J. E. Mergott Co.
Comm'r of Internal Revenue

Tax Court of the United States.Jul 19, 1948
11 T.C. 47 (U.S.T.C. 1948)
11 T.C. 47T.C.

Docket No. 14096.



Emanuel P. Scheck, Esq., for the petitioner. John E. Mahoney, Esq., for the respondent.

Factory equipment constructed by petitioner in its own plant and improperly carried on books, first in inventory and later as nondepreciable capital item at constant figure, held to result in no allowable loss upon abandonment in tax year, petitioner having properly deducted cost of labor and materials when expended for manufacture of the equipment. Emanuel P. Scheck, Esq., for the petitioner. John E. Mahoney, Esq., for the respondent.

By this proceeding petitioner challenges respondent's determination of deficiencies in declared value excess profits tax for the taxable year 1943 in the amount of $323.07 and in excess profits tax for the taxable year 1944 in the amount of $18,651.96.

The only question in dispute is whether petitioner is entitled to deduct in 1943 the sum of $17,068.68, or any lesser amount, as a loss resulting from the scrapping of tumbling barrels and tanks in that year. That deduction by a carry-over to 1944 affects excess profits tax liability for 1944.


Petitioner, a Delaware corporation, with its principal office in Newark, New Jersey, has engaged in the business of manufacturing metal handbag frames and other metal specialties. Its returns for the years involved were filled with the collector for the fifth district of New Jersey.

As a means of polishing its products, it used tumbling barrels, known as Fuller barrels, and tanks containing a chemical solution in which the barrels revolved. The tanks and barrels were constructed of specially selected wood planking in petitioner's own shops by carpenters in its employ. It purchased the necessary planking. A small number of other types of barrels were used, but these are not involved in this proceeding.

Because of their constant immersion in water and chemicals, the life of the barrels and tanks ranged from six months to two years, the average life being about one year.

Petitioner's experience demonstrated that it was impractical to repair the barrels and tanks and they were replaced by new ones as soon as they fell into disrepair. Petitioner made on the average three barrels every two weeks, there being a constant turnover and no reserve stock being maintained. Each year petitioner abandoned, as worn out, approximately the same number of barrels and tanks as it built during the year.

Petitioner considered the barrels and tanks as a factory supply item, and up to the close of 1930 their cost was included in merchandise inventory. As of January 1, 1931, the inventory figure was reduced by the amount of all barrels and tanks, then totaling $18,980, of which only $16,410 represented the type of barrels and tanks which are the subject of the contested deduction.

In 1931 a ledger entry was made as follows:

+---------------------------------------------------------------------------+ ¦Machinery and Equipment ¦75¦$18,980.00¦ ¦ +--------------------------------------------------+--+----------+----------¦ ¦Inventories ¦9 ¦ ¦$18,980.00¦ +--------------------------------------------------+--+----------+----------¦ ¦To transfer tumbling barrels included in inventory¦ ¦ ¦ ¦ +---------------------------------------------------------------------------+

On December 31, 1931, petitioner both debited and credited the account ‘General Machinery‘ with $18,980.

On its 1931 tax return it reduced both opening and closing inventory by that figure.

The ‘General Machinery‘ account was thereafter adjusted as follows until December 31, 1935:

+------------------------------------------------------------+ ¦January 1 [year undated] ¦$18,980.00¦ +-------------------------------------------------+----------¦ ¦December 31, 1933 barrels discarded ¦2,420.00 ¦ +-------------------------------------------------+----------¦ ¦December 31, 1935 barrels discarded ¦1,280.00 ¦ +-------------------------------------------------+----------¦ ¦December 31, 1935 transferred to separate account¦15,280.00 ¦ +------------------------------------------------------------+

On December 31, 1935, a separate account was created, designated as ‘Tumbling Barrels,‘ which was debited in the sum of $15,280. On December 31, 1936, this account was debited in the amount of $508.68, with the explanation ‘Adj. to appraised.‘ On the same date it was credited in the amount of $15,788.68, with the explanation that the sum was being transferred back to the ‘General Machinery‘ account, which was debited in that sum on the same date. The item remained in that account, unchanged in amount, until 1943.

From the beginning of 1932 up to the end of 1936 the fluctuations in the value of tumbling barrels and tanks on hand at the end of each year were adjusted in accordance with the actual fluctuations in the account, such changes being reflected as operating expense charges if the number decreased, or as a credit to income if the number increased.

In 1936 it was decided that a physical count of the number of tanks and barrels on hand every year should not be made, because experience had shown that the number of barrels and tanks on hand at the close of every year varied very slightly because of the practice of replacing discarded barrels and tanks.

Petitioner did not claim depreciation for the barrels and tanks involved. Labor and material costs for their construction were treated in the same manner as were the costs incident to the creation of the products it sold.

Inventory records of petitioner for the years ended December 31, 1931, 1932, 1933, and 1934, show that the tumbling barrels and tanks were carried as inventory, and that inventory value was $130 per barrel and $60 per tank, their approximate cost in 1936. The cost of making barrels and tanks in 1943 was at least doubled.

During the war the manufacture of petitioner's regular line of civilian merchandise was discontinued. In 1943 contracts were obtained for war materials, the manufacture of which did not require the use of tumbling barrels, but did require the space occupied by the tumbling barrels for other manufacturing processes. As it appeared certain at that time that civilian work could not be resumed in the near future, and as it was impossible to preserve the barrels in storage, petitioner decided to scrap them. In May 1943, 50 barrels and 28 tanks were dismantled and scrapped, and in the latter part of 1943 the remainder, or about 53 barrels and 30 tanks, was also disposed of in the same way.

Barrels and tanks had been made almost up to the time that scrapping was undertaken.

Respondent has disallowed a claimed loss in the amount of $17,068.68, said to result from the scrapping of the tanks and barrels in 1943.


OPPER, Judge:

Although accounting entries neither make nor reduce income, Helvering v. Midland Mutual Life Insurance Co., 300 U.S. 216, 223, the instant problem is difficult, mainly because of accounting methods actually pursued on the one hand, and a consideration of proper accounting practice on the other. Historically, the present controversy is grounded on petitioner's initial inclusion of certain of its equipment, which we shall for simplicity refer to as tumbling barrels, in its inventory account. When this procedure was changed by reducing inventory and adding the property to a machinery account, the tumbling barrels continued to be carried separately as a nondepreciated item. The figure thus retained without change on the books for many years is not claimed as an abandonment loss by reason of the scrapping in the tax year in issue of the barrels then in existence.

Petitioner's apparent reason for including the barrels originally in inventory and later in a nondepreciated account was, first, that they had an anticipated average life of only one year, and, second, that they were being constantly replaced in the same quantity and character by new barrels manufactured in a virtually continuous process by petitioner's own workmen in its own shop.

The difficulty with petitioner's method of treating the barrels for accounting purposes and with allowing its present claim seems to us to stem from the basic concept that the cost of producing the barrels was in all instances deducted as a current expense. If petitioner had done nothing more, it would have been currently compensated by the deductions thus resulting from year to year, and any casualty to the barrels would not constitute a loss at any time for which additional compensation taxwise would be necessary. This treatment was proper, and consistent with, indeed required by, the principle that articles with an anticipated life of one year or less are to be dealt with by means of deductions for current expense. W. B. Harbeson Lumber Co., 24 B.T.A. 542, 550.

The present issue arises because petitioner did do something more. It is claimed that in the years when the item was being accumulated on its books it simultaneously credited the completed barrels to its inventory account, thus, it is said, canceling the tax benefit of the expense deductions by increasing the income side of its annual operating statement. But that treatment was erroneous. There was no justification for adding production equipment not designed for sale or even as a means of distribution, cf. Read Phosphate Co., 13 B.T.A. 39, to the inventory account. Burroughs Adding Machine Co., 9 B.T.A. 938; Pierce-Arrow Motor Car Co. v. United States (Ct. Cls.), 9 Fed.Supp. 577. Such a process would not properly reflect the petitioner's income at the time, and the attempt to compensate for that error now by a procedure equally unsound, even though compensatory, may not be permitted to succeed.

If petitioner improperly increased its income in much earlier years by adding the barrels to inventory, that is an error which it is now too late to correct. Cf. American Light & Traction Co., 42 B.T.A. 1121; affd. (C.C.A., 7th Cir.), 125 Fed.(2d) 365. The fact is, on the undisputed record, that the barrels abandoned in 1943 were acquired either in that year or in the one preceding it. For each one petitioner was given a simultaneous deduction for the full amount expended in labor and materials. To permit the present claim would constitute allowance of a double deduction for the same item or a deduction for a loss of an asset without basis, neither of which is permissible. See Keystone Auto Club Casualty Co., 40 B.T.A. 291, 308; supplemental opinion, 42 B.T.A. 356; affd. (C.C.A., 3d Cir.), 122 Fed. (2d) 886; certiorari denied 315 U.S. 814; Detroit Edison Co. v. Commissioner, 319 U.S. 98.

Decision will be entered for the respondent.