Lincoln Electric Company v. CIR

• Citation: 444 F.2d 491
• Decision Date: 23 June 1971
• Docket Number: No. 20733.,20733.
• Parties: The LINCOLN ELECTRIC COMPANY, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (6th Circuit)

444 F.2d 491 (1971)

The LINCOLN ELECTRIC COMPANY, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 20733.

United States Court of Appeals, Sixth Circuit.

June 23, 1971.

Henry C. Harvey, Cleveland, Ohio, for appellant; Wallace M. Wright, Jones, Day, Cockley & Reavis, Cleveland, Ohio, on brief.

Charles E. Anderson, Tax Div., Dept. of Justice, Washington, D. C., for appellee; Johnnie M. Walters, Asst. Atty. Gen., Joseph M. Howard, Harry Baum, Attys., Tax Div., Dept. of Justice, Washington, D. C., on brief.

Before WEICK, PECK and KENT, Circuit Judges.

KENT, Circuit Judge.

Petitioner-appellant, The Lincoln Electric Company, hereinafter Lincoln, appeals from the United States Tax Court's decision, '54 T.C. 926, finding deficiencies in petitioner's Federal Income Tax for taxable years 1964 and 1965. The deficiencies, as found by the Tax Court, resulted from the fact that Lincoln did not include its annual "bonus" paid to each of its employeees as a "cost" of the production of the year-end inventory which the Tax Court found therefore did not reflect the full value of that inventory.

Petitioner pointed out in its brief:

"Representatives of the Commissioner have examined Lincoln\'s federal income tax returns in years prior to 1964 and in such years have never adjusted the inventory cost to reflect any portion of the bonus payments. In his examination of Lincoln\'s returns for 1961-1963, a representative of the Commissioner specifically considered whether any bonus payments should be included in inventory cost but, after such consideration, finally made no adjustment in this respect."

It has long been recognized that the Commissioner is not bound by prior accounting methods merely because the tax returns have been examined and no deficiency has been asserted. Carver v. C.I.R., 173 F.2d 29 (6th Cir. 1949); Fruehauf Corporation v. C.I.R., 356 F.2d 975 (6th Cir. 1966).

The evidence shows that for 30 years Lincoln has paid an annual "bonus" to each of its employees, except the company president, in December of each year. The amount of the "bonus" has been determined by the Board of Directors. There has never been an express agreement between Lincoln and its employees in regard to the payment of the "bonus." There has never been any fixed formula for determining the total amount of money to be paid as "bonus" to Lincoln employees as a group or individually. However, in Lincoln's publication The Employee Handbook, available to each employee, under the heading, "Incentive Compensation and Merit Rating," Lincoln describes the "bonus" as follows:

"Each year since 1934 workers at Lincoln have received a substantial cash payment in December. This is not a gift. It represents a sharing of the results of efficiencies created in production during the past twelve months. The total bonus amount is determined by the Board of Directors, based on the success of the company for that year. The bonus is not guaranteed but is entirely dependent on the successful, profitable operation of the company, which to a very large extent depends on your enthusiasm and `will-to-work.\' Your share in the bonus depends on two major factors — your wages in the twelve months prior to and including October 31st and your merit ratings made as of April 30th and October 31st."

Attached to this opinion, as an appendix, is a schedule showing Lincoln's average number of employees, net sales, gross profit before bonus and taxes, regular payroll, cash bonus, and total compensation for the years 1934 to 1965, inclusive.

In this case the Commissioner has taken the position that the money paid to employees in the form of "year-end bonus" is either an expenditure for direct labor or an indirect expense incident to and necessary for the production of the goods involved, and that necessarily a portion of the "bonus" paid must be included in determining the value of the year-end inventory. Lincoln, on the contrary, asserts that the "bonus" paid has nothing to do with the cost of production of the goods involved, but is simply a sharing of the wealth, i. e., profits resulting from the efficient operation of the business. It will be noted that in the tax years in question the "bonus" equaled 118% of the 1964 regular payroll, and 121% of the 1965 regular payroll. It is undisputed that the average hourly earnings of Lincoln's production and production related workers were consistently higher than the average hourly earnings of other workers in Lincoln's industrial classification group in the Cleveland metropolitan area as reported by the Ohio Bureau of Employment Services. It is clear and undisputed that no portion of the "bonus" was included in the valuation of Lincoln's ending inventory, although it is equally clear and undisputed that most of the "bonus" paid in the tax years in question was considered by Lincoln as a part of the "cost of goods sold" and deducted as such on Lincoln's tax return.

Upon examination the Commissioner of Internal Revenue determined that Lincoln's income was not clearly reflected in its tax returns in the years 1964 and 1965 because of failure to include some part of the "bonus" paid during the years in question in valuing the year-end inventory, either as a direct or indirect cost of labor. Accordingly, the Commissioner made adjustments under Int.Rev.Code of 1954, § 446(b)¹ which resulted in a tax deficiency of $381,811, plus interest for 1964, and $75,702.24, plus interest for 1965. The taxpayer challenges the propriety of the allocation of any part of the annual "bonus" to year-end inventory, but does not challenge the amount of such allocation, if proper.

The taxpayer claims in part that because its annual audit for the years in question was certified by its Certified Public Accountants as having been prepared in accordance with the "generally accepted accounting principles," therefore it was justified in its failure to include any part of the annual "bonus" in the valuation of the year-end inventory for tax purposes.

Internal Revenue Code of 1954, § 446(a)² provides the general rule for computing taxable income and authorizes the computation on the basis of the regularly used accounting practices. However, Section 446(b)¹ authorizes the Internal Revenue Service to require a different method if the regular method "does not clearly reflect income." It is clear that "the Commissioner has broad powers in determining whether accounting methods used by a taxpayer clearly reflect income." Commissioner of Internal Revenue v. Hansen, 360 U.S. 446, at page 467, 79 S.Ct. 1270 at page 1282, 3 L.Ed.2d 1360 (1950). These broad powers are limited as stated by this Court in Glenn v. Kentucky Color and Chemical Co., 186 F.2d 975 (6th Cir. 1951) at page 977:

"But the Commissioner\'s authority to order a change in accounting methods when the taxpayer has regularly employed a consistent method depends upon his finding that the taxpayer\'s method does not clearly reflect income." and see authorities therein cited.

This Court has examined certain text material related to accounting practices and has concluded that while there may be variations in the treatment of "bonus" payments, application of the principles enumerated would necessarily result in inclusion of a portion of the "bonus" paid to production workers and production related workers for the purpose of computing the value of the year-end inventory for tax purposes.

As stated in Matz, Curry & Frank, Cost Accounting, (Third Edition, 1962), South-Western Publishing Company, Cincinnati, Ohio, at page 231:

"Bonus payments may be a fixed amount per employee, a fraction of one month\'s wages, or some other calculated amount. The amount of bonus for each employee may be a fixed and long-established tradition of a company, or the amount may vary from year to year. Bonus payments are production labor costs, selling expenses, or administrative expenses as the case may be; but when and how should they be charged to operations? If a factory worker earns $300 a month and the company pays him one month\'s salary at years\' end, his earnings actually amount to $325 per month with $300 paid during the month and the additional $25 per month paid in a lump sum at the end of the year. In order to spread the bonus cost over production, the following entry each month would be in order:

                   Work in Process ...... 325
                      Payroll ................. 300
                      Liability for Bonus .....  25
                        (or Provision for Bonus)
                

"The bonus could also be treated as factory overhead and be included in the predetermined overhead rate, in which case the monthly entry would be:

                   Work in Process ...... 300
                  Factory Overhead ......  25
                      Payroll .................. 300
                      Liability for bonus ..... 25."
                

It should be noted that either of the above two treatments would result in including of the bonus in the valuation of year-end inventory.

In the report of a survey made of a large number of businesses (including Lincoln) by the National Association of Accountants to ascertain the normal method of accounting for labor and labor related costs, the following is found in the report, entitled, Accounting for Labor Costs and Labor Related Costs, (N.A.A. Research Series Number 32, November 1, 1957, New York), at page 31 of the report:

"Some companies omit from manufacturing costs for inventory costing such labor-related costs as pensions, past service pension accruals, separation pay, special year-end compensation, group life insurance, and compensation to consultants for professional labor relations services. Their explanation for such omissions was that they consider these costs to be administrative costs rather than manufacturing costs. Generally they recognize that the total cost of these items chargeable against manufacturing personnel is substantial and that by not charging manufacturing costs they are not showing full cost of manufacturing. While certain items of

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