*770 GROSS INCOME - PERSONAL HOLDING COMPANY - DAIRY FARM. - Gross income, for the purpose of section 351(b)(1)(a) of the Revenue Act of 1936, as amended by section 1 of the Revenue Act of 1937, in the case ofa dairy farm, is determined by deducting the cost of production from gross sales of dairy products. The cost of feed for the cows and the wages of employees who take care of and milk the cows and prepare the dairy products for market are included in the cost of production.
*1124 The Commissioner accepted the income tax return as filed by the petitioner for 1937 and made no change whatsoever in the items reported *1125 on that return. He determined, however, that the petitioner was a personal holding company and was liable for a deficiency of $1,273.69 in personal holding company surtax and a penalty of 25 percent, or $318.42, for failing to file a personal holding company return. The only issue for decision is whether the petitioner was a personal holding company.
FINDINGS OF FACT.
The petitioner is*771 a corporation which filed its income tax return for the calendar year 1937 with the collector of internal revenue for the first district of New York. Its books were kept and the return was filed upon an accrual method of accounting.
The petitioner had income from interest, dividends, and rent for 1937 in the amount of $67,212.08, of which $1,325.08 was from rents.
The petitioner was the owner of about 150 acres of land at Syosset, New York. A part of the property was occupied by a residence and appurtenances thereof. About 75 acres were under cultivation and about 40 acres were in pasture. The petitioner operated a dairy on the property. It owned about 68 head of cattle during 1937, the larger part of which were milk cows and the remainder heifers or heifer calves. It also owned two bulls, two pigs, and three farm horses.
The petitioner delivered and sold milk in a number of nearby villages. The gross receipts from the farm in 1937 were as follows:
| Sale of milk | $23,903.01 |
| Sale of butter | 51.50 |
| Sale of live stock | 200.50 |
| Sale of pork products | 54.98 |
| Sale of honey | 8.10 |
| Sale of manure and straw | 217.00 |
| Sale of wood | $28.00 |
| Sale of trees | 100.00 |
| Breeding service | 100.00 |
| Total | 24,663.09 |
*772 The petitioner purchased milk and cream for resale in the amount of $1,790.13 during 1937.
Expenditures for 1937 in connection with the farm and dairy operations were as follows:
| Salaries and wages | $14,377.77 |
| Repairs | 1,579.45 |
| Taxes | 7,435.36 |
| General expense | 7,828.75 |
| Feed | 5,860.92 |
| Fertilizers and sprays | 1,188.21 |
| Fuel, oil, and gas | $1,869.86 |
| Insurance | 1,109.21 |
| Blacksmith | 330.45 |
| Seeds and plants | 266.65 |
| Total | 41,846.63 |
The petitioner sustained depreciation for the year in the amount of $2,631.39.
The labor expenses included $3,154.50 for farming and harvesting; $7,138.13 for dairy operation; $830.61 for general carting and trucking; and $1,110 for supervision of farming. The item dairy operation labor included an annual salary of $1,680 for the manager of the *1126 dairy, about $100 paid to the manager's wife for clerical work, and the wages of the following men employed at about $100 a month: four milkers and barn hands, one man in charge of pasteurizing, one delivery man for the entire year, and another delivery man for a part of the year.
The item general expense included $1,980, the salary of the secretary of the petitioner who*773 worked in the office; electricity, $630.13; telephone, $130.85; milk supplies and equipment, $517.97; and hardware, paints, enamels, brushes, rags, and hoses, $368.20.
The item supplies $829.06 represents supplies such as bottle caps, etc., for the dairy room and farm.
Part of the expense of spraying was for the cattle.
A farm manager and about 10 men were employed to run the farm as distinguished from the dairy. Three or four additional men were employed during the harvest season.
The stocks and bonds held by the petitioner were carried on its books during 1937 at $564,372. The buildings, machinery and equipment, fences, plus depreciation, were carried at about $60,000, and the land at $126,313.70. The livestock was carried at $7,408.50 at the beginning of the year and $8,220 at the end of the year.
The Commissioner determined that the petitioner was a personal holding company for 1937. The petitioner did not file a personal holding company return for 1937. The evidence does not show how the stock of the petitioner was held or that more than 50 percent in value was not owned directly or indirectly by as few as five individuals during the last half of the taxable*774 year.
At least 80 percent of the gross income of the petitioner for the taxable year was interest, dividends, and rents. The rents constituted less than 50 percent of the gross income.
OPINION.
MURDOCK: The Commissioner has determined that the petitioner is a personal holding company. The petitioner, apparently conceding that it meets the definition in other respects, claims that it is not a personal holding company because more than 20 percent of its gross income was other than personal holding company income. Sec. 351(b)(1)(A), Revenue Act of 1936, as amended by sec. 1, Revenue Act of 1937. Its personal holding company income amounted to $67,212.08 and the question is thus narrowed to whether the petitioner had more than one-fourth of that amount, or $16,803.03, of gross income from other sources. It had gross receipts from its farm and dairy of $24,663.09, from which it subtracted $2,056.78 as cost of operation and reported $22,606.31 as "gross profit where inventories are not an income-determining factor." The $2,056.78 subtracted as cost of operation apparently consisted of $1,790.13, the cost of milk *1127 and cream purchased for resale, and $266.65 paid*775 for seeds and plants. The petitioner now concedes that about $1,200 paid for pasteurizing should also be subtracted to determine gross income from the dairy business. The Commissioner contends that additional amounts must be subtracted from the gross receipts mentioned above in order to arrive at gross income from the dairy. The operation of the farm was collateral to the operation of the dairy and the gross income from the farm is so small that it need not be separately considered.
The Commissioner starts with the amount of $23,954.51 as gross receipts from the sale of milk, cream, and butter. He first subtracts the amount subtracted by the petitioner on the return, $2,056.78, and he also subtracts $5,860.92 paid for feed and $5,973.13, the amount paid for dairy labor after excluding the amount paid for clerical help and delivery men. He thus determines that the gross income from the farm was $10,063.68, an amount less than 20 percent of the petitioner's gross income for the taxable year.
The petitioner contends that those items should not be subtracted, except that part of the wages paid for pasteurizing. One of its arguments is that the amounts which the Commissioner*776 would thus subtract in determining gross income from the dairy are deductible under section 23(a) as ordinary and necessary expenses. The same might be said for the wages paid for pasteurizing and the cost of milk, seeds, and plants purchased. Congress, as a matter of grace, has allowed some specific deductions under section 23. If it has allowed a deduction for some item which is in fact a part of the cost of production, the allowance of the deduction would not change the character of the item and the amount should, nevertheless, be subtracted from gross receipts in determining gross income from the business operation. The petitioner cites no authority to the contrary.
The petitioner also contends that the method of computing gross income from the dairy business used by the Commissioner violates the provisions of article 22(a)(7) of Regulations 94. That article defines a farm as including a dairy farm and it defines a farmer as including a corporation which owns and operates a farm for gain. The petitioner qualifies as a farmer under the definition. The article is entitled "Gross Income of Farmers." The first paragraph provides what shall be included in the gross income*777 of "a farmer reporting on the basis of receipts and disbursements (in which no inventory to determine profits is used)." The second paragraph provides what shall be included in gross income " in the case of a farmer reporting on the accrual basis (in which an inventory is used to determine profits)." It might be argued that these two paragraphs were intended to be all-inclusive and to exclude the use of any other method in reporting income from a farm. But it should be noted in this *1128 connection that the petitioner did not report its income in accordance with either paragraph. It used an accrual method of accounting, but it did not compute its gross income in accordance with the second paragraph of the article, which involves the use of an opening and closing inventory. The petitioner did not use inventories in computing its gross income from the dairy business or the farm. The Commissioner made no change in the income as reported by the petitioner and, thus, he did not make the computation in accordance with the second paragraph of this article. Perhaps the regulation does not exclude other methods of reporting farm income.
Neither in the first paragraph nor in*778 the second paragraph of article 22(a)(7) is there any indication that costs of production are to be subtracted from gross receipts in arriving at gross income of farmers. A similar provision has been in effect for many years for income tax purposes. The petitioner argues that the regulation has the force and effect of law. It also contends that gross income for personal holding company surtax purposes is the same as gross income for income tax purposes. Net income under section 21 for income tax purposes is the same amount regardless of whether certain costs are deducted as ordinary and necessary expenses or are subtracted from gross receipts in computing gross income. But the difference is vital for personal holding company surtax purposes.
Article 22(a)(5), entitled "Gross Income From Business," provides that the cost of goods sold must be subtracted from total sales in arriving at gross income from a manufacturing, merchandising, or mining business. The Commissioner contends that similar subtractions must be made here. But the petitioner replies that since article 22(a)(5) does not include a dairy business, gross income from that business must be computed in some other*779 way, particularly the way prescribed in the second paragraph of article 22(a)(7).
The personal holding company surtax appeared for the first time in the Revenue Act of 1934. Obviously, the provisions of article 22(a)(7), which originated many years previously, were not written by anyone who had in mind the personal holding company surtax provisions or the problems which would arise under that new tax. Therefore, in arriving at the correct answer to the present controversy, the provisions of article 22(a)(7) should not be followed blindly. It would seem just as reasonable to subtract the cost of production and the cost of goods sold in the dairy business to arrive at gross income as it would to make similar subtractions in any other business.
Products of this dairy business were sold. They consisted of milk, cream, and butter. The process was not entirely analogous to that of a manufacturing plant where raw materials are purchased and then changed by human hands or by machines into a salable *1129 finished product. The petitioner argues that its cows produced milk and cream without aid. Writers on the subject recognize that there are certain direct costs of producing*780 milk. These include the cost of feed, the cost of labor, and various other expenses such as bedding, depreciation on buildings, equipment, and the cows themselves, bull service, and other items. See Milk Production Cost Accounts, by Carl W. Larson, Columbia University Press 1916; Calculating the Cost of Milk Production, by E. G. Misner, published at Cornell University, February 1919 as lesson 142, Farm Management Series; Accounting, Theory and Practice, by Roy B. Kester, vol. 3, ch. 7; Ranch Cost Accounting, by Clem W. Collins. Expenditures included in the cost of production of the milk certainly include the cost of feed for the cows and the wages of the men who took care of the animals and milked them. The milk then had to be separated from the cream and had to be pasteurized. The butter had to be churned. The wages of the men who pur the product through these processes are properly a part of the cost of production. It is unnecessary to consider other items. The amount left after subtracting these costs from the gross receipts is less than $16,000. Therefore, more than 80 percent of the gross income of the petitioner for the year is personal holding company income as defined*781 in section 351(b)(1)(a).
The Commissioner did not err in taxing this petitioner as a personal holding company. No independent contention is made in regard to the penalty and in this case it follows the tax, since no return was filed.
Decision will be entered for the respondent.