15 T.C. 683">*683 This1950 U.S. Tax Ct. LEXIS 40">*41 cause involves excess profits tax liability for fiscal years ending April 30 in each of the years 1943, 1944, 1945, and 1946, and the propriety of the respondent's denial of claims for relief and refund under section 722 of the Internal Revenue Code. Relief is claimed primarily under section 722 (b) (4), but it is the petitioner's contention that the same facts there applicable give right to relief under section 722 (b) (5).

A stipulation of facts and two supplementary stipulations of facts were filed and we adopt such stipulations by reference and find the facts therein set forth. So far as necessary to examination of the question involved they are set forth, together with other evidence adduced, in our findings of fact.

15 T.C. 683">*684 FINDINGS OF FACT.

The petitioner is a corporation organized in 1936 to operate a candy jobbing and merchandising business. It has since that date been continuously engaged therein. It has since April 30, 1937, kept its books and filed its Federal income and excess profits tax returns on the accrual basis, using a fiscal year ending April 30. Corporation income and declared value excess profits tax returns and corporation excess profits tax returns 1950 U.S. Tax Ct. LEXIS 40">*42 were filed by the petitioner with the collector for the fifth district of New Jersey for the years ending April 30 in 1943, 1944, 1945, and 1946.

The candy jobbing business was started in 1895 by Joseph S. Singer and his two brothers. About 1924 Joseph S. Singer became sole proprietor and from that time to May 1936, under the trade name of Singer Bros., he operated the candy jobbing business in and around Jersey City, New Jersey. That business was the predecessor of the petitioner. Singer never engaged in any other business. The business started to slip about 1932 and in 1936 credit was shut off by most of the larger creditors. About May 1936 a committee of the creditors was organized and held a meeting to decide the future of the business. A lawyer had been called in by one creditor to institute bankruptcy proceedings but that was not done. The creditors decided to continue the business and elected trustees. The creditors required incorporation of the business with provision for its control by the trustees representing the creditors. The underlying purpose of the arrangement was to obtain the payment of debts incurred by the predecessor business aggregating $ 49,162. The1950 U.S. Tax Ct. LEXIS 40">*43 incorporation of the petitioner on May 8, 1936, was the result. The corporation did not take a transfer of the real estate where the business was located but paid rent to Singer. Having faith in the integrity of Joseph S. Singer the creditors agreed to an arrangement under which the business was to be managed by Joseph S. Singer under the supervision of the trustees chosen by the creditors. Each creditor received a participating certificate dated May 28, 1936, indicating its participation. The certificate was signed by the chairman of the board of trustees. Stock in the corporation was not issued to the creditors but was held in trust by the trustees. The only stock ever issued was issued about 1946, after all creditors were paid. Stock was then issued, in effect, to the estate of Joseph Singer, who had died in December 1942.

Joseph S. Singer as a sole proprietor had had an exclusive distributorship or sole agency for W. F. Schrafft & Sons Corporation (sometimes hereinafter referred to as Schrafft's), covering certain territory in New Jersey and upon a competitive basis with the other jobbers in certain other territory. Schrafft's was the largest creditor. In January 19361950 U.S. Tax Ct. LEXIS 40">*44 Schrafft's took over Singer's accounts and restricted his 15 T.C. 683">*685 credit. Aside from Schrafft products he sold many other items, totaling approximately 1,500 brands. After the incorporation Singer Bros., Inc., continued to handle as many of those brands as possible. Joseph Singer had operated in the Staten Island territory on a competitive basis. That territory was of doubtful value at the time of the incorporation. The trustees gave up the Staten Island territory. It was taken over again in May 1940 and was being serviced at time of trial. Some of the smaller creditors did not go into the arrangement and were paid off immediately. Thereafter the income was divided up between the creditors on a pro rata basis with occasional dividend payments. The first dividend payment was made about a year after the organization of the corporation. Eventually, by about 1946, all creditors were paid off in full.

The customers to whom Joseph S. Singer and later the petitioner sold were small businesses such as stationery stores, confectionery stores, drug stores, and news stands. The trustees after they took over the management were strict with credit. Nothing was done without permission1950 U.S. Tax Ct. LEXIS 40">*45 of the trustees. All checks were signed by one of them. An accountant selected by them checked the books of the business. It was not until about the end of 1938 that there was any relaxation of credit. No new capital was contributed by the trustees. It was necessary to pay all bills promptly in order to get discounts, and some discounts were lost because of inability to pay promptly. Salesmen were employed on a commission basis without salary. Morton I. Singer, the son of Joseph S. Singer, had been connected with the company since 1926, first as a salesman then as assistant to his father. He and other salesmen handled definite trade routes for the business. Delivery was made by truck. After the trustees took over, two or three salesmen were let go and the territory was restricted. The only territory abandoned entirely was Staten Island. The principal creditors who had been suppliers to the business continued to supply the corporation with its needs.

Morton I. Singer felt at the time of the incorporation that the business should be continued, that it was his life as well as his father's. The alternative was bankruptcy and the arrangement was a good one for both the creditors1950 U.S. Tax Ct. LEXIS 40">*46 and the Singers. Joseph S. Singer had built up a good will and a place in the candy industry. Morton I. Singer was in accord with the action taken by the trustees in carrying out the duties imposed by the trust to operate the business and make it a success and pay off the creditors.

Of the purchase discounts received by the corporation from about 1936 to 1940 about 38 to 40 per cent were from Schrafft's. The business done with Schrafft's ran from about 40 per cent in 1937 to 38 per cent in 1938, 1939, and 1940, using fiscal years ending April 30. The bills paid to Schrafft & Sons on which the discounts were applied 15 T.C. 683">*686 amounted to $ 143,781 for the fiscal year ending April 30, 1943. The average discount thereon was 1.91 per cent. The average discount on all purchases for the same year was 1.95 per cent.

The petitioner first reconstructed the base period years using the year ending April 30, 1939, as a basis. The actual sales were pushed back for a 2-year period ¹1950 U.S. Tax Ct. LEXIS 40">*48 with adjustment for expenses that would be directly affected by the increased volume of business such as salesmen's commissions and delivery expenses. Fixed expenses having no relation to sales -- such as rent1950 U.S. Tax Ct. LEXIS 40">*47 -- were not adjusted. The reconstruction contained adjustments for actual purchase discounts lost, and purchase discounts computed upon the larger amount of business considered in the reconstruction as lost, but no adjustment for increase of bad debts. The figure 1.91 per cent was used instead of the usual 2 per cent discount. The percentage 1.95 per cent was used to arrive at the purchase discounts considered lost upon the amount of business considered in the reconstruction to be lost. By this method the petitioner arrived at an average base period net income of $ 12,684. ²

1950 U.S. Tax Ct. LEXIS 40">*49 15 T.C. 683">*687 The petitioner also reconstructed the sales on another basis, using the general trend in the industry as a base and comparing its actual sales with the sales of the confectionery industry as a whole. The calendar year 1939 was used as 100 per cent, and petitioner reconstructed the sales backward for the years 1938, 1937, and 1936. The figures used were those used in a protest filed by the petitioner as to excess profits for 1943. Adjustments were made. Office salaries remained fixed. Sales commissions and delivery expenses were adjusted, as were purchase discounts. Bad debts went up the last year of the base period. In comparison with 1937 they went down in 1938. The sales for the fiscal year ending April 30, 1940, were much higher than the previous year and bad debts were also higher than the previous year. The reconstructed average base period net income arrived at as a result of the second reconstruction, taking the 1939 sales as normal, was $ 9,601. In the second reconstruction no effect was given to the $ 7,200 adjustment for Staten Island.

At a meeting of the board of directors of petitioner on September 10, 1937, it was agreed to have an inventory taken 1950 U.S. Tax Ct. LEXIS 40">*50 every 3 months. The minutes of a meeting of the board of directors held February 25, 1938, recite that "possibly the corporation might be carrying too much stock for the amount of capital which it has, which has a tendency to slow up payments, so that the corporation is not getting the benefit of all the discounts which it should have * * *." The minutes of a meeting of the board of directors on June 10, 1938, recite that the corporation had too big an inventory and that "Mr. Kellman said he would try to have this reduced to $ 20,000 or less." The minutes of a meeting of the board of directors held March 24, 1939, recite as follows:

The matter of the Inventory being carried by the corporation was carefully gone into and it was agreed by all present that this Inventory is altogether too high, namely, about $ 33,000.00. It was decided to notify Mr. Singer that this inventory must be reduced by May 1st, 1939 to a sum not in excess of $ 20,000.00, inasmuch as the corporation is losing the advantage of the discount it could be availing itself of were it not for this very high Inventory, and that if the Inventory was not reduced, someone would be designated to supervise the buying.

The1950 U.S. Tax Ct. LEXIS 40">*51 minutes of a meeting of the board of directors held December 27, 1939 recite that:

* * * the merchandise inventory is entirely too high. * * * and then Mr. Singer would be contacted personally regarding the Inventory.

* * * *

Mr. Singer is to be notified immediately that he is not to increase his payroll or any other overhead expenses without first submitting them to the Trustees for their approval.

Minutes of a meeting of the board of directors on March 15, 1940, recite that:

15 T.C. 683">*688 * * * it was again found that the merchandise inventory was entirely too high. It was agreed by the Trustees to notify Mr. Singer that it will be necessary that his Inventory on the 1st day of April, 1940, should not exceed 110% of the Inventory of the same date for the preceding year.

In computing its excess profits tax for each of the fiscal years ended April 30, 1943, April 30, 1944, and April 30, 1945, petitioner computed its excess profits credit of $ 5,011.03 under the income method under the provisions of section 713 (e) of the Internal Revenue Code, and this basis of computing such excess profits credit was accepted by the respondent.

In computing the excess profits tax for the fiscal1950 U.S. Tax Ct. LEXIS 40">*52 year ended April 30, 1946, petitioner computed an excess profits credit of $ 5,529.86 under the invested capital method under the provisions of section 714 of the Internal Revenue Code, but, because such invested capital credit was reduced upon audit to $ 4,853.31, the alternative credit of $ 5,011.03 under the income method was used in determining petitioner's correct excess profits tax for such year before the application of section 722.

Petitioner's average base period net income, computed under section 713 (e) of the Internal Revenue Code (the so-called 75 per cent rule), for each of the fiscal years ended April 30, 1943, April 30, 1944, April 30, 1945, and April 30, 1946, is $ 5,274.77, determined as follows:

The amount of $ 5,274.77 was used as petitioner's average base period net income in the final determination of petitioner's excess profits tax liability for the fiscal years ended April 30, 1943, April 30, 1944, April1950 U.S. Tax Ct. LEXIS 40">*53 30, 1945, and April 30, 1946, as set forth in the notice of disallowance of petitioner's applications for relief under section 722 for the fiscal years ended April 30, 1943, April 30, 1944, April 30, 1945, and April 30, 1946.

The following schedule shows, in so far as available, for the calendar years 1928 through 1935, and for the fiscal period beginning January 1, 1936, and ending April 30, 1936, the gross sales, sales allowances and sales discounts, net sales, gross profit on sales, net income from business, and purchase discounts of the candy jobbing business operated by petitioner's predecessor, Joseph S. Singer, trading as Singer Brothers: 15 T.C. 683">*689

1950 U.S. Tax Ct. LEXIS 40">*54 The following schedule shows for the fiscal years ended April 30, 1937 to April 30, 1943, inclusive, the total purchase discounts extended petitioner, its total purchases, and the percentage, its purchases from W. F. Schrafft & Sons Corporation and the percentage of purchases from Schrafft to total purchases:

The following schedule shows for the years 1926 to 1939, inclusive, the composite gross sales in millions of dollars for all United States corporations filing Federal income tax returns as compiled1950 U.S. Tax Ct. LEXIS 40">*55 by the Bureau of Internal Revenue and published in "Statistics of Income for 1940," Part 2, pp. 284-285:

The following schedule shows, for the years 1922 to 1939, inclusive, the total combined net profit (or loss) less tax-exempt income plus interest paid, in millions of dollars, of all United States corporations filing Federal income tax returns as compiled by the Bureau of Internal 15 T.C. 683">*690 Revenue and reported in its annual publication entitled "Statistics of Income":

The following are the petitioner's or petitioner's predecessor's net sales for the calendar years indicated:

1950 U.S. Tax Ct. LEXIS 40">*56 Petitioner's net sales, and percentage of net profit, as above appearing, to net sales, by fiscal years in the base period were as follows:

The following table represents a reconstruction of petitioner's average base period net income upon the index of gross sales for all United States corporations using the year 1939 as 100 per cent and applying 1.34 per cent, the percentage of net profit to net sales for the last fiscal year of the base period:

1950 U.S. Tax Ct. LEXIS 40">*57 15 T.C. 683">*691 OPINION.

The petitioner seeks relief from excess profits taxes under section 722 of the Internal Revenue Code, primarily under subsection (b) (4). At the trial the issue was limited to that subsection and on brief only subsection (b) (4) is quoted as being involved. However, petitioner's brief also states that since subsection (b) (5) is "a 'catch-all' provision which has not yet been fully defined by the Tax Court, the way is open in this case for the Court to grant relief under Section 722 (b) (5) if it finds the situation requires." We set forth in the margin the pertinent portions of the basic section 722 (a), (b) (4), and (b) (5). ³

1950 U.S. Tax Ct. LEXIS 40">*58 The gist of petitioner's position is that it "commenced business or changed the character of the business" during the base period within section 722 (b) (4) either because of or at the time of the incorporation in May 1936, or because about 1938 the trustees released the credit restrictions upon petitioner's business.

Considering the conclusions to which we have come, as set forth below, we find it unnecessary to pass upon the question as to whether there was in fact commencement or change of character of the business, for, as the text of the statute shows, the petitioner must not only demonstrate, on its theory, that there was such commencement or change in character of the business but must also demonstrate that "the 15 T.C. 683">*692 average base period net income does not reflect the normal operation for the entire base period of the business." Under the language of section 722 (a) relief is given only to the taxpayer who "establishes * * * what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income * * *." It is stipulated that petitioner's average base period net income computed under section 713 (e) for the fiscal years1950 U.S. Tax Ct. LEXIS 40">*59 here involved is $ 5.274.77 and that amount is used as petitioner's average base period net income in the final determination of its excess profits tax liability.

It is, therefore, incumbent upon petitioner, assuming that it shows commencement of the business or change in character of the business, to reconstruct an average base period net income of more than $ 5,274.77 -- otherwise it would not be shown that its "average base period net income does not reflect the normal operation for the entire base period of the business."

Petitioner has failed to set up such reconstruction and to make the necessary showing. The petitioner presents two reconstructions. The first, "as a result of a two year push back," shows constructive average base period net income of $ 12,684. The second, arrived at by applying the industry index for candy jobbers, used in petitioner's protest, to the petitioner's sales for the calendar year 1939, which is asserted to be normal, shows constructive average base period net income of $ 9.601. Petitioner on brief says that it is entitled to use one of the two figures. We consider the two reconstructions separately:

The first, under the "push back" rule, must1950 U.S. Tax Ct. LEXIS 40">*60 be rejected. The "push back" rule arises from the following language in section 722 (b) (4):

* * * If the business of the taxpayer did not reach, by the end of the base period, the earning level which it would have reached if the taxpayer had commenced business or made the change in the character of the business two years before it did so, it shall be deemed to have commenced the business or made the change at such earlier time. * * *

Not only does the petitioner fail to show that its business did not reach by the end of the base period the earning level which it would have reached if the taxpayer had commenced business or made a change in the character of the business 2 years before it did so, but petitioner's net earnings were greater, in the fiscal years ending in May 1937 and 1938 than they were in the following 2 years. Petitioner has misunderstood the effect of the statutory language above quoted. As shown in the facts, and as stated in the petitioner's brief, in its first reconstruction the petitioner threw the actual sales volume for the fiscal year ended April 30, 1939, back 2 years and then followed the actual rate of increase, in addition to making certain adjustments, 1950 U.S. Tax Ct. LEXIS 40">*61 that is, adding $ 7,200 to sales figures because of abandonment 15 T.C. 683">*693 of Staten Island, adjusting for expenses which would be affected by added sales, and adjusting for purchase discounts. This procedure is not justified by the "push back" rule. In addition, petitioner's first reconstruction can not be accepted, for the following reasons: (a) Petitioner adds in each year $ 7,200 as alleged loss in sales because the trustees abandoned Staten Island upon petitioner's incorporation, but there is no evidence in the record to sustain the $ 7,200 figure. The evidence is that the Staten Island territory abandoned was of doubtful value. There is none as to amount of sales in that territory. Nothing in the record affords a basis for adjustment at $ 7,200 or any other figure because of the Staten Island abandonment. (b) The adjustment for loss of purchase discounts as to Schrafft's was based upon the ratio of purchase discounts earned to payments made to Schrafft's for the fiscal year ending April 30, 1943. Since section 722 (a) specifically provides that in determining constructive average base period net income "no regard shall be had to events or conditions * * * occurring or 1950 U.S. Tax Ct. LEXIS 40">*62 existing after December 31, 1939, * * *," it is obvious that the reconstruction, based in part upon the prohibited facts, is vitiated. (c) Likewise the petitioner made adjustment for estimated loss in purchase discounts "which we would have realized upon the additional purchases arising from the adjustment of our sales volume," and in so adjusting took into consideration the percentage of discounts earned to all purchases for the fiscal year ending April 30, 1943, so that for the above reason this adjustment is not permissible. ⁴ (d) In the first reconstruction adjustment was made for $ 1,400 legal fees disbursed within the fiscal year ending April 30, 1937. Though the evidence is that they were "in connection with reorganization of the business," the record does not justify treating the entire amount as abnormal expenses of the change in business and no allocation of the amount is shown. ⁵ (e) The reconstruction also took into consideration a $ 1,238.16 loss contended to have been incurred to merchandise because of the bursting of some water pipes in the fiscal year ending June 30, 1939. The record before us contains no evidence whatever on the point and no reason appears for1950 U.S. Tax Ct. LEXIS 40">*63 an adjustment for abnormality on that account. No adjustment was made on the first reconstruction for increase in bad 15 T.C. 683">*694 debts. It thus appears that since the figures for adjustment in net profits ($ 6,106, etc.) and adjustment for additional purchase discounts ($ 1,445, etc.) are based upon events or conditions after December 31, 1939, and since the abnormal expenses ($ 1,400 and $ 1,238) are unproven, all of such adjustments must be eliminated, thus leaving the net profits as adjusted by the revenue agent as shown in the claim for relief, therefore leaving the petitioner without showing of any "reconstructed net profit."

1950 U.S. Tax Ct. LEXIS 40">*64 Therefore, even if we were to assume, contrary to our conclusion above, that the "push back" is otherwise justified under the statute, petitioner's first reconstruction must be rejected since it fails to establish any fair and just amount representing normal earnings to be used as a constructive average base period net income.

With reference next to petitioner's second reconstruction of a constructive average base period net income of $ 9,601, it is to be noted that it assumes that the calendar year 1939 was normal, whereas the first reconstruction under the "push back" rule must be upon the theory that the business did not reach by the end of the base period the earning level which it would have reached if the taxpayer had commenced business or made the change in the character of the business 2 years earlier. The second reconstruction is, therefore, inconsistent with the first.

On brief the petitioner says that the second reconstruction "proceeds on the theory that the reorganization in May, 1936, was a change in the character of the business * * *. The reconstruction uses the actual calendar year -- 1939 sales as normal." Passing the question whether, petitioner's last base period1950 U.S. Tax Ct. LEXIS 40">*65 year ending April 30, 1940, it may compute upon the base of its actual sales in the last calendar year, and whether the calendar year 1939 was in fact normal for the petitioner, it appears that the change in 1936 was not substantial in the sense of Regulations 112, sec. 35.722-3 (d), since such change "must be reflected in an increased level of earnings * * *," and the evidence is that the net earnings were greater in the first 2 years of the base period than in the last 2 years. Thus, it appears that any effect, upon earnings, of the alleged change in 1936, was felt only in the first 2 years and the second reconstruction of the whole base period based on such a theory lacks rational basis.

Again we find that the facts in evidence do not support the purported reconstruction. It uses the calendar year 1939 as normal, and adjusts earlier years to it. The figures which petitioner uses as the industry figures for the second reconstruction are those appearing in Joint Exhibit 3-C (a protest, as to excess profits tax for 1943) as to which the stipulation to which it is attached specifically states that the 15 T.C. 683">*695 matters, statements and figures are not stipulated to be true or false; 1950 U.S. Tax Ct. LEXIS 40">*66 therefore, the figures used by petitioner for the industry are not in evidence before us. Moreover, the parties offered as Exhibit 5-E the "Confectionery Sales and Distribution," issued by the United States Department of Commerce, with agreement that the contents were true. The figures in the two exhibits are not the same and they do not give the same results. Petitioner's accountant as a witness stated that the figures in Exhibit 5-E are not the same as those used in the second reconstruction. Petitioner's second reconstruction, therefore, appears to that extent without basis in the evidence. The petitioner suggests that based upon stipulated figures for gross sales for all United States corporations the results would be approximately the same. This is not, however, demonstrated, and it appears from applying the index of such gross sales to petitioner's net sales, and applying 1.34, the percentage of petitioner's net profit to net sales for its last base period year, which it regards as normal, that average base period net income so reconstructed would be $ 4,556.21. Therefore the reconstruction proposed by petitioner does not give the petitioner relief greater than the $ 1950 U.S. Tax Ct. LEXIS 40">*67 5,274.77 computed under section 713 (e).

Moreover, the petitioner has adjusted for purchase discounts as in its first reconstruction, which as above seen is contrary to the provisions of section 722 (a) prohibiting giving regard to events after 1939.

The second reconstruction appears to assume, without proof, that the operational policies of the petitioner's trustees in the last base period year would, if applied to the two first years, have produced net results equal to the greater net profits in those years. The assumption is seen to be unjustified. Arden-Rayshine Co., 43 B. T. A. 314; 7- Up Fort Worth Co., 8 T.C. 52, 63.

We conclude that neither of petitioner's reconstructions establishes a fair and just amount representing normal earnings used as constructive average base period net income, and that they do not demonstrate that actual average base period net income is not an adequate standard of normal earnings or that the average base period net income as computed under section 713 (e) does not reflect the normal operation for the entire base period of the business. We find no reason to apply section 722 (b) (5)1950 U.S. Tax Ct. LEXIS 40">*68 as suggested in the alternative by the petitioner.

We, therefore, conclude that the petitioner has not shown it is entitled to relief under section 722 (b) (4) or (b) (5).

Decision will be entered for the respondent.