Surface Combustion Corp. v. Comm'r of Internal Revenue

Decision Date09 October 1947
Docket Number7441,7440,Docket Nos. 7438,7442.,7439
Citation9 T.C. 631
PartiesSURFACE COMBUSTION CORPORATION, PETITIONER, ET AT.,1 v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
CourtU.S. Tax Court

OPINION TEXT STARTS HERE

1. Expenses incurred during base period in the correction of basic defects in design of new model unit heater manufactured and sold by petitioner, held, abnormal in character, and not the consequence of an increase in gross income, nor of a decrease in any other deduction, nor of a change at any time in the type, manner of operation, size or condition of petitioner's business, and, therefore, not properly deducted in computation of base period net income for excess profits tax purposes.

2. Expenditures made in efforts to solve corrosion problem which arose in connection with the experimental stages of the manufacturing and installation of air-conditioning equipment, a new field for petitioner, held, to be a consequence of a change in the type, manner of operation, size or condition of petitioner's business, and therefore, not excludible from computation of base period net income for excess profits tax purposes.

3. Contributions made by petitioner to employees' trusts, held, deductible as ordinary and necessary business expenses under section 23 (a) of the Internal Revenue Code.

4. Held, proper method of computing petitioner's excess profits net income for the first eleven months of 1941 to be in accordance with section 711 (a) (3) (A) of the Internal Revenue Code, since petitioner's books and methods of computation used in its return accurately reflected its income. John J. Kendrick, Esq., for the petitioners.

Thomas F. Callahan, Esq., for the respondent.

The Commissioner determined deficiencies in the income, declared value excess profits, and excess profits taxes of Surface Combustion Corporation for the years 1940 and 1941, as follows:

+---------------------------------------------------------------+
                ¦                                 ¦1940          ¦1941          ¦
                +---------------------------------+--------------+--------------¦
                ¦Income Tax                       ¦--------------¦$6,505.69     ¦
                +---------------------------------+--------------+--------------¦
                ¦Declared value excess profits tax¦--------------¦3,177.47      ¦
                +---------------------------------+--------------+--------------¦
                ¦Excess profits tax               ¦$22,698.03    ¦1   356,623.89¦
                +---------------------------------------------------------------+
                

The proceeding which is numbered 7438 is the appeal of Surface Combustion Corporation from that determination and Docket No. 7439 is the appeal of General Properties Co., against whom liability is determined as transferee of Surface Combustion Corporation. Docket Nos. 7440, 7441, and 7442 are appeals of Charles A. Fruehauff, W. Alton Jones, and Grace R. Doherty, respectively, against whom deficiencies were determined as individual transferees of the assets of General Properties Co.

The five proceedings were consolidated for hearing.

Five issues remain for decision, four having been resolved by stipulation of the parties. The remaining questions concern (1) and (2), whether certain deductions for alleged abnormal expenditures made during the base period may be restored for the purposes of computing base period net income; (3) the correctness of respondent's disallowance of a deduction of $350,000 claimed in 1941 as ‘contributions to trusts created for benefit of employees‘; (4) the method of computing excess profits net income for an 11-month period in 1941; (5) whether the transferees named above are liable as such for the deficiencies determined.

FINDINGS OF FACT.

A partial stipulation of facts was filed herein, and we find the facts contained therein to be as stipulated.

Petitioner Surface Combustion Corporation was a New York corporation, organized on July 14, 1916, which maintained its principal place of business during all the years involved here in Toledo, Ohio. Its corporate tax returns were filed with the collector of internal revenue for the tenth Ohio district. For convenience, it will be referred to herein as petitioner,‘ and the other petitioners will be specifically designated by name whenever necessary.

The business activities of petitioner during the period involved here were divided into three separate and distinct divisions, which were, first, the designing, manufacture, and installation of industrial furnaces; second, the designing, manufacture, and marketing of space-heating equipment; and, third, the designing, manufacture, and installation of air-conditioning equipment.

Petitioner had been engaged in the first of the three activities, the industrial furnace field, from the time of its incorporation in 1916 down through the year 1941. The industrial furnaces manufactured and installed by petitioner included practically all types of furnaces, except melting furnaces, used in the steel and ferrous and nonferrous metal-working industries, consisting generally of two classes: Standard burner equipment and small furnaces produced in the Toledo factory, and special furnaces, or large furnaces designed and built to customer's specifications and assembled in the customer's plants. This division was essentially an engineering and contracting business to meet the requirements of customers of petitioner with respect to their products, capacities, layouts and the heat-treating processes required.

Janitrol.— The second division of petitioner's activities was the space-heating equipment field, in which petitioner first became engaged in 1927. This division manufactured and marketed conversion burners, warm air furnaces, boilers, and unit heaters, all gas-fired, and almost entirely manufactured at the Columbus, Ohio, plant of petitioner. These products were marketed under petitioner's trade name of ‘Janitrol.‘

In the fall of 1937 petitioner developed a new line of Janitrol unit heaters for commercial use, featuring an improved control valve for regulating the gas pressure and controlling the flow of gas to the unit. Several of the new units had been constructed in petitioner's laboratory and extensively tested, in each case having functioned satisfactorily with respect to each of the new developments.

In 1937 petitioner went into production of the newly developed Janitrol unit heaters, basing its production on the estimated requirements of the 1937-1938 season and, just prior to that season, shipped several thousand of said heaters to its customers, who were equipment dealers or independent distributors. All of the 1937 models were sold under a warranty of freedom from defects of material and workmanship, for a period of 12 months after delivery.

Shortly after the 1937 models were shipped into the field, and when they were put into practical use by purchasers, the valves in the heaters refused to control the flow of gas into the units, and this caused, among other things, overheating of the combustion chambers units and, consequently, overheating of space to be heated. Very unsatisfactory and potentially dangerous conditions resulted. As a result, petitioner received from its customers and dealers many complaints and requests for service.

In order to correct the existing defect, petitioner replaced every valve with valve which was used in earlier models. Since the old type valve did not provide any regulation of gas pressure, it was necessary to install in each heater unit a separate gas pressure regulator, as well as to replace the defective combustion chambers. These changes were relatively simple operations, and, in the case of units held in stock by dealers, were accomplished simply by furnishing the necessary parts and instructions to the dealers, who made the changes. With respect to the heaters which were in the hands of the customers, however, it was necessary for petitioner to send out crews of trained workmen to call on all customers, whose names had been secured by petitioner from its dealers, and to make the necessary changes. The defects so discovered and corrected were within the scope of the warranty under which the heaters were sold.

By way of the labor costs of the crews sent out, the operating costs incurred in the manufacture of the replacement parts, the premiums paid for prompt delivery of necessary materials required therefor, and the employment of tracers throughout the country to locate the equipment which had been sold, petitioner expended in 1937 the sum of $36,131.90, and in 1938 the sum of $140,908.95.

These amounts do not include the cost of rebuilding the units held in petitioner's inventory, the cost of alteration and replacement of special dies, templates and fixtures, or the cost of development engineering expense in analyzing the difficulties and determining the necessary corrective measures.

It has been petitioner's experience that some defects and inferiorities are found in every line of equipment manufactured and sold, which require servicing or replacement at some time after they are placed in operation. This experience is accentuated in the period of from six months to a year after a new model or line of equipment is first marketed.

During the years 1927 to 1941, inclusive, petitioner maintained upon its books and records reserves against which charges were made evidencing expenditures made by petitioner in servicing equipment theretofore sold by petitioner. The credits to said reserves were established under a regular formula devised by petitioner, based upon its experience. During the years 1927 to 1941, both inclusive, the following charges were made against said reserves in the various divisions of petitioner's business:

+-------------------------------------------------------+
                ¦    ¦Space heating  ¦            ¦          ¦          ¦
                +----+---------------+------------+----------+----------¦
                ¦Year¦division,      ¦Industrial  ¦Industrial¦          ¦
                +----+---------------+------------+----------+----------¦
                ¦
...

To continue reading

Request your trial
23 cases
  • Graev v. Comm'r
    • United States
    • U.S. Tax Court
    • June 24, 2013
    ...contingency "'within the control * * * of the Commissioner'", O'Brien v. Commissioner, 46 T.C. at 591(quoting Surface Combustion Corp. v. Commissioner, 9 T.C. 631, 655 (1947), aff'd, 181 F.2d 444 (6th Cir. 1950)),12 without regard to the merits of the Commissioner's decision. We held, to th......
  • Graev v. Comm'r
    • United States
    • U.S. Tax Court
    • November 30, 2016
    ...Forms 1040. 35. In its analysis, in O'Brien v. Commissioner, 46 T.C. 583 (1966), the Court cited with approval Surface Combustion Corp. v. Commissioner, 9 T.C. 631 (1947), aff'd, 181 F.2d 444 (6th Cir. 1950), as involving a type of contingency similar to that in O'Brien but involving a diff......
  • Engineered Timber Sales, Inc. v. Comm'r of Internal Revenue
    • United States
    • U.S. Tax Court
    • July 22, 1980
    ...contribution outside the control of an employer. Surface Combustion Corp. v. Commissioner, 181 F.2d 444, 448 (6th Cir. 1950), affg. 9 T.C. 631, 655 (1947); 555, Inc. v. Commissioner, 15 T.C. 671 (1950). However, the instant case is distinguishable. Because of petitioner's failure to inaugur......
  • Wallace v. United States
    • United States
    • U.S. District Court — Eastern District of Arkansas
    • October 31, 1968
    ...O'Brien v. C. I. R., 46 T.C. 583; Meldrum & Fewsmith, Inc. v. C. I. R., 20 T.C. 790; 555, Inc. v. C. I. R., 15 T.C. 671; Surface Combustion Corp. v. C. I. R., 9 T.C. 631, aff'd 6 Cir., 181 F.2d However, as the Court understands it, the Government's argument is that initial approval or disap......
  • Request a trial to view additional results

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT