*138 Decision will be entered under Rule 50.
Excess Profits Credit. -- Upon the facts, held (1) that petitioner was an acquiring corporation under section 740 (a) (1) (D), I. R. C., read with section 740 (b), (f), and (h), and that it is entitled to an excess profits credit under section 713 and 742, based on income.
*236 Respondent determined deficiencies in the income and excess profits tax liabilities of petitioner for the fiscal year ended January 31, 1941, in the respective amounts of $ 2,603.30 and $ 21,861.38. The issue relating to petitioner's income tax liability has been resolved by stipulation at the trial. The only question remaining is whether petitioner was an "acquiring corporation" under sections 740 and 742 of the Internal Revenue Code for purposes of computing its excess profits credit on the income, rather than on the invested capital, basis. On motion of respondent, consideration of petitioner's alternative claim for section 722 relief, and hearing thereon, were postponed until the question here involved is determined.
Petitioner filed its returns with the collector at Detroit, Michigan.
FINDINGS OF FACT.
The following facts are found from the oral evidence, exhibits, and stipulation of facts. The stipulation of facts is incorporated herein by reference.
The petitioner, Faigle Tool & Die Corporation, *140 is a Michigan corporation engaged in the business of manufacturing various machine tools, dies, and jigs. It keeps its books on the accrual basis and has filed its returns on the basis of a fiscal year ending January 31.
In June 1931 the Faigle Tool & Die Co., hereinafter referred to as the old corporation, was organized. Karl Faigle was one of the incorporators and later became the sole shareholder. The old corporation was engaged in the manufacture of machine tools, dies, and jigs. It owned the machinery and equipment used in the manufacture of its products, but leased its plant and building. In March 1938 the old corporation decided to cease its manufacturing business.
On March 1, 1938, Karl Faigle, in accordance with Michigan law, filed a certificate for the purpose of conducting a business under the assumed name of the Faigle Tool & Die Co., a sole proprietorship, hereinafter referred to as the proprietorship. The old corporation, by *237 written agreement, leased to the proprietorship for a term ending December 31, 1939, all the machinery and equipment it had used in the manufacture of its machine tools, dies, and jigs. The proprietorship obligated itself to pay *141 a rent of $ 1,000 a month to the old corporation. The old corporation also transferred to the proprietorship its month-to-month lease on the plant and building. Thereafter the old corporation engaged in no manufacturing activities. The proprietorship, in the old corporation's former plant and with the leased equipment, manufactured dies, jigs, and fixtures weighing as much as six or seven tons.
On July 8, 1939, the lessor of the plant and building notified the proprietorship of the termination of its month-to-month lease and gave the proprietorship formal notice to vacate. Suitable floor space was not available elsewhere. Accordingly, on October 3, 1939, the proprietorship moved all of the machinery and equipment which it had previously been using, consisting solely of the machinery and equipment it was leasing from the old corporation, into a storage warehouse. No power lines were connected and no products were manufactured at the warehouse. However, the proprietorship retained its key personnel, consisting of an office manager, plant superintendent, tool crib man, night watchman, and repair and maintenance men who cleaned and repaired the stored equipment and machinery. These*142 men were paid their regular salary by the proprietorship until the formation of petitioner. The proprietorship continued to pay the $ 1,000 per month rent on the leased machinery to the old corporation. The proprietorship, acting through Faigle, the sole proprietor, kept up its personal contacts with its customers, which included Ternstedt, Buick, Studebaker, Pontiac, and General Spring Bumper, and informed them of its plans for resuming production.
In November 1939 the proprietorship purchased land and contracted for the construction of a plant thereon in accordance with its plans to resume manufacturing. Title to the land was taken in Faigle's name, individually. The proprietorship purchased additional machinery and equipment, consisting of boring mills, radical drill presses, and milling machines. The plant was completed in the latter part of January 1940. Although, by the terms of the leasing agreement between the old corporation and the proprietorship, the lease of the machinery and equipment terminated on December 31, 1939, the proprietorship thereafter continued to lease the machinery and equipment from the old corporation on a month-to-month basis. During the latter*143 part of January all the machinery and equipment leased from the old corporation and stored in the warehouse and the additional machinery purchased were moved to the newly completed plant. By the early part of February 1940 the business of manufacturing machine tools, dies, and jigs was resumed.
*238 During November 1939 Faigle decided to form a corporation which would take over the manufacturing business of the proprietorship and would relieve him of the responsibilities of a sole proprietor. Faigle instructed his attorney to organize the new corporation. Because of the pressure of other affairs, the attorney was delayed in having the new corporation incorporated. On February 29, 1940, the articles of incorporation were filed and the charter was issued to the new corporation, petitioner herein.
Around November 1939 Faigle's brother instituted suit against the proprietorship and the old corporation. Prior to a garnishment of the funds of the proprietorship, Faigle was able to withdraw $ 75,000 of proprietorship funds. Of this $ 75,000 he expended on behalf of the proprietorship, $ 5,591.83 for the machinery and equipment purchased, $ 4,000 for the land, and $ 33,771.82 for*144 the construction of the plant. One thousand dollars represented the cost of land which Faigle and his wife deeded to the city of Dearborn for use as a public street.
In order to release the garnishment obtained by Faigle's brother in the suit against the proprietorship and old corporation, the proprietorship deposited with the Wayne County Circuit Court a cash bond of $ 30,000. On November 19, 1940, $ 13,500 of the $ 30,000 cash bond was paid to Faigle's brother in full settlement of his claim and the remaining $ 16,500 was released by the circuit court and deposited in Faigle's personal bank account.
Contemplating the formation of petitioner, the manufacture of machine tools, dies, and jigs was resumed in the early part of February 1940. After petitioner was incorporated on February 29, 1940, the proprietorship transferred to petitioner all of the properties of the proprietorship. As of January 31, 1940, the net assets of the proprietorship amounted to $ 48,053.18. Faigle transferred to petitioner an additional $ 5,028.94 which was not listed among the assets of the proprietorship on its books. Petitioner issued to Faigle, in exchange for the properties of the proprietorship*145 and cash not listed among such properties, all of its authorized stock in the amount of 50,000 shares of $ 1 par value common stock and a demand note in the amount of $ 17,050.58.
Petitioner began to manufacture the same products which the proprietorship previously manufactured. It used all the machinery and equipment which the proprietorship had leased from the old corporation. The business contracts of the proprietorship have continued with petitioner. Ninety per cent of the old employees of the proprietorship have been reemployed by petitioner. Faigle became the president and general manager of petitioner and devoted his full time to the business. The proprietorship ceased functioning after it transferred its properties to petitioner.
*239 The proprietorship transferred to petitioner:
(a) The lease which the proprietorship had on a month-to-month basis after December 31, 1939, from the old corporation for all the machinery and equipment the proprietorship had ever used in the conduct of its business. Petitioner took over this lease at a rental of $ 200 per month and used all the machinery and equipment of the old corporation.
(b) The business contacts, good will, and*146 personnel of the proprietorship.
(c) All the machinery and equipment purchased by the proprietorship in the amount of $ 5,591.83.
(d) Accounts receivable control, sundry raw materials, and prepaid insurance in the respective amounts of $ 30, $ 90.63, and $ 96.14.
(e) Land of the proprietorship valued at $ 4,000.
(f) The plant of the proprietorship valued at $ 33,771.82.
(g) Cash of the proprietorship. Petitioner received $ 23,470.16, of which $ 5,028.94 was not represented on the books of the proprietorship.
(h) Liabilities of the proprietorship which petitioner assumed, consisting of accounts payable and accrued pay roll, taxes, and insurance in the total amount of $ 13,968.46.
The value of the total assets which petitioner acquired was $ 67,050.58, for which petitioner issued to Faigle its common stock having a par value of $ 50,000 and a demand note for $ 17,050.58. The $ 13,968.46 of liabilities assumed, however, reduced the net amount of properties transferred to $ 53,082.12.
The minutes of the board of directors of petitioner record the acquisition of these properties. At the first meeting of the board of directors, on March 9, 1940, the following motions were carried:
Moved*147 by Mr. Wild, seconded by Mr. Karl Faigle, that inasmuch as One Thousand Dollars ($ 1,000.00) had been paid into the Corporation by Karl Faigle, as set forth in the Articles of Incorporation, that 1,000 shares of the capital stock of the Corporation, $ 1.00 par value, be turned over to Karl Faigle. Unanimously carried.
Moved by Mr. Wild, seconded by Mr. Karl Faigle, that whereas the Corporation, prior to the formal filing and acceptance of its Articles of Incorporation, had borrowed funds from Karl Faigle in order to begin operations, and that it will need to borrow more money from Karl Faigle from time to time, that the Corporation be authorized to borrow Seventy Thousand Dollars ($ 70,000.00) from Karl Faigle, it being understood that capital stock will subsequently be issued to Karl Faigle for said loans up to the total authorized capital of $ 50,000.00 on the basis of $ 1.00 par value stock for each $ 1.00 loaned by said Karl Faigle to the Corporation. Unanimously carried.
At the second meeting of the board of directors, on May 28, 1940, the following motions were carried:
Moved by Mr. Wild, and seconded by Mr. Karl Faigle, that
*240 Whereas, Karl Faigle has from time *148 to time since the Corporation started functioning advanced sums totaling $ 22,470.16 to the Corporation for use by the Corporation; and
Whereas, Karl Faigle turned over and transferred to the Corporation $ 30.00 of Accounts Receivable due to him personally; and
Whereas, Karl Faigle has turned over and transferred to the Corporation $ 90.63 in raw materials; and
Whereas, Karl Faigle has turned over and transferred to the Corporation new machinery purchased by him within the past few months, costing said Karl Faigle $ 5,591.83; and
Whereas, Karl Faigle has turned over and transferred to the Corporation prepaid fire insurance on said machinery, the unexpired value at the time of said transfer being $ 96.14; and
Whereas, Karl Faigle did on November 27, 1939, purchase from B. C. Schram, Receiver for First National Bank -- Detroit, land in the City of Dearborn, Wayne County, Michigan, for $ 5,000.00, * * *
* * * *
Whereas, Karl Faigle has personally advanced $ 33,771.82 towards the cost of constructing a plant on said property, the address of said plant being 6500 Chase Road, Dearborn, Michigan; and
Whereas, Karl Faigle is willing to transfer to the Corporation the land acquired by him as*149 heretofore described, excepting the portion of said land heretofore conveyed to the City of Dearborn, as set forth above, for the sum of $ 4,000; and Karl Faigle is willing to transfer and convey to the Corporation all of his right, title and interest in the building erected on said land for the sum of $ 33,771.82, being the actual amount he has paid towards the cost of said building; and
Whereas, all of the above sums and properties advanced and turned over to the Corporation by Karl Faigle, including the land and the building which Karl Faigle is willing to transfer and convey to the Corporation, total $ 66,050.58; and
Whereas, the Corporation has 49,000 shares of unissued stock, all of which has been subscribed for by said Karl Faigle;
Now, therefore, Karl Faigle, shall turn over, transfer and convey to the Corporation all of the cash; accounts receivable; raw materials; machinery; prepaid insurance; land, excepting that portion heretofore conveyed to the City of Dearborn, and the building erected on said land, to the Corporation, and the Corporation will issue to said Karl Faigle in payment thereof 49,000 shares of its $ 1.00 par value stock and the Corporation's demand note payable*150 to Karl Faigle in the sum of $ 17,050.58 bearing six per cent interest. Unanimously carried.
The parties have stipulated that if petitioner is entitled to compute its excess profits credit on the income basis, its base period net income is as follows:
| 1936 | $ 2,342.30 |
| 1937 | 2,342.30 |
| 1/1/38-5/31/38 | 975.00 |
| 6/1/38-12/31/38 | 28,242.36 |
| 1939 | 62,714.43 |
Petitioner acquired substantially all the properties of the Faigle Tool & Die Co., a sole proprietorship, solely in exchange for the stock and demand note of petitioner.
*241 OPINION.
The issue in this case is whether petitioner is entitled, for excess profits tax purposes, to an excess profits credit based on income. Normally, a domestic corporation has the choice, under section 712 of the Internal Revenue Code, of computing its excess profits credit under either the income method or the invested capital method, whichever results in the lesser tax. But the availability of this choice presupposes that the corporation was in existence during the base period, usually the years 1936 to 1939, inclusive, and that it earned income from which the average base period net income, necessary for the computation of the income credit, *151 can be determined. Hence, if the corporation did not come into existence until after December 31, 1939, it must, with exceptions to be hereinafter noted, compute its excess profits credit under the invested capital method prescribed by section 714. Petitioner was incorporated in February 1940. Accordingly, respondent asserts that petitioner is restricted to the invested capital method of computing its excess profits credit.
However, Supplement A to the excess profits tax provisions of the Internal Revenue Code recognizes that even though a corporation may not actually have been in existence during any of the years 1936-1939, it may have acquired, in a tax-free reorganization, the properties of a corporation or another type of business organization which was in existence during those years. If so, the acquiring corporation may compute its excess profits credit under the income method, using as its average base period net income the history of earnings of the business organization it acquired. For present purposes, section 740 defines such an "acquiring corporation" entitled to base its excess profits credit on income as one which has acquired "substantially all the properties" *152 of a "sole proprietorship" in an exchange to which section 112 (b) (5) or 12 (c) was applicable. 1*153 It is not disputed *242 that the Faigle Tool & Die Co. was a sole proprietorship. Nor is it disputed that Faigle, the sole proprietor, received in exchange for the properties of the proprietorship which were transferred to petitioner stock and a demand note of petitioner within the purview of section 112 (b) (5) and 112 (c). 2 After the exchange, Faigle owned all of petitioner's authorized stock and was in complete control of petitioner. The only reason which respondent asserts for denying petitioner the use of the excess profits credit based on income and for restricting petitioner to the excess profits credit based on invested capital, is that petitioner has not shown that it acquired "substantially all the properties" of the Faigle Tool & Die Co. The only question presented for our decision, therefore, is whether petitioner has satisfactorily made this showing.
The facts in this case are somewhat unusual. The proprietorship was formed in March 1938, and for the ensuing year and a half it was actively engaged in the manufacture of machine tools, dies, and jigs. Yet, the proprietorship actually owned during that time neither the machinery and equipment which it used in the manufacture of its products, nor the building in which its plant was set up. It leased both. When its month-to-month lease on the building was terminated, it bought land and constructed its own building and plant. After petitioner was formed, the proprietorship transferred to petitioner this land, plant, and building. It also transferred to petitioner the lease on the machinery and equipment which it then was renting on a month-to-month basis from the old corporation, as well as *154 other machinery which it had purchased with proprietorship funds. Thus, petitioner has acquired all the machinery and equipment which was ever used by the proprietorship, has the same leasehold interest therein as had the proprietorship, and, in addition, has acquired the land, building, and machinery owned outright by the proprietorship. Some $ 18,000 *243 of proprietorship cash was also transferred to petitioner, as well as an additional $ 5,000 which probably had its source in proprietorship funds. The accounts receivable, inventory, and prepaid insurance of the proprietorship were likewise acquired, and almost $ 14,000 of proprietorship liabilities were assumed by petitioner. The net worth of the proprietorship prior to the transfer to petitioner was $ 48,053.18, and petitioner acquired all of this, not in the form of net assets alone, but in the form of gross assets of the proprietorship, reduced by the liabilities of the proprietorship which petitioner assumed. See Milton Smith, 34 B. T. A. 702. Petitioner is engaged in exactly the same business of manufacturing machine tools, dies, and jigs as was the proprietorship. The business contacts*155 and good will of the proprietorship have been acquired by petitioner. Ninety per cent of the old employees of the proprietorship have been reemployed by petitioner. Faigle, who was the sole proprietor, is now the president and general manager of petitioner, devoting his full time to the business. Had petitioner never been formed at the end of February 1940 there could be no doubt that the resumption of manufacturing would have been by the same proprietorship which was operating in 1938 and 1939. In essence, the incorporation of petitioner has not changed the former proprietorship business in any respect. It is one and the same business, with exactly the same assets.
Respondent contends that petitioner did not acquire substantially all of the assets of the proprietorship. It is part of petitioner's burden of proof to show that it did, and we think petitioner has met this burden of proof. Consideration has been given to respondent's contention. However, the entire record explains satisfactorily that certain liabilities must have offset what appeared to be, during the course of the trial, free assets to respondent, with the result that the assets of the proprietorship were actually*156 less than respondent argues in his brief. Respondent has seized upon one item in the record without taking into consideration other related items of evidence. For example: During the trial reference was made orally to an accounting statement which, it was said, showed that as of September 30, 1939, the proprietorship had gross assets of over $ 138,000. This was immediately prior to the date on which the proprietorship was forced to vacate its leased plant site. The gross assets of about $ 138,000 consisted chiefly of three items, cash and accounts receivable of approximately $ 105,000 and notes receivable from the old corporation of about $ 26,500. The oral reference to such gross assets, at the trial, did not extend to any description of net assets after the existing liabilities of the proprietorship. We are satisfied from the entire record that there were liabilities and that the proprietorship had to pay out certain amounts, which, of course, would reduce the liquid assets. We think respondent's argument suffers from the defect of not reconstructing *244 items of expense and liabilities from the record. It is clear that the proprietorship continued to pay $ 1,000 a*157 month rent on leased machinery; that it continued to pay the regular salaries to key personnel which it retained; and that it had some accounts payable (some of which were later assumed by petitioner). Furthermore, income tax had to be paid by Faigle on the net earnings of the proprietorship, for which some reserve had to be set up, for it appears that Faigle's chief source of income was the earnings of the proprietorship, and he had to pay income tax out of distributions from the business.
Respondent contends that petitioner has not shown that Faigle did not liquidate and pay to himself, personally, the cash, the notes receivable, and the accounts receivable of the proprietorship. On the contrary, the record amply demonstrates that any of these amounts not shown to have been actually transferred to petitioner were used up in the operations of the proprietorship in the interval between the shut-down of active manufacturing and the organization of petitioner. The $ 105,000 of accounts receivable and cash appears to correspond to the $ 75,000 cash which Faigle withdrew from the proprietorship bank account prior to the garnishment obtained by his brother in the suit against the old*158 corporation and the proprietorship, and to the $ 30,000 cash bond which the proprietorship deposited to release the garnishment. Approximately $ 67,000 of this $ 105,000 went to petitioner in the form of fixed assets and cash, and $ 13,500 was paid to Faigle's brother in settlement of his claim. Out of the remaining $ 25,000, rent on the leased machinery, salaries to the retained key personnel, and Faigle's 1939 income tax liability had to be paid. We are satisfied that Faigle, personally, did not keep any portion of the $ 25,000 in any amount of any consequence.
The third item of gross assets to which respondent's argument is directed consists of the $ 26,500 of notes receivable from the old corporation appearing on the books of the proprietorship as of September 30, 1939. Petitioner, as a matter of fact, did not acquire any notes receivable of the proprietorship. On account of this, respondent contends that a substantial asset was not transferred from the proprietorship to petitioner. There were included on the proprietorship books as of January 31, 1940, notes receivable from the old corporation, and they were listed as proprietorship assets. But it has now been explained*159 by petitioner's accountant, who testified at the trial, that the notes receivable which appeared on the proprietorship books on January 31, 1940, represented an obligation of the old corporation to Faigle, personally. They were not connected with the proprietorship business. The accountant testified that, therefore, such notes receivable were not transferred to petitioner when petitioner was organized.
The amount of notes receivable listed on the books on January 31, 1940, was smaller than the $ 26,500 of notes listed on the books as of *245 September 30, 1939, about which respondent argues. The crucial date for the purposes of the issue presented is January 31, 1940, the date closest to the time petitioner was organized. As has been pointed out above, the controversial item of $ 26,500 of notes was not an asset of the proprietorship even on September 30, 1939, and consequently it should not have been transferred to petitioner. If any doubt remains, and it could be said that these notes receivable were assets of the proprietorship, there is ample indication in the record that the proceeds were used to discharge proprietorship liabilities, or were transferred to petitioner*160 in the form of cash or other property.
We hold, therefore, that within both the spirit and the letter of section 740 of the Internal Revenue Code, petitioner acquired substantially all of the properties of the Faigle Tool & Die Co., a sole proprietorship, in an exchange to which section 112 (b) (5) or 112 (c) was applicable, and that petitioner, therefore, is entitled to compute its excess profits credit under the income method.
Decision will be entered under Rule 50.
Footnotes
1. SEC. 740. DEFINITIONS [as added by sec. 201, Second Revenue Act of 1940; amended by sec. 8, Excess Profits Tax Amendments of 1941; and further amended by sec. 228, Revenue Act of 1942].
For the purposes of this Supplement --
(a) Acquiring Corporation. -- The term "acquiring corporation" means --
(1) A corporation which has acquired --
* * * *
(D) substantially all the properties of a partnership in an exchange to which section 112 (b) (5), or so much of section 112 (c) or (e) as refers to section 112 (b) (5), or to which a corresponding provision of a prior revenue law, is or was applicable.
* * * *
(b) Component Corporation. -- The term "component corporation" means --
* * * *
(5) In the case of a transaction specified in subsection (a) (1) (D), the partnership whose properties were acquired.
* * * *
(d) In the case of a taxpayer which is an acquiring corporation the base period shall be the four calendar years 1936 to 1939, both inclusive, except that, if the taxpayer became an acquiring corporation prior to September 1, 1940, the base period shall be the same as that applicable to its first taxable year ending in 1941.
* * * *
(f) Existence of Acquiring Corporation. -- For the purposes of section 712 (a), if any component corporation of the taxpayer was in existence before January 1, 1940, the taxpayer shall be considered to have been in existence before such date.
* * * *
(h) Sole Proprietorship. -- For the purposes of sections 740 (a) (1) (D), 740 (b) (5), and 742 (g), a business owned by a sole proprietorship shall be considered a partnership.
SEC. 742. SUPPLEMENT A AVERAGE BASE PERIOD NET INCOME [as added by sec. 201, Second Revenue Act of 1940; amended by secs. 8 (d) and 15, Excess Profits Tax Amendments of 1941; and further amended by sec. 228, Revenue Act of 1942].
In the case of a taxpayer which is an acquiring corporation, its average base period net income (for the purpose of the credit computed under section 713) shall be the amount computed under section 713 or the amount of its Supplement A average base period net income, whichever is the greater. * * *↩
2. Respondent likewise does not challenge the fact that, pursuant to section 228 (f) of the Revenue Act of 1942 and section 30.742-2 of Regulations 109, petitioner is entitled to have the amendments to Supplement A made by the Revenue Act of 1942 apply retroactively to the 1941 taxable year here involved.↩