Sartor Jewelry Co.
Comm'r of Internal Revenue

Tax Court of the United States.Jun 30, 1954
22 T.C. 773 (U.S.T.C. 1954)
22 T.C. 773T.C.

Docket No. 26107.



Roger V. Dickeson, Esq. , for the petitioner. David Karsted, Esq. , for the respondent.

Section 722 claim for relief denied where excess profits credits based on the most favorable constructive average base period net income allowable on the evidence would not exceed the credits allowed by the respondent based on invested capital. Roger V. Dickeson, Esq., for the petitioner. David Karsted, Esq., for the respondent.

The respondent disallowed petitioner's section 722 claim for relief based on drought in its trade area during the base period. Petitioner claims a refund of all of the excess profits taxes paid in the taxable years 1942 and 1943, in the respective amounts of $1,553.45 and $959.60.

This proceeding was heard in conjunction with S. N. Wolbach Sons, Inc., 22 T. C. 152, and it was stipulated that the evidence as to the drought, in each proceeding, would be accepted as evidence in both.


Petitioner is a corporation organized under the laws of the State of Nebraska, with its principal place of business located at Lincoln, Nebraska. Its returns for the taxable years involved were filed with the collector at Omaha. The returns were made on the accrual basis and for calendar years.

Petitioner's business is the operation of a retail jewelry store. During the years involved it was under the management of its sole stockholder, E. W. Sartor. The corporation was dissolved pursuant to a stockholder's resolution of May 31, 1943, and since January 1, 1944, the business has been operated as a sole proprietorship.

Petitioner's store was located at 13th and O Streets from 1933 until 1942 when it was moved to its present location at 12th and O Streets. These locations are in the heart of the city's retail merchandising district.

Petitioner handled high quality merchandise, including diamonds, watches, jewelry, and silverware. The sale of diamonds comprised 50 or 60 per cent of its business, and watches about 15 per cent.

Lincoln is the capital of Nebraska and is the trade center for about 28 counties in the southern section of the State. It is the site of the State university and several other colleges. The annual State fair is held in Lincoln, as are various trade conventions.

Nebraska is essentially an agricultural State. While it has some manufacturing and other industries, its economy is based largely on the production and processing of farm products, the most important of which are cattle, hogs, corn, and wheat.

Beginning about 1934 and extending through petitioner's base period, Nebraska and other adjoining areas suffered it severe drought. Average rainfall in Nebraska, over the period 1936 to 1939, inclusive, was less than 70 per cent of normal. Severe heat and lack of moisture at the critical stages of development caused an almost total crop failure of major crops in some of those years.

In addition to the drought there was also a serious infestation of grasshoppers in Nebraska during the base period years which added to the short production of most farm crops over large areas of the State. This damage in the State of Nebraska alone was estimated at between 11 and 12 million dollars in each of the years 1936, 1937, and 1938.

The adverse effects of the drought in Nebraska and neighboring States were intensified by the fact that the drought followed a prolonged economic depression, due to low prices for farm commodities and other factors, which began in the early 1930's. These results are reflected in the following statistics relating to ‘cash receipts from farm marketings' in the State of Nebraska:

+----------------------------------------------------------------------------+ ¦Year¦Cattle ¦Hogs ¦Corn ¦Wheat ¦Total livestock¦ ¦ ¦ ¦ ¦ ¦ ¦and crops ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦ ¦(Thousands of¦(Thousands of¦(Thousands of¦(Thousands of¦(Thousands of ¦ ¦ ¦dollars) ¦dollars) ¦dollars) ¦dollars) ¦dollars) ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1924¦$114,881 ¦$109.981 ¦$56,897 ¦$50,370 ¦$421,087 ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1925¦121,455 ¦141,226 ¦42,958 ¦47,411 ¦444,867 ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1926¦130,683 ¦135,306 ¦28,783 ¦40,987 ¦434,244 ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1927¦107,046 ¦113,212 ¦23,881 ¦74,815 ¦418,364 ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1928¦138,851 ¦121,314 ¦61,177 ¦55,494 ¦484,618 ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1929¦138,316 ¦136,824 ¦40,645 ¦54,941 ¦489,102 ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1930¦119,019 ¦118,172 ¦39,094 ¦32,412 ¦408,392 ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1931¦90,729 ¦79,287 ¦18,463 ¦20,715 ¦279,142 ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1932¦57,506 ¦43,426 ¦7,736 ¦8,368 ¦166,669 ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1933¦57,628 ¦43,253 ¦21,826 ¦16,035 ¦193,353 ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1934¦78,802 ¦53,644 ¦16,767 ¦13,816 ¦227,176 ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1935¦72,216 ¦40,185 ¦1,690 ¦25,204 ¦209,398 ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1936¦92,841 ¦68,838 ¦5,935 ¦34,011 ¦281,020 ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1937¦91,876 ¦39,190 ¦2,893 ¦39,690 ¦250,783 ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1938¦72,603 ¦32,436 ¦9,507 ¦22,312 ¦200,521 ¦ +----+-------------+-------------+-------------+-------------+---------------¦ ¦1939¦78,850 ¦36,701 ¦17,882 ¦24,441 ¦221,494 ¦ +----------------------------------------------------------------------------+ The totals shown in the last column above include other lesser livestock and livestock products such as dairy products, sheep, and poultry and other lesser crops such as potatoes, beets, oats, and hay not shown separately in the table.

The loss of farm production and farm income affected all types of business throughout the drought stricken area, particularly those which depended largely on farm trade.

As a result of the short production of feed crops during the drought period there was a reduction in the quantity and quality of marketable cattle and hogs. Large quantities of feeds were brought in from other States at additional costs to the farmers, and much of the livestock was sold in poor condition at distress prices. Because of these extra costs of production there was a proportionately greater reduction in farm net income and purchasing power than there was in gross income.

The farmers of Nebraska, in most instances, exhausted their cash reserves as well as their credit and their spending was reduced to bare necessities. Their houses and farm equipment of all types suffered from lack of repairs and proper maintenance. Government and State agencies instituted various relief programs. The Farm Security Administration made many loans, and in some instances outright grants, to distressed farm families. The Farm Service Administration assisted in working out minimum cost subsistence recipes and budgets. The Agricultural Extension Service of the University of Nebraska organized instruction courses for farm families in repairing, and in some instances making, their household necessities and personal clothing. Feed sacks were used to make underclothes for the children and other wearing apparel; old blankets were converted into clothing; and sewing centers were established where overalls, dresses, and other articles, even toys, were made and distributed free to needy families. Altogether, about 4 million garments and as many other articles were made and distributed free to Nebraska families. At the beginning of 1938, over 200,000 persons, approximately 15 per cent of the total population of Nebraska, were on some form of relief.

The distress conditions described above prevailed not only among the farm families but also in the urban areas, and particularly in the small towns which largely depended upon farm income. The following table shows the total income payments and the per capita income payments to individuals in Nebraska and in the United States as a whole over the period 1929 to 1939, inclusive:

+-----------------------------------------------------------+ ¦Year¦Total income payments ¦Per capita income payments ¦ +----+------------------------+-----------------------------¦ ¦ ¦United States ¦Nebraska¦United States ¦Nebraska ¦ +----+---------------+--------+------------------+----------¦ ¦1929¦$82,617 ¦$764 ¦$680 ¦$557 ¦ +----+---------------+--------+------------------+----------¦ ¦1930¦73,325 ¦749 ¦596 ¦544 ¦ +----+---------------+--------+------------------+----------¦ ¦1931¦61,971 ¦578 ¦500 ¦421 ¦ +----+---------------+--------+------------------+----------¦ ¦1932¦47,432 ¦344 ¦380 ¦251 ¦ +----+---------------+--------+------------------+----------¦ ¦1933¦46,273 ¦374 ¦368 ¦275 ¦ +----+---------------+--------+------------------+----------¦ ¦1934¦53,038 ¦378 ¦420 ¦279 ¦ +----+---------------+--------+------------------+----------¦ ¦1935¦58,558 ¦476 ¦460 ¦353 ¦ +----+---------------+--------+------------------+----------¦ ¦1936¦68,000 ¦534 ¦531 ¦399 ¦ +----+---------------+--------+------------------+----------¦ ¦1937¦72,211 ¦549 ¦561 ¦412 ¦ +----+---------------+--------+------------------+----------¦ ¦1938¦66,045 ¦509 ¦509 ¦384 ¦ +----+---------------+--------+------------------+----------¦ ¦1939¦70,601 ¦523 ¦539 ¦397 ¦ +-----------------------------------------------------------+

In millions of dollars.

In dollars.
Regs. 112.SEC. 35.722–3. DETERMINATION OF EXCESSIVE AND DISCRIMINATORY TAX; TAXPAYER ENTITLED TO EXCESS PROFITS CREDIT BASED ON INCOME.—* * * * * * *( a) Interruption or diminution of normal production, output, or operation in the base period.—If the taxpayer establishes that in one or more taxable years in its base period normal production, output, or operation was interrupted or diminished because of the occurrence either immediately prior to, or during the base period, of events unusual and peculiar in the experience of the taxpayer, the average base period net income shall be considered to be an inadequate standard of normal earnings. * * * Normal production, output, or operation means the level of production, output, or operation which would have been reached by the business of the taxpayer had the unusual and peculiar events not occur.* * * * * * *

Cash farm income from marketings of crops and livestock and Government payments, including all cash agricultural payments, such as rentals, price supports, conservation payments, and parties for the State of Nebraska, over the period 1924 to 1939, inclusive, was as follows:

+-----------------------------------------------------------------------------+ ¦Year¦Total crops and ¦Government ¦Cash farm income and Government ¦ ¦ ¦livestock ¦payments ¦payments ¦ +----+---------------------+----------------+---------------------------------¦ ¦1924¦$421,087 ¦ ¦$421,087 ¦ +----+---------------------+----------------+---------------------------------¦ ¦1925¦444,867 ¦ ¦444,867 ¦ +----+---------------------+----------------+---------------------------------¦ ¦1926¦434,244 ¦ ¦434,244 ¦ +----+---------------------+----------------+---------------------------------¦ ¦1927¦418,364 ¦ ¦418,364 ¦ +----+---------------------+----------------+---------------------------------¦ ¦1928¦484,618 ¦ ¦484,618 ¦ +----+---------------------+----------------+---------------------------------¦ ¦1929¦488,997 ¦ ¦488,997 ¦ +----+---------------------+----------------+---------------------------------¦ ¦1930¦408,359 ¦ ¦408,359 ¦ +----+---------------------+----------------+---------------------------------¦ ¦1931¦279,149 ¦ ¦279,149 ¦ +----+---------------------+----------------+---------------------------------¦ ¦1932¦166,604 ¦ ¦166,604 ¦ +----+---------------------+----------------+---------------------------------¦ ¦1933¦193,330 ¦$1,011 ¦194,341 ¦ +----+---------------------+----------------+---------------------------------¦ ¦1934¦227,176 ¦23,496 ¦250,672 ¦ +----+---------------------+----------------+---------------------------------¦ ¦1935¦209,398 ¦33,125 ¦242,523 ¦ +----+---------------------+----------------+---------------------------------¦ ¦1936¦281,020 ¦17,293 ¦298,313 ¦ +----+---------------------+----------------+---------------------------------¦ ¦1937¦250,783 ¦17,468 ¦268,251 ¦ +----+---------------------+----------------+---------------------------------¦ ¦1938¦200,521 ¦15,371 ¦215,892 ¦ +----+---------------------+----------------+---------------------------------¦ ¦1939¦221,494 ¦28,078 ¦249,572 ¦ +-----------------------------------------------------------------------------+

In relation to the 1924–1929 average, the percentages of land values over the period 1930 to 1939 and of forced sales related defaults on purchases of farms in the State of Nebraska and the United States as a whole, were as follows:

+-------------------------------------------------------------+ ¦Year¦Land values ¦Forced sales and related defaults¦ +----+----------------------+---------------------------------¦ ¦ ¦United States¦Nebraska¦United States ¦Nebraska ¦ +----+-------------+--------+--------------------+------------¦ ¦1930¦94 ¦93 ¦20.8 ¦17.0 ¦ +----+-------------+--------+--------------------+------------¦ ¦1931¦87 ¦88 ¦26.1 ¦24.4 ¦ +----+-------------+--------+--------------------+------------¦ ¦1932¦73 ¦74 ¦41.7 ¦39.0 ¦ +----+-------------+--------+--------------------+------------¦ ¦1933¦60 ¦57 ¦54.1 ¦63.9 ¦ +----+-------------+--------+--------------------+------------¦ ¦1934¦62 ¦60 ¦39.1 ¦51.0 ¦ +----+-------------+--------+--------------------+------------¦ ¦1935¦65 ¦60 ¦28.3 ¦45.0 ¦ +----+-------------+--------+--------------------+------------¦ ¦1936¦67 ¦60 ¦26.2 ¦44.4 ¦ +----+-------------+--------+--------------------+------------¦ ¦1937¦70 ¦60 ¦22.4 ¦42.4 ¦ +----+-------------+--------+--------------------+------------¦ ¦1938¦70 ¦57 ¦17.4 ¦38.9 ¦ +----+-------------+--------+--------------------+------------¦ ¦1939¦69 ¦54 ¦17.0 ¦39.9 ¦ +-------------------------------------------------------------+

The population of Nebraska dropped from approximately 1,378,000 persons in 1930 to approximately 1,316,000 in 1940. About 35 per cent of the 1930 and the 1940 population was urban. The population of Lincoln, according to the United States census figures, was approximately 76,000 in 1930, 81,000 in 1940, and 99,000 and 1950.

Petitioner's sales, gross profit, expenses, and net profit or loss for the years 1922 to 1939, inclusive, were as follows:

+------------------------------------------------------------+ ¦Year¦Sales ¦Gross profit¦Expenses ¦Net profit (or loss)¦ +----+----------+------------+----------+--------------------¦ ¦1922¦$84,901.60¦$39,092.15 ¦$36,862.71¦$2,308.75 ¦ +----+----------+------------+----------+--------------------¦ ¦1923¦77,592.48 ¦38,037.41 ¦40,546.40 ¦(2,261.74) ¦ +----+----------+------------+----------+--------------------¦ ¦1924¦83,514.80 ¦33,170.14 ¦35,497.46 ¦(2,090.92) ¦ +----+----------+------------+----------+--------------------¦ ¦1925¦72,825.11 ¦33,115.66 ¦33,719.03 ¦(531.87) ¦ +----+----------+------------+----------+--------------------¦ ¦1926¦78,361.20 ¦32,106.47 ¦33,800.76 ¦(1,495.44) ¦ +----+----------+------------+----------+--------------------¦ ¦1927¦68,120.18 ¦32,473.70 ¦32,011.50 ¦536.20 ¦ +----+----------+------------+----------+--------------------¦ ¦1928¦68,510.70 ¦30,347.07 ¦28,819.64 ¦1,582.23 ¦ +----+----------+------------+----------+--------------------¦ ¦1929¦65,244.50 ¦30,648.42 ¦32,228.33 ¦(1,294.41) ¦ +----+----------+------------+----------+--------------------¦ ¦1930¦57,756.05 ¦26,648.82 ¦31,586.74 ¦(4,937.92) ¦ +----+----------+------------+----------+--------------------¦ ¦1931¦41,330.36 ¦19,561.22 ¦25,399.49 ¦(5,744.94) ¦ +----+----------+------------+----------+--------------------¦ ¦1932¦35,664.53 ¦20,808.85 ¦21,336.31 ¦(527.46) ¦ +----+----------+------------+----------+--------------------¦ ¦1933¦39,383.19 ¦16,086.58 ¦17,909.89 ¦(1,786.31) ¦ +----+----------+------------+----------+--------------------¦ ¦1934¦39,327.88 ¦18,653.44 ¦17,772.38 ¦914.06 ¦ +----+----------+------------+----------+--------------------¦ ¦1935¦43,961.45 ¦20,918.68 ¦19,759.93 ¦1,204.75 ¦ +----+----------+------------+----------+--------------------¦ ¦1936¦52,712.37 ¦24,629.74 ¦23,096.59 ¦1,550.15 ¦ +----+----------+------------+----------+--------------------¦ ¦1937¦54,481.04 ¦24,335.31 ¦22,736.56 ¦1,648.42 ¦ +----+----------+------------+----------+--------------------¦ ¦1938¦51,483.95 ¦23,858.34 ¦23,291.69 ¦566.65 ¦ +----+----------+------------+----------+--------------------¦ ¦1939¦49,108.16 ¦24,242.97 ¦23,234.71 ¦1,008.26 ¦ +------------------------------------------------------------+

The expenses shown above include the salaries of E. W. Sartor, petitioner's only officer, and seven or eight other regular employees, including salespeople, watchmakers, and clerical help. Sartor's salary was $5,000 in each of the base period years. For prior years it varied from a high of $9,500 in 1923 to less than $2,000 in 1933.

Petitioner's balance sheets for the base period years show total assets of between $44,000 and $45,000, including inventories of from approximately $21,800 to $25,100. The bulk of its other assets consisted of notes and accounts receivable.

Petitioner reported in its returns, and paid, excess profits taxes of $1,553.45 in 1942 and $959.60 in 1943, and respondent accepted those figures. Petitioner later filed claims for refund of all of the excess profits taxes so paid under section 722 of the Internal Revenue Code. Petitioner's excess profit net income for 1942 and 1943 and excess profits credits, computed under the invested capital method, as reported in the returns, were as follows:

+----------------------------------------------------+ ¦ ¦Excess profits net income¦Excess profits credit¦ +----+-------------------------+---------------------¦ ¦1942¦$11,737.95 ¦$3,728.07 ¦ +----+-------------------------+---------------------¦ ¦1943¦4,676.70 ¦3,727.30 ¦ +----------------------------------------------------+

Petitioner's claims for relief are based solely on the drought and related factors affecting economic conditions in Nebraska and claim a constructive average base period net income of $7,334.59 computed under the income method.

Because of the drought and, to a lesser extent, insect infestation, and their effect on farm income and business generally in the State of Nebraska, petitioner's earnings were depressed during the base period years, so that its average base period net income was an inadequate standard of normal earnings.

The excess profits tax paid by petitioner for the years in issue was not excessive or discriminatory. Petitioner was not entitled to a constructive average base period net income large enough to produce a credit greater than any of the invested capital credits used by petitioner and allowed by respondent. Petitioner was not entitled to a constructive average base period net income large enough to result in a lower excess profits tax for any of the years in issue than the excess profits tax actually paid by petitioner for those years.


OPPER, Judge:

Petitioner contends that its base period net earnings were depressed because of a drought which prevailed throughout Nebraska and adjoining areas during the base period. The evidence leases no doubt, and a finding to that effect has been made, that because of the drought and the resulting decline in farm income, petitioner's business was depressed, along with most other types of business in the drought area, and that as a result petitioner's average base period net income is an inadequate standard of normal earnings. See sec. 35.722–3( a) of Regs. 112.1 The drought is a qualifying factor under section 722(b)(2) of the Internal Revenue Code. S. N. Wolbach Sons, Inc., 22 T. C. 152. And petitioner is entitled for each of the years to an excess profits credit based on income if that should result in a lesser tax. Sec. 712, I. R. C.

To be entitled to relief, however, the petitioner must show to what extent its earnings were depressed and provide some reasonably accurate means of reconstructing its base period earnings. Moreover, petitioner must show that it is entitled to a constructive average base period net income which will result in a larger excess profits credit, based on income, than that allowed by the respondent under the invested capital method. Godfrey Food Co., 18 T. C. 1083.

It will be noted that petitioner's excess profits credit under the invested capital method, which petitioner used in its returns, amounted to approximately $3,700 in each of the taxable years 1942 and 1943. Its average base period income was approximately $1,200. Petitioner contends that it is entitled to a constructive average base period net income of not less than $7,334.59, as set out in its rejected claims for refund.

In reconstructing its base period income, petitioner offers several alternative computations, all of which are designed to adjust gross sales, and net profits, for the drought factor. In all of these computations petitioner uses indices based on statistical serious purporting to reflect the base period depression in cash farm income or combined farm values in the Stat of Nebraska, attributable to the drought. In some instances the Statewide series are converted to petitioner's more limited trade areas. For the purpose of comparison in establishing the extent of the base period depression petitioner uses either the 1924–1930 or the 1926–1935 periods. It selects the period 1924–1930 as the most normal period prior to 1939.

For reconstructing net sales, petitioner uses two methods, described as the ‘net profit ratio’ and the ‘reconstructed expenses' methods. In the application of the net profits ratio method it assumes that 10 per cent is a normal and reasonable rate of net profits on sales. With the reconstructed expenses method each expense item is considered separately and adjusted, if necessary, to reflect the increased sales. The constructive average base period net income determined under the several computations ranges from $8,207.27 to $10,781.19, as against petitioner's actual average base period net earnings of $1,193.37. The respondent objects to petitioner's reconstruction of both base period gross sales and net profits. He contends that the evidence fails to establish any significant correlation between the drought and petitioner's earnings.

Except for the last paragraph containing our ultimate finding, we have made findings of fact which are virtually identical with the proposed findings communicated to the parties in the report of the commissioner who heard the evidence. Petitioner took exception in only three respects to the findings so suggested. Of the three exceptions noted, one, a typographical error in the excess profits taxes paid, has been corrected in the present findings. The two others relating to the census figures for the city of Lincoln and the date of the dissolution of the petitioner-corporation have been found as meticulously as the evidence permits. On the latter point, however, slightly more ambiguous statements have been employed to reflect the actual condition of the record.

The acceptance of these evidentiary facts, however, by no means establishes petitioner's case. We think that petitioner has overestimated the effect of the drought on its base period sales, as well as the ratio of net profits to sales. While, quite possibly, petitioner's business felt the effect of the curtailment of farm income it was not wholly dependent upon farm income. There were other industries and other sources of income, particularly in the city of Lincoln, less sensitive to the drought. The evidence is that about one-half or more of petitioner's customers were residents of Lincoln and its environs.

Petitioner had a long history of low net profits. Its net earnings did not exceed $2,400 in any year from 1922 to 1935, inclusive. It had an average net loss of approximately $1,000 over that period. It had much larger losses in the ‘depression years' 1930 and 1931. One of the internal factors affecting petitioner's net profits was the salary drawn by Sartor, its principal officer and sole owner. For instance, in 1923, one of petitioner's loss years, his salary was $9,500 while during the base period profit years it was only $5,000.

The actual results of the drought on petitioner's business are perhaps more accurately reflected in petitioner's gross sales than in its net profits. The gross sales varied from a high of approximately $85,000 in 1922 to a low of $35,600 in 1932. The average for the period 1922–1935 was approximately $61,200, and for the period 1922–1939 approximately $59,000. For the base period the average was approximately $52,000. To increase the average base period gross sales to $90,000 or even to $70,000, as petitioner proposes, would far overstep any point of normalcy established by the petitioner over the long period of its operations.

Any proper reconstruction of petitioner's base period earnings, however sound in theory, must be compatible with its own experience. Goodfrey Food Co., supra. Correcting for the drought factor in the base period years could not change petitioner's long-established pattern of operations.

Even with an adjustment of petitioner's gross sales to the highest point justified by the evidence, and a computation of net profits in any manner compatible with its actual experience, the reconstructed average base period net income would not result in an excess profits credit as great as that allowed to petitioner under the invested capital method. That credit, as stated above, amounted to $3,700 in each of the taxable years 1942 and 1943. We cannot find that under normal conditions petitioner would have had profits which would have resulted in a greater excess profits credit. We conclude, therefore, that there was no error in respondent's disallowance of petitioner's claim for relief under section 722. Green Spring Dairy, Inc., 18 T. C. 217.

Reviewed by the Special Division.

Decision will be entered for the respondent.