Snow Mfg. Co. v. Commissioner

*260 Respondent determined deficiencies in petitioner's income tax for petitioner's taxable years ended June 30, 1979, and June 30, 1980, in the respective amounts of $ 109,816 and $ 70,968. After concessions, the issue before *261 us is whether petitioner is liable for the accumulated earnings tax imposed by section 531. ¹

*151 FINDINGS OF FACT

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

Petitioner, a California corporation, was incorporated in 1959 and was dissolved and liquidated into its parent as of July 1, 1982. Petitioner's primary place of business during its corporate existence was City of Commerce, California. For the taxable years at issue, petitioner filed Federal corporate income tax returns with the Internal Revenue Service Center, Fresno, California.

Prior to its dissolution, petitioner was a wholly owned subsidiary of Alma Piston Co. (Alma), a Michigan corporation. When petitioner was liquidated, all of its assets and liabilities were transferred to Alma. Thereafter, petitioner's business was carried on as an operating division of Alma. ²

*152 During the years at issue, members of the E.E. Tracy family beneficially owned all of Alma's stock. E.E. Tracy (Tracy) made petitioner's major decisions, such as deciding whether or not to acquire additional property. E.E. Tracy resided in a city distant from petitioner's business location. Day-to-day decisions involving production schedules, the purchase of materials, plant maintenance, labor relations, and personnel management were made by Lowell Lewis (Lewis), petitioner's on-site vice president and general manager, who began working for petitioner in 1973. Although a member of petitioner's board of directors, Lewis did not attend board meetings, which were usually held in the Detroit area.

Petitioner's business consisted of reconditioning and re-building small automobile parts, such as pumps, generators, *262 brakes, starters, and distributors. Petitioner purchased materials and used parts from various vendors; it sold essentially all of its remanufactured parts to Genuine Parts Distributors (Genuine), a division of Alma.

Petitioner's manufacturing activities were conducted in a 20,000-square-foot building rented from Alma located at 7215 1/2 E. Gage Avenue, City of *153 Commerce, California, which was situated on a lot approximating 58,000 square feet. A 20,000-square-foot warehouse used by Genuine was located next to petitioner's building. The total square footage of the lot on which the two warehouses were located was approximately 100,000 square feet.

Between 1974 and 1979 new antipollution laws led to an increase in the number of models of parts remanufactured by petitioner presumably because of the public's tendency to attempt to retain "pre-antipollution" vehicles. During this period petitioner experienced a growth in its total sales, from approximately $ 1.9 million in 1974 to approximately $ 3.1 million in 1979. Between 1974 and 1979 petitioner added new remanufacturing equipment to meet the growing demand for its products.

Petitioner required operating space for the machinery used in the remanufacturing process, and storage space for new and used parts, finished goods, and materials. As early as 1973 (and perhaps before) and continuing through the taxable years at issue, petitioner stored some of these items on its property outside its building.

On January 21, 1975, the Environmental*154 Protection Inspector for City of Commerce wrote petitioner and advised it that a recent field inspection had found its property to be in violation of a local ordinance regulating the appearance of materials placed in outside storage. Lewis sent the letter to Tracy and, in an accompanying memorandum dated February 25, 1975, requested his approval to purchase screening to comply with the ordinance. On February 27, 1976, Lewis wrote Tracy and described petitioner's lack of storage and efforts to make the best use *263 of available space. Lewis requested Tracy's approval to purchase steel racks to increase storage space in petitioner's stockroom. Tracy approved the request.

The storage problems continued through 1979 and 1980. During those years, petitioner used part of its driveway and parking area for storage. Parts were stored outside in drums and in metal baskets that were sometimes stacked 10 feet high. Occasionally, vehicles in the driveway were damaged by falling parts. Weather and theft caused further losses. A lean-to built on one side of petitioner's building helped protect some of the stored items, but enlargement of the building itself was not possible without*155 acquisition of additional property for parking facilities.

On January 25 and 26, 1979, Lewis again wrote Tracy regarding the overcrowded conditions at petitioner's property. Lewis complained that the crowded conditions diminished labor efficiency and resulted in "considerable" weather damage to stock, finished goods, and new cartons stored outside the building. He stated that he "hoped" petitioner would soon start on a new building. Along with his memos, Lewis sent Polaroid and professionally taken photographs to illustrate the conditions on petitioner's property.

Storage problems affected petitioner's choice of present and future product lines. Lewis wanted to add additional product lines and generate more business, work, and profit. Lewis met with a management consultant in 1978 or 1979 in an effort to improve the efficiency of petitioner's operation. The consultant concluded that petitioner's operations were not very efficient from a labor standpoint, and that its production lines ought to be rearranged. The consultant suggested that petitioner would need to acquire additional space before much could be done.

Immediately south of petitioner's property was*156 an L-shaped piece of land covering 20,805 square feet (including 2,431 square feet dedicated to the municipality) owned at one time by a Mr. Luben (Luben property). The Luben property was next to the Genuine building. A 10-foot county sewer easement ran the length of the side of the *264 Luben property contiguous to the Genuine building. Three residences were located on the Luben property.

Petitioner, prior to the taxable years at issue, considered purchasing the Luben property to meet its needs for space. Negotiations went on for some time. The negotiations and prospects for development of the Luben property are the principal topic of the Lewis memo of February 25, 1975. On March 11, 1975, petitioner by its president, L.L. Upshur, wrote to Luben regarding the property. Petitioner stated that $ 50,000 was a "ridiculous" price for the property.

Because of size limitations and permit restrictions, the Luben property was not a likely site for construction of a new industrial building for petitioner. Although acquisition of the property for this purpose was considered, petitioner's primary interest was in using the site as a parking lot, which would have allowed more of the*157 parking area around petitioner's building to be used for storage. Luben died in 1975 or 1976, and petitioner's negotiations with Luben's daughter regarding the property were fruitless. In January 1979, the Luben property was purchased by Ignacio Moitnio for $ 95,000. No attempt has been made on behalf of petitioner to purchase the property from Moitnio.

Lewis, who had negotiated with Luben, was also interested in the property of another nearby landowner, the W.R. Grace Co. (Grace). At some point, Lewis informally approached Grace's manager about purchasing some of its property. Petitioner was advised that Grace's home office was not interested in selling any of its property.

Lewis made other inquiries. Prior to and during 1979 and 1980, Lewis contacted or received correspondence from a number of real estate brokers regarding the location of additional property for petitoner. Lewis visited several proposed sites but found each of them unacceptable.

Lewis and Tracy were in frequent contact, and Lewis thought that Tracy agreed with his belief that petitioner needed more space. In February of 1979, Alma applied for a permit to construct a new 36,000-square-foot warehouse for Genuine*158 in City of Industry, California, and construction began shortly thereafter. About this time, Lewis advised Tracy that petitioner should buy land and build a suitable manufacturing building, purchase land with an existing *265 building, or purchase Genuine's property in City of Commerce. The latter alternative was the most attractive to Lewis because it would allow petitioner to remain in a community where it was established and avoid the loss of employees and production that a move would entail. Lewis believed that it would cost approximately $ 1.5 million for petitioner to purchase the land and both 20,000-square-foot buildings on the East Gage property (the building petitioner was renting from Alma and the Genuine building) and approximately $ 1.05 million for petitioner to acquire land in City of Commerce and construct an additional 30,000-square-foot building ($ 300,000 for the land and $ 750,000 for the building).

In October 1979, Genuine moved part of its operations from its building on East Gage to City of Industry, and petitioner obtained access to a small amount of additional space in Genuine's building (500 to 1,000 square feet).

On December 15, 1979, petitioner's*159 board of directors held a special meeting in Grosse Point, Michigan. The minutes of the meeting in part provide:

The increasing neccessity [sic] of an additional 30,000 square foot building and the purchase of sufficent [sic] land for the building and the neccessary [sic] parking space was discussed. The Board approved increasing the purchase price for the adjoining property or other land as continueing [sic] to operate in the present small facility with outside storage for expensive parts and cores was becoming a heavy burden in inclement weather.

At the time of the meeting, petitioner did not own property on which to build a 30,000-square-foot building, was no longer considering the Luben property, and was not negotiating for the purchase of other property.

In December 1980, Coldwell Banker, a real estate broker, advised Lewis that the two buildings on East Gage could be sold for about $ 33 per square foot. In November 1981, Majestic Realty wrote Thomas Tracy, vice president of Tomadur*160 Engine Co., a division of Alma, that the market *266 value of the two 20,000-square-foot buildings was $ 37 per square foot.

In 1983 and 1984, Genuine moved the rest of its operations from its building next to petitioner to City of Industry. As determined in November 1984, Genuine's move to its new warehouse cost $ 1,225,548, inclusive of the cost for land and improvements, buildings and facilities, other equipment, and moving costs.

Petitioner moved into the old Genuine building in June 1984. Except for some office space in the old Genuine building, petitioner is now using all of the land and both of the buildings on the East Gage property in City of Commerce. Petitioner still keeps some items in outside storage.

On February 7, 1984, W.H. Daum & Staff, a real estate broker, wrote E.E. Tracy and advised him that the two buildings on the East Gage property could be sold for between $ 33 and $ 35 per square foot. Tracy, in a memorandum dated June 22, 1984, stated that effective June 1, 1984, the East Gage property, including the two buildings on it, was to be sold to the Snow division by Alma for $ 1.5 million. By that time, Snow Manufacturing Co. had dissolved and liquidated*161 and become a division of Alma. Title to the property remained with Alma after the transfer.

The following table presents petitioner's accumulated earnings and profits, and additions thereto:

The next table summarizes petitioner's net liquid assets (excess of current assets over current liabilities) for the same taxable years:

*267 Prior to the end of the first taxable year in this case, respondent determined deficiencies in accumulated earnings tax against petitioner. The following table summarizes the deficiencies determined, and the ultimate deficiencies reflected in stipulated decisions filed with the Tax Court:

*162 Petitioner at the end of each taxable year at issue in this case had a reasonable need to retain $ 256,544 as a reserve for payment of the above accumulated earnings taxes.

Petitioner's accumulated taxable income under section 535, prior to the accumulated earnings credit for the reasonable needs of the business, is as follows:

Throughout its existence as a corporation, petitioner paid no dividends.

On May 3, 1979, petitioner purchased a tax-exempt Michigan Housing bond for $ 904,239. The bond had a par value of $ 900,000 and a coupon rate of 6.5 percent.

On June 16, 1982, respondent mailed petitioner a certified letter, pursuant to section 534(b), informing petitioner that a proposed notice of deficiency for the taxable years*163 ending June 30, 1979, and June 30, 1980, would include amounts *268 for accumulated earnings tax. Petitioner filed no statement under section 534(c) of grounds upon which it was relying to establish that all or any portion of its earnings and profits had not been permitted to accumulate beyond reasonable business needs.

Respondent issued a notice of deficiency to petitioner on August 3, 1982. On October 29, 1982, petitioner petitioned the Tax Court for a redetermination of the deficiencies determined by respondent. In its petition, which was prepared by counsel in Michigan, petitioner maintained that it needed at least $ 915,000 as a reserve for expansion. Petitioner did not refer to any need to purchase its own building. On April 18, 1983, petitioner's Michigan counsel stated petitioner's position in a letter to respondent. Counsel stated in the letter that --

Expansion at Snow's current location is really feasible only in one direction. * * * The "Luben property" * * * is the intended area for expansion. Snow would move its parking facility and rail siding to this lot and would add additional plant space over the existing driveway and parking area.

The letter refers*164 to a reserve of $ 915,000 set aside during 1979 and 1980 for expansion and does not mention any plan by petitioner to acquire its own building.

OPINION

The disparity during the years in question between corporate and individual tax rates may have encouraged the use of corporations to reduce shareholders' overall tax liabilities through the accumulation of earnings in excess of reasonable business needs. The accumulated earnings tax is a means of discouraging the accumulation of corporate earnings not needed in the conduct of a business. See Ivan Allen Co. v. United States, 422 U.S. 617, 624 (1975). The tax is imposed on the accumulated taxable income of corporations "availed of for the purpose of avoiding the income tax with respect to [their] shareholders or the shareholders of any other corporation, by permitting earnings and profits to accumulate instead of being divided or distributed." Sec. 532(a); sec. 531. The tax is considered to *269 be a penalty and therefore is to be strictly construed. Ivan Allen Co. v. United States, supra at 626.

Where a corporation accumulates earnings and profits, the most significant*165 factor in determining whether the accumulated earnings tax applies is the reasonableness of the corporate accumulation. United States v. Donruss Co., 393 U.S. 297, 307 (1969). Section 533(a) establishes the presumption that a corporation that accumulates earnings and profits beyond its reasonable business needs does so for the proscribed purpose of tax avoidance. The section 533(a) presumption, however, is rebuttable by a preponderance of evidence to the contrary. Therefore, the accumulated earnings tax is not imposed where a corporation has made an unreasonable accumulation but lacks the proscribed purpose. Pelton Steel Casting Co. v. Commissioner, 28 T.C. 153, 173 (1957), affd. 251 F.2d 278 (7th Cir. 1958), cert. denied 356 U.S. 958 (1958). The ultimate question upon which imposition of the tax rests is whether tax avoidance with respect to shareholders was one of the purposes of a corporate accumulation. United States v. Donruss Co., supra at 301.

Whether a corporation has permitted its earnings and profits to accumulate beyond *166 its reasonable business needs and whether the corporation was availed of for tax-avoidance purposes are both questions of fact. Bremerton Sun Publishing Co. v. Commissioner, 44 T.C. 566, 582 (1965), and cases cited therein. The reasonable needs of a business should be determined by the officers and directors of the corporation. We are reluctant to substitute our business judgment for theirs unless the facts and circumstances, buttressed by the presumptive correctness of respondent's determination, require us to do so. Atlantic Properties, Inc. v. Commissioner, 62 T.C. 644, 656 (1974), affd. 519 F.2d 1233 (1st Cir. 1975); Faber Cement Block Co. v. Commissioner, 50 T.C. 317, 329 (1968).

Section 534 fixes the burden of proof in any Tax Court proceeding based in whole or in part on the allegation that all or any part of the earnings and profits have been permitted to accumulate beyond the reasonable needs of the business. If the Secretary, before mailing the taxpayer a notice of deficiency, sends notification informing the taxpayer *270 that the proposed notice*167 of deficiency includes an amount with respect to the accumulated earnings tax, the burden of proof rests with the taxpayer, unless the taxpayer submits a statement under section 534(c) of the grounds on which the taxpayer relies to establish that the allegation is in error. Petitioner filed no section 534(c) statement, and consequently bears the burden of proof in this proceeding.

Very generally, both parties in comparing petitioner's resources to its needs follow the approach adopted by this Court in Bardahl Manufacturing Corp. v. Commissioner, T.C. Memo. 1965-200, and since used in many cases. In Bardahl Manufacturing Corp. v. Commissioner, supra, we determined the reasonableness of a corporate accumulation by numerically comparing the corporate taxpayer's resources with its total business needs. Petitioner and respondent disagree on three critical points that relate to the Bardahl comparison: (1) How to compute petitioner's needed working capital; (2) whether petitioner was justified in retaining funds for expansion; and (3) whether to compare petitioner's total business needs to its accumulated earnings and profits*168 or its net liquid assets.

One of the needs of a business is the need for working capital. A corporation may accumulate earnings and profits to provide its necessary working capital. See sec. 1.537-2(b)(4), Income Tax Regs. The parties agree that petitioner needed working capital to meet expenses for one operating cycle. An operating cycle is the period of time required to convert cash into raw materials, raw materials into inventory, inventory into accounts receivable, and accounts receivable into cash. ³*169 Bardahl Manufacturing Corp. v. Commissioner, supra.The parties compute petitioner's working capital requirements differently, because they disagree as to *271 how to determine petitioner's credit cycle, a common component of each party's operating cycle calculations. ⁴

The operating cycle calculated by each party consists in part of an inventory cycle and an accounts receivable cycle. The inventory cycle is arrived at by dividing the number of days in the year by the inventory turnover rate, which is the cost of goods sold divided by the dollar amount of inventory. ⁵ The accounts receivable cycle is reached by dividing the number of days in the year by the accounts receivable turnover rate, which is net sales divided by the amount of accounts receivable. ⁶ For each fiscal year at issue, petitioner and respondent in their separate calculations use the inventory and accounts receivable amounts for the peak month, when the aggregate of inventory and accounts receivable was at its yearly high. ⁷ Petitioner and respondent then each reduce the length of the total of the inventory and accounts receivable cycle by a credit cycle (which, as we have stated, they calculate differently) to arrive at a total operating cycle. Expressed as a decimal part of the year, the total operating cycle is multiplied*170 by total operating expenses to arrive at current operating needs. The parties in their calculations each adjust total operating expenses for inflation. ⁸

*171 The parties' computations of working capital diverge at the point where they reduce the inventory and accounts receivable cycles by a credit cycle. ⁹ Each party arrives at *272 the length of the credit cycle ¹⁰*172 by dividing the number of days in the year by a figure representing what each refers to as the trade payables turnover. Petitioner maintains that its trade payables turnover is calculated by dividing total operating expenses by average accounts payable. ¹¹ This latter item is the average of accounts payable trade plus other current liabilities excluding accrued Federal and state income taxes. Respondent on the other hand proposes that the true measure of petitioner's trade payables turnover is the total cost of materials purchased for the year divided by average trade payables.

As the parties forthrightly acknowledge, both methods of computing the credit cycle are supported by authority. ¹² The operating cycle approach is not a rigid mathematical formula, and the decided cases do not prescribe a universal method for calculating the credit cycle.

*173 The weakness in respondent's position when utilized in this case is that it ignores the credit period of petitioner's nontrade payables, which was shorter than the credit period of petitioner's trade payables. Credit often has a significant impact on all aspects of a business' operations. We see no reason to restrict our focus here to trade payables alone and, as a result, produce what we believe would be an artificially high estimate of the length of petitioner's credit cycle and a correspondingly low estimate of petitioner's *273 working capital needs. ¹³ We, accordingly, conclude that petitioner has correctly calculated its credit cycle, and therefore its working capital needs as well.

A business may *174 need funds to expand. To provide for the bona fide expansion of its business, a corporation may accumulate earnings and profits. See sec. 1.537-2(b)(1), Income Tax Regs. The Code permits such accumulations even where expansion is not an immediate prospect. See S. Rept. 1622, 83d Cong., 2d Sess. 69 (1954); H. Rept. 1337, 83d Cong., 2d Sess. 53 (1954). Section 537(a) provides that the term "reasonable needs of the business," a concept critical to a determination of whether the accumulated earnings tax applies, includes the "reasonably anticipated needs of the business." As section 1.537-1(b), Income Tax Regs., indicates, "reasonably anticipated needs of the business" do not include the vague or uncertain plans of a corporate taxpayer to acquire new property:

(b) Reasonably anticipated needs. (1) In order for a corporation to justify an accumulation of earnings and profits for reasonably anticipated future needs, there must be an indication that the future needs of the business require such accumulation, and the corporation must have specific, definite, and feasible plans for the use of such accumulation. Such an accumulation need not be used immediately, nor must the plans*175 for its use be consummated within a short period after the close of the taxable year, provided that such accumulation will be used within a reasonable time depending upon all the facts and circumstances relating to the future needs of the business. Where the future needs of the business are uncertain or vague, where the plans for the future use of an accumulation are not specific, definite, and feasible, or where the execution of such a plan is postponed indefinitely, an accumulation cannot be justified on the grounds of reasonably anticipated needs of the business.

(2) Consideration shall be given to reasonably anticipated needs as they exist on the basis of the facts at the close of the taxable year. Thus, subsequent events shall not be used for the purpose of showing that the retention of earnings or profits was unreasonable at the close of the taxable year if all the elements of reasonable anticipation are present at the close of such taxable year. However, subsequent events may be considered to determine whether the taxpayer actually intended to consummate or has actually consummated the plans for which the *274 earnings and profits were accumulated. In this connection, *176 projected expansion or investment plans shall be reviewed in the light of the facts during each year and as they exist as of the close of the taxable year. If a corporation has justified an accumulation for future needs by plans never consummated, the amount of such an accumulation shall be taken into account in determining the reasonableness of subsequent accumulations.

The specificity requirements were written into the regulations because a loosely run corporation presents a high potential for post hoc, unsupported rationalizations for the prohibited hoarding of profits. Bahan Textile Machinery Co. v. United States, 453 F.2d 1100, 1102 (4th Cir. 1972). The requirement of a "specific, definite, and feasible" plan does not demand that the taxpayer produce meticulously drawn, formal blueprints for action. Faber Cement Block Co. v. Commissioner, 50 T.C. 317, 332 (1968); John P. Scripps Newspapers v. Commissioner, 44 T.C. 453, 469 (1965). A corporation, however, cannot immunize itself from the accumulated earnings tax merely by referring to expansion in its corporate minutes. See Faber Cement Block Co. v. Commissioner, supra at 332.*177 Definiteness of plan coupled with action taken towards its consummation are essential to justify an accumulation as reasonable. Dixie, Inc. v. Commissioner,