5 T.C. 627">*627 The respondent determined deficiencies in the petitioner's taxes as follows:

1945 U.S. Tax Ct. LEXIS 98">*99 Various issues were raised and abandoned. The remaining issues are:

1. The deductibility of $ 15,400 as a part of the compensation paid to Harry Resnick, general manager, for services rendered during 1941.

2. The deductibility of $ 14,000 as a part of the compensation paid to E. J. Shapiro, salesman, for services rendered during 1941.

3. The propriety of imposing a surtax upon the petitioner's income for the year 1941, pursuant to the provisions of section 102, Internal Revenue Code.

FINDINGS OF FACT.

The petitioner is a corporation, organized in December 1925 under Ohio laws, with its principal office in Cleveland, Ohio. It filed its returns for the taxable years with the collector of internal revenue for the eighteenth district at Cleveland, Ohio.

The petitioner has a capital of $ 100,000, represented by 1,000 shares of common stock. Its stock has been held primarily by its incorporators. During the taxable years Harry Resnick owned 238 shares, a 5 T.C. 627">*628 partnership known as the Columbia Iron & Metal Co. (hereinafter called Columbia), and its nominees owned 720 shares, and two individuals owned the remaining 42 shares. The partnership of Columbia was composed of J. Miller; 1945 U.S. Tax Ct. LEXIS 98">*100 his two sons, Alexander Miller and Lewis Miller; and his wife, Ida Miller, each having a share of 25 percent of the net profits after deducting the salaries of the active partners. The petitioner's board of directors is composed of Joseph Miller, president; Alexander Miller, vice president; Lewis Miller, treasurer; and Harry Resnick, secretary and general manager.

The petitioner is engaged in the business of warehousing, processing, and distributing steel sheets, strip steel, and such steel as is to be formed and stamped. It does not handle scrap steel (except such scrap as is made by it), bars, rods or ingots. The major portion of its business is in sheet steel.

The petitioner rents its building, a warehouse 60 feet by 360 feet and 120 feet high, equipped with three 10-ton overhead cranes. It must pay for repairs and maintenance. Petitioner installed four shearing machines and testing apparatus. The offices are separate and apart from the warehouse. The petitioner must keep the warehouse dry and maintain an even temperature therein in order to prevent rust. Rusted material is sometimes reduced to scrap, having only salvage value.

From 60 percent to 65 percent of the petitioner's1945 U.S. Tax Ct. LEXIS 98">*101 purchases are "rejects," that is, a sheet with slight imperfections, due to uneven surface, off-gauge width and thickness, bad drawing, improper rolling or shearing, and other such defects, or to an excess of mill run stock. During the taxable years the petitioner maintained substantial inventories.

In order to supply customers with the required sizes the petitioner cuts sheets or plates accordingly, using four large shears, overhead cranes, testing machines, and other equipment. For the purpose of maintaining its favorable contacts with the large steel mills in its locality, the petitioner is compelled to take as a lot "rejects" of assorted sizes and gauges as selected and offered by the mill. Consequently, sizes not in current demand are included in the petitioner's purchases, thus enlarging its inventory by the excess purchases.

Harry Resnick, as general manager, supervises everything in connection with the petitioner's business, from buying the steel to selling its products and controlling its salesmen. He is in full charge of and directs the petitioner's activities of all kinds and character. He is regarded as the operating head of the business, to which he devotes all of1945 U.S. Tax Ct. LEXIS 98">*102 his time and attention.

Prior to 1941 the petitioner's principal business was in light steel 5 T.C. 627">*629 sold to manufacturers of kitchen utensils, electrical appliances, toys, and lighter automobile parts. In 1941 there were no controls by the United States Government on the manufacture, sale, or use of steel. Sales dropped in 1942, due primarily to the establishment of Government controls.

The petitioner guarantees the steel sold by it. It has not been necessary to spend much money on such guarantees. In a few instances defective stock has been replaced. No reserve is set up on the petitioner's books to take care of its obligations under such guarantee. In 1941 the cost of replacement of defective goods was several thousand dollars.

The petitioner conducts its business in the same building as Columbia. The two concerns have separate offices. The building is owned by the Miller family, the partners in Columbia. There is no business relation between Columbia and the petitioner. The members of the Miller family are not related to Resnick.

Harry Resnick was one of the organizers of the petitioner in 1925, when he was about 39 years of age. Prior to 1925 he had had some 22 years1945 U.S. Tax Ct. LEXIS 98">*103 of experience in the business and management of concerns engaged in the scrap iron and steel business.

Resnick joined with the Millers to organize the petitioner in order to "get into business for himself." He started with a salary of $ 50 a week. The salary from his previous employer was $ 12,800 when he left to form the petitioner corporation.

In 1928 Resnick's salary from the petitioner was $ 9,700 a year. In the following year he reduced it to $ 5,860, approximately where it remained until 1936, when it was increased to $ 10,000. In 1937, 1938, and 1939 his salary was $ 10,400, and in 1940, $ 15,400. It was the understanding between Resnick and the Millers that his salary would be increased when the petitioner's financial condition would so warrant, although no specific amount was fixed.

In 1941 the petitioner's board of directors voted to give Resnick a bonus of $ 30,000. The resolution of the board of directors was as follows:

Minutes of a special meeting of the Directors of the Universal Steel Company held at the Office of the Company at 6600 Grant Avenue, Cleveland, Ohio, on Saturday, December 20, 1941.

Mr. J. Miller, President, acted as Chairman of the meeting and H. 1945 U.S. Tax Ct. LEXIS 98">*104 Resnick as Secretary. Messrs. Lewis Miller and Alex Miller, the other directors, were present.

After an examination of the financial affairs of the Company and a determination that the earned surplus was sufficient for the purpose, it was moved by Lewis Miller that a dividend amounting to $ 8.00 per share be paid forthwith 5 T.C. 627">*630 to all shareholders of record this date. This motion was seconded by Alex Miller and carried by unanimous vote.

The Chairman then suggested that in view of the fact that sales during the year 1941 were approximately three times as great as in the previous year, occasioned largely by the extraordinary efforts of Mr. Harry Resnick and partially to the efforts of salesmen, additional compensation to them was in order. Lewis Miller then moved that the sum of $ 48,250.00 be set aside for the payment of bonuses, that out of said sum $ 30,000 be paid as additional compensation to Harry Resnick and $ 18,250.00 be paid to various salesmen selected by Harry Resnick and in amounts determined by him. This motion was seconded by Alex Miller and carried by unanimous vote.

There being no further business before the meeting, same was duly adjourned.

The Millers had1945 U.S. Tax Ct. LEXIS 98">*105 rejected requests for salary adjustments in prior years because they were dissatisfied with Resnick's actions in granting credit to the Rochester Manufacturing Co. and others, with his refusal to scrap a large amount of "old inventory," consisting of accumulated sheets in bad condition, and with a continuing debt, running as high as $ 50,000, due to Columbia.

In 1939 the Rochester Manufacturing Co. account, at times as much as $ 32,000, was settled with a loss of about $ 1,100. By 1940 the petitioner paid all of its debts to Columbia and the "old inventory" was sold at a profit. In that year, for the first time in the history of petitioner, it was out of debt.

In 1941 the Millers had no further excuse for objecting to the payment of a higher salary to Resnick. Resnick's salary for 1941 was $ 10,400. The total of salaries of officers in 1941 was $ 50,800. The amount of $ 30,000 so paid by the petitioner was fair additional compensation for Resnick's services for the taxable year.

E. J. Shapiro, a graduate of Ohio State University, was employed by the petitioner during the latter part of 1939. He is not related to any of the petitioner's officers and he was never an officer thereof. 1945 U.S. Tax Ct. LEXIS 98">*106 Resnick needed a salesman to secure new customers for the petitioner's products. He trained Shapiro for about six months in the office and plant and sent him out with other salesmen for three months. Shapiro was then instructed to solicit new accounts and also to contact older trade. He was given the worst accounts by the petitioner for his own development and for the good of the company.

Resnick started Shapiro at $ 25 a week and promised to "take care of him as soon as he produced." In 1939 Shapiro secured 2 new accounts, amounting to $ 413.90; in 1940, 20 new accounts, totaling $ 20,139.97; and in 1941, 30 new accounts (some repeat orders from previous new customers), aggregating $ 45,234.67. He left the petitioner's employ in April 1942 to enter the military service. During the few months of that year he secured orders of $ 21,763.59 credited to his new account. Shapiro's customers were chiefly in Cleveland, 5 T.C. 627">*631 but he sold to concerns in Akron, Canton, Columbus, and 12 other smaller cities in Ohio.

On December 20, 1941, the petitioner's directors authorized Resnick to distribute $ 18,250 to its three salesmen as additional compensation or bonuses, in amounts to be1945 U.S. Tax Ct. LEXIS 98">*107 determined by him. Thereupon, of such sum Resnick gave Shapiro $ 16,000. A second salesman received $ 2,000, and the third received $ 250. The sum of $ 4,500 is a fair and adequate amount of additional compensation or bonus for Shapiro's services as paid in the year 1941.

The petitioner began business in 1926. It had financial difficulties characteristic of new concerns, especially through the depression. It was compelled to borrow from the Guardian Bank, which closed its doors, and then from the Millers (or Columbia). It owed the Millers about $ 35,000 in 1935. It did not have sufficient working capital. For five or six years prior to 1939 the petitioner carried one large customer's account and several smaller ones, all hazardous.

It also was compelled to maintain large inventories of steel, purchased in considerable quantities and including odd sizes, in order to anticipate the demands of its customers. Unpredictable conditions required unusually large commitments for stock and a commensurate amount of available cash.

Following the acquisition of steel the petitioner warehouses it and proceeds to find buyers. Sheets and plates are cut to size, cleaned, pickled, etc., according1945 U.S. Tax Ct. LEXIS 98">*108 to demand. To avoid loss through oxidation, equipment designed to maintain constant temperature and humidity must be employed in the warehouse. Often the sheet steel rusts very quickly and has no value except as scrap or salvage material.

Competition was becoming more keen during the years prior to the taxable year and the petitioner needed certain additional equipment in order to keep abreast with its competitors. It had no pickling equipment and the charge for pickling increased materially. Subsequent to 1941 the petitioner was very much restricted in its activities, due to war regulations. Price controls went into effect about the middle of 1942.

The petitioner's sales for 1940 were $ 537,426.37; for 1941 they were $ 1,652,314.96, or an advance of more than 200 percent. Sales for the first quarter of 1942 exceeded sales for the comparable prior year period. The petitioner's purchases during the first quarter of 1941 totaled $ 183,910.12. During the same quarter of 1942 purchases totaled $ 311,456.04, an advance of $ 127,545.92.

During 1941 inventories were low. In December 1941 the inventory level was raised, and it was maintained in 1942 at a much higher figure.

5 T.C. 627">*632 1945 U.S. Tax Ct. LEXIS 98">*109 The petitioner's practice has been to discount its bills within 10 days. At the end of December 1941 it had bills payable of $ 29,320.49. The petitioner's purchases during December 1941 were $ 126,157.83. The petitioner's collection experience shows that, while little has been lost during the past, payments are made on a 30-to 45-day basis. Prior to 1941 some accounts were carried as long as 6 months.

During the latter part of December 1941 the petitioner's board of directors gave consideration to its general financial condition, the possibility of declaring and paying dividends, etc. Resnick, as managing head of the business, explained that an income of $ 300,000 was anticipated for the year, this figure having been reached through a prognostication that the closing inventory would be about $ 82,000. The petitioner's accountant gave his report of the tax based on such income. Resnick made a recommendation against the payment of anything beyond a small dividend, pointing out that heavy purchase commitments had been made for the following year and that such commitments had been predicated on an anticipated continuation of the petitioner's increase of business. Resnick also 1945 U.S. Tax Ct. LEXIS 98">*110 pointed out the probability that prices might continue to advance and that the commitments, running about $ 350,000 for the first three months of 1942, might be increased.

The directors concluded that if the petitioner should declare a larger dividend than 8 percent it would not have ample funds to carry on the business because of the increase of purchases and sales and the necessity for new equipment. They also desired to avoid the troubles of earlier years caused by borrowing.

The inventory, completed about March 1, 1942, was underestimated by about $ 36,000 and the final computation, made after that date, showed the petitioner's income for 1941 to be approximately $ 367,000.

A further reason then assigned by the petitioner's officers for not paying a dividend, to conform to the 70 percent rule set forth in the Treasury decision relative to section 102 (a regulation discussed by the petitioner's directors and its accountant), was the tentative plan to obtain pickling equipment costing about $ 50,000, a slitter costing $ 10,000 or $ 12,000, a roller leveler costing $ 10,000, and additional shears.

Steel must be pickled in order to remove the scale therefrom. Scale injures the dies1945 U.S. Tax Ct. LEXIS 98">*111 of the stampers. The petitioner was required to send such of its steel as required this treatment to other plants for pickling. The petitioner's officers discussed the matter of obtaining priorities for the pickling plant equipment with officials of the War Production Board and were told by them that such priorities could not be secured. On March 13, 1942, upon the recommendation of its stockholders, the 5 T.C. 627">*633 petitioner's directors, by resolution, set aside $ 25,000 in cash as a "pickling plant fund." They also agreed that further sums would be added to the fund as the company's financial condition might permit. The petitioner has available space set aside for the plant.

Petitioner now pays as high as $ 14 per ton for pickling, including the cost of extra trucking. The same cost in its plant would not be more than $ 5 per ton.

The comparative balance sheets of the petitioner as of December 31, 1939, to December 31, 1942, inclusive, are as follows:

The petitioner's surplus account from December 31, 1934, to December 31, 1942, inclusive, according to its books, was as follows:

1945 U.S. Tax Ct. LEXIS 98">*113 5 T.C. 627">*634 The petitioner's book income and expense statement for the calendar years 1939, 1940, and 1941, inclusive, is as follows:

1945 U.S. Tax Ct. LEXIS 98">*114 The amounts paid by the petitioner as compensation to its officers for the years 1926 to 1941, inclusive, are as follows:

The relationship between officers' salaries and gross sales and the percentage of taxable income to gross sales for the years 1935 to 1941, inclusive, are 1945 U.S. Tax Ct. LEXIS 98">*115 as follows:

The figures in all of the above statements do not take into account1945 U.S. Tax Ct. LEXIS 98">*116 the adjustments to revenue agents' reports.

In 1941 there was a large increase in the production of steel products throughout the United States and corresponding increase in goods made from steel sheets and strips, due chiefly to war purchases. From 50 percent to 60 percent of petitioner's customers were engaged in defense work.

A distribution of the entire earnings of the petitioner for the year 1941 would have increased the surtaxes chargeable to the petitioner's stockholders, Harry Resnick, and the four members of the Miller family, as follows:

In its 1945 U.S. Tax Ct. LEXIS 98">*117 income tax return for the year 1941 the petitioner deducted the sums of $ 40,400 and $ 17,850.24 paid to Harry Resnick and to E. J. Shapiro, respectively, as compensation for their services. In his notice of deficiency the Commissioner allowed $ 25,000 as reasonable compensation for the services rendered by Resnick and $ 3,850.24 as reasonable compensation for services rendered by Shapiro. The Commissioner also held the petitioner subject to surtax for the year 1941 under the provisions of section 102 of the Internal Revenue Code.

The petitioner was not availed of for the purpose of preventing the imposition of surtax upon its stockholders.

OPINION.

The first and second issues present the question of the proper compensation of Resnick and Shapiro as the petitioner's general manager and salesman, respectively, for the year 1941. The 5 T.C. 627">*636 background and history of Resnick's connection with the petitioner and his duties as its supervising head are well established. The record shows that Resnick was largely responsible for the petitioner's successful operation since its formation in 1925. He carried it through periods of financial stress with a voluntary reduction of salary and1945 U.S. Tax Ct. LEXIS 98">*118 with the tacit understanding that, when the company should become financially able to do so, appropriate adjustment of his compensation would be made.

During the years prior to 1941 three obstacles stood in the way of such adjustment: First, the existence of the shaky Rochester Manufacturing Co. account; second, the unliquidated "old inventory" composed of accumulated stock which could have been sold only at a loss prior to 1940; and, third, a continued obligation to Columbia (the Miller family) for the repayment of large amounts of money borrowed from them. While these conditions existed, the petitioner's directors were reluctant to increase Resnick's salary.

The Rochester Manufacturing Co. account was closed with only a comparatively small loss. This result was accomplished largely through Resnick's efforts. Then the debts to Columbia were fully paid. And, finally, the "bad inventory" which had been retained by Resnick over the vigorous protests of the Millers was liquidated at a handsome profit. These fortunate events removed the objections of the petitioner's directors and consequently the appropriate adjustment of Resnick's salary was made by way of a bonus or additional1945 U.S. Tax Ct. LEXIS 98">*119 compensation. The increase in the petitioner's sales during 1941 from $ 537,000 to $ 1,692,000 under Resnick's supervision was a potent argument for additional compensation.

Under all the facts and circumstances, the total amount of $ 40,400 paid by the petitioner to Resnick in 1941 was reasonable, fair, and proper compensation for the services rendered by him in that year, and it is approved.

In 1941 the petitioner paid Shapiro $ 17,850.24 for his services as salesman. Shapiro had come to the petitioner in 1939 and had been given specialized training to sell the petitioner's products. At first he was given a small salary with the promise of a proper adjustment if he "produced." He secured a number of new accounts and likewise "serviced" old accounts. He accomplished his duties to the complete satisfaction of the petitioner's officers. Resnick allotted to Shapiro $ 16,000 of the $ 18,250 authorized by the petitioner's directors to be distributed to its salesmen as bonuses. We do not share Resnick's opinion of the worth of the young salesman to the company. In view of all the facts we feel that a total payment of $ 4,500 is reasonable and adequate compensation for Shapiro's 1945 U.S. Tax Ct. LEXIS 98">*120 services by way of a bonus.

5 T.C. 627">*637 The third issue presents the taxability of the petitioner for the year 1941 under the provisions of section 102 of the Internal Revenue Code. The determination of this question, as in the preceding issues, rests on the facts. See Helvering v. National Grocery Co., 304 U.S. 282">304 U.S. 282, and many similar cases. In the numerous discussions and conclusions in cases of this character there is no set standard of measurement. Prominent factors in one case may become minor in another. Petitioner has the burden of establishing by a clear preponderance of the evidence that it did not permit its earnings or profits to accumulate beyond the reasonable needs of the business.

There are certain familiar features, needing neither detailed definition nor supporting citations, which unmistakably mark the conduct of a taxpayer as within or without the law. The petitioner predicates its position on certain "facts" which, its counsel contends, show conclusively that it is not taxable under section 102. They may be summarized as follows:

1. Petitioner was engaged in a hazardous business which had just passed the usual "growing pains" 1945 U.S. Tax Ct. LEXIS 98">*121 period.

2. Certain explainable errors of estimation of 1941 income and inventory occurred.

3. Petitioner categorically denies any intent to use the corporation to shield the stockholders from taxes.

4. In this case a minority stockholder, as general manager, was in complete control of operation of the business.

5. Its conduct was marked by the adoption of sound business policies based on the outlook under most unusual and highly competitive conditions.

6. There was pressing need for additional material and improved methods of preparation and servicing of goods.

7. We have a situation where the capital retained by the petitioner was less than the amount needed to finance its business for the succeeding three-month period and there was involved the operation of a business during one of the most erratic periods in history and under rapidly changing governmental controls.

8. The operations of the business were conducted under a buying program over which petitioner had little control but was dependent upon the vagaries of mill development, with the consequent necessity of keeping a strong financial position.

To this summary we may add that the petitioner had a consistent prior dividend1945 U.S. Tax Ct. LEXIS 98">*122 record; that its officers and stockholders borrowed or withdrew no money from it, and that it invested no funds in securities or investments unrelated to its business. It is also to be borne in mind that the year 1941 was, as one witness expressed it, a "flash year," in which petitioner tripled its business over 1940, and that, 5 T.C. 627">*638 while the total for 1942 showed a leveling off toward normal, the sales in the first quarter of 1942 were greater even than those in 1941. There is no contention that petitioner was formed for the purpose of preventing the imposition of surtax on its shareholders or the shareholders of any other corporation.

The respondent's counsel cites many cases which are more or less helpful in appraising the situation but which need not be noted, briefed, or distinguished here. He then attempts to analyze and compare the figures relating to the several years prior to 1941 with the year 1941, and concludes therefrom that the petitioner had ample funds with which to pay additional dividends.

Petitioner's profit after taxes for 1941 was $ 134,756.59. The question is: Did petitioner act prudently under the law in distributing only $ 8,000 in dividends, or, 1945 U.S. Tax Ct. LEXIS 98">*123 to state the question otherwise, was petitioner justified in concluding that it was good business practice to retain a sufficient margin of funds to cover the uncertainties inherent in the situation, to provide possible additional facilities, and to maintain a strong liquid position?

The petitioner contends that it had urgent need for additional equipment, such as a pickling plant, slitter, shears, and roller leveler. The record discloses that the pickling plant, slitter, and roller leveler would cost about $ 72,000. No cost was alloted to the shears, but the petitioner's counsel claims that the entire cost of the additional equipment would range from $ 75,000 to $ 100,000. The respondent argues that, even if the petitioner were correct in its estimate, it took no positive action toward meeting the alleged needs for such equipment.

The respondent's position is but partially supported by the record. The petitioner has shown conclusively that it was seriously handicapped in its business by the lack of the required equipment. It took steps to secure the necessary priorities, but was told by the War Production Board that it would be given no priorities to obtain the facilities from1945 U.S. Tax Ct. LEXIS 98">*124 the manufacturers. Any formal application to the War Production Board, therefore, would have been a useless gesture. It then set aside $ 25,000 in a special fund for the purchase of the pickling plant. About one-half of the petitioner's customers were engaged in war production. We believe the petitioner had a right to hope, if not to expect, that the War Production Board restrictions would be lifted as the proportion of its war industry customers might rise.

We believe that in the situation in which petitioner found itself, considering the whole picture, the ratio of working capital to sales, the prospective increase in sales, the reasonable desire and plans for increased facilities, the absence of any history of prior accumulations, the fact that the law does not envision the stifling of normal growth, together with other facts of record, petitioner acted prudently 5 T.C. 627">*639 and has proven by a clear preponderance of the evidence that it did not permit its earnings or profits to accumulate beyond the reasonable needs of the business. It follows that it has justified the nonpayment of dividends beyond the $ 8,000 declared and that petitioner is not subject to the provisions of1945 U.S. Tax Ct. LEXIS 98">*125 section 102.

The petitioner was no "incorporated pocketbook" of a single individual or a group of wealthy stockholders who used it for holding or investment purposes. The complete absence in its balance sheet of any loans to officers or stockholders and of any investment or securities unrelated to its business tends to confirm its lack of either an intent to circumvent the law or of action imputing a "purpose of preventing imposition of the surtax upon its stockholders * * * through the medium of permitting its earnings and profits to accumulate instead of being divided or distributed." Its accumulations in 1941 were impelled by sound and cogent business reasons and were not beyond the reasonable needs of its business (section 102 (c)). As we have found as a fact, it was not availed of for the proscribed purpose.

Decision will be entered under Rule 50.