Berkley Machine Works & Foundry Co. v. Commissioner
This text of 1983 T.C. Memo. 477 (Berkley Machine Works & Foundry Co. v. Commissioner) is published on Counsel Stack Legal Research, covering United States Tax Court primary law. Counsel Stack provides free access to over 12 million legal documents including statutes, case law, regulations, and constitutions.
Opinion
1. Petitioner owned and maintained three buildings on Ocracoke Island, North Carolina, which it used, as hunting and fishing lodges, for the entertainment of employees of its major customers and a few of its smaller customers during 1968 through 1978. Petitioner's officers would decide which customer-companies were to be invited on a particular hunting and/or fishing trip to Ocracoke, and the sales representatives for the customers would phone contacts of theirs in a position of authority in the companies, who would in turn designate the employees who were to go.
2.
MEMORANDUM FINDINGS OF FACT AND OPINION
IRWIN,
| Docket No. | Year | Deficiency |
| 485-76 | 1968 | $49,461.44 |
| 1969 | 39,329.80 | |
| 1970 | 41,041.53 | |
| 1971 | 35,331.00 | |
| 1972 | 54,292.00 | |
| 3683-77 | 1973 | 154,524.00 |
| 1974 | 295,086.00 | |
| 1975 | 248,294.00 | |
| 22859-80 | 1976 | 244,469.00 |
| 1977 | 57,322.00 | |
| 1978 | 73,896.00 |
By an amendment to his answer, respondent claimed an increase of $14,623.50 in the deficiency in docket no. 3683-77 for the taxable year 1974. 1
Concessions having *308 been made by both parties, the issues remaining for our decision are:
(1) Whether petitioner is entitled to deduct expenses incurred in connection with entertainment facilities maintained and activities conducted at Ocracoke, North Carolina, during each of the taxable years in issue; and
(2) Whether for the taxable years 1973, 1974, 1975, and 1976, petitioner was availed of for the purpose of avoiding the income tax with respect to its shareholders by permitting earnings and profits to accumulate instead of being divided or distributed and is, therefore, liable for the accumulated earnings tax imposed by section 531. 2
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of facts and the exhibits attached thereto are incorporated herein by this reference.
The petitioner, Berkley Machine Works & Foundry Company, Inc., was incorporated in 1914 under the laws of the Commonwealth of Virginia. Throughout the years in issue, *309 petitioner maintained its principal office in Norfolk, Virginia, where its plant is also located. Petitioner filed its Federal income tax returns for the years 1968 to 1971 with the Mid-Atlantic Service Center in Philadelphia, Pennsylvania. For each of the years 1972 through 1978, inclusive, petitioner filed its Federal income tax returns with the Internal Revenue Service Center in Memphis, Tennessee.
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1. Petitioner owned and maintained three buildings on Ocracoke Island, North Carolina, which it used, as hunting and fishing lodges, for the entertainment of employees of its major customers and a few of its smaller customers during 1968 through 1978. Petitioner's officers would decide which customer-companies were to be invited on a particular hunting and/or fishing trip to Ocracoke, and the sales representatives for the customers would phone contacts of theirs in a position of authority in the companies, who would in turn designate the employees who were to go.
2.
MEMORANDUM FINDINGS OF FACT AND OPINION
IRWIN,
| Docket No. | Year | Deficiency |
| 485-76 | 1968 | $49,461.44 |
| 1969 | 39,329.80 | |
| 1970 | 41,041.53 | |
| 1971 | 35,331.00 | |
| 1972 | 54,292.00 | |
| 3683-77 | 1973 | 154,524.00 |
| 1974 | 295,086.00 | |
| 1975 | 248,294.00 | |
| 22859-80 | 1976 | 244,469.00 |
| 1977 | 57,322.00 | |
| 1978 | 73,896.00 |
By an amendment to his answer, respondent claimed an increase of $14,623.50 in the deficiency in docket no. 3683-77 for the taxable year 1974. 1
Concessions having *308 been made by both parties, the issues remaining for our decision are:
(1) Whether petitioner is entitled to deduct expenses incurred in connection with entertainment facilities maintained and activities conducted at Ocracoke, North Carolina, during each of the taxable years in issue; and
(2) Whether for the taxable years 1973, 1974, 1975, and 1976, petitioner was availed of for the purpose of avoiding the income tax with respect to its shareholders by permitting earnings and profits to accumulate instead of being divided or distributed and is, therefore, liable for the accumulated earnings tax imposed by section 531. 2
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of facts and the exhibits attached thereto are incorporated herein by this reference.
The petitioner, Berkley Machine Works & Foundry Company, Inc., was incorporated in 1914 under the laws of the Commonwealth of Virginia. Throughout the years in issue, *309 petitioner maintained its principal office in Norfolk, Virginia, where its plant is also located. Petitioner filed its Federal income tax returns for the years 1968 to 1971 with the Mid-Atlantic Service Center in Philadelphia, Pennsylvania. For each of the years 1972 through 1978, inclusive, petitioner filed its Federal income tax returns with the Internal Revenue Service Center in Memphis, Tennessee. In reporting its taxable income for each of the years 1968 to 1978, inclusive, petitioner utilized the accrual method of accounting.
Until his death on September 27, 1977, at 84 years of age, Samuel G. Jones, Sr., was petitioner's president and owned 83 percent of petitioner's capital stock. From 1963 through October 1, 1977, Samuel G. Jones, Jr., was petitioner's vice-president and owned the remaining 17 percent of petitioner's capital stock. Since October 1, 1977, Samuel G. Jones, Jr., has been petitioner's president.
1. Entertainment Expenditures
Petitioner's business involved the operation of a foundry for iron, steel, brass, and aluminum, including a pattern shop and a machine shop, and the manufacture of metal castings and forgings. Berkley manufactured both parts used *310 by other companies in their production of a finished product and repair parts for equipment used by other companies in their production process. Patterns for parts that petitioner manufactured were provided either by existing plans and specifications or by using old parts as a sample. Petitioner's ability to acquire a particular job of manufacturing equipment repair parts was often dependent upon its ability to produce them more quickly and less expensively than the original equipment manufacturer.
Because of the nature of petitioner's business, media advertising was of limited usefulness. The company's policy for promoting sales was that of developing and maintaining personal contact with the appropriate personnel of its customers--individuals often in various departments of the same company. Berkley's principal sales efforts were directed toward a small number of major customers, including Albemarle Paper Company, American Oil Company, Bowater Carolina Corporation, Bowen-McLaughlin-York Company, Continental Can Company, Drill Carrier Corporation, Federal Paper Board Company, Penn Central Railway, Texas Gulf Corp., Union Camp Corporation, Westvaco Company, and Weyerhaeuser Company. *311 The number of contracts entered into between petitioner and its major customers during the years 1968 to 1978 total 4,732. Petitioner's other customers (approximately 150) only accounted for roughly 15 to 25 percent of petitioner's total sales.
Petitioner's contact with its major customers, the frequency of which varied from as often as three or four times a day to as seldom as once a week, was maintained primarily through two sales representatives. E. M. Weber concentrated his activities in the area around York, Pennsylvania, where the Pennsylvania Railroad and Bowen-McLaughlin-York were located. From the Norfolk office, C. M. Halsey directed the sales effort toward local customers and customers located in other southeastern states. However, petitioner's largest customer, Drill Carrier Corporation, was serviced by Samuel G. Jones, Jr., and F. P. Huber, the foundry superintendent. 3
When an employee of one of petitioner's customers wanted a part manufactured, he consulted with one of petitioner's *312 sales representatives. The sales representative then reviewed drawings of the part prepared by the customer's employee to determine if petitioner could make the part to the mututal advantage of the customer and petitioner, prepared an estimate or "quote" of the price for the part, and "follow[ed] up to get an order." If an order was received, the sales representative was responsible for making sure that the job was completed on time. Petitioner's customers could get in touch with petitioner's sales representatives at any time.
One of the means by which petitioner cemented its relationships with its customers was by use of an entertainment facility owned and maintained by it on Ocracoke Island. Ocracoke is an isolated island off the Atlantic Coast of North Carolina, just south of Hatteras, consisting of a small cluster of homes at one end and a succession of sand dunes and marshes leading to the other end.
Petitioner's Ocracoke facility consisted of three buildings of wood-frame construction, known as "Berkley Castle," "Berkley Manor," and "Berkley Ranch House," the exteriors of which were covered with fir shingles. Each building was designed as a home, with a living room, a dining *313 room, and several bedrooms. The interiors were nicely furnished to reflect the taste of Jones, Sr. On the second floor of Berkley Castle, the largest of the three buildings, was a conference room containing a drafting board, a large table, and a number of chairs. Berkley Castle was used as a fishing lodge. Berkley Manor was used infrequently for overflow purposes, and Berkley Ranch House was used rarely, if at all, for that purpose.
During 1968 through 1978, employees from all of petitioner's major customers and from a few of its smaller customers were invited by petitioner's officers and sales representatives to visit the Ocracoke facility for hunting and/or fishing trips. Berkley's officers would decide which customers would be invited for a particular weekend, and the sales representative for that customer would phone a contact of his in a position of authority in that company, who would in turn designate the employees who were to go. On occasion, petitioner's business associates would be accompanied by members of their families, or other guests having no direct business relationship with petitioner. The number of guests present at a single time varied between about six and *314 30, the general number approaching the arithmetical mean of these extremes. Guests typically received, as mementos of their Ocracoke visit, gifts distributed by petitioner such as hunting and fishing knives, model ducks to be used as doorstops, cookbooks or other books, and neckties with a Berkley label.
Petitioner's Ocracoke facility was used throughout the year, but primarily on weekends from late spring through early fall. However, guests were not invited each and every week, even during this period. A typical fishing trip to Ocracoke began on Thursday afternoon or Friday morning. After breakfast on Friday, the fishermen split into teams of four, five, or six and fished until lunchtime from boats chartered by petitioner from various individuals who were engaged in the business of taking out fishing parties off the coast of North Carolina. The fishermen returned to Berkley's facility for lunch and then resumed fishing for the remainder of the afternoon. Saturday's activities duplicated those of Friday. Guests generally left the island after breakfast on Sunday.
The Ocracoke setting established a congenial and relaxing atmospohere in which petitioner's sales representatives *315 pursued petitioner's business interests, i.e., promoting sales. Business discussions often centered around specific jobs that Berkley was in the process of performing for its customer-guests. At other times, determinations were made whether Berkley could perform specific jobs which the customer-guests needed done.On occasion, petitioner's guests would initiate discussions about problems that arose only a few days prior to their trip to Ocracoke, after the visit had been planned. The conference room in Berkley Castle was used when examination of plans and specifications was pertinent. Discussions of anticipated business needs and job scheduling were conducted in even less formal surroundings, e.g., on the fishing boats, during meals, and while relaxing after dinner.
In composing the parties to be invited to Ocracoke on a particular occasion, Berkley's representatives sometimes included employees from several different customer-companies. By so mixing its guests, petitioner was able to make certain customers aware of the work that it was performing for others--the underlying purpose of which was to inform each company of the different and additional types of work that petitioner *316 could do for it.
Business guests visiting Ocracoke believed the trips there to be meaningful and beneficial to both their employers and to Berkley because of the actual substantive matters discussed and resolved and also because of the information they received about various other functions that Berkley could perform for them. The business discussions which took place at Ocracoke during 1968 through 1978 were substantially the same in nature (although not identical as to the specific business discussed on particular occasions) as those which took place during the years 1963 through 1967.
Petitioner's former president and major stockholder, Samuel G. Jones, Sr., owned and maintained a vacation home on Ocracoke Island.The home was not adjacent to petitioner's recreational facilities. Although it was usual for Jones, Sr., to attend the Berkley facility while guests were being entertained, he did not participate in the hunting or fishing, and he returned to his personal residence in the evenings. During the years 1968 - 1978, inclusive, petitioner's Ocracoke facilities were never used for the personal benefit of its officers, nor were these facilities ever used by members of their *317 families. In fact, the Ocracoke facilities were used exclusively in connection with the fishing trips for customers. When the facilities were not used in connection with the fishing trips, they were not used at all. The parties have stipulated that petitioner's Ocracoke Island facilities were "used primarily for the furtherance of petitioner's business."
Mr. Weber's testimony indicated that he sometimes prepared agendas before he went to Ocracoke Island. However, he did not relate his testimony to any particular trip or year. 4 Mr. Halsey prepared no agendas outlining business matters he wanted to discuss before he went on trips to Ocracoke Island.No other evidence in the record indicates that agendas were prepared before any of the trips to Ocracoke Island during the years in question.
Petitioner employed a caretaker to oversee the operation of its Ocracoke facility. The caretaker was responsible for preparation of the *318 facility for use by petitioner's representatives and guests which, when appropriate, included chartering the required number of fishing boats. Other islanders were hired to do cleaning, laundering, and the cooking and serving of meals at the facility. The caretaker collected bills for the various expenses incurred on the island, e.g., boat charter fees, restaurant meals, and groceries, and forwarded them to petitioner's Norfolk office for payment.
For each of the years 1968 through 1978, petitioner claimed deductions for depreciation of buildings, furniture and fixtures, boats, a marine railway, and an airplane, which were used as parts of petitioner's entertainment facility on Ocracoke Island, in the following total amounts.
| Year | Amount |
| 1968 | $46,387.35 |
| 1969 | 42,407.69 |
| 1970 | 39,639.20 |
| 1971 | 35,480.33 |
| 1972 | 44,633.89 |
| 1973 | 47,402.00 |
| 1974 | 38,303.00 |
| 1975 | 31,184.00 |
| 1976 | 57,332.00 |
| 1977 | 54,928.00 |
| 1978 | 34,770.00 |
Respondent disallowed the amounts listed above in their entirety pursuant to section 274. The cost bases assigned by petitioner to the assets on which depreciation was claimed are not in dispute. Respondent determined, and petitioner has conceded, that some assets depreciated under the heading "Berkley *319 Manor Furniture and Fixtures" constitute antiques or artworks having indeterminate useful lives and salvage values greater than their costs. Petitioner has agreed that respondent properly disallowed deductions claimed for depreciation of the items determined to constitute antiques or artworks, regardless of the resolution of the section 274 issue. Neither the useful lives nor salvage values assigned by petitioner to the remaining assets on which depreciation was claimed are in dispute.
Except for reports of Ocracoke trips prior to 1969, petitioner's books and records were kept in the regular course of its business and conformed to generally accepted accounting principles, and the entries reflected in petitioner's books and records were made contemporaneously with the events recorded therein. The parties have stipulated that the amounts, times, and place of the expenses incurred in entertaining at Ocracoke have been established, pursuant to section 274(d) and the regulations thereunder.Whether the remaining substantiation requirements provided by section 274(d) and the regulations thereunder--concerning the business relationshiip between the taxpayer and its guests and the business *320 purpose of the entertainment--have been satisfied is in dispute.
Reports concerning each of the trips to Ocracoke during the years 1969 through 1978 were prepared by petitioner's sales representatives contemporaneously with the trips to which the reports relate. No reports were prepared contemporaneously with the trips to Ocracoke during 1968.
For the years 1969 through 1978, petitioner has somewhat over 130 trip reports. Approximately one-third of the trip reports do not indicate the job titles of the individuals entertained. Those titles which are mentioned are not sufficient to establish that all of the entertainees had dealings with petitioner. The trip reports which show job titles indicate that petitioner permitted its customers to include individuals in the groups entertained at Ocracoke who, from their designations, clearly had no business dealings with petitioner, as set forth in Table I on pages 14-17. Only a few of the individuals entertained were named in the reports as having specific discussions with petitioner's personnel. Many of the reports did not identify any guests by name as having business discussions with petitioner's personnel. According to the reports, *321 it was not unusual for employees of petitioner's customers to be accompanied by their wives and children on the Ocracoke trips. The reports indicate that wives and children were present on all the trips for employees of companies serviced by Mr. Weber.
At trial petitioner introduced into evidence a booklet prepared for it reflecting the name and job title of each individual entertained at Ocracoke during 1968 through 1978 and the date(s) of each individual's visit(s) to Ocracoke. The entries in the booklet, which is arranged by the companies that employed the individual guests, were not made at or near the time of the particular expenditures related to each guest.
| Designation | Customer-Company | Individual | Dates Attended |
| Retired | Weyerhaeuser Co. | Holbrook | October 13-15, 1972 |
| June 28-30, 1974 | |||
| May 30 - June 1, 1975 | |||
| Retired | Union Camp Corp. | Duck | October 11-13, 1974 |
| October 8-10, 1976 | |||
| Retired | Union Camp Corp. | Scott | June 6-8, 1975 |
| September 17-19, 1976 | |||
| Retired | American Oil Co. | Scott | September 8-10, 1978 |
| October 12-15, 1978 | |||
| Retired | Union Camp Corp. | Eubanks | June 10-12, 1977 |
| Retired | Continental | Mitchell | July 15-17, 1977 |
| Can Co. | |||
| Retired | Union Camp Corp. | Brenner | July 22-24, 1977 |
| June 16-18, 1978 | |||
| Retired | Federal Paper | Jones | July 7-9, 1978 |
| Board Co. | |||
| Data Processing | Albemarle Paper | Oliver | July 27-29, 1973 |
| Co. | |||
| I.B.M. (which | Elks | June 2-4, 1972 | |
| is not | |||
| a customer of | May 25-27, 1973 | ||
| petitioner) | |||
| Chemist | Continental Can | Boone | August 11-13, 1972 |
| Co. | |||
| Chemist | Continental Can | Erhspomer | October 25-27, 1974 |
| Co. | |||
| July 11-13, 1975 | |||
| September 12-14, 1975 | |||
| July 15-17, 1977 | |||
| Credit Manager | Federal Paper | Hunley | October 8-10, 1976 |
| Board Co. | |||
| Communications | Union Camp Corp. | March | May 25-27, 1973 |
| Communications | Union Camp Corp. | Pearson | June 10-12, 1977 |
| (in 1977); Clerk | July 21-23, 1978 | ||
| and Router (in | |||
| 1978) | |||
| Merchandising | Weyerhaeuser Co. | Tilly | October 13-15, 1972 |
| Superintendent | |||
| Salesman | American Oil Co. | Scott | June 8-10, 1973 |
| Sales Manager | Union Camp Corp. | Stevens | September 17-19, 1976 |
| Salesman | Union Camp Corp. | Gay | September 17-19, 1976 |
| Sales | Continental Can | Simon | June 3-5, 1977 |
| Co. | |||
| Supply Sales | Weyerhaeuser Co. | Keener | July 29-31, 1977 |
| Instrument | Weyerhaeuser Co. | Norris | June 18-20, 1971 |
| Superintendent | October 13-15, 1972 | ||
| June 8-10, 1973 | |||
| September 27-29, 1974 | |||
| May 30 - June 1, 1975 | |||
| Electrical and | Continental Can | Dansby | June 3-5, 1977 |
| Instrument | Co. | ||
| Superintendent | |||
| Instrument | Continental Can | Harrison | July 15-17, 1977 |
| Foreman | Co. | ||
| Accounting | Union Camp Corp. | Copeland | June 2-4, 1972 |
| September 21-23, 1973 | |||
| Comptroller | Albemarle Paper | Farley | July 14-16, 1972 |
| Co. | |||
| Accountant | Hoerner Waldorf | Farley | June 17-19, 1977 |
| Corp. | |||
| Accounting | Weyerhaeuser Co. | Lamb | June 8-10, 1973 |
| Accounting | Weyerhaeuser Co. | Jasper | June 8-10, 1973 |
| Comptroller | Albemarle Paper | Henderson | July 12-14, 1974 |
| Co. | |||
| Comptroller | Continental Can | Dodson | July 11-13, 1975 |
| Co. | |||
| June 25-27, 1976 | |||
| July 15-17, 1977 | |||
| July 14-16, 1978 | |||
| Auditor | Continental Can | Goodrich | September 12-14, 1975 |
| Co. | |||
| Accountant | Union Camp Corp. | Earley | September 17-19, 1976 |
| Plant Controller | Continental Can | Ball | June 3-5, 1977 |
| Co. | |||
| Accounting | Hoerner Waldorf | Watkins | September 9-11, 1977 |
| Corp. | |||
| Personnel | Albemarle Paper | Burgwyn | July 14-16, 1972 |
| Co. | |||
| Director, Salaried | |||
| Personnel | |||
| Personnel Director | Albemarle Paper | Morris | July 14-16, 1972 |
| Co. | |||
| Hourly Personnel | |||
| Personnel | Hoerner Waldorf | Morgan | May 21-23, 1976 |
| Corp. | |||
| Personnel Manager | Amoco Oil Co. | Smith | July 29-31, 1977 |
| July 7-9, 1978 | |||
| Personnel Manager | Hoerner Waldorf | Fields | June 2-4, 1978 |
| Corp. | |||
| Chief Security | Penn Central | Wolfe | June 26 - July 1, 1971 |
| Railway | |||
| Officer | June 16-23, 1972 | ||
| June 22-29, 1973 | |||
| Clerk in Planning | Union Camp Corp. | Barrett | June 6-8, 1975 |
| Clerk | Continental Can | Daniels | June 22-25, 1978 |
| Co. |
*322 The majority of the trip reports, aside from listing a few machines or parts which were discussed, include little or no information concerning the substance of the conversations about those parts or machines, that is, whether petitioner previously manufactured or repaired the parts or machines for the customer involved, whether petitioner was manufacturing or repairing the parts or machines for the customer at or near the time of the trip, whether petitioner desired to manufacture such parts or machines for the customer, or whether the parts or machines were being discussed in general and not in terms of petitioner's work. Those reports which disclose the substance of the conversations concerning various parts or machines indicate topics such as repairs or parts which customers advised petitioner they were "going to order", handling of orders already placed, the progress of orders already placed, and petitioner's need for additional lead time on certain orders.
Drawings or plans are mentioned in only 14 of the over 130 trip reports. 5*324 Ten of those 14 reports concern trips for employees of petitioner's largest customer, Drill Carrier Corporation or Gardner-Denver Corporation. See *323 page 6,
Three of the 14 trip reports which mention drawings or plans report on trips for employees of Penn Central Railway and Bowen-McLaughlin-York, which were 6 or 7 days long. A group meeting was conducted on one evening during each of those trips. See n.4,
The final report which mentions drawings is a report for a fishing trip for employees of Union Camp Co. and TexasGulf Corp. on October 2-4, 1970. This report also does not indicate whether petitioner's sales representative engaged in any negotiations or discussions during the fishing trip to obtain orders of the parts to which the drawings relate. Insofar as the drawings are concerned, the report indicates only that the customers brought the drawings along.
The trip reports reflect only 5 occasions on which petitioner received orders during the Ocracoke trips. All those orders were received from Drill Carrier or Gardner-Denever, petitioner's largest customer. On at least one of the trips (October 1-3, 1971), an employee of Drill Carrier brought the order with him. Whether petitioner's sales representatives engaged in negotiations or discussions at Ocracoke to secure the other four orders is not indicated by the pertinent trip reports (May 7-10, 1970; June 19-21, 1970; September 24-27, 1970; and June 4-6, 1971).
Only 8 of *326 the over 130 reports mention formal or group meetings at which business was discussed. The majority of those are reports of the 6 or 7-day trips for employees of companies serviced by Mr. Weber, during which a meeting was held on one evening. In addition, 34 other reports mention the showing of picture slides of petitioner's plant and/or operations.7
Most of petitioner's trip reports do not state in what context discussions regarding business arose, aside from the formal or group meetings. Some of the reports indicate that business was discussed at "opportune times" or "whenever there was a suitable opportunity."
A number of the trip reports contain references to the goodwill benefits petitioner expected to derive from the Ocracoke entertainment.
The total amounts, excluding depreciation, expended by petitioner in connection with the operation of its entertainment facility at Ocracoke and disallowed by respondent are as follows:
| 1968 | 1969 | 1970 | 1971 | 1972 | 1973 | |
| SUPPLIES | ||||||
| USED AT | ||||||
| OCRACOKE | $2076.00 | $2269.20 | $13453.35 | $1663.62 | $12427.76 | $2647.00 |
| SALARIES | ||||||
| AND PAYROLL | ||||||
| TAXES | 27890.92 | 18091.20 | 29924.88 | 27083.48 | 32510.49 | 28479.00 |
| INSURANCE | 951.00 | 893.00 | 893.00 | 922.00 | 1292.00 | |
| REPAIRS | 5246.53 | 4823.51 | 2395.00 | 617.61 | 2761.90 | |
| UTILITIES | 2457.10 | 979.23 | 1503.07 | 1699.26 | 2169.48 | |
| TRAVEL AND | ||||||
| PROMOTION | 8667.01 | 8943.38 | 5442.22 | 8537.79 | 17568.00 | |
| AIRPLANE | ||||||
| EXPENSE | 4176.74 | 12017.90 | 8834.00 | |||
| PILOT'S | ||||||
| SALARY AND | ||||||
| TAXES | 396.08 | 1462.92 | 959.00 | |||
| TOTALS | $47288.56 | $35999.52 | $4816.930 | $42001.01 | $73180.24 | $58487.00 |
| 1974 | 1975 | 1976 | 1977 | 1978 | |
| SUPPLIES USED AT | |||||
| OCRACOKE | $5993.00 | $22151.00 | $6091.00 | $12131.00 | $12896.00 |
| SALARIES AND PAYROLL | |||||
| TAXES | 28068.00 | 23864.00 | 23670.00 | 27727.00 | 26400.00 |
| INSURANCE | |||||
| REPAIRS | |||||
| UTILITIES | |||||
| TRAVEL AND PROMOTION | 11897.00 | 14235.00 | 10744.00 | 15306.00 | 12625.00 |
| AIRPLANE EXPENSE | 42673.00 | 18671.00 | 10157.00 | 14073.00 | 11707.00 |
| PILOT'S SALARY AND | |||||
| TAXES | 743.00 | 1278.00 | 853.00 | 1238.00 | 978.00 |
| TOTALS | $89374.00 | $80199.00 | $51515.00 | $70475.00 | $64606.00 |
2. Accumulated Earnings Tax
The board of directors was presented a report entitled "Plant Survey - 1971" concerning the question of machine tool equipment and plant improvement. We find after the survey of equipment by Mr. Weber and Mr. Landis that we need $2,246,450 to replace old, obsolete equipment. This large amount necessary for equipment is on account of the fact that we have not been financially able to make replacements from year to year that should have been made. We find now that competition is more pressing and we will have to put more effort toward replacement of obsolete equipment than we have in the past. To bear this out, we are attaching *328 hereto report entitled "Plant Equipment Survey" made November 17, 1971.
In addition to the above, at least $300,000 is neeced to build a new building suitable to take care of heavier work than we are able to take care of now, and equipment for this building would cost an estimated half million dollars.
In accordance, we feel it appropriate to designate one million dollars to be applied from our Retained Earnings and set aside in a special account as a Reserve for Major Capital Expenditures. We shall continue to set aside funds in our Machinery Reserve Account with the United Virginia Bank and when sufficient funds are in the account we shall continue a program of acquisition of equipment and start plans for a new building.
The report entitled "Plant Survey - 1971" recommended that any combination of the following seven proposals contained therein be undertaken:
1. Dispose of the oldest equipment, marked "S" on a schedule of equipment, and apply any money derived from their disposal toward upgrading buildings or machinery;
2. Fix the old foundry and relocate the blacksmith and his equipment in that building at an estimated cost of $32,900;
3. Extend the then-existing heavy machine *329 shop to the area vacated by the blacksmith (assuming that proposal number 2 is undertaken) which would entail renovating and properly equipping the vacated area at an estimated cost of $213,100;
4. Rearrange the smaller machine tools at an estimated cost of between $2,000 and $3,000;
5. As an alternative to proposal number 3, find another place for the weld shop and clearning department at an estimated cost of $273,400;
6. Move all saws to a single location where all raw materials could be received and processed at an estimated cost of $2,500; and
7. Purchase a "Clarklift" fork truck to use for transportation of materials within petitioner's building at an estimated cost of $8,000 for a truck with a capacity of 5,000 pounds or $9,000 for a truck with a capacity of 6,000 pounds. The survey also indicated the condition of each of petitioner's machines: excellent, very good, good, fair, poor, or "S." It recommended that the machines which were in excellent or very good condition be retained and maintained, that those which were in poor condition be sold and replaced, and that those in "S" condition be sold or scrapped to provide petitioner with additional floor space. The survey *330 did not recommend the construction of a new building as one of its alternatives.
In the mid-sixties, petitioner began acquiring parcels of land adjoining its then-existing plant. The table below sets forth the dates of acquisition and the costs to petitioner of such parcels.
| Parcel | Sale Date | Price |
| 700 Pine Street | August 1966 | $1,500 |
| 702 Pine Street | June 1966 | 500 |
| 710-712 Pine Street | August 1974 | 2,000 |
| Demolition | 795 | |
| 704 Pine Street | May 1975 | 2,015 |
| 706 Pine Street | May 1975 | 2,015 |
| 716 Pine Street | September 1975 | 6,402 |
| Demolition | 1,400 | |
| 708 Pine Street | October 1977 | 16,660 |
The parcels listed above were improved by occupied dwellings. As the various dwellings were vacated and the parcels were placed on the market, petitioner bought them. The parcel designated as 708 Pine Street cost more than the other parcels because it was in the middle of the block and its sellere apparently held out for the highest price he could get for it.
On August 10, 1977, petitioner entered into an agreement with Acorn Construction, Ltd. (hereinafter Acorn), whereby Acorn was to construct a new plant facility for petitioner.The total cost of construction was estimated to be $380,200. On August 10, 1977, petitioner made a downpayment of $100,000 *331 to Acorn.
The minutes of a special meeting of petitioner's board of directors held on October 17, 1977, read, in pertinent part, as follows:
After a full discussion of plant expansion plans for new building on Pine Street at an approximate value of $350,000, and the $650,000 approximate cost of new equipment for the building, it was duly moved and seconded to proceed with the project.
* * *
The Board approved the purchase of a lot at the rear of the plant, known as 708 Pine Street, for $16,600.
Acorn constructed the new plant facility for petitioner.
Petitioner's new plant facility is located on the parcels mentioned earlier, which are adjacent to its old plant. Upon completion of the new facility, petitioner owed Acorn $351,166. Petitioner paid that amount to Acorn in 1979.
During the taxable year 1978, petitioner acquired new equipment for $500,641.
From January 1, 1968, through December 31, 1978, petitioner's cash on hand increased from $103,900.40 to $2,054,306, a net increase of $1,950,405.60. During this same period, petitioner's buildings and other fixed depreciable assets increased from $1,162,259.44 to $2,651,787, a net increase of $1,489,527.56. On its income tax *332 returns for 1968 through 1978, petitioner claimed deductions for depreciation totaling $1,457,258.
During 1978, the year in which petitioner paid most of the costs for its plant expansion and equipment acquisition, petitioner's net liquid assets decreased by only $61,215.
Revenue Agent Lucille Stephenson recommended imposition of the accumulated earnings tax for 1973, 1974, and 1975 in her revenue agent's report dated July 16, 1976. The Internal Revenue Service notified petitioner that it proposed to impose the tax in a notice mailed to petitioner pursuant to section 534(b) on January 11, 1977. The formal determination that petitioner *333 was liable for the accumulated earnings tax was made in the statutory notice of deficiencies mailed to petitioner on March 14, 1977.
Petitioner was first advised that its income tax returns for 1976 through 1978 would be examined on November 20, 1979.
| 1973 | 1974 | 1975 | 1976 | |
| Current Assets: | ||||
| Cash | $ 764,149 | $1,391,207 | $1,182,172 | $1,652,199 |
| Accounts Receivable | 310,546 | 453,152 | 515,746 | 543,975 |
| Inventories | 66,645 | 91,855 | 94,348 | 90,315 |
| Other Current Assets | 16,570 | 2,810 | 21,159 | 83,471 |
| Total Current Assets | $1,157,910 | $1,939,024 | $1,813,425 | $2,369,960 |
| Current Liabilities: | ||||
| Accounts Payable | 60,582 | 84,719 | 82,749 | 82,690 |
| Income Tax Payable | 90,176 | |||
| Total Current | ||||
| Liabilities | $ 60,582 | $ 174,895 | $ 82,749 | $ 82,690 |
| Net Liquid Assets | $1,097,328 | $1,764,129 | $1,730,676 | $2,287,270 |
As of the close of the taxable years 1973 through 1976, petitioner's prior earnings available for reasonable needs of its business were as follows:
| 1973 | 1974 | 1975 | 1976 | |
| Net Liquid Assets | ||||
| at End of Year | $1,097,328 | $1,764,129 | $1,730,676 | $2,287,270 |
| Current Earnings | ||||
| and Profits | 244,813 | 544,764 | 521,272 | 475,666 |
| Prior Earnings | ||||
| Available for | ||||
| Reasonable | ||||
| Needs | $ 852,515 | $1,219,365 | $1,209,404 | $1,811,604 |
As *334 of the end of each of the taxable years 1973 through 1976, petitioner reasonably anticipated the need to retain earnings (1) for working capital and (2) to discharge contingent liabilities for state income tax and interest in the following amounts:
| 1973 | 1974 | 1975 | 1976 | |
| Working Capital | $255,709 | $266,720 | $452,637 | $445,623 |
| State income tax | ||||
| and interest | 61,116 | 70,362 | 81,300 | 91,733 |
Reasonably anticipated needs of petitioner for the years 1973 through 1976 for contingent liabilities for federal income tax and interest thereon amounted to not less than the following amounts:
| 1973 | 1974 | 1975 | 1976 |
| $610,318 | $696,041 | $799,448 | $891,429 |
In addition, reasonably anticipated needs of petitioner for legal and accounting fees amounted to not less than $100,000 for each of the years 1973 through 1976.
From May 18, 1920, until 1977, petitioner neither declared nor distributed any dividends. During 1977, 1978, and the first 2-1/2 months of 1979, petitioner paid the following dividends:
| Date Paid | Amount |
| November 1, 1977 | $48,000 |
| December 1, 1977 | 24,000 |
| March 13, 1978 | 36,000 |
| June 16, 1978 | 60,000 |
| September 15, 1978 | 48,000 |
| January 2, 1979 | 96,000 |
| March 15, 1979 | 39,600 |
Respondent determined that petitioner is liable for the accumulated earnings tax *335 imposed by section 531 for each of the years 1973 through 1976 in the following amounts: 8
| 1973 | 1974 | 1975 | 1976 |
| $105,894 | $237,678 | $184,631 | $194,697 |
In the notices of deficiency issued to petitioner, determining the taxes under section 531, respondent determined that petitioner's reasonable business needs for 1973 through 1976 were as follows:
| 1973 | 1974 | 1975 | 1976 | |
| Working Capital | $ 64,756 | $183,509 | $ 228,617 | $ 218,293 |
| State Income Tax and Interest | ||||
| Federal Income Tax and Interest | 610,318 | 696,041 | 799,448 | 841,657 |
| Accumulated Earnings Tax | ||||
| Plant and Equipment | ||||
| Legal and Accounting Fees | 100,000 | 100,000 | 100,000 | 100,000 |
| Total | $775,074 | $979,550 | $1,128,065 | $1,159,950 |
Petitioner timely submitted statements, as provided in section 534(c), setting forth the grounds upon which it relied *336 to establish that all or part of its earnings had not been permitted to accumulate beyond the reasonable needs of its business. On September 9, 1981, this Court ruled that the burden of proof is on petitioner as to whether its earnings and profits were permitted to accumulate beyond the reasonable needs of its business.
OPINION
The first issue for our decision is whether petitioner is entitled to deductions for expenses incurred in connection with its entertainment facilities maintained and activities conducted at Ocracoke Island, North Carolina, during the tax years 1968 through 1978, inclusive. Respondent has conceded that the entertainment expenses in question are "ordinary and necessary" business expenses within the meaning of section 162. The pivotal question is, therefore, whether petitioner has satisfied the additional requirements for deduction of entertainment expenses imposed by section 274.
Section 274(a)(1)(A) denies any deduction otherwise allowable with respect to an activity generally considered to constitute entertainment, unless the taxpayer shows that the activity was directly related to, or, if the activity directly preceded or *337 followed "a substantial and bona fide business discussion," that the activity "was associated with, the active conduct of the taxpayer's trade or business." During the years in issue, section 274(a)(1)(B) denied any deduction otherwise allowable with respect to a facility used in connection with an entertainment activity, unless the taxpayer showed "that the facility was used primarily for the furtherance of the taxpayer's trade or business and that the" particular expenses were "directly related to the active conduct of such trade or business." 9
The term "facility used in connection with entertainment" is broadly defined by respondent's regulations to include any personal or real property owned, rented, or used by a taxpayer for, or in connection with, entertainment.
An exception to the rules contained in section 274(a), denying deductions for entertainment-related expenses, is provided by section 274(e)(1) in the case of business meals furnished under circumstances which are *339 generally considered to be conducive to a business discussion. This exception, however, does not relieve a taxpayer from the responsibility of complying with the substantiation requirements imposed by section 274(d).
In 1977, this Court, in
The Commissioner appealed from this Court's decision in that case.
We think it clear that the discussions that took place during the Ocracoke weekends, while certainly business-related and undoubtedly of general economic benefit to Berkley, were not properly established on the evidence as
Two customers did testify that they had on one or more occasions brought plans or specifications along for the purpose of going over specific projects with Berkley representatives.Though this type of activity may constitute a negotiation or discussion for the purpose of obtaining a "specific trade or business benefit" under * * *
At trial respondent amended his answers in the cases before us to allege that petitioner is collaterally estopped by the decision of the Court of Appeals in
Petitioner, on the other hand, contends that respondent's claim of collateral estoppel suffers from various fatal procedural infirmities and that, in any event, respondent's claim of collateral estoppel must fail since the evidence submitted in this case is substantially different from the evidence in the earlier proceeding.
The landmark case on the application of collateral estoppel in tax cases is
As to the application of collateral estoppel to the license agreements which had not previously been considered by the Board, the Supreme Court stated:
* * * * if the very same facts and no others are involved in * * * [a subsequent proceeding], a case relating to a different tax year, the prior judgment will be conclusive as to the same legal issues which appear, assuming no intervening doctrinal change.
It is readily apparent in this case that the royalty payments growing out of the license contracts which were not involved in the earlier action before the Board of Tax Appeals and which concerned different tax years are free from the effects of the collateral estoppel doctrine. That is true even though those contracts are identical in all important respects with the 1928 contract, the only one that was before the Board, and even though the issue as to those contracts is the same as that raised by *346 the 1928 contract. For income tax purposes, what is decided as to one contract is not conclusive as to any other contract which is not then in issue, however similar or identical it may be. * * * [Emphasis supplied. Fn. ref. omitted.
Although we would agree that petitioner is estopped from relitigating any fact decided in
Notwithstanding that the holding of the Fourth Circuit as to the deductibility of the expenses for entertainment in the years 1963 through 1967 is not determinative of the question here, many of the facts involved in the present case are the same as the facts involved in the earlier case and a number of legal questions presented in this case were presented to the Fourth Circuit in the earlier case. Since there are differences between the present case and the preceding case, however,
Petitioner first argues that it is clear, based upon the evidence in the present case, that its expenditures incurred in connection with the trips to Ocracoke should be considered to be directly related to the active conduct of its trade or business under *348 either
We do not doubt that any recipient of the entertainment furnished by petitioner would have known that petitioner had no significant motive other than promoting its trade or business. See
Recognizing that the evidence presented in
The foregoing argument of petitioner is without merit. Although it appears that no evidence was submitted in the earlier proceeding concerning how many contracts petitioner entered into with its major customers and when each contract was entered into, a reading of our opinion and the Court of Appeals' opinion in the earlier case indicates that evidence of the amount of petitioner's sales to its major customers and of petitioner's ongoing relationships with such customers was in the record. Among our findings of fact (
Although business activity undeniably took place during the Ocracoke fishing and/or hunting trips, petitioner has not established that the trips were "directly related to" the active conduct of its trade or business, in that it has failed to clearly establish that the principal character or aspect of the trips was the active conduct of its trade or business. The bulk of the evidence indicates that petitioner's purpose, in entertaining employees of its customers, was to create goodwill among customers and to cement business relationships.Formal or group business meetings are mentioned in few of the trip reports (approximately six percent). In addition, most of those meetings took place on only a single evening of six or seven days of combined business and entertainment. Although more time need not be devoted to business than to entertainment to satisfy the requirement that the principal *353 character of entertainment to which an expenditure relates be the active conduct of the taxpayer's trade or business,
The trip reports for approximately 94 percent (or nearly 130) of the occasions on which petitioner entertained employees of its customers contain no reference to business meetings or negotiations in which petitioner engaged. It is clear from the Fourth Circuit's opinion in
As to certain out-of-pocket expenditures, such as those for food and beverages, for which deductions may not be disallowed by section 274(a)(1)(A), although they are not "directly-related" expenditures,
The Ocracoke weekends clearly do not come within the statute's contemplation of entertainment that takes place purely as an adjunct to formal business meetings. Nor do we consider that expenses may qualify under the test when the claimed business discussions take place during the course of a combined social/business function. * * *
We conclude that section 274(a), as interpreted by the Fourth Circuit in
Petitioner contends that deductions for depreciation of its facilities maintained at Ocracoke should be allowed since the facilities were used solely to furnish meals and sleeping accommodations to its guests, not to engage in the activity of fishing. In this connection, petitioner contends that the only facilities used in connection with the entertainment, viz, the fishing, were boats owned by other individuals and rented by petitioner for a fee. Petitioner alternatively argues that if expenditures for meals and sleeping accommodations furnished to its guests are not deductible, deductions for depreciation, nevertheless, should be permitted for the portion of time its facilities were not used during each of the years 1968 through 1978, inclusive. In support of this argument, petitioner cites
Petitioner's contention that its facilities maintained at Ocracoke were not facilities used in connection with an activity generally considered to constitute entertainment, amusement, or recreation within the meaning of section 274(a)(1)(B) ignores the plain import of respondent's regulations under section 274. See
We also are unable to agree with petitioner's assertion that deductions for depreciation should be allowed for the portion of time its facilities were not used during each of the years under review.
As noted earlier, in order for a taxpayer to obtain a deduction for any item related *360 to an entertainment facility, he must demonstrate that the facility was primarily used for the furtherance of his trade or business. The deduction will be disallowed, however, if the item was not directly related to the active conduct of such trade or business.
Under section 274(g), a taxpayer's use of a facility for purposes for which a deduction is disallowed under section 274(a) is deemed to be for personal, living, and family purposes. See sec. 262. Since we have concluded that *361 deductions for expenditures incurred in connection with petitioner's use of its facilities maintained at Ocracoke are disallowed by section 274(a), it follows that petitioner is entitled to no deductions for depreciation. Secs. 167, 262, and 274(g).
Petitioner finally contends that it is entitled to deduct its expenditures for food or beverages furnished to its guests, including depreciation on its Ocracoke facilities, under section 274(e)(1) and the corresponding regulations. Respondent, on the other hand, claims that
On the basis of the record before us, we are unable to conclude that petitioner's expenditures for food and beverages fall within the exception to section 274(a) contained in section 274(e)(1).
In determining whether food and beverages were furnished under circumstances generally considered to be conducive to a business discussion, we must take into account *362 the relationship to the taxpayer's business of the persons to whom the food and beverages are furnished. Section 274(e)(1). The regulations provide that, generally, the quiet business meal exception is not applicable to meals or beverages furnished in an atmosphere where there are substantial distractions to business discussions, such as large cocktail parties or sizeable social gatherings. Sec 1.274-2(f)(2)(i)(
As we indicated earlier in connection with our discussion of petitioner's argument concerning its expenditures having been incurred in a clear business setting, petitioner's Ocracoke trips involved large groups of people, including some people who definitely were not business associates. In addition, other people who have not been established by petitioner to be business associates as defined by
Petitioner states that ample support for its position *364 is contained in
Since we have concluded that the deductions in question are disallowed by section 274(a) and do not fall within the ambit of section 274(e)(1), we do not reach the question whether petitioner has met the substantiation requirements of section 274.
The remaining issue for decision is whether petitioner is liable for accumulated earnings taxes, pursuant to section 531, for each of the years 1973 through 1976.
The accumulated earnings tax is imposed on the "accumulated taxable income" of those corporations formed or availed of for the purpose of avoiding tax liability with respect to their shareholders by permitting earnings and profits to accumulate instead of being distributed. Secs. *365 531 and 532. If a corporation permits its earnings and profits to accumulate beyond its reasonable business needs, section 533 gives rise to a presumption that the interdicted purpose is present. That presumption is determinative of the proscribed purpose unless the taxpayer by a preponderance of the evidence proves to the contrary. Sec. 533. The term "accumulated taxable income" is defined by section 535(a) as taxable income, with certain adjustments, reduced by the sum of the dividends paid deduction provided by section 561 and the "accumlated earnings credit" as defined by section 535(c). The accumulated earnings credit, as a general rule, is an amount equal to that part of the earnings and profits of the current year which are retained for the corporation's reasonable business needs. Sec. 535(c).
It follows from the foregoing that a determination of petitioner's reasonable business needs is important for two reasons: (1) to determine whether the proscribed purpose is presumed to be present pursuant to section 533 and (2) to calculate the amount of the credit for earnings and profits of the years in question retained to meet petitioner's reasonable business needs.
Whether *366 a corporation has accumulated earnings beyond its reasonable business needs is a question of fact to be determined with reference to the conditions existing in the year of accumulation.
In determining whether petitioner has allowed its earnings and profits to accumulate beyond its reasonable business needs, a simple comparison of petitioner's reasonable business needs with its total accumulated earnings will not suffice. Since some of petitioner's accumulated earnings may have been converted into illiquid assets, such as business plant and equipment, and thus not have been available for dividends, we must, instead, compare petitioner's reasonable business needs with its net liquid assets. See
Petitioner contends that $800,000 of its accumulation was needed during each of the years 1973 through 1976 "to provide funds for renovation of plant and for new equipment."
Respondent at least tacitly concedes that petitioner needed to replace its old equipment and to build a new building and that its board of directors anticipated these needs as early as 1972. Respondent contends, however, that petitioner's plans to expand its plant and to acquire new equipment were too vague and uncertain during the years 1973 through 1976 to warrant an accumulation of earnings and that no action had been taken in furtherance of those plans. Respondent further contends that assuming, arguendo, that petitioner had a concrete plan to expand its plant and acquire equipment during 1973 through 1976, the plan did not require a substantial accumulation inasmuch as "petitioner funded almost all of its plant expansion and equipment acquisition through depreciation," rather than through accumulated earnings.
Section 537(a)(1) provides that the term "reasonable needs of the business" encompasses reasonably anticipated needs of the business.
(b)
(2) Consideration shall be given to reasonably anticipated needs as they exist *369 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 earnings and profits were accumulated. In this connection, 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.
In other words, the regulations require that the corporation have a need which requires an accumulation and a specific, definite, and feasible plan for the use of the accumulation to satisfy such need. It is not necessary that the taxpayer have meticulously drawn blueprints for action *370 or formal minutes detailing its plans.
Petitioner has failed to carry its burden of proving that it had a specific, definite, and feasible plan for expansion as of the close of the taxable years 1973 and 1974. Although petitioner's board of directors recognized the need for a new facility on March 8, 1972, the corporate minutes of March 8, 1972, indicate that it resolved only to
We are satisfied that by the end of 1975 petitioner's plans for construction of a new building were specific, definite, and feasible. Petitioner's purchase of 3 additional parcels during the year 1975 indicates that its plans to construct a new plant were "a real consideration during the taxable year." See
The evidence shows that in 1972 petitioner's board of directors anticipated that the cost of petitioner's new building would be $300,000. In 1977, the total cost of construction was estimated to be $380,200. On this record, we conclude that petitioner reasonably anticipated the need to accumulate $300,000 for construction of its new plant in 1975 and 1976.
We do not believe that petitioner has shown that it had a specific and definite plan to acquire new equipment during 1973 and 1974. On March 8, 1972, petitioner's board of directors was presented a survey of its plant equipment which recognized that some of petitioner's machine tools were approaching antiquity and which recommended alternative proposals for dealing with the problem. The corporate minutes of March *374 8, 1972, refer to the survey of petitoner's equipment and recognize a need for $2,246,450 to replace old, obsolete equipment. Nevertheless, the corporate minutes do not indicate which, if any, of the proposals contained in the survey petitioner's board of directors planned to implement. In addition, none of the proposals recommended by the survey were estimated to cost any amount near $2,246,450. The corporate minutes of March 8, 1972 also state that equipment for a new "building would cost an estimated half million dollars.?
Petitioner's recognition of its need to replace old, obsolete equipment and consideration of alternative ways to meet that need is insufficient.
For the reasons discussed above in connection with the year when petitioner first had specific, definite, and feasible plans to construct a new plant, we have concluded that petitioner has not established that it had specific, definite, and feasible plans to acquire equipment for a new plant during 1973 and 1974. We conclude that petitioner had reasonable business needs for equipment for its new plant as of the end of the years 1975 and 1976 to the extent of $500,000.
Respondent's argument that petitioner's needs for a new plant and equipment were funded through depreciation demonstrates a misunderstanding on his part concerning the concepts underlying depreciation accounting. Depreciation entries are merely book entries, *376 which are intended to promote the integrity of periodic income statements by allocating in a meaningful way the cost (excluding maintenance expense) of an asset previously acquired to the periods to which the asset contributes.
Petitioner contends that, as a result of past difficulties with the Internal Revenue Service, it needed to retain $105,894, $343,572, and $528,203 in the years 1974, 1975 and 1976, respectively, to meet the probability that the Internal Revenue Service would assert accumulated earnings tax liabilities. Respondent contends that petitioner cannot show that it reasonably anticipated the need until 1977, when the accumulated earnings tax liabilities were actually asserted.
As we assess the situation, having found that petitioner reasonably anticipated the need to retain $800,000 for construction of a new plant and acquisition of equipment at the end of the years 1975 and 1976, it is unnecessary *377 for us to consider whether contingent liabilities for accumulated earnings tax were a reasonable need for which petitioner might provide as of December 31, 1975, and December 31, 1976. (See the table on page 61,
It is well settled that a contingent liability may be a reasonable need for which a business may provide.
The only hint in the record that petitioner feared adverse circumstances could take place as a result of its tax return for 1973 being audited is contained in the minutes of a special meeting of petitioner's board of directors held on June 4, 1975, 18 i.e., more than 5 months after 1974. The record before us, being singularly devoid of evidence as to whether petitioner's *378 directors and/or officers were concerned about (or even aware of) the possibility of petitioner's liability for accumulated earnings tax in 1973 and 1974, does not permit us to conclude that petitioner retained earnings in 1973 and 1974 to meet the possible imposition of the tax. 19*379 See
The following table compares our conclusions as to petitioner's reasonable business needs with petitioner's net liquid assets available to meet these needs as of the close of the taxable years 1973, 1974, 1975, and 1976.
| Taxable Year Ended December 31 | ||||
| 1973 | 1974 | 1975 | 1976 | |
| I. Needs | ||||
| A. Working Capital | $ 255,709 | $ 266,720 | $ 452,637 | $ 445,623 |
| B. Prior | ||||
| Federal Income | ||||
| Tax Deficiencies | 610,318 | 696,041 | 799,448 | 891,429 |
| (Including Interest) | ||||
| C. Prior State Income | ||||
| Tax Deficiencies | 61,116 | 70,362 | 81,300 | 91,733 |
| (Including Interest) | ||||
| D. Accumulated Earnings | ||||
| Tax | ||||
| E. Plant and Equipment | 800,000 | 800,000 | ||
| F. Legal and Accounting | ||||
| Fees | 100,000 | 100,000 | 100,000 | 100,000 |
| Total Needs | $1,027,143 | $1,133,123 | $2,233,385 | $2,328,785 |
| II. Petitioner's net | ||||
| liquid assets | 1,097,328 | 1,764,129 | 1,730,676 | 2,287,270 |
| (page 29, supra) | ||||
| III. Surplus (Deficit) | $ 70,185 | $ 631,006 | ($ 502,709) | ($ 41,515) |
The *380 foregoing chart clearly indicates that during the years 1973 and 1974 petitioner permitted its earnings and profits to accumulate beyond its reasonable business needs. Petitioner has presented no evidence to rebut the presumption created by section 533 that such accumulation is determinative of the purpose to avoid tax at the shareholder level. Instead, petitioner only argued that its accumulations were justified by the pressing needs of its business.Since we have found that the evidence does not wholly support petitioner's argument, we must perforce uphold respondent's determination that petitioner was formed or availed of during the years 1973 and 1974 for the purpose of avoiding the income tax with respect to its shareholders by permitting earnings and profits to accumulate instead of being distributed.
Inasmuch as the foregoing chart indicates that petitioner's business needs exceeded its net liquid assets for the years 1975 and 1976, we need not consider whether petitioner was availed of for the proscribed purpose in those years.
Our holding with respect to the year 1976 makes it unnecessary for us to consider petitioner's contention concerning (1) its need for an accumulation in that year of $200,000 to cover anticipated legal and accounting fees and (2) the affect of a portion of a deficiency in its income tax, resulting from its failure to satisfy the requirements for postponing recognition of gain under section 1033, on the calculation of its accumulated taxable income for 1976.
Footnotes
1. The increase of $14,623.50 in the deficiency is attributable to the inclusion by respondent of a capital gain of $48,745, which petitioner realized upon the condemnation of some of its real property. Petitioner agrees that its taxable income for 1974 should be increased by $48,745.↩
2. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954, as amended and in effect during the years in issue and all references to Rules are to the Tax Court Rules of Practice and Procedure.↩
3. In 1973, Drill Carrier Corporation was purchased by the Gardner-Denver Corporation. Prior to the merger, Gardner-Denver was the primary marketing force for Drill Carrier's product.↩
4. Mr. Weber usually conducted a group meeting on one evening during each of the trips for the customers serviced by him. Each Ocracoke trip for his customers was 6 or 7 days long. Mr. Weber represented petitioner on july 6 trips, the last of which was in 1974.↩
5. The dates of those 14 trip reports are as follows: October 9-12, 1969; May 7-10, 1970; June 19-21, 1970; October 2-4, 1970; June 4-6, 1971; June 26-July 1, 1971; May 18-21, 1972; June 16-23, 1972; August 24-27, 1972; May 10-12, 1973; June 22-29, 1973; June 23-25, 1977; October 13-16, 1977; and June 9-11, 1978.
6. Those orders were received on the trips during May 7-10, 1970; June 19-21, 1970; and June 4-6, 1971.↩
7. On one trip (September 17-19, 1976) picture slides, although available, could not be shown because the light in the viewer was not functioning.↩
8. Respondent also determined that, for the taxable year 1978, petitioner was formed or availed of for the purpose of avoiding the income tax with respect to its shareholders by permitting earnings and profits to accumulate instead of being distributed. In his brief, he has conceded, however, that under sections 535(a) and (c)(1) petitioner had no "accumulated taxable income" in the year 1978 upon which to base an accumulated earnings tax. See section 531.↩
9. Section 274(a)(1)(B) was amended by section 361(a) of the Revenue Act of 1978, Pub. L. 95-600, 92 Stat. 2847, to disallow entirely deductions relating to entertainment facilities for taxable years ending after December 31, 1978.↩
10. Petitioner argues that, inasmuch as "goodwill is generally not considered to be, 'an ordinary and necessary business expense,'" respondent's contention that petitioner entertained at Ocracoke primarily to derive the goodwill of the individuals entertained is at odds with his concession that the expenses for Ocracoke weekends are ordinary and necessary business expenses under section 162. The fallacy in petitioner's argument is readily apparent from an examination of it. Although expenses for creating goodwill have
generally been held not to constitute ordinary and necessary business expenses, that rule is subject to a number of exceptions. Seesec. 1.162-20(a)(2), Income Tax Regs.↩ ; 4A Mertens, Law of Federal Income Taxation, sec. 25.38 (1979 rev.). We see no inconsistency between respondent's contention and his concession.11. We agree with petitioner that its sales representatives had to use different methods to secure orders than the methods used by wholesalers or retailers of finished products. Nonetheless, petitioner's contention that its business was so unique as to place it in a category by itself is of no help to it in this case. In this regard, we refer petitioner to
section 1.274-2(b), Income Tax Regs. , which states in pertinent part:(b)
Definitions - (1)Entertainment defined - (i)In general. For purposes of this section, the term "entertainment" means any activity which is of a type generally considered to constitute entertainment, amusement, or recreation, such as entertaining at night clubs, cocktail lounges, theaters, country clubs, golf and athletic clubs, sporting events, and on hunting, fishing, vacation and similar trips including such activity relating solely to the taxpayer or the taxpayer's family. * * *(ii)
Objective test. An objective test shall be used to determine whether an activity is of a type generally considered to constitute entertainment. Thus, if an activity is generally considered to be entertainment, it will constitute entertainment for purposes of this section and section 274 (a) regardless of whether the expenditure can also be described otherwise, and even though the expenditure relates to the taxpayer alone. This objective test precludes arguments such as that "entertainment" means only entertainment of others orthat an expenditure for entertainment should be characterized as an expenditure for advertising or public relations. However, in applying this test the taxpayer's trade or business shall be considered.Thus, although attending a theatrical performance would generally be considered entertainment, it would not be so considered in the case of a professional theater critic, attending in his professional capacity. Similarly, if a manufacturer of dresses conducts a fashion show to introduce his products to a group of store buyers, the show would not be generally considered to constitute entertainment. However, if an appliance distributor conducts a fashion show for the wives of his retailers, the fashion show would be generally considered to constitute entertainment. [Emphasis supplied.]The quoted language of the regulation is consistent with the legislative history of section 274, S. Rept. 1881, 87th Cong. 2d Sess. (1962),
1962-3 C.B. 707, 733-734 (stating "with respect to a taxpayer whose trade or business consists of selling machine tools * * * a hunting trip generally would be considered a recreation-type activity"); H.R. Rept. 1447, 87th Cong., 2d Sess. (1962),1962-3 C.B. 405, 424 . SeeWalliser v. Commissioner, 72 T.C. 433Moreover, the Fourth Circuit in
Berkley Machine Works & Foundry Co. v. Commissioner, supra , accepted the finding of this Court that media advertising is of limited usefulness in a business such as petitioner's business.623 F.2d at 900↩ .12. See
Superior Container, Inc. v. Commissioner, T.C. Memo 1980-434↩13. See
Hilliker v. Commissioner, T.C. Memo. 1972-183↩14. Implicit in the Fourth Circuit's opinion in
Berkley Machine Works & Foundry Co. v. Commissioner, supra , is the proposition that not every individual who is employed by a company which is a customer of a taxpayer has a business relationship to the taxpayer. See623 F.2d at 907 . In fact, the record in this case indicates that petitioner's method of inviting entertainees resulted in individuals who were employed by its customers, but who clearly had no business dealings with petitioner, being included in the groups entertained. See table 1 and the text related thereto. Whether certain other employees of petitioner's customers who participated in the Ocracoke trips, although designated as being engineers, maintenance supervisors, foremen, managers, superintendents, mechanics, or the like, were in positions which caused petitioner to reasonably expect to engage or deal in the active conduct of its business with those employees, is unclear from the record. SeeSec. 1.274-2(b)(2)(iii), Income Tax Regs. The aforementioned designations certainly suggest that petitionermight have expected to engage or deal in the active conduct of its business with the employees so designated. Nevertheless, that suggestion is insufficient to meet petitioner's burden of proof that the individuals were business associates or persons closely connected with business associates.Welch v. Helvering, 290 U.S. 111↩ (1933)15. See
Barrow Manufacturing Co. v. Commissioner, 294 F.2d 79↩ (5th Cir. 1961)16. See
Suwannee Lumber Manufacturing Co. v. Commissioner, T.C. Memo. 1979-477↩17. We note that a depreciation schedule submitted as a joint exhibit shows that petitioner also acquired equipment having a cost or other basis of $35,869.40, $5,054.25, and $42,000.85 in 1974, 1975 and 1977, respectively. Petitioner did not argue, or produce any evidence to show, that it had any plans to acquire the equipment that was in fact acquired in those years.↩
18. Those minutes read, in pertinent part, as follows:
[The board of directors] * * * reflected on the tax case pending for the years 1963 through 1967, as well as the alleged tax due for years 1968 through 1974. In view of the economic conditions and the potential tax liability, the board of directors decided to continue to accumulate cash reserves sufficient to continue operations in case of adversity. ↩
19. The case relied on by petitioner,
Marie's Shoppe, Inc. v. Commissioner, T.C. Memo. 1977-381Marie's Shoppe, Inc. asserted that it needed to retain its earnings and profits in 1973 to provide for, inter alia, the possible imposition of an accumulated earnings tax for the taxable year 1971. We found as a fact, inMarie's Shoppe, Inc., that the taxpayer, to whom the Commissioner had sent a statement pursuant to section 534(b) on December 2, 1973, had become aware in 1973 that the Commissioner might impose an accumulated earnings tax for its taxable year 1971. In addition, we cannot agree with petitioner that theBusiness Needs Compared to to the argument advanced by him in the present case. In that case, respondent's argument, which we rejected, was that it was unreasonable for petitioner to consider the proposed tax to be a contingent liability, since the notification issued pursuant to section 534(b) did not specify the amount of the proposed tax.↩
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1983 T.C. Memo. 477, 46 T.C.M. 1060, 1983 Tax Ct. Memo LEXIS 306, Counsel Stack Legal Research, https://law.counselstack.com/opinion/berkley-machine-works-foundry-co-v-commissioner-tax-1983.