*211 Decision will be entered for the respondent.
Excess profits tax relief under section 722 (b) (4), Internal Revenue Code of 1939, denied where the change in the character of petitioner's business is not shown to have been potentially productive of base period earnings sufficient to give petitioner excess profits tax credits greater than those allowed by respondent under sections 713 (f) and 714.
*24 This proceeding involves a claim for relief under section 722 for the years 1940 to 1945, inclusive, in the following amounts:
| Year | Amount |
| 1940 | $ 2,597.08 |
| 1941 | 17,253.39 |
| 1942 | 78,485.72 |
| 1943 | $ 77,680.85 |
| 1944 | 44,593.96 |
| 1945 | 25,328.92 |
Petitioner contends that its average base period net income is an inadequate*212 standard of normal earnings because there was a change in the character of its business in its first base period year, within the meaning of section 722 (b) (4) of the Internal Revenue Code of 1939.
FINDINGS OF FACT.
Petitioner is a corporation organized under the laws of the State of New York on July 31, 1926. Its principal place of business is at 401 Broadway, New York, New York.
Petitioner's business consists of the manufacture and sale of canvas goods, including bags, duffel bags, tarpaulins, gymnasium mats, drop cloths, tents, and hospital supplies. It also maintains a jobbing department through which it buys and sells canvas goods and other related products.
Prior to 1936, petitioner's business was divided into three departments designated "Jobbing," "Factory No. 1," and "Factory No. 2." Factory No. 1 was located at Victor, New York. It produced mostly flat goods, such as tents, bags, etc. It had about 10 employees. Factory No. 2 was located at 359 Broadway. It produced specialized goods made to specifications submitted by its customers. It was the larger operation with about 15 employees.
About July 1936, petitioner began the manufacture of a line of hospital supplies, *213 including strait-jackets, restraint sheets, hydrotherapy blankets, and similar products. This was set up as a separate department designated "Factory No. 3." The manufacturing was done at petitioner's Broadway factory and occupied about 1,500 square feet of floor space. There, products were sold to hospitals, hospital supply and surgical dealers, penal institutions, and others. Many of them were made to exact specifications and had to be designed, as well as manufactured, by petitioner.
In setting up the hospital supply department, petitioner employed, as its manager, Clarence Gosman, who had been engaged in that business for many years, and about six other employees. Gosman designed the products to be manufactured, trained the new employees, and exercised general supervision over the department. His compensation was a fixed salary plus a percentage of the net profits of *25 the department. Other employees, mostly sewing machine operators, were added as the business required. The average number of employees, up to the end of 1939, was about 14. New employees required a training period of several months.
The following table shows gross sales of petitioner's different products*214 and its total sales for the base period years, 1936 to 1939, inclusive:
| Year | Hospital | Jobbing | Other | Total sales |
| supplies | goods | products | ||
| 1936 | $ 4,943.32 | $ 101,670.78 | $ 121,027.50 | $ 227,641.60 |
| 1937 | 13,750.47 | 136,720.92 | 130,187.15 | 280,658.54 |
| 1938 | 14,301.23 | 100,677.49 | 94,307.03 | 209,285.75 |
| 1939 | 19,699.95 | 114,961.63 | 126,271.79 | 260,933.37 |
Petitioner's net sales and net income before officers' salaries, officers' salaries, net income as reported in its returns, and net income as adjusted in the revenue agent's reports, for the years 1926 to 1939, inclusive, were as follows:
| Net | |||||
| Net sales | income | Net | Net | ||
| Year | less returns | before | Officers' | income | income |
| and | officers' | salaries | per tax | per | |
| allowances | salaries | returns | R. A. R.'s | ||
| 1926 | $ 57,646.70 | $ 5,450.82 | $ 4,760.00 | $ 690.82 | $ 690.82 |
| 1927 | 127,097.07 | 19,013.85 | 15,320.00 | 3,693.85 | 3,693.85 |
| 1928 | 148,878.59 | 14,138.60 | 15,320.00 | (1,181.40) | (1,181.40) |
| 1929 | 191,825.99 | 18,745.49 | 14,120.00 | 4,625.49 | 4,625.49 |
| 1930 | 162,718.51 | 16,995.03 | 16,920.00 | 75.03 | 75.03 |
| 1931 | 133,853.06 | 18,394.38 | 19,520.00 | (1,125.62) | (1,125.62) |
| 1932 | 94,475.29 | 11,178.55 | 11,208.50 | (29.95) | (29.95) |
| 1933 | 95,958.51 | 16,475.75 | 14,957.00 | 1,518.75 | 1,518.75 |
| 1934 | 163,185.19 | 20,822.35 | 19,691.00 | 1,131.35 | 1,131.35 |
| 1935 | 160,649.63 | 12,498.40 | 12,920.00 | (421.60) | (421.60) |
| 1936 | 227,693.63 | 23,234.74 | 21,720.00 | 1,514.74 | 4,424.21 |
| 1937 | 278,895.51 | 20,037.09 | 20,120.00 | (82.91) | 310.49 |
| 1938 | 209.938.92 | 24,960.41 | 24,000.00 | 960.41 | 4,184.51 |
| 1939 | 262,815.47 | 31,948.89 | 22,800.00 | 9,148.89 | 9,148.89 |
*215 In the years 1940 to 1945, inclusive, petitioner's adjusted excess profits net income was as follows:
| Excess profits | |
| Year | net income |
| 1940 | $ 22,652.16 |
| 1941 | 59,009.03 |
| 1942 | 114,395.88 |
| 1943 | $ 103,464.52 |
| 1944 | 76,253.35 |
| 1945 | 55,648.12 |
Petitioner had no salesmen for its hospital supplies. Gosman, through his contacts with the trade, was responsible for some of the sales, and petitioner advertised in a trade journal and distributed printed catalogs and price lists.
According to petitioner's books and records, there was a net loss in its hospital supply department of $ 2,544.70 for the last 6 months of 1936, and net profits for the years 1937, 1938, and 1939, respectively, of $ 142.43, $ 2,838.26, and $ 783.78. In these computations, there was *26 no allocation to the hospital supply department of officers' salaries and certain other indirect expenses. Petitioner's president, William W. Stanley, devoted about half of his time to the hospital supply department, during the base period years, and other officers lesser amounts of their time.
Petitioner's capacity for production of hospital supplies was sufficient, during the base period years, to fill all of its orders.
*216 In 1938 petitioner began to receive orders for hospital supplies from the United States Medical Corps Base in Brooklyn, New York. The sales of hospital supplies through civilian outlets and the sales on Government orders during 1938, 1939, 1940, and 1941, were as follows:
| Total sales of | Sales of hospital | |
| Year | hospital | supplies to U. S. |
| supplies | Government | |
| 1938 | $ 14,301.23 | $ 7,338.00 |
| 1939 | 19,699.95 | 14,273.84 |
| 1940 | 42,976.70 | 38,248.18 |
| 1941 | 136,206.34 | 126,260.55 |
Petitioner's margin of profit on the Government sales was much less than on civilian sales.
An important feature of petitioner's business was the manufacture of so-called "technical products." These consisted principally of filter cloths used by various commercial concerns, such as oil refineries, mining and steel concerns, and chemical manufacturers. The filter cloths were not woven by petitioner but were fabricated by it according to the purchaser's specifications. The work on these technical products was all done at petitioner's Broadway No. 2 plant.
Some of the filters manufactured by petitioner were made of cotton fabric and some of the new synthetic fabrics. Some were coarsely woven, some*217 finely, and some were chemically treated for heat or mildew resistance and for tolerance of certain chemicals with which they were to come into contact. Petitioner's officers made a special study of these products and from time to time sought the aid of professional chemists and other technical men.
There were no strict rules of classifying products as technical products or otherwise. This was left largely to the discretion of petitioner's president and other officers in charge, and depended somewhat on whether the products were for commercial use, that is, in established industry, or for private use. Some of the products had been manufactured by petitioner prior to 1936 and some were developed during the base period years. Petitioner had produced commercial filters of various sorts for many years. There was a trend, during the base period years, to new fabrics and new methods, and, also, a trend to more technical products, as distinguished from *27 standard products. This trend was brought about by the development and technical progress of the industries in which the products were used.
No separate department was ever set up by petitioner for its technical products. The*218 sales of these items were recorded with other sales from petitioner's Factory No. 2 and are reflected in the sales of "other products" in our findings.
The following excess profits credits were used by petitioner on its returns or were allowed by respondent for the years 1940 to 1945, inclusive:
| Average base | ||
| Year | period net | Credit |
| income | ||
| 1940 | $ 7,646.15 | $ 7,263.84 |
| 1941 | 8,816.38 | 8,375.56 |
| 1942 | 10,050.51 | |
| 1943 | 12,152.46 | |
| 1944 | 14,096.68 | |
| 1945 | 16,023.66 |
Note. -- The credits shown for 1942 to 1945, inclusive, were based on invested capital.
The stipulated facts with exhibits attached, insofar as they are not set out above, are incorporated herein by this reference.
OPINION.
Petitioner seeks to recover the excess profits taxes paid for the years 1940-1945, inclusive, in the aggregate amount of $ 245,939.92. It contends that there was a change in the character of its business during the base period, within the meaning of section 722 (b) (4), and that by reason of such change the average base period net income does not reflect the normal operations of the entire base period. The change is said to have resulted when, in addition to its regular business of manufacturing*219 standard canvas products, petitioner began the manufacture and sale of hospital supplies and of so-called technical products for industrial use.
We have found on the evidence before us that the manufacture and sale of the hospital supplies was begun by the petitioner in 1936 and that petitioner set up a separate department for that branch of its business. We have not made such a finding with respect to the so-called technical products. The evidence is that these, or similar products, had been manufactured by the petitioner for a number of years prior to the base period but that the demand for them increased during and after the base period years. Improvements were made in materials and designs to keep abreast of newly developed materials and techniques during the base period but there were no dominant changes in the methods of manufacturing or in the commodities produced.
*28 There was no separation in petitioner's records of the production costs or sales of the technical products. The records of all products other than hospital supplies were lumped together and carried under the heading "other products." For the purpose of this trial, a schedule was prepared of the sales*220 of technical products from invoices and other records which showed the sales amounting to $ 31,707 in 1936; $ 37,339 in 1937; $ 43,152 in 1938; and $ 46,868 in 1939, out of total sales of "other products" amounting to $ 121,027.50 in 1936; $ 130,187.15 in 1937; $ 94,307.03 in 1938; and $ 126,271.79 in 1939. In this schedule an article was classified as technical or nontechnical on purely arbitrary bases, depending upon its use and the opinion of those who prepared the schedule.
On the evidence of record, we cannot find that there was any change in the character of petitioner's business with respect to the technical products nor are we able to determine how much of petitioner's earnings may have been attributable to the manufacture and sale of them. See Avey Drilling Machine Co., 16 T. C. 1281; A B C Brewing Corporation, 20 T. C. 515; West Flagler Amusement Co., 21 T. C. 486.
We will assume that the establishment of the hospital supplies department was a change in the character of petitioner's business which would qualify it for relief under section 722 (b) (4), with respect to that segment*221 of its business, if the other requirements of the statute were met. Our crucial questions are whether, with application of the push-back rule, the evidence affords a proper basis for a reconstruction of base period earnings attributable to the hospital supplies department which would result in greater excess profits credits than those allowed by the respondent and, if so, the amount of such constructive average base period earnings.
The gross sales of hospital supplies were approximately $ 5,000 for the last 6 months of 1936; $ 13,700 for 1937; $ 14,300 for 1938; and $ 19,700 for 1939. After an initial net loss on those sales of $ 2,544.70 in 1936, there were net profits for 1937, 1938, and 1939 of $ 142.43, $ 2,838.26, and $ 783.78, respectively, without any allocation to that department of officers' salaries and certain other indirect expenses. Officers' salaries amount to over $ 20,000 for each of those years. With correct accounting, the net profits on the hospital business would have been further reduced. While there was a somewhat constant growth of sales during the 4 base period years, the profits declined substantially in 1939, the fourth year of operations. At the same*222 time, petitioner's over-all net profits for 1939 were more than twice those of 1938. It is apparent from the record of petitioner's actual experience that the time element was not the sole determining factor in the sales or profits of hospital supplies and that a proper adjustment for initial development under the push-back rule would result in but little advantage to the petitioner.
*29 Even if we assume, in application of the push-back rule, that with 2 years of additional experience in manufacturing hospital supplies there would have been a continuing pattern in the growth of sales throughout the base period somewhat similar to that actually experienced, and that petitioner might have reached a 1939 gross sales figure of $ 30,000 (and in our opinion the record would warrant no greater figure) against actual gross sales of $ 19,700, we would still be at a loss in reconstructing net profits on these sales. The hospital supplies profits declined from $ 2,838.26 in 1938 to $ 783.78 in 1939, while the sales increased from approximately $ 14,300 in 1938 to $ 19,700 in 1939. Over $ 14,000 of the 1939 sales were to the United States Government, and the evidence is that petitioner's*223 margin of profit was smaller on Government sales. This might account for the percentagewise decrease in profits on hospital supplies sales in 1939. The percentage of Government sales to total sales of hospital supplies continued to increase after 1939. There is no evidence on which we can determine to what extent, if any, the actual ratio of 1939 profits to gross sales would have improved with a larger volume of sales.
In its proposed reconstruction, petitioner estimates a 1939 volume of sales of hospital supplies of $ 65,000 to $ 66,000, exclusive of all sales to the United States Government. This estimate rests on the opinion of petitioner's principal officer, William W. Stanley, and is not otherwise supported by the evidence. We are not persuaded that the volume of sales would have reached such rosy heights. See 7- Up Fort Worth Co., 8 T. C. 52; Industrial Supplies, Inc., 18 T. C. 1067, 1075.
The other evidence before us contains no factual basis for a reconstruction based on increased profits in the hospital supplies department. The excess profits credits computed under section 713 (f), the so-called growth formula, *224 for 1940 and 1941, amounted to $ 7,263.84 and $ 8,375.56, respectively, against petitioner's actual average base period net income, as computed under the law applicable to those years, of $ 3,958.35 for 1940 and $ 4,517.02 for 1941. Much larger excess profits credits were allowed for the years 1942, 1943, 1944, and 1945 under the invested capital method.
Where the excess profits credits based on a constructive average base period net income are less than those allowed by the Commissioner no relief is available under section 722. Green Spring Dairy, Inc., 18 T. C. 217; Sartor Jewelry Co., 22 T. C. 773.
It is alleged in the petition that "During the base period, the Petitioner changed the character of the business, within the intendment of Section 722 (b) (4) and (b) ( 5) of the Internal Revenue Code." Petitioner's brief contains no argument relating to, or specific reference to, section 722 (b) (5). Presumably, that issue is no longer pressed. In any event, as there is no evidence before us of any factors *30 affecting petitioner's base period earnings other than those advanced in support of petitioner's claims under*225 subsection (b) (4), the application of subsection (b) (5) will not be considered. The Wadley Co., 17 T. C. 269; Granite Construction Co., 19 T. C. 163; Mitchell & Co., 20 T. C. 110.
Reviewed by the Special Division.
Decision will be entered for the respondent.