Dearborn Gage Co. v. Comm'r of Internal Revenue

• Decision Date: 19 May 1967
• Docket Number: Docket No. 733-65.
• Citation: 48 T.C. 190
• Parties: DEARBORN GAGE COMPANY, PETITIONER V. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

48 T.C. 190

DEARBORN GAGE COMPANY, PETITIONER V. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 733-65.

Tax Court of the United States.

Filed May 19, 1967.

Victor R. Wolder, for the petitioner.

Charles H. Powers, for the respondent.

Petitioner, a corporation and successor in interest to a partnership in a 1957 transaction qualifying under sec. 351, was a manufacturer of gages and gage blocks.If and its predecessor valued inventory by including only direct costs of labor and materials.Overhead expenses were deducted in the year spent.Held, petitioner's method of accounting does not clearly reflect income and therefore respondent's change in accounting method requiring the inclusion of overhead in inventory is sustained.Held, further, sec. 481 is applicable.Held, further, in computing the sec. 481 adjustment to the opening inventory for the year of the change in accounting method, i.e., 1960, the opening inventory for the first year of the corporation, i.e., 1957, shall be used without any adjustment for overhead.

TANNENWALD, Judge:

Respondent determined deficiencies in petitioner's income tax for the taxable years ended November 30, 1960, 1961, and 1962, in the amounts of $32,962.47, $4,218.02, and $979.78, respectively.

Petitioner having conceded all other items in the deficiency notice, two issues remain for our consideration:

(1) Was respondent entitled to require petitioner to include overhead costs in inventory values instead of deducting such costs in the year spent?

(2) If so, to what extent, if any, were adjustments properly made under section 481?¹

FINDINGS OF FACT

Some of the facts are stipulated and are found accordingly.

Petitioner was incorporated in Michigan on May 1, 1957, and, at the time of the filing of the petition herein, had its principal office at Garden City, Mich.It filed its returns for the taxable years involved herein on the accrual basis with the district director of internal revenue, Detroit, Mich.

At the time petitioner was incorporated, the assets of a partnership, Dearborn Gage Co., of which Elmer Ellstrom, Jr., and Olaf W. Ellstrom were the sole partners, were transferred to petitioner in a transaction qualifying under section 351.Elmer, Jr., and Olaf, on June 30, 1947, and July 31, 1954, respectively, acquired their interests in the partnership from Ralph Ellstrom and Elmer Ellstrom, respectively, who were the parties referred to in Ralph Ellstrom, T.C. Memo. 1955-91, affd.235 F.2d 181(C.A. 6, 1956).

Petitioner is engaged in a manufacturing business in which substantial inventories of finished goods and work in process are maintained.In its business, petitioner has two divisions operating at separate plants— The Standards Division and the General Gage Division.

The Standards Division is segregated into two departments, which keep separate inventories.Chromium-plated gage blocks are manufactured in the Gage Block Department while gage block accessories and special gages are manufactured in the Accessories Department.

The General Gage Division is also divided into two departments— the Air Gage Division and the ‘AGD’.(American Gage Design)Gage and Special Gage Department.Various types of gages are manufactured in the General Gage Division.

Petitioner, since its inception on May 1, 1957, has used the first-in, first-out (FIFO) method in valuing inventory and has included only direct costs of labor and material in such valuation.Petitioner has never included therein any indirect costs and administrative expenses, i.e., overhead costs, and has deducted the same in the year spent.Petitioner's predecessor partnership treated overhead costs in the same manner as petitioner but valued its inventory at the lower of cost or market.

Petitioner's income tax returns and those of its predecessor partnership were audited by respondent's agents every 2 years prior to fiscal year 1960; the propriety of expensing overhead costs was never raised, and no change was recommended by any agent with respect to the manner in which petitioner's inventory should be computed.

In 1963, respondent's agent audited petitioner's returns for the fiscal years 1960, 1961, and 1962 and determined that petitioner had improperly valued its inventory by failing to include overhead costs.Accordingly, respondent determined that the following adjustments should be made to petitioner's inventory and income to reflect such costs:

+----------------------------------------------------------------------+
                ¦               ¦                               ¦Adjustment¦Increase in¦
                +---------------+-------------------------------+----------+-----------¦
                ¦Year ended Nov.¦Adjustment to opening inventory¦to closing¦inventory  ¦
                +---------------+-------------------------------+----------+-----------¦
                ¦30—            ¦                               ¦inventory ¦and income ¦
                +---------------+-------------------------------+----------+-----------¦
                ¦               ¦                               ¦          ¦           ¦
                +---------------+-------------------------------+----------+-----------¦
                ¦1960           ¦No adjustment shown            ¦$63,389.36¦$63,389.36 ¦
                +---------------+-------------------------------+----------+-----------¦
                ¦1961           ¦$63,389.36                     ¦71,500.93 ¦8,111.57   ¦
                +---------------+-------------------------------+----------+-----------¦
                ¦1962           ¦71,500.93                      ¦73,385.11 ¦1,884.18   ¦
                +---------------+-------------------------------+----------+-----------¦
                ¦               ¦                               ¦          ¦           ¦
                +----------------------------------------------------------------------+
                

The parties have stipulated that, if petitioner and its predecessor partnership had added overhead costs to inventory, the following adjustments to inventory would have resulted:

+--------------------------------------------------------+
                ¦    ¦            ¦Closing       ¦Omitted   ¦Net increase¦
                +-----------------+--------------+----------+------------¦
                ¦Year             ¦inventory     ¦cumulative¦or decrease ¦
                +-----------------+--------------+----------+------------¦
                ¦    ¦            ¦per tax       ¦overhead  ¦in income   ¦
                +----+------------+--------------+----------+------------¦
                ¦    ¦            ¦return        ¦costs     ¦per year    ¦
                +----+------------+--------------+----------+------------¦
                ¦    ¦            ¦              ¦          ¦            ¦
                +----+------------+--------------+----------+------------¦
                ¦Dec.¦31, 1953 1  ¦1   $93,520.20¦$10,087.47¦$10,087.47  ¦
                +----+------------+--------------+----------+------------¦
                ¦Dec.¦31, 1954 1  ¦1   80,757.20 ¦8,596.99  ¦(1,490.48)  ¦
                +----+------------+--------------+----------+------------¦
                ¦Dec.¦31, 1955 1  ¦1   82,737.39 ¦11,800.47 ¦3,203.48    ¦
                +----+------------+--------------+----------+------------¦
                ¦Dec.¦31, 1956 1  ¦1   126,888.92¦14,897.07 ¦3,096.60    ¦
                +----+------------+--------------+----------+------------¦
                ¦Apr.¦30, 1957 1  ¦1   131,449.58¦16,730.73 ¦1,833.66    ¦
                +----+------------+--------------+----------+------------¦
                ¦May ¦1, 1957     ¦2   131,449.58¦16,730.73 ¦1,833.66    ¦
                +----+------------+--------------+----------+------------¦
                ¦Nov.¦30, 1957    ¦155,915.52    ¦25,596.57 ¦8,865.84    ¦
                +----+------------+--------------+----------+------------¦
                ¦Nov.¦30, 1958    ¦162,895.23    ¦55,859.86 ¦30,263.29   ¦
                +----+------------+--------------+----------+------------¦
                ¦Nov.¦30, 1959    ¦143,577.91    ¦39,483.79 ¦(16,376.07) ¦
                +----+------------+--------------+----------+------------¦
                ¦Nov.¦30, 1960    ¦176,004.10    ¦63,389.36 ¦23,905.57   ¦
                +----+------------+--------------+----------+------------¦
                ¦Nov.¦30, 1961    ¦218,513.01    ¦71,500.93 ¦8,111.57    ¦
                +----+------------+--------------+----------+------------¦
                ¦Nov.¦30, 1962    ¦252,403.10    ¦73,385.11 ¦1,884.18    ¦
                +----+------------+--------------+----------+------------¦
                ¦    ¦            ¦              ¦          ¦            ¦
                +--------------------------------------------------------+
                

Of the $63,389.36 cumulative increase to the inventory for 1960, $52,112.19 was allocable to the Gage Block Department.For 1961, $7,098.51 of the $8,111.57 net increase in inventory was allocable to the Gage Block Department.For 1962, $923.43 of the $1,884.18 net increase in inventory was allocable to the Gage Block Department.

The following table reflects per-unit costs and revenues of the Gage Block Department under the so-called ‘net profit’ test:

+---------------------------------------------+
                ¦                     ¦1961 ¦1962 ¦1963 ¦1964 ¦
                +---------------------+-----+-----+-----+-----¦
                ¦                     ¦     ¦     ¦     ¦     ¦
                +---------------------+-----+-----+-----+-----¦
                ¦Labor cost per unit  ¦$2.28¦$2.04¦$2.28¦$2.39¦
                +---------------------+-----+-----+-----+-----¦
                ¦Cost of materials    ¦.17  ¦.14  ¦.13  ¦.16  ¦
                +---------------------+-----+-----+-----+-----¦
                ¦per unit             ¦     ¦     ¦     ¦     ¦
                +---------------------+-----+-----+-----+-----¦
                ¦Per unit expense     ¦     ¦     ¦     ¦     ¦
                +---------------------+-----+-----+-----+-----¦
                ¦for sales,           ¦     ¦     ¦     ¦     ¦
                +---------------------+-----+-----+-----+-----¦
                ¦administrative       ¦     ¦     ¦     ¦     ¦
                +---------------------+-----+-----+-----+-----¦
                ¦and delivery 1       ¦1.76 ¦1.89 ¦2.30 ¦2.29 ¦
                +---------------------+-----+-----+-----+-----¦
                ¦Overhead per unit    ¦2.33 ¦2.26 ¦2.18 ¦1.91 ¦
                +---------------------+-----+-----+-----+-----¦
                ¦Total cost           ¦6.54 ¦6.33 ¦6.89 ¦6.75 ¦
                +---------------------+-----+-----+-----+-----¦
                ¦Per unit sales       ¦6.52 ¦6.72 ¦7.00 ¦6.93 ¦
                +---------------------+-----+-----+-----+-----¦
                ¦price                ¦     ¦     ¦     ¦     ¦
                +---------------------+-----+-----+-----+-----¦
                ¦Profit (or loss)     ¦(.02)¦.39  ¦.11  ¦.18  ¦
                +---------------------+-----+-----+-----+-----¦
                ¦Percentage profit 2  ¦     ¦5.8  ¦1.6  ¦2.6  ¦
                +---------------------+-----+-----+-----+-----¦
                ¦

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