Opinion
Docket No. 29906.
1954-04-26
C-O-TWO FIRE EQUIPMENT COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Richard P. Jackson, Esq. , and William B. VanBuren, III, Esq. , for the petitioner. Jules I. Whitman, Esq. , for the respondent.
Petitioner manufactured coin-operated music boxes in 1946 and 1947. In 1946 it ceased manufacturing 5-cent boxes, and planned to manufacture boxes that could be operated by a nickel or a dime. In 1947 it made about 800 such boxes. Petitioner originally wrote down its closing inventory of boxes and parts as of December 31, 1946, to $162,385.08. By amended petition, petitioner claims it is entitled to a further write-down of $117,134.54 on the ground that the inventory by the end of 1946 had only a scrap value of $45,250.54. Respondent allowed some of the write-down, but disallowed a part thereof in the sum of $110,919.93 on the ground that this portion of the inventory was not obsolete in 1946.
Held, respondent did not err in his determination since that portion of the inventory write-down disallowed had not become obsolete by the end of 1946. Richard P. Jackson, Esq., and William B. VanBuren, III, Esq., for the petitioner. Jules I. Whitman, Esq., for the respondent.
Respondent determined deficiencies in petitioner's income and excess profits taxes for 1944 in the amounts of $1,305.47 and $67,089.48, respectively. By amended petition, petitioner seeks the determination that there was an overpayment.
The only issue presented for our consideration relates to adjustments to petitioner's 1946 closing inventory by reason of obsolescence. The consideration of 1946 is necessary in order to ascertain the amount of petitioner's net operating loss for that year, to be carried back to the taxable year 1944.
This proceeding was heard before Edward C. Radue as a commissioner designated for that purpose by the Court. Objections filed by the parties to the report of the commissioner have been carefully considered.
Some of the facts were stipulated.
FINDINGS OF FACT.
The stipulated facts are so found, and are incorporated herein.
The income and excess profits tax returns for the year 1944 and the income tax return for the year 1946 were filed by the petitioner with the collector of internal revenue at Newark, New Jersey. The petitioner, a corporation organized under the laws of Delaware on April 29, 1933, is and always has been principally engaged in the manufacture of carbon dioxide fire protection equipment and smoke detection apparatus.
In 1944, however, the officers of the petitioner began giving serious thought to the possible condition of the industry following the end of World War II. It was the general impression that the tremendous production of fire protection equipment during the war years would adversely affect the postwar market, particularly in view of the fact that considerable quantities of the equipment sold to the Government might be thrown onto the market as surplus.
Therefore, petitioner's officers decided to seek some type of postwar production activity which would help utilize petitioner's facilities and would supplement its regular line of business.
Scott E. Allen, president and a director of petitioner, first met Harold F. Dennison at the office of petitioner's patent counsel and learned of his activities in the music box field. Dennison was engaged in the operation of coin-activated music boxes, called ‘phonettes,’ in the Los Angeles area. Phonettes were different from the ordinary juke box and operated in the following manner: An operator, such as Dennison, would establish a studio in a heavily populated area, and in the studio he would install two record players or changers. The music from records being played continuously would be amplified by the studio amplifiers and then transmitted over leased telephone lines to the various restaurants, lunch counters, or other locations having phonette installations. The phonettes were installed in the booths or at regular intervals on a counter. Each phonette contained a speaker and, by the insertion of a coin, would individually and independently play for a limited period, the music being transmitted from the studio.
One of the basic ideas behind the system was that the volume of music would be limited to the extent that it could be enjoyed only by the person sitting in the particular booth or at the counter location where the box or phonette was situated. Thus, if the occupants of another booth or counter location wished music, they would have to drop a coin in the phonette located in their booth or nearest them on the counter.
This multiple-play feature was thought to be one moneymaking aspect of the phonette system which was lacking in the ordinary juke box delivering its music from a central location. For example, if a particular restaurant had 25 phonettes installed in the various booths, it would be possible to obtain 25 nickels at one time for the music then being transmitted from the studio.
Another feature of the phonette system, however, was that the individual, while receiving 6 minutes of music for his nickel instead of the usual 3 minutes juke box play, would have to be satisfied with whatever selection happened to be in the process of transmission at the time he placed his coin in the phonette. If his 6 minutes commenced in the middle of a record, he would hear the remainder of that record, the complete play of another record, and his 6 minutes would end in the middle of a third record. Thus, of course, the individual could not select a particular record he might wish to hear. This lack of selectivity, as will be brought out later, was an important factor in the eventual failure of the phonette system.
In contrast to juke boxes, phonettes were not intended for bars, but, rather, were for restaurants and lunch counters and primarily were used to provided background music.
The officers of the petitioner were interested in Dennison's report of his activities in the Los Angeles area where he reported he had some 600 or 700 phonettes in operation from which he realized net profits of approximately $1,300 a month.
Dennison also pointed out that he had an opportunity to acquire presently functioning operations in New York and Detroit for approximately $16,000; and while these operations were then on about a break-even basis, he was certain that improved service and changes in some of the instruments would result in considerably increased revenue.
After several conferences with Dennison, Scott Allen, Ralph Batch, secretary of the petitioner, and Frank Allen, chief engineer of the petitioner, made a trip to Los Angeles to observe at first hand Dennison's operations there.
Finally, in the fall of 1944, Dennison proposed to petitioner that a new corporation be formed to take over the operations of the phonettes in the Los Angeles area and also to acquire the operations in New York and Detroit.
The idea of entering the music box field appealed to petitioner's directors. It fitted into petitioner's production scheme; and in order to go into production, petitioner was required to purchase very little additional equipment. Being somewhat different from the juke box, it was thought that there would be a definite demand for the phonette.
Dennison had been a successful operator of the phonette; and petitioner's officers, who had no prior experience in this field, relied substantially on his opinions and guidance.
At a meeting held on November 6, 1944, the board of directors of petitioner considered Dennison's offer, voted unanimously to accept it and to take all steps necessary in the formation of the new corporation.
Upon the formation of a new corporation, named ‘Personal Music Corporation,’ the following were named as officers and directors:
Harold F. Dennison, president and director, sales manager
Ralph F. Batch, vice president and director
Maynard A. Laswell, 2d vice president and director
Scott E. Allen, treasurer and director
Bernard S. MacCabe, secretary, assistant treasurer, and director. All of the above were to serve without compensation with the exception of Dennison.
Three hundred fifty shares of Personal Music common stock were originally issued to Dennison, pursuant to subscription dated November 30, 1944, in consideration of his transfer to Personal Music of his interest in the Los Angeles operation, as well as those in New York and Detroit which he had recently acquired with an advance of $16,250. Personal Music took over these operations subject to the liability to repay the advance of $16,250 to Dennison and an encumbrance of $8,000 held by a Los Angeles bank on the Los Angeles operation.
Six hundred fifty shares were originally issued to petitioner by subscription dated December 8, 1944, for $30,000.
After Personal Music paid off the liabilities owing by Dennison and assumed by Personal Music of $16,250 and $8,000, it had left out of the $30,000 cash subscribed by petitioner a balance of $5,750 for its operations.
On December 1, 1944, petitioner, Dennison, and Personal Music entered into an employment contract entitling him to a salary of $100 per week plus 2 per cent of Personal Music's sales and receipts from operations of music boxes.
From November 1944 until January 1946, the new corporation, Personal Music Corporation, was engaged exclusively in its operations of the phonettes. No sales of phonettes occurred during this period because petitioner was unable to commence the manufacturer of phonettes due to the restrictive allocations of materials during the war years. Production of the phonettes by petitioner commenced in January 1946.
All of the phonettes produced by petitioner, after commencing production in January 1946, were sold to Personal Music Corporation. Petitioner never sold to any third party. Personal Music in turn, while it retained some of the phonettes for use in its own operations, sold the bulk of them to distributors buying for resale to the operators who actually installed them in a particular restaurant or lunch counter.
At the outset the phonettes were sold to the distributors only on a cash or c. o. d. basis with the distributors themselves making financing arrangements. Subsequently, some sales were made on open account in cases where Dennison personally recommended the extension of credit.
Coin Machine Acceptance Corporation, herein referred to as CMAC, was the only company which exclusively financed the purchase of coin-operated machines. Some of the distributors, whose inventories of other merchandise such as phonographs and juke boxes had been financed by CMAC, proposed to CMAC that it should finance the phonettes purchased by the dealers from Personal Music.
It was at first generally thought throughout the CMAC organization that the company should not undertake the financing of phonette purchases from Personal Music. However, CMAC finally agreed to do so; and an agreement dated May 21, 1946, was entered into by CMAC and Personal Music whereby CMAC undertook to finance sales by Personal Music to customers financed by CMAC unless it notified Personal Music to the contrary prior to any shipment.
CMAC financed the distributors in the purchase of phonettes on a floor-plan type of contract. It had $33,000.00 employed and outstanding in its financing arrangements in the fall of 1947. In a contract of this type, the distributor agreed to purchase from Personal Music the music boxes he felt capable of selling and to repay CMAC's floor-plan loan within a period of 90 days after his shipment from Personal Music was received.
CMAC also financed the operator's purchase of phonettes. In this case, CMAC loaned money to the operators to enable them to buy music boxes from distributors. This financing was accomplished through an extended conditional sales contract running for 15 to 18 months.
Shortly after the production of music boxes was commenced by petitioner in January 1946, production and sales reached a substantial level.
The following is a comparison by months of the number of music boxes produced by petitioner in 1946 with the number sold to and returned by distributors and operators, through the joint efforts of petitioner and Personal Music:
+-----------------------------------------------------------------------------+ ¦1946 ¦Number of music ¦Number of music boxes sold to distributors and ¦ ¦ ¦boxes produced ¦operators by Personal Music, less returns ¦ +---------+-----------------+-------------------------------------------------¦ ¦ ¦ ¦Sold ¦Returned ¦Net ¦ +---------+-----------------+-------------+------------------+----------------¦ ¦January ¦1,462 ¦ ¦ ¦ ¦ +---------+-----------------+-------------+------------------+----------------¦ ¦February ¦2,367 ¦ ¦ ¦ ¦ +---------+-----------------+-------------+------------------+----------------¦ ¦March ¦3,983 ¦2,004 ¦ ¦2,004 ¦ +---------+-----------------+-------------+------------------+----------------¦ ¦April ¦4,152 ¦3,254 ¦100 ¦3,154 ¦ +---------+-----------------+-------------+------------------+----------------¦ ¦May ¦6,457 ¦5,970 ¦ ¦5,970 ¦ +---------+-----------------+-------------+------------------+----------------¦ ¦June ¦4,048 ¦6,146 ¦50 ¦6,096 ¦ +---------+-----------------+-------------+------------------+----------------¦ ¦July ¦4,503 ¦1,197 ¦298 ¦899 ¦ +---------+-----------------+-------------+------------------+----------------¦ ¦August ¦6,985 ¦1,724 ¦19 ¦1,705 ¦ +---------+-----------------+-------------+------------------+----------------¦ ¦September¦5,744 ¦4,102 ¦34 ¦4,068 ¦ +---------+-----------------+-------------+------------------+----------------¦ ¦October ¦4,078 ¦7,055 ¦128 ¦6,927 ¦ +---------+-----------------+-------------+------------------+----------------¦ ¦November ¦990 ¦2,303 ¦399 ¦1,904 ¦ +---------+-----------------+-------------+------------------+----------------¦ ¦December ¦ ¦200 ¦2,176 ¦(1,976) ¦ +---------+-----------------+-------------+------------------+----------------¦ ¦Total ¦44,769 ¦33,955 ¦3,204 ¦30,751 ¦ +-----------------------------------------------------------------------------+
The high level of music box sales from March through October 1946 was in large measure attributable to the fact that the phonette was a product coming into the picture soon after the war ended as something new. It was attractive to the distributors inasmuch as there was little or no other merchandise available for them to sell at the time, and Dennison had impressed many distributors with the reports of his Los Angeles operations.
Petitioner's production of music boxes was hampered by a parts shortage. It was told by its purchasing agent that it would have to allow up to 6 months for him to obtain delivery of material. In October 1946, petitioner had a backlog of $785,000 in orders, representing about 20,000 phonette units. Petitioner could not fill these orders due to shortages in certain parts. Petitioner had built up a substantial inventory in other parts.
Toward the end of October 1946, petitioner and Personal Music had reports that despite recent sales of phonettes the product was not being received favorably.
On November 4, 1946, CMAC, acting under the advance notice provisions of its contract of May 21, 1946, advised Personal Music that it would no longer finance any of the sales of the phonette.
CMAC took this action because of the poor experience it had had in its financing arrangements in connection with phonette purchases. The operators were not making their payments when due; and the distributors were requesting extensions on their floor-plan contracts inasmuch as large quantities of the phonettes remained on their floors, unsold to the operators.
Petitioner, on November 12, 1946, ceased production of the phonettes entirely. Production of the nickel box was never thereafter resumed. there was no production of any type box for the balance of 1946. They subsequently designed a nickel-dime box.
As of the end of 1946, Personal Music had accounts receivable, on open account, of approximately $75,000, of which $25,00 was considered to be uncollectible.
In November 1946, Personal Music had increased requests from distributors to accept the return of phonettes and credit the distributors with the returns. As indicated above, 399 returns were so accepted in November 1946; 2,176 were accepted in December 1946; and sales for the month of December totaled 200. Thereafter, Personal Music refused to accept the returns or give the distributions credit for many boxes sought to be returned. Other boxes were returned without credit, to be held subject to disposition instructions from CMAC. This was particularly true of some shipments which were in transit when CMAC withdrew its financing arrangements.
Faced with this state of affairs, the officers of petitioner and Personal Music, in December 1946, sought advice from Dennison, the only person in the organization familiar with the music box industry, on what future course of action to follow. Dennison stated that, in view of the operators' refusal to accept the nickel box, it was a nullity and no good, and that the only hope of continuing the business lay in the immediate production of the nickel-dime box (i. e., a phonette which could be operated by nickels or dimes) which he felt would be favorably received by the distributors. By the end of 1946, they had agreed among themselves that they were going to design a nickel-dime box.
The following is an excerpt of the minutes of a meeting of the directors of petitioner on December 31, 1946:
however, that inventory included about $490,000 of music box and related materials, a considerable portion of which was obsolete and the balance speculative, and that a substantial portion of this should be written off at the end of the year and a further reserve provided out of surplus.
The President drew attention to his report to the Directors dated October 30, 1946, regarding the backlog of unfilled Personal Music orders in the amount of $785,000 and reported a refusal, since that date, on the part of music merchants to accept deliveries of our present Personal Music boxes, causing for all practical purposes a cancellation of this backlog.
* * * * * * *
It was agreed, without resolution, that the most rigid economy in the management of the Company's affairs was necessary and that a reduction of inventories should be effected at the earliest possible date.
On motion duly made and seconded, it was
RESOLVED, that the officers be authorized, after consultation with the accountants, to write off such inventory as they determine to be obsolete and to set up such reserves out of surplus as they determine necessary to provide for further losses.
Petitioner's officers were convinced that the nickel box was obsolete at the end of 1946. Petitioner's 1946 income tax return contained adjusting entries to reflect the reduction in the value of petitioner's inventory because of the obsolescence of the nickel box, which respondent concedes ‘were correct write downs.’
In December 1946, as above indicated, petitioner's officers agreed to attempt to design and manufacture a nickel-dime model. In order to eliminate the necessity of putting more money into this enterprise, it was decided to fit the nickel-dime mechanism into the body of the nickel box. This proved to be difficult and involved some retooling at a cost of $10,000 to $15,000 early in 1947.
Twelve handmade models of a nickel-dime box was completed at the end of January 1947, and were flown to Chicago in time to be shown at the annual coin machine industries exhibit held around February 1, 1947. To observed the industry's reaction to the new boxes, many officials of petitioner and Person Music attended the Chicago show. Personal Music set up the largest exhibit on the floor. The show was well attended by operators and distributors, but they showed no enthusiasm or even interest in the nickel-dime box; and no orders for the box were placed with Personal Music. This was a complete surprise to petitioner's top management who attended the show.
Having received no orders for the new boxes at the Chicago show, the officers of Personal Music instructed Dennison to make a tour of the country and contact those distributors and operators who had not attended the show. Dennison, who remained optimistic about the sales possibilities of the new box, visited Los Angeles, San Francisco, Reno, Salt Lake City, Ogden, Chicago, Philadelphia, and many other cities in his tour of the country, but returned to the offices of Personal Music without a single order. Thereupon, Dennison's resignation was demanded by the directors of Personal Music and was tendered by him by letter dated March 6, 1947.
By contract dated March 14, 1947, petitioner acquired from Dennison his 350 shares of Personal Music stock which represented the only outstanding stock other than the 650 shares held by petitioner. In consideration for these 350 shares, petitioner transferred to Dennison certain music box equipment and undertook to discharge certain debts owing to Personal Music by D. & L. Distributing Company, a music box operating company in which Dennison had an interest. The debts owing by D. & L. Distributing Company represented purchase price of music box parts from Personal Music. In net effect, petitioner acquired the 350 shares of Personal Music stock in exchange for certain music box equipment.
The officers of both Personal Music and petitioner lacked any experience in the music box field and relied on Dennison's judgment in all matters involving this business. Allen felt that Dennison had ‘dragged us into very deep water on this thing,’ and wondered whether Dennison's eternal optimism was not traceable to the terms of his employment contract whereby he was to receive 2 per cent of net receipts from all sales. The facts that petitioner had a large parts inventory would work to Dennison's advantage.
The phonette business was in perilous state in November or December 1946, from want of a market. The failure of the phonette in 1946 may be traced to the following:
(a) The system lacked selectivity in that, contrary to the setup of the ordinary juke box, the individual dropping in the coin could not choose the music he wished to hear.
(b) The cost of installation of the phonette system was much more expensive than in the case of the ordinary juke box which was simply plugged into the electric wall socket.
(c) In case of removal, none of the installation costs could be salvaged, and the removal costs were also appreciable.
(d) It was impractical to leave the adjustment of the volume of music under the direction of the manager of the location. Furthermore, adjustment of such volume by the phonette operator at an optimum level was difficult due to the fact that noise levels in a restaurant or lunchroom fluctuated during different periods of the day. For example, if the volume were set high enough to be heard within a booth during the noisy period, one phonette would provide music for the entire room at quieter periods, thereby defeating the multiple-play feature. If, on the other hand, the volume were set to confine the music to one booth during a quiet period, it would not be heard by all occupants of the booth during a noisy period.
(e) A phonette system with its studio and leased telephone lines could be profitably operated only in a city of approximately 250,000, inasmuch as only in such a city would there be enough location outlets to warrant the studio equipment costs.
Also contributing to the sudden evaporation of the market was the fact that the market itself was in some measure a false one arising from the postwar demand which, in this field, resulted in the buying of any type of coin-operated machine offered for sale. And, while the juke box could not compete with the phonette in all locations, particularly where background music was desired, improvements in the juke boxes, such as separate selector boxes in the various booths, did seriously encroach upon the area in which the phonette was considered preferable.
At the beginning of 1947 when petitioner first completed a nickel-dime box, it was making an effort to remain in the business. Its officers hoped that the nickel-dime box would revive the sales. On November 12, 1946, petitioner had placed an order for 25,000 phonette nameplates; and on January 14, 1947, the supplier was instructed to produce only 5,000 and to hold the material for the balance of 20,000 until further instructions. Five hundred of these nameplates were delivered in February 1947 and 4,586 in March 1947. Of this number, 3,980 nameplates were returned in June 1947. Petitioner was charged $313 for the nameplates delivered in February and $2,760 for those delivered in March. Against these charges, petitioner was credited with $2,396 for the nameplates returned in June. One nameplate would be used on each phonette unit.
In 1947 the number of nickel-dime music boxes produced, sold, and returned was as follows:
+--------------------------------------+ ¦1947 ¦Produced¦Sold¦Returned¦Net ¦ +---------+--------+----+--------+-----¦ ¦January ¦ ¦ ¦ ¦ ¦ +---------+--------+----+--------+-----¦ ¦February ¦16 ¦ ¦ ¦ ¦ +---------+--------+----+--------+-----¦ ¦March ¦307 ¦317 ¦ ¦317 ¦ +---------+--------+----+--------+-----¦ ¦April ¦ ¦1 ¦167 ¦(166)¦ +---------+--------+----+--------+-----¦ ¦May ¦ ¦ ¦1 ¦(1) ¦ +---------+--------+----+--------+-----¦ ¦June ¦ ¦ ¦17 ¦(17) ¦ +---------+--------+----+--------+-----¦ ¦July ¦234 ¦234 ¦ ¦234 ¦ +---------+--------+----+--------+-----¦ ¦August ¦ ¦ ¦2 ¦(2) ¦ +---------+--------+----+--------+-----¦ ¦September¦6 ¦ ¦ ¦ ¦ +---------+--------+----+--------+-----¦ ¦October ¦ ¦ ¦50 ¦(50) ¦ +---------+--------+----+--------+-----¦ ¦November ¦168 ¦176 ¦4 ¦172 ¦ +---------+--------+----+--------+-----¦ ¦December ¦100 ¦102 ¦85 ¦17 ¦ +---------+--------+----+--------+-----¦ ¦Total ¦831 ¦830 ¦326 ¦504 ¦ +--------------------------------------+ Some of the 504 boxes indicated as net sales were used by Personal Music in its own operations. Some of the boxes manufactured in 1947 were completed when petitioner's employees were not busy. In June 1947, the price of phonette units was reduced from $21 to $7.50, retroactively.
Excerpts from petitioner's general journal for December 1946 are as follows:
[Page 59]
+--------------------------------------------------+ ¦ ¦Dr. ¦Cr. ¦ +----------------------------+-----------+---------¦ ¦Inventory adjustment account¦$130,423.39¦ ¦ +----------------------------+-----------+---------¦ ¦Raw materials ¦ ¦$6,248.13¦ +----------------------------+-----------+---------¦ ¦Work in process ¦ ¦5,914.77 ¦ +----------------------------+-----------+---------¦ ¦Finished parts ¦ ¦51,266.69¦ +----------------------------+-----------+---------¦ ¦Finished stock ¦ ¦66,993.80¦ +--------------------------------------------------+
To reduce foregoing inventories by items becoming obsolete as a result of the change from F–5 to F–10 boxes.
+-----------------------------------------------------------------------------+ ¦ ¦Obsolete but convertible—cost of ¦Obsolete and ¦Total ¦ ¦ ¦reconversion ¦unusable ¦ ¦ +------------+-----------------------------------+----------------+-----------¦ ¦Raw ¦ ¦$6,248.13 ¦$6,248.13 ¦ ¦materials ¦ ¦ ¦ ¦ +------------+-----------------------------------+----------------+-----------¦ ¦Work in ¦$4,245.88 ¦1,668.89 ¦5.914.77 ¦ ¦process ¦ ¦ ¦ ¦ +------------+-----------------------------------+----------------+-----------¦ ¦Finished ¦48,313.61 ¦2,953.08 ¦51,266.69 ¦ ¦parts ¦ ¦ ¦ ¦ +------------+-----------------------------------+----------------+-----------¦ ¦Finished ¦66,993.80 ¦ ¦66,993.80 ¦ ¦stock ¦ ¦ ¦ ¦ +------------+-----------------------------------+----------------+-----------¦ ¦ ¦$119,553.29 ¦$10,870.10 ¦$130,423.39¦ +-----------------------------------------------------------------------------+
[Page 60]
+---------------------------------------------------+ ¦ ¦Dr. ¦Cr. ¦ +----------------------------+-----------+----------¦ ¦Inventory adjustment account¦$105,982.15¦ ¦ +----------------------------+-----------+----------¦ ¦Raw materials ¦ ¦$20,923.11¦ +----------------------------+-----------+----------¦ ¦Work in process ¦ ¦9,248.93 ¦ +----------------------------+-----------+----------¦ ¦Finished parts ¦ ¦75,810.11 ¦ +---------------------------------------------------+
Inventory items becoming unusable as a result of disappearance of demand for music boxes,—Based on estimated sales potential of 15,000 boxes for 1947.
[Page 61]
+-------------------------------------------------+ ¦ ¦Dr. ¦Cr. ¦ +----------------------------+---------+----------¦ ¦Raw materials ¦$8,315.92¦ ¦ +----------------------------+---------+----------¦ ¦Finished parts ¦3,281.15 ¦ ¦ +----------------------------+---------+----------¦ ¦Inventory adjustment account¦ ¦$11,597.07¦ +-------------------------------------------------+
Estimated recoverable value of nonusable music-box parts and materials.
[Page 62]
+--------------------------------------------------+ ¦ ¦Dr. ¦Cr. ¦ +----------------------------+----------+----------¦ ¦Finished parts ¦$21,728.65¦ ¦ +----------------------------+----------+----------¦ ¦Inventory adjustment account¦ ¦$21,728.65¦ +--------------------------------------------------+
To reinstate certain music-box parts—per inventory schedules.
[Page 63]
+------------------------------------------------+ ¦ ¦Dr. ¦Cr. ¦ +----------------------------+---------+---------¦ ¦Inventory adjustment account¦$3,281.15¦ ¦ +----------------------------+---------+---------¦ ¦Finished parts ¦ ¦$3,281.15¦ +------------------------------------------------+
To remove salvage value of music parts previously set up. These items were reinstated.
[Page 64]
+--------------------------------------------------+ ¦ ¦Dr. ¦Cr. ¦ +----------------------------+----------+----------¦ ¦Inventory adjustment account¦$27,718.02¦ ¦ +----------------------------+----------+----------¦ ¦Finished parts ¦ ¦$27,718.02¦ +--------------------------------------------------+
Additional write down of music-box parts based on 10,000 units—estimated sales for 1947.
[Page 66]
+--------------------------------------------------------+ ¦ ¦Dr. ¦Cr. ¦ +----------------------------------+----------+----------¦ ¦Inventory adjustment account ¦$42,000.00¦ ¦ +----------------------------------+----------+----------¦ ¦Raw materials inventory in transit¦ ¦$42,000.00¦ +--------------------------------------------------------+
To write off inventory of JoE 65–47, consisting of various component parts to manufacture 2,000 Model F Master Power Supply Units. Based upon an estimate sales of 15,000 boxes. These units will not be required,—and the parts of no value,—per Mr. Drury. The estimate of a sales potential of 15,000 boxes for 1947 was made some time between February 20 and the middle of March 1947. After Dennison's trip around the country, after the Chicago show, 15,000 boxes seemed high, and after ‘a great deal of soul searching’ and consideration, it was concluded that the best that could be hoped for 1947 was the sale of 10,000 boxes.
The total reduction of the inventory effected as a result of such entries on the books of petitioner was $276,078.99, comprised of $165,159.06 being the amount applicable to obsolescence of 5-cent boxes and cost of conversion to make adaptable to 5- and 10-cent boxes, and $110,919.93, being the amount applicable to unusability of parts in excess of those required for 5-and 10-cent music boxes.
The entry on page 59 of $130,423.39 explained as ‘To reduce foregoing inventories by items becoming obsolete as a result of the change from F–5 to F–10 boxes' was allowed by the respondent.
The entry on page 62 which applied to a portion of the entry on page 59 was allowed.
The entry on page 66 of $42,000 was allowed by the respondent.
The writing off of inventory effected by the entries on pages 60, 63, and 64, together with the adjustment on page 61 and the remaining portion of the adjustment on page 62, was disallowed.
The total write-off disallowed by the respondent was therefore $110,919.93. This net amount of $110,919.93 is the total amount written of based on the alleged estimate of potential sales of 10,000 music boxes, and the various entries set forth above which were disallowed have that net effect.
Events subsequent to the middle of March 1947 demonstrate that in setting up a value of $162,385.08 for its music inventory in closing its books for 1946, petitioner made an error in business judgment. The scrap or salvage value of such inventory at that time is estimated by petitioner to have been $45,250.54, and was comprised as follows:
+---------------------------+ ¦Raw materials ¦$11,993.54¦ +----------------+----------¦ ¦Finished parts ¦29,757.00 ¦ +----------------+----------¦ ¦Finished stocks ¦3,500.00 ¦ +----------------+----------¦ ¦ ¦$45,250.54¦ +---------------------------+ These estimates were made in about 1950. No estimate was made in 1947.
At the end of 1946, the nickel box was obsolete. At that time petitioner contemplated but had not designed a nickel-dime box. The only chance that the inventory of the component parts of the nickel boxes would acquire any substantial value was if they could be utilized in a nickel-dime box.
Carrying forward in the inventory the value of the material that would go into 10,000 nickel-dime boxes, ‘was a very bad error in judgment,’ as was the phonette proposition from the start.
Petitioner's inventory at all times pertinent to this proceeding has been consistently valued on the basis of cost or market, whichever is lower.
Petitioner's inventory as at the close of business December 31, 1946, was taken with the same procedures consistently followed over many years:
(a) A careful physical count was taken during the period December 26, 1946, to January 1, 1947. The taking of the count was observed and test-checked by the petitioner's firm of independent auditors, Peat, Marwick, Mitchell & Co. In 1947, four representatives of Peat, Marwick, Mitchell & Co. test-checked the taking of the inventory and were consulted from time to time in connection with the details in the taking of the inventory.
(b) Individual count cards were used in the physical counting and weighing of the inventory. Quantities were transferred from these cards to tabulating cards upon which were inserted unit costs taken from the accounting records of the company and which were used in determining the aggregate value of each part and of the entire inventory for each part. The quantities, unit costs, and amounts were entered on the perpetual inventory record of the company which consisted of separate cards showing ins, outs, and balance for each item of stock part, subassembly, or assembly in the company's inventory.
(c) At each step in the process of taking the inventory, adequate provision was made to correct any errors which might have been made; and any differences between the book perpetual inventory and the physical counts were investigated.
(d) Somewhere between February 22 and March 17, the posting to the perpetual inventory was completed; and Drury, petitioner's comptroller, together with the engineering department and the manager of the production department, conferred to determine the adjustments to be made to the perpetual inventory because of obsolescence or unusability of the inventory. In doing this work, they were able, by virtue of the records kept by petitioner, to analyze each component part, subassembly, etc., on an individual basis.
Revenue Agent Van Blarcum examined the petitioner's tax liability for 1946. He went to the petitioner in November 1947 to determine its 1946 tax liability. During the years 1946 and 1947, the following procedure was to be followed by the petitioner for the disposal of scrap:
At the time the scrap is to be sold, the plant superintendent sends the scrap to the receiving room where it is weighed and the scrap material recovered ticket is then forwarded to the shipping room where a bill of lading is prepared. The copy of the bill of lading, with a copy of the scrap material recovered form, is forwarded to the accounting department where the junk dealer is billed. Material requisition tickets are to be prepared by the plant superintendent for materials which he feels he cannot use and which he considers to be junk. At the time Van Blarcum examined petitioner, he was aware of the foregoing instructions for the disposal of scrap and ascertained that such procedure was not followed in regard to the inventory in the claimed $110,919.93 write-off for obsolescence except as to a very small amount. Van Blarcum examined the petitioner's stock room to see if it had made any effort to segregate inventory involved in the $110,919.93 adjustment, and found that there was no segregation of the parts so written off with minor exceptions. It was not until October or November 1947 that petitioner began any substantial scrapping or salvaging of the parts written off which composed the $110,919.93 item, and none of it was scrapped before March 15, 1947, though petitioner began scrapping obsolete material in the first week of January 1947.
The petitioner, in filing its 1947 income tax return, brought forward an opening inventory of $162,385.08 for 1947 and wrote off the losses resulting from such opening inventory in 1947.
OPINION.
RICE, Judge:
Respondent has conceded that petitioner is entitled to adjustments in its closing inventory for 1946 of certain write-downs to reflect the obsolescence of the nickel box. See Mrs. C. J. Barnard, 18 B. T. A. 1022 (1930). Petitioner's return for 1946 also reflected the obsolescence of parts other than those required to manufacture 10,000 nickel-dime boxes
which petitioner estimated it could sell. Respondent increased petitioner's inventory by the value of these items, and included this adjustment in the determination of the deficiencies. But petitioner's present position is that it does not now attempt to justify the foregoing but, instead, claims that the entire phonette inventory was obsolete at the end of 1946, and that for this reason it is entitled to a determination of an overpayment.
First estimated on petitioner's books for 15,000.
There appears to be a dearth of pertinent adjudicated cases. The opinions of this Court which seem to be nearest to the present problem are American Manganese Steel Co., 7 B. T. A. 659 (1927), and Dunn Manufacturing Co., 14 B. T. A. 225 (1928). In the former, the taxpayer, similarly confronted at the end of the year with the possible need for an adjustment to its inventory, undertook a sales campaign to dispose of the goods calling for the adjustment. The sales campaign resulted in the disposition of some of the questionable inventory in the following year, and developed the fact that there was no market for the greater part of that inventory. The taxpayer thereupon scrapped the inventory, and it was held that it was entitled to reduce its inventory on account of the merchandise scrapped in the subsequent year. The Court, in its opinion, said:
It clearly appears from the evidence that the castings had been properly made and it was believed by the management of petitioner at the end of 1919 that at least a considerable portion of them might be disposed of as a result of a sales campaign. Under such circumstances we believe that petitioner was justified in leaving the castings in the inventory at their cost price until the result of the sales campaign could be determined. It was not until the following year of 1920 that it was definitely determined that there was no present market for most of these castings and during that year, and not before, the unsold castings were in fact scrapped. We are of the opinion that the inventory loss was properly taken in the year 1920.
In Dunn Manufacturing Co., supra, the reduction of closing inventory taken by the taxpayer for 1920 on a claim of certain goods having become obsolete was disallowed. This Court said:
It is the contention of the petitioner that in its closing inventory for the year 1920 there were included certain casing elevators which had cost $37,373.34, but which were in fact obsolete and of no value, and that the inventory should now be adjusted by excluding the elevators therefrom, and the petitioner's net income for 1920 reduced accordingly. On the record we are unable to agree with the petitioner's contention. It may be that in the light of events occurring since 1920 the elevators in question were worthless at that time, but if they were obsolete and worthless, it does not appear that they were so known to be or considered by the petitioner's officers. While sales of the elevators had fallen off materially since the spring of 1920, some sales had been made throughout the year. The inventory was taken by one of the petitioner's officers and he included the elevators therein at their cost. The only explanation of his action in including the elevators in inventory is his statement made at the hearing of this case that ‘Well, I overlooked it, I guess that is all.’ This appears to be a belated claim for a deduction from 1920 income on account of goods on hand at that time which have since proved to be unsalable. On the evidence we hold that the cost should not be excluded from the closing inventory.
We believe the rationale of these cases is controlling here, and that they preclude the petitioner from its claim that its closing inventory should be reduced at the end of 1946 because its entire phonette inventory was obsolete and worthless, except for its scrap value. At the end of that year, petitioner contemplated the use of the inventory in question in 1947 in its nickel-dime box.
It is true that there was an error of judgment with respect to the inventory at the end of 1946 in the same sense that hindsight demonstrated that this and the entire operation was an error of business judgment. The error in judgment in 1946 with respect to the inventory was not without support in optimistic hope petitioner had in the prospect of the nickel-dime box. Petitioner contemplated the manufacture of the nickel-dime box, and in 1947 did produce 831 of them for sale. The failure of this prospect was not definitely demonstrated until about the middle of 1947.
Petitioner has cited several cases in other courts which appear to be of contrary import,
but we have found nothing to indicate that the Tax Court's position is other than as expressed in the above cases.
See Lucker v. United States, 53 F. 2d 418 (Ct. Cl. 1931); Queen City Woodworks & Lumber Co. v. Crooks, 7 F. Supp. 684 (D. C. Mo., 1934).
Decision will be entered for the respondent.