Apollo Industries, Inc. v. Commissioner , 44 T.C. 1 ( 1965 )

Apollo Industries, Inc., Successor to A & F, Inc. (Formerly Alles & Fisher, Inc.), Petitioner, v. Commissioner of Internal Revenue, Respondent

Apollo Industries, Inc. v. Commissioner

Docket No. 723-63

United States Tax Court

44 T.C. 1; 1965 U.S. Tax Ct. LEXIS 106;

April 2, 1965, Filed

---

Decision will be entered under Rule 50.

The petitioner's predecessor was engaged in the business of manufacturing cigars. It also processed some of the tobacco used in its cigars. New machinery for the manufacture of a new product known as "reconstituted tobacco" was being developed and it was the plan of the predecessor corporation to acquire and incorporate such equipment into its operations when it was perfected and to expand its plant to accommodate such added operation. For each of the taxable years herein the corporation accumulated all of its earnings and profits, which it is here claimed were required for the purchase of the machinery and the necessary plant expansion. From prior accumulations adequate funds were at all time available to cover the needs therefor and the accumulations here in question were beyond the reasonable needs of the business. Held, that within the meaning of section 532(a), I.R.C., the corporation was availed of for the purpose of avoiding the income tax with respect to its shareholders by permitting earnings and profits to accumulate instead of being divided or distributed, and hence was subject to the accumulated earnings tax imposed by section 531, I.R.C.

Lawrence M. Levinson, Jack H. Calechman, and Stephen N. Subrin, for the petitioner.

John R. Berman, for the respondent.

Turner, Judge.

---

TURNER

The respondent determined deficiencies in income tax against the petitioner for the years 1956 and 1957 and for the taxable period from January 1, 1958, to June 30, 1958, in the amounts of $ 59,527.80, $ 45,110.91, and $ 3,818.46, respectively. The only issue for decision is whether the petitioner's predecessor, Alles & Fisher, Inc., was subject to the accumulated earnings tax imposed by section 531 of the Code.

FINDINGS OF FACT

Some of the facts have been stipulated and are found as stipulated.

The petitioner is a Maine corporation with its principal place of business in Pittsburgh, Pa. It is the successor to Alles & Fisher, Inc. (later known as A & F, Inc., and hereinafter referred to as Alles), a Massachusetts corporation which had its principal place of business at Boston, Mass. Alles filed its income tax returns for the taxable years 1956 and 1957 and for the taxable period from January 1, 1958, through June 30, 1958, with the district director of internal revenue at Boston, Mass.

Alles was incorporated in 1918 and was the successor to a business originally founded in 1863. It was engaged in the business of manufacturing cigars and also processed some of the tobacco used in its cigars.

The cigars manufactured by Alles were sold under brand names, primarily the "63" and "J-A" brands. During the taxable years the "63" brand cigars were sold at retail at the rate of two for 15 cents and represented almost 80 percent in volume of cigars sold by Alles. The "J-A" brand cigars were sold at retail primarily at the rate of two for 25 cents, although there were larger sizes which were sold at higher prices. Each of the two brands was the largest selling brand in its respective class in the New England area. Alles also had a third brand of cigars, the "Pippin" brand, sales of which were comparatively negligible in amount. The brand names were important to Alles' business, and it spent large sums of money in promoting and advertising them.

Cigar manufacturing is a highly competitive business. Between 1936 and 1962, the number of cigar factories in operation in the United States declined from over 5,250 to 456. Between 1950 and 1962 the number of cigar factories in Massachusetts was reduced from 92 to 19. In 1939, cigar factories producing less than 20 million cigars per year numbered 4,069 and accounted for 22.22 percent of the total cigars manufactured in the United States. In 1958, the number of factories producing less than 20 million cigars per year had decreased to 570 and accounted for only 6.79 percent of the cigars manufactured in the United States.

The annual cigar consumption in the United States during the following years was as follows:

Year	Cigars consumed
1920	8,502,008,000
1933	4,591,511,000
1950	5,538,887,000
1955	6,020,965,000
1960	6,954,682,000

Alles installed automatic cigar-making machines in its factory in 1926, being the first cigar manufacturer in the New England area to do so. It also was a pioneer in the use of various other types of machinery for cigar manufacturing and tobacco processing, including tobacco-stripping machines, to strip the large center veins out of tobacco leaves; "scrap" manufacturing machines, to chop up and dry tobacco leaves into "filler" for cigars; ¹ a stem-crushing machine, to crush the stems of tobacco plants and chop them into pieces to be used for filler; and automatic packaging machines, to package cigars in small packs of 5 or 10 each. The use of progressive manufacturing methods helped Alles to grow and increase its share of the cigar market. By the mid-1950's it was producing approximately 50 million cigars per year

During the years 1951 through 1955, dividends were declared and paid by Alles to its shareholders as follows:

Date declared	Date paid	Dividend	Total amount
		per share	paid
Nov. 30, 1951	Dec. 28, 1951	$ 0.25	$ 19,666
Nov. 28, 1952	Dec. 31, 1952	.25	19,166
Dec. 10, 1953	Jan. 2, 1954	.25	18,841
Nov. 26, 1954	Jan. 3, 1955	.25	18,466
Dec. 21, 1955	Dec. 30, 1955	.25	18,116

Reuben B. Gryzmish (hereinafter referred to as Gryzmish) became the treasurer of Alles upon joining the corporation in 1920. His experience in the cigar-manufacturing field dated back to 1905. He was also engaged in successful business ventures in other fields while affiliated with Alles. His brother, Mortimer C. Gryzmish (hereinafter referred to as Mortimer), was the president of the corporation from an undisclosed time until May 16, 1956.

During the taxable years Alles had 150,000 shares of capital stock authorized, of which approximately 72,464 shares were issued and outstanding. The stock was publicly traded on the American and Boston Stock Exchanges.

In 1956, Mortimer was the largest single shareholder, ² while Gryzmish and other members of his immediate family held shares as follows:

Shareholder	Relationship to Gryzmish	Shares held
Reuben and Ethel Gryzmish	Self and wife	11,779
Benjamin and Ruby Schulman	Son-in-law and daughter	3,480
Harry and Edna Shpiner	do	8,225
Karen Schulman	Grandchild	240
David Schulman	do	240
Ellen Schulman	do	240
Susan Shpiner	do	240
Bruce Shpiner	do	240
Total		24,684

At various times, Gryzmish and Mortimer loaned money to Alles. The following schedule shows the amounts owed by Alles to Gryzmish on unsecured loans and notes, bearing no interest, and for accrued salary, as of December 31 of the years indicated:

	1951	1952	1953
Loan	$ 150,000.00
Note		$ 150,000.00	$ 175,000.00
Salary	24,813.60	26,745.30	26,745.60
Total	174,813.60	176,745.30	201,745.60
Less: Offsets	4,937.50	4,937.50	5,132.29
Net amount owed	169,876.10	171,807.80	196,613.31

	1954	1955	1956
Loan
Note	$ 125,000.00	$ 80,000.00	$ 25,000.00
Salary	27,153.21	27,336.00	22,879.00
Total	152,153.21	107,336.00	47,879.00
Less: Offsets	6,687.50	10,149.36	10,149.36
Net amount owed	145,465.71	97,186.64	37,729.64

In the spring of 1956, a dispute arose between Gryzmish and Mortimer. In December 1955, Mortimer had agreed to sell his stock in Alles to Gryzmish. At that time and subsequently, Gryzmish had made payments to Mortimer on account totaling $ 75,000. Mortimer, however, refused to deliver the stock to Gryzmish and did not return the $ 75,000 he had received.

At the annual meeting of the shareholders of Alles held on May 16, 1956, Gryzmish, by virtue of his own shares and proxies from other shareholders, voted 35,669 shares out of the 36,396 shares represented at the meeting. Mortimer was not present at the meeting, although he was represented by an attorney. At the meeting, a board of directors, consisting of Gryzmish, Mortimer, Benjamin Schulman, Harry Shpiner, and four others, was elected. Immediately following the shareholders meeting the board of directors met and elected Gryzmish president of the corporation, replacing Mortimer. Gryzmish was also elected chairman of the board and a vice president of the corporation, and retained his position as treasurer.

By virtue of the stockholdings of Gryzmish and the members of his family and the offices he held in Alles, Gryzmish controlled the affairs of Alles and was its operating head during the taxable years. The board of directors generally followed his advice with respect to key business decisions.

During 1956 Gryzmish intended to have Alles go into the manufacturing of a new product, known as "reconstituted tobacco," as soon as the product had been perfected. Reconstituted tobacco, also known as homogenized tobacco, is made by a highly technical process in which tobacco leaves are ground into a fine powder, then water and a chemical adhesive agent are added and the mixture is processed into sheets of a brown, pliable material as thin as paper. The sheets of the material are wound into large rolls, which are cut to the size required and are used to make "binders" for cigars. ³ Prior to the development of reconstituted tobacco, natural tobacco leaves were used to make cigar binders.

Gryzmish had first seen reconstituted tobacco in the spring of 1955 when, in response to an inquiry, he was invited by American Machine & Foundry Co. to visit its pilot plant in Brooklyn, N.Y., in which the new product was being produced in small quantities. Alles had purchased machinery from American Machine & Foundry for many years prior to that time. After viewing the operation of the pilot plant, Gryzmish was of the opinion that reconstituted tobacco, if successfully developed, would revolutionize the cigar industry. He believed that use of the product would provide large savings to cigar manufacturers and tobacco processors by eliminating waste due to imperfections in natural tobacco and shrinkage in the drying process. He also believed that it would make possible the elimination of one operator from each cigar-making machine, and would produce a smoother appearing cigar than natural tobacco. It was the opinion of Gryzmish that by using reconstituted tobacco Alles could save at least $ 5 on each 1,000 cigars manufactured, which would approximately double the profit the corporation was then making on cigars.

Alles obtained small amounts of reconstituted tobacco from American Machine & Foundry for experimental purposes during 1955, being among the first manufacturers to receive samples of the product. Since reconstituted tobacco could not be used on regular cigar-making machines without special adapters, which were not then available, Alles tested the product in cigars made by hand, which were given to employees and others to smoke.

On June 20, 1955, Alles obtained from International Cigar Machinery Co., a subsidiary of American Machine & Foundry, a written quotation of the cost of a unit capable of producing 250,000 pounds of reconstituted tobacco per year. It was estimated therein that the cost of such a unit would be approximately $ 193,145. Accompanying the estimate was a layout showing the arrangement and dimensions of the plant which would be necessary to house the unit. Alles' existing plant was not large enough for the purpose. Based upon the plant layout, Gryzmish, who was experienced in real estate matters, estimated that the cost of providing a building of the size needed would make the total cost of the project $ 500,000.

The first license from American Machine & Foundry for the manufacture of reconstituted tobacco was granted in 1955 to a newly formed corporation named Nu Way Tobacco Co. Nu Way was formed and operated by Jean Shepard, a tobacco grower from whom Alles had previously purchased tobacco. During July or August 1955, Gryzmish and several other representatives of Alles inspected the Nu Way plant, which was located in Rockville, Conn. Nu Way did not begin to produce reconstituted tobacco for sale until November 1955.

During 1956, Alles purchased quantities of reconstituted tobacco from Nu Way for experimental purposes. At that time the product itself had not yet been perfected and the manufacturing process had not yet been made economical. The reconstituted tobacco was not uniform in thickness, color, taste, or moisture content. It did not hold an ash well and it caused the filler to crumble in the smoker's mouth. Gryzmish did not wish Alles to risk the reputation of its brand names by using reconstituted tobacco in its cigars until the product was perfected, but he was confident that American Machine & Foundry would eventually solve the problems.

Gryzmish wanted Alles to manufacture reconstituted tobacco when it was perfected because he believed the corporation could realize additional profit and could produce a more uniform binder if it manufactured the product itself rather than purchasing it from an outside manufacturer. He also was reluctant to have Alles be dependent for its supply on Nu Way, which at that time was the only manufacturer of reconstituted tobacco.

Gryzmish planned to have Alles raise the money for the new equipment and plant by accumulating the necessary funds out of its earnings, if possible, and to borrow money only if its own funds were not sufficient. He discussed the manufacture of reconstituted tobacco and the probable costs of the equipment and plant with the other directors of Alles, who were agreeable to the plan. It was contemplated that, of the 250,000 pounds of reconstituted tobacco which Alles would produce per year, the corporation would use approximately 150,000 pounds itself and would sell the remainder to smaller cigar manufacturers.

Gryzmish indicated to Jean Shepard that Alles was interested in going into the manufacture of reconstituted tobacco and learned from Shepard that the cost to Nu Way of the equipment which it had purchased from American Machine & Foundry was $ 690,000, exclusive of the cost of the building and land for the plant. Shepard desired to have Alles go into business jointly with Nu Way, rather than to compete with it. General discussions along that line were held between Shepard and representatives of Alles, but no concrete proposals materialized.

Alles began to put reconstituted tobacco binders into some of its "63" brand cigars late in 1956 and early in 1957. In March 1957, it put a supply of such cigars on the market in Fall River, Mass., for their first public test. There were a certain number of complaints, but the product was generally accepted.

On January 26, 1957, Gryzmish and Mortimer signed a mutual release under which each released the other "from any claims, demands and liabilities which either of them may have against the other arising from any dealings, acts or transactions between them relating to Alles & Fisher, Inc., its affairs or its securities, or from any dealings, acts or transactions which either of them has had with Alles & Fisher, Inc." At the same time or at some other undisclosed time, the stock owned by Mortimer was transferred to Gryzmish and the members of his family. Mortimer resigned as a director of the corporation, effective February 12, 1957.

On or about June 3, 1957, Gryzmish obtained a loan from Alles, in the amount of $ 160,000, without security and without interest, in order to enable him to complete the purchase of the shares of Alles stock held by Mortimer. Gryzmish was willing and able to repay the loan at any time the funds were needed by the corporation. The loan was repaid on or about May 27, 1958.

After the purchase of the shares held by Mortimer, Gryzmish and members of his family held shares of Alles stock as follows:

	Shares held
Shareholder
	1957	1958 1
Reuben and Ethel Gryzmish	16,925	15,125
Benjamin and Ruby Schulman	7,121	5,991
Harry and Edna Shpiner	13,880	11,080
Karen Schulman	3,330	2,730
David Schulman	3,329	2,729
Ellen Schulman	3,166	2,766
Henry Schulman 2	2,691	2,441
Richard Schulman 2	2,529	2,279
Susan Shpiner	3,662	3,062
Bruce Shpiner	3,570	2,970
Total	60,203	51,173

Due to the use of reconstituted tobacco in the "63" brand cigars, it became unnecessary to carry a large inventory of natural broad-leaf tobacco and, therefore, during the taxable years Alles embarked upon a program of reducing its inventory of broad-leaf tobacco in order to provide additional liquid funds.

For the years 1956 and 1957, Alles' income tax returns showed the following:

	1956	1957
Net sales	$ 2,979,061.52	$ 2,812,673.24
Less: Cost of goods sold	2,168,490.28	2,019,012.30
Gross profit from sales	810,571.24	793,660.94
Other income	33,492.59	65,644.05
Total income	844,063.83	859,304.99
Less: Expenses	613,018.80	617,321.95
Taxable income before special deductions	231,045.03	241,983.04
Less: Dividends-received deductions	8,032.50	10,098.00
Net amount	223,012.53	231,885.04
Federal income tax	110,466.52	115,080.22
Net income after taxes	112,546.01	116,804.82

No dividends were declared or paid by Alles during 1956 or 1957 or during the period from January 1, 1958, through June 30, 1958.

As of December 31, 1955, 1956, and 1957, the balance sheets of Alles, as shown by its returns, were as follows:

	Dec. 31 --
	1955	1956	1957
Assets
Cash	$ 5,919.41	$ 92,076.44	$ 230,704.05
Accounts receivable	233,587.32	219,453.85	216,166.57
Inventory	1,123,447.08	1,079,583.65	579,437.80
Prepaid expenses and supplies	10,049.84	18,216.39	8,370.38
Note receivable -- Reuben B. Gryzmish			160,000.00
Securities	210,584.26	516,886.00	516,886.00
Land	27,041.49	27,041.49	27,041.49
Building and other fixed depreciable
assets (net)	386,915.82	398,519.21	356,641.27
Intangible assets	201,653.28	151,352.45	101,051.63
Other assets	18,134.46	23,004.51	51,945.78
Total assets	2,217,332.96	2,526,133.99	2,248,244.97
Liabilities and capital
Accounts payable	66,601.88	132,605.31	85,950.82
Notes payable	146,000.00	280,000.00
Accrued expenses and provision for taxes	86,402.61	185,537.14	191,279.81
Mortgages payable	5,379.77	4,483.28	3,536.21
Other liabilities	99,505.84	37,729.64
Reserve for bad debts	10,500.00	10,500.00	10,500.00
Capital stock	322,125.29	322,125.29	322,125.29
Earned surplus	1,480,817.57	1,553,153.33	1,634,852.84
Total liabilities and capital	2,217,332.96	2,526,133.99	2,248,244.97

In Alles' financial statements, the accounts receivable of the corporation as of December 31, 1956 and 1957, were broken down by age as follows:

	Dec. 31, 1956	Dec. 31, 1957
Under 1 month	$ 174,332.92	$ 182,707.82
1 to 3 months	43,685.76	30,924.57
3 to 6 months	433.23	636.24
6 months to 1 year	231.75	88.69
More than 1 year	144.97	301.20
Debit balances -- accounts payable	225.38	1,508.05
Total	1 219,054.01	216,166.57

Based on the balance sheets shown on its returns Alles' working capital as of December 31, 1955, 1956, and 1957, was as follows:

	Dec. 31 --
	1955	1956	1957
Current assets
Cash	$ 5,919.41	$ 92,076.44	$ 230,704.05
Accounts receivable (net)	223,087.32	208,953.85	205,666.57
Inventory	1,123,447.08	1,079,583.65	579,437.80
Note receivable -- Reuben B. Gryzmish			160,000.00
Securities	210,584.26	516,886.00	1 433,920.95
Total	1,563,038.07	1,897,499.94	1,609,729.37
Current liabilities
Accounts payable	66,601.88	132,605.31	85,950.82
Notes payable	146,000.00	280,000.00
Accrued expenses and provision for
taxes	86,402.61	185,537.14	191,279.81
Total	299,004.49	598,142.45	277,230.63
Working capital	1,264,033.58	1,299,357.49	1 1,332,498.74

The securities owned by Alles during 1956 and 1957 consisted of the following:

		Number of
Date purchased	Type of security	shares or face	Cost
		value
1946	General Stores stock	366	1 $ 20.40
Jan. 22, 1954	American Telephone & Telegraph
	Co. stock	1,000	158,375.00
Sept. 12, 1956	do	200	2 31,828.10
Nov. 1, 1956	do	120	2 12,000.00
Mar. 21, 1956	Missouri Pacific RR. 5 percent
	bonds	$ 500,000	3 314,662.50
Total			516,886.00

The notes payable of $ 280,000 shown on Alles' balance sheet at December 31, 1956, were payable to banks in connection with the purchase of certain of the securities shown, and were paid during 1957.

In September 1957, Gerald Glunts, one of the certified public accountants for Alles, informed Gryzmish that a Massachusetts business trust named National Associates was seeking to acquire successful businesses. Glunts suggested that Gryzmish meet with George Friedlander, a principal in National Associates, to discuss the possibility of a sale of the Alles stock owned by Gryzmish and his family to National Associates. Gryzmish agreed to do so. Gryzmish had not previously asked Glunts or anyone else to find a purchaser for the stock in Alles owned by him or his family.

On October 9, 1957, Gryzmish, representing himself and the other members of his family, met with Glunts, Friedlander, and the attorney for National Associates. At the meeting Friedlander showed a definite interest in having National Associates acquire the Alles stock owned by Gryzmish and his family, and Gryzmish showed an interest in selling. Certain terms were discussed, and the two sides agreed to meet again. Friedlander requested a balance sheet of Alles as of September 30, 1957, which was subsequently prepared by the accountants and furnished to him. Friedlander also requested Gryzmish to see that, pending the outcome of the negotiations, Alles would engage in no transactions outside of the ordinary course of business, such as the acquisition of substantial physical assets or the payment of dividends. Gryzmish agreed to the requests.

Reconstituted tobacco was being continually improved during 1956 and 1957. As of the end of 1957 Alles was making a large part, if not all, of its "63" brand cigars with reconstituted tobacco binders, although it had not yet introduced them into the higher priced "J-A" brand. By the end of 1957 or the early part of 1958, reconstituted tobacco had been perfected and the manufacturing process had become economical. Alles, however, had suspended plans to manufacture the product because of the pending negotiations with National Associates.

On January 9, 1958, the attorney for National Associates sent to Gryzmish a draft of a proposed agreement for the purchase by National Associates of the Alles stock owned by Gryzmish and his family. The draft provided for a purchase price which was equal to $ 30 per share. Under the provisions set forth in the draft, a balance sheet of Alles as of September 30, 1957, was to be attached to the agreement, and the sellers were to warrant the following to the buyer:

Since September 30, 1957, there has not been --

(i) any change in Alles' financial condition, assets, liabilities, or business, other than changes in the ordinary course of business, none of which has been materially adverse;

* * * *

(iii) any declaration, or setting aside or payment of any dividend or other distribution in respect of Alles' capital stock, or any direct or indirect redemption, purchase, or other acquisition of any such stock;

On April 10, 1958, a corporation named Waitt & Bond, Inc., made a written offer to purchase the stock of Alles owned by Gryzmish and his family. This offer was not accepted.

On June 20, 1958, an agreement was executed between Gryzmish, the other members of his family, and National Associates, providing for the sale of 60,203 shares of Alles stock owned by Gryzmish and the other family members to National Associates, effective as of May 31, 1958, and the transaction was consummated. ⁴ The agreement provided for a purchase price of $ 31 per share, for an aggregate purchase price of $ 1,866,293. It was provided that an initial payment was made, at the time the agreement was executed, of $ 559,887.90, which was to pay certain of the selling shareholders in full and certain of them in part, and that there was a balance due in the aggregate amount of $ 1,306,405.10, which was evidenced by negotiable promissory notes of the buyer. It was provided in the agreement that financial statements of Alles as of December 31, 1957, which were attached thereto, were substantially accurate, and it was also provided that Gryzmish warranted the following:

During the period January 1, 1958 to the date hereof the affairs of [Alles], excepting certain sales of tobacco, were conducted in the ordinary course of its business in a manner not materially adversely affecting its financial condition, and no dividends were declared or paid during said period.

Since National Associates was not experienced in cigar manufacturing, it decided, after acquiring control of Alles, not to proceed with the plan to enter the manufacture of reconstituted tobacco. Alles did, however, begin at some time thereafter to use reconstituted tobacco binders in the "J-A" brand cigars as well as the "63" brand. Reconstituted tobacco continued to gain acceptance, and by July 1964 approximately 93 percent of all cigars manufactured in the United States had reconstituted tobacco binders.

The returns filed by Gryzmish and the other members of his family who were shareholders of Alles during 1956 and 1957 each show charitable contributions in excess of the deductible limits. The amounts, as shown on the returns, are as follows:

	Year	Charitable	Limitations	Excess
		contributions	on deductions	contributions
Reuben and Ethel Gryzmish	1956	$ 26,719.17	$ 8,975.46	$ 17,743.71
	1957	25,000.00	18,707.03	6,292.97
Benjamin and Ruby Schulman	1956	10,637.00	9,827.85	809.15
	1957	16,835.00	11,444.97	5,390.03
Harry and Edna Shpiner	1956	12,100.00	11,716.43	383.57
	1957	15,100.00	11,797.04	3,302.96
Karen Schulman	1956	1,300.00	1,248.17	51.83
	1957	1,975.00	1,953.51	21.49
David Schulman	1956	2,350.00	2,312.49	37.51
	1957	2,500.00	2,290.60	209.40
Ellen Schulman	1956	2,400.00	2,363.78	36.22
	1957	2,000.00	1,993.00	7.00
Henry Schulman	1957	1,150.00	1,128.80	21.20
Richard Schulman	1957	1,200.00	1,186.07	13.93
Susan Shpiner	1956	2,100.00	2,043.62	56.38
	1957	2,500.00	2,153.54	346.46
Bruce Shpiner	1956	2,300.00	2,257.01	42.99
	1957	2,400.00	2,389.07	10.93

By a letter dated August 23, 1962, the respondent notified the petitioner, in accordance with the provisions of section 534 of the Internal Revenue Code of 1954, that he proposed to issue a statutory notice of deficiency for the calendar years 1956 and 1957 and the period ended June 30, 1958, with respect to the accumulated earnings tax imposed by section 531. On November 29, 1962, a letter was submitted on behalf of the petitioner to the respondent purporting to be a statement of the grounds upon which the petitioner relied to establish that the earnings and profits of Alles had not been permitted to accumulate beyond the reasonable needs of its business.

In his determination of the deficiencies herein, the respondent determined Alles' "accumulated taxable income" and "accumulated earnings tax" as follows:

Taxable year or period	Accumulated	Accumulated
	taxable income	earnings tax
1956	$ 136,995.14	$ 41,743.13
1957	131,842.65	39,759.42
Jan. 1, 1958, to June 30, 1958	28,175.10	7,748.15

The earnings and profits of Alles during the taxable years 1956 and 1957 were accumulated beyond the reasonable needs of its business. Alles was availed of during those years for the purpose of avoiding the income tax with respect to its shareholders by permitting earnings and profits to accumulate instead of being divided or distributed.

OPINION

Under sections 531 and 532 of the Internal Revenue Code of 1954, an accumulated earnings tax is imposed upon a corporation "formed or availed of for the purpose of avoiding the income tax with respect to its shareholders * * * by permitting earnings and profits to accumulate instead of being divided or distributed." In section 533 it is provided that "the fact that the earnings and profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation by the preponderance of the evidence shall prove to the contrary." By section 537 it is further provided that "the term 'reasonable needs of the business' includes the reasonably anticipated needs of the business."

The issue for decision is whether the petitioner's predecessor, Alles & Fisher, Inc., was availed of during 1956 and 1957 for the purpose of avoiding the income tax with respect to its shareholders within the meaning of the above sections. The respondent concedes on brief that Alles was not so availed of during the taxable period from January 1, 1958, through June 30, 1958.

The petitioner contends that the earnings and profits of Alles for the years 1956 and 1957 were not permitted to accumulate beyond the reasonable needs of the business. It maintains that the accumulations were required in order to allow Alles to enter the manufacture of reconstituted tobacco and to meet ordinary business needs.

It is the respondent's contention that Alles' plans for entering the manufacture of reconstituted tobacco were not specific, definite, and feasible during the taxable years in question and hence may not be relied upon to justify the accumulations.

Much of the evidence presented by the petitioner and much of the discussion in its brief are concerned with establishing the definiteness during the years in issue of its plans for manufacturing reconstituted tobacco. In our Findings of Fact we have set forth in considerable detail the facts with respect to the alleged plans. We do not, however, find it necessary to decide whether those plans were sufficiently specific, definite, and feasible, because in any event the facts show that sufficient funds were available to the corporation to cover the alleged needs for the project without accumulating any earnings for 1956 or 1957.

The facts show that in June 1955, Alles obtained an estimate that the equipment necessary for the production of reconstituted tobacco would cost approximately $ 193,145. Gryzmish testified that after receiving the estimate and an accompanying plant layout he estimated that the cost of providing a building of the dimensions needed would make the total cost of the project "around one half a million dollars." The petitioner has made its computations and based its arguments on brief primarily on the proposition that the amount needed for the project was $ 500,000.

Taking into consideration, therefore, an assumed need for $ 500,000 for the reconstituted tobacco project, we turn to a consideration of the funds on hand during the taxable years to meet Alles' needs. Based upon the balance sheets shown in its returns, Alles had working capital of $ 1,299,357.49 as of December 31, 1956, and $ 1,332,498.74 as of December 31, 1957. ⁵

In determining the working capital, we have included the note receivable from Gryzmish as of December 31, 1957, in the amount of $ 160,000 as a current asset, even though it is not regarded as such in Alles' 1957 financial statement. Gryzmish testified that he was in a position to repay the loan at any time and that he would have repaid it "in a minute's notice" had the corporation requested. The loan was in fact repaid on or about May 27, 1958. For these reasons, we conclude that the note may properly be considered a current asset for our purposes as of December 31, 1957. Indeed, had the circumstances been otherwise than they were, the existence of such an outstanding loan to the principal shareholder, without security or interest, might be strong evidence of the purpose proscribed by the statute. Sec. 1.533-1(a)(2), Income Tax Regs.

Alles had current assets of $ 1,897,499.94 at December 31, 1956, and $ 1,609,729.37 at December 31, 1957, as compared with current liabilities at those dates of $ 598,142.45 and $ 277,230.63. Of noteworthy significance, we think, is the fact that of the current assets at those dates, $ 817,916.29 at December 31, 1956, and $ 1,030,291.57 at December 31, 1957, were in highly liquid form, i.e., cash, accounts receivable (net), the note receivable from Gryzmish, and securities.

The reason for the substantial increase in liquidity during 1957 is readily apparent from the record. During the taxable years Alles embarked upon a program of reducing its large inventory of broadleaf tobacco, the maintenance of which was made unnecessary by its plan to use reconstituted tobacco in its cigars. According to Gryzmish's testimony, the reductions were made in order to provide funds for the proposed new plant and equipment. Alles' balance sheets show that the total inventory was reduced from $ 1,079,583.65 at December 31, 1956, to $ 579,437.80 at December 31, 1957, and that the more liquid assets were increased accordingly. It thus appears that the reduction in inventory alone provided $ 500,000 in additional liquid funds, an amount equal to the claimed needs for the reconstituted tobacco project. The substantial increase in the available liquid funds was apparent as of the end of 1957, and from all indications in the record should have been reasonably anticipated as of the end of 1956.

Giving full effect to the claimed needs for the reconstituted tobacco project, it is apparent that Alles could have distributed its earnings for 1956 and 1957 to its shareholders and still have maintained a substantial working capital.

The petitioner maintains, however, that additional funds were required for ordinary business operations. As evidence of this alleged need, the petitioner presented certain testimony and computations by the certified public accountant who had prepared Alles' financial statements. The accountant applied what he termed a "rule of thumb" and added, for each of the taxable years in question, amounts equal to the closing accounts receivable, the closing inventory, the total operating expenses for the year (excluding depreciation), and the fixed assets acquired during the year, to arrive at a figure purportedly representing the amount of capital needed for Alles' operations. He testified that his computations had been prepared in connection with the trial of this case, having been "thought of by our attorney," and there is no indication that any similar analysis had been made for Alles during the taxable years.

Working capital needs of businesses vary, being dependent upon such factors as the nature of the business, its credit policies, the amounts of inventories and rate of turnover, the amount of accounts receivable and the collection rate thereof, the availability of credit to the business, and similar relevant factors. Smoot Sand & Gravel Corp. v. Commissioner, 241 F. 2d 197, 207. "Rules of thumb" may be helpful, but the search must always be concerned with the needs of the particular business as they existed during the particular year. Dixie, Inc. v. Commissioner, 277 F. 2d 526, 528, affirming 31 T.C. 415">31 T.C. 415; Barrow Mfg. Co., Inc. v. Commissioner, 294 F. 2d 79, 81, affirming a Memorandum Opinion of this Court; Motor Fuel Carriers, Inc. v. United States, 322 F.2d 576">322 F. 2d 576.

The evidence of record does not support the accountant's analysis, which, among other things, assumed that sufficient funds had to be available to pay operating expenses for an entire year.

It appears that Alles' accounts receivable were normally collected in the ordinary course of business within relatively short periods of time. The aging schedules in Alles' financial statements show that approximately 80 percent or more of the closing accounts receivable for 1956 and 1957 were less than 1 month old and that accounts more than 3 months old were negligible. Bad debt losses were minimal. Insofar as the record indicates, Alles' inventory of finished cigars was "turned over" regularly in the ordinary course of business and, as previously stated, the inventory of tobacco was substantially reduced during 1957. There is no suggestion that any business difficulties were anticipated. The record indicates that Alles had a healthy, going business which would of its own accord generate substantial funds through its normal operations in the course of a year. As such, an assumption that sufficient capital was required in advance to cover operating expenses for an entire year is not warranted.

The petitioner may not rely merely upon a rule of thumb to establish its alleged needs for working capital where the evidence not only does not support the method employed, but requires a contrary conclusion. We do not regard our decisions in J. L. Goodman Furniture Co., 11 T.C. 530">11 T.C. 530, and F. E. Watkins Motor Co., 31 T.C. 288">31 T.C. 288, cited by the petitioner, as holding otherwise.

We have carefully considered the accountant's computations and testimony in light of the record as a whole and have not found them to be convincing evidence of the amount of working capital required in Alles' business.

On the basis of all of the evidence of record, including the evidence concerning Alles' ordinary business operations and the claimed needs pursuant to the plans to manufacture reconstituted tobacco, we have concluded and found as a fact that the earnings and profits of Alles during the taxable years 1956 and 1957 were accumulated beyond the reasonable needs of its business.

Under section 533(a) a finding that the earnings and profits of a corporation are permitted to accumulate beyond the reasonable needs of the business is deemed determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation proves to the contrary by the preponderance of the evidence.

The petitioner maintains that the avoidance of income tax with respect to its shareholders was not Alles' purpose in accumulating the earnings in question.

The facts show that Gryzmish controlled the affairs of Alles during the taxable years, and the respondent agrees that "the acts of Reuben B. Gryzmish were the acts of Alles & Fisher, Inc." Gryzmish testified that the avoidance of income tax with respect to the shareholders was not his purpose for having Alles accumulate its earnings for 1956 and 1957. He testified that the entering of the manufacture of reconstituted tobacco was his primary motive, and he also mentioned certain additional alleged reasons for such accumulations.

Gryzmish testified that, in addition to the purported needs for the reconstituted tobacco project, another reason why he kept Alles from paying dividends with respect to the earnings for 1956 was that he did not believe that his brother Mortimer was entitled to receive any dividends after Mortimer's refusal to transfer his shares of Alles stock to Gryzmish in accordance with their agreement. This explanation fails to impress us. Had a dividend been declared, Gryzmish, who admittedly had working control of the corporation, undoubtedly could have seen to it that no dividends were paid to Mortimer until the disputed ownership of the stock was resolved. Furthermore, it is apparent that the dispute was settled by February 12, 1957, the date when Mortimer resigned as a director of the corporation, and apparently it was settled even earlier, since Gryzmish and Mortimer signed mutual releases against each other on January 27, 1957. Therefore, even after the dispute was settled, ample time remained for the payment of a dividend with respect to the 1956 earnings. ⁶

The petitioner emphasizes another alleged reason why no dividends were paid with respect to the 1957 earnings. The reason offered is that at a meeting held on October 9, 1957, Gryzmish assented to a request made by George Friedlander, a representative of National Associates, that no dividends be paid by Alles pending the outcome of negotiations for the sale of the Alles stock owned by the Gryzmish family group to National Associates. The petitioner does not contend that there was at any time any legal obligation on Alles to forego the payment of dividends, but cites testimony of Gryzmish to the effect that he felt "morally bound" to see that the corporation did so because of his statement to Friedlander.

In our opinion, the reason offered for the failure to pay dividends is not inconsistent with a purpose to avoid income tax with respect to the shareholders. If the earnings of the corporation were accumulated so that its controlling shareholders could sell their stock and thereby transform what would otherwise be ordinary income to them into capital gain, this seems to present a classic example of a purpose to avoid the income tax with respect to the shareholders.

Moreover, the facts of record do not in our opinion warrant giving Gryzmish's statement to Friedlander the significance which the petitioner would have us attach to it. The meeting on October 9, 1957, which was the first meeting between Gryzmish and representatives of National Associates, was apparently merely a preliminary discussion at which the possibility of a sale of the Alles stock held by the Gryzmish family was explored. At the time, a recent balance sheet of the corporation was not even available for Friedlander's inspection. Friedlander requested a balance sheet of Alles as of September 30, 1957, which was subsequently prepared by the accountants and furnished to him. He also requested Gryzmish to see that, pending the outcome of the negotiations, Alles would engage in no transactions out of the ordinary course of business, such as the acquisition of substantial physical assets or the payment of dividends. Gryzmish agreed to the requests.

The record shows, however, that no purchase agreement was executed until June 20, 1958, at which time the transaction was consummated. This was more than 8 months after the initial meeting. The existence of a firm understanding between the Gryzmish group and National Associates at any time prior to the actual execution of the agreement has not been shown. In his testimony, Friedlander said that Gryzmish had not been an "anxious seller" and described the negotiations as "chase and go." He also testified that he thought "it was like in April of 1958 when we learned that he [Gryzmish] was negotiating or selling with somebody else." The facts show that on April 10, 1958, a corporation named Waitt & Bond, Inc., made a written offer to purchase the stock of Alles owned by Gryzmish and his family, and that this offer was not accepted.

The purchase price, a prime factor in any transaction, was apparently unsettled for a considerable period of time. We cannot determine from the record how soon before the execution of the agreement the actual purchase price, which turned out to be $ 31 per share, was agreed upon. Although Friedlander testified that he had a "feeling" that the final purchase price was agreed upon "sometime in December," this testimony is contradicted by the fact that a draft of a proposed agreement sent to Gryzmish on January 9, 1958, provided for a purchase price of $ 30 per share, which, of course, was lower than that in the final agreement. Being in a constant state of flux, as the negotiations seem to have been, the purchase price could have been adjusted to take into consideration any distributions of dividends to the shareholders in the interim.

The petitioner points out that in both the proposed draft of the purchase agreement sent to Gryzmish on January 9, 1958, and the actual agreement of June 20, 1958, there were provisions whereby the sellers warranted that since the date of a balance sheet attached to the agreement (Sept. 30, 1957, in the former case and Dec. 30, 1957, in the latter) Alles had paid no dividends. We do not regard this as significant. It is understandable that National Associates, which was purchasing the controlling interest in Alles in reliance upon a prior balance sheet of the corporation, would require a warranty that the assets shown on the balance sheet were not depleted since the date thereof by the payment of dividends. This does not necessarily mean, however, that it would not have purchased the stock if dividends had been paid, so long as it was apprised of the situation and the purchase price was reduced accordingly. In this regard, Friedlander testified merely that he would expect that the purchase price of the shares would be reduced by at least the amount of any dividends paid.

In view of the record, we cannot find that Gryzmish's assent to Friedlander's request at their initial meeting shows that the avoidance of income tax with respect to the shareholders was not the purpose for the accumulation of the 1957 earnings.

The petitioner also stresses the fact that the 1956 and 1957 income tax returns of Gryzmish and each of the members of his family who were shareholders of Alles show charitable contributions which, in varying degrees, exceeded the applicable limitations for deductibility. Therefore, any additional income received by one of these individuals would have been offset by additional deductions for charitable contributions equal to 30 percent ⁷ of the additional income. This, of course, would reduce the tax on additional income, but would far from eliminate it. According to schedules prepared by the petitioner's accountants and introduced into evidence by the petitioner, the additional income tax which would have been paid by Gryzmish and the members of his family who were shareholders, if the net earnings for 1956 and 1957 after taxes had been paid out as dividends, would have been approximately $ 9,411.63 in 1956 and $ 41,575.18 in 1957. Certainly these are not insignificant amounts.

The petitioner seems to argue, however, that the Gryzmish group of shareholders did not actually avoid any income taxes because any tax savings they enjoyed by not receiving dividend distributions with respect to the 1956 and 1957 earnings were later offset by increased capital gains tax on the sale of their stock, which presumably commanded a higher price by reason of the accumulated earnings. The schedules prepared by the petitioner's accountants compare the aforesaid figures as to taxes saved by the shareholders with other figures purportedly representing the amounts by which the capital gains taxes paid by the shareholders were increased because of the accumulated earnings.

The argument is not persuasive. The schedules introduced by the petitioner are based upon conjecture as to the effect that distributions would have had upon the price the shareholders could receive for their stock and upon tax returns of the shareholders which are not even in evidence. The issue is the purpose of the corporation in accumulating the earnings. Helvering v. National Grocery Co., 304 U.S. 282">304 U.S. 282. At least with respect to the 1956 earnings, the record does not indicate that, at the time the earnings were accumulated, the possibility that the tax savings to the Gryzmish family group might be offset by future capital gains taxes was even contemplated, since there apparently was no thought by them of selling their stock in Alles. Gryzmish himself testified that prior to the suggestion by Gerald Glunts in September 1957, that he meet with Friedlander, he had not asked Glunts or anyone else to find a purchaser for the stock in Alles owned by him or his family.

With respect to the 1957 earnings, under the petitioner's own calculations the amounts of additional tax which the Gryzmish group would have paid had the earnings been distributed exceeded the amount of the purported "additional" capital gains tax paid by them by reason of the accumulation of the earnings for that year.

Even if this were not so, there was in any event a deferral of taxes from the years when the shareholders would have paid income tax on any dividends received to the subsequent time when they paid the capital gains tax by reason of the sale of their stock. ⁸

In our opinion, the petitioner has failed to establish by a preponderance of the evidence that Alles was not availed of during the years in question for the purpose of avoiding the income tax with respect to the shareholders. Accordingly, the respondent's determination of liability for the accumulated earnings tax for the taxable years 1956 and 1957 must be sustained.

Decision will be entered under Rule 50.

---

Footnotes

• 1. The "filler" consists of small pieces of tobacco and forms the body of the cigar.↩

• 2. Presumably Mortimer owned 35,519 shares of Alles stock inasmuch as Gryzmish and his family held 60,203 shares after the transfer of Mortimer's shares to them in 1957. See later finding of fact to that effect.↩

• 3. The "binder" of a cigar is the sheet of tobacco wrapped around the "filler," the small pieces of tobacco forming the body of the cigar. A thin leaf of tobacco, known as the "wrapper," is then placed around the binder to form the outer surface of the cigar.↩

• 1. After gifts of stock made to various charities.↩

• 2. Additional grandchildren of Gryzmish who were not shareholders in 1956.↩

• 1. In the balance sheet for Dec. 31, 1956, in Alles' income tax return, the accounts receivable were shown as $ 219,453.85. The discrepancy between the two figures is not explained in the record.↩

• 1. $ 433,920.95 represents market value of the securities at Dec. 31, 1957, rather than cost. A listing of the securities as of that date at cost, namely $ 516,886, would indicate working capital at Dec. 31, 1957, as $ 1,415,463.79, instead of the lower figure of $ 1,332,498.74.↩

• 1. Received pursuant to bankruptcy or receivership reorganization.↩

• 2. Acquired pursuant to exercise of rights to acquire bonds, subsequently converted to stock.↩

• 3. Purchased pursuant to deposit made in early 1955 to purchase bonds when issued.↩

• 4. It was stipulated that Gryzmish and the other members of the family group owned a total of 60,203 shares of Alles stock in 1957, but only owned 51,173 shares in 1958. Gryzmish testified that the reduction was due to gifts of stock having been made to various charities. The record does not explain why the agreement with National Associates provided for the sale of 60,203 shares, rather than the lower figure.↩

• 5. The securities owned by Alles were shown on the balance sheets in the tax returns at $ 516,886, their cost to the corporation, as of Dec. 31, 1956, and Dec. 31, 1957. On the other hand, the corporation's audited financial statements for those years, which are in evidence, contain "comments" to the effect that the securities had a "market" value of $ 527,297.50 at Dec. 31, 1956, and $ 433,920.95 at Dec. 31, 1957. The certified public accountant who prepared the statements testified that he had ascertained the market price of the securities as of the specified dates and the amounts were as reported in the statements. Since, in computing working capital, we are concerned with the assets available to meet business needs, the true market value would be a much more meaningful figure than cost. Cf. C. H. Spitzner & Son, Inc., 37 B.T.A. 511">37 B.T.A. 511↩. We have, therefore, given the petitioner the benefit of the doubt as to the evidence by using in our computations the lower of the cost or "market" figures for each year (i.e., $ 516,886 as of Dec. 31, 1956, and $ 433,920.95 as of Dec. 31, 1957).

• 6. It is provided in sec. 535(a) that in arriving at "accumulated taxable income" (upon which the accumulated earnings tax is levied) the taxable income of the corporation must be reduced by, among other things, the "dividends paid deduction." Under secs. 561 and 563(a), the dividends paid deduction, for purposes of the accumulated earnings tax, includes not only dividends paid during the taxable year but also those paid "after the close of any taxable year and on or before the 15th day of the third month following the close of such taxable year." Alles having been on a calendar year basis, any dividends paid on or before Mar. 15, 1957, would have reduced its "accumulated taxable income" for 1956.

• 7. Sec. 170(b)(1)(B) imposes a general limitation of 20 percent of an individual's adjusted gross income (computed without regard to any net operating loss carryback) as the amount which he may deduct for charitable contributions during the taxable year. Sec. 170(b)(1)(A), however, allows the deduction of an additional 10 percent of adjusted gross income for charitable contributions by an individual to certain specified types of organizations, with the consequence that a total deduction of up to 30 percent of adjusted gross income is possible for individuals who contribute at least 10 percent of their adjusted gross income to the types of organizations specified in sec. 170(b)(1)(A). According to the returns, the contributions made by the individuals in question entitled each of them to the maximum 30-percent limitation, and the returns are not disputed by the respondent.

• 8. The record does not indicate whether the entire capital gain was reported by all the shareholders on their returns for 1958, the year in which the stock was sold, or whether perhaps some of the shareholders who did not receive full payment at the time of the sale deferred the reporting of a portion of their gain to subsequent years under the installment sale provision of sec. 453 of the Code. No returns for the shareholders for 1958 or any subsequent year are in evidence. The accountant who prepared the schedules introduced testified merely that the figures were based on "the tax returns of each of the taxpayers for the years when the gain on the sale of the stock of Alles & Fisher, Incorporated, had been reported."↩