Sommerfeld Mach. Co.
v.
Comm'r of Internal Revenue

This case is not covered by Casetext's citator
Tax Court of the United States.Oct 10, 1950
15 T.C. 453 (U.S.T.C. 1950)

Docket No. 16040.

1950-10-10

SOMMERFELD MACHINE COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

R. J. Cleary, Esq., for the petitioner. Albert J. O'Connor, Esq., for the respondent.


1. Petitioner's receipt of income from manufacture and sale of lathes developed in prior years over a period in excess of 12 months held to entitle petitioner to special relief from excess profits tax under Internal Revenue Code, section 721(a)(2)(C), with adjustments for expenses deductible in computing net abnormal income, and after application of business improvement factor. W. B. Knight Machinery Co., 6 T.C. 519, followed.

2. Deductions for compensation to petitioner's officer-stockholders, held partly excessive.

3. Deductions for traveling expenses and sales commissions held to be justified by evidence submitted. R. J. Cleary, Esq., for the petitioner. Albert J. O'Connor, Esq., for the respondent.

By this proceeding petitioner seeks a redetermination of deficiencies in income and declared value excess profits and excess profits tax as follows:

+----------------------------------------------------------------+ ¦Year¦Income tax¦Declared value ¦Excess profits tax¦Totals ¦ +----+----------+------------------+------------------+----------¦ ¦ ¦ ¦excess profits tax¦ ¦ ¦ +----+----------+------------------+------------------+----------¦ ¦1941¦$10,223.64¦$6,326.16 ¦$34,333.63 ¦$50,883.43¦ +----+----------+------------------+------------------+----------¦ ¦1942¦ ¦716.99 ¦78,922.56 ¦79,639.55 ¦ +----+----------+------------------+------------------+----------¦ ¦1943¦ ¦1,508.23 ¦73,466.43 ¦74,974.66 ¦ +----+----------+------------------+------------------+----------¦ ¦1944¦ ¦ ¦24,614.14 ¦24,614.14 ¦ +----------------------------------------------------------------+

The deficiencies result in part from respondent's action in reducing its deductions for salaries and ‘miscellaneous‘ expenses. Other adjustments are not contested.

Petitioner's claim for a refund of excess profits tax in the years 1941 to 1943, inclusive, under Internal Revenue Code section 721(a)(2)(C), is also in issue.

The case was heard on a stipulation of facts and other evidence.

FINDINGS OF FACT.

The stipulated facts are hereby found accordingly.

Petitioner, a Pennsylvania corporation, filed its returns on an accrual basis for the years in question with the collector of internal revenue at Pittsburgh, Pennsylvania.

Salary Deduction Issue.

Karl and Frank Sommerfeld, brothers, were 55 and 52 years of age, respectively, at the time of the hearing herein. They attended public school and Carnegie Tech night school at Pittsburgh, Pennsylvania, where they studied mechanical engineering but did not graduate. In 1913 both began working in the machine shop of Sommerfeld Machine & Manufacturing Co., owned by their father. Frank worked for the company from 1913 until 1917, when he joined the Army, and returned in 1918 to become office manager. He became secretary and treasurer in 1922.

In 1924, when their father died, the brothers began operating the business, then located at 216 Second Avenue, Pittsburgh. In 1928 they borrowed money from a bank and bought the stock of older stockholders. The company failed and the brothers moved to Braddock, Pennsylvania, where they acquired a run-down building and engaged in general machine shop work.

Petitioner, originally called Sommerfeld Co., situated in Braddock, was incorporated under Pennsylvania law on January 5, 1933, with an authorized capital of $5,000 represented by 100 shares of $50 par value stock. The stock was represented by certificates dated January 10, 1933, and issued to the following persons:

+-----------------------------+ ¦Stockholder ¦Shares ¦ +--------------------+--------¦ ¦John N. Piatt ¦95 ¦ +--------------------+--------¦ ¦Frank H. Sommerfeld ¦3 ¦ +--------------------+--------¦ ¦Agnes W. Sommerfeld ¦1 ¦ +--------------------+--------¦ ¦Karl E. Sommerfeld ¦1 ¦ +--------------------+--------¦ ¦Total ¦100 ¦ +-----------------------------+

Agnes was Karl and Frank's mother. On February 23, 1933, Piatt transferred his 95 shares, 38 to Agnes, 33 to Karl, and 24 to Frank.

On August 16, 1935, Agnes transferred 19 shares to Karl's wife, Pauline A. Sommerfeld, and 19 shares to Frank's wife, Helen P. Sommerfeld. At the same time Karl transferred 33 shares to Pauline, and Frank transferred 24 shares to Helen. As of August 16, 1935, the stock was held of record as follows:

+-----------------------+ ¦Stockholder ¦Shares ¦ +--------------+--------¦ ¦Pauline ¦52 ¦ +--------------+--------¦ ¦Helen ¦43 ¦ +--------------+--------¦ ¦Frank ¦3 ¦ +--------------+--------¦ ¦Karl ¦1 ¦ +--------------+--------¦ ¦Agnes ¦1 ¦ +--------------+--------¦ ¦Total ¦100 ¦ +-----------------------+

In 1936 petitioner's name was changed from Sommerfeld Co. to Sommerfeld Machine Co. In 1937 the authorized capital stock was increased from $5,000 to $50,000. On December 1, 1937, certificates were issued for the following no par value shares to replace the $50 par value shares then outstanding:

+-----------------------+ ¦Stockholder ¦Shares ¦ +--------------+--------¦ ¦Pauline ¦52 ¦ +--------------+--------¦ ¦Helen ¦43 ¦ +--------------+--------¦ ¦Frank ¦4 ¦ +--------------+--------¦ ¦Karl ¦1 ¦ +--------------+--------¦ ¦Total ¦100 ¦ +-----------------------+

On December 20, 1937, petitioner issued additional no par value shares as stock dividends to the stockholders: 51 to Pauline, 42 to Helen, 4 to Frank, and 1 to Karl. During the years in question, petitioner's stock was held of record as follows:

+-----------------------+ ¦Stockholder ¦Shares ¦ +--------------+--------¦ ¦Pauline ¦103 ¦ +--------------+--------¦ ¦Helen ¦85 ¦ +--------------+--------¦ ¦Frank ¦8 ¦ +--------------+--------¦ ¦Karl ¦2 ¦ +--------------+--------¦ ¦Total ¦198 ¦ +-----------------------+

Both brothers devoted full time to petitioner's business during the tax years. Karl's only vacation consisted of 10 days during one of the years, and Frank was not absent from work more than two days. Karl has been president since 1933 and general manager since 1935. He attended to the hiring of personnel until 1938 or 1939, when that work was transferred to the shop foreman. Karl was in call 24 hours a day, 7 days a week, and frequently was required to come to the plant at night in the case of emergencies. The general machine shop business was highly competitive. All of petitioner's products, including lathes, competed with products of other companies.

In addition to his supervisory duties during the tax years, Karl installed a second hand heating system, a toilet and wash room, and a light plant at substantially lower costs than the price of new equipment. He also rebuilt all of petitioner's cranes.

Frank has been secretary and treasurer of petitioner since its creation, and during the years in question was in charge of purchasing. He had to obtain priorities from Washington and travel all over the country to find needed materials. In addition, Frank was thoroughly familiar with the production work, and was on call 24 hours a day. He and Karl cooperated to petitioner's benefit in supervising all phases of its operations.

Under date of February 8, 1940, petitioner entered into a contract with J. W. Hemmerle under which he was appointed distributor of lathes at 10 per cent commission. Karl went out with Hemmerle and helped close at least 90 per cent of the sales. The contract was discontinued and no commissions were paid in 1944. On some sales during the tax years petitioner also paid commissions to other persons. The total commissions paid were as follows:

+----------------------------------------------------------+ ¦ ¦1941 ¦1942 ¦1943 ¦ +----------------------+---------+----------+--------------¦ ¦Hemmerle ¦20,419.86¦$70,634.84¦$41,247.90 ¦ +----------------------+---------+----------+--------------¦ ¦J. Haetten ¦ ¦5,959.00 ¦900.00 ¦ +----------------------+---------+----------+--------------¦ ¦Industrial Plants Corp¦7,682.00 ¦31,909.00 ¦9,357.00 ¦ +----------------------+---------+----------+--------------¦ ¦George V. Murphy ¦15,785.16¦14,280.84 ¦ (3,006.50)¦ +----------------------+---------+----------+--------------¦ ¦R. G. Sommerfeld ¦3,808.60 ¦ ¦ ¦ +----------------------+---------+----------+--------------¦ ¦Total ¦47,695.62¦122,783.68¦48,498.40 ¦ +----------------------------------------------------------+ FN* Deduction for refund of commission.

1,004,963.94 ¦

In its returns for each of the years 1941, 1942, and 1943, petitioner deducted the total commissions paid during that year.

The number of persons employed by petitioner increased from 20 in 1939 to 42 in 1940; 76 in 1941; 95 in 1942 and 1943; and dropped to 75 in 1944. Business slacked during 1944 because of the decreased demand for petitioner's products, and in at least part of that year petitioner operated on two shifts instead of three.

During the years in question the aggregate amounts paid to the brothers as ‘salaries‘ and ‘bonuses‘ were as follows:

+-------------------------------------------+ ¦Year¦Officer¦Salary ¦Bonus ¦Total ¦ +----+-------+---------+---------+----------¦ ¦1940¦Karl ¦$7,500.00¦$9,700.00¦$17,200.00¦ +----+-------+---------+---------+----------¦ ¦1940¦Frank ¦6,000.00 ¦9,300.00 ¦15,300.00 ¦ +----+-------+---------+---------+----------¦ ¦ ¦Total ¦13,500.00¦19,000.00¦32,500.00 ¦ +----+-------+---------+---------+----------¦ ¦1941¦Karl ¦12,000.00¦32,000.00¦44,000.00 ¦ +----+-------+---------+---------+----------¦ ¦1941¦Frank ¦10,000.80¦30,000.00¦40,000.80 ¦ +----+-------+---------+---------+----------¦ ¦ ¦Total ¦22,000.80¦62,000.00¦84,000.80 ¦ +----+-------+---------+---------+----------¦ ¦1942¦Karl ¦18,000.00¦26,010.00¦44,010.00 ¦ +----+-------+---------+---------+----------¦ ¦1942¦Frank ¦18,000.00¦22,549.60¦40,549.60 ¦ +----+-------+---------+---------+----------¦ ¦ ¦Total ¦36,000.00¦48,559.60¦84,559.60 ¦ +----+-------+---------+---------+----------¦ ¦1943¦Karl ¦18,000.00¦26,010.00¦44,010.00 ¦ +----+-------+---------+---------+----------¦ ¦1943¦Frank ¦18,000.00¦22,549.60¦40,549.60 ¦ +----+-------+---------+---------+----------¦ ¦ ¦Total ¦36,000.00¦48,559.60¦84,559.60 ¦ +----+-------+---------+---------+----------¦ ¦1944¦Karl ¦18,000.00¦7,000.00 ¦25,000.00 ¦ +----+-------+---------+---------+----------¦ ¦1944¦Frank ¦18,000.00¦7,000.00 ¦25,000.00 ¦ +----+-------+---------+---------+----------¦ ¦ ¦Total ¦36,000.00¦14,000.00¦50,000.00 ¦ +-------------------------------------------+

Prior to 1940 the compensation of petitioner's officers consisted entirely of ‘salaries‘, no ‘bonuses‘ being paid. During 1933 Karl and Frank received salaries of $1,305.73 and $1,769.26, respectively. At a directors' meeting held January 9, 1934, they were awarded 1933 ‘salaries‘ of $8,700 and $5,700, to be reduced by the payments already received. Beginning in 1934 and including 1939, their ‘salaries‘ were fixed at $7,500 for Karl and $6,000 for Frank. The amounts designated ‘salaries‘ for the years 1940 and 1941 were authorized at meetings of petitioner's board of directors held on January 9, 1940, and January 14, 1941. The ‘salaries‘ of $18,000 fixed for 1942 and subsequent years were authorized at directors' meetings held during January of each year. Of the total ‘bonuses‘ received in 1940, $7,500 to each was authorized at a directors' meeting held December 12, 1940, and the remaining ‘bonuses‘ were paid without apparent authorization. The dates of directors' meetings at which ‘bonuses‘ were authorized during the taxable years, and the amounts paid to each officer were as follows:

+---------------------------------------------+ ¦Date ¦Karl ¦Frank ¦Total ¦ +--------------+---------+---------+----------¦ ¦Mar. 11, 1941 ¦$8,000.00¦$7,000.00¦$15,000.00¦ +--------------+---------+---------+----------¦ ¦Nov. 20, 1941 ¦24,000.00¦23,000.00¦47,000.00 ¦ +--------------+---------+---------+----------¦ ¦Total ¦32,000.00¦30,000.00¦62,000.00 ¦ +--------------+---------+---------+----------¦ ¦Apr. 2, 1942 ¦10,000.00¦9,500.00 ¦19,500.00 ¦ +--------------+---------+---------+----------¦ ¦July 20, 1942 ¦5,687.00 ¦5,183.60 ¦10,870.60 ¦ +--------------+---------+---------+----------¦ ¦Sept. 11, 1942¦3,687.00 ¦3,183.00 ¦6,870.00 ¦ +--------------+---------+---------+----------¦ ¦Oct. 15, 1942 ¦1,500.00 ¦1,500.00 ¦3,000.00 ¦ +--------------+---------+---------+----------¦ ¦Dec. 4, 1942 ¦5,136.00 ¦3,183.00 ¦8,319.00 ¦ +--------------+---------+---------+----------¦ ¦Total ¦26,010.00¦22,549.60¦48,559.60 ¦ +--------------+---------+---------+----------¦ ¦Mar. 3, 1943 ¦5,000.00 ¦5,000.00 ¦10,000.00 ¦ +--------------+---------+---------+----------¦ ¦May 31, 1943 ¦5,500.00 ¦5,000.00 ¦10,500.00 ¦ +--------------+---------+---------+----------¦ ¦Aug. 27, 1943 ¦5,500.00 ¦4,500.00 ¦10,000.00 ¦ +--------------+---------+---------+----------¦ ¦Nov. 15, 1943 ¦3,460.00 ¦2,749.80 ¦6,209.80 ¦ +--------------+---------+---------+----------¦ ¦Dec. 3, 1943 ¦3,460.00 ¦2,749.80 ¦6,209.80 ¦ +--------------+---------+---------+----------¦ ¦Dec. 30, 1943 ¦3,090.00 ¦2,550.00 ¦5,640.00 ¦ +--------------+---------+---------+----------¦ ¦Total ¦26,010.00¦22,549.60¦48,559.60 ¦ +--------------+---------+---------+----------¦ ¦Mar. 8, 1944 ¦3,500.00 ¦3,000.00 ¦6,500.00 ¦ +--------------+---------+---------+----------¦ ¦July 20, 1944 ¦1,750.00 ¦1,750.00 ¦3,500.00 ¦ +--------------+---------+---------+----------¦ ¦Dec. 14, 1944 ¦1,750.00 ¦2,250.00 ¦4,000.00 ¦ +--------------+---------+---------+----------¦ ¦Total ¦7,000.00 ¦7,000.00 ¦14,000.00 ¦ +---------------------------------------------+

During 1942, 1943, and 1944 petitioner's board of directors authorized bonuses to George Elzer, shop foreman, aggregating $9,900, and to two other employees of $490.

The minutes do not disclose that the directors intended the ‘salaries‘ or ‘bonuses‘ to compensate the officers for services rendered in prior years.

Section 5 of petitioner's by-laws provided that ‘a majority of Directors in office shall be necessary to constitute a quorum for the transaction of business.‘ Karl and Frank have at all times constituted a majority of directors in office. The board was composed of Karl, Frank, and Agnes until 1937, when Agnes was replaced by Pauline. As disclosed by the corporate minutes, both wives attended the annual meetings of stockholders, and Pauline attended some of the directors' meetings. Karl and Frank have at all times determined petitioner's policies, and fixed the amounts of their own compensation, without consulting their wives. If the wives knew of the amounts of compensation, they raised no objections. As disclosed by the minutes, Karl and Frank were the only directors present at the meetings authorizing ‘bonuses‘ in 1942, 1943, and 1944.

In its return for the years 1933 to 1944, inclusive, petitioner reported net sales, gross profits from sales, deduction for officers' compensation, total Federal income, and excess profits taxes, taxable net income and dividends paid as follows:

+------+ ¦¦¦¦¦¦¦¦ +------+

Total Federal Gross Officers' income and profit compensation excess Taxable Dividends Year Net sales from sales claimed profits net paid taxes income 1933 $18,216.09 $8,072.76 $3,074.99 None $1,191.44 1934 26,926.70 11,271.90 13,500.00 None 11,768.33 1935 62,708.14 20,170.12 13,500.00 None 1,342.48 1936 105,281.47 30,384.03 13,500.00 None 1,599.88 1937 174,176.12 44,522.89 13,500.00 $406.66 4,242.20 6,000.00 1938 110,747.67 39,505.45 13,500.00 1,029.23 6,983.16 1939 51,648.64 10,115.34 13,500.00 None 15,270.52 1940 195,006.97 89,968.12 32,500.00 948.06 6,245.83 1941 502,712.73 235,043.13 84,000.80 21,953.03 49,286.41 1,980.00 1942 1,004,963.94 420,658.13 84,559.60 91,616.32 158,991.88 11,880.00 1943 737,352.00 372,797.08 84,559.60 103,644.26 162,939.68 11,880.00 1944 370,256.36 129,043.01 50,000.00 4,915.14 18,574.59 FN* Loss.

933,417.12 ¦ +------+-----------------+-----------------¦ ¦1943 ¦737,352.00 ¦550,511.77 ¦ +------+-----------------+-----------------¦ ¦ ¦ ¦ ¦ +------------------------------------------+

7,139.70 Real estate taxes 1,600.00 $1,600.00 Pay roll taxes 2,800.00 2,800.00 Depreciation on plant assets 2,000.00 2,000.00 Factory supervision 12,500.00 12,500.00 Total 147,575.55 140,435.85 159,335.85 18,900.00 Less: Ending inventory 35,397.00 35,397.00 35,397.00 Cost of sales 112,178.55 105,038.85 123,938.85

13,049.83 Real estate taxes 1,600.00 1,600.00 Pay roll taxes 6,000.00 6,000.00 Depreciation on plant assets 4,698.15 4,698.15 Factory supervision 12,500.00 12,500.00 Total 459,608.23 446,558.40 471,356.55 24,798.15 Less: Ending inventory 178,888.80 178,888.80 178,888.80 Cost of sales 280,719.43 267,669.60 292,467.75

22,155.44 Real estate taxes 2,200.00 2,200.00 Pay roll taxes 8,100.00 8,100.00 Rent of factory premises 504.00 504.00 Depreciation on plant assets 7,829.55 7,829.55 Repairs (plant and machinery) 2,700.00 2,700.00 Factory supervision 12,500.00 12,500.00 Total 689,163.35 667,007.91 700,841.46 33,833.55 Less: Ending inventory 82,702.10 82,702.10 82,702.10 Cost of sales 606,461.25 584,305.81 618,139.36

30,984.59 Real estate taxes 2,300.00 $2,300.00 Pay roll taxes 7,600.00 7,600.00 Rent of factory premises 720.00 720.00 Depreciation on plant assets 17,430.58 17,430.58 Repairs to plant and machinery 1,600.00 1,600.00 Factory supervision 12,500.00 12,500.00 Total 413,960.85 382,976.26 425,126.84 42,150.58 Less: Ending inventory 18,421.34 18,421.34 18,421.34 Cost of sales 395,539.51 364,554.92 406,705.50

The dividends paid during the years in question were authorized at director's meetings held on the following dates:

+-------------------------------------+ ¦ ¦Dividend ¦ ¦ +-----------------+-----------+-------¦ ¦Date of meeting ¦per share ¦Total ¦ +-----------------+-----------+-------¦ ¦ ¦ ¦ ¦ +-----------------+-----------+-------¦ ¦Nov. 20, 1941 ¦$10 ¦$1,980 ¦ +-----------------+-----------+-------¦ ¦ ¦ ¦ ¦ +-----------------+-----------+-------¦ ¦June 4, 1942 ¦30 ¦5,940 ¦ +-----------------+-----------+-------¦ ¦Dec. 22, 1942 ¦30 ¦5,940 ¦ +-----------------+-----------+-------¦ ¦ ¦ ¦ ¦ +-----------------+-----------+-------¦ ¦Total ¦60 ¦11,880 ¦ +-----------------+-----------+-------¦ ¦ ¦ ¦ ¦ +-----------------+-----------+-------¦ ¦June 21, 1943 ¦30 ¦5,940 ¦ +-----------------+-----------+-------¦ ¦Nov. 23, 1943 ¦30 ¦5,940 ¦ +-----------------+-----------+-------¦ ¦ ¦ ¦ ¦ +-----------------+-----------+-------¦ ¦Total ¦60 ¦11,880 ¦ +-------------------------------------+

When petitioner began business it engaged in general machine shop work and made some glass forming machinery. It continued exclusively in this general line of work until 1940 when it also began the manufacture and sale of lathes. The percentage of total gross receipts attributable to sales of lathes and parts increased from approximately 16 per cent in 1940 to 70 per cent in 1941, and 93 per cent in 1942, and dropped to 75 per cent in 1943.

The decision to produce heavy duty lathes was made in or about 1936. At that time petitioner's plant consisted of one building 90 by 200 feet in size. Prior to the tax years it added a 30-by 160-foot addition to the building and erected a second building about 40 by 100 feet in size. A railroad siding was built and new types of machinery were installed. The expansion program was planned and supervised by Karl and Frank without outside help.

Manufacture and sale of the lathes would not have been possible except for the research and development by Karl, Frank, and other employees of petitioner from 1936 to 1939.

Other companies whose stock is publicly traded in, classified in the Securities and Exchange Commission list as manufacturers of general industrial and metal working machinery, during the years in question paid officers' salaries having ratios to gross sales and to ‘net profit before officers' compensation and federal taxes‘ ranging from .5 and 1.4 per cent to 32.2 and 56.7 per cent, respectively.

In its returns for the years in question, petitioner deducted as business expense the total amounts of ‘salaries‘ and ‘bonuses‘ paid to Karl and Frank in each year.

In his notices of deficiency respondent allowed deductions as ‘compensation of officers‘ of $12,500 for each officer in each of the taxable years and disallowed the remainder of the deductions claimed.

Reasonable allowances as compensation for personal services by petitioner to its officers in each of the years 1941 through 1944 were $22,000 for Karl and $20,000 for Frank.

Section 721 Issue.

In 1933 or 1934 Karl saw the opportunity for petitioner to design and produce large lathes. He was familiar with the metal working lathes with ‘swings‘ of between 27 inches and 60 inches then available and believed that he could design a more rigid product in that size group. In 1935 or 1936 he began making sketches at home in the evenings and employed a draftsman named Allen Goeppel. During the experimental period, sixty or seventy drawings were made for each lathe that was actually produced. The first lathes, two 27 inch ones, were built in 1937. One was sold to Arch Machinery Co. for $2,860, an amount substantially under cost, in order to get one of the lathes before the public. The other lathe was retained in petitioner's plant for continued experiments.

The drawings and buildings of test lathes by trial and error methods continued into the year 1939, one drawing being made as late as July 18 of that year. The principal advantages which petitioner sought to incorporate in its product were increased rigidity (the ability to take a heavy cut of material) and the addition of a mechanical-electrical remote control system. In the process of attempting to develop a more rigid lathe than was then available on the market, petitioner subjected its experimental machines to production tests, and where a part of the lathe showed a need of greater rigidity, that part was replaced by one of improved design and additional tests were run.

Before production of the lathes could be conducted on a large scale, petitioner was required to expand its plant as previously indicated under the salary issue. The first sales were made in 1940. Petitioner continued its general machine shop work. Its total net sales reported in its returns as compared to the total sales of lathes and parts for the years 1940 to 1943, inclusive, were as follows:

+------------------------------------------+ ¦ ¦ ¦Sales of lathes ¦ +------+-----------------+-----------------¦ ¦Year ¦Total net sales ¦and parts ¦ +------+-----------------+-----------------¦ ¦1940 ¦$195,006.97 ¦$31,196.00 ¦ +------+-----------------+-----------------¦ ¦1941 ¦502,712.73 ¦366,678.20 ¦ +------+-----------------+-----------------¦ ¦1942 ¦ FN* Not adjusted for 1942 renegotiation rebate.

No lathes were sold in 1944.

During the years in question, petitioner produced and sold lathes with swings of 27, 32, 50 and 60 inches, varying in length from 22 to 100 feet, and weighing up to about sixty tons. Three lathes were sold in 1940, 16 in 1941, 24 in 1942, and 12 in 1943.

Petitioner's lathes were sold to the armed forces and to private concerns doing war work in the ship-building and armament industries. They were used to turn and bore propeller shafts for ships and large caliber gun barrels. All lathe purchasers were required to have Government priorities.

Lathe manufacturers generally follow a liberal policy of furnishing detailed drawings of their machines to outsiders. However, if petitioner as a prospective competitor had approached a lathe manufacturer and disclosed that he desired such drawings as a means of producing a competitive lathe, it would have refused the request. Petitioner has never applied for a patent on any lathe or part thereof. It is not a usual practice in the industry for large lathes and parts to be patented.

A comparative analysis for each year of the amounts designated ‘Cost of Sales‘, showing adjustments by respondent, is as follows:

+----+ ¦1940¦ +----¦ ¦¦¦¦¦¦ +----+

As adjusted Amount of Origina Amended by adjustments Item petition petition respondent Beginning inventory $8,984.50 $8,984.50 $8,984.50 Purchases for manufacture 52,535.08 52,535.08 52,535.08 Labor 71,149.48 71,149.48 71,149.48 Other costs 7,766.79 7,766.79 7,766.79 Other expenses

1941 Beginning inventory 35,397.00 35,397.00 35,397.00 Purchases for manufacture 242,265.81 242,265.81 242,265.81 Labor 154,195.14 154,195.14 154,195.14 Shop expense 5,813.04 5,813.04 5,813.04 Light, heat, power 5,358.22 5,358.22 5,358.22 Insurance 1,067.33 1,067.33 1,067.33 Hauling and freight 2,461.86 2,461.86 2,461.86 Other deductions

1942 Beginning inventory 178,888.80 178,888.80 178,888.80 Purchases for manufacture 258,208.62 258,208.62 258,208.62 Labor 210,274.87 210,274.87 210,274.87 Shop expense 7,894.92 7,894.92 7,894.92 Light, heat, power 5,104.88 5,104.88 5,104.88 Insurance 2,715.69 2,715.69 2,715.69 Hauling and freight 3,920.13 3,920.13 3,920.13 Other deductions

1943 Beginning inventory $82,702.10 $82,702.10 $82,702.10 Purchases for manufacture 79,114.62 79,114.62 79,114.62 Labor 200,230.64 200,230.64 200,230.64 Shop expense 7,819.76 7,819.76 7,819.76 Light, heat, power 6,042.29 6,042.29 6,042.29 Insurance 3,971.08 3,971.08 3,971.08 Hauling and freight 3,095.77 3,095.77 3,095.77 Other deductions FN* Petitioner's original claim deducted an amount for taxes, depreciation, and other expenses which items were excluded in its amended claim.

During the years 1941 through 1943, petitioner had ‘direct costs and expenses‘ applicable to the sale of lathes, and parts, in addition to those included in cost of sales, as follows:

+----------------+ ¦1941¦$53,395.69 ¦ +----+-----------¦ ¦1942¦127,950.07 ¦ +----+-----------¦ ¦1943¦63,581.55 ¦ +----------------+

An Internal Revenue Agent, assigned to verify petitioner's returns and to investigate its claim for relief under section 721, Internal Revenue Code, made adjustments after examining petitioner's books and conversing with its officers. $35,000 of adjustments increasing ‘Total Sales‘ and ‘Sales of Lathes and Parts‘ for 1942 represented rebates made in that year by petitioner to the War Department in renegotiation of war contracts. Adjustments increasing ‘Cost of Sales‘ by $18,900 in 1940, $24,798.15 in 1941, $33,833.55 in 1942, and $42,150.58 in 1943, were based upon accounts on petitioner's books. In some instances, the increases substantially restore deductions appearing in petitioner's original petition but excluded in the amended petition. $12,500 increase in each year for ‘Factory Supervision,‘ the only item among the adjustments which was not represented in the original petition, is 50 per cent of $25,000, the amount determined by respondent to be the total deductible compensation paid to the officers. The allocation to ‘Factory Supervision‘ was based upon conversations with Karl and Frank concerning the amount of time they spend in the plant.

Adjustments to ‘Cost of the Lathe Sales‘ of $3,023.48 in 1940, $17,930.92 in 1941, $29,837.62 in 1942, and $31,470.07 in 1943, reflect the adjustments to ‘Cost of Sales,‘ described above, computed on the ratio of ‘Total Sales‘ to ‘Sale of Lathes & Parts.‘

$1,249.25 adjusting other ‘direct costs‘ applicable to 1941 lathe sales, represents a ‘premium on performance bond * * * held to constitute a direct cost or expense applicable to the sale of lathes,‘ and was included as a deduction in the original petition but excluded in the amended petition. The bond was posted in connection with a contract for construction of lathes.

In its claim for relief under section 721, Internal Revenue Code, petitioner computed the following ‘research and development‘ expenses for the years 1936 to 1939, inclusive:

+----+ ¦1936¦ +----¦ ¦¦¦¦ ¦ +----+

Estimated time Total salary allotted to Expense development

Per cent Karl $7,500 25 $1,875.00 Frank 6,000 25 1,500.00 Goeppel 3,000 50 1,500.00 Total 4,875.00

1937 Direct labor $3,767.02 Material 4,565.75 Shop overhead 5,234.25 Special tooling 4,111.64 Total 17,678.66 Less: Received for 27-inch test lathe 2,860.00 Total 14,818.66

1938 Per cent Labor and material $7,764.00 Karl $7,500 20 1,500.00 Frank 6,000 20 1,200.00 Total 10,464.00

1939

Per cent Karl $7,500 20 $1,500.00 Frank 6,000 10 600.00 Total 2,100.00

Petitioner now contends that its ‘research and development‘ expenses for 1937 were $18,193.66, being the claimed $14,818.66, above, plus 25 per cent of Karl's and Frank's salaries for 1937.

In the years 1936 through 1939, petitioner did not have a summary account recording its expenditures for ‘research and development‘ of the lathes. Except for the amounts estimated for time spent by Karl, Frank, and Goeppel in research and development, items appearing in the above computations were taken from petitioner's labor sheets and other records. The ‘Shop overhead‘ expense is based upon a one-dollar hourly rate.

During the years 1936 through 1939, petitioner's total expenses connected with research and development of the lathes were as follows:

+------------------+ ¦Year ¦ ¦ +------+-----------¦ ¦ ¦ ¦ +------+-----------¦ ¦1936 ¦$4,875.00 ¦ +------+-----------¦ ¦1937 ¦18,193.66 ¦ +------+-----------¦ ¦1938 ¦10,464.00 ¦ +------+-----------¦ ¦1939 ¦2,100.00 ¦ +------+-----------¦ ¦Total ¦$35,632.66 ¦ +------------------+

In its amended petition, petitioner computes ‘Gross Abnormal Income‘ and ‘Net Abnormal Income‘ as follows:

+---+ ¦¦¦¦¦ +---+

Year Gross abnormal Net abnormal income income 1941 $171,283.41 $129,772.99 1942 390,710.79 231,494.75 1943 278,332.88 81,461.71 The ‘Gross Abnormal Income‘ for each year, above, is the same as petitioner's computation of ‘Gross Income from Lathes & Parts.‘ The amounts designated ‘Net Abnormal Income,‘ above, were calculated by reducing ‘Gross Abnormal Income‘ by the statutory deductions for 125 per cent of the average amount of income from lathes for the four prior years, and direct costs and expenses.

Shipments of machine tools of all types during the years 1936 to 1944, inclusive, were as follows:

+---------------------+ ¦Year ¦Amount ¦ +------+--------------¦ ¦1936 ¦$133,000,000 ¦ +------+--------------¦ ¦1937 ¦195,000,000 ¦ +------+--------------¦ ¦1938 ¦145,000,000 ¦ +------+--------------¦ ¦1939 ¦200,000,000 ¦ +------+--------------¦ ¦1940 ¦440,000,000 ¦ +------+--------------¦ ¦1941 ¦775,000,000 ¦ +------+--------------¦ ¦1942 ¦1,320,000,000 ¦ +------+--------------¦ ¦1943 ¦1,180,000,000 ¦ +------+--------------¦ ¦1944 ¦497,000,000 ¦ +---------------------+

Business improvement factors result therefrom as follows: 3.163265 for 1941, 3.384615 for 1942, and 1.72578 for 1943.

In computing ‘Abnormal income on lathes and parts resulting from research and development,‘ respondent reduced the ‘Total Gross income from sale of lathes and parts‘ (as adjusted by the revenue agent) by amounts determined to represent income from ‘manufacturing and selling.‘ Respondent applied the ‘Business improvement factor‘ for each year to ‘Abnormal Income,‘ less ‘Direct costs and expenses.‘

Petitioner's ‘Gross income from lathes and parts‘ in each of the years 1940 through 1943 was as follows:

+-------------------+ ¦Year ¦Deduction ¦ +------+------------¦ ¦1940 ¦$11,369.04 ¦ +------+------------¦ ¦1941 ¦153,352.49 ¦ +------+------------¦ ¦1942 ¦325,873.17 ¦ +------+------------¦ ¦1943 ¦246,862.81 ¦ +-------------------+

The deduction in each taxable year for 125 per cent of the gross income of the same class for the four previous years is as follows:

+-------------------+ ¦Year ¦Deduction ¦ +------+------------¦ ¦1941 ¦$3,552.83 ¦ +------+------------¦ ¦1942 ¦51,475.48 ¦ +------+------------¦ ¦1943 ¦153,310.85 ¦ +-------------------+

The deduction in each taxable year for direct costs or expenses, bearing the same ratio to total direct costs as the excess of abnormal income over the foregoing figures for the 125 per cent bears to abnormal income, is as follows:

+-------------------+ ¦Year ¦Deduction ¦ +------+------------¦ ¦1941 ¦$52,158.63 ¦ +------+------------¦ ¦1942 ¦107,738.86 ¦ +------+------------¦ ¦1943 ¦24,095.08 ¦ +-------------------+

During the period from 1936 to 1939, inclusive, petitioner conducted a program of research and development on its lathes extending over a period of more than 12 months, resulting in the receipt of net abnormal income in the taxable years as follows:

+--------------------------------------------------------------------------+ ¦ ¦1941 ¦1942 ¦1943 ¦ +--------------------------------------+-----------+-----------+-----------¦ ¦a. Gross income from lathes and parts ¦$153,352.49¦$325,873.17¦$246,862.81¦ +--------------------------------------+-----------+-----------+-----------¦ ¦b. Less: 125 per cent of prior 4 years¦ ¦ ¦ ¦ +--------------------------------------+-----------+-----------+-----------¦ ¦average ¦$3,552.83 ¦$51,475.48 ¦$153,310.85¦ +--------------------------------------+-----------+-----------+-----------¦ ¦ ¦$149,799.66¦$274,397.69¦$93,551.96 ¦ +--------------------------------------+-----------+-----------+-----------¦ ¦c. Less: Direct costs and expenses ¦ ¦ ¦ ¦ +--------------------------------------+-----------+-----------+-----------¦ ¦applicable to abnormal income ¦$52,158.63 ¦$107,738.86¦$24,095.08 ¦ +--------------------------------------+-----------+-----------+-----------¦ ¦d. Net abnormal income from lathes and¦ ¦ ¦ ¦ +--------------------------------------+-----------+-----------+-----------¦ ¦parts ¦$97,641.03 ¦$166,658.83¦$69,456.88 ¦ +--------------------------------------+-----------+-----------+-----------¦ ¦e. Business improvement factor ¦3.163265 ¦3.384615 ¦1.72578 ¦ +--------------------------------------+-----------+-----------+-----------¦ ¦f. Net abnormal income due to business¦ ¦ ¦ ¦ +--------------------------------------+-----------+-----------+-----------¦ ¦improvement ¦$66,773.86 ¦$117,418.72¦$29,210.22 ¦ +--------------------------------------+-----------+-----------+-----------¦ ¦g. Net abnormal income due to research¦ ¦ ¦ ¦ +--------------------------------------+-----------+-----------+-----------¦ ¦and development and attributable ¦ ¦ ¦ ¦ +--------------------------------------+-----------+-----------+-----------¦ ¦to other years ¦$30,867.17 ¦$49,240.11 ¦$40,246.66 ¦ +--------------------------------------------------------------------------+

The net abnormal incomes due to research and development are attributable to each of the years 1936 to 1939, inclusive, in the proportion that each year's development expenses bears to the total thereof.

The ‘Miscellaneous Expense‘ Deduction.

On February 14, 1941, petitioner drew a check on Braddock National Bank to the order of ‘Cash‘ for $1,000. The check was paid by the bank on the same date. It was shown on petitioner's cash receipts and disbursements book as cash disbursement under the designation ‘Miscellaneous.‘ The proceeds were paid to Hemmerle as commissions.

On February 21, 1941, petitioner drew its check on the same bank to the order of ‘Cash‘ for $6,546.08. The bank paid the check on the same date. On petitioner's books $3,546.08 was recorded as ‘Shop Salaries,‘ and $3,000 as ‘Miscellaneous Expense.‘ Of the $3,000, $2,000 was paid for traveling expenses and $1,000 for commissions.

Payment of commissions and traveling expenses by cash or by checks drawn to the order of cash was not customarily practiced by petitioner and was an unusual occurrence.

In its income and declared value excess profits tax return for the year 1941 under ‘Other deductions,‘ petitioner claimed ‘Miscellaneous Expenses‘ of $12,803.24. In his notice of deficiency respondent disallowed $4,481.85, of which the $4,000 in question is a part, ‘for the reason that the deduction has not been substantiated as an ordinary and necessary business expense.‘

The $4,000 in issue was an ordinary and necessary business expense of petitioner in 1941.

OPINION.

OPPER, Judge:

Whether the salaries paid to petitioner's office-stockholders were reasonable is a question of fact. We have disposed of it in our findings.

No one factor was decisive in the formulation of our conclusion. The salaries paid in prior years, the nature of the duties performed, the increase in the demands of the business upon the principal officers, the success of petitioner's operations, and petitioner's dividend history are some of the aspects to which consideration has been given. J. J. Hart, Inc., 9 T.C. 135, 140; Wagegro Corp., 38 B.T.A. 1225; Miller Manufacturing Co., Inc. (CCA-4), 149 Fed.(2d) 421; 4 Mertens, ‘Law of Federal Income Taxation,‘ section 25.51. The upshot, as our findings show, is that while we agree with petitioner that respondent's determination has been too drastic, we likewise view the payments actually made as excessive.

A number of sub-issues are interwoven in the controversy under section 721(a)(2)(C). We conclude in the first place, although not without reservation, that petitioner did in fact engage during the base period in research and development leading to the creation of its principal product. W. B. Knight Machinery Co., 6 T.C. 519; Keystone Brass Works, 12 T.C. 618.

The remaining matters concern the method of computation of the net abnormal income so realized which is attributable to other years. We have found as a fact the figures which seem to us appropriate for use in the computation of this amount. Respondent's contention that certain ‘direct costs and expenses‘ shown by petitioner's books should be deducted, we think justifiable, and have so held. See Soabar Co., 7 T.C. 89. We come to a similar conclusion with respect to adjustments to the net sales figure, including the deduction of the renegotiation rebate which seems to us to have been either an offset against gross sales or an exclusion from gross income. See Baltimore Foundry & Machinery Corp., 7 T.C. 998; cf. National Builders, Inc., 12 T.C. 852. In either event the effect on the ultimate figures would be the same.

An additional controversy deals with the necessity of attributing some part of the petitioner's income from the developed product to its activities of manufacture and sale, as opposed to pure development. See Regulations 112, section 35.721-7. Although as a matter of law we assume for present purposes that such a distinction may be valid, cf. Rochester Button, Co., 7 T.C. 529, with Morrisdale Coal Mining Co., 13 T.C. 448; see Phelps ‘Relief under Section 721‘ Taxes, March 1950; the presentation of the case by respondent seems to us to preclude it here. On the previous issue dealing with the reasonableness of the salaries paid, respondent insists that a minimum of weight be given to the activities of petitioner's principal officers in the expansion of the business. If their services were as negligible as respondent contends in this connection, we are unable to conclude that the operations under their direction of manufacture and sale contributed measurably to the abnormal income. Furthermore, our deduction of the renegotiation rebate tends to eliminate the factor of increased prices. The Toledo Engineering Co., 14 T.C. 765.

In W. B. Knight Machinery Co., supra, 534, the business improvement factor, 2.6152, was applied ‘to petitioner's net abnormal income of $72,053.61, * * * (leaving) $44,501.76 * * * due to improved business conditions and * * * $27,551.85 * * * attributed to the expenditures which petitioner made during the period 1936 to 1940 in bringing its machines * * * to commercial production.‘ In the present proceeding respondent seeks to apply the business improvement factors to abnormal income as distinguished from net abnormal income. Nothing in this record convinces us that what respondent concedes to be a novel method of computing the portion of net abnormal income due to business improvement is necessary to achieve a correct ultimate figure. On authority of the Knight Machinery Co., case, supra, this contention is rejected.

On the final question, payment of the contested $4,000 in 1941 to defray travel and commission expenses was substantiated by testimony of petitioner's treasurer. In the absence of rebuttal evidence casting doubt upon the issue, deductibility of the $4,000 as ordinary and necessary business expense in 1941 is allowed.

Reviewed as to section 721(a)(2)(C) by the Special Division.

Decision will be entered under Rule 50.

MURDOCK, J., dissenting: The question of a reasonable deduction for officers' salaries is necessarily involved in the 721(a)(2)(C) issue and, since the amount allowed is, in my opinion, too low, I disagree as to the result reached under section 721(a)(2)(C).