Opinion
Docket No. 65080.
1960-03-18
ELECTRICAL FITTINGS CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Sigmund Metz, Esq., for the petitioner. Anthony S. Del Giudice, Esq., for the respondent.
Sigmund Metz, Esq., for the petitioner. Anthony S. Del Giudice, Esq., for the respondent.
Petitioner manufactured electrical fittings from metal castings. Several months before the outbreak of hostilities in Korea, it was faced with a shortage of malleable iron castings, the most suitable type for use in its manufacturing business. Castings made from ductile iron, although unsatisfactory in many respects, were the best available substitute. To insure its supply of ductile iron castings which was also endangered, petitioner in 1951 joined with two other corporations and an individual in organizing a corporation to produce ductile iron castings. Petitioner subscribed and paid for approximately one-third of the preferred stock and one-fourth of the common stock of the new corporation. Being again able to purchase malleable iron castings after the end of the Korean conflict, petitioner sold the stock in 1953, receiving a nominal amount therefor. Held, that the loss upon the sale of the stock is deductible from ordinary income, rather than as a capital loss, in the fiscal year ended May 31, 1954. Tulane Hardwood Lumber Co., 24 T.C. 1146.
The respondent determined a deficiency in income tax against the petitioner for the taxable year ended May 31, 1954, in the amount of $45,424.25.
The issues for decision are (1) whether the loss sustained by the petitioner upon the sale of preferred and common stock of Ductile Iron Foundry, Inc., constitutes a capital loss or a loss deductible from ordinary income as cost of goods sold, as an ordinary and necessary business expense, or as a business loss; and (2) whether the petitioner is entitled to a bad debt deduction because an alleged ‘loan’ it made to the corporation was not repaid.
FINDINGS OF FACT.
Some of the facts have been stipulated and are found as stipulated.
Petitioner is a New York corporation, organized in 1935, with its principal place of business in Woodside, New York. It filed its income tax return for the fiscal year ended May 31, 1954, with the district director of internal revenue at Brooklyn, New York. It keeps its books and files its returns on an accrual method of accounting and by fiscal year ending May 31.
Petitioner is engaged in the manufacture and sale of electrical conduit fittings of many varieties. The fittings in their original state consist of castings produced by foundries from patterns supplied by the petitioner. These castings are stamped, cut, shaped, plated, reamed, and packed by the petitioner on its own premises. The petitioner sells the fittings to wholesalers. The petitioner did not find it feasible to maintain facilities for manufacturing its own castings.
Prior to 1951, the petitioner had never owned any proprietary interest in a foundry. Its only source of castings had been various foundries operated by other corporations. Petitioner's business depends upon a steady supply of castings specially produced and constructed for electrical conduit fittings.
Because of its tensile strength, its proper malleability, and its low cost, malleable iron was the metal usually employed in the manufacture of castings for the petitioner. Since the end of World War II, the petitioner has often had difficulty in obtaining a constant and adequate source of malleable iron castings and has occasionally purchased substitute castings manufactured from aluminum, ductile iron, and plastic when malleable iron castings were in short supply.
Several months before the outbreak of hostilities in Korea, the petitioner was unable to obtain a steady supply of malleable iron castings. As a result, during the spring of 1950 it withdrew its patterns from some of the foundries which had previously supplied it with malleable iron castings and sent them to Acme Shear Company, hereafter referred to as Acme. Acme was a manufacturer of shears and other products from ductile iron and in its own foundry was able to produce quantities of ductile iron beyond its then existing needs. ‘Ductile Iron’ is the registered trade name of a licensed iron alloy which was the best available substitute for malleable iron in the manufacture of petitioner's castings. Acme was one of three foundries in the country licensed by the International Nickel Company, the holder of the patent, to manufacture ductile iron.
Castings produced by Acme were not uniformly soft, resulting in considerable damage and tool wear to the high-speed machinery used by the petitioner in the finishing of the fittings. From 20 to 25 per cent of the castings had to be returned to Acme. In contrast, only about 1 per cent of the malleable iron castings had been rejected.
The petitioner tried without success to obtain malleable iron castings from foreign countries. Since malleable iron castings were unavailable, the petitioner was forced to accept castings made from ductile iron. For about a year and a half, the petitioner received a limited supply of ductile castings from Acme. But in 1951 Acme's shear business increased. Due to its need for its facilities in its own business, Acme began to ship the petitioner's orders late. During the latter part of 1951, the relationship between the petitioner and Acme was terminated.
Early in 1951, Stanley Joselson, president of the petitioner, was informed by Emil Laufer, foreman of the Acme foundry, that two other manufacturers were interested in organizing a ductile iron foundry. Brink & Cotton Manufacturing Company and the A. Lincoln Company, hereafter referred to as Brink and Lincoln, respectively, were Connecticut corporations who had previously purchased ductile iron castings from Acme and who could no longer be supplied by Acme. Brink was engaged in the manufacture of clamps, vices, and handtools. Lincoln was engaged in the manufacture of shears.
The petitioner, Brink, Lincoln, and Laufer decided to form a corporation for the purpose of building their own foundry to manufacture ductile iron and grey iron, thus providing a convenient and controlled supply of materials. On June 15, 1951, Ductile Iron Foundry, Inc., hereafter referred to as Ductile, was organized under the laws of Connecticut.
The petitioner did not attempt to establish a company for the manufacture of malleable iron castings because Laufer had told Joselson that there was no new or secondhand equipment available for such purpose. There was, however, secondhand equipment available for the production of ductile iron castings.
The stockholders, amount of stock held by each, and the cost of capital stock of Ductile from the date of its inception to the date the stock was sold, were as follows:
+----------------------------------------------------------------------------+ ¦ ¦Capital stock ¦ +-------------------------------+--------------------------------------------¦ ¦Stockholder ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-------------------------------+--------+-----+----+----------+-----+-------¦ ¦ ¦Common ¦ ¦ ¦1 per cent¦ ¦ ¦ ¦ ¦Par ¦ ¦ ¦Par ¦ ¦ ¦ +-------------------------------+--------+-----+----+----------+-----+-------¦ ¦ ¦ ¦value¦Cost¦cumulative¦value¦Cost ¦ +-------------------------------+--------+-----+----+----------+-----+-------¦ ¦ ¦ ¦ ¦ ¦preferred ¦ ¦ ¦ +-------------------------------+--------+-----+----+----------+-----+-------¦ ¦ ¦Shares ¦ ¦ ¦Shares ¦ ¦ ¦ +-------------------------------+--------+-----+----+----------+-----+-------¦ ¦Electrical Fittings Corporation¦300 ¦$1.00¦$300¦600 ¦$100 ¦$60,000¦ +-------------------------------+--------+-----+----+----------+-----+-------¦ ¦Brink & Cotton Manufacturing Co¦300 ¦1.00 ¦300 ¦600 ¦100 ¦60,000 ¦ +-------------------------------+--------+-----+----+----------+-----+-------¦ ¦The A. Lincoln Co ¦300 ¦1.00 ¦300 ¦600 ¦100 ¦60,000 ¦ +-------------------------------+--------+-----+----+----------+-----+-------¦ ¦Emil Laufer ¦300 ¦1.00 ¦300 ¦50 ¦100 ¦5,000 ¦ +----------------------------------------------------------------------------+
1,200 1,200 1,850 185,000
The Ductile stock purchased by the petitioner at a total cost of $60,300 was recorded in its general ledger on June 15, 1951, in account 91, entitled ‘Ductile Iron Foundry— Investment.’
In July of 1952, the petitioner, Brink, Lincoln, and Laufer each advanced $5,000 to Ductile and each received a demand note of the corporation in the same amount, bearing interest at the rate of 1 per cent. No other security was given, and no effort was made to enforce these obligations.
Ductile purchased land in Stratford, Connecticut, on which it erected a building to house its foundry operations. Laufer was retained as president and general manager of the new corporation. Ductile began manufacturing castings in September 1951. All of the castings were purchased by the petitioner, Brink, and Lincoln, with the petitioner being Ductile's principal customer.
In October 1951, Ductile borrowed $50,000 from the Bridgeport-City Trust Company and as security gave a mortgage on all of its real estate, machinery, and equipment. The petitioner, Brink, and Lincoln were required to and did guarantee the payment of this mortgage.
The petitioner received its first shipment of castings from Ductile in September or October of 1951, but they were no better for the manufacture of electrical fittings than the castings which had been produced by Acme. The rejects ranged from 18 to 48 per cent.
At a meeting of the directors of Ductile in October of 1952, Sigmund Metz, representing petitioner, stated that the petitioner wished to dispose of its stock. The other stockholders rejected the petitioner's offer to sell out to them, although they did agree to sell their stock if a buyer could be found. Metz was then authorized to place an advertisement in the New York Times for the purpose of selling the foundry, but no satisfactory offer was received. The petitioner's orders from Ductile continually decreased as malleable iron castings began to be available again, so that by June of 1953 no more shipments were being received from it. With the end of the Korean conflict in July of that year the petitioner was able to obtain malleable iron castings in sufficient quantities.
In August of 1953, Cooley & Company, an investment corporation, was given an option to purchase the Ductile stock. This option was exercised by Cooley & Company in November 1953, which then assigned its rights to the Hartford Electrical Steel Corporation.
Pursuant to the terms of an agreement dated November 24, 1953, the stockholders of Ductile, on December 9, 1953, turned over the Hartford Electrical Corporation all of their common and preferred stock and Ductile's four stockholder notes. In return, Hartford Electrical Corporation paid each of the four stockholders $25, a total of $100, and obtained the release by the Bridgeport-City Trust Company of the petitioner, Brink, and Lincoln from their agreement guaranteeing payment of the $50,000 first mortgage on the property of Ductile held by the bank.
The petitioner's holdings in Ductile for the fiscal year ending May 31, 1954, were recorded in its general ledger account 91, as follows:
+-------------------------------------------------------------------+ ¦91 ¦ ¦ ¦ ¦ ¦ +------+-----------------------------------+--------------+---------¦ ¦ ¦Ductile Iron Foundry—Investment ¦ ¦ ¦ +------+-----------------------------------+--------------+---------¦ ¦6/1/53¦Balance ¦65,300.00 ¦5/31/54 ¦25.00 ¦ +------+--------------+--------------------+--------------+---------¦ ¦ ¦ ¦ ¦5/31/54 ¦5,000.00 ¦ +------+--------------+--------------------+--------------+---------¦ ¦ ¦ ¦ ¦5/31/54 ¦11,380.25¦ +------+--------------+--------------------+--------------+---------¦ ¦ ¦ ¦ ¦5/31/54 to P&L¦48,894.75¦ +------+--------------+--------------------+--------------+---------¦ ¦ ¦ ¦65,300.00 ¦ ¦65,300.00¦ +-------------------------------------------------------------------+
The petitioner carried on its accounting records the amount of $11,380.25 as an account payable to Ductile. This account was never paid. In determining its loss with respect to the sale of its Ductile stock, the petitioner reduced the amount of the loss by $11,380.25, as follows:
+------------------------------------------------------+ ¦Cost ¦$60,300.00¦ ¦ +--------------------------------+----------+----------¦ ¦Less: Balance in account payable¦11,380.25 ¦$48,919.75¦ +--------------------------------+----------+----------¦ ¦Sales price of Ductile shares ¦ ¦25.00 ¦ +--------------------------------+----------+----------¦ ¦Amount of loss ¦ ¦48,894.75 ¦ +------------------------------------------------------+
The preferred and common shares of Ductile stock were the only securities owned by petitioner during the period from its inception through the taxable year involved herein. The petitioner received no interest from Ductile on its so-called loan of $5,000, nor any dividends on the Ductile preferred or common stock.
Without the castings supplied by Ductile, the petitioner could not have maintained its operations. The only reason for the organization of Ductile, as far as the petitioner was concerned, was to insure a supply of castings. If it had been able to obtain castings elsewhere, it would not have purchased the Ductile stock. It was the petitioner's plan to operate Ductile only during the shortage of malleable iron and to return to the use of malleable iron as quickly as possible in view of the unsatisfactory results achieved in the use of ductile iron.
The petitioner did not intend to hold the Ductile stock as an investment.
OPINION.
TURNER, Judge:
The first issue involves a loss sustained by petitioner on the sale of stock in Ductile, a corporation which produced castings for use in petitioner's manufacturing business. The respondent has determined that the loss was a capital loss, and disallowed the deduction of the amount from ordinary income.
A supply of iron castings is essential to the petitioner's business of manufacturing electrical fittings. Several months before the start of the Korean conflict, it became exceedingly difficult for it to obtain malleable iron castings, the most suitable type for electrical fittings. As a substitute, it purchased castings made from ductile iron, although they were much less suitable. Within a year the petitioner's principal supplier of ductile iron castings needed its foundry for its own products. To insure its supply of castings, the petitioner joined with two other corporations and an individual in organizing Ductile, to operate a foundry to produce ductile iron castings. All of the castings made by Ductile were used by the petitioner and the other two corporations in their manufacturing businesses.
The tax treatment of the loss on the sale of the Ductile stock depends on the purpose for which the petitioner acquired the stock. Stock purchased as an investment is a capital asset; when sold, it creates capital gain or loss. But stock purchased in the ordinary course of business where the only purpose is to insure a vital source of inventory is not a capital asset, and the loss upon its sale is deductible from ordinary income. Commissioner v. Bagley & Sewall Co., 221 F.2d 944, affirming 20 T.C. 983; Tulane Hardwood Lumber Co., 24 T.C. 1146; Smith & Welton v. United States, 164 F.Supp. 605. These cases raise a question as to whether the loss should be deducted as cost of goods sold, as an ordinary and necessary business expense, or as a business loss. In most instances, however, the particular section under which the loss is deducted will not affect the result in the case.
On the record before us, we conclude that the petitioner has sustained its burden of proving that it had no investment purpose in buying the Ductile stock. Factors pointing to the lack of an investment purpose are these: No other securities were owned by the petitioner. Since the Ductile stockholders used all of the castings produced by the foundry in their manufacturing businesses, there could be no profit from the sale of castings to other consumers. Without the stock purchase the petitioner would have been unable to obtain castings. The stock was held by the petitioner only as long as reasonably necessary under the practical considerations involved.
To show an investment purpose, the respondent calls attention to the recording of the stock in the petitioner's accounting records as an ‘investment.’ Although the manner in which the asset is carried upon the books and tax returns could be an indication of the purpose for which the asset was acquired, the accounting entry is by no means conclusive. Tulane Hardwood Lumber Co., supra; Smith & Welton v. United States, supra. The other evidence outweighs the accounting entry in this case.
In an attempt to distinguish the Bagley & Sewall, Tulane Hardwood, and Smith & Welton cases, the respondent argues that in those cases the stock or debenture purchases were not sufficient to give the taxpayers control of the supplier corporation. Even if this distinction is meaningful, which it is not necessary to decide here, the petitioner in this case was neither a sole stockholder nor a majority stockholder. True, the petitioner did have a voice in the management of Ductile, but it was the owner of only one-fourth of the common stock. The respondent thus has failed in our opinion to distinguish the cited cases.
We accordingly hold that the petitioner is entitled to deduct in its fiscal year ended May 31, 1954, its loss on the sale of the Ductile common and preferred stock. Though it is not necessary to state under which section the loss should be allowed, the circumstances here indicate that section 23(f) of the Internal Revenue Code of 1939
SEC. 23. DEDUCTIONS FROM GROSS INCOME.In computing net income there shall be allowed as deductions:(f) LOSSES BY CORPORATIONS.— In the case of a corporation, losses sustained during the taxable year and not compensated for by insurance or otherwise.
The respondent contends that the cancellation of the petitioner's account payable to Ductile of $11,380.25 creates ordinary income to the petitioner of that amount. But since we have held above that the loss on the Ductile stock was a business loss and the petitioner on its return has reduced the amount of such loss by $11,380.25, the effect is the same as if there had been $11,380.25 of additional income without a corresponding reduction in the amount of the loss claimed.
Similarly, we do not find it necessary to consider whether the $5,000 advance made by the petitioner to Ductile and never recovered was a capital contribution, as urged by the respondent, or a debt, as the petitioner claims. In the light of our holding that the loss on the stock was a business loss, not a capital loss, it is of no consequence whether the $5,000 be regarded as a contribution to capital or a loan.
Decision will be entered under Rule 50.