Coe Labs., Inc. v. Comm'r of Internal Revenue

• Decision Date: 24 June 1960
• Docket Number: Docket No. 50268.
• Citation: 34 T.C. 549
• Parties: COE LABORATORIES, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
• Court: U.S. Tax Court

34 T.C. 549

COE LABORATORIES, INC., PETITIONER,
v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Docket No. 50268.

Tax Court of the United States.

Filed June 24, 1960.

[34 T.C. 550]

Carl J. Batter, Esq., for the petitioner.

David H. Nelson, Esq., for the respondent.

1. For many years, among other activities, petitioner has been engaged in the development and selling of dental impression materials. Beginning in February 1941 and continuing through the taxable years petitioner conducted research on an alginate impression material, the sales of which gave rise to income during the taxable years 1943 to 1946, inclusive. Held, petitioner has failed to prove that any portion of its income for the years 1943 to 1946, of the class described in section 721(a)(2)(c) of the Internal Revenue Code of 1939, as amended, was ‘net abnormal income’ resulting from research and development that could be attributed to prior years, and fails to qualify for the relief provided by section 721(c). Held, further, petitioner fails to qualify for relief under section 722. It has failed to prove that it changed the character of its business within the meaning of section 722(b)(4), and the existence of other factors within the ambit of section 722(b)(5).

2. Petitioner's president and majority shareholder during the years in question owned a farm and leased a portion of it to petitioner for a 5-year term, the lease providing that petitioner was to make improvements thereon, and to have no claim to the improvements nor renewal rights at the end of the term. To an undetermined extent, petitioner used the property leased during the taxable years for the entertaining of various persons interested in petitioners products. Held, petitioner has failed to prove that this property was used for ‘the purpose of’ or ‘in’ its trade or business within the meanings of section 23(a)(1)(A) and (1)(1), respectively, and is not entitled to deductions for rental payments to its president for the years 1947, 1948, and 1950, nor for the amortization of the improvements for the years 1944 to 1949, inclusive.

3. Amounts constituting reasonable rentals and deductible pursuant to section 23(a)(1)(A), for possession of certain properties used by petitioner in its business, and owned by two persons related to petitioner's president or majority shareholders, determined.

4. Amounts constituting reasonable allowance for salaries to petitioner's president during the years 1942, and 1946 to 1950, inclusive, and deductible pursuant to section 23(a)(1)(A), determined.

TRAIN, Judge:

The petitioner claimed refunds and relief from excess profits taxes under sections 721 and 722¹ as follows:

+--------------------------------------------------------+
                ¦ ¦Net abnormal ¦Refund claimed¦
                +-------------------+---------------------+--------------¦
                ¦Year ended July 31—¦income to be excluded¦under sec. 722¦
                +-------------------+---------------------+--------------¦
                ¦ ¦under sec. 721 ¦ ¦
                +-------------------+---------------------+--------------¦
                ¦1943 ¦$61,686.79 ¦$30,486.34 ¦
                +-------------------+---------------------+--------------¦
                ¦1944 ¦52,188.40 ¦31,067.29 ¦
                +-------------------+---------------------+--------------¦
                ¦1945 ¦63,775.27 ¦84,571.89 ¦
                +-------------------+---------------------+--------------¦
                ¦1946 ¦16,311.78 ¦32,397.84 ¦
                +--------------------------------------------------------+
                

The respondent denied the relief claimed, and determined deficiencies in income and excess profits taxes for the years and in the amounts as follows:

+--------------------------------------+
                ¦ ¦Deficiencies ¦
                +----------+---------------------------¦
                ¦Year ended¦ ¦ ¦
                +----------+------------+--------------¦
                ¦July 31— ¦Income taxes¦Excess profits¦
                +----------+------------+--------------¦
                ¦ ¦ ¦taxes ¦
                +----------+------------+--------------¦
                ¦1942 ¦$2,243.00 ¦ ¦
                +----------+------------+--------------¦
                ¦1943 ¦7,410.53 ¦$3,429.17 ¦
                +----------+------------+--------------¦
                ¦1944 ¦ ¦100,044.69 ¦
                +----------+------------+--------------¦
                ¦1945 ¦ ¦90,739.19 ¦
                +----------+------------+--------------¦
                ¦1946 ¦$8,698.13 ¦$37,929.26 ¦
                +----------+------------+--------------¦
                ¦1947 ¦21,138.76 ¦ ¦
                +----------+------------+--------------¦
                ¦1948 ¦14,765.64 ¦ ¦
                +----------+------------+--------------¦
                ¦1949 ¦2,483.33 ¦ ¦
                +--------------------------------------+
                

[34 T.C. 551]

Respondent further determined that petitioner was liable for an addition to tax in the amount of $112.15 under section 291 for failure to file a timely return for the year ended July 31, 1942, which determination petitioner concedes the correctness of. Both petitioner and respondent have conceded certain other issues, which will be given effect under the Rule 50 computation.

The issues to be decided are:

(1) Whether petitioner derived any net abnormal income during the fiscal years ended July 31, 1943 to 1946, inclusive, of the class described in section 721(a)(2)(C) which is attributable to prior years, so as to entitle it to the relief provided by that section;

(2) Whether petitioner changed the character of its business within the meaning of section 722(b)(4) either during or immediately prior to the base period, and otherwise qualifies for the relief accorded by that section;

(3) Whether petitioner is entitled to amortize over the period of its lease the cost of improvements to its president's Indiana farm for the fiscal years 1944 to 1949, inclusive;

(4) Whether amounts paid by petitioner to its president for rental of his Indiana farm were deductible expenses for the fiscal years 1947, 1948, and 1950;

(5) Whether any portion of the rents paid and deducted by petitioner for the fiscal years 1945 to 1950, inclusive, for properties located on West 62d Street and on Wentworth Avenue were excessive and unreasonable; and

(6) Whether any portion of the salary paid to petitioner's president and principal stockholder was excessive and unreasonable for the fiscal years 1942 and 1946 to 1950, inclusive.

FINDINGS OF FACT.

Some of the facts are stipulated and are hereby found as stipulated.

The petitioner (hereinafter sometimes referred to as Coe) was incorporated in 1928 under the laws of Illinois for the purpose of acquiring the assets and assuming the liabilities of Ernest E. Dalton, an individual who had been doing business as Coe Laboratories.

Petitioner's income and declared value excess-profits tax return (Form 1120) for the fiscal year ended July 31, 1942, which was due to be filed on October 15, 1942, was not filed until October 29, 1942.

Petitioner filed timely income, declared value excess-profits, and excess profits tax returns for the fiscal years ended July 31, 1943 through 1946, and corporation income tax returns for the fiscal years ended July 31, 1947 through 1949. The return for the fiscal year ended July 31, 1950, showing a net loss of $72,137.38, was filed

[34 T.C. 552]

on December 1, 1950. All the above returns were filed with the collector of internal revenue, first district of Illinois.

During the years here involved petitioner maintained its principal office at 6033 Wentworth Avenue, Chicago, Illinois.

The business of the petitioner is that of compounding impression material for dentists, the wholesale distribution of dental supplies, and the operation of a laboratory devoted to research in the science of dentistry. It keeps its books and files its income tax returns on a fiscal year ending July 31, using an accrual method of accounting. Its base period consists of the fiscal years ended July 31, 1937 to 1940, inclusive.

Ernest E. Dalton (hereinafter referred to as Dalton) was president of petitioner from its inception until his death in August 1935. Immediately after Dalton's death, W. S. Rice (hereinafter referred to as Rice) became president, and continued in that capacity until his own death in 1955.

Sections 721 and 722.

Prior to 1931, among other activities, petitioner sold gold for use in dental bridgework. Petitioner's net sales, including sales of gold, for the fiscal years 1929 and 1930 averaged approximately $1,191,000 per annum. By the year 1926, Polk E. Akers (hereinafter referred to as Akers) had developed a technique of partial denture engineering. He had come to be associated with Coe Laboratories. In the year 1926, Dalton directed his advertisements promoting the Akers technique. As a result, in 1926, there appeared in the August issue of the American Dental Association Journal, advertisements directed to dentists describing, on behalf of 10 different laboratories, the advantages of having those laboratories, as practitioners of the Akers technique, construct partial dentures for the dentists' clients. The arrangement between Coe Laboratories and such laboratories sponsoring the Akers technique was that Coe would pay for 50 per cent of the cost of the journal space, and each laboratory (whose name appeared always at the bottom of and sometimes in the page of advertisement) would pay 50 per cent of the cost of that page. The Akers technique involved a gold casting; Coe Laboratories' gold was advertised by it as ‘Coe 4 Gold.’ In the same issue of the journal, petitioner's predecessor had two advertisements promoting the Akers technique, and emphasizing the use of Coe 4 Gold.

Further advertisements and other publications were prepared by Parsons for these laboratories which were sponsoring the Akers technique, and which were advertised in such publication by petitioner

[34 T.C. 553]

as ‘Certified Akers Laboratories.’ Some of these publications were directed to the certified laboratories 5 themselves, for their technical information, and others were directed both to them and to dentists, and advertised both a particular certified laboratory, and the advantages of Akers and certain techniques and products developed or marketed by petitioner. These publications originally had placed conspicuously on them an emblem reading ‘Certified Akers Technicians,’ ‘Better Removables'; by 1930 the emblem had been changed to read...