Edward Orton, Jr., Ceramic Foundation v. Commissioner

*147 The Commissioner determined the following deficiencies in petitioner's Federal income taxes: ¹

In an amended answer respondent determined the following alternative deficiencies:

We are to decide*147 whether petitioner for the years in issue fails to qualify as an organization exempt from taxation under section 501(c)(3), ² or is a feeder organization under section 502, or, in the alternative, is the recipient of unrelated-business income under sections 511, 512, and 513.

FINDINGS OF FACT

Some of the facts have been stipulated and the stipulation of facts and the exhibits attached thereto are incorporated herein by this reference.

The Edward Orton, Jr., Ceramic Foundation (sometimes hereinafter referred to as the petitioner or the foundation) filed exempt *148 organization returns with the district director of internal revenue, Cincinnati, Ohio, for each of the following periods: January 1, 1962, through December 31, 1962; January 1, 1963, through June 30, 1963; July 1, 1963, through June 30, 1964; and July 1, 1964, through June 30, 1965. At the time of filing the petition herein, petitioner's principal office*148 was located in Columbus, Ohio. For purposes of this case the parties have stipulated that the calendar year is the proper period of accounting for each of the years in issue.

Petitioner was established under the will of Edward Orton, Jr., deceased, which was admitted to probate February 28, 1932. Edward Orton, Jr. (sometimes hereinafter referred to as testator), was an outstanding authority on ceramics. His particular interest lay in scientific research and education in the field of ceramics and ceramic engineering. He received a degree as an engineer of mines from Ohio State University and later became a member of the faculty. He procured the establishment, by legislative enactment, and became the head of the Department of Ceramics at Ohio State University. He first began the manufacture of pyrometric cones in the university laboratory.

The testator later established a laboratory on a privately owned site near the university campus and conducted the business of manufacturing the cones as a private enterprise. Just prior to his death, the testator acquired a new site and erected a new laboratory known as the Orton Memorial Laboratory, in which the business of manufacturing *149 cones is now being conducted.

Pyrometric cones are used in the manufacture of ceramics for testing the firing process and maturing of various clay products. They are described as small, slender, trihedral pyramids made of a mixture of minerals very similar to the minerals of which the ceramic bodies are composed. The cone bodies and the ceramic bodies are sufficiently alike that they react approximately the same thermochemically. The function of the pyrometric cone is to provide a convenient means of measuring the combined effect, during firing, of temperature, time, and firing atmosphere on ceramic ware. Thus the cones provide a reference standard and serve as a means of measuring and communicating the results of heat treatment of ceramic ware within the ceramic industry. In addition to being a production control, the cones are tools for basic research, and fundamental aids in ceramic education.

In his will the testator divided his estate into two parcels. The first parcel contained his pyrometric cone business and all the assets related to it. The will bequeathed the first parcel to a specified board of trustees which was to hold and operate the business in a trust known as*150 the Edward Orton, Jr., Ceramic Foundation. Testator in his will specified the purpose of petitioner in some detail:

*149 Sub-Item 2. Purpose of the trust. There are two purposes for which this trust is created. The first and principal purpose is to provide a stable and dependable organization for continuing the manufacture and sale of Standard Pyrometric Cones of the highest quality and most exact accuracy that is commercially feasible, at a reasonable price. The second and subsidiary purpose of this trust is to provide a Research Organization for the prosecution of studies and researches for overcoming technical and manufacturing difficulties, and for thus advancing the ceramic arts and industries in the United States.

Sub-Item 3. Historical statement concerning the manufacture of the Standard Pyrometric Cones. Prior to 1896, there was no convenient or generally accepted mode of regulating the firing process or heat treatment of Claywares in the Ceramic Industries of the United States, and virtually no mode of comparing kiln-firing practice, as between different factories, and different industries. I entered the manufacture and sale of pyrometric cones, with *151 the purpose of performing a definite and needed service to the Ceramic Industries: (1) by enabling them to better control the firing of their products, which is the weakest point of the manufacturing process; (2) by facilitating the freer exchange of exact information concerning the firing process between ceramic manufacturers, and (3) thus inducing a better and more cooperative relationship among them, and thus making greater scientific and industrial progress probable. In this enterprise, while manufacturing profit is essential to permit its continuance, it has, from the first, been my purpose to make financial profit incidental to the principal idea of furnishing to ceramic manufacturers, a mode of controlling or regulating the firing process of their wares with the highest attainable degree of dependability at the lowest reasonable cost. Having been successful in obtaining the confidence of manufacturers of ceramic products in Standard Pyrometric Cones, it is my desire to assure myself that the manufacturing establishments which I have built up shall continue to fulfill this same useful purpose, upon the same high plane, and with the same ideals of public service, after my death.

*152 * * * *

Sub-Item 6. Mode of financing the continued operation of the trust. It is my intention, in this Trust, to provide an organization, not for profit whose real or ultimate objects are altruistic, and wholly devoted to producing industrial, scientific and social betterments, without any personal or private gain to anyone, other than as wages paid for services rendered. To this end, it is my will that the surplus produced by the manufacturing and vending organization, known as The Standard Pyrometric Cone Company, shall be expended by the Research Organization, whose product is knowledge, given free to all who are interested. The magnitude of the surplus, necessarily, will determine the extend [sic] of the research activity. In effect, money taken from cone consumers in the form of profits on the manufacture of cones, will be returned to them in form of technical and scientific knowledge of the Ceramic Arts and Industries, which, in the nature of the case, cannot, at all times, be equally valuable and interesting to all persons from whom the money is taken. * * *

* * * *

(d) [The] price at which cones shall be sold shall be set to produce a gross income, of which approximately*153 eighty percent will be required to meet the manufacturing costs, including sales, overhead, and the maintenance of proper capital reserves for extensions, depressions, or disasters, and including the cost of experimental work undertaken specifically for the needs of the cone manufacturing process itself. The remainder of the gross receipts of the cone manufacturing business being approximately twenty percent of the same, should be *150 expended upon Research. It is the testator's belief that the great majority of consumers of cones will willingly approve of the principle of charging a profit of twenty percent the same to be spent in research for their own ultimate benefit.

The board of trustees, according to the will, is composed of seven individuals who are: The president of Ohio State University, a representative from the National Bureau of Standards, the head of the Engineering Experiment Station of Ohio State University, the head of the Ceramic Engineering Department of Ohio State University, the secretary of the American Ceramic Society, one other representative from the American Ceramic Society, and an attorney at law. The trustees receive from the petitioner $ 1 per*154 year plus expenses incurred in relation to trust business. The attorney on the board, however, receives compensation for legal services he renders to the trust.

The trustees have full power over the general policy of, and the relationship between, the trust, the cone-manufacturing operation, and the research effort. They select the general manager for manufacturing and a research director, which positions can be occupied by the same person. The board has power to alter the manufacturing operation and to enter into related lines of endeavor if the cone becomes obsolete or unable to compete with other measuring devices. Further, the trustees:

have authority * * * to cease manufacture and close up the cone manufacturing business, if, for any reason, the same has become unable to longer function successfully, or if scientific progress makes it no longer necessary or advisable to continue * * *

If the trust is dissolved, all of its assets are required to be turned over to Ohio State University.

The will gives the trustees power to organize the research effort as an in-house operation, or as a program to supplement and assist ceramic research being carried on by other organizations. *155 The will further provides that:

In whatever manner the Trustees may organize and operate the Research Department, they shall publish the results of its researches and activities through trade journals, the Transactions of scientific and industrial societies, reports of Universities or Experiment Stations or in other appropriate manner, to the end that said results shall be given freely to the public and made available for the use of the Ceramic Industries, and said Trustees shall not sell or permit its agents and employees to sell, or to make any charge, direct or indirect, for any information furnished through or by said Research Department, to [the] end that all surplus over and above the cost of production made upon the sale of Standard Pyrometric Cones shall be returned to the Ceramic Industries in the form of technical knowledge.

The executors of testator's estate transferred all of the assets of his cone business to the trustees of petitioner in December of 1933. Petitioner *151 has continuously been under the jurisdiction of the Probate Court of Franklin County, Ohio. The Probate Court closely supervises the trustees' administration of petitioner to be sure the purposes*156 of the will are being carried out.

Although the board of trustees has formed an executive committee consisting of three of its members, the daily operations of petitioner are left to the general manager and research director. The board has followed the practice of filling the posts of general manager and research director with the same individual. Regular meetings of the board are held in which it considers matters concerning the allocation of funds and receives reports from the general manager/research director.

The manufacturing of cones has been carried on by the trustees under the terms of the will since 1933 and during the years in issue. Most of petitioner's sales are to manufacturers of ceramic products. Some sales are made to scientific and research laboratories and to ceramic art studios throughout the United States. Substantial sales are also made outside the United States.

The American Standard Materials Society specifies Orton Standard Pyrometric Cones be used in the Pyrometric Cone Equivalent Test. This is a test which evaluates the refractoriness of refractory materials. The PCE value resulting from the test is an important specification of refractory material, *157 and is utilized in describing and purchasing such material. The American Ceramics Society cooperates with ASTM in establishing this standard. The Orton Pyrometric Cones have been accurately established as a reference standard by the National Bureau of Standards.

During the years before the Court another manufacturer, Bell Research, Inc., Chester, W. Va., competed with petitioner in the production of standard pyrometric cones in the United States. The Bell series of cones is not as long as petitioner's and does not deal with as wide a temperature range. Pyrometric cones produced by Bell do not perform identically to petitioner's; they appear to have a greater variability within a lot. The prices on petitioner's cones were higher than those on the Bell-produced cones. German-manufactured cones have been tested by petitioner and found to have an even greater variability within a lot than the Bell cones.

There are two other known devices designed to measure the combined effect of temperature and time in the firing of ceramics. They are the "Fire-Chek Keys" manufactured by Bell Research, Inc., and the "Veritas Ring" manufactured by Fortune Ceramics, Trenton, N.J. In addition the*158 ceramic industry also relies upon the use of separate devices measuring time or measuring temperature, such as *152 clocks and pyrometers, which are used for both measurement and control of one or all the other factors in connection with the regulation of the heat treatment of ceramic products. Some of these devices are the "Tempilstiks" manufactured by the Burrell Corp., Pittsburgh, Pa., and "Thermochrom Crayons" and "Detecto-Temp Paints" manufactured by H.V. Hardman Co., Inc., Belleville, N.J., and Curtiss-Wright Corp., East Paterson, N.J. Although these products are available, the pyrometric cone is a control over the firing aspect of production for which industry has no substitute.

For the years involved herein, petitioner employed the advertising agency Wheeler, Kight and Gainey, Inc., of Columbus, Ohio, to handle all of its advertising. For each of the calendar years involved petitioner incurred the following advertising expenses:

Advertisements pertaining to the sale of the Orton Pyrometric Cones appeared in the various ceramic publications as full-page, half-page, or one-third-page ads on a regular or periodic*159 basis.

In early 1964, petitioner introduced a new product known as the "Orton Automatic Recording Dilatometer." Petitioner's advertising agency prepared a one-page brochure for use in the press release of this new product. The Dilatometer measures the thermal behavior of materials in relationship to their dimensional change. The first Dilatometer unit was completed and delivered in January 1964 to the Mosaic Tile Co. Five additional units were completed by December 1964. Petitioner realized a profit of $ 343 on the sale of the first Dilatometer in 1964 but sales in subsequent years have failed to produce a profit. A testing service was available through petitioner which made use of the new Dilatometer. The charge for this service was $ 10 per specimen with a quantity discount of 10 percent if 10 or more samples were forwarded to the petitioner for testing.

Petitioner's returns reveal it computed its income in the following manner for the periods indicated: ³*153

*161 Respondent, in the statutory notice, made the following recomputation of petitioner's income on the calendar year basis in line with respondent's contention that petitioner does not qualify as an exempt organization during the periods indicated:

*162 *154 Respondent in his amended answer asserted in the alternative that petitioner was liable for unrelated-business income tax, and, consistently therewith, made the following computation of petitioner's income:

*163 The return from cone manufacturing was not petitioner's only source of income. Rather, during the years in issue petitioner realized a goodly portion of its net income from interest on savings accounts, and Government and corporate bonds, from dividends on mutual funds, and from rent on real estate.

Petitioner's accumulated income at the end of the indicated periods was as follows:

During the years in issue petitioner conducted research in its facility, and also sponsored research in universities. Thirty percent of petitioner's facility was devoted to research during 1962, 1963, and 1964. The approximate salary and overhead costs of petitioner's in-house research during the period relevant to this case were as follows:

*155 Research activities conducted in the petitioner's physical plant have been confined primarily to problems directly connected with the manufacture and *164 use of the pyrometric cone.

The research which the petitioner sponsored in certain universities was funded by the net income realized from the cone-manufacturing operation and the few investments the petitioner had. This research was concerned with the firing process in the field of ceramic engineering. The bulk of the grants made by petitioner was in the form of fellowships to selected graduate students in the major ceramic engineering departments of colleges or universities in the United States. Although the funds were channeled through a given college, the funding took the form of a specific grant to a selected candidate who was to work on a given project. Normally application for a grant would be made by, e.g., the head of a university ceramic engineering department. The department head would request funds for a specific student stating his qualifications, and outlining his proposed project. Petitioner's general manager/research director would handle the administrative details of the applications and make an initial recommendation to the board of trustees which made the final determination. Although a member of a university faculty might recommend a student for a grant, *165 the final selection rested with the board. The end products of the research conducted by a grant recipient were theses, a number of which were published in ceramic trade and professional journals.

Petitioner also had a program of honorariums designed to encourage higher quality and publication of the research funded by the grants. The honorarium was usually $ 200 granted to the individual who supervised the researching student if the results of the research were published.

Some grants were made to two or three endowments already established at Ohio State University. In the case of one of these endowments the selection process for a grant recipient was the same as applied to other individual research grants made by petitioner. Determination of distributions from the other endowments was made by the university. Petitioner has also made grants for equipment and special projects to universities and other institutions conducting research in the field of ceramics.

Petitioner did not necessarily make grants to or through the same institutions every year. The following aggregate distributions were made by petitioner for research in other institutions, honorariums, and equipment during*166 the indicated periods: