*148 Decision will be entered for the respondent.
Petitioner has paid a bonus to its employees for 30 years and has accounted for it by taking a deduction in the year of payment. Held, such treatment does not clearly reflect income, since the bonus was a labor cost, a portion of which should have been included in ending inventory as are other labor and labor-related costs.
*927 The Commissioner determined deficiencies in petitioner's Federal income tax in the amounts of $ 381,811 and $ 75,702.24 for taxable years 1964 and 1965, respectively. The only issue for decision is whether the value of petitioner's inventories, for income tax purposes, should include an allocable share of incentive compensation payments made to employees or whether petitioner's practice of deducting the entire payment in the year it was made and excluding it from inventory was in accordance with generally accepted accounting principles and clearly reflected income.
FINDINGS OF FACT
Some of the facts have been stipulated. The stipulation and exhibits attached thereto are incorporated herein by this reference.
Petitioner is an Ohio corporation with its principal office in Cleveland, Ohio. Petitioner filed its Federal income tax returns for the taxable years 1964 and 1965 with the district director of internal revenue at Cleveland, Ohio.
Petitioner was organized on June 19, 1906, and has since then continuously engaged in the business of manufacturing and selling electric motors and has, *150 since 1917, also been engaged in the manufacture and sale of electric arc-welding machines and electrodes. The arc-welding portion of petitioner's business accounts for approximately 90 percent of gross receipts. At all times, including 1964 and 1965, petitioner has followed the accrual method of accounting. Petitioner has little competition in the Cleveland area, although on a nationwide basis, the arc-welding field is quite competitive.
Petitioner pays its employees semimonthly on one of three bases: Piecework rate, hourly rate, or on a monthly salary scale. Production workers are primarily paid on a piecework basis. Under this pay system, the amount of an employee's earnings is in direct relation to the amount of skill and effort applied to the job. Petitioner's employees are expected to guarantee their work and are not paid for rejected work.
In addition to the piecework rates, hourly rates, and monthly salary scales, petitioner has had a system of incentive compensation (bonus) for its employees for more than 30 years. For the years 1934-65, petitioner's average number of employees, net sales, gross profit before bonus and taxes, and aggregate amounts paid as regular salaries*151 and wages, as bonus and as total compensation were as follows: *928
| SCHEDULE OF NET SALES, WAGES, AND BONUS | |||
| 1934 to 1965 | |||
| (000's omitted) | |||
| Average | Gross profit | ||
| Year | number of | Net sales | before bonus |
| employees | and taxes | ||
| 1934 | 404 | $ 4,065 | $ 1,768 |
| 1935 | 485 | 5,262 | 2,130 |
| 1936 | 535 | 8,291 | 2,816 |
| 1937 | 666 | 10,709 | 3,658 |
| 1938 | 650 | 6,791 | 1,817 |
| 1939 | 637 | 9,258 | 2,956 |
| 1940 | 740 | 13,570 | 4,182 |
| 1941 | 979 | 24,024 | 7,687 |
| 1942 | 1,222 | 33,515 | 11,969 |
| 1943 | 1,245 | 32,988 | 10,615 |
| 1944 | 1,115 | 28,190 | 8,031 |
| 1945 | 1,110 | 24,306 | 6,763 |
| 1946 | 1,167 | 23,717 | 6,904 |
| 1947 | 1,157 | 31,297 | 9,291 |
| 1948 | 1,099 | 31,162 | 8,730 |
| 1949 | 1,026 | 25,662 | 6,433 |
| 1950 | 1,005 | 31,895 | 8,599 |
| 1951 | 1,016 | 35,798 | 10,346 |
| 1952 | 1,170 | 43,062 | 11,329 |
| 1953 | 1,243 | 43,119 | 10,634 |
| 1954 | 1,153 | 39,538 | 9,774 |
| 1955 | 1,181 | 50,851 | 13,050 |
| 1956 | 1,320 | 63,256 | 17,801 |
| 1597 | 1,395 | 64,861 | 16,304 |
| 1958 | 1,365 | 52,101 | 12,479 |
| 1959 | 1,344 | 62,029 | 16,277 |
| 1960 | 1,333 | 57,410 | 15,360 |
| 1961 | 1,317 | 56,701 | 13,601 |
| 1962 | 1,307 | 61,346 | 15,328 |
| 1963 | 1,354 | 66,362 | 17,458 |
| 1964 | 1,475 | 79,498 | 22,308 |
| 1965 | 1,641 | 89,289 | 23,628 |
| SCHEDULE OF NET SALES, WAGES, AND BONUS | |||
| 1934 to 1965 | |||
| (000's omitted) | |||
| Regular | Total compensation | ||
| Year | payroll | Cash bonus | |
| 1934 | $ 752 | $ 132 | $ 884 |
| 1935 | 930 | 226 | 1,156 |
| 1936 | 1,138 | 436 | 1,574 |
| 1937 | 1,512 | 673 | 2,185 |
| 1938 | 1,144 | 212 | 1,356 |
| 1939 | 1,403 | 496 | 1,899 |
| 1940 | 1,817 | 981 | 2,798 |
| 1941 | 2,721 | 2,071 | 4,792 |
| 1942 | 3,787 | 2,962 | 6,749 |
| 1943 | 3,822 | 3,186 | 7,008 |
| 1944 | 3,525 | 2,969 | 6,494 |
| 1945 | 3,407 | 3,057 | 6,464 |
| 1946 | 3,242 | 2,891 | 6,133 |
| 1947 | 3,816 | 3,768 | 7,584 |
| 1948 | 4,101 | 3,825 | 7,926 |
| 1949 | 3,357 | 3,007 | 6,364 |
| 1950 | 3,717 | 3,679 | 7,396 |
| 1951 | 4,442 | 4,120 | 8,562 |
| 1952 | 5,310 | 5,134 | 10,444 |
| 1953 | 5,120 | 5,105 | 10,225 |
| 1954 | 4,823 | 4,461 | 9,284 |
| 1955 | 5,701 | 5,407 | 11,108 |
| 1956 | 7,040 | 7,424 | 14,464 |
| 1597 | 7,577 | 6,602 | 14,179 |
| 1958 | 6,830 | 5,147 | 11,977 |
| 1959 | 7,578 | 6,490 | 14,068 |
| 1960 | 7,685 | 6,485 | 14,170 |
| 1961 | 7,704 | 6,387 | 14,091 |
| 1962 | 8,280 | 7,375 | 15,655 |
| 1963 | 9,137 | 8,471 | 17,608 |
| 1964 | 10,587 | 12,496 | 23,083 |
| 1965 | 11,652 | 14,089 | 25,741 |
*152 The bonus represents a "sharing of the results of efficiencies created in production" during the preceding 12 months. The total amount of the bonus is determined by the board of directors in the fall of each year and is paid to the employees in December of each year. Any particular employee's share in the bonus depends on his wages during the 12 months prior to October 31 and on petitioner's merit-rating system. There is no formula for determining the amount of the bonus. The amount is determined by the board of directors. There has never been an express contract, agreement, or guarantee of the payment in any year of a bonus. Nevertheless, the bonus has been paid continuously since 1934.
To be eligible for the bonus, an employee must be on the payroll prior to November 1 of a particular year and remain on the payroll until the bonus is paid. Workers with 1 year or more of service who leave petitioner's employ between August 1 and the payment date are eligible to receive the bonus if their separation is approved. Women who have been with petitioner 1 year or longer and are leaving because of pregnancy will receive a bonus for the time worked during the bonus period. Workers*153 hired after October 31 are eligible for the bonus the following year. Workers who are discharged are not given a bonus. In the case of death, an employee's estate is entitled to the bonus earned prior to death. Employees called for military duty under Selective *929 Service receive a bonus for the time they have worked. Only petitioner's regular employees are entitled to receive a bonus.
The merit-rating system of petitioner is a large factor in determining an employee's bonus. Twice a year, April 30 and October 31, the employee is rated as to his general performance and contribution to the company. There are four basic rating factors:
A. Supervision Required (Dependability):1. Knowledge of job and helpfulness by imparting it to the others.
2. The ability to supervise himself.
3. Initiative and all around skill.
4. Orderliness and care of equipment.
B. Workmanship and Attitude Toward Quality:1. Quality of work produced.
2. Elimination of scrap.
3. Elimination of errors.
4. Attitude toward improving the quality of the finished product.
C. Output:1. Dependability; on the job, not absent, tardy or wasting time.
2. Putting out, not holding back.
3. Willingness to do*154 any job available.
4. Teamwork and extra effort in case of absence of others or in emergencies.
D. Ideas and Cooperation:New ideas, new methods and new thinking are important. This factor credits an employee if he is using initiative and intelligence to:
1. Reduce costs.
2. Increase output.
3. Improve quality.
4. Improve customer and public relations.
Teamwork, attitude towards supervision and coworkers, is important. This factor also credits an employee for his willingness to:
1. Meet emergencies.
2. Help others.
3. Share knowledge.
An employee is rated as to the various categories by his department head and others. The employee receives a set of rating cards showing his rating which can be as high as 120 points. Any points above 120 are not included in the totals for a rating group so as not to unduly penalize workers who are not considered outstanding in the same group.
On October 27, 1964, the board of directors met. The first order of business was the amount of the bonus. It was determined that an amount not to exceed $ 12,900,000 should be paid. The board then considered the following subjects in order: Continuance of the employment retirement annuity plan; donations*155 to be made by the Lincoln Electric Foundation; the amount of gift to the Lincoln Electric Foundation; the amount of gift to the James F. Lincoln Arc Welding *930 Foundation; dividends for 1965; an additional yearend dividend for 1964; compensation for Mr. J. F. Lincoln for 1964; an amendment to the employment retirement annuity plan; and lastly, the president's report on operations during the past year and the plans for the near future.
On November 4, 1965, the board met. The first order of business concerned the employees' retirement plan. Next the board considered the annual contributions to the James F. Lincoln Arc Welding Foundation and the Lincoln Electric Foundation. Then followed the bonus for 1965. It was determined the bonus should be $ 14,500,000. Then the board discussed payment of a yearend dividend; payment of 1966 dividends; other matters; and lastly, the president's report on present operations and plans for the future.
The bonus payments for 1964 and 1965 were in the amounts of $ 12,496,000 and $ 14,089,000, respectively. These amounts were 118 percent and 121 percent of the regular payroll, exceeded 15 percent of net sales, and were greater than 50 percent*156 of gross profit before bonus and taxes. Also, petitioner withheld the appropriate taxes that relate to compensation.
The bonus payments have been consistently deducted by petitioner on its tax returns as a component of cost of goods sold. For 1964, petitioner's cost of goods sold schedule in its tax return reflects the following:
| Salaries and wages | |
| Direct labor | $ 4,075,354.87 |
| Salaries of foremen, supervisors, etc | 1,156,801.80 |
| Indirect labor | 371,189.00 |
| Vacation pay | 315,253.00 |
| Overtime premium | 487,066.00 |
| Yearend incentive compensation | 9,005,793.05 |
| Total | 15,411,457.72 |
In petitioner's 1964 tax return, a deduction was taken in the amount of $ 1,041,920.78 for payment to a pension or annuity-type plan. On Form 2950, "Statement in Support of Deduction," petitioner reported total nondeferred compensation paid or accrued for all employees as $ 23,083,450, which includes the bonus payment.
On petitioner's tax return for 1965, the schedule of cost of goods sold reflects the following:
| Salaries and wages | |
| Direct labor | $ 4,707,513.13 |
| Salaries of foremen, supervisors, etc | 1,239,069.78 |
| Indirect labor | 499,873.00 |
| Vacation pay | 349,627.00 |
| Overtime premium | 513,766.00 |
| Yearend incentive compensation | 10,408,881.92 |
| Total | 17,718,730.83 |
*157 *931 Petitioner took a deduction on his 1965 tax return in the amount of $ 1,426,566.83 for payment to a pension or annuity-type plan. On Form 2950, total nondeferred compensation paid or accrued for all employees is stated as $ 25,740,684, which includes the bonus payment.
In 1964 and 1965, total cash dividends paid to stockholders were $ 3,597,781.25 and $ 4,786,886.75, respectively.
In 1964 and 1965, and in all previous years petitioner, on its books and Federal income tax returns deducted the full amount of the bonus in the year of payment not treating any portion of the bonus as direct or indirect labor costs of producing its inventories or including any portion thereof in the value of its inventories. In computing its yearend inventories, petitioner allocated as part of overhead portions of salaries of foremen, supervisors, etc.; indirect labor; vacation pay; overtime premium; and total payroll taxes, in addition to the allocation of direct labor.
The Commissioner determined that for taxable years 1964 and 1965 "yearly incentive compensation bonus paid with respect to direct and indirect labor is a factor to be considered in valuing your inventories. Since you have not*158 included such bonuses * * *, adjustment is made under section 446(b) of the Internal Revenue Code for the effect of these bonuses on your inventories, and under section 481 * * * to prevent amounts from being duplicated or omitted." The Commissioner's determination is reflected in the following schedule (the column headed "12/31/53" is for section 481 purposes) in which the dollar amounts, percentages, and descriptive headings in lines 1 through 7 are stipulated to be correct:
| COMPUTATION OF INVENTORY ADJUSTMENT | |
| Dec. 31, 1953 | |
| 1. Direct labor in reported closing inventory | $ 391,941 |
| 2. Labor included in total yearly overhead | $ 1,985,402 |
| 3. Total overhead for year | $ 3,749,594 |
| 4. Percentage of labor in total overhead (line 2 / line 3) | 52.95 |
| 5. Total overhead in reported closing inventory | $ 760,321 |
| 6. Labor included in overhead of closing inventory (line 4 X | |
| line 5) | $ 402,59. |
| 7. (a) Percentage of bonus paid on total direct wages | 95.4 |
| (b) Percentage of bonus paid on total wages | 103.6 |
| 8. Bonus attributable to wages in closing inventory: | |
| (a) Direct wages [line 1 X 7(a)] | $ 373,912 |
| (b) Indirect wages [line 6 X 7(b)] | $ 417,083 |
| 9. Total bonus attributable to wages in closing inventory | $ 790,995 |
| Less amounts attributable to years prior to 1954 | |
| Bonuses not applied to inventory, Dec. 31, 1964 | |
| Adjustment for 1964 | |
| Adjustment for 1965 |
| COMPUTATION OF INVENTORY ADJUSTMENT | |
| Dec. 31, 1964 | |
| 1. Direct labor in reported closing inventory | $ 668,994 |
| 2. Labor included in total yearly overhead | $ 4,290,761 |
| 3. Total overhead for year | $ 7,194,542 |
| 4. Percentage of labor in total overhead (line 2 / line 3) | 59.64 |
| 5. Total overhead in reported closing inventory | $ 997,214 |
| 6. Labor included in overhead of closing inventory (line 4 X | |
| line 5) | $ 594,738 |
| 7. (a) Percentage of bonus paid on total direct wages | 119.3 |
| (b) Percentage of bonus paid on total wages | 127.2 |
| 8. Bonus attributable to wages in closing inventory: | |
| (a) Direct wages [line 1 X 7(a)] | $ 798,110 |
| (b) Indirect wages [line 6 X 7(b)] | $ 756,507 |
| 9. Total bonus attributable to wages in closing inventory | $ 1,554,617 |
| Less amounts attributable to years prior to 1954 | $ 790,995 |
| Bonuses not applied to inventory, Dec. 31, 1964 | |
| Adjustment for 1964 | $ 763,622 |
| Adjustment for 1965 |
| COMPUTATION OF INVENTORY ADJUSTMENT | |
| Dec. 31, 1965 | |
| 1. Direct labor in reported closing inventory | $ 735,949 |
| 2. Labor included in total yearly overhead | $ 4,740,191 |
| 3. Total overhead for year | $ 8,010,187 |
| 4. Percentage of labor in total overhead (line 2 / line 3) | 59.18 |
| 5. Total overhead in reported closing inventory | $ 1,074,844 |
| 6. Labor included in overhead of closing inventory (line 4 X | |
| line 5) | $ 636,093 |
| 7. (a) Percentage of bonus paid on total direct wages | 121.0 |
| (b) Percentage of bonus paid on total wages | 129.2 |
| 8. Bonus attributable to wages in closing inventory: | |
| (a) Direct wages [line 1 X 7(a)] | $ 890,498 |
| (b) Indirect wages [line 6 X 7(b)] | $ 821,832 |
| 9. Total bonus attributable to wages in closing inventory | $ 1,712,330 |
| Less amounts attributable to years prior to 1954 | |
| Bonuses not applied to inventory, Dec. 31, 1964 | $ 1,554,617 |
| Adjustment for 1964 | |
| Adjustment for 1965 | $ 157,713 |
*160 *932 OPINION
The sole issue before us is whether petitioner's inventories for income tax purposes should include an allocable share of incentive compensation (bonus) payment to production and production-oriented workers. The answer will depend on whether or not petitioner's method of accounting for the bonus payment clearly reflects income.
Both parties rely on section 446, I.R.C. 1954, which provides in part:
SEC. 446. GENERAL RULE FOR METHODS OF ACCOUNTING.
(a) General Rule. -- Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.
(b) Exceptions. -- If no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary or his delegate, does clearly reflect income.
The petitioner argues that its method of accounting for the bonus, i.e., deducting it in full in the year of payment and not including any portion in inventories, is an acceptable method of accounting which clearly reflects income and therefore cannot be changed *161 by the Commissioner to another acceptable method. Photo-Sonics, Inc. v. Commissioner, 357 F. 2d 656 (C.A. 9, 1966), affirming 42 T.C. 926">42 T.C. 926 (1964); Fort Howard Paper Co., 49 T.C. 275">49 T.C. 275, 286, 287 (1967). The Commissioner, however, argues that petitioner's method of accounting does not clearly reflect income and therefore the Commissioner is within his authority in changing the method. Commissioner v. Hansen, 360 U.S. 446">360 U.S. 446 (1959). Further, he argues if a method of accounting does not so clearly reflect income, it is not binding on the Commissioner even if such method is in accord with generally accepted accounting principles. Fort Howard Paper Co., supra.
With these introductory positions established, it is apparent that we must decide if petitioner's method of accounting clearly reflects income. We hold that it does not.
The Code, in section 471 and the regulations thereunder, makes specific reference to inventories. In section 1.471-2(a), Income Tax Regs., it is provided:
Sec. 1.471-2 Valuation of inventories.
(a) Section 471*162 provides two tests to which each inventory must conform:
(1) It must conform as nearly as may be to the best accounting practice in the trade or business, and
(2) It must clearly reflect the income.
With respect to conformity to accounting practice, we find it unnecessary to resolve the technical issue of conformity to the best accounting *933 practice in the trade or business; accord with such practices is not sufficient; it is also necessary for the method of accounting to clearly reflect income. Here is where we disagree with petitioner. As with other issues, whether a method of accounting clearly reflects income is to be determined on the basis of the particular facts and circumstances of each case and that is the basis on which our decision herein rests. Sam W. Emerson Co., 37 T.C. 1063">37 T.C. 1063 (1962); Fort Howard Paper Co., supra at 284.
We have indulged in the foregoing discussion because the parties have dealt extensively with questions of accounting principles and generally accepted accounting practices and methods in their argument. We believe their argument in this respect is really beside the point and that*163 the nub of this case is essentially whether payment of the bonus was a discretionary distribution of profits by the petitioner or whether the payment was an obligatory distribution. If it was merely discretionary, the petitioner's treatment was correct; if obligatory, the Commissioner's determination should not be disturbed.
Petitioner argues that the bonus was a discretionary distribution to employees of profits earned during the year. The bonus was not fixed by any formula, but rather by the board of directors in its discretion depending on the amount of estimated profit for the year.
We cannot agree with this argument. Although legally the employees might not be able to sustain an action to compel payment of the bonus, the bonus had in fact been paid consistently for 30 years. The fact of this sustained payment over the years, we think, results in at least an understanding between petitioner and its employees that they would receive a yearend bonus. Further, this past action tends to limit the discretion of the board of directors to discretion as to amount rather than discretion of whether or not to pay a bonus at all. As a factor in reaching our conclusion, though*164 not a determinative one, we note that the first or almost first action of the board at its 1964 and 1965 fall meetings was the amount of the bonus. This decision was reached before any discussion of present and future operations, yearend dividends and other matters which petitioner contends the board considered before deciding on the payment of a bonus. The minutes of these meetings belie the course of action by the board contended for by petitioner.
Next petitioner argues that it would be inequitable and absurd to defer the bonus as a cost of yearend inventory because of the manner in which it is distributed. This method stems from the merit-rating system for the past 12 months ended October 31, and since petitioner's inventory completely turns over every 45 days, there is no inventory at yearend to which the bonus relates. We do not accept this argument. *934 Inventory turnover is a tool for comparison, measuring the relationship between cost of merchandise sold and merchandise inventory, in terms of days of sale. It is not a means for valuing inventory, but is useful in comparing one accounting period to another.
However, probably the most significant reason for including*165 a portion of the bonus in yearend inventory stems from the reason the bonus exists at all. That reason is production. To say, as petitioner does, that the bonus is a form of profit sharing is an oversimplification. We think it is more correct to look behind the obvious and ascertain the true nature of the payment.
When the payment is so analyzed, it becomes apparent that it derives its existence from production. As stated in our Findings of Fact, an employee's share of the bonus is determined from his wages during the preceding 12 months ended October 31, and from his merit rating. With respect to wages, most production employees are on a piecework basis, i.e., their wages are in direct proportion to their production. The merit rating system measures a worker's performance on the job and thereby "[his] contribution to the company." A brief glance at the various factors used in the rating (as stated in our Findings of Fact) shows that they measure in large part how well the worker does his job, i.e., produces. Thus the entire bonus arrangement is tied to production. When this is combined with the uninterrupted 30-year payment of the bonus yielding at least an understanding *166 between petitioner and its employees that a bonus will be forthcoming and with the fact that the bonus represents a reward for a year's effort from November 1 to October 31, we fail to see why a portion of it should not be reflected in yearend inventory representing that production on which either a bonus has been paid or to which one will be paid in the following December.
We think that such an inclusion of costs clearly reflects income on an annual basis and that petitioner's present system of accounting does not. The consistency of payment by petitioner and the basis for the bonus require an allocation of a portion of the bonus to yearend inventory so as to clearly reflect income. The bonus has become, by virtue of years of payment, a fixture in petitioner's operations. We fail to see why it should not be accrued and allocated as petitioner does with overtime and vacation pay and with payroll taxes. We think it can be safely said that at present the bonus represents a labor or labor-related cost of petitioner which should be accounted for as is done with other costs falling within this same category. Accordingly,
Decision will be entered for the respondent.