Telfair Stockton & Co.
v.
Comm'r of Internal Revenue

This case is not covered by Casetext's citator
Tax Court of the United States.Nov 19, 1953
21 T.C. 239 (U.S.T.C. 1953)

Docket No. 6164.

1953-11-19

TELFAIR STOCKTON AND COMPANY, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Robert P. Smith, Esq., for the petitioner. Newman A. Townsend, Jr., Esq., and William J. Stetter, Esq., for the respondent.


Robert P. Smith, Esq., for the petitioner. Newman A. Townsend, Jr., Esq., and William J. Stetter, Esq., for the respondent.

1. SEC. 711(b)(1)('j) and ('k), I.R.C.— Petitioner deducted a payment of 50 per cent of its yearly profits as an expense attributable to the profits earned during each base period year. Held, petitioner did not sustain the burden of proving that such payment was abnormal or that the increased payment was not in consequence of an increase in gross income in petitioner's base period.

2. SEC. 722 RELIEF.— Petitioner has not established that the actual base period net income was not normal for the purpose of comparison with the income of the tax years, section 722(a) and (b)(5), Internal Revenue Code.

In this proceeding the petitioner contests the determination of a deficiency by the Commissioner as follows:

+-----------------------------------------------+ ¦ ¦ ¦Amount of ¦ +-------------------+--------------+------------¦ ¦Fiscal year ended ¦Tax ¦deficiency ¦ +-------------------+--------------+------------¦ ¦Feb. 28, 1943 ¦Excess profits¦$1,284.3 ¦ +-----------------------------------------------+

The petitioner also requests review of respondent's disallowance of a claim for relief under section 722, Internal Revenue Code, for the fiscal year ended February 28, 1943. The issues for decision are:

(1) In determining petitioner's excess profits credit under section 713, Internal Revenue Code, for the fiscal year ended February 28, 1943, should certain payments which were made by petitioner during the base period to Telco Holding Company pursuant to their contract, dated March 1, 1932, be disallowed as abnormal deductions under section 711(b)(1)(J) and (K), Internal Revenue Code?

(2) Is petitioner entitled to relief under section 722, Internal Revenue Code, for the fiscal year ended February 28, 1943, and, if so, what amount may be used as its constructive average base period net income in computing its excess profits credit?

FINDINGS OF FACT.

The stipulated facts are so found.

The petitioner, Telfair Stockton and Company, Inc., was organized under the laws of the State of Florida under date of March 1, 1932, by a group of key employees and stockholders of Telco Holding Company, hereinafter called Telco.

For the fiscal year ended February 28, 1943, the petitioner filed with the collector of internal revenue for the district of Florida a consolidated corporation income and declared value excess-profits tax return, Form 1120, and a consolidated corporation excess profits tax return, Form 1121, with the following corporations:

Fairfax Manor, Inc.

The Vault Corporation

Colonial Manor, Inc.

Stockton Homes, Inc.

Colonial Homes, Inc.

The subsidiary corporations are not parties to this proceeding and the issues in controversy do not involve any adjustment to their base period income.

Telco, a corporation existing under the laws of the State of Florida, had long been engaged in the management and development of property in its own right and through a number of affiliated corporations, namely, the Avondale Company, Marco Investment Company, Bond Corporation of Jacksonville, Porterfield Company, Stockton Mortgage Company, and Better Homes Company, and likewise was engaged in the insurance and brokerage business. Prior to March 1, 1932, the major part of Telco's income was derived from the real estate management business.

During the early part of 1932 Telco was in serious financial difficulties. All of Telco's assets including those of its affiliates, except the brokerage and insurance accounts which did not lend themselves to assignment, were encumbered, mortgaged, or assigned as collateral to the Florida National Bank of Jacksonville and the Barnett National Bank of Jacksonville, Florida, for obligations totaling $201,500 which matured March 31, 1932. In addition, Telco had outstanding current obligations totaling $27,500 which it was unable to meet. The banks were on the verge of placing Telco in receivership or bankruptcy. The situation was discussed with the two banks by James R. Stockton, president of Telco, hereinafter called Stockton, and his associates in the hope that some arrangement might be worked out to avoid foreclosure and enable Telco and its affiliates to continue their operations. The banks were anxious to retain Telco's personnel to liquidate the assets and the indebtedness because it was felt that their knowledge of Telco's business would produce more satisfactory results than would be the case if strangers were employed. The negotiations resulted in the formulation of a 10-year plan under which a new company was to be organized to take over management of the properties and businesses of Telco and its affiliates. All the physical assets of Telco and its affiliates that were not already mortgaged would be pledged to the banks to secure their indebtedness, except the insurance business, furniture, fixtures, and office equipment which were to be acquired by the new company.

Pursuant to the aforesaid plan petitioner was organized March 1, 1932, by Stockton and other employees and stockholders of Telco. It sold 270 shares of preferred stock for $100 per share. In addition, the stockholders received 1 share of petitioner's common stock and 1 share of Telco common stock for which they paid $1. Stockton and the estate of his mother, Florence O. Stockton, were the principal stockholders of both petitioner and Telco. Together they held about 80 per cent of Telco's stock and about 60 per cent of petitioner's shares. Stockton was coexecutor of his mother's estate.

Upon organization of the petitioner, it entered into the following contract with Telco on March 1, 1932.

THIS AGREEMENT made this 1st day of March, A.D. 1932, by and between TELCO HOLDING COMPANY and TELFAIR STOCKTON & COMPANY, INC., both corporations organizes and existing under and by virtue of the laws of the State of Florida.

WITNESSETH:

WHEREAS Telco Holding Company has heretofore determined to effect a sale of its real estate brokerage business and insurance brokerage business; and

WHEREAS said Telco Holding Company, either directly or indirectly, through subsidiary ownership, is the owner of part of the capital stock of Avondale Company, Marco Investment Company, the Bond Corporation of Jacksonville, and Porterfield Company, and owns and/or controls the entire issued common capital stock of Stockton Mortgage Company and Better Homes Company, all of said companies being corporations organized and existing under and by virtue of the laws of the State of Florida; and

WHEREAS said Telco Holding Company has endorsed to The Florida National Bank of Jacksonville, a banking corporation organized and existing under and by virtue of the laws of the United States of America, the promissory note of said Better Homes Company in the sum of Fifty Thousand Dollars ($50,000.00) maturing March 31, 1932, and is indebted to said The Florida National Bank of Jacksonville in the sum of Eight-five Thousand Dollars ($85,000.00) evidenced by its promissory note therefor maturing March 31, 1932, and whereas said Telco Holding Company is further indebted to The Barnett National Bank of Jacksonville in the sum of Sixty-six Thousand Five Hundred Dollars ($66,500.00) evidenced by its promissory note therefor maturing March 31, 1932, and whereas the payment of all the indebtedness aforesaid, in addition to the collateral securities described in said notes, is secured by a certain deed of trust given by said Telco Holding Company to said The Florida National Bank of Jacksonville, as Trustee, under date of May 20, 1931; and

WHEREAS said Telfair Stockton & Company, Inc., has agreed to purchase said real estate brokerage business and insurance brokerage business now owned as aforesaid by Telco Holding Company upon the terms and conditions hereinafter set forth, and whereas both seller and purchaser have determined that it is to their mutual advantage that said indebtedness owed by said seller to said The Florida National Bank of Jacksonville and said The Barnett National Bank of Jacksonville should be paid by said seller as quickly as conditions permit, but that the payment of such indebtedness should not be enforced;

NOW, THEREFORE, THIS INDENTURE FURTHER WITNESSETH:

THAT for and in consideration of the premises and the sum of Twenty-seven Thousand Four Hundred Thirty-five Dollars and seventy six cents ($27,435.76) cash in hand paid to said Telco Holding Company by said Telfair Stockton & Company, Inc., receipt whereof is hereby acknowledged, the parties hereto agree as follows:

1. That said Telco Holding Company does by these presents grant, bargain, sell, transfer and set over unto said Telfair Stockton & Company, Inc. all and singular its real estate brokerage business and insurance brokerage business, including each and every the operations pertaining thereto now or formerly engaged in by said Telco Holding Company, and hereby further bargains, sells, transfers and sets over to said Telfair Stockton & Company, Inc., all and singular the furniture and fixtures, contracts, leases, etc., referred to and/or described in that certain schedule attached hereto and marked Exhibit ‘A‘, which said schedule by reference thereto is made part hereof, and further hereby transfers, sets over and assigns to said Telfair Stockton & Company, Inc., all and singular the insurance accounts referred to or described in, and all sums of money now due or to become due and payable thereon in that certain schedule attached hereto and marked Exhibit ‘B‘, which said schedule by reference thereto is made a part hereof (it being understood and agreed by and between the parties hereto that said Telco Holding Company does not in any wise guarantee the payment of said accounts or any of them mentioned in said Schedule ‘B‘);

2. That as a further consideration for the transfer aforesaid, said Telfair Stockton & Company, Inc., does hereby assume and agree to pay, only, all and singular the sums of money owed by said Telco Holding Company upon certain insurance accounts as set forth and described in that certain schedule attached hereto and marked Exhibit ‘C‘, which said schedule by reference thereto is made part hereof (it being understood and agreed by and between the parties hereto that said Telfair Stockton & Company, Inc., does not in any wise or manner assume and agree to pay any other indebtedness of said Telco Holding Company except as set forth and described in said Schedule ‘C‘);

3. That so long as, but not under any conditions or circumstances for a period beyond the term of ten years from date hereof, the aforesaid indebtedness owed by said Telco Holding Company to said Florida and Barnett Banks shall remain unpaid and the payment thereof has not been enforced or attempted to be enforced by said Florida and/or Barnett Banks or said Florida Bank as Trustee, as aforesaid, and/or their successors, or the holder and/or holders of said indebtedness or any renewals or extensions there by

I. The sale, without consent of Telco Holding Company, of the collateral now or hereafter described in the aforesaid notes held by said Florida or Barnett Banks, or any extensions or renewals thereof,

and/or by

II. The enforcement in the event of default by sale or otherwise, without consent to Telco Holding Company, of said ‘Deed of Trust‘ hereinbefore described, or any subsequent agreement effecting and/or purporting to effect the purposes for which said ‘Deed of Trust‘ was given,

and/or by

III. Suits and/or other proceedings to enforce such payment,

and

IV. Provided further that no legal proceedings to involuntarily liquidate and/or have adjudicated bankrupt said Telco Holding Company and/or any of its associate companies hereinbefore named become effective (with and/or without the exercise of appellate jurisdiction), whether or not such proceedings are instituted by parties hereto or herein named:

said Telfair Stocking & Company, Inc., further agrees as follows:

(a) To render, without charge to said companies hereinbefore mentioned, viz., Avondale Company, Marco Investment Company, the Bond Corporation of Jacksonville, Porterfield Company, Stockton Mortgage Company and Better Homes Company, such services are are now rendered to said last named companies, without charge by said Telco Holding Company, including the management of such companies' properties and keeping of the books of accounts of such companies, it being understood and agreed however, that said Telfair Stockton & Company, Inc., shall make the usual charges in connection with such operations and management as are now made by Telco Holding Company therefor, including a charge for collection of rentals and commission for the sale and/or disposal of properties, real and personal, now or hereafter owned by said companies, it being further understood and agreed between the parties hereto that Telco Holding Company has charged The Bond Corporation of Jacksonville the sum of Fifteen Hundred Dollars ($1500.00) yearly for the services aforesaid, exclusive of commission from the collection of rentals and the sale of properties, and that said Telfair Stockton & Company, Inc., hereunder shall continue for the aforesaid period to render such services to said The Bond Corporation of Jacksonville for said stipulated yearly sum of Fifteen Hundred Dollars ($1500.00);

(b) To pay to said Telco Holding Company for the term aforesaid, viz., so long as, but not under any conditions of circumstances for a period beyond the term of ten years from date hereof, the aforesaid indebtedness owed by said Telco Holding Company to said Florida and Barnett Banks shall remain unpaid and the payment thereof has not been enforced or attempted to be enforced by said Florida and/or Barnett Banks or said Florida Bank as Trustee, as aforesaid, and/or their successors, or the holder and/or holders of said indebtedness or any renewals or extensions thereof by

I. The sale, without consent of Telco Holding Company, of the collateral now or hereafter described in the aforesaid notes held by said Florida or Barnett Banks, or any extensions or renewals thereof,

and/or by

II. The enforcement in the event of default by sale or otherwise, without consent of Telco Holding Company, of said ‘Deed of Trust‘ hereinbefore described, or any subsequent agreement effect (sic) and/or purporting to effect the purposes for which said ‘Deed of Trust‘ was given,

and/or by

III. Suits and/or other proceedings to enforce such payment,

and

IV. Provided further that no legal proceedings to involuntarily liquidate and/or have adjudicated bankrupt said Telco Holding Company and/or any of its associate companies hereinbefore named become effective (with and/or without the exercise of appellate jurisdiction), whether or not such proceedings are instituted by parties hereto or herein named;

after deduction and/or provision for the payment of an eight per cent (8%) semi-annual cumulative dividend on the new outstanding or hereafter issued preferred capital stock of said Telfair Stockton & Company, Inc., one-half of the annual net profits earned by said Telfair Stockton & Company, Inc., said net profits after provision for said preferred dividend as aforesaid shall be determined by good accounting practice, and there shall be charged to the expenses for the purpose of determining the same all salaries, wages, commissions, rents, stamps, stationary, printing, supplies and other operating charges, the listing of the aforesaid items not to 0e deemed to be exclusive or to constitute a limitation; also all interest paid on borrowed money, accrued Federal and/or State tax assessments of every nature and kind, whether due and payable or not, and all other taxes, charges and impositions whatsoever levied by governmental authorities, as well as a reasonable reserve for depreciation, amortization and obsolescence, and all other charges properly included in determining the net profits according to good accounting practice. It being further stipulated and agreed that said one-half of the annual net profits earned by Telfair Stockton & Company, Inc., if any there be, shall be paid to said Telco Holding Company yearly, commencing on the first day of January, A.D. 1933, it being understood that on said last date there shall be paid to said Telco Holding Company one-half of the net profits, if any, earned by said Telfair Stockton & Company, Inc., during the year 1932.

4. It is further stipulated and agreed by and between the parties hereto that this agreement shall be binding upon the successors, legal representatives and assigns of the parties hereto.

It was collaterally understood that the money received from petitioner would be used by Telco to liquidate its obligations to the two banks.

Petitioner had consolidated gross income, paid to Telco under the contract, and had consolidated net taxable income for the fiscal years ended February 28, 1933, to February 28, 1942, inclusive, as follows:

+-------------------------------------------------+ ¦ ¦ ¦Payment to¦Net taxable¦ +-------------+------------+----------+-----------¦ ¦Date ¦Gross income¦Telco ¦income ¦ +-------------+------------+----------+-----------¦ ¦Feb. 28, 1933¦$105,343.22 ¦$1,558.03 ¦$10,018.04 ¦ +-------------+------------+----------+-----------¦ ¦Feb. 28, 1934¦99,901.53 ¦88.09 ¦(889.71) ¦ +-------------+------------+----------+-----------¦ ¦Feb. 28, 1935¦121,366.93 ¦3,960.23 ¦8,919.11 ¦ +-------------+------------+----------+-----------¦ ¦Feb. 28, 1936¦118,072.27 ¦5,015.26 ¦8,309.22 ¦ +-------------+------------+----------+-----------¦ ¦Feb. 28, 1937¦128,711.40 ¦3,761.75 ¦7,669.88 ¦ +-------------+------------+----------+-----------¦ ¦Feb. 28, 1938¦198,809.72 ¦15,300.00 ¦35,024.56 ¦ +-------------+------------+----------+-----------¦ ¦Feb. 28, 1939¦178,444.06 ¦10,424.68 ¦14,725.35 ¦ +-------------+------------+----------+-----------¦ ¦Feb. 28, 1940¦177,835.34 ¦13,704.04 ¦19,642.29 ¦ +-------------+------------+----------+-----------¦ ¦Feb. 28, 1941¦222,226.18 ¦28,699.43 ¦38,225.49 ¦ +-------------+------------+----------+-----------¦ ¦Feb. 28, 1942¦288,257.61 ¦33,629.93 ¦65,393.99 ¦ +-------------------------------------------------+

The above listed payments to Telco were deducted by petitioner on its income tax returns for the years February 28, 1933, to February 28, 1942, inclusive. The deductibility of these payments was questioned by the Commissioner in 1938. In that year Stockton filed an affidavit with the Bureau of Internal Revenue in which he stated:

that the new company (petitioner) acquired no interest whatsoever in the assets of the Telco Holding Company or its subsidiary companies, other than the insurance accounts and furniture and fixtures for which it paid a definite consideration; * * *

that * * * (petitioner) agreed to pay fifty per cent (50%) of its income * * * to the Telco Holding Company to be used by said Telco Holding Company to pay interest and liquidate its indebtedness.

that this profit sharing basis was a year to year proposition not to exceed ten years, or until the banks made demands for their notes * * * .

that the payment of a part of its profits is a yearly expense attributable to the profits earned during each year.

that the income of * * * (petitioner), including the income from insurance, is derived largely from the assets of the Telco Holding Company and its subsidiary corporations.

that in the remote event that the indebtedness and obligations are liquidated within the ten-year period, it was and is the intention of the parties to the contract that the Telco Holding Company may then resume the management of its own properties.

that the arrangement by the * * * (petitioner) is no different that it would have been and * * * (Stockton) set out to manage the properties as an individual, splitting his commissions and fees with creditors.

The respondent determined the 50 per cent payments to be an ordinary and necessary business expense and the amounts representing such payments were then allowed as deductions. Petitioner has made no 50 per cent payments since the fiscal year ended February 28, 1942.

Petitioner, without the income of its subsidiary corporations, had the following excess profits credit income in the base period:

+------------------------+ ¦Feb. 28, 1937 ¦$7,582.70¦ +--------------+---------¦ ¦Feb. 28, 1938 ¦34,924.56¦ +--------------+---------¦ ¦Feb. 28, 1939 ¦14,725.35¦ +--------------+---------¦ ¦Feb. 29, 1940 ¦19,642.39¦ +------------------------+

As events developed after 1932 the aforementioned affiliates of Telco produced very little income in the way of management fees for petitioner. Beginning in 1937 and 1936 petitioner's insurance commissions and real estate fees increased. Some of the insurance income was derived from commissions on insurance covering assets of Telco and its subsidiaries.

OPINION.

Issue 1. Section 711(b)(1)(J) and (K) Adjustment.

SEC. 711. EXCESS PROFITS NET INCOME.(b) TAXABLE YEARS IN BASE PERIOD.—(1) GENERAL RULE AND ADJUSTMENTS.— The excess profits net income for any taxable year subject to the Revenue Act of 1936 shall be the normal-tax net income, as defined in section 13(a) of such Act; and for any other taxable year beginning after December 31, 1937, and before January 1, 1940, shall be the special-class net income, as defined in section 14(a) of the applicable revenue law. In either case the following adjustments shall be made (for additional adjustments in case of certain reorganizations, see section 742(e)):(J) Abnormal Deductions.— Under regulations prescribed by the Commissioner, with the approval of the Secretary, for the determination, for the purposes of this subparagraph, of the classification of deductions—(i) Deductions of any class shall not be allowed if deductions of such class were abnormal for the taxpayer, and(ii) If the class of deductions was normal for the taxpayer, but the deductions of such class were in excess of 125 per centum of the average amount of deductions of such class for the four previous taxable years, they shall be disallowed in an amount equal to such excess.(K) Rules for Application of Subparagraphs (H), (I), and (J).— For the purposes of subparagraphs (H), (I), and (J)—(ii) Deductions shall not be disallowed under such subparagraphs unless the taxpayer establishes that the abnormality or excess is not a consequence of an increase in the gross income of the taxpayer in its base period or a decrease in the amount of some other deduction in its base period, and is not a consequence of a change at any time in the type, manner of operation, size, or condition of the business engaged in by the taxpayer.

WITHEY, Judge:

During the base period years, February 28, 1937 to 1940, inclusive, petitioner paid the following amounts to Telco Holding Company under the provisions of the March 1, 1932, contract:

+------------------------+ ¦Feb. 28, 1937 ¦$3,761.75¦ +--------------+---------¦ ¦Feb. 28, 1938 ¦15,300.00¦ +--------------+---------¦ ¦Feb. 28, 1939 ¦10,424.68¦ +--------------+---------¦ ¦Feb. 29, 1940 ¦13,704.04¦ +------------------------+

These amounts were deducted each year by petitioner and allowed by respondent in computing its net taxable income. The issue before us is whether in determining petitioner's excess profits credit under section 713, Internal Revenue Code, for the fiscal year ended February 28, 1943, these payments which were made by petitioner during the base period to Telco Holding Company pursuant to their contract, dated March 1, 1932, should be disallowed as abnormal deductions under section 722(b)(1)(J) and (K), Internal Revenue Code.

The petitioner argues alternative contentions on this issue. It first contends that the 50 per cent payments to Telco were abnormal deductions (section 711(b)(1)(J)(i), or, secondly, if the 50 per cent payments to Telco were normal deductions, they are in excess of 125 per cent of the 50 per cent payments to Telco allowed as deductions for the 4 previous years (section 711(b)(1)(J)(ii)). It further asserts that the abnormality is not in consequence of an increase in its gross income in its base period or a decrease in the amount of some other deduction in the base period and is not a consequence of a change at any time in the type, manner of operation, or condition of its business.

Respondent admits the 50 per cent payments to Telco exceed 125 per cent of the average of the payments allowed to Telco for the 4 previous years but claims the payments are not abnormal and also that the disallowance of the payments is prohibited by the provision of section 711(b)(1)(K)(ii), Internal Revenue Code, because the abnormality was a consequence of an increase in gross income.

Petitioner's contention that the 50 per cent payments were abnormal deductions is based on the argument that it entered into a ‘bad deal,‘ that the management business, which was expected to furnish the majority of the income, was a failure and the major part of the income that it earned was a result of its development of the insurance brokerage business. The contract provided as follows: (1) The petitioner was to purchase Telco's real estate and insurance brokerage business and furniture and fixtures for the sum of $27,500, which would be sufficient to satisfy Telco's current obligations; (2) Telco would then hypothecate all remaining assets, not encumbered, as additional collateral for the obligations owed to the banks; and (3) petitioner would pay to Telco 50 per cent, after adjustment, of its profits for the right to operate and manage the properties of Telco. The contract is actually in two parts, i.e., the purchase of the real estate and insurance business being one part and the right to manage Telco's properties in return for 50 per cent of its profits, after adjustment, being the other part. The petitioner would have acquired no more after having made payments for the full 10-year period than it would have acquired if the banks had taken steps to enforce their rights at the end of the first year. The contract is an outright conveyance to petitioner by Telco of Telco's real estate and insurance brokerage business. The period in which petitioner would operate and manage Telco's properties and pay to Telco 50 per cent of its profits would be terminated by the happening of (a) liquidation of Telco's obligations to the banks, (b) the banks', contrary to the wishes of Telco, enforcement of their legal rights as creditors, and (c) the expiration of the 10-year period. The contract expressly provides that 50 per cent of all income is to be paid to Telco and does not distinguish the sources of income. Petitioner's conclusion is that the deal was improvident and gives basis to an abnormal deduction. In effect, petitioner's position is that if the management business had continued to provide the major portion of the total income of all business done by petitioner the deduction would have been normal, but, since it was a failure, the deduction is abnormal. We fail to see any basis for petitioner's argument, as the contract expressly provides that 50 per cent of petitioner's income from all sources to be paid to Telco. It simply received what it contracted for. While an abnormal deduction may result from an improvident contract, the deduction must be an expenditure which is not ordinary or usual for the petitioner. Frank Shepard Co., 9 T.C. 913. ‘Abnormal‘ is defined by Webster's New International Dictionary as meaning ‘Not conformed to rule or system; deviating from the type, anomalous, irregular.‘ Abnormality is dependent upon the facts and circumstances affecting the particular taxpayer. What would be normal for one taxpayer might be abnormal for another taxpayer and vice versa. City Auto Stamping Co., 7 T.C. 354. While the contract here appears to be unusual, it had a definite purpose, which was to help Telco out of its financial troubles. The petitioner existed because of the dilemma in which Telco had found itself. The petitioner's operations from its inception were based on the 50 per cent payments to Telco. These payments were not abnormal to petitioner.

In view of the fact that the payments to Telco exceeded in each instance 125 per cent of the average of the same payments for the 4 previous years, we must determine whether or not the payments were a consequence of an increase in petitioner's gross income or a decrease in the amount of some other deduction and whether they are a consequence of a charge at any time in the type, manner of operation, size, or condition of petitioner's business.

Petitioner contends that the 50 per cent payment was to be based on management income and due to the fact that the insurance brokerage business furnished most of the income, the excess deduction is not a consequence of an increase in the management income. The contract provided that the payments were to be ‘one-half of the annual net profits earned by said Telfair * * * .‘ Consequently, the source of the profits was not limited to management income as the petitioner contends. The payment was to be made from profits derived from any source.

In Willian Leveen Corporation, 3 T.C. 593, we noted that a taxpayer might have difficulty in establishing that an excess deduction was not a consequence of an increase in gross income in its base period, but stated that, in view of the provisions of section 722(b)(1)(K)(ii), such a showing was necessary in order for the taxpayer to prevail.

The record shows there was an increase in petitioner's income in the base period, in that the average gross income for the base period was $170,950.13 compared with a maximum of $121,366.93 for any previous year. The gross income for the lowest year in the base period was approximately $7,500 greater than that of any year prior to the base period. We also note that the yearly payments to Telco increased from $5,015.26, the highest for any year prior to the base period, to an average of $10,797.62 in the base period.

Petitioner has not demonstrated the required lack of relationship between its increase in gross income and the excess deduction in controversy. Horton & Converse, 8 T.C. 487, 491.

Decision upon this issue is for the respondent.

Issue 2. Section 722.

The petitioner filed an application for relief, July 1, 1943, on Form 991, in which it stated it was claiming relief under section 722(b)(5). It attached the following statement as grounds for relief:

SEC. 722. GENERAL RELIEF— CONSTRUCTION AVERAGE BASE PERIOD NET INCOME.(a) GENERAL RULE.— In any case in which the taxpayer establishes that the tax computed under this subchapter (without the benefit of this section) results in an excessive and discriminatory tax and establishes what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income for the purposes of an excess profits tax based upon comparison of normal earnings and earnings during an excess profits tax period, the tax shall be determined by using such constructive average base period net income in lieu of the average base period net income otherwise determined under this subchapter. In determining such constructive average base period net income, no regard shall be had to events or conditions affecting the taxpayer, the industry of which it is a member, or taxpayers generally occurring or existing after December 31, 1939, except that, in the cases described in the last sentence of section 722(b)(4) * * * regard shall be had to the change in the character of the business under section 722(b)(4) * * * to the extent necessary to establish the normal earnings to be used as the constructive average base period net income.(b) TAXPAYERS USING AVERAGE EARNINGS METHOD.— The tax computed under this subchapter (without the benefit of this section) shall be considered to be excessive and discriminatory in the case of a taxpayer entitled to use the excess profits credit based on income pursuant to section 713, if its average base period net income is an inadequate standard of normal earnings because—(5) of any other factor affecting the taxpayer's business which may reasonably be considered as resulting in an inadequate standard of normal earnings during the base period and the application of this section to the taxpayer would not be inconsistent with the principles underlying the provisions of this subsection, and with the conditions and limitations enumerated therein.

STATEMENT REGARDING FACTORS PRODUCING AN AVERAGE BASE PERIOD NET INCOME WHICH IS AN INADEQUATE STANDARD OF NORMAL EARNINGS FOR YEAR ENDED 2-28-43

For a ten year period ended February 28, 1942, Telfair Stockton & Company, Inc. was operating under a contract with Telco Holding Company, a Florida corporation, The Barnett National Bank, Jacksonville, Florida and The Florida National Bank, Jacksonville, Florida, whereby one-half of the profits of Telfair Stockton & Company, Inc., after providing for income taxes and dividends on preferred stock, was paid to Telco Holding Company.

The earnings for the fiscal year ended February 28, 1943 and subsequent years, are not subject to this contract. Therefore, the base period earnings, after the payment of the bonus to Telco Holding Company are not an adequate standard for determining the excess profits credit.

This claim is made on the basis that since Telfair Stocking & Company, Inc., for the fiscal year ended February 28, 1943, and subsequent is subject to taxes on its entire earnings that the base period earnings, after paying one-half of its earnings to another corporation under a contract expiring prior to the fiscal year ended February 28, 1943, are not an adequate standard of earnings for determining its excess profits tax credit. Therefore the base period earnings, before the payment of fifty per cent to Telco Holding Company are claimed.

On July 13, 1944, the Commissioner notified petitioner of the disallowance of its application for relief. On November 21, 1946, petitioner first claimed it was entitled to relief under section 722(b)(2) when it filed, with the Field Committee on Claims for Relief Under Section 722, a statement asking relief for the same taxable year 1943 under section 722(b)(2) and (b)(5). This new ground for relief was raised subsequent to the disallowance of petitioner's application for relief. Respondent objected to this statement being introduced as it has the effect of adding a ground for relief not considered or passed upon by the Commissioner. The statement was admitted with permission to argue its admissibility on brief. The record contains no copies of or information in regard to a claim by petitioner on Form 843 for this taxable year. On brief, petitioner requests relief under section 722(b)(1), (2), (4), and (5).

The Court has clearly indicated in its prior decisions that it will not consider grounds for relief or supporting facts unless they have been presented to the Commissioner for his consideration prior to his rejection of the applications and claims. Hummel & Downing Co., 19 T.C. 61, 64; Blum Folding Paper Box Co., 4 T.C. 795; Monarch Cap Screw & Manufacturing Co., 5 T.C. 1220; Alexandria Amusement Corporation, 16 T.C. 446; Wadley Co., 17 T.C. 269. It does not appear in this case that petitioner amended its application to include a claim for relief under section 722(b)(1), (2), and (4) prior to the denial of the claims by the Commissioner or that the Commissioner ever waived such filing or considered such claims prior to the rejection of the application for relief. We, therefore, limit out consideration to the section 722(b)(5) factor.

In order to be entitled to the relief under consideration the petitioner is required by section 722(a) and (b)(5) to establish (1) that the tax without relief is excessive and discriminatory and (2) ‘what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income for the purpose of an excess profits tax based upon comparison of normal earnings and earnings during an excess profits tax period, * * * ‘ The first requirement is met if the ‘average base period net income is an inadequate standard of normal earnings because * * * of any other factor affecting the taxpayer's business which may reasonably be considered as resulting in an inadequate standard of normal earnings during the base period * * * ‘ and the granting of relief would not be inconsistent with the underlaying principles and limitations of subsection (b).

The petitioner argues that ‘the earnings of the base period were adversely affected by the necessity of being required to pay a portion of those profits to another company, a source from which no income was derived.‘ While the management business taken over by petitioner may not have been as productive of income as was expected by its officers, we do not see how this contention merits any consideration, as petitioner is by that argument taking a position which is inconsistent with and contrary to the provisions of the contract with Telco and also contrary to the affidavit of its president. It was understood by both parties to the contract that petitioner was to pay to Telco half of its profits for the right to manage Telco's properties. Petitioner's president stated that the income was to include insurance income and this arrangement was carried out for 10 years. Where parties have entered into a contract and their conduct thereunder has given construction to its terms, the court will give great weight to such construction. Wooster Rubber Co. v. Commissioner, 189 F.2d 878. In view of this interpretation, the earnings were not adversely affected as there would not have been any earnings unless the petitioner had entered into the contract to make the 50 per cent payments.

The contract entered into between petitioner and Telco is in two parts, i.e., (1) the purchase of the real estate and insurance business for $27,500 and (2) the right to manage Telco's properties for 10 years, or less, in consideration of petitioner's paying 50 per cent of its profits to Telco. The fact that the payments which came from all of petitioner's income were to be used to pay Telco's indebtedness to the banks, in effect, unites the two parts of the contract. The banks by liquidating Telco's obligations or by enforcing its creditors' rights could have severed the contract and petitioner would have been left with its real estate and insurance business. The parties agree the 50 per cent payments to Telco were properly allowed as deductions on the ground that they were ordinary and necessary business expenses. The petitioner did not acquire any rights of a fixed or permanent value in the properties managed and Telco was to assume management of the properties at the end of the 10-year period or sooner if the notes were liquidated.

The petitioner also argues that its base period earnings were not normal when compared to tax year earnings because the tax year earnings are not reduced by the factor, the 50 per cent payments to Telco. This same issue was raised in Clinton Carpet Co., 14 T.C. 581. There the Court said:

The petitioner looks at the earnings of the tax years which were earned without the payment of anything for the right to earn them and says that the actual earnings of the base period years are not proper for the purpose of comparison with those of the tax years unless the deduction taken for the cost of the right to represent American during the base years is eliminated. Unfortunately for the petitioner that is not the scheme of the statute. It does not allow the taxpayer to look at the tax years and then try to determine what would be normal earnings of those years to compare with them, but requires instead that the taxpayer look at the base years, closing its eyes to events taking place after December 31, 1939, to determine what were normal earnings of the base years. * * * A reasonable person looking at the actual earnings for the base period years could say that they were not less than normal, even though he knew that there would be no amortization deduction after 1940. * * *

It was the normal for petitioner to deduct the 50 per cent payments to Telco in the base period and it would be an incorrect interpretation of the statute to consider as normal, earnings for the base period which did not give effect to the 50 per cent payments to Telco.

Petitioner has not established that its actual average base period net income is ‘an inadequate standard of normal earnings during the base period.‘ See Park & 46th Street Corporation, 14 T.C. 588, and Philadelphia, Germantown & Norristown, R.R. Co., 6 T.C. 789.

Reviewed by the Special Division.

Decision will be entered for the respondent.

RAUM, J., dissenting: Assuming that the payments to Telco were deductible business expenses (but cf. Vermont Transit Co., 19 T.C. 1040), I think that the denial of relief fails to give proper effect to the purpose of section 722, although it appears to be supported by Clinton Carpet Co., 14 T.C. 581.