9 T.C. 1132">*1132 The Commissioner determined deficiencies in excess profits tax of $ 132,190.90 and 1947 U.S. Tax Ct. LEXIS 10">*12 $ 191,695.64 for 1941 and 1942. The questions involved are: (1) Whether the petitioner is entitled to relief under section 721 because of abnormal net income of the class described in section 721 (a) (2) (C) attributable to prior years, and (2) whether the amounts paid as certain officers' salaries in 1941 and 1942 were excessive.

FINDINGS OF FACT.

The petitioner was incorporated under the laws of California on September 12, 1934. It filed its returns with the collector for the first district of California.

The petitioner was caused to be formed by William W. Eitel and Jack A. McCullough, for the purpose of manufacturing and improving vacuum tubes in the high frequency field. In 1934 there was relatively 9 T.C. 1132">*1133 little commercial activity in the high frequency field. Eitel and McCullough were primarily interested in tubes generating power at high frequencies. Tubes generating power at lower frequencies were being manufactured in large volume on a production line basis by well established tube manufacturers.

Both Eitel and McCullough had been radio amateurs, actively interested in radio since their early youth.

In about 1929, when he was 21 years of age, Eitel was employed by1947 U.S. Tax Ct. LEXIS 10">*13 Heintz & Kaufman, Ltd., of San Francisco, California, which company manufactured vacuum transmitting tubes almost exclusively for Globe Wireless, of which it was a subsidiary. In 1930 McCullough, then about 22 years of age, entered the employ of the same company. During the period of their employment with Heintz & Kaufman, Ltd., which ended shortly prior to the organization of petitioner, Eitel and/or McCullough developed at least fifteen inventions relating to anode structure, electrode supporting structure, amplifier, metal-to-glass seal, vacuum tube grid, electrode mounting, method of making thermionic tube grids, electrode support, method of forming electrodes, V-shaped filament support, thermionic tube stem machine, glass working apparatus, cathode, induction heating of enclosed elements, and support for multiple filaments.

A few months before Eitel and McCullough left the employ of Heintz & Kaufman, Ltd., that company advertised for sale a new transmitting tube with 100 watt output, designated the "354 Gammatron" and featuring (a) no getter to impede heat radiation, (b) no plate supporting collar on stem, (c) no internal insulators, (d) grid and plate of tantalum, and (e) 1947 U.S. Tax Ct. LEXIS 10">*14 thoriated tungsten filament.

Upon the organization of petitioner, Eitel and McCullough, together with one employee, immediately began to design and build a vacuum transmitting tube in a small shop located in San Bruno, California. Eitel and McCullough naturally relied to a large extent upon the knowledge and experience acquired by them during their employment with Heintz & Kaufman, Ltd. It was their intent to build for petitioner a better tube than any made by that firm or any other tube manufacturer and, in doing so, to avoid infringement upon any patent held by Heintz & Kaufman, Ltd., or any one else in the industry.

Petitioner did not manufacture any equipment in which its tubes could be used. Hence, its sales outlet was limited. Up to 1940 about 75 per cent of sales were made to individuals or organizations interested in developing equipment in the high frequency field, in which tubes of other manufacture had not given the service required or had failed. It also made sales to amateur operators. By 1940 petitioner was selling tubes to airlines and commercial users.

The first tube completed and sold in 1934 was the 150T, meaning 150 watts dissipation on the plate in a triode1947 U.S. Tax Ct. LEXIS 10">*15 or three-element tube. 9 T.C. 1132">*1134 The three-element tube, consisting of the filament, grid, and plate, was discovered in 1907 and the basic patents relating to it had expired.

The 150T was built with bulb-shaped glass envelope, metal base, tantalum plate having leads sealed to upper stem and connected to cemented cap, tantalum grid supported on glass flare of lower stem with a lead sealed to side wall and connected to cemented cap, and a pair of hairpin filaments of thoriated tungsten connected to leads sealed to lower stem.

In advertisements announcing the 150T type tube, the following points of superiority were stated: High degree of vacuum, gas-free metals, tantalum grid and plate, absence of getter, and thoriated tungsten filament. Although this tube and the 50T, the second tube type built and sold in 1934, had features similar to those of the 354 Gammatron made by Heintz & Kaufman, Ltd., they were different in appearance and construction. Structural changes were made to overcome some of the difficulties encountered in the use of the 354 Gammatron. The general design of the 150T was not common in the industry.

The 150T and 50T type tubes were not entirely satisfactory. It1947 U.S. Tax Ct. LEXIS 10">*16 was found that the manufacturing technique and processes previously known and used were inadequate. Experimental work continued as tubes were built, not only in the various structural parts and design of the tubes, but also in the processing and treatment of the elements or parts used and in assembling them. Each tube was made by hand. It was necessary to design and make tools and other equipment for use in the manufacture of the tubes. Equipment necessary to produce tubes on a mass scale was made beginning in about the latter part of 1940. To eliminate as much as possible the failure and break-down of tubes, a testing method or procedure was developed which was unique with petitioner. During this procedure each tube was submitted to very exacting conditions which disclosed defects, if any. As changes were made to improve a tube in order to correct its irregularities or defects, new problems were encountered which had to be solved so as to produce a properly functioning tube.

To improve the 150T and to overcome some of the difficulties and faults disclosed by its use, the plate leads were connected to a terminal button, the grid lead cap was eliminated, and a filament tensioning1947 U.S. Tax Ct. LEXIS 10">*17 device was added. The filament tensioning device was a problem upon which Eitel and McCullough had worked at Heintz & Kaufman, Ltd., but which had not been solved satisfactorily at the time they left that concern. The petitioner later, prior to 1941, obtained a patent (No. 2,240,557) on the device. In July 1942, in settlement of certain litigation instituted by Heintz & Kaufman, Ltd., against petitioner involving patents owned by petitioner, the latter granted to Heintz & Kaufman, Ltd., a royalty-free, nonexclusive, noncancelable license under the 9 T.C. 1132">*1135 above patent for its life. Under the agreement similar license was granted to Heintz & Kaufman, Ltd., under patent No. 2,134,710, covering a method and apparatus for exhausting tubes for which patent application was filed June 1, 1936, as well as patents Des. 127,757 and Des. 127,758, all of which patents had been obtained prior to 1941.

The tube 150T so changed was rerated and named the 250T. It was rerated because it had more capabilities than the original tube and because it would be easier to sell at the same price at the higher rating. The tube was made with a high MU and with a low MU and named 250TH and 250TL, respectively. 1947 U.S. Tax Ct. LEXIS 10">*18 MU is a designation used in describing the control exercised by the grid on the plate. The essential difference was in the grid design. Certain transmitting radio equipment worked better with a high MU tube and certain other such equipment worked better with a low MU tube. Petitioner built both so as to cover all applications or uses of the tube of its size.

In 1936 the 250T contributed substantially to the art of transmitting tubes. There was nothing like it available and, therefore, petitioner had no competitors as to this tube. It was used in communication equipment, both civilian and later in high priority equipment used by the Army and Navy during the war.

During 1938 the 250T was changed by having the grid supported on a side lead instead of on the stem, which improved its high frequency capabilities by lowering the interelectrode capacity between the grid and filament and allowing more grid voltage to be used. This particular feature was important in radar work and was unique with petitioner. During the same year the filament tensioning device was improved by using a pusher sleeve instead of rods, which made a more reliable filament structure, preventing it from warping1947 U.S. Tax Ct. LEXIS 10">*19 after many hours of use. This improvement was new with petitioner. During 1939 a shield was added to the filament stem to keep the radiant heat off the filament stem and prevent it from cracking, which had occurred in many of the tubes. This change prolonged the life of the tube. During 1941 a single plate lead was used, a plate hat was added, and a shield on grid lead included. The single plate lead and plate hat were used to prevent stray electrons from bombarding the seals, bulb, and outside of plate. They increased the efficiency of the tube at high frequencies and also prolonged its life by overcoming punctures due to the bombardment by electrons in the envelope which allowed air to enter.

The second tube built and sold in 1934 by petitioner was the 50T. It was a triode built with bulb-shaped envelope, metal base, tantalum plate having leads sealed to upper stem and connected to cemented cap, tantalum grid supported on lower tripod stem with a lead sealed to side wall and connected to cemented cap, and a M-shaped thoriated tungsten filament with leads sealed to lower stem. The bulb-shaped 9 T.C. 1132">*1136 envelope and the metal base were typical in the industry. Having leads1947 U.S. Tax Ct. LEXIS 10">*20 sealed to upper stem and connected to cemented cap was not a common method of fabrication of this type of tube in the industry in 1934, nor were the other remaining features common in the industry.

At some time after 1934 the M-shaped filament was changed to a spiral filament, of a short heavy construction on which the diameter of the wire was larger than had been used in the industry up to that time in a tube of this type. The use of this larger diameter wire required a new method of processing to activate it, which method was developed by Eitel and McCullough. Petitioner was not a pioneer in the use of a spiral filament, nor was it the first tube manufacturer to use a thoriated tungsten filament. The metal base was changed to a ceramic base. Both were used in the industry. The change had no effect upon the efficiency of the tube. The plate leads were connected to a terminal button. Experience with the tube disclosed that the heat developed at high frequency melted the solder at the connections of the leads and overheated the cement basing. To eliminate such difficulties, the improved type connector was developed. Connecting the plate leads to a terminal button was not a1947 U.S. Tax Ct. LEXIS 10">*21 common practice in the industry and contributed substantially to the efficiency of the tube at high frequency, which was the end sought. The grid lead cap caused overheating in the operation of the tube at high frequency and was eliminated. The industry generally used metal caps and the elimination of the grid lead cap was a departure from the common practice in the industry. Sometime during 1936 the tube as changed was rerated and named the 100T, as experience indicated that the tube would handle more power. It was made with a high MU and with a low MU.

After 1936 the envelope of the 100TL was changed to one with a straight side with annular bulge; twin lateral leads were provided for plate and grid and the filament stem was simplified. Later a second spiral was added to the filament, the base removed and solid filament leads extended, and plate and grid supports and seals improved. The tube so changed was designated in 1938 the 100TS.

Experimental use of the 100T in radar development disclosed that it had the necessary stamina and characteristics to give satisfactory results. The changes from which the 100TS evolved were logical improvements to meet the requirements of operation1947 U.S. Tax Ct. LEXIS 10">*22 at very high frequencies and very high voltages in radar equipment. The 100TS was sold to the Army Signal Corps laboratories. At that time radar was a secret and petitioner did not know that the tubes were used in the development of radar, being given merely a rough idea of what was wanted and what was sought to be accomplished.

To prevent cracking of the stem due to excessive heat, which had occurred after continued operation, a stem shield was added in 1940. Late in 1940 the Signal Corps designated the tube as the "VT127." 9 T.C. 1132">*1137 To prevent puncturing of the envelope by the bombardment of stray electrons, a plate hat was added in 1940. The same type tube with a platinum grid was designated "VT127A" by the Signal Corps.

In 1940 petitioner was also working with the Naval Research Laboratory. As more power from a small tube was required for Navy search radar, changes were made in the 100T to meet such requirements. This included the incorporation of a heavier filament by using a series double spiral of larger wire and using a high MU grid. This tube was first named the "VT127 Hi-1941", but later in 1941 it was named the "227." Same type tube with a platinum grid was designated1947 U.S. Tax Ct. LEXIS 10">*23 "227A."

After experimenting with single vertical plate leads late in 1940 or early 1941, its use became practical in 1941. The tube in which such lead was incorporated was named the "327." The change made it possible to obtain more power and to use more plate voltage. It was not operated in the same manner as the 227. Its end use was shipborne search radar and it was developed for the Naval Research Laboratories. The same type with platinum grid was called "327A."

In 1936 an experimental tube was built along the lines of the 100T but of smaller size to fit in smaller installations or equipment. Work continued on this type tube from time to time until the early part of 1939, when the tube was considered ready to be put into production for practical use and sale. It was named the 75T and was used in amateur stations and low power radio transmitters. Except that the plate lead came out of the top and the grid lead out the side near the bottom, its other characteristics were identical with the UH51, first sold in 1938.

The 152T and the 304T, the first embodying two 75T units in a single envelope and the second embodying four 75T units in a single envelope, were completed for practical1947 U.S. Tax Ct. LEXIS 10">*24 use before the end of 1940.

The 152T was used chiefly in amateur radio transmitters and in some commercial radio installations with both telephone and telegraph.

The 304T resulted from the efforts of petitioner to make a better tube which would operate at low plate voltage and give high power outputs. Experiments showed that the 304T had four times the power at the same plate voltage used in the 75T. It was a tube of very high current-handling capacity and for that reason was of considerable aid in the radar development program. Although not designed for that purpose, its chief use later was in Signal Corps and Navy radar equipment. It was used in submarine radar after 1941. The tube was unique with petitioner.

In 1941 a shield was added to prevent both heat and electrons from bombarding the filament stem, which impaired the efficiency of the tube and caused cracking of the stem. In 1942 the grids were unitarily 9 T.C. 1132">*1138 supported on a single lead to better the tube electrically and made it more dependable for radar use, to which the tube was being applied in great numbers at that time. The same change was made in the 152T in 1942.

The sales in number and value of the tube1947 U.S. Tax Ct. LEXIS 10">*25 types heretofore mentioned were as follows:

1947 U.S. Tax Ct. LEXIS 10">*26 The following schedule shows the various tubes developed and produced for sale by petitioner, listed in the year in which sales thereof were first made:

Petitioner's tubes were designated as "Eimac" tubes.

The 15E was first used about 1941 in Navy airborne radar equipment. Its performance was phenomenal. It was the smallest and most compact high frequency radar tube which had been designed up to that 9 T.C. 1132">*1139 time and was unique with petitioner. Its sales in number and in value from the time it was first offered for sale through 1942 were as follows:

The 15R is a small rectifier and was developed with the 1947 U.S. Tax Ct. LEXIS 10">*27 15E. It was used in both Navy airborne and shipborne radar. Its sales in number and in value from the time it was first offered for sale through 1942 were as follows:

The 158VT, a high frequency power radar tube, was developed in conjunction with the Army Signal Corps. Its sales in number and value were as follows:

The 53A was used in some form of radar equipment. Its sales in number and value were as follows:

The UH50 was used in some naval ground plane landing equipment for blind-landing aircraft. Its sales were as follows:

One of the uses of the 300T was in hospital diathermy machines. It was replaced by the 450T. By 1940 the 450T was standard in nearly all airline ground stations throughout the United States. It was also used in broadcast stations, in police radio systems, and in Army radar equipment.

9 T.C. 1132">*1140 The sales of the 300T, 450TL, and 450TH 1947 U.S. Tax Ct. LEXIS 10">*28 were as follows:

The tube 500T was replaced by the 750T, which was used in naval communication equipment and broadcast transmitters and for other purposes. The sales of such tubes were as follows:

The Naval Research Laboratory also used the 35T type tube in its radar experiments. The sales of that tube were as follows:

The 1000UHF was used in certain modulation experiments and also by the Army1947 U.S. Tax Ct. LEXIS 10">*29 Signal Corps. The sales thereof were as follows:

The total number of tubes sold each year from 1934 to 1942, inclusive, was as follows:

9 T.C. 1132">*1141 All of petitioner's triodes are traceable to the fundamental structure embodied in the original 50T and 150T built in 1934. While subsequent tube types were built in different sizes, shapes, and arrangements of the parts to satisfy different kinds of services or use, all of the tubes possessed the distinctive cylindrical plate and cage type grid structure characterizing the first tubes designed and built by petitioner. As changes or improvements were made in one tube type, they were promptly introduced whenever applicable to the other types. Petitioner endeavored at all times after its organization to improve its products and experimented to that end. Some changes were made in tubes to overcome limitations or defects disclosed by their use by customers. New tube types were1947 U.S. Tax Ct. LEXIS 10">*30 built to meet and satisfy the needs and demands of customers, to meet or excel products of petitioner's competitors, and to establish and complete a comprehensive line of tubes for sale.

Early in 1934 the Naval Research Laboratory began its experimental work on radar. By 1936 equipment had been built which would operate at a frequency of 28 megacycles. This equipment was too large for use on ships. In addition to reduction in size, operation of the equipment at a frequency of a minimum of 200 megacycles was required. In June 1936 work was begun on 200 megacycles for radar. The major part of the time until about January 1938 was spent in trying to find a vacuum tube that would stand up under the necessary voltage and deliver the necessary power at 200 megacycles or higher. Every tube available, including the 354 Gammatron, was tried out. The Naval Laboratory worked with laboratories of well established tube and equipment manufacturers, but it was unable to obtain any tube which would stand up under the required voltage or provide the power. All tubes used had power limitations of a few hundred watts per tube in radar application. The minimum required was about 10 kilowatts. 1947 U.S. Tax Ct. LEXIS 10">*31 The first of petitioner's tubes, the 100T, was used in about January 1938. This tube, which had been built for commercial purposes, gave power of 3 kilowatts per tube. With the use of six 100TH tubes in an oscillator, power of 20 kilowatts operating at 200 megacycles was obtained. The radar set built around that tube was completed and tested in about February 1938 and all performance requirements were met. A subsequent test on a ship was successful and 20 sets were immediately ordered. Nineteen of these sets had been installed on ships at the time of the Pearl Harbor attack and played a prominent role in the early months of the war.

The next tube used by the Naval Laboratory was the 227 in a type of Navy search radar. The tube was capable of giving about 75 kilowatts per tube.

9 T.C. 1132">*1142 There were no tubes manufactured at that time comparable to the 100T or 227. A well established manufacturer of equipment attempted to duplicate these tubes in order to sell its own tubes with its equipment manufactured by it for Navy use, but none of the tubes developed by it were successful. Most of them would not stand the required voltage and failed prematurely. Later other equipment1947 U.S. Tax Ct. LEXIS 10">*32 manufacturers attempted to do likewise, with similar results.

The Army was experimenting and developing radar equipment during the same period, but used petitioner's 100TS and 127 type tubes.

Petitioner differed from other manufacturers of tubes in that it never produced tubes on a conventional assembly line or production line basis. It used skilled workers, required strict tolerances and accurate alignment of the elements or parts, and was unusually exacting in testing its products and rejecting defective tubes. Petitioner insisted on a very high standard of workmanship.

The superiority of petitioner's tubes resulted not only from its high standard of workmanship, but also, among other things, from its improved manufacturing technique, its improvement in processing and treating the various elements or parts used, its improved tools, machinery and equipment, and its method of assembling and structure of its tubes. All of these factors substantially contributed to the art of making high power frequency tubes and resulted in some of the most efficient tubes of their kind produced.

On May 22, 1942, petitioner contracted with the Government to make all of petitioner's processes and1947 U.S. Tax Ct. LEXIS 10">*33 methods of manufacturing of tubes in the fields of communication, signaling, remote control, navigation, and direction and position finding available license-free to other manufacturers. Other manufacturers had their agents investigate in detail petitioner's methods and technique of manufacture and the structure of its products. Petitioner fully cooperated with such investigations both by giving information and by furnishing samples of its tube parts.

Thereafter, the Government had other tube manufacturers make some of petitioner's types of tubes, but they never manufactured as satisfactory a tube as did petitioner. Although similar in appearance to petitioner's tubes, petitioner's competitors did not produce tubes equal in power, performance, or life to those manufactured by petitioner.

From the time of petitioner's organization to 1941, Eitel and McCullough filed about ten applications for patents, of which patents the petitioner became owner by assignment, including patents numbered 9 T.C. 1132">*1143 2,134,710, 2,240,557, Des. 127,757, and Des. 127,758, heretofore mentioned. Petitioner is the owner of other patents, all but two of which cover inventions of Eitel and McCullough, as1947 U.S. Tax Ct. LEXIS 10">*34 follows:

1947 U.S. Tax Ct. LEXIS 10">*35 In the latter part of 1940 petitioner received its first large order, it being for 10,685 127VT, 3,892 304TL, and 865 250TL, aggregating approximately $ 500,000, which order represented a subcontract in connection with the defense program of the Government. About 550 tubes were shipped on this order in 1940 and the remainder in 1941. Prior to that time an order of 40 tubes was considered a large order.

The bulk of petitioner's production for 1941 and 1942 was for the Army and Navy.

The increased sale in 1941 and 1942 of radar tubes was due to the demand for tubes in radar sets used in the war program.

In 1939 amateur business began to decline.

The following schedule shows the net sales, total manufacturing costs, including compensation paid to Eitel and McCullough, sales expenses, 9 T.C. 1132">*1144 administration expenses, and net profit or loss as shown by petitioner's books for the years 1936 to 1942, inclusive:

Exhibit 3, which contains profit and loss statements in detail for each year from the organization of petitioner in 1934 to 1942, inclusive, is incorporated herein by reference.

The inclusion of the salary and other compensation paid to Eitel and McCullough under manufacturing costs was a consistent practice of petitioner from its organization to 1942, inclusive.

Prior to 1941 some laboratory expenses, difficult of identification, were commingled with other expenses. In 1941 an account "Laboratory Expense" was set up and the account "Experimental Work, Miscl. Chgs." discontinued. In addition to development expenses, the account "Laboratory Expense" 1947 U.S. Tax Ct. LEXIS 10">*37 contained expenses not ordinarily in the production line, such as expenses of testing and proving the product.

In 1943 and 1944 petitioner reported gross sales in the amount of $ 17,188,257.94 and $ 13,079,250.67, respectively.

Exhibit 1, containing balance sheets of petitioner for each year ended December 31, 1934, to December 31, 1942, inclusive, is incorporated herein by reference.

The only distribution by petitioner to its stockholders charged against earned surplus was a cash dividend of $ 4,000 in 1937.

Compensation paid by petitioner to its officers during 1935 to 1942, inclusive, was as follows:

9 T.C. 1132">*1145 During 1941 and 1942 Eitel was president and director of petitioner, McCullough was vice president, treasurer and director, and Harrison was secretary1947 U.S. Tax Ct. LEXIS 10">*38 and director. Each of them owned one-third of the outstanding stock of petitioner. The reduction in officers' salaries in 1942 was made to conserve finances. In 1943 Eitel and McCullough each received compensation of $ 40,000.

Eitel and McCullough devoted their entire time to the affairs of petitioner, not only in 1941 and 1942, but also in prior years, and were primarily responsible for its operation and success. Harrison devoted only part time to the affairs of the petitioner. He was familiar with the building and insurance business and took care of the building expansion and insurance, including the erecting of a large plant at Salt Lake City.

The number of employees of petitioner was approximately 22 by the end of 1939 and approximately 60 at the end of 1940, and it increased to 300 by the end of 1941 and to 1,125 by the end of 1942.

By the end of 1935 the area of the San Bruno plant covered 4,850 square feet. Beginning in 1940, this area was expanded until by the end of 1942 the plant covered an area of 38,791 square feet. By March 31, 1943, an additional area of 11,352 square feet had been added.

The construction of a second plant was begun in Salt Lake City in the spring1947 U.S. Tax Ct. LEXIS 10">*39 of 1942. It became an operating unit during the summer of 1942. Whatever advances petitioner had made to build the Salt Lake City plant were reimbursed to it by the Defense Plant Corporation. Both Harrison and Eitel moved to Salt Lake City. Harrison was largely responsible for the construction of the plant. Eitel operated the plant, which was as large as the San Bruno plant. During their absence, McCullough operated the San Bruno plant.

The Commissioner disallowed, as excessive, $ 16,000 of the salary paid to Eitel and McCullough in 1941 and $ 17,000 and $ 4,575 of the salary paid to Harrison in 1941 and 1942, respectively.

Petitioner's 1942 return discloses the following relation between its original facilities and its emergency (defense and war) facilities subject to special amortization, for which certificates of necessity had been obtained or applied for:

1947 U.S. Tax Ct. LEXIS 10">*40 9 T.C. 1132">*1146 The amount of $ 40,000 paid by petitioner to Eitel and McCullough, respectively, in 1941 was reasonable compensation for their services rendered to it.

The amounts of $ 10,000 for 1941 and $ 6,450 for 1942 constitute reasonable compensation for services rendered by Harrison.

OPINION.

In proving a case under section 721, petitioner has both an affirmative and a negative burden. That these burdens are onerous may be admitted, but the burdens are fixed and the proof must be made. Petitioner must show that it had abnormal income of the designated class (here research and development of tangible property, sec. 721 (a) (2) (C)) ¹ in excess of 125 per centum of the average amount of the gross income of the same class for the four previous years. "Once the amount of the income of the class for the [taxable] years and the base period is shown then the abnormal amount of the tax years is merely a matter of mathematics under section 721 (a) (1)." Soabar Co., 7 T.C. 89, 94. But it does not suffice to do as petitioner suggests, merely take the income tax net income or loss figures for the base period and one of the two taxable years and apply the 1947 U.S. Tax Ct. LEXIS 10">*41 formula. This is to prove your case by false assumptions. 9 T.C. 1132">*1147 As said in Producers Crop Improvement Association, 7 T.C. 562, 566:

* * * But such a theory is unsound. The "class of income" described in (2) (C) and in (1) is a "class includible in the gross income." Those provisions and (a) (3), relating to the elimination of costs and expenses, show clearly that a "class" is not to consist of income tax net income, net income, net loss, or any combination thereof.

1947 U.S. Tax Ct. LEXIS 10">*42 A taxpayer has "abnormal income" under section 721 (a) (1) only if the income of the taxable years and that of the base period to which the statutory formula is to be applied be "recognized as a separate class." Geyer, Cornell & Newell, Inc., 6 T.C. 96. The statute by its terms requires identification of a "class" of income, either of any class described in subsections (a) (2) (A) to (F), inclusive, or of some other class under the regulations prescribed by the Commissioner with the approval of the Secretary. The petitioner has chosen "research and development in tangible property" (section 721 (a) (2) (C)) as its class. Undoubtedly, some of the petitioner's income in both periods was the product of research and development, just as part of its income in both periods was due to manufacturing. On the record made, however, we can not make even an approximation of an amount of such development income as contrasted with manufacturing income. Throughout the base period, albeit some part of the income was due to development, we also know that much of it was due to sales effort and manufacturing efficiency.

In the taxable years the failure of proof is 1947 U.S. Tax Ct. LEXIS 10">*43 even clearer. Petitioner's development work was carried on throughout those years. Petitioner's gross income was the result of a concatenation of many factors, viz., high standard of workmanship, advertising and other sales efforts, the unique ability of Eitel and McCullough exercised not only in research and development, but in plant operation and management, and, more largely than any other fact, the greatly increased demand for petitioner's product incident to the defense program, with its normal consequence, the improvement of business conditions. As to the existence of these factors, we have no doubt -- no other conclusion is possible on the record. There is no proof, however, from which we can formulate an approximation or even a guess of the amount properly attributable to the vital factors. Thus it is, there is no way on the record made by which to determine in either the base period or the tax years the amount of income attributable to research and development and the amount attributable to manufacturing under improved business conditions, with the consequent inability to determine the amount of petitioner's abnormal income, if any.

9 T.C. 1132">*1148 In consonance with the above, 1947 U.S. Tax Ct. LEXIS 10">*44 without more, we would be obliged to rule against petitioner, but there are yet other vital defects in the record. One requirement of the statute is that the development extend "over a period of more than 12 months." If it be considered that petitioner's product was various types of vacuum tubes, each tube being a separate product, with but one or two possible exceptions out of the many tube types manufactured, we are unable to hold that the development extended over a period of more than 12 months. The proof is too general to permit specific holdings as to the time required to develop any of the several tubes. Even if the petitioner's premise, that the years 1934 to 1940 were exclusively devoted to development, were accepted and if the periods of development of tubes were tacked together so that petitioner's product could be considered as a series of tubes rather than individual tubes, it would not overcome all the deficiencies of proof in the record. There are still lacking the data on which to allocate the expenses and income attributable to the increased demand for tubes for war end use and consequent improved business conditions.

This requirement of the regulations (Regulations1947 U.S. Tax Ct. LEXIS 10">*45 109, sec. 30.721-3; Regulations 112, sec. 35.721-3) is attacked by petitioner as invalid, it being urged that it imposes an impossible burden and disqualifies all applicants for relief automatically. We are fully conscious of the difficulty of proof under section 721, but we are not persuaded that it imposes an impossible burden or that the regulation is invalid. Precise proof may be difficult, but here the record reveals no attempt at proving even reasonable approximations. There is simply an absence of proof. In W. B. Knight Machinery Co., 6 T.C. 519, the parties were able to agree on a stipulation measuring the effect on income of increased sales due to improved business conditions.

We would be obliged to shut our eyes to the obvious were we not to hold that a very large part of the increase in petitioner's sales in 1941 and 1942, and consequently its increase in income, was due to the impact of the war in Europe on American business economy, with the unusual demand of the defense and armament program. Petitioner received its first large contract under that program in 1940. From 1934 through 1939 petitioner's business had a slow but steady 1947 U.S. Tax Ct. LEXIS 10">*46 growth. It was only with the stimulus of war orders that petitioner's sales mounted to spectacular figures. McCullough testified that the sale of radar tubes in 1941 and 1942 was due to the increased demand for tubes in radar sets. Eitel testified that the bulk of petitioner's production in 1942 was for the Army and Navy and that the same was 9 T.C. 1132">*1149 probably true in 1941. The sales of the VT127, used in Army radar equipment, in 1940 amounted to $ 13,866, whereas, in 1941 and 1942 the sales were $ 744,891 and $ 3,405,643. The sales of the 304TL, used chiefly in Army and Navy radar equipment, increased from $ 10,931 in 1940 to $ 511,159 in 1941 and $ 1,185,267 in 1942. All of these sales were related to the war program.

Thus it is, in sum, that on the issue of applicability of section 721 we find that petitioner has failed to prove certain affirmative factors or disprove certain negative factors basic to granting the relief sought. The clear inference and conclusion from the record made are aptly characterized in Soabar Co., supra, where it is stated:

* * * Its greater profits in the tax years came to it because of improved business conditions, 1947 U.S. Tax Ct. LEXIS 10">*47 stimulated, apparently, by the prospect that the war then raging would or might soon involve this country. Congress intended the excess profits tax to apply to such increased or excess profits. See House Rept. No. 146, p. 9, 77th Cong., 1st sess. (1941-1 C. B. 557). The regulation which the Commissioner prescribed, with the approval of the Secretary, carries out this intent by providing that such part of the net abnormal income of a tax year which was due to improved business conditions, resulting in a greater demand for the taxpayer's products, should not be allocated to any other years. It carries out the intent of Congress and is in harmony with the spirit and purpose of the provisions, as well as the wording thereof.

The Commissioner also disallowed a part of the salary of $ 40,000 paid each to Eitel and to McCullough in 1941 and a part of the salary of $ 20,000 paid in 1941 and $ 6,450 paid in 1942 to Harrison, on the ground that the amounts represented excessive compensation.

The successful production and operation of the business of petitioner were primarily due to the ability and efforts of Eitel and McCullough. Both were highly skilled technical1947 U.S. Tax Ct. LEXIS 10">*48 men, skilled in the art of making vacuum tubes, and proficient in organization, management, and operation of the company. Sales increased from $ 200,197.54 in 1940 to $ 1,827,687.04 in 1941 and $ 5,232,792.61 in 1942 after war contract renegotiation. These increased sales necessitated expansion in plant, equipment, production, and personnel, in which the three officers carried the burden. The fact that these three men were the only stockholders of petitioner is not important unless the salaries were unreasonable. In the findings of fact we have found that the compensation paid to Eitel and McCullough in 1941 was reasonable in amount for the services rendered by them to or for the petitioner. As to Harrison, we have found the amounts which we deem reasonable. Petitioner is entitled to deduction of the amounts so found.

Reviewed by the Special Division as to the 721 issue.

Decision will be entered under Rule 50.