Briarcliff Candy Corporation v. Commissioner of Internal Revenue
| Citation | 475 F.2d 775 |
| Decision Date | 12 March 1973 |
| Docket Number | Docket 72-1755.,No. 465,465 |
| Parties | BRIARCLIFF CANDY CORPORATION, (formerly Loft Candy Corporation), Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Appellee. |
| Court | United States Courts of Appeals. United States Court of Appeals (2nd Circuit) |
John J. Yurow, Washington, D. C. (John Harllee, Jr., and Arent, Fox, Kintner, Plotkin & Kahn, Washington, D. C., on the brief), for appellant.
William S. Estabrook, III, Tax Division, Department of Justice, Washington, D. C. (Scott P. Crampton, Asst. Atty. Gen., Meyer Rothwacks, and Ernest J. Brown, Tax Division, Department of Justice, Washington, D. C., on the brief), for appellee.
Before KAUFMAN, ANDERSON and OAKES, Circuit Judges.
This is an appeal by Briarcliff Candy Corp. (taxpayer), formerly Loft Candy Corp. (Loft), from a decision of the Tax Court which held that substantial expenditures made by Loft in the tax year July 1, 1961 to June 30, 1962, in developing a market for the sale of its candy to wholesale customers were made to acquire a capital asset, 26 U.S.C. § 263(a)(2), and not deductible as ordinary and necessary business expenses under 26 U.S.C. § 162(a).
The Loft Candy Corp. and its predecessors had, since late in the 19th century, engaged in the manufacture and sale of candy and confectionery products. More than 80% of its sales were made through its own retail stores, and the rest were through wholesale customers. Its retail stores were located in the thickly populated urban centers in the northeastern part of the country.
During the 1950's there began in this country, particularly in the northeast, a major demographic phenomenon in the form of a population shift of thousands of people from the urban centers to the suburbs. This gave and has continued to give rise to very serious problems for municipal, state and the federal governments, many of which still remain unresolved. The social and economic consequences have been far reaching; and urban centered businesses, large and small, have been compelled to take measures to meet the change, in the interest of survival.
In response to the effect of this exodus, the taxpayer at first sought to retain the numbers of its customers by opening retail candy stores in the suburbs but each such outlet could only attract a fraction of the sales volume achieved by the stores in the urban centers, which resulted in proportionately higher operating cost and a lower profit margin. Its operating profits for the fiscal years ending June 30, or thereabouts, of 1958 through 1961 were as follows:
Operating profit before
Federal
Year Ended Income Tax
June 28, 1958 $886,614
June 27, 1959 623,722
July 2, 1960 612,388
July 1, 1961 257,390
In the latter part of 1961 taxpayer's management instituted a program of soliciting independently operated retail outlets such as drugstores, card stores and the like, to include in their businesses the retail sale of Loft's candies. Taxpayer, in its own organization, set up a separate "franchise" division headed by a vice president and staffed with a sales manager, several salesmen and clerical personnel. Its task was to persuade these storekeepers to take on the retail sale of Loft's candies, to enter into agency or franchise contracts with them, specifying the terms under which candy would be furnished at wholesale by taxpayer and handled and sold by the retailer, and to see that the contracting stores were properly serviced and had a proper flow of merchandise. In each of these contracts the retail store proprietor agreed to set aside a space in the store for refrigerating display and storage counters at his own expense, to be exclusively devoted to the sale of Loft candies, and to use his best efforts to sell these candies to his customers. Taxpayer agreed to supply the retailer with its candies at a discount from retail prices and to assist the proprietor in setting up and operating the facility. It also agreed not to enfranchise a competing drugstore within a specified area. The contracts remained in operation for terms varying from one to five years and after the initial term, it was to continue from year to year unless terminated by one party giving 30 days notice to the other.
Beginning in the latter part of 1961, the franchise division of the taxpayer embarked upon an extensive advertising campaign. It advertised in drugstore trade journals and circularized proprietors by mail to interest them in becoming a retail outlet for taxpayer's products. In the tax year ending June 30, 1962, it mailed circulars, with attached reply cards to 50,000 independent drugstores. The 2,000 response cards received were followed up by telephone calls and personal visits by salesmen. By June 30, 1962, 600 appointments were arranged and 159 contracts were entered into.
The net expenses incurred by the taxpayer in operating the franchise division for the taxable year ending June 30, 1962 were $332,869. The Commissioner divided the items making up this total into two categories of expenses which he labeled, "Promotional Expenses" and "Recurring Operational Expenses."1 The promotional expenses aggregated $212,028, and these he disallowed as part of taxpayer's claimed net operating loss carry back from the taxable year ended June 30, 1962 to the taxable year ended June 27, 1959. The Commissioner's action was upheld by the Tax Court and the taxpayer has appealed. We reverse.
On May 3, 1971 the taxpayer sold its business to Barricini Stores Inc. The history of taxpayer's franchise division between year ending June 30, 1962 and the date of the sale of the business is significant and of interest. The following shows the agencies opened and closed during each year through June 1968, and the number in operation at the end of each year through June, 1969:
Agencies operating
Agencies Agencies at close
Taxable year opened closed of tax year
June 30, 1962 159 — 159
June 29, 1963 339 8 490
June 27, 1964 392 36 846
June 26, 1965 415 75 1,186
July 2, 1966 268 74 1,380
July 1, 1967 112 132 1,360
June 27, 1968 195 90 1,465
June 28, 1969 1,640
Of the original 159 agencies in operation on June 30, 1962 about 120 were continuing to sell Loft's candies on June 28, 1969. The taxpayer's management, however, decided by January 1, 1969 that the returns from the franchise division were not sufficient to compensate for the administrative problems and particularly the restrictions (such as territorial restrictions) with which it was burdened under the agency contracts, and it therefore determined to terminate the agency contracts as soon as it could under their terms. The entire expenditures for and efforts of the franchise division made very little change in net sales. In the fiscal years 1958 through 1970 the net sales were as follows:
NET SALES2
Franchise
Fiscal year Division Other Total
1958 $17,334,310 $17,334,310
(unaudited)
1959 17,690,409 17,690,409
1960 18,380,263 18,380,263
1961 17,601,868 17,601,868
1962 $ 400,729 17,061,929 17,462,658
1963 1,645,462 16,128,649 17,774,111
1964 2,692,244 15,143,061 17,835,305
1965 3,516,812 14,459,572 17,976,384
1966 3,855,340 14,503,729 18,359,069
1967 3,507,244 14,824,558 18,331,802
1968 3,432,995 14,009,960 17,442,955
1969 2,901,799 13,284,191 16,185,990
1970 3,301,616 15,257,689 18,559,305
As of the fiscal year ending June 28, 1969, Loft's divisional sources of sales were as follows: 66% came from 250 company operated retail candy shops; 18% from 1,640 agency stores; 8% from 160 department stores and candy shops; and 8% from other outlets.
When the taxpayer sold its business to Barricini Stores Inc. it was paid $10,000 for a group of assets made up of trademarks and tradenames, usable inventories, customer lists, agency contracts, manufacturing formulae, standards, guidelines and other production knowhow, and a portion of its plant equipment and machinery.
The Commissioner concluded that the taxpayer's expenditures of $212,028 in 1962 were for capital assets "consisting of 159 valuable franchise contracts." But in 1971, in the sale of the business, 179 of some of the same and similar franchise or agency contracts brought only a fraction of $10,000. The $212,028 were only those described by the Commissioner as promotional expenses. The total expenses of the franchise division for 1962 amounted to $332,869. Nor was that the end of this kind of outlay. In subsequent full years through June 30, 1970, it was necessary to pay out an average in excess of twice what was spent in the half year ending June 30, 1962, in order to hold onto most of the contracting storekeepers and add new ones. The yearly totals were as follows:
1962 $332,869
1963 580,702
1964 603,817
1965 808,965
1966 740,689
1967 687,224
1968 730,852
1969 727,483
1970 635,013
_______
Total $5,847,614
Taxpayer's management considered that these...
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