EW Bliss Company v. United States

• Decision Date: 25 June 1963
• Docket Number: No. 35729.,35729.
• Citation: 224 F. Supp. 374
• Parties: E. W. BLISS COMPANY, Plaintiff, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — Northern District of Ohio

224 F. Supp. 374

E. W. BLISS COMPANY, Plaintiff, v. UNITED STATES of America, Defendant.

No. 35729.

United States District Court N. D. Ohio, E. D.

June 25, 1963.

James C. Davis, Laurence E. Oliphant, Jr., Squire, Sanders & Dempsey, Cleveland, Ohio, Richard Hawkins, James P. Murtagh, Chester C. Davis, John E. Terzis, Simpson, Thacher, & Bartlett, New York City, for plaintiff.

Russel E. Ake, Merle M. McCurdy, Cleveland, Ohio, John B. Jones, Jr., First Asst. Atty. Gen., Edward S. Smith, Jerome Fink, Peter Ciano, Solomon Fisher, Dept. of Justice, Washington, D. C., for defendant.

McNAMEE, District Judge:

This is an action by The E. W. Bliss Company, a Delaware corporation, (hereinafter Bliss) against the Government to recover an alleged overpayment of corporate income taxes for the year 1951. The alleged overpayment was made pursuant to a statutory notice of deficiency issued by the Commissioner of Internal Revenue on June 10, 1959. On September 2, 1959, plaintiff paid the alleged deficiency in the amount of $621,983.30, together with interest from March 15, 1952 in the sum of $278,622.96. The notice of deficiency included various adjustments to the income shown on plaintiff's income tax return for 1951. The two adjustments challenged by the plaintiff in this action are:

(1) An adjustment increasing income in the sum of $1,125,600 by disallowing a so-called "write-down" by the plaintiff of its inventory of work in process; this adjustment increased the income tax shown on plaintiff's return by $571,242.00.

(2) An adjustment increasing income in the sum of $100,129.96 as a result of refunds of New York State franchise taxes received by the plaintiff; the effect of this adjustment was to increase plaintiff's income tax in the amount of $50,815.95.

Plaintiff seeks to recover the entire amount of the additional tax and interest paid by reason of the adjustments relating to the inventory of work in process. Plaintiff concedes that $844.94 of the adjustment relating to the refund of franchise tax is correct. This operates to reduce the plaintiff's claim on the latter adjustment by the sum of $428.80. The aggregate sum sought to be recovered on both adjustments, including interest paid to September 2, 1959, is $900,093.94, plus interest from September 2, 1959, the date of payment by plaintiff.

Bliss is a manufacturer of machine tools of various types and dimensions. Many of the machine tools manufactured by Bliss consist of rolling mills and huge presses used in the manufacture of steel and fabrication of steel products. These products of plaintiff were manufactured and sold on a custom basis in accordance with orders placed and specifications furnished by its customers. The price of the presses made to individual orders was fixed before work thereon commenced and ranged between a few thousand dollars and hundreds of thousands of dollars for each press. In 1951 Bliss had manufacturing plants at Hastings, Michigan, Toledo, Ohio, Salem, Ohio and Canton, Ohio. The Canton plant was organized in 1950 but its first full year of operation was in 1951. Bliss also did business in New York state. Plaintiff's securities are listed on the New York Stock Exchange and it has a large number of shareholders. Its financial reports are subject to the juridsiction of the Securities and Exchange Commission and the regulations of the New York Stock Exchange. Plaintiff's books of account are kept on an accrual basis. For more than 25 years its books of account have been audited by Arthur Young & Company and its predecessor firm. Arthur Young & Company is one of the eight largest and most prominent firms of certified public accountants in the United States. It is plaintiff's position that its inventory of work in process was valued in accordance with the best accounting practices in the trade or business and clearly reflected its income as required by the applicable law and regulations. The Government justifies its disallowance of the write-down of the inventory on the ground that generally plaintiff's method of valuing the work in process as of December 31, 1951 was contrary to law and did not "most clearly reflect income." The franchise tax issue arises because of the Government's contention that the refund of franchise tax received by plaintiff in 1951 accrued in that year while plaintiff contends that such refund accrued in 1944. These issues will be discussed in the order stated above.

INVENTORY OF WORK IN PROCESS

At the end of 1951 plaintiff computed the value of its inventory of work in process on the basis of cost or market, whichever was lower, as permitted by Regulation 111-29.22(c) 2. The method adopted was to accumulate all direct costs of each job more than 50% complete. To this amount was added the estimated cost of completion. The total cost of each press as thus determined was then compared with the sale price of presses manufactured at Canton, Ohio, less an allowance of 15% for gross profit margin and the sale price of presses manufactured at Toledo, less a gross profit margin of 20%. If the projected cost of a completed press exceeded 80 or 85% of the sale price, the excess was eliminated from the inventory and the resulting reduced value represented the market value of the inventory as of the end of the current year. The evidence shows that it is practicable to make an approximately correct estimate of the cost to finish a job more than 50% complete. It is unlikely at that stage of manufacture that the expense of completing the job will involve any excessive cost. The addition therefore of normal costs to complete a job causes no increase in the excessive costs, if any, that were in the inventory at the end of the year. Consequently, if the actual cost at the end of the year plus the estimated cost to complete exceeds the normal cost of 80 or 85% of the sale price, the excess is properly attributable to the inventory as of December 31, 1951 and eliminated therefrom to determine market value as of the inventory date. All but a very small portion of the write-down of the inventory of December 31, 1951 related to the unfinished presses at the Canton plant as of that date. The amount of the write-down at that plant was $1,018,000. Six months later when all of the unfinished presses of 1951 were completed, the actual costs of completion were found to be $1,037,000 in excess of 85% of the selling price, a difference of but $19,000, or less than a 2% variance from the additional cost to complete as determined originally. This confirmed with substantial accuracy the estimate of the cost to complete and indicates that plaintiff's method of determining excess costs and market value is a reasonable one. The tax law and generally accepted principles of accounting recognize that substantial accuracy is the objective to be achieved and that in many situations exact determinations are neither practicable nor necessary. Huntington Securities Corporation v. Busey, 112 F.2d 368, (6th Cir. 1940).

The above method of computing inventory has been applied by plaintiff under the direction of Arthur Young & Company since about 1935.

The issues arising from the writedown of inventory are governed by Section 22(c) of the Internal Revenue Code of 1939 and the pertinent regulations promulgated thereunder. Section 22(c) reads:

"(c) Inventories. Whenever in the opinion of the Commissioner the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer upon such basis as the Commissioner, with the approval of the Secretary, may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income."

Regulation 111-29.22 (c) 2 (hereafter Reg.(c) 2), in pertinent part, reads:

"Section 22(c) provides two tests to which each inventory must conform:

"(1) It must conform as nearly as may be to the best accounting practice in the trade or business, and

"(2) It must clearly reflect the income.

"It follows, therefore, that inventory rules cannot be uniform but must give effect to trade customs which come within the scope of the best accounting practice in the particular trade or business. In order clearly to reflect income, the inventory practice of a taxpayer should be consistent from year to year, and greater weight is to be given to consistency than to any particular method of inventorying or basis of valuation so long as the method or basis used is substantially in accord with these regulations. An inventory that can be used under the best accounting practice in a balance sheet showing the financial position of the taxpayer can, as a general rule, be regarded as clearly reflecting his income.

"The bases of valuation most commonly used by business concerns and which meet the requirements of section 22(c) are (a) cost and (b) cost or market, whichever is lower. * * *"

Plaintiff carries the burden of establishing that the Commissioner acted arbitrarily in disallowing the so-called write-down of plaintiff's inventory of work in process. Lucas v. Kansas City Structural Steel Co., 281 U.S. 264, 50 S. Ct. 263, 74 L.Ed. 848; Lenox Clothes Shops v. Commissioner, 6 Cir., 139 F.2d 56; Finance & Guaranty Co. v. Commissioner, 4 Cir., 50 F.2d 1061. Plaintiff contends that its inventory of work in process is computed without regard to tax considerations and is used primarily for balance sheet purposes to inform its shareholders and the public of its true financial position. As shown above, by the express terms of Reg. (c) 2, as a general rule, such an inventory may be regarded as clearly reflecting income. Plaintiff emphasizes the requirement of Regulation (c) 2 that "greater weight is to be given to consistency * * *." Certainly, if plaintiff's method of valuing its inventory of work in process is substantially in accord with the regulations, great weight must be given to its long record of consistent...