EMI Corp. v. Commissioner

1985 T.C. Memo. 386, 50 T.C.M. 569, 1985 Tax Ct. Memo LEXIS 248

• Court: United States Tax Court
• Decided: July 31, 1985
• Docket: Docket No. 1163-81.
• Status: Unpublished

Opinion

EMI CORPORATION, AN ILLINOIS CORPORATION, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

EMI Corp. v. Commissioner

Docket No. 1163-81.

United States Tax Court

T.C. Memo 1985-386; 1985 Tax Ct. Memo LEXIS 248; 50 T.C.M. (CCH) 569; T.C.M. (RIA) 85386;

July 31, 1985.

---

Leslie R. Bishop,Robert A. Hall, and Leonard S. DeFranco, for the petitioner.

Thomas E. Ritter, for the respondent.

---

PARKER

MEMORANDUM FINDINGS OF FACT AND OPINION

PARKER, Judge: Respondent determined deficiencies in petitioner's corporate income tax of $41,600.72, $49,041.66, and $104,576.55 for its respective fiscal years ending August 31, 1975, August 31, 1976, and August 31, 1977. The sole issue for decision is whether, under section 532(a), ¹ petitioner was availed of for the purpose of avoiding the income tax with respect to its shareholders, by permitting its earnings and profits to accumulate instead of being divided or distributed so that petitioner is therefore subject to the accumulated earnings tax imposed by section 531.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulations of facts and exhibits attached thereto are incorporated herein by this reference.

Petitioner, an Illinois corporation, had its principal place of business in Des Plaines, Illinois, at the time it filed its petition in this case. Petitioner keeps its books and records and reports its income on a fiscal year basis ending August 31. Petitioner uses the completed contract method of reporting income within the meaning of section 1.451-3(d)(1), Income Tax Regs. Petitioner timely filed its fiscal 1975, 1976, and 1977 corporate income tax returns (Forms 1120) with the Internal Revenue Service.

Petitioner was organized in 1957 by Edward J. Loew to provide consultation services in the field of industrial extraction and processing of vegetable and animal products. Loew, a chemical engineer, had extensive experience in the extraction of vegetable oils. In organizing and operating his company, Loew followed a very conservative business philosophy and tried to protect against all foreseeable risks and to avoid getting over his head financially. Loew had began the business with a capital investment of only two to four thousand dollars, and slowly built up the business over the years.

Around 1960, Edward D. Milligan, Arnold M. Gavin, and Ralph W. Berger--all of whom were chemical engineers--began working for petitioner. Milligan's experience, like Loew's was primarily in oil extraction. Gavin and Berger were experienced in oil refining and related fats and oils technologies. By 1970, all three were shareholders in petitioner.

Originally, petitioner was simply a consulting firm, observing and recommending changes for its clients' plant operations. Throughout the early 1960's, the scope of petitioner's business grew to include the acquisition and resale of equipment to clients. By the late 1960's, petitioner had begun to design and engineer entire processing plants, including purchasing, storing, and shipping the equipment to be installed in such plants. Petitioner sometimes supervised construction, testing, and placing into operation of the plants.

By 1970, petitioner was completely owned and run by Loew, Milligan, Gavin, and Berger. These four individuals owned the following percentages of petitioner's stock and held the following positions in petitioner:

	Percentage
Individual	Ownership	Positions
Loew	60%	President, Director
Milligan	13-1/3%	Vice-President, Director
Gavin	13-1/3%	Vice-President, Secretary, Director
Berger	13-1/3%	Vice-President, Treasurer, Director

On September 1, 1970, petitioner and its shareholders entered into a stock purchase agreement. Under this agreement, the shareholders were required to offer their shares for sale only to petitioner, and petitioner was required to purchase all shares so offered. The agreement also provided that the corporation would redeem all of the shares of a stockholder who had died, retired, become disabled, or left petitioner's employ. The selling price of any stock so purchased was based upon the book value of the shares--100 percent of book value in the event of death or disability, and 90 percent of book value in the event of retirement, severance of employment, or sale pursuant to an offer. The agreement defined book value as "the total assets of the Corporation (not including any value for goodwill, patents, trademarks, licensing agreements or contracts) less total liabilities of the Corporation, computed on the accrual basis of accounting . . . in accordance with generally accepted accounting principles." [Emphasis supplied.] Book value was to be conclusively determined in an audit by an independent Certified Public Accountant. At the time of the stock purchase agreement, Loew was 59 years of age, Milligan 45, Gavin 47, and Berger 50.

From 1970 through the years in issue, petitioner specialized in designing and providing equipment and materials for the construction of plants to extract and process oil from various vegetable and animal raw materials. Each of petitioner's contracts had varying specifications and work to be performed. Petitioner's basic contract would be to provide the design of the facility and the materials and equipment necessary to complete the design.Each plant was essentially a custom-designed plant. Sometimes, petitioner would have to design and provide the superstructure for the customer's facility. In certain cases, petitioner was requested to provide on-site engineering services during the construction of the plant, and on-site inspection of the equipment once construction was completed. Occasionally, petitioner was requested to provide the contractor to actually build the facilities and/or to supervise such construction. Petitioner did not itself perform any construction work. Petitioner did not fabricate any of the material or equipment that it shipped to its customers; instead petitioner subcontracted that work to other companies.

Because of the nature of its business, petitioner had no regularly recurring cycle of work. The bulk of petitioner's gross sales was bunched in a limited number of contracts of relatively long duration, as follows:

Fiscal		Average
Year	Number of Contracts	Duration
1975	9	19.33 months
1976	6	21.67 months
1977	7	14.29 months

Because petitioner reported its income on the completed contract method of accounting, its gross sales from contracts completed and reported did not necessarily correspond to the cash it received during these taxable years.

Nearly all of petitioner's contracts guaranteed that each of the plants would provide a certain quantity and quality of product, given certain measurable variables such as raw materials processed, available utilities, climate and plant location. The proposals and contracts also guaranteed the performance of the equipment acquired and sold by petitioner. Petitioner could not obtain performance bonding for its contracts because of the prohibitive costs. Petitioner's management was aware that the plants it designed generally occupied an intermediate stage in its customers' overall operations. Petitioner's management was equally aware that failure of its plants could severely disrupt its customers' businesses. Petitioner's contracts contained clauses attempting to disavow any liability for consequential damages, but petitioner's management doubted the validity and efficacy of such exculpatory clauses.

During the years 1970 through 1977, petitioner incurred losses on two of its contracts. Those losses were incurred as a result of design and construction deficiencies that, due to its guarantees, petitioner had to rectify at its own expense. At no time from petitioner's inception through the taxable year 1977 did petitioner so wholly fail to meet contract specifications that it was required to return all monies previously paid. However, petitioner's profits on certain contracts were reduced by various modifications to plant processes and equipment that petitioner was required to make pursuant to its guarantees.

During the years in issue, approximately half of petitioner's contracts were for facilities located in the United States and the other half for facilities located in foreign countries. On its domestic contracts, petitioner usually obtained a down payment of approximately 10 percent of the contract price and then made progress billings as its work progressed. On its foreign contracts, petitioner obtained a down payment, sometimes as much as 20 percent of the contract price, and received the balance when it shipped the equipment, generally pursuant to short term letters of credit. On many of its foreign contracts, petitioner obtained insurance from the Foreign Credit Insurance Association, a Federal agency that helped promote exports by providing insurance policies to cover various political and economic risks of doing business in foreign countries. That insurance did not cover petitioner's liability under its process and equipment guarantees.

The manufacturing processes that petitioner incorporated into the plants it designed and sold involved the use of highly volatile chemicals. Similar plants designed by some of petitioner's competitors had experienced safety problems, including explosions causing loss of life and substantial destruction of property. Many of the plants petitioner designed and sold produced vegetable and animal oils for human consumption. Similar plants designed by some of petitioner's competitors had malfunctioned, producing adulterated oils that killed several people. None of petitioner's plants had encountered either problem up through the years before the Court. From its inception through its fiscal year 1977 petitioner had never been sued and had been threatened with only one lawsuit.

Petitioner was considerably smaller than any of its competitors. Petitioner self-financed all of its business operations from its own capital and retained earnings. Petitioner has never received a loan from any bank or commercial lending institution. Although petitioner self-insures most of its various business risks, such as legal fees, warranty and process guarantees, and products liability, it has not booked formal reserves for these or other contingencies. Despite the absence of such formal reserves, petitioner's management was at all times well aware of its potential liabilities.

Petitioner's market was highly unpredictable, subject not only to general business cycles of "booms or busts" but particularly to fluctuations in the agricultural industry. From time to time, petitioner has been unable to obtain any new contracts for as long as six months. It cost petitioner about $25,000 (mostly salary) per month just to keep its doors open. Despite concerns over its financial health, petitioner has always managed to meet its payroll and other basic expenses. However, because of the variations in the business from period to period, petitioner's management has never been able to forecast or predict these hills or valleys in its business operations. It has been very difficult for petitioner's management to determine the minimum working capital needs of the business at any given time.

In comparison to its competitors, petitioner was a tiny company and its operations were on a very small scale. Because of the nature of its business, petitioner had little equipment or other fixed assets, and its net worth was reflected primarily in its liquid assets and retained earnings. To judge petitioner's ability to perform its contemplated contracts and to meet the attendant guarantees, some of petitioner's customers sought financial data from petitioner. On occasion, petitioner has lost contracts to competitors because of its small size and its limited financial resources. Petitioner sought to increase its net worth in order to obtain larger contracts and increase its business.

During the 1970's, petitioner continued to grow slowly, reflecting Loew's conservative business philosophy. Milligan, Gavin, and Berger favored more rapid growth, including larger scale plants and heavier emphasis on foreign sales to offset slow periods in the domestic market.

During 1975 and 1976, this long-continuing management dispute escalated and became fairly open and intense, reducing petitioner's productivity. The minority group (Milligan, Gavin, and Berger) were considering leaving petitioner for other companies. Loew, the majority shareholder, considered selling his shares to outsiders but decided against it for a number of reasons. First, the minority group represented a large part of petitioner's management and engineering talent. Loew recognized that without their expertise petitioner would not be an attractive investment to an outsider; the minority stockholders had indicated that they would be unwilling to continue their employment with any new company taking over petitioner. Loew was also fearful that the minority group would leave and set up their own company in competition with petitioner. More importantly, Loew was obligated under the terms of the 1970 Stock Purchase Agreement to offer his shares only to petitioner; thus, Loew could not sell his shares to an outsider without the consent of the minority group (e.g., without a rescission of the 1970 agreement). Late in 1976, Loew chose to eliminate the management dispute by retiring, having the corporation redeem his shares pursuant to the 1970 agreement, and thus leaving management and ownership of petitioner to Milligan, Gavin, and Berger. Loew had never given any thought to retiring up until about a year before he left. He was in good physical condition at the time and had no particular desire to retire. However, he did not want to see EMI, the company he had worked so long and so hard to build up, destroyed by his continuing conflict with the minority shareholders.

In November of 1976, Loew resigned from his positions with petitioner. Pursuant to the 1970 Stock Purchase Agreement, petitioner purchased Loew's outstanding shares for $654,000. The transaction was designed to comply with section 302(b)(3). Although he was advised that an installment sale would be more beneficial to him from a tax viewpoint, Loew insisted upon and received a lump sum cash payment for his shares. He did so because he did not want to subject any portion of his payment to the minority group's future management of petitioner. With his conservative business philosophy, Loew could not accept the views of the minority group as to business expansion, and was unwilling to risk his interest in the business to their policies.

At the same time, Low and petitioner entered into a covenant not to compete under which petitioner agreed to pay Loew $180,000 in monthly installments of $3,000 for his promise not to engage in any competing business activities for five years. Although 65 years old at the time he retired from petitioner, Loew was vigorous and in good health. Since his retirement from petitioner, Loew has continued in good health and has engaged in some business activities, including some consulting work for petitioner.

After Loew's departure in 1976, Milligan became petitioner's president. Milligan, Gavin, and Berger instituted many changes in petitioner's operations. In accordance with their growth plans, they began seeking more foreign business and began seeking to design and sell larger plants. The new management group also opened up stock ownership in petitioner to more of petitioner's employees. They modernized their office equipment, including adding a Telex machine and word processing.They also embarked on a program of expanded employee benefits (for both shareholder and nonshareholder employees), including expense reimbursements, medical benefits, employee loans, and salary continuation during illness or injury. Because of the depletion of petitioner's cash and other liquid assets, which were used to buy back Loew's shares, the new management was seriously concerned about the survival of the business and had to work very hard the next couple of years to assure its survival and to implement growth plans for the future.

The balance sheet (Schedule L) included in petitioner's fiscal 1975 return reported the following items for the beginning of the taxable year (e.g., as of September 1, 1974):

ASSETS
Cash		$ 91,946.19
Trade notes and accounts receivable		723,210.09
Inventories		182,473.28
Other Current Assets:
Time deposits	$700,000.00
Accrued interest	6,423.85
Prepaid insurance	1,716.11
		$ 708,139.96
Municipal bonds		94,206.45
Buildings and other fixed
depreciable assets	21,869.98
Less accumulated depreciation	15,435.92
		6,434.06
Intangible assets (amortizable only)	2,162.28
Less accumulated amortization	1,729.85
		432.43
Other Assets:
Foreign tax credits	26,468.80
Employee travel advances	1,950.00
		28,418.80
Total Assets		$1,835,261.26
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable		$ 340,796.04
Other Current Liabilities:
Federal income tax refund (under audit)	$ 6,776.46
Profit sharing trust contributions	35,000.00
Deposits on contracts	501,899.13
Accrued salaries	119,900.00
Accrued FICA employer	204.75
Federal corporation income tax	41,665.11
Accrued costs on closed contracts	27,436.00
Deferred interest on investments	1,765.37
State income tax	4,206.67
Accrued state unemployment comp.	44.08
Accrued Federal unemployment comp.	24.49
Accrued state franchise tax	117.51
Accrued dividends payable
		739,039.57
Capital stock:
Common stock		460,000.00
Paid-in or capital surplus		9,856.90
Retained earnings--appropriated
(attached sch.)
Retained earnings--Unappropriated		285,568.75
Total liabilities and stockholders' equity		$1,835,261.26

Petitioner's quarterly balance sheets, prepared in-house and unaudited, reflected the following:

ASSETS

	7411	7502	7505	7508
Current Assets
Cash	127,354.12	182,350.64	70,804.70	84,460.50
Marketable securities	94,325.55	327,579.45	224,455.42	119,600.81
Commercial paper	200,000.00		800,000.00	800,000.00
Certificate of deposit	300,000.00	200,000.00
U.S. Treasury bills	250,000.00
Employee loan
Accounts receivable	206,162.35	239,555.90	117,809.87	608,744.27
Accounts receivable
unbilled	2,938.94	4,750.00
Accrued Interest
receivable	3,162.15	2,879.33	4,534.87	2,220.94
Prepaid Insurance	1,017.29	318.47	705.74	943.38
Prepaid rent
Inventory of work in
process	424,715.49	960,993.80	1,264,363.25	466,717.66
Notes receivable less
discount	30,285.00	30,285.00	25,237.50	25,237.50
Foreign tax credits	28,061.74	27,748.30	1,279.50
Federal and state tax
deposits
Corporate preferred
stock
	1,668,022.63	1,976,460.89	2,509,190.85	2,108,005.06
Fixed assets
Automobiles
office equipment and
furniture	22,306.04	22,306.04	21,941.07	22,300.17
Less accumulated
depreciation	15,799.07	16,187.90	16,482.89	16,857.53
	6,506.97	6,118.14	5,458.18	5,442.64
Other assets
Travel advance	3,050.00	2,650.00	1,800.00	1,750.00
Organization expense
less amortization	324.32	261.21	108.10
	3,374.32	2,911.21	1,908.10	1,750.00
	1,677,903.92	1,985,490.24	2,516,557.13	2,115,197.70

	7511	7602	7605	7608
Current Assets
Cash	99,239.46	32,200.43	22,435.20	77,708.76
Marketable securitles	69,492.37	69,495.43	69,498.49	69,501.55
Commercial papaer	1,000,000.00	1,000,000.00	900,000.00	900,000.00
Certiticate of deposit			300,000.00	300,000.00
U.S. Treasury bills
Employee loan
Accounts receivable	29,853.77	192,474.10	241,281.99	83,558.69
Accounts receivable
unbilled			29,283.33
Accrued Interest
receivable	3,323.07	5,042.91	4,912.08	1,407.72
Prepaid Insurance	497.87		1.947.82	1,306.72
Prepaid rent
Inventory of work in
process	672,483.81	525,791.69	290,545.48	42,033.05
Notes receivable less
discount	48,014.00	45,231.60	40,184.10	37,401.70
Foreign tax credits		2,599.38	2,599.38
Federal and state tax
deposits
Corporate preferred
stock
	1,922,904.35	1,872,835.54	1,902,687.87	1,512,918.19
Fixed assets
Automobiles
office equipment and
furniture	23,413.11	24,616.41	24,616.41	24,709.44
Less accumulated
depreciation	17,240.04	17,679.85	18,133.99	18,516.27
	6,173.07	6,936.56	6,482.42	6,193.17
Other assets
Travel advance	1,750.00	1,750.00	2,600.00	2,000.00
Organization expense
less amortization
	1,750.00	1,750.00	2,600.00	2,000.00
	1,930,827.42	1,881,522.10	1,911,770.29	1,521,111.36

	766	7702	7705	7708
Current Assets
Cash	199,801.54	154,609.69	223,302.83	71,383.15
Marketable	69,504.61	69,188.70	116,475.27	115,498.05
securitles
Commercial paper	200,000.00			699,505.00
Certificate		200,000.00	300,000.00	200,000.00
of deposit
U.S. Treasury		147,254.86	177,483.00
bills
Employee loan			30,000.00	22,000.00
Accounts	175,061.27	179,923.28	125.677.10	375,962.75
receivable
Accounts
receivable
unbilled	55,224.80	208,380.09	75,564.13	334,265.73
Accrued Interest
receivable	5,293.25	8,468.64	7,397.07	7,662.82
Prepaid Insurance	662.55	57.95	(604.48)	2,964.06
Prepaid rent
Inventory
of work in
process	69,662.38	177,302.06	346,366.49	127,977.83
Notes
receivable less
discount	32,354.20	30,963.00	23,133.10	21,741.90
Foreign tax credits
Federal and
state tax
deposits
Corporate preferred
stock			48,300.00	48,300.00
	807,564.60	1,176,148.27	1,473,094.51	2,027,261.29
Fixed assets
Automobiles		15,640.87	23,661.92	21,610.18
office equipment and
furniture	24,709.44	17,394.97	18,937.66	38,815.93
Less accumulated
depreciation	18,895.73	(8,078.37)	(9,541.67)	(9,389.41)
	5,813.71	24,957.47	33,057.91	51,036.70
Other assets
Travel advance	2,000.00	2,250.00	2,400.00	2,400.00
Organization expense
less amortization
	2,000.00	2,250.00	2,400.00	2,400.00
	815,378.31	1,203,355.74	1,508,552.42	2,060.697.99

LIABILITIES

EMI CORPORATION Balance Sheet

Liabilities	7411	7502	7505	7508
Current Liabilities
Account payables	76,110.26	11,753.65	15,822.62	71,513.51
Contract deposits	674,464.88	1,105,473.58	1,478,689.62	704,660.33
Federal Income tax	56,907.26	11,894.44	38,388.52	105,310.76
State Income tax	5,188.69	1,434.43	4,609.07	11,229.81
Accrued engineering	20,926.00	13,482.00	15,344.00	32,390.00
Project prepayment	51,500.00
Deferred credits	4,475.72		2,886.09	2,050.32
Accrued payroll tax	41.64	203.41	47.86	5.38
Accrued compensation
& profit sharing
contributions	22,400.00	45,000.00	115,000.00	240,184.85
Accrued dividend				46,000.00
	912,014.45	1,189,241.51	1,670,787.78	1,213,344.96
Stockholders equity
Common stock	460,000.00	460,000.00	460,000.00	460,000.00
Paid on capital	9,856.90	9,856.90	9,856.90	9,856.90
Retained earnings	285,568.75	285,568.75	285,568.75	285,568.75
Net Income	10,463.82	40,778.08	90,343.70	192,427.09
Dividends paid				(46,000.00)
Treasury stock
	765,889.47	796,203.73	845,769.35	901,852.74
	1,677,903.92	1,985,445.24	2,516,557.13	2,115,197.10

Liabilities	7511	7602	7605	7608
Current Liabilities
Account payables	18,122.40	13,000.11	32,253.60	20,256.30
Contract deposits	898,860.36	718,145.44	454,303.76	89,676.42
Federal Income tax	54,726.48	43,438.75	59,456.83	54,896.41
State Income tax	11,737.19	4,715.65	13,464.18	13,188.46
Accrued engineering	18,530.00	22,198.00	27,424.00	24,450.00
Project prepayment
Deferred credits	1,903.47	3,426.05	4,601.35	2,131.80
Accrued payroll tax	7.48	247.31	26.00	236.00
Accrued compensation
& profit sharing
contributions	16,800.00	98,000.00	225,000.00	206,954.62
Accrued dividend				55,200.00
	1,020,687.38	903,171.31	816,529.72	466,990.01
Stockholders equity
Common stock	460,000.00	460,000.00	460,000.00	460,000.00
Paid on capital	9,856.90	9,856.90	9,856.90	9,856.90
Retained earnings	431,995.84	431,995.84	431,995.84	431,995.84
Net Income	8,287.30	76,854.91	193,387.83	207,468.62
Dividends paid				(55,200.00)
Treasury stock
	910,140.04	978,707.65	1,095,240.57	1,054,121.36
	1,930,827.42	1,881,878.96	1,911,770,29	1,521,111.37

Liabilities	7611	7702	7705	7708
Current
Liabilities
Account payables	47,146.74	124,241.23	20,923.05	514,651.96
Contract deposits	250,244.51	505,457.27	880,260.96	214.153.39
Federal Income tax	34,792.88	8,812.37	(1,491.90)	206,606.45
State Income tax	14,513.33	119.61	(536.90)	18,888.74
Accrued engineering	26,690.00	26,516.00	21,122.00	36,338.00
Project
Prepayment
Deferred credits	490.97
Accrued payroll tax	30.36	1,486.88	321.20	362.51
Accrued
compensation
& profit sharing
contributions	17,316.00	84,417.13	120,231.07	334,312.59
Accrued dividend				27,771.15
	391,224.79	751,050.49	1,040,829.48	1,353,084.79
Stockholders
equity
Common stock	460,000,00	460,000.00	460,000.00	460,000.00
Paid on capital	9,856.90	9,856.90	9,856.90	10,169.58
Retained earnings	584,264.46	584,264.46	584,264.46	584,264.46
Net Income	24,032.16	44,258.31	57,295.10	337,066.34
Dividends paid				(27,771.15)
Treasury stock	(654,000.00)	(646,074.42)	(643,693.52)	(636,116.03)
	424,153.52	452,305.25	467,722.94	727,613.20
	815,378.31	1,203,355.74	1,508,552.42	2,080,697.99

Note: The imbalances for petitioner's fiscal quarters 7502 (February 28, 1975), 7602 (February 29, 1976), and 7608 (August 31, 1976), reflect mathematical errors in these statements, a stipulated joint exhibit, that we have been unable to reconcile.

Respondent contends in this proceeding that petitioner's balance sheet accounting for its uncompleted contracts did not follow generally accepted accounting principles and that only petitioner's balance sheet for its fiscal quarter 7611 (November 30, 1976), which was prepared by an independent outside CPA firm in conjunction with the determination of the book value of Loew's shares pursuant to the stock purchase agreement, was prepared in accordance with proper accounting standards. See footnote 2 below. However, respondent has never asserted that petitioner's method of accounting failed to clearly reflect income under section 446.Respondent, in determining petitioner's net liquid assets, working capital needs under the Bardahl-Mead formula, and accumulated taxable income, utilized the information from petitioner's tax returns, including the Schedule L balance sheets.

In computing petitioner's accumulated taxable income, respondent's revenue agent and appeals conferee calculated petitioner's working capital needs using the formula set forth in Bardahl Manufacturing Corp. v. Commissioner,T.C. Memo. 1965-200, as modified by W.L. Mead, Inc. v. Commissioner,T.C. Memo. 1975-215, affd. 551 F. 2d 121 (6th Cir. 1977). The revenue agent's Bardahl-Mead calculations, corrected to reflect respondent's concessions on brief and certain methematical errors, are as follows:

		1976	1977
1. Yearly revenues	$2,441,583.	$2,539,744.	$3,206,635.
2. Average accounts
receivable	678,595.	377,419.	426,465.
3. Turnover rate
(line 1 divided by line 2)	3.598	6.73	7.52
4. Days in accounts
receivable
cycle (365 divided by line 3)	101.45	54.23	48.54
5. Accounts
receivable as percent
of year (line 4 divided by 365)	27.79%	14.86%	13.30%
6. Yearly expenses	2,170,189.	2,228,923.	2,653,938.
7. Expenses needed
for accounts
receivable cycle	603,096.	331,218.	352,974.
(line 6 X line 5)
8. Average accounts payable	206,154.	45,884.	267,454.
9. Turnover rate of
average accounts
payable (line 6	10.53	48.58	9.92
divided by line 8)
10. Days in accounts
payable cycle
(365 divided by line 9)	34.66	7.51	36.79
11. Difference in
accounts receivable
and accounts	66.79	46.72	11.75
payable cycles (line 4
minus line 10)
12. Nondeferred
expenses for one
accounts receivable cycle (line
11 divided by line 4)	.658	.86	.242
13. Operating
capital needs for one
business	$ 396,837.	$ 285,510.	$ 85,420.
cycle (line 7 X line 12)

Current Assets	1975	1976	1977
Cash	$ 84,460	$ 77,708	$ 71,383
Accounts Receivable	633,981	120,960	731,970
Inventory	466,717	42,033	127,978
Other current assets	803,164	1,202,714	958,432
Other investments:
Municipal Bonds	119,681	69,502	115,498
Loans to Stockholders			22,000
	$2,108,003	$1,512,917	$2,027,261

Current Liabilities	1975	1976	1977
Accounts Payable	$ 71,513	$ 20,256	$ 514,652
Other current liabilities	1,141,831	446,734	838,433
Total Liabilities	$1,213,344	$ 466,990	$1,353,085
Total Available Working
Capital (Current Assets -
Current Liabilities)	$ 894,659	$1,045,927	$ 674,176
Working Capital Needs for
Business Cycle	396,837	285,510	85,420
Excess Available Working	$ 497,822	$ 760,417	$ 588,756
Capital

Respondent's computations came from the financiall data from the balance sheets (Schedules L) attached to petitioner's corporate Federal income tax returns for the years in issue, using an average of the opening and closing figures. Respondent's agent did not include an inventory cycle in computing petitioner's working capital needs under the Bardahl-Mead formula.²

Petitioner's management, in determining working capital needs, used the figures from its tax return balance sheets, as respondent did, but applied a rough rule of thumb, a ratio of current assets to current liabilities to determine the level of working capital needed. The current net liquid asset to current liability ratios for fiscal years 1975, 1976, and 1977 were 2.13 to 1, 3.36 to 1, and 1.52 to 1. Petitioner's management normally sought to maintain a 3.0 to 1 ratio.

Petitioner's balance sheets (both tax return balance sheets and in-house quarterly balance sheets) showed the following unappropriated retained earnings for the fiscal years 1975 through 1977:

Fiscal Year	Retained	Increase over
Ended 8-31	Earnings	Prior Year
1974	$285,568.75
1975	431,995.84	146,427.09
1976	584,264.46	152,268.62
1977	893,559.65	309,295.19

The redemption of Loew's shares on November 30, 1976 did not reduce the corporation's retained earnings on its balance sheets, but petitioner's liquid assets were reduced by the $654,000 cash payment. ³

Both respondent and petitioner determined petitioner's available net liquid assets using figures from petitioner's tax return balance sheets (Schedules L), with slight differences from rounding off and errors in addition. ⁴ The available net liquid assets (current liquid assets less current liabilities) were as follows:

Fiscal Year
1975	$894,660
1976	1,045,928
1977	674,176

The gross income and taxable income for each of petitioner's shareholders for the taxable years 1974 through 1977 were as follows:

				Marginal Rate *
Shareholder	Year	Gross Income	Taxable Income	Tax Bracket
Loew	1974	$68,208.75	$55,204.33	53%/62%
	1975	119,443.83	106,612.12	62%/70%
	1976	458,726.60	** 442,091.16	70%/70%
	1977	70,449.98	*** 58,653.35	53%/62%
Berger	1974	69,854.43	61,248.76	53%/64%
	1975	98,114.87	87,994.57	58%/68%
	1976	110,119.51	99,237.28	60%/69%
	1977	149,171.25	*** 141,890.84	64%/70%
Gavin	1974	43,870.00	35,904.00	42%/50%
	1975	66,355.00	57,331.00	53%/62%
	1976	76,297.00	66,849.77	55%/64%
	1977	132,128.00	*** 125,335.00	64%/70%
Milligan	1974	49,012.00	37,032.00	45%/50%
	1975	74,093.00	61,375.00	53%/64%
	1976	83,882.05	71,013.51	55%/66%
	1977	133,652.72	*** 125,255.31	64%/70%

In 1976 petitioner loaned Milligan, a shareholder, officer and director of petitioner, $33,000 for Milligan to finance the purchase of a pleasure boat.During the years in issue, there were no other loans by petitioner to employees, officers, shareholders or directors. However, on February 11, 1977, at a special meeting, petitioner's board authorized a program of employee loans on the following terms:

1. Any loan granted would carry an interest rate at least equal to available short term rates.

2. Any loan granted must be protected by a promissory note and must be paid in a period no longer than four years, with interest, and on a pre-arranged payback schedule.

3. Security requirements for loans granted would be established by the Board of Directors on a case-by-case basis and would depend upon all of the factors involved in the loan.

Petitioner declared and distributed to its shareholders the following dividends:

FYE	Dividend
8-31-70
8-31-71
8-31-72
8-31-73
8-31-74
8-31-75	46,000.00
8-31-76	55,200.00
8-31-77	27,771.00
8-31-78	41,050.00
8-31-79	51,312.50
8-31-80	157,687.50

The dividends during the years before the Court represented 25%, 26%, and 8.5%, respectively, of petitioner's net income after Federal taxes for each such year.

Petitioner's returns for its fiscal years in issue reported its income and expenses follows:

Item	1975	1976	1977
Gross receipts/sales	$2,441,583.24	$2,539,744.82	$3,206,635.28
Cost of goods sold	(1,564,505.32)	(1,557,852.17)	(1,716,582.89)
Gross profit	877,077.92	981,892.65	1,490,052.39
Other income (interest, etc.)	60,072.37	70,474.74	49,773.46
Total income	937,150.29	1,052,367.39	1,539,825.85
Operating expenses	(605,683.68)	(671,071.26)	(937,356.15)
Noncash deductions
(depreciation, amortization,
etc.)	(1,854.04)	(1,658.74)	(6,812.33)
Taxable Income	329,612.57	379,637.39	595,657.37
Federal income taxes	(145,707.83)	(170,552.31)	(269,043.57)
Net income after Federal
income taxes	$ 183,904.74	$ 209,085.08	$ 326,613.80

Respondent, in his statutory notice, accepted these figures.

In his statutory notice, respondent computed petitioner's accumulated earnings tax liability as follows:

Computation of Accumulated	7508	7608	7708
Taxable Income
Taxable Income (Line 4, Schedule 1)	$329,612.57	$379,637.39	$595,657.37
Add: Special deductions			1,356.18
disallowed, section 535(b)(3)
Total	329,612.57	379,637.39	597,013.55
Less: Federal income	145,707.83	165,885.64	269,043.57
tax paid per return
Foreign income tax paid per return	1,279.50	2,599.38
Taxable income as adjusted	182,625.24	211,152.37	327,969.98
Less: Dividends paid	46,000.00	55,200.00	27,771.15
deduction (section 535(a))
Current earnings and profits retained	136,625.24	155,952.37	300,198.83
Less: Accumulated earnings credit
Accumulated taxable income	$136,625.24	$155,952.37	$300,198.83
Computation of Accumulated
Earnings Tax
Accumulated taxable income	$136,625.24	$155,952.37	$300,198.83
27 1/2% on first $100,000.00	27,500.00	27,500.00	27,500.00
38 1/2% excess over $100,000.00	14,100.72	21,541.66	77,076.55
Total accumulated earnings tax	$ 41,600.72	$ 49,041.66	$104,576.55
Computation of Accumulated
Earnings Credit
Minimum accumulated	$150,000.00	$150,000.00	$150,000.00
earnings credit
Less: Accumulated	285,568.75	431,995.84	584,264.46
earnings as of close of prior year
Allowable minimum credit
under section 535(c)(2)
Current earnings andprofits
determined to be retained
for reasonable needs of
business, (section 535(c)(1)(A)
Less: Deduction for long-term
capital gains,
(section 535(b)(6)
Allowable credit under
section 535(c)(1)

ULTIMATE FINDING OF FACT

Petitioner was not availed of for the purpose of avoiding the income tax with respect to its shareholders.

OPINION

An accumulated earnings tax is imposed upon "every corporation * * * formed or availed of for the purpose of avoiding the income tax with respect to its shareholders or the shareholders of any other corporation, by permitting earnings and profits to accumulate instead of being divided or distributed." Secs. 532(a), 531. The ultimate question, upon which the corporate taxpayer has the burden of proof, is whether a purpose of its accumulation was avoiding the income tax with respect to its shareholders (the "proscribed purpose"). United States v. Donruss Co.,393 U.S. 297 (1969). This is a question of fact. Atlantic Properties, Inc. v. Commissioner,519 F. 2d 1233, 1235 (1st Cir. 1975), affg. 62 T.C. 644, 656 (1974); American Metal Products Corp. v. Commissioner,287 F. 2d 860, 863-864 (8th Cir. 1961), affg. 34 T.C. 89 (1960); Kerr-Cochran, Inc. v. Commissioner,253 F. 2d 121, 124 (8th Cir. 1958), affg. a Memorandum Opinion of this Court.

The major factor in determining the applicability of the accumulated earnings tax is the taxpayer's reasonable business needs for accumulating its earnings and profits. See United States v. Donruss Co.,supra,393 U.S. at 307; Faber Cement Block Co. v. Commissioner,50 T.C. 317, 327 (1968). A determination of reasonable business needs is critical in two respects: (1) to compute the section 535(c) credit in calculating the accumulated taxable income, and (2) the decide whether the presumption of a tax-avoidance purpose under section 533 applies. If the taxpayer can show that all of its current earnings were accumulated for the reasonable needs of its business, there is no accumulated earnings tax since the accumulated earnings credit, section 535(c), eliminates the amount against which the tax is imposed. Chaney & Hope, Inc. v. Commissioner,80 T.C. 263, 281 (1983); Magic Mart, Inc. v. Commissioner,51 T.C. 775, 799 (1969); John P. Scripps Newspapers v. Commissioner,44 T.C. 453, 474 (1965). Even if the retention of all of its current earnings is not justified, the amount of the taxpayer's reasonable business needs is nonetheless necessary to properly determine the section 535(c) credit.

Whether a taxpayer's accumulation of earnings and profits is in excess of its reasonable business needs is also a question of fact. Helvering v. National Grocery Co.,304 U.S. 282 (1938). In determining the reasonable business needs of a corporation, we are reluctant to substitute out judgment for the business judgment of corporate management who are most familiar with the complexities and make-up of their corporation and its business, and we will not substitute our judgment unless the facts and circumstances compel our doing so. Atlantic Properties, Inc. v. Commissioner,supra; Faber Cement Block Co. v. Commissioner,supra,50 T.C. at 329, and cases cited therein.

A taxpayer's reasonable business needs include its reasonably anticipated business needs. Sec. 537(a)(1). Section 1.537-1(b)(1), Income Tax Regs., provides:

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 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.

In a closely held corporation, the type of corporation normally involved in an accumulated earnings case, it is not necessary that the "specific, definite, and feasible" plans alleged in support of an accumulation be inscribed in formal minutes. Doug-Long, Inc. v. Commissioner,72 T.C. 158, 171 (1979); John P. Scripps Newspapers v. Commissioner,supra,44 T.C. at 469. And the taxpayer need not produce meticulously drawn formal blueprints for action. Faber Cement Block Co. v. Commissioner,supra,50 T.C. at 332; John P. Scripps Newspapers v. Commissioner,supra,44 T.C. at 469. It is not sufficient, however, for the corporation merely to recognize a future need and discuss possible and alternative solutions concerning the same. Atlantic Commerce and Shipping Co. v. Commissioner,500 F. 2d 937, 940 (2d Cir. 1974), affg. a Memorandum Opinion of this Court; Estate of Lucas v. Commissioner,71 T.C. 838, 853 (1979), affd. 657 F. 2d 841 (6th Cir. 1981). Definiteness of plan coupled with action taken toward the consummation thereof are essential. Dixie, Inc. v. Commissioner,277 F. 2d 526, 528 (2d Cir. 1960), affg. 31 T.C. 415 (1958), cert. den. 364 U.S. 827 (1960); Doug-Long, Inc. v. Commissioner,supra,72 T.C. at 171; Estate of Lucas v. Commissioner,supra,71 T.C. at 853. In other words, "the intention claimed must be manifested by some contemporaneous course of conduct directed toward the claimed purpose." Smoot Sand & Gravel Corp. v. Commissioner,241 F. 2d 197, 202 (4th Cir. 1957), affg. in part a Memorandum Opinion of this Court, cert. denied 354 U.S. 922 (1957). The test is a practical one, namely, whether the alleged plan appears to have been "a real consideration during the taxable year, and not simply an afterthought to justify challenged accumulations." Faber Cement Block Co. v. Commissioner,supra,50 T.C. at 332-333.

In determining whether the earnings and profits of any taxable year have been accumulated beyond the reasonable needs of the business, it is necessary to consider whether accumulated earnings and profits of prior years were sufficient to meet the taxpayer's reasonable business needs (including reasonably anticipated needs) for the current year. Atlantic Properties,Inc. v. Commissioner,supra, 62 T.C. at 656. We do not, however, merely compare the total amount needed in the business with the taxpayer's total accumulated earnings and profits. Rather, we look to the accumulated earnings and profits that are reflected in net liquid assets. Ivan Allen Co. v. United States,422 U.S. 617, 628 (1975); Smoot Sand & Gravel Corp. v. Commissioner,274 F. 2d 495, 501 (4th Cir. 1960), cert. denied 362 U.S. 976 (1960), affg. a Memorandum Opinion of this Court; Montgomery Co. v. Commissioner,54 T.C. 986, 1008 (1970). As the Supreme Court said in Ivan Allen Co. v. United States,supra,422 U.S. at 628, "The question, therefore, is not how much capital of all sorts, but how much in the way of quick or liquid assets, it is reasonable to keep on hand for the business." When accumulated surplus is retained in the form of liquid assets, it is available to meet business needs, and if sufficient to meet the current and reasonably anticipated future business needs of the corporation, there is a strong indication that any additional accumulation of profits of the current year is beyond the reasonable needs of the business. Atlantic Properties, Inc. v. Commissioner,supra, 62 T.C. at 656; Novelart Manufacturing Co. v. Commissioner,52 T.C. 794 (1969), affd. 434 F. 2d 1011 (6th Cir. 1970), cert. denied, 403 U.S. 918 (1971); John P. Scripps Newspapers v. Commissioner,supra,44 T.C. at 467-468; sec. 1.535-3(b)(1)(ii), Income Tax Regs.

The fact that a corporation has accumulated its earnings and profits beyond its reasonable business needs raises a presumption that the accumulation was for the proscribed purpose, "unless the corporation by the preponderance of the evidence shall prove to the contrary." Sec. 533(a). For the accumulated earnings tax to apply, it is enough if the proscribed purpose is one of the purposes behind the accumulation, even if it is not the "dominant, controlling, or impelling" one. United States v. Donruss Co.,supra,393 U.S. at 301. Indeed, the taxpayer must show a complete lack of the proscribed purpose. Pelton Steel Casting Co. v. Commissioner,28 T.C. 153, 174 (1957), affd. 251 F. 2d 278 (7th Cir. 1958), cert. denied 356 U.S. 958 (1958).

With the foregoing principles in mind, we turn to the facts of this case. Petitioner has the burden of proving the reasonable business needs for its accumulations and the overall burden of proving the absence of the proscribed purpose. ⁵ While the decisional law furnishes us many guidelines and virtually innumerable cases can be cited for the various legal propositions, the inquiry nonetheless remains quintessentially a factual one. Reasonable business needs cannot be determined in a vacuum or out of the context of the given business or industry. In evaluating petitioner's reasonable business needs, we must keep in mind the nature of petitioner's particular business and the business environment in which it operated.

Petitioner's business is to design and engineer complete processing plants for its customers. Petitioner's work involves engineering services, design and purchase of equipment and material for such plants, on-site engineering and inspection services during construction, and inspection and testing of the completed plants. Each such plant is essentially custom-designed. Each of petitioner's contracts has varying specifications and work to be performed. The bulk of petitioner's gross sales is bunched in just a few contracts of relatively long duration. Because of the nature of its work, petitioner has no regularly recurring cycle of work and petitioner reports its income for tax purposes on the completed contract method of accounting.

Petitioner is a small company, much smaller than any of its competitors. Because of the nature of its business petitioner has few fixed assets and its net worth is reflected in its liquid assets and retained earnings. Because petitioner is so small, customers often seek financial data about petitioner's net worth and petitioner occasionally loses prospective contracts because of its small size. Petitioner tries to increase its net worth in order to obtain larger contracts and increase its business. Petitioner self-finances all of its operations and has never borrowed any money. Petitioner also self-insures its various business risks. Since about half of its work is in foreign countries, petitioner encounters additional risks, political and economic, flowing from that fact. Petitioner's contracts guarantee that the plants it designs will provide a certain quantity and quality of product. Petitioner also guarantees the performance of the equipment it sells to its customers. Petitioner cannot obtain performance bonding to cover its work and these process and equipment performance guaranties because of prohibitive cost. The plants designed by petitioner occupy an intermediate stage in the customer's overall operations, and any failure of such plant will have a ripple effect throughout the customer's business. Petitioner tries to include exculpatory clauses in its contracts to protect itself at least from claims for consequential damages from malfunctioning or failure of plants it designs. However, petitioner's management doubts the efficacy of such exculpatory clauses and is well aware of the company's potential liabilities. Occasionally there are design and construction deficiencies that petitioner has to rectify at its own expense, and therefore petitioner occasionally suffers a loss on a contract. Also many of these plants use volatile raw materials with potential for explosions, and many of the plants process materials for human consumption, with attendant risks of product liability claims. Petitioner has not had any explosions or other product liability claims, but its competitors have. Petitioner does not set up formal reserves on its books for these various items, but its management is will aware of and has in mind these various needs for its liquid assets and retained earnings.

Respondent accords little consideration to the peculiar nature of petitioner's business, the competitive environment in which it operates, or the various factors that petitioner's management think warrant the retention of liquid assets and its accumulated earnings. Respondent seemingly looks only to what he regards as petitioner's high liquidity ⁶ and to his computation of working capital needs, which is the only business need respondent acknowledges and which respondent computes under the Bardahl-Mead formula. BardahlManufacturing Corp. v. Commissioner,T.C. Memo. 1965-200, as modified by W.L. Mead, Inc. v. Commissioner,T.C. Memo. 1975-215, affd. 551 F. 2d 121 (6th Cir. 1976). Respondent's computation includes no inventory cycle although petitioner has a substantial inventory of equipment and materials it purchases for installation in the plants it designs for its customers. First, we will discuss petitioner's working capital needs and then its other reasonable business needs.

A. Reasonable Business Needs

1. Working Capital Needs

Working capital is of course a reasonable business need. Sec. 1.537-2(b)(4), Income Tax Regs.; Doug-Long, Inc. v. Commissioner,supra,72 T.C. at 176; Magic Mart, Inc. v. Commissioner,supra,51 T.C. at 791-793. To inject a degree of objectivity into this determination, we have generally endeavored to calculate a taxpayer's working capital needs for a single, complete operating cycle. This cycle attempts to trace a taxpayer's application of cash, representing working capital, through the taxpayer's operations until it emerges again as cash. Generally, an operating cycle is the period of time needed to convert cash into raw materials, raw materials into finished goods, inventory into sales and accounts receivable, and any accounts receivable into cash. See Bardahl Manufacturing Corp. v. Commissioner,supra;Alma Piston Co. v. Commissioner,T.C. Memo. 1976-107, affd. 579 F. 2d 1000 (6th Cir. 1978).

We and other courts have employed the Bardahl operating cycle test flexibly to reflect more accurately the business realities of the particular taxpayer involved. See Cataphote Corp. of Mississippi v. United States,210 Ct. Cl. 125, 535 F. 2d 1225, 1234-1235 (1976); Magic Mart, Inc. v. Commissioner,supra,51 T.C. at 791-794; Suwannee Lumber Manufacturing Co. v. Commissioner,T.C. Memo. 1979-477 and cases cited at n. 16; Delaware Trucking Co., Inc. v. Commissioner,T.C. Memo. 1973-29. Indeed, we and other courts have approved application of the Bardahl operating cycle approach to various non-manufacturing businesses, including service businesses, although generally with certain modifications to reflect the particular taxpayer's circumstances. See Central Motor Co. v. United States,583 F. 2d 470, 482-483 (10th Cir. 1978) (finance companies); C.E. Hooper, Inc. v. United States,210 Ct. Cl. 615, 539 F. 2d 1276 (1976) (market analysis corporation); W.L. Mead, Inc. v. Commissioner,supra (motor freight company). However, the operating cycle approach is not a rule of law--" [T]heBardahl formula is an attempt to inject a degree of objectivity into a quantification of business needs; it is a tool to be used when helpful and its use is not mandated in all events." Thompson Engineering Co. v. Commissioner,80 T.C. 672, 697 (1983), revd. on another point 751 F. 2d 191 (6th Cir. 1985). See also Dielectric Materials Co. v. Commissioner,57 T.C. 587, 599 (1972).

Respondent argues that the Bardahl-Mead formula has been "sanctioned" by this Court and should be applied in this case. We disagree. Because of the computational steps in the Bardahl-Mead formula, its application here would create an illusion of exactitude and would leave a strong impression of mathematical certainty. We think, however, any such impression of mathematical precision is wholly illusory in this particular case. This is graphically demonstrated by comparing respondent's computations set out in our Findings of Fact with our own vastly different computations set out in Appendix I to this opinion. Quite apart from respondent's failure to include an inventory cycle, which we have rectified in our computation (Appendix I), the fundamental flaw here is that there simply is no recurring business cycle. To try to erect such a cycle through the computational steps of the Bardahl formula, with or without the Mead modification, is misleading.

We agree with petitioner's officers that the peaks and valleys in its business cannot be predicted with any reasonable degree of accuracy and that its "lean years" and its "fat years" simply do not lend themselves to the formulistic quantification of Bardahl-Mead. The Court believed the testimony of petitioner's officers that they themselves could never predict their working capital needs with any degree of accuracy. That being so, the Court is peculiarly loathe to substitute its judgment for the business judgment of petitioner's management on this matter. That is particularly so where the Court has little faith in its own Bardahl computation (Appendix I) save a belief that it is more accurate than respondent's computation.

For example, respondent's Bardahl-Mead computation determines working capital needs of only $85,420 for 1977. We think that is a totally unrealistic figure. The record shows that there were periods of up to six months during which petitioner could obtain no new contracts and that it cost petitioner about $25,000 a month (mainly salary) just to keep its doors open. The Court thinks that a bare minimum working capital figure for petitioner would be $150,000 (6 months X $25,000) per year. The Court also finds respondent's $85,420 figure for 1977 wholly unacceptable because that was a year when there was an increase in gross revenue and a sharp decrease in liquid assets as a result of the redemption of Loew's shares for a lump sum cash payment of $654,000. The record shows that the new controlling management group was cash-starved after the redemption, had doubts as to whether the corporation would survive, and had to work extremely hard to rebuild the liquid assets needed to operate the business. Even the Court's Bardahl computation shows some decline in working capital needs that year (which we think is clearly not the case), but certainly a less precipitous decline than that proposed by respondent.

Under the circumstances of this case, with petitioner's longterm contracts, with its income bunched in just a few contracts of relatively long duration, with its use of the completed contract method of accounting, and most importantly with the absence of any regularly recurring operating cycle, we decline to apply the Bardahl formula. We think that any attempt to apply the Bardahl formula "flexibly" or otherwise in this case would be no more accurate than applying a rough rule of thumb to determine working capital needs. We also think an attempt to use the Bardahl formula might well give an air of precision to something that would be simply a usurpation of petitioner's exercise of its own best business judgment.

We are not suggesting, however, that we must always defer to the business person's "judgment calls" in such cases. Petitioner's management used a rough rule of thumb (current liquid assets to current liability ratio of 3.0 to 1) to forecast working capital needs. That may be too rough a guideline and may perhaps too often result in a negative figure (working capital needs in excess of current net liquid assets). Still some kind of rule of thumb may well be a reasonable way for petitioner's management to try to even out the hills and valleys in their efforts to estimate reasonable working capital needs from year to year.

Because of our conclusion that petitioner also had other reasonable business needs each year, the need for working capital is not the sole determining factor, as respondent assumes it to be. Suffice it to say, the Court does not wholly accept petitioner's rule of thumb. On the other hand, the Court is satisfied that petitioner's working capital needs for each year somewhat exceeded those recomputed by the Court under the Bardahl formula (Appendix I), probably by an amount of $150,000 (the bare minimum working capital figure). We would add this $150,000 figure each year because fiscal 1975 and 1976 were slow years as far as obtaining new business, which was another source of tension between Loew and the minority group, and because in fiscal 1977 after Loew's departure there was a cash crunch just when the new controlling group was trying to expand petitioner's operations, particularly in the foreign market. Therefore, we conclude petitioner's management would not be acting unreasonably in assuming that the working capital needs projected for the next year would be liquid assets of approximately 1.0 to 1.5 times its liabilities at the end of each year, and thus a reasonable amount to retain at the end of each year. This historical approach would have some degree of accuracy as to the actual liabilities it had encountered, with some factor for contingencies or expanded needs that might occur in the future. We will next discuss the factor of contingent liabilities.

2. Contingent Liabilities

A taxpayer may reasonably accumulate earnings as a reserve against some contingent liabilities. "[A] contingency is a reasonable need for which a business may provide if the likelihood of its occurrence reasonably appears to a prudent businessman." Dahlem Foundation, Inc. v. United States,405 F. 2d 993, 1003 (6th Cir. 1969); C.E. Hooper, Inc. v. United States,supra, 569 F. 2d at 1289; Smoot Sand & Gravel Co. v. Commissioner,supra,241 F. 2d at 206. On the other hand, an accumulation is not justifiable if the contingent liability is merely a remote possibility. Chaney & Hope, Inc. v. Commissioner,supra,80 T.C. at 285-286; J. Gordon Turnbull, Inc. v. Commissioner,41 T.C. 358, 374-375 (1963), affd. 373 F. 2d 87 (5th Cir. 1967). Whether a corporation's accumulation of earnings for a contingent liability is reasonable depends upon all the facts and circumstances. William C. Atwater & Co. v. Commissioner,10 T.C. 218, 230 (1948);Estate of Kriesel v. Commissioner,T.C. Memo. 1978-50.

Petitioner argues that it was entitled to accumulate earnings to satisfy its process and equitpment performance guarantees, including possible consequential damages from the interruption of its customers' manufacturing processes, and as a reserve against potential legal liability arising from plant accidents or adulterated food products at the plants it designed and sold. Respondent argues that the liability for additional costs petitioner incurred in satisfying its warranty obligations were already accounted for in the same manner as a formal reserve by the deferred profit element in petitioner's customer deposits liability account. Respondet also argues that any potential legal liability of petitioner from these risks is entirely too remote and speculative to justify an accumulation of earnings. We do not fully agree with either party.

The record clearly indicates that petitioner incurred substantial costs in satisfying its equipment and process guarantees, reducing its overall profit on these contracts. The record, however, also indicates that petitioner deducted these expenses as incurred. To the extent that such costs were accrued but not paid at year's end, they were already reflected in liability accounts on petitioner's books. This liability has already reduced petitioner's net liquid asset figures. Moreover, these deductions have already been taken into account in petitioner's taxable income for each year in issue, the starting point for calculating the accumulated earnings tax. See sec. 535(a). Accordingly, we do not allow any additional amount as a reasonable business need justifying retention of accumulated earnings.

We reject respondent's argument that the clauses in petitioner's contracts with its clients by whith it attempted to exculpate itself from consequential damages preclude any accumulation of earnings for such a potential liability. Such exculpatory clauses are of uncertain enforceability, see UCC § 2-719 (1976); Restatement (Second) Contracts §§ 356, 208 and 356 commented (1981), a fact that petitioner's management recognized. We also reject respondent's argument that as a matter of law, "there must be some actual or threatened legal action justifying the reserve or, at least, an historical basis from which future liability appears likely or uncertain." An accumulation as a reserve against a potential liability is not precluded simply because the taxpayer itself has no history of such liability. See Wilcox Manufacturing Co., Inc. v. Commissioner,T.C. Memo. 1979-92. We must examine all the facts to ascertain whether a prudent business person in petitioner's position would reasonably anticipate and hedge against such a potential liability.

We are persuaded that these potential legal liabilities were reasonably anticipated business needs of petitioner's that justified some accumulations of earnings. Although petitioner had no history of damage claims for plant accidents, adulterated food-stuffs, or consequential damages from plant breakdowns, we think that a prudent business person would nonetheless endeavor to guard against such risks. Petitioner's competitors had suffered plant accidents and food adulteration of large magnitude, involving loss of life and large scale destruction of property. Similarly, the ripple effects from the interruption of the middle stage of a large, integrated manufacturing process are obvious. A business person cannot prudently ignore such risks simply because the business had been sufficiently competent (or lucky) in the past to avoid any such liability. Moreover, even assuming successful legal defense against such claims, the possibility of litigation expense is neither remote nor speculative.

Given the nature of petitioner's business, we do not consider such possibilities too remote. Exercising our best judgment on the facts in this case, including some cushion provided by the unrealized profit on petitioner's uncompleted contracts reflected in its customer deposits and considering the expansion of the scope and scale of petitioner's business after the buy-out of Loew, we hold that petitioner was entitled to accumulate $50,000 in fiscal 1975 and 1976, and $100,000 in fiscal 1977, as reserves against these potential liabilities.

3. Business Expansion

A corporation may reasonably accumulate earnings to fund an expansion of its business. Sec. 1.537-2(b)(1), Income Tax Regs.; Chaney & Hope, Inc. v. Commissioner,supra,80 T.C. at 290-291; Bremerton Sun Publishing Co. v. Commissioner,supra, 44 T.C. 583; Crawford County Printing & Publishing Co. v. Commissioner,17 T.C. 1404, 1414 (1952). Of course, a taxpayer's plans to expand must be "specific, definite, and feasible" to justify the accumulation of earnings for such plans. Sec. 1.537-1(b)(1), Income Tax Regs.

Because petitioner was unable to obtain performance bonds, some potential clients looked to petitioner's financial status (net worth) to satisfy themselves that petitioner would be able to perform its contractual obligations. Because of its small size in relation to its competitors, petitioner lost some potential clients. Petitioner argues that it accumulated its earnings to increase its net worth to make itself more attractive to potential clients and to enable it to bid on larger contracts. We agree, but the stockholders disagreed among themselves over how to use effectively any such increased net worth. Loew, as majority stockholder in fiscal 1975 and 1976, wanted more or less passively to increase net worth and have the clients seek petitioner out. Loew wanted to rely upon the considerable expertise and reputation of the four individual stockholders, assuming that would continue to bring in prospective clients and that increased net worth would assure petitioner of getting more of the contracts from those clients. The minority stockholders wanted to pursue new business, particularly in the foreign market, more vigorously--i.e. spend money to make money.

During petitioner's fiscal years 1975 and 1976, it is clear that petitioner had no plans to expand. Loew and his conservative business philosophy were still in the ascendant. It was Loew's slow-growth policy that caused the feud with the minority group, eventually leading to Loew's retirement and petitioner's redemption of Loew's shares. While Loew was in control of petitioner, there were no expansion plans as such. From our observance of Loew and his testimony at trial, we are satisfied that he genuinely believed his "plan" (slow steady growth through plowing the earnings back into the business) was in the best interest of the company. He simply could not accept the views of the minority stockholders as shown by the fact that he insisted on a lump-sum payment for his shares even though he knew that installment payments would result in a considerable tax saving to him. Loew simply would not risk his interest in the business to the control of the minority stockholders and their plans for more rapid expansion of the business.

During petitioner's fiscal year 1977 after Loew's departure, the new management group sought to expand petitioner's business. However, because the liquid assets of the company were reduced by the $654,000 cash payment to Loew and the payments on the covenant not to compete, the new managers were short of cash and did not draw up or implement any specific plan of action that first year. The record does show that they made a number of changes in petitioner's operations and did pursue contracts for larger scale plants and more foreign business. While respondent urges that there was no "specific, definite and feasible" plan of expansion (sec. 1.537-1(b)(1), Income Tax Regs.), we think respondent overemphasizes formalities in this instance. We think the new controlling group at least made a beginning. While we are not able or willing to place a dollar figure on expansion plans as a reasonable business need, we think it is clear from the record as a whole that that was nonetheless a real consideration in the minds of petitioner's management at least in 1977 and in the minds of the monority shareholders in all three years. As it turned out, the minority shareholders could do little until Loew's shares were redeemed by the corporation.

4. Redemption Needs

A corporation may reasonably accumulate its earnings to fund a redemption of the shares of dissident or departing minority stockholders. C.E. Hooper, Inc. v. United States,supra,539 F. 2d at 1289-1290; Mountain State Steel Foundries, Inc. v. Commissioner,284 F. 2d 737, 744-745 (4th Cir. 1960), revg. T.C. Memo. 1959-59; Dill Manufacturing Co. v. Commissioner,39 B.T.A. 1023 (1939). ⁷ Whether the redemption of a majority stockholder's shares is a reasonable business need for the accumulation of the corporation's earnings and profits is a more difficult question. Compare Pelton Steel Casting Co. v. Commissioner,251 F. 2d 278 (7th Cir. 1958), affg. 28 T.C. 153 (1957), cert. denied 356 U.S. 958 (1958) and Lamark Shipping Agency, Inc. v. Commissioner,T.C. Memo. 1981-284 with Vulcan Steam Forging Co. v. Commissioner,T.C. Memo. 1976-29. See generally, D. Herwitz, Stock Redemptions and the Accumulated Earnings Tax, 74 Harv. L. Rev. 866, 908-931 (1961).

Relying on Pelton Steel Casting Co. v. Commissioner,supra, respondent paints a picture of Loew, as majority stockholder, causing the corporation to accumulate its earnings beyond its reasonable business needs for his personal reasons, namely, in order to redeem his shares so he can bail out his earnings and profits from the business at capital gains rates. Respondent emphasizes the fact that the corporate minutes state Loew was retiring because of age--age 65 which respondent describes as "a standard time in life to retire." We think the facts of the present case are wholly different from those in Pelton SteelCasting.

Here there was a stock purchase agreement whereby all shareholders were required to sell their shares only to the corporation and at a stated percentage of book value. This 1970 Stock Purchase Agreement long antedated the redemption of Loew's shares. There is no suggestion that this Stock Purchase Agreement was designed to serve the personal interests of the stockholders rather than the business interest of the corporation. Moreover, despite respondent's arguments to the contrary, Loew at age 65 was vigorous, in good health, and had no desire to retire. He had never thought about retirement until the last year before the redemption. He retired because the tension and disputes with the minority shareholders, caused by the clash of his conservative business philosophy with their more aggressive plans for the company's future, could not be resolved. He retired because he did not want to see the company he had worked so long and so hard to build up destroyed. Under the facts of this case, we think redemption of the majority stockholder's shares served a corporate purpose and could be a reasonable business need of the company.

However, petitioner has never argued that it was accumulating its earnings in order to redeem Loew's share, and we need not resolve the question of redemption of a majority stockholder's shares as a reasonable business need. What petitioner argues is that its obligation under the 1970 Stock Purchase Agreement to purchase the shares of any stockholder leaving petitioner's employ justifies accumulations of $57,114, $86,399, and $116,853 during its respective fiscal years 1975, 1976 and 1977. Those figures apparently represent 20 percent of petitioner's total accumulated earnings for each preceding fiscal year. While we do not necessarily accept the basis for these figures, we agree with the general idea. Without regard to Loew, any of the minority shareholders, each of whom had a 13.33 percent ownership interest, could have required petitioner to purchase his shares at 90 percent of book value at any time. Since the minority shareholders were threatening to leave the company, petitioner had a reasonable business need to be able to purchase the shares of at least one minority stockholder or possibly all three minority stockholders. Since the redemption price for one minority stockholder could be as much as $145,333.33 and that for all three as much as $436,000, ⁸ petitioner's figures seem eminently reasonable, and no doubt much too low. If we used the 20 percent of accumulated earnings approach, we would apply that rate to the current year's accumulation, for figures of $86,399, $116,853, and $178,712, for fiscal years 1975, 1976, and 1977, respectively. That is because we are determining the portion of the total earnings petitioner could reasonably retain at the end of each year.

5. Summary of Reasonable Business Needs

We must summarize our conclusions as to petitioner's reasonable business needs to determine whether petitioner accumulated and retained its earnings beyond its reasonable business needs so as to give rise to the presumption of the existence of the proscribed tax-avoidance purpose. Sec. 533(a). Since we have not availed ourselves of a Bardahl-Mead computation and have determined working capital needs within a range of figures and since we have found other reasonable business needs, some quantified and some not and some of which may be subsumed in the category of working capital needs and some not, our holdings cannot be readily or neatly tabulated.

In our opinion, the bare minimum working capital needs for each year would be no less than the Court's Bardahl computation figures (Appendix I) which we think should be increased by $150,000 for each year as discussed above; the maximum would be 1.5 times petitioner's liabilities each year. Thus, the range for petitioner's working capital needs would be as follows:

		Court's Bardahl	Petitioner's Quick Asset
Fiscal	Court's Bardahl	Computation	to Liability Ratio
		(Appendix I)
Year	Computation	Plus $150,000	1.0	1.5
	(Appendix I)
1975	$627,566	$777,566	$1,213,344	$1,820,166
1976	573,472	723,472	* 466,990	700,485
1977	540,339	690,339	1,353,085	2,029,628

For contingent liabilities, we have found an amount of $50,000 for 1975 and 1976 and $100,000 for 1977. We have allowed no specific dollar amount for expansion plans although we think it was a genuine consideration in each year, even by Loew in his own conservative view of how the company should continue to develop. For redemption needs which we think were critical for the company's survival given the impasse between Loew and the minority stockholders, we think a range from $145,000 to $436,000 was a bare minimum for 1975 and 1976. Because of possible overlapping, we would use the high figure with the low working capital figure and the low figure with the high working capital figures. Since the net liquid assets for the years at issue were only $894,660, $1,045,928, and $674,176, respectively, it is clear that under any combination of our figures, petitioner's reasonable business needs exceeded its net liquid assets each year.

B. The Proscribed Purpose

We have compared petitioner's reasonable business needs to its net liquid assets above, and concluded that the net liquid assets did not exceed petitioner's reasonable business needs. We think, however, a comparison of petitioner's total accumulated earnings to its net liquid assets is also instructive in this case.

		Total Accumulated
Fiscal Year	Net Liquid Assets	Earnings
1975	$894,660	$431,995.84
1976	1,045,928	584,264.46
1977	674,176	893,559.65

The proscription of the statute is against an unreasonable accumulation of earnings (for the proscribed purpose), not against the company's having its assets in liquid form. The total accumulated earnings were 48.3%, 55.9%, and 133% of net liquid assets in each respective year. In 1977 the total accumulated earnings exceeded petitioner's net liquid assets by $219,383.65; in other words, after the redemption of Loew's shares, the company was short of cash and other liquid assets. In the two previous years when the net liquid assets were much higher, they greatly exceeded petitioner's total accumulation of earnings. This satisfies the Court that the nature of petitioner's business and its method of operation called for large amounts of liquid assets, and that petitioner's high liquidity was not necessarily related to some plan to try to avoid tax on the shareholders or to bail out the majority shareholder's earnings and profits in the corporation at capital gains rates.

Since we have found that petitioner did not retain or accumulate its earnings beyond its reasonable business needs in the years before the Court, the presumption of a tax-avoidance purpose under section 533(a) does not come into play. Moreover, with or without any such presumption, we would not find the proscribed purpose in this case. The record is simply devoid of any evidence that in the 1975 and 1976 fiscal years Loew's tax situation (let alone that of the minority shareholders) played any part in the corporation's decision to retain or accumulate earnings. The Court believed Loew's testimony that the accumulations were for entirely different reasons, namely, his conservative business philosophy of growth through increasing the company's net worth. In fiscal 1975 and 1976, petitioner paid dividends amounting to 25 and 26 percent of its net income after Federal taxes. Contrary to respondent's scenario, Loew did not cause the corporation to accumulate its earnings so that he could bail out his share of the earnings at capital gains rates. Certainly in 1977 the new controlling group never gave any thought to availing of the corporation to reduce their own income taxes; the new owners were busy trying to rebuild the depleted liquid assets and to expand the business. Even in fiscal 1977 when the new management group was struggling to expand the corporation's operations, petitioner paid dividends of 8.5 percent of its net income after taxes.

In any event, having found that petitioner did not retain or accumulate its earnings beyond its reasonable business needs, we really need not consider whether petitioner was availed of for the proscribed purpose in the years before the Court. John P. Scripps Newspapers v. Commissioner,supra,44 T.C. at 474. That is so because the accumulated earnings credit provided for in section 535(c) would be equal to the full amount of petitioner's current earnings and profits retained in those years (amounts or $146,427.09, $152,268.62, and $309,295.19 for the fiscal years 1975, 1976, and 1977, respectively). This would result in accumulated taxable income equal to zero. We, therefore, hold that petitioner is not liable for accumulated earnings tax in any of its fiscal years 1975, 1976, or 1977. See Chaney and Hope, Inc. v. Commissioner,supra,80 T.C. at 281 and cases cited therein.

To reflect the above holdings,

Decision will be entered for petitioner.

APPENDIX I

To determine petitioner's working capital needs under the Bardahl-Mead formula, we would first adjust petitioner's unaudited balance sheets to more closely reflect proper accounting principles (which will be discused below) as follows:

ASSETS

	7411	7502	7505	7508
Current Assets
Cash	127,354.12	182,350.64	70,804.70	84,460.50
Marketable securities	94,325.55	327,579.45	224,455.42	119,680.81
Commercial paper	200,000.00		800,000.00	800,000.00
Certificate of deposit	300,000.00	200,000.00
U.S. Treasury bills	250,000.00
Employee Loan
Accounts receivable	206,162.35	239,555.90	117,809.87	600,744.27
Accounts receivable
unbilled	2,938.94	4,750.00
Accrued interest
receivable	3,162.15	2,879.33	4,534.87	2,220.94
Prepaid insurance	1,017.29	318.47	705.74	943.38
Prepaid rent
Inventory of work in
process	21,235.78	48,049.69	63,218.16	23,335.88
Notes receivable less
discount	30,285.00	30,285.00	25,237.50	25,237.50
Foreign tax credits	28,061.74	27,748.30	1,279.50
Federal and state tax
deposits
Corporate preferred
stock
	1,264,542.92	1,063,516.78	1,308,045.76	1,664,623.28
Fixed assets
Automobiles
office equipment and
furniture	22,306.04	22,306.04	21,941.07	22,300.17
furniture
Less accumulated
depreciation	15,799.07	16,187.90	16,482.89	16,857.53
	6,506.97	6,118.14	5,458.18	5,442.64
Other assets
Travel advance	3,050.00	2,650.00	1,800.00	1,750.00
Organization expense
Less amortization	324.32	261.21	108.10
	3,374.32	2,911.21	1,908.10	1,750.00
	1,274,424.21	1,072,546.13	1,315,412.04	1,671,815.92

	7511	7602	7605	7608
Current Assets
Cash	99,239.46	32,200.43	22,435.20	77,708.76
Marketable securities	69,492.37	69,495.43	69,498.49	69,501.55
Commercial paper	1,000,000.00	1,000,000.00	900,000.00	900,000.00
Certificate of deposit			300,000.00	300,000.00
U.S. Treasury bills
Employee loan
Accounts receivable	29,853.77	192,474.10	241,281.99	83,550.69
Accounts receivable
unbilled			29,283.33
Accrued interest
receivable	3,323.07	5,042.91	4,912.08	1,407.72
Prepaid insurance	497.87		1,947.82	1,306.72
Prepaid rent
Inventory of work in
process	33,624.19	26,289.58	14,527.27	2,101.65
Notes receivable less
discount	48,014.00	45,231.60	40,184.10	37,401.70
Foreign tax credits		2,599.38	2,599.38
Federal and state tax
deposits
Corporate preferred
stock
	1,284,044.73	1,373,333.43	1,626,669.66	1,472,986.79
Fixed assets
Automobiles
office equipment and
furniture	23,413.11	24,616.41	24,616.41	24,709.44
Less accumulated
depreciation	17,240.04	17,679.85	18,133.99	18,516,27
	6,173.07	6,936.56	6,482.42	6,193.17
Other assets
Travel advance	1,750.00	1,750.00	2,600.00	2,000.00
Organization expense
less amortization
	1,750.00	1,750.00	2,600.00	2,000.00
	1,291,967.80	1,382,019.99	1,635,752.08	1,481,179.96

	7611	7702	7705	7708
Current Assets
Cash	199,801.54	154,609.69	223,302.83	71,383.15
Marketable
securities	69,188.70	69,188.70	116,475.27	115,498.05
Commercial paper	199,185.00			699,505.00
Certificate
of deposit		200,000.00	300,000.00	200,000.00
U.S. Treasury
bills		147,254.86	177,483.00
Employee loan			30,000.00	22,000.00
Accounts
receivable	175,061.27	179,923.28	125,677.10	375,962.75
Accounts
receivable
unbilled	55,224.80	208,380.09	75,564.13	334,265.73
Accrued interest
receivable	5,618.00	8,468.64	7,397.07	7,662.82
Prepaid insurance	662.55	57.95	(604.48)	2,964.06
Prepaid rent
Inventory of
work in
process	2,525.00	17,730.21	51,954.97	25,595.57
Notes receivable
less
discount	32,354.20	30,963.00	23,133.10	21,741:90
Foreign tax
credits
Federal and
state tax
deposits
Corporate preferred
stock			48,300.00	48,300.00
	739,621.06	1,016,576.72	1,178,682.99	1,924,879.03
Fixed assets
Automobiles		15,640.87	23,661.92	21,610.18
office
equipment and
furniture	24,709.44	17,394.97	18,937.66	38,815.93
Less accumulated
depreciation	(18,895.73)	(8,078.37)	(9,541.67)	(9,389.41)
	5,813.71	24,957.47	33,057.91	51,036.70
Other assets
Travel advance	2,000.00	2,250.00	2,400.00	2,400.00
Organization
expense
less amortization
	2,000.00	2,250.00	2,400.00	2,400.00
	747,434.77	1,043,783.89	1,214,140.90	1,978,315.73

LIABILITIES

	7411	7502	7505	7508
Current Liabilities
Account payable	76,110.26	11,753.65	15,822.62	71,513.51
Contract deposits	270,985.17	192,529.47	277,544.53	261,278.55
Federal income tax	56,907.26	11,894.44	38,388.52	105,310.76
State income tax	5,188.69	1,434.43	4,609.07	11,229.81
Other taxes
Accrued engineering	20,926.00	13,482.00	15,344.00	32,390.00
Project prepayment	51,500.00
Deferred credits	4,475.72		2,886.09	2,050.32
Accrued payroll tax	41.64	203.41	47.86	5.38
Accrued compensation
& profit sharing
contributions	22,400.00	45,000.00	115,000.00	240,184.85
Accrued dividend				46,000.00
	508,534.74	276,297.40	469,642.69	769,963.18
Stockholders equity
Common stock	460,000.00	460,000.00	460,000.00	460,000.00
Paid on capital	9,856.90	9,856.90	9,856.90	9,856.90
Retained earnings	285,568.75	285,568.75	285,568.75	285,568.75
Net income	10,463.82	40,778,08	90,343.70	192,427.09
Dividends paid				(46,000.00)
Treasury stock
	765,889.47	796,203.73	845,769.35	901,852.74
	1,274,424.21	1,072,501.13	1,315,412.04	1,671,815.92

	7511	7602	7605	7608
Current Liabilities
Account payables	18,122.40	13,000.11	32,253.60	20,256.30
Contract deposits	260,000.74	218,643.33	178,285.55	49,745.02
Federal income tax	54,726.48	43,438.75	59,456.83	54,896.41
State income tax	11,737.19	4,715.65	13,464.18	13,188.46
Other taxes
Accrued engineering	18,530.00	22,198.00	27,424.00	24,450.00
Project prepayment
Deferred credits	1,903.47	3,426.05	4,601.35	2,131.80
Accrued payroll tax	7.48	247.31	26.00	236.00
Accrued compensation
& profit sharing
contributions	16,800.00	98,000.00	225,000.00	206,954.62
Accrued dividend				55,200.00
	361,827.76	403,669.20	540,511.51	427,058.61
Stockholders equity
Common stock	460,000.00	460,000.00	460,000.00	460,000.00
Paid on capital	9,856.90	9,856.90	9,856.90	9,856.90
Retained earnings	431,995.84	431,995.84	431,995.84	431,995.84
Net income	8,827.30	76,854.91	193,387.83	207,468.62
Dividends paid				(55,200.00)
Treasury stock
	910,140.04	978,707.65	1,095,240.57	1,054,121.36
	1,291,967.80	1,382,376.85	1,635,752.08	1,481,179.97

	7611	7702	7705	7708
Current Liabilities
Account payables	47,731.00	124,241.23	20,923.05	514,651.96
Contract deposits	183,108.00	345,885.42	585,849.44	111,771.13
Federal income tax	34,792.88	8,812.37	(1,491.90)	206,606.45
State income tax	14,513.33	119.61	(536.90)	18,888.74
Other taxes	2,409.20
Accrued engineering	26,690.00	26,516.00	21,122.00	36,338.00
Project prepayment
Deferred credits	875.00
Accrued payroll tax	30.36	1,486.88	321.20	362.51
Accrued compensation
& profit sharing
contributions	17,316.00	84,417.13	120,231.07	334,312.59
Accrued dividend				27,771.15
	327,465.77	591,478.64	746,417.96	1,250,702.53
Stockholders equity
Common stock	460,000.00	460,000.00	460,000.00	460,000.00
Paid on capital	9,856.90	9,856.90	9,856.90	10,169.58
Retained earnings	584,264.46	584,264.46	584,264.46	584,264.46
Net income	19,848.00	44,258.31	57,295.10	337,066.34
Dividends paid				(27,771.15)
Treasury stock	(654,000.00)	(646,074.42)	(643,693.52)	(636,116.03)
	419,969.36	452,305.25	467,722.94	727,613.20
	747,435.13	1,043,783.89	1,214,140.90	1,978,315.73

Note: Petitioner's balance sheet for its fiscal quarter 7611 (November 30, 1976) reflects the figures in the balance sheet prepared for that quarter by petitioner's outside CPA. The slight discrepancy between total assets and liabilities for this quarter results from the fact that the in-house balance sheet included cents while the outside statement was rounded to even dollars.

The above adjustments to petitioner's unaudited balance sheets involve on the asset side decreasing the item of "Inventory of work in process" and on the liability side decreasing the item of "Contract deposits." These decreases are to reflect costs not reimbursed by the client deposits and progress payments, primarily those on foreign contracts, as explained below.

Petitioner objects strenuously to respondent's omission of an inventory cycle from his Bardahl-Mead calculation, noting that petitioner in fact purchases and resells equipment. Petitioner's books reflect as an asset item its "Inventory of work in process." This represents equipment, engineering, and other related costs on petitioner's uncompleted contracts. Respondent argues that the omission of the inventory cycle is justified because petitioner's so-called inventory costs are funded through the deposits and progress payments it receives from its clients.

We agree with respondent that petitioner's equipment and other related costs on its uncompleted contracts should not be included in an operating cycle calculation to the extent that such costs are met through client deposits and progress payments on such contracts. Petitioner may not reasonably accumulate earnings for working capital to fund costs already paid by its clients. To the extent that petitioner's "Inventory of work in process" account represent costs not reimbursed by the client deposits and progress payments, however, it represents a cost to which petitioner must devote its own working capital. Consequently, we think that to the extent petitioner's "Inventory of work in process" accounts represents its own use of its working capital, it is appropriate to include an "inventory" cycle in determining petitioner's operating cycle.

We are unpersuaded by respondent's argument that the clients' deposits on petitioner's uncompleted contracts adequately perform the function of an inventory cycle. We think respondent's argument mixes apples and oranges. The inventory cycle is part of a working cycle determination that attempts to trace a taxpayer's application and recoupment of its working capital. Petitioner's customer deposits on its uncompleted contracts represent a source of funds for its interim costs on its uncompleted contracts, generally reflected as accounts receivable, cash, or other liquid assets. Such deposits do not represent an application of petitioner's working capital and hence do not serve the function of an inventory cycle.

Unfortunately, petitioner's books and records do not indicate the extent to which its "Inventory of work in process" account represents its use of its own working capital rather than client deposits. Petitioner reported as an asset item on its quarterly balance sheets the gross amounts of its costs on its uncompleted contracts; it similarly reported as liabilities the gross amounts of customer deposits on the uncompleted contracts. This reporting position is contrary to generally accepted accounting principles. The proper method of reporting these items involves netting on a contract-by-contract basis. The asset item "Costs of uncompleted contracts in excess of related billings" (the description preferred over "Inventory of work in process") properly includes only the sum of the amounts of excess costs incurred over related billings for that group of contracts having excess costs. Likewise, the liability item "Billings on uncompleted contracts in excess of related costs" (e.g., "customer deposits"), properly includes only the sum of the excess of billings over related costs for the group of contracts having excess billings. The separate asset and liability accounts, however, are not netted. See AICPA Accounting Research Bulletin No. 45 (ARB 45). See also Construction Contractors, Audit and Accounting Guide 50-51 (AICPA 1981). Although accounting principles are not conclusive for tax purposes, Thor Power Tool Co. v. Commissioner,435 U.S. 914 (1978), we think that a taxpayer's books and records under the completed contract method of accounting prepared in accordance with ARB 45 will more accurately identify the amount of a taxpayer's excess costs over related billings on its uncompleted contracts, which we think is the proper measure of that taxpayer's "inventory" cycle in making an operating cycle analysis.

For petitioner's fiscal quarter ending November 30, 1976, its books and records were audited by an outside CPA in conjunction with petitioner's purchase of Edward Loew's shares pursuant to the 1970 Stock Purchase Agreement. The audited balance sheet, prepared in accordance with ARB 45, showed $2,525 as "Costs of uncompleted contracts in excess of related billings" instead of the $69,662 of "Inventory of work in process" shown on petitioner's unaudited statement. Likewise, the audited balance sheet reported as a liability the amount of $183,108, identified as "Billings on uncompleted contracts in excess of related costs" rather than the $250,245 of "contract deposits" reported on petitioner's unaudited balance sheets. Except for this one quarter, there is no precise way of reconstructing petitioner's unaudited balance sheets under ARB 45 to accurately show the amount of petitioner's excess costs over related billings, which we have determined to be the appropriate starting point for the so-called "inventory" cycle. Nonetheless, in light of the large amount of foreign contracts (about 50 percent) for which petitioner could not obtain progress payments, we are persuaded that petitioner did in fact incur costs on many of its uncompleted contracts in excess of its related billings. Respondent's total omission of this element from the working cycle was erroneous. Accordingly, exercising our best judgment upon the facts of record, we would recast petitioner's books and records to approximate what we think would be the proper reportings under ARB 45. See Cohan v. Commissioner,39 F. 2d 540 (2d Cir. 1930). Our revision, reported in the above statements of assets and liabilities, also reflects petitioner's expansion of its foreign business after Loew's retirement in November of 1976.

Finally, in computing petitioner's basic working capital needs under the working cycle formula, we would have used its peak inventory and accounts receivable figures rather than the average figures used by respondent's revenue agent. Most cases using peak figures have determined the period during which the aggregate of accounts receivable and inventory was the highest, rather than the separate periods during which each figure was highest. See Suwannee Lumber Manufacturing Co. v. Commissioner,T.C. Memo. 1979-477 n. 16 and cases cited therein. The underlying theory for this aggregation is that a peak accounts receivable period will usually follow a peak inventory period, representing a single application of the taxpayer's working capital in a single working cycle, and thus, the aggregation is necessary to prevent double dipping. In determining working capital needs as with the taxpayer's other reasonable business needs, we must allow accumulations that a prudent businessman would consider appropriate for his present and reasonably anticipated future business needs. Sec. 1.537-1(a), Income Tax Regs. Given the fluctuations of petitioner's market, we believe that a prudent businessman in petitioner's position would reasonably accumulate enough working capital to satisfy his peak needs. Moreover, given the long duration of the bulk of petitioner's contracts (14.29 to 21.67 months), we would use separate rather than aggregated peaks for inventory and accounts receivable; this long duration eliminates the double dipping concern.

Our determination of petitioner's working capital under the Bardahl-Mead formula for one operating cycle would be as follows:

	Fiscal Year
Item	1975	1976	1977
1. Gross sales/receipts	$2,441,583.24	$2,539,744.82	$3,206,635.28
2. Peak accounts receivable	723,210.09	633,981.77	731,970.38
3. Cost of goods sold	1,564,505.32	1,557,852.17	1,716,582.89
4. Peak "work in process"	63,218.16	33,624.19	51,954.97
5. Annual operating expenses	2,170,621.43	2,228,923.43	2,652,582.86
6. Average accounts payable *	103,199.22	31,029.18	145,443.86
7. Accounts receivable cycle
as percentage of tax year
(line 2 divided by line 1)	.2962054	.2496242	.2282674
8. "Inventory" cycle as per-
centage of tax year
(line 4 divided by line 3)	.0404078	.0215837	.0302665
9. Accounts payable cycle as
percentage of tax year
(line 6 divided by line 5)	.0475436	.0139212	.0548310
10. Working cycle as percentage
of tax year (line 7 plus line
8 minus line 9)	.2891182	.2572867	.2037029
11. Working capital needed for
one cycle (rounded)
(line 5 times line 10)	$ 627,566.00	$ 573,472.00	$ 540,339.00

APPENDIX II

We would thus determine net liquid assets as follows:

Current Assets	1975	1976	1977
Cash	$ 84,460.50	$ 77,708.76	$ 71,383.15
Marketalbe securities	119,680.81	69,501.55	163,798.05
Commercial paper	800,000.00	900,000.00	699,505.00
Certificates of deposit		300,000.00	200,000.00
Accounts receivable	608,744.27	83,558.69	710,228.48
1 "Inventory of work in process"	23,335.88	2,101.65	25,595.57
2 Other current assets	3,164.32	2,714.44	32,626.88
Total Current Assets	$1,639,385.78	1,435,585.09	$1,903,137.13
Current Liabilities
Accounts payable	$ 71,513.51	$ 20,256.30	$ 514,651.96
1 "Contract deposits"	261,278.55	49,745.02	111,771.13
3 Taxes	116,540.57	68,084.87	225,495.19
4 Other current liabilities	320,630.55	289,972.42	398,784.25
Total Current Liabilities	$ 769,963.18	$ 427,058.61	$1,250,702.53
Net Liquid Assets (Current
assets minus current	$ 869,423.00	$1,008,526.00	$ 652,435.00
liabilities) (Rounded)

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Footnotes

• 1. 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 Rule references are to the Tax Court Rules of Practice and Procedure.

• 2. As will be discussed in the Opinion below, we conclude that application of the Bardahl-Mead formula for determining petitioner's working capital needs is inappropriate under the facts of this case. Moreover, were we to apply that formula, we would reach a result entirely different from that reached by respondent. If the Bardahl-Mead formula were to be used, then petitioner's balance sheets should be revised to follow generally accepted accounting principles and to correct the errors in petitioner's accounting for its uncompleted contracts that respondent pointed out. We would use peak figures rather than an average of opening and closing figures. Also petitioner did have inventory, and an inventory cycle should have been included in respondent's Bardahl-Mead computation. Thus, were we to apply the Bardahl-Mead formula in this case, we would find that petitioner's working capital needs under that formula would be $627,566, $573,472, and $540,339 for fiscal years 1975, 1976, and 1977, respectively, rather than the $396,837, $285,510, and $85,420 determined by respondent. See Appendix I to this Opinion for such computations and discussion thereof.

• 3. Generally, a distribution in redemption of stock is treated as a distribution of earnings and profits to the extent not properly chargeable to the capital account. Sec. 312(a), (2). Of course, under section 535(c), such distributions do not reduce "accumulated taxable income." The parties have not raised, and we have not addressed, the nettlesome issue presented in GPD, Inc. v. Commissioner,60 T.C. 480 (1973) (Court reviewed), revd. and remanded 508 F. 2d 1076 (6th Cir. 1974). There has been no argument in this case that the redemption of Loew's shares reduced petitioner's earnings and profits so that there was no accumulation of earnings in fiscal 1977. Here the issue is whether accumulation of some part of the earnings to fund purchases of stock by the corporation under the 1970 Stock Purchase Agreement was a reasonable business need of the corporation in fiscal 1975 and 1976.

• 4. We will use these same figures. We are aware that if we used the balance sheets as adjusted to reflect generally accepted accounting principles (Footnote 2 and Appendix I to this Opinion), petitioner's available net liquid assets would be somewhat less, namely, $869,423, $1,008,526, and $652,435 for fiscal years 1975, 1976, and 1977, respectively. See Appendix II to this Opinion. Because of the result we reach in this case, we need not recast the balance sheets, particularly since neither party has requested us to do so.

  This $466,990 figure for working capital for 1976 would be clearly understated. That was the year during which the impasse between Loew and the minority stockholders was at its most critical point. That year there was little new business coming in and petitioner was spending practically nothing to try to obtain new business, hence the exacerbation of the problems between the factions. In this instance the 1.5 ratio is clearly the more reasonable figure and will be used.

  ^* The first rate assumes each shareholder was married and filed joint returns; the second assumes each was single.

  ** This includes Loew's net gain from petitioner's redemption of his shares.

  *** Tax table income.

• 5. Although petitioner submitted a timely statement pursuant to section 534(c), we found the grounds stated therein to be inadequate and accordingly denied petitioner's motion to shift the burden of proof to respondent pursuant to section 534(c)(2). See Rule 142(e). See generally Rutter v. Commissioner,81 T.C. 937 (1983) (on appeal 5th Cir. March 8, 1984).

• 6. While petitioner's balance sheets may show high liquidity, we cannot ignore the reasons for maintaining the assets in liquid form. In view of petitioner's business and method of operation, we do not regard the total net liquid assets as unusually large: amounts of $894,660, $1,045,928, and $674,176 for fiscal years 1975, 1976, and 1977, respectively. In any event, the total accumulated earnings and the yearly increases in same are considerably smaller for 1975 and 1976:

  Fiscal	Amount of	Increase Over
  Year	Accumulated Earnings	Prior Year
  1974	$285,568.75
  1975	431,995.84	$146,427.09
  1976	584,264.46	152,268.62
  1977	893,559.65	309,295.19

  While accumulated earnings for 1977 and the increase for that year may seem substantial, the net liquid assets had in fact been substantially reduced that year by the corporation's redemption of Loew's shares for $654,000 in cash (which will be discussed in the text below), and the new controlling management group was cash-starved. The total accumulated earnings shown on the books exceeded the net liquid assets by some $219,383 in fiscal 1977.

• 7. See also Wilcox Manufacturing Co. v. Commissioner,T.C. Memo. 1979-92; Farmers and Merchants Investment Co. v. Commissioner,T.C. Memo. 1970-161.

• 8. Since Loew received $654,000 under the terms of the 1970 Stock Purchase Agreement for his 60 percent stock interest, the minority would be entitled to $436,000 under that agreement.

• *. The cases uniformly apply an average accounts payable figure in determining the accounts payable cycle, even in those cases where peak inventory and accounts receivable figures are used. We do likewise here. Our average accounts payable for each taxable year is calculated using the quarterly figures reflected in petitioner's in-house balance sheets rather than on the basis of the opening and closing figures used by respondent's revenue agent.

• 1. These items use petitioner's labels, but the amounts are revised to reflect our adjustment to petitioner's books and records to follow generally accepted accounting principles, as discussed in Appendix I to this Opinion.

• 2. Employee Loan, accrued interest, and prepaid insurance. It appears that petitioner's asset "notes receivable less discount" was a long-term asset. The only period for which we are able to ascertain the current portion of this long-term asset was petitioner's fiscal quarter ended November 30, 1976. We are unable to ascertain the current portion of any of the periods herein; accordingly, we have excluded the full amounts of the notes.

• 3. Federal income taxes, state income taxes, and other taxes.

• 4. Accrued engineering (e.g., costs on completed contracts) deferred credits, accrued payroll taxes, accrued compensation and profit sharing contributions, and accrued dividends.