1991 U.S. Tax Ct. LEXIS 80">*80
Ps engaged in the photo-finishing business. Both the photographic film Ps received from their customers for developing and the paper purchased by Ps for use in making prints contain silver halide compounds, which are removed during the developing process. Ps extracted silver-bearing waste materials from the chemical solutions used in photo-finishing and sold them in the ordinary course of their photo-finishing business. The sales were frequent and generated substantial income. Ps originally reported the sales proceeds as ordinary income on their tax returns, but subsequently amended such returns, reclassifying such proceeds as short-term capital gains.
97 T.C. 308">*309 Respondent determined the following deficiencies in petitioners' Federal income tax:
Year | Deficiency |
1983 | $ 8,128,580 |
1984 | $ 728,942 |
After1991 U.S. Tax Ct. LEXIS 80">*81 concessions by both parties, the sole issue remaining for decision is whether silver-bearing waste material generated in the course of petitioners' photo-finishing business is property held by petitioners primarily for sale to customers in the ordinary course of petitioners' trade or business.
FINDINGS OF FACT
Some of the facts have been stipulated for trial pursuant to Rule 91. 1 The stipulations and accompanying exhibits are incorporated in this Opinion irrespective of any restatement below. When the petition in the instant case was filed, petitioners' principal place of business was located in Northville, Michigan.
Petitioners are engaged in three principal lines of business: the manufacture of glass (glass); the manufacture of insulation products (insulation); and the finishing of photographs (photo-finishing). 1991 U.S. Tax Ct. LEXIS 80">*82 Gross revenues of each line of business for the years in issue were as follows:
1983 | 1984 | |
Glass | $ 358,053,000 | $ 406,009,000 |
Photo-finishing | 83,823,000 | 96,648,000 |
Insulation | 22,926,000 | 33,120,000 |
Pretax income from photo-finishing equalled $ 7,934,000 in 1983 and $ 6,446,000 in 1984.
Petitioners entered the photo-finishing business in 1968 by purchasing ABC Photo. At that time, ABC Photo operated one plant, at Northville, Michigan, and had been in business since 1955. Petitioners expanded their photo-finishing business into new markets during the 1970's and 1980's by acquiring other finishers and constructing new plants.
During the years in issue, petitioners operated as few as 10 and as many as 12 photo-finishing plants across the United States, and employed approximately 1,500 persons in connection with their photo-finishing operations. Petitioners performed photo-finishing services for 9,500 national and regional chain stores, discount stores, and independent retail outlets (retail outlets), which in turn offered photo-finishing services to amateur photographers. Petitioners also supplied photographic products to the retail outlets.
Petitioners collected1991 U.S. Tax Ct. LEXIS 80">*83 exposed film from the retail outlets on a daily basis, processed the film in their plants, and returned developed images and negatives to the retail outlets. In order to maintain its competitive position in the market, a photo-finisher was expected to process film within 24 hours. Furthermore, the terms of petitioners' agreements with the retail outlets did not allow petitioners to charge for prints and film that were not returned within 24 hours of pickup. Petitioners accordingly processed film within 24 hours of receipt.
Photography involves the use of silver halide compounds, which record images when exposed to light. Both photographic film and the paper used for making prints contain silver halide compounds. Various chemical solutions are used to develop and fix latent images on film and paper (photo-finishing solutions). High quality alternatives to the silver compounds and chemical processes used to produce the final photographic image do not exist.
97 T.C. 308">*311 In black and white photography, the exposed silver compounds react with the developer solution to form the final image, while unexposed silver is washed away in the fixing baths. In color photography, various dyes are incorporated1991 U.S. Tax Ct. LEXIS 80">*84 into the film and paper in addition to the light-sensitive silver halides, and a chemical reaction between the developer solution, the silver halide compounds, and the dyes produces the color image. After the chemical reaction occurs, the silver halides must be removed from the film or paper because they otherwise would hide the color image. Removal is accomplished by passing the film or paper through bleaching and fixing solutions in which the silver halides react with other chemicals to form silver thiosulfate. After the silver halides are removed, the silver compounds have no further utility in the developing process. Approximately 60 percent of the silver compounds introduced into photo-finishing solutions are attributable to photographic paper, while the remaining 40 percent are attributable to film. The photographic paper is purchased by petitioners as a raw material, whereas the exposed film is furnished by petitioners' customers for developing.
During the years in issue, petitioners utilized a "closed-loop" photo-finishing system, which mixed new and used photo-finishing solutions and continuously recirculated the solutions within the system. Petitioners' predecessor, 1991 U.S. Tax Ct. LEXIS 80">*85 ABC Photo, began to use such a system for some film processing in 1963, and had installed a closed-loop system in its newly constructed Northville, Michigan, plant when petitioners acquired it in 1968. Petitioners installed closed-loop systems in the finishing plants they built or purchased between the time they entered the photo-finishing business and the years in issue. Use of such a system was necessary in order to be competitive in the photo-finishing industry, as it was the most efficient and least time-consuming method of processing film and prints on a high-speed basis. The closed-loop system enabled petitioners to reduce the volume of solutions used in their operations by two to four times, which saved labor, material, and storage costs. Additionally, use of a closed-loop system reduced the volume of discharge required to be treated prior to disposal, thus decreasing the cost of compliance with applicable environmental laws.
97 T.C. 308">*312 In order to reuse solutions in the closed-loop process, petitioners had to remove certain material, including silver thiosulfate, from the photo-finishing solutions. The silver thiosulfate that was washed from film and paper contaminated the photo-finishing1991 U.S. Tax Ct. LEXIS 80">*86 solutions and interfered with the ability of the solutions to produce negatives and prints of marketable quality. To remove silver thiosulfate, among other substances, from their photo-finishing solutions, petitioners incorporated electrolytic cells (cells) into the closed-loop system. Petitioners' predecessor, ABC Photo, first used cells in 1962 or 1963, and was operating them in its Northville, Michigan, plant prior to its acquisition by petitioners in 1968. Petitioners installed cells in each plant they built or acquired between 1968 and the years in issue. The cells passed an electric current through the solutions, causing silver and other substances to be deposited on the cells' cathodes. The material deposited on the cathodes, called "flake," consisted of, on average, 92 percent silver, with the remainder of the material consisting of other substances removed by electrolytic action (the silver and other substances removed from the photo-finishing solutions are hereinafter referred to as "silver waste"). Approximately 95 percent of the silver waste removed from the photo-finishing solutions was attributable to the cells in the closed-loop system.
To ensure continued efficient1991 U.S. Tax Ct. LEXIS 80">*87 operation, the cells were cleaned at least once a month by scraping the built-up silver waste off the cathodes. The silver waste was then weighed and placed in containers for shipment to a refiner. Quality control personnel also prepared reports concerning the amount of silver waste collected, which was compared to the total amount of silver entering the photo-finishing process, in order to monitor the efficiency of the waste removal process and to detect pilferage. To further monitor the efficiency of processes used to remove silver waste from the solutions, petitioners also weighed scrap photographic paper prior to discarding it, although petitioners did not recover the silver compounds in such paper. Petitioners produced periodic reports concerning the percentage of silver in the developing process which was recovered, the dollar value of such silver, and the success of its plants in 97 T.C. 308">*313 meeting target recovery rates. Petitioners desired to maximize the silver content of the waste material.
During the years in issue, petitioners were subject to a variety of Federal, State, and local laws and regulations governing the levels of certain substances in the waste waters discharged1991 U.S. Tax Ct. LEXIS 80">*88 from their plants into sewers or elsewhere (environmental regulations). The environmental regulations classified silver as a "toxic pollutant," and required petitioners to reduce significantly the concentration of silver thiosulfate in photo-finishing solutions before disposing of the solutions. Petitioners had to take steps to comply with environmental regulations beginning in 1968, and could not have complied with the standards in effect at that time without removing silver waste from their photo-finishing solutions.
Even though treatment in the closed-loop system removed much of the silver waste in the photo-finishing solutions, petitioners were required to further reduce the concentration of silver waste before discharging the solutions into the environment. Petitioners reduced the concentration of silver waste in the solutions by passing used photo-finishing solutions and wash waters through a system of electrolytic cells and steel wool cartridges (tailing process). Approximately 5 percent of all silver waste collected by petitioners was attributable to the tailing process. Material collected in the steel wool cartridges, called "sludge," contained between 1 percent and1991 U.S. Tax Ct. LEXIS 80">*89 9 percent silver. During 1984, petitioners recovered silver compounds from film scraps by placing them in the tailing process. Petitioners' quality control personnel checked the level of silver waste in the effluent every day to ensure compliance with environmental regulations. Silver waste collected in the tailing process was weighed and shipped to a refiner in the same manner as silver waste removed from the closed-loop system.
In order to continue in the photo-finishing business, petitioners had to comply with the environmental regulations. Severe penalties could be imposed for violation of the environmental regulations, including large fines for each day a violation of clean water standards continued, closure of petitioners' plants, and jail terms for petitioners' employees. The environmental regulations were enforced actively, and, 97 T.C. 308">*314 despite their best efforts to comply, petitioners occasionally were cited for discharging effluent containing excessive levels of silver waste. Petitioners would have removed the silver waste from the solutions in order to comply with the environmental regulations even if the silver waste had been valueless.
The silver waste generated by petitioners' 1991 U.S. Tax Ct. LEXIS 80">*90 plants was sold to refiners. Petitioners' predecessor, ABC Photo, had begun selling silver waste in 1958 or 1959. During the years in issue, Metalex Systems Corporation, later known as Drew/Metalex, (Metalex) purchased substantially all of the silver waste generated by petitioners' plants. Occasionally, petitioners sent a shipment or part of a shipment to another refiner in order to test the accuracy of Metalex's silver assay. Metalex, like other refiners, actively solicited petitioners and other finishers to sell their silver waste to it, maintaining a sales force for such purpose. Two contracts entered into by petitioners governed the sale of silver waste during the years in issue. The first contract applied to shipments of silver waste made after April 30, 1983, through July 31, 1984, and the second applied to shipments made after July 31, 1984. Metalex and petitioners conducted brief negotiations concerning each agreement, which Metalex had drafted.
Dealings between Metalex and petitioners during the years in issue followed a standard pattern. When a shipment was ready, petitioners placed the silver waste in containers provided by Metalex and then notified Metalex; Metalex1991 U.S. Tax Ct. LEXIS 80">*91 arranged for the transportation of the silver waste to Metalex's plant at Metalex's expense. Risk of loss with respect to the silver waste passed to Metalex when the carrier took possession of the silver waste. Usually, one shipment per month was made from each plant, but a second shipment might have occurred during peak processing periods.
When the silver waste arrived at the refinery, Metalex defined the amount of silver in the silver waste, processed it to remove most impurities, and then resold it to another refiner for processing into marketable silver bullion. The price Metalex paid petitioners was based on the amount of silver in the shipment and the spot market price of silver 21 97 T.C. 308">*315 days after shipment, less refining and assay charges. The charges in the agreements were based on the understanding that petitioners would sell Metalex substantially all silver waste generated by their finishing plants in a year, approximately 23,000 pounds. Petitioners received $ 2,949,933 from sales of silver waste in 1983, and received $ 2,546,287 from silver waste sales in 1984.
Petitioners originally reported the proceeds of silver waste sales as ordinary income on their Federal income1991 U.S. Tax Ct. LEXIS 80">*92 tax returns for the years in issue. Subsequently, petitioners amended such returns, recharacterizing such proceeds as short-term capital gain, and applied such proceeds against a long-term capital loss incurred after the years in issue that had been carried back to the years in issue.
OPINION
The issue we must decide is whether the silver waste was held by petitioners primarily for sale to customers in the ordinary course of their trade or business, as respondent contends, or whether the silver waste was held primarily for the operation of petitioners' photo-finishing business and then sold as an "incidental" part of such business.
Section 1221 provides the general rule that a capital asset is "property held by the taxpayer (whether or not connected with his trade or business)." Congress has provided in section 1221(1)-(5) five specific classes of property that comprise the exclusive exceptions to capital asset status.
Congress intended that capital asset treatment be 1991 U.S. Tax Ct. LEXIS 80">*93 an exception to the normal requirements of the Code and that the profits generated by everyday business operations be ordinary income.
Whether property is held primarily for sale to customers in the ordinary course of a taxpayer's trade or business is essentially a question of fact, which must be decided by a consideration of all the surrounding circumstances.
The controlling factor in determining the character of the silver waste is the purpose for which it is held,
To decide the character of the silver waste, we will consider a variety of factors which have been found useful in shedding light on the taxpayer's purpose for holding property; however, no single factor or combination of factors is dispositive.
Under
1991 U.S. Tax Ct. LEXIS 80">*97 Respondent argues that petitioners sold the silver waste on a regular and frequent basis, thus indicating that the silver waste was held for the purpose set forth in section 1221(1). Petitioners respond with the argument that the contracts between themselves and Metalex effected a single sale of all silver waste shipments occurring during the time such contracts were in force. 3 Respondent counters, arguing that each shipment of waste to a refiner should be 97 T.C. 308">*318 considered a separate sale. We agree with respondent that each shipment constitutes a separate sale.
In considering whether each shipment is a separate sale, we give the term "sale" its1991 U.S. Tax Ct. LEXIS 80">*98 ordinary meaning, that is, a transfer of property for a fixed price in money or its equivalent.
In
Applying such factors, we hold that the sale of the silver waste occurred when it was shipped to Metalex, not when the contracts were executed. Although petitioners contracted to sell their entire output of silver waste to Metalex, we do not find that the execution of the contracts between 1991 U.S. Tax Ct. LEXIS 80">*100 Metalex and petitioners effected an immediate transfer of ownership in all silver waste produced during the periods 97 T.C. 308">*319 they were in force. Petitioners did not possess the great bulk of the silver waste covered by the contracts at the time of execution. Manifestly, petitioners could not transfer what they did not own; furthermore, under the principles of the Uniform Commercial Code, 5 a transfer of title cannot occur until property is identified to the contract, see
1991 U.S. Tax Ct. LEXIS 80">*101 Shipment of the silver waste was made f.o.b. petitioners' place of business, and the risk of loss passed from petitioners to Metalex when such shipment was picked up by the common carrier for transport to Metalex. Metalex had neither the risks nor the benefits associated with ownership of the silver waste prior to shipment. For instance, if the silver waste had been stolen or destroyed prior to shipment, petitioners, and not Metalex, would have suffered the loss. Metalex was not obligated to pay a price for the silver waste until after shipment occurred. Consequently, until such time, the silver waste was petitioners' property; petitioners could, and sometimes did, sell some of it to other refiners. Therefore, the contracts upon which petitioners rely were executory in nature and a sale of silver waste did not occur until such material was shipped. Accordingly, we hold that each shipment was a separate sale.
Each of petitioners' 10 to 12 plants made shipments at least monthly while in operation during the years in issue. Respondent has argued, and petitioners do not dispute, that at least 228 shipments of silver waste occurred in the years in issue. A corollary to our conclusion1991 U.S. Tax Ct. LEXIS 80">*102 that each shipment is 97 T.C. 308">*320 a separate sale is a holding that such sales create a pattern of frequent, regular, and continuous sales, and we so hold.
We also consider the amount of the proceeds of silver waste sales during the years in issue, $ 2,949,933 in 1983 and $ 2,546,287 in 1984. The large dollar amount of the sales suggests that the property is held for the purpose described in section 1221(1).
Respondent argues that the percentage of petitioners' net income attributable to the silver waste sales, 37.2 percent in 1983 and 39.5 percent in 1984, shows that the sales were substantial. Petitioners respond with the argument that the proceeds of silver waste sales were not substantial, as they comprised only 3.5 percent of the $ 83,823,000 in revenues received by petitioners' photo-finishing business in 1983, and only 2.6 percent of the $ 96,648,000 in such revenues received in 1984. We do not find petitioners' comparison of the proceeds from silver waste sales to total revenue, however, to be1991 U.S. Tax Ct. LEXIS 80">*103 persuasive. The percentage of receipts attributable to silver waste sales is low because petitioners' other activities produced large quantities of revenue, not because silver waste sales yielded insubstantial income. In
Our conclusions that the silver waste sales were frequent and substantial weighs heavily against petitioners, as frequency and substantiality of sales1991 U.S. Tax Ct. LEXIS 80">*104 often have been held to be the most important objective indicators of whether property falls within the terms of section 1221(1).
Frequency and substantiality of sales, however, are not the sole considerations supporting our conclusion that the silver waste was held for the purpose described in section 1221(1). We also consider the nature of petitioners' 1991 U.S. Tax Ct. LEXIS 80">*105 business, the relationship of the silver waste to such business, and whether the sales of silver waste were in furtherance of petitioners' business.
The silver waste sales comprised more than an insignificant component of petitioners' photo-finishing business, as the silver waste sales yielded a large part of the profits of such business and accomplished the disposal of a toxic pollutant. Petitioners conducted the silver waste removal 97 T.C. 308">*322 operation in a businesslike manner, monitoring the efficiency of the extraction process, setting target recovery rates, placing film scraps in the tailing process to harvest the silver they contained, and seeking to maximize the silver content of the silver waste. We also note that petitioners' predecessor, ABC Photo, began selling silver waste in 1958 or 1959, well before the closed-loop processing system was adopted and before environmental regulations required its removal from waste water. Petitioners generated approximately 23,000 pounds of silver waste annually, most of which consisted of flake containing 92 percent silver, a valuable commodity. The sale of the silver waste was closely1991 U.S. Tax Ct. LEXIS 80">*107 related to, and occurred in furtherance of, petitioners' photo-finishing business and was more than an "incidental" part of petitioners' photo-finishing business. 7
Petitioners make much of the fact that they removed the silver waste from their photo-finishing solutions for business reasons unrelated to its sale. Specifically, petitioners were required to extract the silver waste in order to produce developed prints and negatives of 1991 U.S. Tax Ct. LEXIS 80">*108 marketable quality, to reuse photo-finishing solutions in the closed-loop system, and to comply with environmental regulations governing the level of silver in waste waters discharged from their plants. Petitioners would have removed the silver waste for the foregoing reasons even if it had been valueless. We note, however, that the reasons petitioners removed the silver waste from the photo-finishing solutions are not conclusive of the purpose for which the silver waste was held.
1991 U.S. Tax Ct. LEXIS 80">*109 We also consider the fact that approximately 60 percent of the silver waste removed from the photo-finishing solutions was attributable to silver compounds removed from photographic paper purchased by petitioners to make prints from film processed by them. Such photographic paper was included in petitioners' inventory. The cost of the paper, including the cost of the silver contained in the paper, was charged against gross receipts as part of the cost of goods sold. Consequently, a portion of the silver which petitioners extracted from the photo-finishing solutions and sold entered their business originally as inventory. Generally, where property is placed in inventory at the time of its acquisition, positive evidence of a change in the purpose for which it is held is required to find that such property has lost its original character.
We do not find that any intervening event in the developing process caused the silver (that originally was contained in the paper) to be held for any purpose other than the purpose set forth in section 1221(1). Although the silver compounds in the photographic paper were transformed into silver waste by the photo-finishing process, that
Although the 40 percent of the silver waste derived from film 1991 U.S. Tax Ct. LEXIS 80">*111 delivered by petitioners' customers to petitioners for developing did not originally enter petitioners' business as inventory, we do not find that such circumstance warrants the conclusion that such portion of the silver waste was held for a purpose other than sale after it was extracted from the photo-finishing solutions. 9 We note also that, during the greater part of the years in issue, petitioners were under a contractual obligation to sell the silver waste provided in the course of their photo-finishing business to Metalex. The existence of such a preexisting sale arrangement indicates that the property sold pursuant to such an arrangement was held primarily for sale.
1991 U.S. Tax Ct. LEXIS 80">*112 Petitioners argue that their lack of efforts to market the silver waste indicates that the silver waste was not held primarily for sale. We do not find petitioners' argument persuasive, however, because market conditions made it unnecessary for petitioners to engage in any sales efforts to dispose of the silver waste -- refiners actively competed to purchase the silver waste. We thus do not attach much significance to the absence of such activities.
Petitioners also argue that they made no improvements to the silver waste before it was sold to refiners, and that such absence suggests that it was not held primarily for sale. 97 T.C. 308">*325 While the failure to improve property sold indicates that such property is not held primarily for sale,
Respondent also points to the fact that petitioners initially reported the gain from the sale of silver waste as ordinary income on their tax returns for the years in issue, and only recharacterized it upon incurring a large capital loss in a year subsequent to the years in issue. While the treatment of an item on a return generally is not included in the list of factors to be considered in determining whether property is a capital asset, such treatment constitutes some evidence of its character, which must be weighed along with all other relevant evidence in reaching a decision.
Respondent further points to petitioners' deduction of the expenses connected with the silver waste, such as the cost of silver compounds in the photographic paper petitioners used to make prints and the expenses of extracting it from the photo-finishing solutions and waste waters. Petitioners maintain that such expenses were deductible even after recharacterizing the proceeds of silver waste sales as short-term capital gain on their amended returns.
1991 U.S. Tax Ct. LEXIS 80">*115 97 T.C. 308">*326 As a general matter, the expenses of acquisition or creation of a capital asset must be added to the taxpayer's basis in the asset and offset against the proceeds of its sale, even if such expenses otherwise would be allowable deductions under section 162.
Petitioners rely upon
1991 U.S. Tax Ct. LEXIS 80">*117 Based on the foregoing, we hold that the silver waste is property held by petitioners primarily for sale to customers in the ordinary course of their business. We, therefore, find it unnecessary to reach respondent's alternative 97 T.C. 308">*327 contentions concerning petitioners' basis in the silver waste and the applicability of the tax benefit rule.
To reflect concessions and stipulations on other issues,
1. Unless otherwise noted, all section references are to the Internal Revenue Code as in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩
2. While the term "to customers" sometimes has been analyzed in isolation to determine whether property is described in section 1221(1), the question of whether a taxpayer is selling to customers is relevant chiefly in the case of persons dealing or trading in securities or commodities. See
3. We note that other taxpayers have unsuccessfully attempted to reduce the probative value of the instant factor by claiming that multiple transfers of property should be treated as one because they were made pursuant to the terms of a single contract.
4. See also
5. We note that applicable State law frequently is relied upon in determining whether a sale has occurred for Federal income tax purposes. See, e.g.,
6.
7. Consequently, cases relied upon by petitioners, such as
8. Petitioners have cited a number of cases holding that the disposal of property no longer usable in a taxpayer's business results in capital gain or loss because such property is not held "primarily for sale."
9. Furthermore, the factors discussed above, such as frequency and substantiality of sales, and the relationship of the sales to petitioners' business, all indicate that the portion of the silver waste attributable to film was held primarily for sale even if such portion is not part of petitioners' inventory.↩
10. At trial, petitioners offered no evidence to explain their original return position with respect to the proceeds of silver waste sales. On brief, petitioners suggest that, in the absence of a net capital loss, petitioners had no need to determine whether the silver waste was a capital asset.↩
11. Respondent also argues that the fact that the silver waste was held for only a short time prior to its disposal indicates that the silver waste was held for sale.