Wallace Barnes Co. v. Commissioner

WALLACE BARNES CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Wallace Barnes Co. v. Commissioner

Docket No. 3653.

United States Board of Tax Appeals

10 B.T.A. 1304 ; 1928 BTA LEXIS 3907 ;

March 12, 1928 , Promulgated

*3907 1. The petitioner and the Bristol Machine Tool Co. were affiliated during the year 1919.

3. Amounts expended by the petitioner in the year 1919 in rearranging its plant for peace-time production held not to be proper deductions in computing the petitioner's net war income for that year.

Dwight C. Buffum for the petitioner.

J. Harry Byrne, Esq., for the respondent.

MARQUETTE

*1304 This proceeding is for the redetermination of a deficiency in income and profits taxes for the year 1919 in the amount of $94,588.59.

FINDINGS OF FACT.

The petitioner is a corporation organized under the laws of the State of Connecticut, prior to the year 1914, with its principal office *1305 and place of business at Bristol, Conn. Its capital stock consisted of 5,100 shares of the par value of $100 each. During the year 1919 the capital stock was owned by the following persons: Shares

C. F. Barnes 3,353

Fuller F. Barnes 700

H. C. Barnes 670

L. F. Barnes 170

J. S. Barnes 85

H. I. Arms 5

J. E. Andrews 5

L. D. Adams 5

R. W. Cook 5

A. H. Wilcox 85

William Muir 17

Total 5,100

C. F. Barnes was president, *3908 Fuller F. Barnes, treasurer, H. C. Barnes, secretary, and H. I. Arms, assistant treasurer of the corporation. L. F. Barnes was the wife of C. F. Barnes, Fuller F. Barnes and H. C. Barnes were his sons, and J. S. Barnes was his nephew. Arms, Andrews, Adams, Cook, Muir and Wilcox had been employed by the corporation for many years and held positions of responsibility and trust. Their stock was held by them under written agreements, indorsed on the faces of the certificates, that they would not sell or transfer their stock without the written consent of the corporation's board of directors. In addition the corporation actually held the stock of Arms, Adams, Andrews and Cook as collateral for notes given to it in payment for the stock. J. S. Barnes also held his stock under a written agreement, duly indorsed on the certificate, that it was not transferable without the written consent of the corporation's board of directors. C. F. Barnes, Fuller F. Barnes, L. F. Barnes and H. C. Barnes had an oral agreement among themselves that none of them would sell his or her stock without first offering it to the board of directors.

During the years 1917 and 1918 the petitioner was engaged *3909 in the manufacture of metal springs and other metal pieces, principally as a subcontractor on war work, and during the year 1918 more than 90 per cent of its facilities were used for that purpose. In order to carry out its contracts it required many special machines, tools, and dies, most of which it had to make for itself in its own machine department. This machine department became in 1917 and 1918 inadequate for the petitioner's needs and it therefore in February, 1918, bought control of the C. G. Garrigus Machine Co., a Connecticut corporation organized in the year 1908 with a capital stock of 500 shares of the par value of $100 each, and with its principal office and plant at Bristol. In May, 1918, the name of this corporation was changed to the Bristol Machine Tool Co. It will hereinafter be referred to as the Tool Company.

*1306 During the year 1919 the capital stock of the Tool Company was held as follows: Shares

The Wallace Barnes Co 343

C. F. Barnes 52

Fuller F. Barnes 10

H. C. Barnes 10

H. I. Arms 5

J. E. Andrews 5

L. D. Adams 10

R. W. Cook 2

F. B. Tibbits 10

L. K. Lasher 2

C. H. Tiffany 40

W. S. Bennett 5

John F. Chidsey 5

A. F. Rockwell 1

Total 500

*3910 H. I. Arms, assistant treasurer of the petitioner, had acquired his stock in the Tool Company at the request of C. F. Barnes, prior to February, 1918; Barnes had acquired 52 shares of the stock prior to that time and wanted Arms to represent him on the board of directors. He therefore sold Arms five shares of the stock, or purchased that amount for him, and had him placed on the board of directors and made secretary of the Tool Company. Although Arms owned and held his stock in his own right, he did not feel free to sell it or to vote it without first consulting the petitioner's officers, because of his interest in the petitioner. Andrews, Adams, and Cook, who were factory manager, mill manager, and foreman, respectively, of the petitioner, also owned and held their stock in their own right, but because of their interests in the petitioner, did not feel free to sell or vote it except in accordance with the desires of the petitioner's board of directors. Adams was a director of the Tool Company and was also made secretary and manager. During the year 1919 he devoted more than three-fourths of his time to the Tool Company for which he was paid a salary of $1,000. For the remainder *3911 of his time the petitioner paid him several times the amount he was paid by the Tool Company. The petitioner was not reimbursed for his inequality in salary.

F. B. Tibbits and L. K. Lasher were respectively New England sales manager and New York sales manager of the petitioner. They acquired their stock in the Tool Company at the request of and from the petitioner. They voted their stock in accordance with the wishes of the petitioner's board of directors and because of their connection with the petitioner they did not feel free to sell or vote their stock except as the board of directors desired.

C. H. Tiffany was a retired business man and a friend of C. F. Barnes. Bennett was also a friend of C. F. Barnes; Tiffany and Bennett were stockholders of the Tool Company prior to February, 1918, and they chose to remain stockholders because of their friendship for and confidence in Barnes. They took no active interest in the affairs of the corporation. *1307 J. F. Chidsey was a close personal friend and business associate of C. F. Barnes and he acquired his stock in the Tool Company at the request of Barnes shortly after Barnes had invested in the stock of one of his, *3912 Chidsey's, companies. Chidsey was made a director of the Tool Company by Barnes and he considered that he was there to represent the petitioner's interest. Rockwell was a stockholder of the Tool Company prior to February, 1918. During the year 1919 he did not attend any stockholder's meeting or vote his stock.

Immediately after acquiring control of the Tool Company the petitioner secured the resignation of the old board of directors, put its own officers and employees on the board, and elected Fuller F. Barnes, president, H. C. Barnes, treasurer, L. D. Adams, secretary, and H. I. Arms, assistant treasurer. From that time the policies of the Tool Company were decided and controlled in the office of the petitioner by the petitioner's officers. None of the Tool Company's officers received any salary from the Tool Company except L. D. Adams, who, as above stated, received $1,000 per year. Only two meetings of the stockholders of the Tool Company were held during the year 1919. Three hundred and seventy-three shares of the capital stock were voted at one meeting and 391 at the other.

The Tool Company sold its products to the petitioner at less than the prices that were charged *3913 other customers. It also borrowed from the petitioner in 1919 the amount of $15,000 for which no interest was charged. In addition the petitioner loaned the Tool Company its credit by indorsing the Tool Company's note for $50,000. No charge was made for this service.

During the years 1917 and 1918 the petitioner, in order to handle its war contracts, was compelled to enlarge and rearrange its plant. New buildings were constructed and new machinery and equipment purchased and installed at a cost of about $420,000. As thus enlarged, rearranged and equipped, the plant was not suited to the petitioner's regular peace-time business and in the year 1919 the petitioner rearranged and revamped the plant by removing the special war-time machinery and reinstalling the peace-time machinery and putting the plant back as nearly as practicable to its prewar condition, at a cost of $16,499.60.

The petitioner and the Tool Company filed a consolidated return of income and invested capital for the year 1919, and in computing the net income from Government contracts deducted the amount of $16,499.60 expended for rearranging the petitioner's plant for peace-time production. The respondent *3914 determined that the two corporations were not affiliated during the year 1919 and that the amount of $16,499.60 should be taken as a general deduction and not as a deduction *1308 from war income, and that as to the petitioner there is a deficiency in tax in the amount of $94,588.59. At the hearing respondent filed an amendment to his answer contending that the above expenditure should be capitalized.

OPINION.

MARQUETTE: The record in this proceeding raises two questions for determination, namely: (1) Were the petitioner and the Tool Company affiliated during the year 1919 within the meaning of section 240(b) of the Revenue Act of 1918 and entitled to file a consolidated return of income and invested capital?, and (2) Is the petitioner, in computing its net income from war contracts for 1919, entitled to deduct the amount expended in that year in rearranging and adapting its plant to peace-time production. The questions will be discussed in the order in which they are set forth:

The evidence which has been presented to us shows that the petitioner was a close corporation owned or controlled by C. F. Barnes, his wife, and their two sons. They owned outright more than *3915 95 per cent of the capital stock and the remainder, which was owned by Barnes' nephew and by certain old and trusted employees of the corporation, was controlled by the Barnes family through written agreements that it would not be sold or transferred without the consent of the petitioner's board of directors which was dominated by the Barnes family. As to the Tool Company, we find that about 69 per cent of its stock was owned by the petitioner and that more than 21 per cent was owned by the petitioner's officers, stockholders and employees. These officers, stockholders, and employees, other than the members of the Barnes family, held their stock at the request of the Barnes and voted it in accordance with their interests and desires. The main interests of these stockholders were with the petitioner and not in the Tool Company, and they willingly supported, furthered, and carried out the policies determined and laid down by the Barnes for the operation of the Tool Company. If they were not directly under the control of the Barnes family, they were, and so considered themselves, closely affiliated with it and with the petitioner.

Of the shares of stock in the Tool Company owned *3916 by persons who were not officers of the petitioner, 5 shares were owned by Chidsey, who was a close personal friend and business associate of C. F. Barnes and who became a stockholder and director at his request and considered that he was there to represent the Barnes interest; 45 shares were owned by Tiffany and Bennett, who were also close personal friends of C. F. Barnes. They, however, took no active part in the affairs of the corporation but were content to let the Barnes family manage and direct it as they saw fit. It appears *1309 that they were quiescent stockholders and that the only stock usually voted at stockholder's meetings was that owned or controlled by the Barnes family. We think that it is clear that the petitioner owned or controlled, through closely affiliated interests, substantially all of the capital stock of the Tool Company during the year 1919 and that the two corporations are entitled to file a consolidated return. See .

The evidence relative to the second issue establishes that during the years 1917 and 1918, the petitioner enlarged, equipped, and rearranged its manufacturing plant, *3917 in order to handle Government war contracts. The cost thereof presumably was capitalized. Upon the conclusion of the war and the termination of the contracts, the petitioner found itself with a plant not suited to its normal peace-time activities. It was, therefore, in 1919, compelled to again rearrange the plant, as set forth in the findings of fact, to conform to peace-time requirements, at a cost of $16,499.60, which it seeks to deduct from its income derived from Government contracts in computing its war income for that year. The respondent now contends that the expenditure should be capitalized.

Section 301(c) of the Revenue Act of 1918 reads as follows:

For the taxable year 1919 and each taxable year thereafter there shall be levied, collected, and paid upon the net income of every corporation which derives in such year a net income of more than $10,000 from any Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive, a tax equal to the sum of the following:

(1) Such a portion of a tax computed at the rate specified in subdivision (a) as the part of the net income attributable to such Government contract or contracts *3918 bears to the entire net income. In computing such tax the excess-profits credit and the war-profits credit applicable to the taxable year shall be used;

(2) Such a portion of a tax computed at the rates specified in subdivision (b) as the part of the net income not attributable to such Government contract or contracts bears to the entire net income.

For the purpose of determining the part of the net income attributable to such Government contract or contracts, the proper apportionment and allocation of the deductions with respect to gross income derived from such Government contract or contracts and from other sources, respectively, shall be determined under rules and regulations prescribed by the Commissioner with the approval of the Secretary.

The regulation promulgated by the Commissioner for the allocation of income from Government contracts as set forth in article 715 of Regulations 45, is as follows:

Whenever it is necessary to determine the portion of net income derived from or attributable to a particular source, the corporation shall allocate to the gross income derived from such source, and to the gross income derived from each other source, the expenses, losses, *3919 and other deductions properly appertaining thereto, and shall apply any general expenses, losses, and deductions (which can not properly be otherwise apportioned) ratably to the gross income *1310 from all sources. The gross income derived from a particular source, less the deductions properly appertaining thereto and less its proportion to any general deductions, shall be the net income derived from such source. The corporation shall submit with its return a statement fully explaining the manner in which such expenses, losses, and deductions were allocated or distributed.

The petitioner relies upon this regulation as authorizing the deduction from its income derived from Government contracts, of the cost of rearranging its plant to conform to its peace-time requirements. We are of opinion that the facts do not bring the petitioner within either the regulation or the intendment of the statute. Even should we assume, in the first instance, that the cost of the change was properly deductible as an expense from income generally, it appears to us that while such cost may have been occasioned by war contracts, it is not cost "appertaining thereto," but rather appertains to *3920 the production of future income and is thus a capital item. We think, therefore, that the Commissioner was correct in refusing to deduct this expenditure from war income but that he erred in allowing the amount as a general deduction from income. The amount of the expenditure should be capitalized.

Other errors on the part of the respondent are alleged in the petition, but they were abandoned at the hearing.

Reviewed by the Board.

Judgment will be entered on 15 days' notice, under Rule 50.

PHILLIPS

PHILLIPS: I dissent from the prevailing opinion so far as it holds that the amounts expended by the petitioner in rearranging its plant for peace-time production may not be deducted as an ordinary and necessary expense of its business in the year when the plant was rearranged.

In the instant case it appears from the findings of fact that the plant of the petitioner was enlarged and rearranged for the purpose of handling war contracts; that new buildings were constructed and new machinery and equipment purchased and installed. The emergency having ended, petitioner found it necessary to restore its plant to the condition in which it was prior to the emergency. *3921 The cost of so doing appears to me to be not only an ordinary and necessary expense of the business but, in my opinion, added nothing to the capital value of the plant as it already appeared in the financial structure of the petitioner.

The Board has heretofore held, and it seems to me properly so, that the cost of installing machinery is properly to be capitalized as a part of the cost of such machinery and recovered by an allowance for the exhaustion thereof, or otherwise, as are other costs. To require the petitioner to include in its capital, as a part of the cost of its plant, the original cost of installing the machinery, the cost of taking *1311 this same machinery out or rearranging it for war-time production, and the cost of reinstalling the same machinery or rearranging it for peace-time production appears to me to be not only a misapprehension of the situation but a distortion of asset values which is contrary to the facts and which can not be justified.

While it may be that in some circumstances the cost of rearranging an entire plant is an extraordinary rather than an ordinary expense, we must look to all of the surrounding circumstances in each particular *3922 case. What may be an extraordinary expense under ordinary circumstances may well be an ordinary expense under extraordinary circumstances. The situation which arose out of the war called upon the industries of the country to abandon peace-time production for the manufacture of the necessities of war. It was generally recognized that production under war-time contracts would be temporary. The expense to which a manufacturer, such as the petitioner, was put in rearranging its machinery to meet the situation and in restoring its plant after the emergency for its normal peace-time pursuits, seems to me properly to be classified, in view of all the circumstances, as an ordinary and necessary expense of the business properly chargeable against the income from war contracts. I can conceive of no basis upon which such expenses can properly be considered as adding to the capital value.