*176 Decisions will be entered under Rule 50.
1. Deduction -- Expense -- Compensation -- Salary Stabilization. -- Reasonable allowance for salaries or other compensation for personal services actually rendered determined.
2. Excess Profits Tax -- Equity Invested Capital -- Accumulated Earnings and Profits -- Taxes for a Prior Year. -- A taxpayer on an accrual basis must eliminate from its earnings and profits as of the beginning of the taxable year its income and excess profits taxes for the preceding year, in determining its equity invested capital under section 718, I. R. C.
3. Excess Profits Tax -- Abnormal Income -- Lack of Proof. -- The taxpayer has failed to prove that it is entitled to any relief under section 721, I. R. C.
*950 The Commissioner determined the following deficiencies against the petitioner for its fiscal years ended November 30:
| Declared value | ||
| Year | excess profits | Excess profits |
| tax | tax | |
| 1943 | $ 180.30 | $ 2,066.68 |
| 1944 | 32.38 | 417.87 |
| 1945 | 26,086.38 |
The issues presented for decision are (1) whether the Commissioner erred in disallowing deductions for 1945 in the total amount of $ 31,368.44 for salaries of its vice president and its general manager, and, in the alternative, whether portions of those salaries applicable to 1943 and 1944 are deductible in those years; (2) whether the Commissioner erred in computing the excess profits tax credit based on invested capital by excluding from invested capital at the beginning of the tax year the entire amount of taxes for the preceding year which would become payable during the taxable year; and (3) whether the petitioner*178 is entitled to relief under section 721 (a) (2) (C) for 1943.
FINDINGS OF FACT.
The petitioner is a corporation, organized in the latter part of 1938 under the laws of Tennessee. Its principal place of business is in Knoxville. It has been engaged at all times material hereto in the business of manufacturing and selling furniture, and also in selling a line of household furnishings. It keeps its books and files its returns on an accrual basis of accounting, using a fiscal year ending November 30. The returns for the years here involved were filed with the collector of internal revenue for the District of Tennessee.
E. R. Lutz was the president and principal stockholder of the petitioner until his death in 1945. William J. Moore became the vice president and sales manager of the petitioner at the time it was formed. He continued to serve in those capacities until the death of Lutz, at which time Moore became president and acquired five fifty-sixths of the stock of the petitioner for $ 5,000. He had not been a stockholder prior thereto.
Lutz was president and Moore was sales manager of another and larger furniture manufacturing company in Knoxville, to which *951 Moore gave*179 two-thirds of his time, receiving a salary of $ 6,000 in 1943, $ 7,200 in 1944, and $ 9,000 in 1945. He devoted one-third of his time to the affairs of the petitioner.
Moore had an oral agreement with Lutz when he came with the petitioner in 1938 that he would work without a salary or a drawing account until such time as the petitioner should start to make profits and thereafter he would receive 10 per cent of the net earnings of the petitioner before taxes. He received no compensation from the petitioner until 1943, when it began to pay him a salary of $ 400 a month.
The petitioner employed John Welmers in 1938 as plant manager and furniture designer. He had an oral agreement with Lutz to work for a salary of $ 60 a week, plus 5 per cent of the net profits before taxes. He had been earning more than $ 60 a week just prior to the time he was employed by the petitioner and he would not have accepted the offer of the petitioner on the basis of a straight salary of $ 60 a week. His salary was increased to $ 70 a week in 1943 and to $ 80 a week for 1945. He owned no stock of the petitioner and gave his full time to his employment with the petitioner.
The contracts between the petitioner*180 and Moore and Welmers were never reduced to writing.
The question of the payment of the 10 per cent to Moore and the 5 per cent to Welmers arose in 1943, for which year the petitioner had profits. Lutz realized at that time the obligation of the petitioner to pay the percentages to those two men. He consulted a certified public accountant and a lawyer on the subject. The lawyer inquired of the Salary Stabilization Board having jurisdiction over that region as to whether the percentages could be paid to these two men, and was told that, since the agreement to pay them was not in writing, the Treasury Department would raise a question about it. Lutz, not wanting to become involved in any controversy with the Treasury Department, decided not to accrue the percentages for 1943. He made a similar decision for 1944.
The board of directors of the petitioner, at a meeting on November 30, 1945, considered the question of paying the precentages to Moore and Welmers for the years 1943, 1944, and 1945. The record does not show whether or not Lutz was then alive. The board at the aforesaid meeting adopted the following resolution:
Be It Resolved, that this corporation pay to William J. *181 Moore as additional compensation for his services as Vice President and Sales Manager, 10% of the net earnings of the Company, before income taxes, for the fiscal years ending November 30th, 1943, 1944 and 1945.
Be It Further Resolved, that the amount due said William J. Moore, under said computation for the fiscal year ending November 30th, 1945 be paid in cash and that the amounts due said William J. Moore for the fiscal years ending November 30, 1943 and 1944 be evidenced by the promissory note of the Company, *952 payable to said William J. Moore, and due on or before November 30th, 1955, without interest, and to this end the officers be, and are hereby authorized to make said cash payment and to execute and deliver to Mr. Moore the promissory note of the Company accordingly.
The board at the same meeting adopted a similar resolution as to Welmers, the only differences being in the name and the amounts.
The petitioner, on or shortly after December 31, 1945, paid Moore $ 7,246.14 and Welmers $ 3,623.07, in cash, those amounts representing the percentage of the profits for 1945 due the two men, in accordance with the resolutions of November 30, 1945. The petitioner at or about*182 the same time delivered its noninterest bearing notes in the amount of $ 13,666.15 to Moore and $ 6,833.08 to Welmers. Each note was dated November 30, 1945, and was made payable on or before November 30, 1955, with interest at 6 per cent after that date until paid. These notes covered the percentages of profits due to Moore and Welmers for the fiscal years 1943 and 1944. The petitioner gave the notes, instead of paying cash, because it did not want to take the additional cash out of its business at that time and Moore did not want to receive cash for 1943 and 1944 until he was sure that the compensation applicable to those years would not have to be returned because of some violation of the salary stabilization law. Welmers also had doubt as to the validity of those payments at that time.
The petitioner deducted on its returns for 1945 the entire amount of the cash and notes given to Moore and Welmers on or about December 31, 1945, amounting to $ 31,368.44. The Commissioner, in determining the deficiency for 1945, disallowed the entire deduction.
A reasonable allowance for compensation for 1945 for personal services rendered to the petitioner by Moore and Welmers is $ 31,368.44.
*183 The petitioner, from the first, endeavored to find a line of furniture to manufacture which would be acceptable to the trade and profitable to the petitioner. It first manufactured a high grade line of living room furniture, but abandoned that line after a year or more because it did not sell well.
Manufacture of a lower priced line of nonperiod furniture was started in about 1940. The petitioner was active up to the close of 1942 in training its sales force to sell that type of furniture and in finding customers who were interested in buying it. It increased its sales force during the years 1941 and 1942 from 5 or 6 to 8 or 10. Moore believed that the petitioner had this line of cheaper furniture balanced, properly styled and priced, and had a sales force and a list of customers at the close of 1942 sufficient to enable it to handle that line successfully. The line consisted of living room, bedroom, and dinette suites and odd tables and beds. It manufactured and sold that line during 1943.
The petitioner showed its furniture, at all times material hereto, in *953 the American Furniture Market shows in Chicago. It made from 20 to 25 per cent of its sales at those shows. *184 Most of its customers had their places of business within a radius of 300 or 400 miles of Knoxville.
The petitioner, in addition to manufacturing, has from its beginning carried for sale a line of household furnishings, including bed springs, mattresses, kitchen cabinets, floor coverings, and other items. These appealed particularly to the small dealer customers, who would come to the petitioner's place of business with a truck, which could then be loaded with the manufactured products and the house furnishing items at one place, thus avoiding shopping for the furnishing items at other places.
The following table shows the petitioner's gross sales from manufacturing, gross sales from jobbing, total gross sales, and net income or loss as reported on its returns:
| Gross sales | Gross sales | |
| Fiscal year ended Nov. 30 -- | from manufacturing | from jobbing |
| 1939 | $ 101,353.40 | $ 40,815.85 |
| 1940 | 169,114.75 | 47,225.47 |
| 1941 | 290,314.72 | 38,204.47 |
| 1942 | 325,838.15 | 25,555.20 |
| 1943 | 741,445.50 | 183,025.99 |
| 1944 | ||
| 1945 |
| Net income | ||
| Fiscal year ended Nov. 30 -- | Total sales | or (loss) |
| 1939 | $ 142,169.25 | ($ 17,314.92) |
| 1940 | 216,340.22 | (8,034.86) |
| 1941 | 328,519.19 | 12,687.18 |
| 1942 | 351,393.35 | (4,277.79) |
| 1943 | 924,471.49 | 72,197.51 |
| 1944 | 906,570.10 | 60,186.15 |
| 1945 | 676,275.92 | 41,092.99 |
*185 The petitioner and most other furniture manufacturers in the southern states belonged to the Southern Furniture Manufacturers' Association. The following figures pertaining to the petitioner's type of business were compiled by that association:
| Percentage | |||
| Average | Average | of profits to | |
| Year | sales | profits | sales |
| 1939 | $ 726,798 | $ 38,013 | 5.2 |
| 1940 | 866,845 | 56,576 | 6.5 |
| 1941 | 1,129,223 | 106,311 | 9.4 |
| 1942 | 1,347,951 | 118,674 | 8.8 |
| 1943 | 1,296,649 | 80,088 | 6.2 |
The demand for furniture manufactured by the petitioner during the taxable years was far in excess of the petitioner's capacity for production, and the same was true of other furniture manufacturers. Some of the other furniture manufacturers were engaged in war work during that period, but the petitioner was not.
OPINION.
The parties have not called the attention of the Court to any provision of the Stabilization Act of 1942 or to any *954 orders or regulations of the President issued pursuant thereto which might have any effect upon this case. The respondent does not argue that the petitioner, under its oral agreement with Moore and Welmers, had a right to accrue the percentages during 1943 and 1944, *186 and he does not argue that there was any prohibition under the Stabilization Act against the accrual of those obligations for 1943 and 1944 in 1945. He "agrees that the proper year of accrual for any bonuses on petitioner's net profits was the fiscal year 1945." He argues that the salaries of $ 4,800 for Moore and $ 4,160 for Welmers for the fiscal year 1945 constituted reasonable compensation for their services and, therefore, no additional amount should be allowed as a deduction under section 23 (a) (1). He also argues that the notes given were worthless, and, in the alternative, that they should be discounted to find their present worth. The question here is not the value of the notes to Moore and Welmers, since accrual of an obligation by the obligor in terms of money does not depend upon worth of the evidence thereof to the obligee. The agreements between the petitioner and Moore and Welmers were the result of free bargaining before the services were rendered and were not influenced by any consideration on the part of the petitioner other than that of securing the services of these men on fair and desirable terms. See Regulations 111, sec. 29.23 (a)-6 (2). The entire amount*187 of $ 31,368.44 was deductible under sec. 23 (a) (1) from 1945 income as a reasonable allowance for compensation for personal services rendered to the petitioner by Moore and Welmers. Lucas v. Ox Fibre Brush Co., 281 U.S. 115">281 U.S. 115.
The Commissioner, in computing the petitioner's equity invested capital for each taxable year, eliminated from its accumulated earnings and profits as of the beginning of the taxable year, its income and excess profits taxes for the preceding year. The petitioner argues that those taxes were not due, payable, or paid at the beginning of the taxable year, they were not accruable at the beginning of the taxable year by a corporation keeping its books and filing its returns upon an accrual basis of accounting, and, therefore, they should not be eliminated from accumulated earnings and profits as of the beginning of the taxable year. It cites Fawcus Machine Co. v. United States, 282 U.S. 375">282 U.S. 375. The Commissioner did not err.
Section 718 provides, inter alia, that the equity invested capital of a corporation shall include "The accumulated earnings and profits as of the beginning of such taxable*188 year." Section 35.718-2 (a) of Regulations 112 provides, in part, that "In computing accumulated earnings and profits as of the beginning of the taxable year, a taxpayer keeping its books and making its income tax returns on the accrual basis shall subtract the income and excess profits taxes for the preceding taxable year." United States v. Anderson, 269 U.S. 422">269 U.S. 422, is *955 authority for accruing a tax even in advance of assessment where all of the events have occurred which fix the amount and determine the liability of the taxpayer to pay, and Lisk Manufacturing Co., Ltd., 11 B. T. A. 179, 184, is authority for the proposition that "Earned surplus is not properly computed until provision for all liabilities has been made." Cf. Altschul's Inc., 9 T. C. 697, and Gifford-Hill & Co., 11 T. C. 802, holding that there should be included in accumulated earnings and profits as of the beginning of the year the amount of the postwar excess profits refund credit provided by section 780 in respect to excess profits tax for the preceding year.
Fawcus Machine Co. v. United States, supra,*189 cited by the petitioner, also supports the Commissioner's determination. The taxpayer there was on an accrual basis and did not eliminate from its invested capital for 1919 any amount representing income and excess profits taxes for 1918. The Commissioner had a regulation providing that "Amounts payable on account of such taxes for the preceding year may be included in the computation of invested capital only until such taxes become due and payable." He reduced invested capital for 1919 by the amount of income and excess profits taxes for 1918 as of the dates in 1919 when the installments became due. The Supreme Court affirmed a judgment of the Court of Claims in favor of the United States and held that the regulation was valid. The Court said: "A corporation cannot claim to have accumulated any net income in any year until provision is made for taxes accrued, based on net income for the same year." The Court went on to indicate that the accounts for 1918 should have been readjusted by including accruals at the end of the year for the taxes based on income of that year in order to reflect clearly its income for 1918. Thus, the opinion not only supported the regulation then in*190 effect requiring a prorated elimination of the 1918 taxes from 1919 invested capital, but would also support the present regulations requiring the elimination from invested capital as of the beginning of the taxable year of the entire tax liability in respect of the preceding year. Decision on this point is for the respondent.
The third and final issue urged for decision by the Court is whether section 721 (a) (2) (C) applies, with the result that the petitioner has some net abnormal income for 1943 attributable to prior years within the provisions of section 721. The petitioner summarizes its contention as follows:
As the result of the development of a line of furniture, petitioner in 1943 realized abnormal income which it is entitled to allocate to the years of development under the provisions of sec. 721 of the Internal Revenue Code.
A separate class of income is described in section 721 (a) (2) (C) as:
Income resulting from exploration, discovery, prospecting, research, or development of tangible property, patents, formulae, or processes, or any combination of the foregoing, extending over a period of more than 12 months.
*956 The petitioner would divide its income into*191 two classes, jobbing and manufacturing. It argues that its 1943 manufacturing income resulted from development of tangible property or processes, or a combination of the two, extending over a period of more than 12 months preceding 1943, during which period it "developed" tangible property, to wit, a line of cheap, nonperiod furniture, properly balanced, styled, and priced, plus a sales force capable of selling and a list of customers interested in buying such a line of furniture, which development enabled the petitioner to sell its manufactured products profitably during 1943. It regards the actual application of section 721 as merely a matter of mathematics. The Commissioner argues that the activities of the petitioner prior to 1943, in trying various products before it found one which it could manufacture profitably, can not be regarded as "development of tangible property" within the meaning of section 721 (a) (2) (C) and that the petitioner has failed to prove facts necessary in applying section 721.
It is essential to the petitioner's contention that the manufacturing income be recognized as a separate class of income. That would be an extremely broad classification. This*192 Court held, in Producers Crop Improvement Association, 7 T.C. 562">7 T. C. 562, 566, that "a 'class' is not to consist of income tax net income, net income, net loss, or any combination thereof." The petitioner would merely eliminate its income from jobbing and regard its entire remaining income as a class within the meaning of section 721. There is also the question of whether any such class could be regarded as due to one or more of the activities mentioned in (C). The evidence on this point does not disclose in any detail what was done to "develop" the line.
The petitioner has failed to prove, even within reasonable limits, the amount of its income from manufacturing for 1943 and for the four prior years. The amount of gross sales of products manufactured and gross sales from jobbing, together with some of the costs and expenses separately incurred in each of the two activities, are in evidence, but only the totals of other expenses and deductions are in evidence, and the petitioner seeks to allocate them between manufacturing and jobbing in proportion to gross sales. It can not be assumed, in the absence of proof, that such an allocation would even approximate*193 the fact. Indeed, the inference is strong that a number of these items were incurred primarily or exclusively in the manufacturing part of the business. The actual figures are in evidence for direct labor and they show that the direct labor actually charged to manufacturing far exceeds that charged to jobbing per dollar of gross sales from each source, yet the petitioner would allocate "factory burden," including coal, electricity, and depreciation on machinery and equipment, on the basis of sales. The evidence is deficient *957 in not showing what the actual costs and expenses attributable to each department would be or in showing some better method of allocation than that of sales.
The petitioner further contends that its entire manufacturing income for 1943 resulted from the development of the line of cheap nonperiod furniture and the means of selling it which took place during the two preceding years. The record fails to support this contention. The demand for furniture of this type, as well as the demand for furniture of certain other types during 1943, far exceeded the supply and also far exceeded the demand in the four preceding years. A large part of the petitioner's*194 income from manufacturing during 1943 may have resulted primarily from this increased demand. The petitioner argues in the alternative that, if any portion of the manufacturing income is to be attributed to increased demand, then not more than 12 per cent should be so attributed. The evidence to support this contention is not at all convincing. The tremendous increase in sales, particularly those from jobbing, which obviously were not due to "development" of the cheap line of manufacturing furniture, tends to show that 12 per cent is wholly inadequate. It was held in Ramsey Accessories Manufacturing Corporation, 10 T. C. 482, that consideration must be given in cases like this to the question of how much of the earnings for the taxable year may be attributed properly to factors other than those mentioned in (C). The petitioner ignores those possibilities in its evidence, and the Court has no way of weighing them. This question of income attributable to development is closely related to the question of allocating net abnormal income of the tax year to other years. Cf. Regulations 112, section 35.721-7, where an example is given of how income might*195 be attributed to development while at the same time eliminating that part which is attributable to other factors in case the taxpayer is using the developed process, or whatever it is, in its own manufacturing activities.
The next question, if the petitioner had gotten over all of the other hurdles, would be to find some basis for allocating the net abnormal income for 1943 to other years. The part of net abnormal income which is due to improved business conditions resulting in an increased demand for the product in the taxable year should not be allocated to a prior year. Soabar Co., 7 T. C. 89, 97. Development expenditures made in prior years have been recognized as a proper basis upon which to attribute to other years whatever part of the net abnormal income is not attributable to the tax year. W. B. Knight Machinery Co., 6 T. C. 519, 534, et seq; Rochester Button Co., 7 T. C. 529, 553, et seq. But the normal cost of sales in prior years is not *958 necessarily the same as cost of development, and neither cost of sales nor sales in prior years would appear to be a proper basis*196 in this case for the allocation of any part of the net abnormal income of 1943 to prior years. The cost of any development which took place in those preceding years has not been shown and no other reasonable method of allocation has been suggested.
The petitioner has failed all along the line to show that it comes within section 721 and what benefit it should derive from that section if it did come within it.
Decisions will be entered under Rule 50.