanded metal. Mr. Minor undertook to design and build two expanded metal presses which would form the nucleus of the Pensacola operation. The vehicle for the venture would be a1988 Tax Ct. Memo LEXIS 54">*59 shell West Virginia corporation which Mr. Battin had established sometime previously pursuant to an unsuccessful prior venture. The corporation would be owned jointly by Messrs. Battin and Minor and would be renamed CEMCO of Florida. CEMCO of Florida would be strictly a manufacturing operation. Orders would be placed with CEMCO of North Carolina which would contract out the actual production work to CEMCO of Florida.
In connection with the name change and qualifying the corporation to do business in Florida, Battin and Minor engaged the services of a Pensacola attorney named Joe Hosner. Mr. Hosner's name had been provided by an officer at the Pensacola bank where CEMCO of Florida's corporate account had been established. After this initial assignment, Mr. Hosner was retained as CEMCO of Florida's attorney and provided additional legal services to the corporation from time to time.
Other Corporations Some time prior to April 22, 1980, Mr. Battin authorized Attorney Hosner to get up a group of corporations on behalf of petitioner. Petitioner, at the direction of Mr. Battin, paid Mr. Hosner $ 10,000 in advance to set up the corporations. The following corporations were1988 Tax Ct. Memo LEXIS 54">*60 then set up by Mr. Hosner: (1) Battin Enterprises, Inc., which was incorporated in the state of Florida on June 30, 1980; (2) SEMCO of Nova Scotia, Ltd., which was incorporated in the province of Nova Scotia, Canada, on July 7, 1980; and (3) Caribbean Equipment & Metals Co., Inc., (hereinafter "Caribbean") which was incorporated in Costa Rica on July 31, 1980.
The A-1 Flattener In late 1979, Mr. Battin determined that it would be advisable to acquire another flattener for petitioner. At that time petitioner was operating with only one flattener. Since 80 percent of petitioner's products required flattening, Mr. Battin realized that petitioner would virtually have to cease operations if this machine should malfunction. In early 1980, Mr. Battin located a used Farrel three-roll vertical calendar (hereinafter the "A-1 Flattener") for sale by the A-1 Chemical Company of Chicago. Mr. Battin knew that petitioner's existing flattener had been converted from a vertical calendar which had been used in the rubber industry. He felt that a similar conversion could be possible with the A-1 machine and asked Mr. Minor to accompany him to Chicago to inspect the machinery and help him1988 Tax Ct. Memo LEXIS 54">*61 determine whether a conversion was feasible. Although the machine was partially disassembled and dirty, Mr. Minor advised Mr. Battin that he felt there was a good chance the calendar could be successfully converted for use in the expanded metal industry by petitioner. Petitioner therefore purchased the calendar from A-1 on March 14, 1980 for $ 7,500.
At some time subsequent to the flattener's purchase, the quotation from A-1 Chemical Company on the A-1 Flattener, petitioner's purchase order, and the original invoice from A-1 Chemical Co. were removed from petitioner's records. In their place, a false invoice from A-1 Chemical was substituted showing the purchase by petitioner of a level roller rather than the flattener.
The A-1 Flattener was shipped to petitioner from Chicago via Superior Trucking Co., arriving at petitioner's plant on or about April 4, 1980. Guy M. Turner, Inc. contracted to assemble and anchor the machine in petitioner's plant, completing work on May 6, 1980. Messrs. Battin and Minor were initially unsuccessful in converting the machine for use in petitioner's business. While they were able to get the flattener to function satisfactorily on lighter metals,1988 Tax Ct. Memo LEXIS 54">*62 it would not flatten the heavier gauge metals which were the bulk of petitioner's business. However, in August 1980, their efforts were successful and the flattener became fully operational at all metal gauges used by petitioner.
Petitioner issued a purchase order to Caribbean dated May 14, 1980, for the purchase of a Farrel Vertical Calendar for $ 60,000. The description of the machine in the purchase order was identical to the description of the machine in the A-1 Chemical Company quotation and invoice and petitioner's purchase order issued to A-1 Chemical Company, all of which had been removed from petitioner's records. Mr. Hosner, acting on behalf of Caribbean, prepared an invoice reflecting the $ 60,000 sales price plus four percent Costa Rican sales tax for a total of $ 60,240. 1988 Tax Ct. Memo LEXIS 54">*63 year 1981, petitioner claimed $ 13,491 of depreciation deductions attributable to the Farrel Vertical Calendar it allegedly purchased from Caribbean for $ 60,240. Petitioner has conceded herein that such depreciation deductions were not allowable.
Inventory Petitioner is a calendar year, accrual basis taxpayer. Petitioner maintains inventories of raw materials, work-in-process, resale items, and finished goods. Raw materials consist of coils of carbon steel, galvanized steel, and aluminum which petitioner either purchases directly from mills or from other suppliers. Work-in-process consists of goods in various states of fabrication at the inventory cut-off date. Resale items consist of sheets of expanded metal which petitioner purchases for resale rather than manufactures itself. Finally, finished goods consist of expanded metal which has been completed and awaits sale. Since the bulk of petitioner's business consists of custom orders, finished goods inventory is rare.
Petitioner uses a periodic, rather than a perpetual, inventory accounting system for both accounting and tax purposes. The periodic system requires counting, measuring, and weighing goods at the end1988 Tax Ct. Memo LEXIS 54">*64 of the accounting period to determine the quantities on hand. Petitioner adjusts its inventory balances based on the results of a single physical count of items on hand at the close of business on December 31. The quantities on hand are then valued at the lower level of their cost or market values as of that date. A journal entry is then made on petitioner's books to adjust inventory to coincide with the results of the physical count. An offsetting entry is made to an inventory adjustment account which has the effect of increasing cost of goods sold if inventory has decreased during the year, or decreasing cost of goods sold if inventory has increased. This single journal entry is the only entry required to be made to petitioner's inventory account during the year.
Although facially satisfactory for tax purposes, the periodic inventory maintained by petitioner did not provide the timely information on raw material availability which was required in order to establish realistic production schedules. To meet this need, petitioner also maintained a production scheduling card system. A separate card was created for each category of metal utilized by petitioner. When a purchase1988 Tax Ct. Memo LEXIS 54">*65 order for a particular metal was placed by petitioner, the quantity (in pounds) ordered was added to the total shown on its card. When a customer order requiring use of metal of a specific thickness and width was received, the card for that specification was consulted to determine whether sufficient quantities of that metal were in the shop so that the order could be filled. Whenever metal was used to fill a customer order, the net weight of the finished product shipped was removed from the total on its production scheduling card. In this way, plant personnel were supposed to be able to determine the quantity of a metal of particular thickness and width on hand by referring to its production schedule card. However, the amounts of material shown on the card were estimates only. The cards consistently overstated the amount of material available. This was because the reductions made when metal was used to fill a customer's order only reduced the quantity by the net weight of the finished product shipped to the customer. The weight of any scrap waste generated in the production process was not deducted from the amount of material reflected on the card. Hence the card might reflect1988 Tax Ct. Memo LEXIS 54">*66 coil raw material as being present in the plant when, in fact, it was not.
During 1981, petitioner began experiencing problems with the accuracy of the production scheduling cards. Work orders were accepted and machinery set up to run jobs, only to find that material to run the job was unavailable even though the card indicated that it was. The breakdown in the card system was attributed to the departure of petitioner's bookkeeper, Ron Alston, at the end of 1980 due to personal problems. Mr. Alston had bee petitioner's bookkeeper for many years and had developed the production scheduling card system. During the five months subsequent to Ron Alston's termination, petitioner had three different bookkeepers. As a result of the apparent confusion generated by this high rate of turnover, maintenance of the card system came to a virtual halt.
In May of 1981, petitioner hired Joseph Iacone to be its bookkeeper. Mr. Iacone had been employed in a number of accounting and bookkeeping positions, but had no experience in the expanded metal industry. One of the first tasks assigned to Mr. Iacone was to reestablish the production scheduling card system and thereby eliminate the production1988 Tax Ct. Memo LEXIS 54">*67 bottlenecks which had been plaguing petitioner since Mr. Alston's departure. In order to accomplish this task, Mr. Iacone instructed another of petitioner's employees, Edward J. O'Connell, to conduct a physical count of petitioner's inventory on or about June 9, 1981. As a result of this physical inventory, Mr. Iacone concluded that petitioner's inventory was understated by more than $ 125,000. 1988 Tax Ct. Memo LEXIS 54">*68 During mid August of 1981, the problems associated with the production scheduling card system continued, and the inventory questions raised by Mr. Iacone remained unresolved. Accordingly, Mr. Battin hired Ron Alston, who had been calling for several weeks in search of work, on a two-week contract basis to compile an accurate inventory and to update the production scheduling card system. Mr. Alston was the individual most familiar with petitioner's accounting system and could thus also advise Mr. Battin regarding certain entries Mr. Iacone had been making in petitioner's books which were not understood. 1988 Tax Ct. Memo LEXIS 54">*69 Tucker, another of petitioner's employees, during the week of August 24, 1981. Mr. Alston's work papers indicate that he determined the value of inventory on hand at that date to be $ 130,931. He also beganm some work on the card system. However, Mr. Alston picked up his check on the afternoon of his fourth day on the job, left the plant, and has not been heard from since. When Mr. Battin returned from an out of town trip and was informed that Mr. Alston had left, he instructed Mr. Iacone to pick up where Alston had left off on the scheduling cards and to conduct a physical count of inventory as of August 31, 1981. Mr. Battin also gave written instructions that he was to receive copies of the physical inventory when complete, the word "all" being underscored twice.
With the assistance of Hylton Tucker, Mr. Iacone conducted a physical count of petitioner's inventory on August 31, 1981. First, the thickness of the metal in a particular coil was established taking a micrometer reading. Next, a tape measure was used to determine the outside and inside diameter of the coil, as well as the width of the coil. These measurements were then entered into a formula for calculating the1988 Tax Ct. Memo LEXIS 54">*70 pounds of metal in the coil. Mr. Iacone was unable to recall what this formula was. Once the measurements for a coil had been taken, a numbered inventory control card was affixed to the coil to signify that it had been counted. This procedure was then repeated for each coil. Similar procedures were followed to determine the weight of resale items and goods in process. Mr. Iacone then valued the inventory using unit values he obtained from recent supplier invoices. His total inventory value at August 31, 1981 was $ 164,225. 1988 Tax Ct. Memo LEXIS 54">*71 transferred the data from the inventory sheets onto a summary sheet and discarded the original data sheets. Using unit costs supplied by Mr. Battin, she determined an ending inventory of $ 55,586.
In his statutory notice of deficiency, respondent determined that petitioner's ending inventory for 1981 was $ 177,959 rather than the $ 55,586 claimed by petitioner. The $ 122,373 difference would result in a decrease in cost of goods sold, and an increase in taxable income of like amount. In calculating ending inventory, respondent took as his starting point, the physical inventory taken by Ron Alston on August 24, 1981. The results of the Alston inventory were then rolled forward to yearend by adding it to the dollar value of raw material purchases and freight-in, and subtracting cost of goods sold for the months of September through December as follows:
