EMI CORPORATION v. Commissioner
| Decision Date | 31 July 1985 |
| Docket Number | Docket No. 1163-81. |
| Parties | EMI Corporation, an Illinois Corporation v. Commissioner. |
| Court | U.S. Tax Court |
Leslie R. Bishop, Robert A. Hall, and Leonard S. DeFranco, for the petitioner. Thomas E. Ritter, for the respondent.
Memorandum Findings of Fact and Opinion
Respondent determined deficiencies in petitioner's corporate income tax of $41,600.72, $49,041.66, and $104,576.55 for its respective fiscal years ending August 31, 1975, August 31, 1976, and August 31, 1977. The sole issue for decision is whether, under section 532(a),1 petitioner was availed of for the purpose of avoiding the income tax with respect to its shareholders, by permitting its earnings and profits to accumulate instead of being divided or distributed so that petitioner is therefore subject to the accumulated earnings tax imposed by section 531.
Some of the facts have been stipulated and are so found. The stipulations of facts and exhibits attached thereto are incorporated herein by this reference.
Petitioner, an Illinois corporation, had its principal place of business in Des Plaines, Illinois, at the time it filed its petition in this case. Petitioner keeps its books and records and reports its income on a fiscal year basis ending August 31. Petitioner uses the completed contract method of reporting income within the meaning of section 1.451-3(d)(1), Income Tax Regs. Petitioner timely filed its fiscal 1975, 1976, and 1977 corporate income tax returns (Forms 1120) with the Internal Revenue Service.
Petitioner was organized in 1957 by Edward J. Loew to provide consultation services in the field of industrial extraction and processing of vegetable and animal products. Loew, a chemical engineer, had extensive experience in the extraction of vegetable oils. In organizing and operating his company, Loew followed a very conservative business philosophy and tried to protect against all foreseeable risks and to avoid getting over his head financially. Loew had begun the business with a capital investment of only two to four thousand dollars, and slowly built up the business over the years.
Around 1960, Edward D. Milligan, Arnold M. Gavin, and Ralph W. Berger — all of whom were chemical engineers — began working for petitioner. Milligan's experience, like Loew's, was primarily in oil extraction. Gavin and Berger were experienced in oil refining and related fats and oils technologies. By 1970, all three were shareholders in petitioner.
Originally, petitioner was simply a consulting firm, observing and recommending changes for its clients' plant operations. Throughout the early 1960's, the scope of petitioner's business grew to include the acquisition and resale of equipment to clients. By the late 1960's, petitioner had begun to design and engineer entire processing plants, including purchasing, storing, and shipping the equipment to be installed in such plants. Petitioner sometimes supervised construction, testing, and placing into operation of the plants.
By 1970, petitioner was completely owned and run by Loew, Milligan, Gavin, and Berger. These four individuals owned the following percentages of petitioner's stock and held the following positions in petitioner:
Percentage
Individual Ownership Positions
Loew ............................ 60% .......... President, Director
Milligan ........................ 13 1/3 % .......... Vice-President, Director
Gavin ........................... 13 1/3 % .......... Vice-President, Secretary, Director
Berger .......................... 13 1/3 % .......... Vice-President, Treasurer, Director
On September 1, 1970, petitioner and its shareholders entered into a stock purchase agreement. Under this agreement, the shareholders were required to offer their shares for sale only to petitioner, and petitioner was required to purchase all shares so offered. The agreement also provided that the corporation would redeem all of the shares of a stockholder who had died, retired, become disabled, or left petitioner's employ. The selling price of any stock so purchased was based upon the book value of the shares — 100 percent of book value in the event of death or disability, and 90 percent of book value in the event of retirement, severance of employment, or sale pursuant to an offer. The agreement defined book value as "the total assets of the Corporation (not including any value for goodwill, patents, trademarks, licensing agreements or contracts) less total liabilities of the Corporation, computed on the accrual basis of accounting ... in accordance with generally accepted accounting principles." Emphasis supplied. Book value was to be conclusively determined in an audit by an independent Certified Public Accountant. At the time of the stock purchase agreement, Loew was 59 years of age, Milligan 45, Gavin 47, and Berger 50.
From 1970 through the years in issue, petitioner specialized in designing and providing equipment and materials for the construction of plants to extract and process oil from various vegetable and animal raw materials. Each of petitioner's contracts had varying specifications and work to be performed. Petitioner's basic contract would be to provide the design of the facility and the materials and equipment necessary to complete the design. Each plan was essentially a custom-designed plant. Sometimes, petitioner would have to design and provide the superstructure for the customer's facility. In certain cases, petitioner was requested to provide on-site engineering services during the construction of the plant, and on-site inspection of the equipment once construction was completed. Occasionally, petitioner was requested to provide the contractor to actually build the facilities and/or to supervise such construction. Petitioner did not itself perform any construction work. Petitioner did not fabricate any of the material or equipment that it shipped to its customers; instead petitioner subcontracted that work to other companies.
Because of the nature of its business, petitioner had no regularly recurring cycle of work. The bulk of petitioner's gross sales was bunched in a limited number of contracts of relatively long duration as follows:
Fiscal Number of Average
Year Contracts Duration
1975......... 9 .............. 19.33 months
1976......... 6 .............. 21.67 months
1977......... 7 .............. 14.29 months
Because petitioner reported its income on the completed contract method of accounting, its gross sales from contracts completed and reported did not necessarily correspond to the cash it received during these taxable years.
Nearly all of petitioner's contracts guaranteed that each of the plants would provide a certain quantity and quality of product, given certain measurable variables such as raw materials processed, available utilities, climate and plant location. The proposals and contracts also guaranteed the performance of the equipment acquired and sold by petitioner. Petitioner could not obtain performance bonding for its contracts because of the prohibitive costs. Petitioner's management was aware that the plants it designed generally occupied an intermediate stage in its customers' overall operations. Petitioner's management was equally aware that failure of its plants could severely disrupt its customers' businesses. Petitioner's contracts contained clauses attempting to disavow any liability for consequential damages, but petitioner's management doubted the validity and efficacy of such exculpatory clauses.
During the years 1970 through 1977, petitioner incurred losses on two of its contracts. Those losses were incurred as a result of design and construction deficiencies that, due to its guarantees, petitioner had to rectify at its own expense. At no time from petitioner's inception through the taxable year 1977 did petitioner so wholly fail to meet contract specifications that it was required to return all monies previously paid. However, petitioner's profits on certain contracts were reduced by various modifications to plant processes and equipment that petitioner was required to make pursuant to its guarantees.
During the years in issue, approximately half of petitioner's contracts were for facilities located in the United States and the other half for facilities located in foreign countries. On its domestic contracts, petitioner usually obtained a down payment of approximately 10 percent of the contract price and then made progress billings as its work progressed. On its foreign contracts, petitioner obtained a down payment, sometimes as much as 20 percent of the contract price, and received the balance when it shipped the equipment, generally pursuant to short term letters of credit. On many of its foreign contracts, petitioner obtained insurance from the Foreign Credit Insurance Association, a Federal agency that helped promote exports by providing insurance policies to cover various political and economic risks of doing business in foreign countries. That insurance did not cover petitioner's liability under its process and equipment guarantees.
The manufacturing processes that petitioner incorporated into the plants it designed and sold involved the use of highly volatile chemicals. Similar plants designed by some of petitioner's competitors had experienced safety problems, including explosions causing loss of life and substantial destruction of property. Many of the plants petitioner designed and sold produced vegetable and animal oils for human consumption. Similar plants designed by some of petitioner's competitors had malfunctioned, producing adulterated oils that killed several people. None of petitioner's plants had encountered either problem up through the years before the Court. From its inception...
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