Thompson Eng'g Co. v. Comm'r of Internal Revenue

• Citation: 80 T.C. 672,80 T.C. No. 32
• Decision Date: 11 April 1983
• Docket Number: Docket No. 9471-77.
• Parties: THOMPSON ENGINEERING COMPANY, INC., PETITIONER v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: United States Tax Court

80 T.C. 672

80 T.C. No. 32

THOMPSON ENGINEERING COMPANY, INC., PETITIONER

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 9471-77.

United States Tax Court

Filed April 11, 1983.

Petitioner, a construction subcontractor, needed to retain earnings and profits to assure adequate bonding capacity; also, it had a reasonable business need to expand its plant. Petitioner had outstanding loans to its sole shareholder; the balance of these loans increased during the years in issue. Held:

1. Petitioner's retentions of earnings and profits exceeded the reasonable needs of its business.

2. Petitioner was availed of for the purpose of avoiding the income tax with respect to its shareholder and is liable for the accumulated earnings tax. Sec. 531, I.R.C. 1954. Charles R. Hembree and Philip E. Wilson, for the petitioner.

Robert J. Kastl, for the respondent.

CHABOT , Judge:

Respondent determined deficiencies in Federal corporate income tax (accumulated earnings tax imposed by sec. 531¹ against petitioner for fiscal years ended August 31, 1972, and August 31, 1973, ² in the amounts of $18,744.83 and $26,996.75, respectively.

The issue for decision is whether petitioner was availed of for the purpose of avoiding the income tax with respect to its shareholder by permitting its earnings and profits to accumulate beyond the reasonable needs of its business (and, if so, what the amount is of the accumulated taxable income).

FINDINGS OF FACT

Some of the facts have been stipulated; the stipulations and the stipulated exhibits are incorporated herein by this reference.

When the petition in this case was filed, petitioner's principal place of business was in Lexington, Ky.

Petitioner was incorporated in Kentucky on September 23, 1959. Throughout its existence, petitioner has been a construction subcontractor engaged primarily in the general plumbing, heating, and air-conditioning business, as well as doing related sheet metal work. During the period 1971 through 1974, this business was highly competitive.

Billy R. Thompson (hereinafter sometimes referred to as Thompson) was petitioner's sole shareholder and president from some time in the mid-1960's through at least the time of trial.³ During the years in issue, Thompson, his wife, and his parents were petitioner's directors; his mother and his wife were petitioner's vice president and secretary-treasurer, respectively. As president, Thompson was responsible for all general decisions for petitioner from 1971 on, including all financial and dividend policies.

From 1959 through at least 1974, petitioner's volume of business increased almost uninterruptedly, and its reputation was excellent. About 95 to 98 percent of petitioner's work was in connection with public works sector contracts (i.e., contracts with Government agencies) involving schools, hospitals, office buildings, boiler plants, utilities, sewer plants, water plants, and federally funded housing. In most public works contracts the mechanical and electrical subcontractors were the two principal types of subcontractors. Petitioner was a mechanical subcontractor. Such contracts were awarded on the basis of a bidding process in which the general (or “prime”) contractor solicited bids from subcontractors (as well as materials suppliers) several weeks in advance of submitting its bid for the contract, analyzed the bids, selected the subcontractors (and materials suppliers) on whose bids it would rely, and formulated and submitted its own bid (listing therein for the contracting agency the names of the selected subcontractors). The subcontractor's bid to the general contractor remained in force for a fixed period of time as set forth in the contract specifications. Once the general contractor was awarded a contract, subcontracts were awarded to the subcontractors. In preparing its bid, the general contractor was not required to use the lowest bidding subcontractor. Along with the amount of the bid, the general contractor considered the subcontractor's financial capability, physical capacity to perform, available personnel, existing workload, and prior knowledge of the type of work involved.

The general contractor in a public works contract was required to provide a performance and bid bond. At the option of the general contractor, the subcontractor might be required to provide a performance and payment bond. If the subcontractor was unable to provide a bond required by the general contractor, the latter would obtain permission from the contracting agency to change the subcontractor listed in the bid to the next acceptable subcontractor, and would be reluctant to use the initially selected subcontractor in future bidding until it was certain that the subcontractor was bondable.

Most public works contracts of the size in which petitioner was involved took from 1 to 2 years to complete, with the average being about 18 months. Ordinarily, on a public works contract, 10 percent of each proportional progress payment to the general contractor was retained by the payor until the contract was completed (on some contracts the retainage was reduced to 5 percent when more than one-half of the contract was completed). Usually, the general contractor applied the same retainage rule as to its payments to the subcontractors.

A mechanical subcontractor's work and involvement typically lasted from the beginning to the end of the construction project and might last beyond that of the general contractor. For example, if the project ended in winter and the air-conditioning system had to be tested and corrected for deficiencies in the equipment and installation, the subcontractor's involvement might last until summer and a portion of the retainage might be withheld until testing or correction (if necessary) occurred. The subcontractor was in a position of greater risk than the general contractor because (1) the latter subcontracted a substantial portion of the work to be performed under the contract, as to which the risk was shifted, and (2) the subcontractor was directly responsible for the cost of material and equipment used. Petitioner subcontracted out only one item involved in its work (temperature control material and wiring) and this amounted to less than one-tenth of its cost of sales for each of the years in issue.

Starting in 1972 and accelerating during 1973 and 1974 in the Lexington, Ky., area, the building industry in general and mechanical contractors and subcontractors in particular experienced dramatic increases in materials and equipment prices, along with a shortage of supply. Many items needed by mechanical contractors and subcontractors increased in price 15 percent or more a year, but some items increased as much as 300 percent in a year. This was also a period when mechanical contractors and subcontractors in this area experienced financial difficulty. Petitioner's contracts with general contractors did not have escalator clauses protecting against increases in costs of materials, equipment, and labor. In order to hedge against such cost increases, petitioner sometimes bought materials as soon as it submitted its bids. During the years in issue, petitioner suffered losses on four or five of its contracts; many of its competitors went bankrupt. The price increases also caused bonding companies to want subcontractors, as well as contractors, to have greater amounts of cash and quick assets. From 1971 through 1974, many subcontractors experienced cash flow problems, which caused them to lower their bids, reducing their profit margins, in order to get new jobs to get cash to pay off past accounts on completed jobs. This increased competition on smaller jobs and caused petitioner to bid on larger jobs in order to avoid this new aspect of competition.

A. Business Needs

1. Bonding

The decision to bid on larger jobs caused petitioner to need additional bonding capacity. Before 1972, petitioner had not achieved its objective of lower bond premium rates and Thompson's objective of eliminating personal indemnity requirements. In 1972, Thompson transferred petitioner's performance and payment bonding business to a different agent, the Progressive Insurance Co. (hereinafter sometimes referred to as Progressive). The president and majority shareholder of Progressive was Russell E. Davis (hereinafter referred to as Davis). With Davis, Thompson wanted petitioner to be in a sufficiently strong position (vis-a-vis net worth and working capital considered by the bonding company) to obtain the necessary bonds at “preferred rates” (reduced from the rates petitioner was paying) and without personal indemnity.

In evaluating a contractor for performance and payment bonding purposes, a bonding company is subjective and considers many factors, including the contractor's personnel, reputation, pay record, working capital,⁴ net worth, and prior experience.

Initially, Davis wrote petitioner's bonds with the United States Fidelity & Guaranty Co. and was not able to do so at preferred rates or without personal indemnity. Sometime during 1972, Davis started writing petitioner's bonds with the American States Insurance Co. (hereinafter referred to as States). States charged standard rates, but had a subsidiary, American Economy Insurance Co. (hereinafter referred to as Economy), which charged preferred rates.

On July 6, 1972, States authorized Progressive to write bonds for petitioner without home office referral. This authority did not apply to contracts of more than $250,000 and did not apply if petitioner's total contracts in force at any one time (whether or not bonded) exceeded $2,500,000.

Subsequently, Davis was able to write bonds for petitioner with Economy at preferred rates and without personal indemnity because of Progressive's experience with petitioner, petitioner's increased net worth and working capital, and petitioner's greater work experience. On February 13, 1973, Economy authorized Progressive to write bonds for ...