Guardian Indus. Corp. & Subsidiaries v. Comm'r of Internal Revenue, Docket No. 27308-87.

Decision Date11 September 1991
Docket NumberDocket No. 27308-87.
Citation97 T.C. 308,97 T.C. No. 21
PartiesGUARDIAN INDUSTRIES CORP. AND SUBSIDIARIES, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
CourtU.S. Tax Court

OPINION TEXT STARTS HERE

Ps engaged in the photo-finishing business. Both the photographic film Ps received from their customers for developing and the paper purchased by Ps for use in making prints contain silver halide compounds, which are removed during the developing process. Ps extracted silver-bearing waste materials from the chemical solutions used in photo-finishing and sold them in the ordinary course of their photo-finishing business. The sales were frequent and generated substantial income. Ps originally reported the sales proceeds as ordinary income on their tax returns, but subsequently amended such returns, reclassifying such proceeds as short-term capital gains. HELD, the silver waste is property held primarily for sale to customers in the ordinary course of Ps' trade or business, and therefore is not a capital asset. C. David Swenson, A. Duane Webber, and David N. Bowen, for the petitioners.

Robert J. Kastl and James E. Kagy, for the respondent.

WELLS, JUDGE:

Respondent determined the following deficiencies in petitioners' Federal income tax:

+--------------------+
                ¦Year  ¦Deficiency   ¦
                +------+-------------¦
                ¦1983  ¦$8,128,580   ¦
                +------+-------------¦
                ¦1984  ¦728,942      ¦
                +--------------------+
                

After concessions by both parties, the sole issue remaining for decision is whether silver-bearing waste material generated in the course of petitioners' photo-finishing business is property held by petitioners primarily for sale to customers in the ordinary course of petitioners' trade or business.

FINDINGS OF FACT

Some of the facts have been stipulated for trial pursuant to Rule 91. 1 The stipulations and accompanying exhibits are incorporated in this Opinion irrespective of any restatement below. When the petition in the instant case was filed, petitioners' principal place of business was located in Northville, Michigan.

Petitioners are engaged in three principal lines of business: the manufacture of glass (glass); the manufacture of insulation products (insulation); and the finishing of photographs (photo- finishing). Gross revenues of each line of business for the years in issue were as follows:

+-----------------------------------------+
                ¦               ¦1983        ¦1984        ¦
                +---------------+------------+------------¦
                ¦Glass          ¦$358,053,000¦$406,009,000¦
                +---------------+------------+------------¦
                ¦Photo-finishing¦83,823,000  ¦96,648,000  ¦
                +---------------+------------+------------¦
                ¦Insulation     ¦22,926,000  ¦33,120,000  ¦
                +-----------------------------------------+
                

Pretax income from photo-finishing equalled $7,934,000 in 1983 and $6,446,000 in 1984.

Petitioners entered the photo-finishing business in 1968 by purchasing ABC Photo. At that time, ABC Photo operated one plant, at Northville, Michigan, and had been in business since 1955. Petitioners expanded their photo-finishing business into new markets during the 1970's and 1980's by acquiring other finishers and constructing new plants.

During the years in issue, petitioners operated as few as 10 and as many as 12 photo-finishing plants across the United States, and employed approximately 1,500 persons in connection with their photo- finishing operations. Petitioners performed photo-finishing services for 9,500 national and regional chain stores, discount stores, and independent retail outlets (retail outlets), which in turn offered photo-finishing services to amateur photographers. Petitioners also supplied photographic products to the retail outlets.

Petitioners collected exposed film from the retail outlets on a daily basis, processed the film in their plants, and returned developed images and negatives to the retail outlets. In order to maintain its competitive position in the market, a photo-finisher was expected to process film within 24 hours. Furthermore, the terms of petitioners' agreements with the retail outlets did not allow petitioners to charge for prints and film that were not returned within 24 hours of pickup. Petitioners accordingly processed film within 24 hours of receipt.

Photography involves the use of silver halide compounds, which record images when exposed to light. Both photographic film and the paper used for making prints contain silver halide compounds. Various chemical solutions are used to develop and fix latent images on film and paper (photo-finishing solutions). High quality alternatives to the silver compounds and chemical processes used to produce the final photographic image do not exist.

In black and white photography, the exposed silver compounds react with the developer solution to form the final image, while unexposed silver is washed away in the fixing baths. In color photography, various dyes are incorporated into the film and paper in addition to the light-sensitive silver halides, and a chemical reaction between the developer solution, the silver halide compounds, and the dyes produces the color image. After the chemical reaction occurs, the silver halides must be removed from the film or paper because they otherwise would hide the color image. Removal is accomplished by passing the film or paper through bleaching and fixing solutions in which the silver halides react with other chemicals to form silver thiosulfate. After the silver halides are removed, the silver compounds have no further utility in the developing process. Approximately 60 percent of the silver compounds introduced into photo-finishing solutions are attributable to photographic paper, while the remaining 40 percent are attributable to film. The photographic paper is purchased by petitioners as a raw material, whereas the exposed film is furnished by petitioners' customers for developing.

During the years in issue, petitioners utilized a “closed-loop” photo-finishing system, which mixed new and used photo-finishing solutions and continuously recirculated the solutions within the system. Petitioners' predecessor, ABC Photo, began to use such a system for some film processing in 1963, and had installed a closed- loop system in its newly constructed Northville, Michigan, plant when petitioners acquired it in 1968. Petitioners installed closed-loop systems in the finishing plants they built or purchased between the time they entered the photo-finishing business and the years in issue. Use of such a system was necessary in order to be competitive in the photo-finishing industry, as it was the most efficient and least time-consuming method of processing film and prints on a high- speed basis. The closed-loop system enabled petitioners to reduce the volume of solutions used in their operations by two to four times, which saved labor, material, and storage costs. Additionally, use of a closed-loop system reduced the volume of discharge required to be treated prior to disposal, thus decreasing the cost of compliance with applicable environmental laws.

In order to reuse solutions in the closed-loop process, petitioners had to remove certain material, including silver thiosulfate, from the photo-finishing solutions. The silver thiosulfate that was washed from film and paper contaminated the photo-finishing solutions and interfered with the ability of the solutions to produce negatives and prints of marketable quality. To remove silver thiosulfate, among other substances, from their photo- finishing solutions, petitioners incorporated electrolytic cells (cells) into the closed-loop system. Petitioners' predecessor, ABC Photo, first used cells in 1962 or 1963, and was operating them in its Northville, Michigan, plant prior to its acquisition by petitioners in 1968. Petitioners installed cells in each plant they built or acquired between 1968 and the years in issue. The cells passed an electric current through the solutions, causing silver and other substances to be deposited on the cells' cathodes. The material deposited on the cathodes, called “flake,” consisted of, on average, 92 percent silver, with the remainder of the material consisting of other substances removed by electrolytic action (the silver and other substances removed from the photo-finishing solutions are hereinafter referred to as “silver waste”). Approximately 95 percent of the silver waste removed from the photo-finishing solutions was attributable to the cells in the closed-loop system.

To ensure continued efficient operation, the cells were cleaned at least once a month by scraping the built-up silver waste off the cathodes. The silver waste was then weighed and placed in containers for shipment to a refiner. Quality control personnel also prepared reports concerning the amount of silver waste collected, which was compared to the total amount of silver entering the photo-finishing process, in order to monitor the efficiency of the waste removal process and to detect pilferage. To further monitor the efficiency of processes used to remove silver waste from the solutions, petitioners also weighed scrap photographic paper prior to discarding it, although petitioners did not recover the silver compounds in such paper. Petitioners produced periodic reports concerning the percentage of silver in the developing process which was recovered, the dollar value of such silver, and the success of its plants in meeting target recovery rates. Petitioners desired to maximize the silver content of the waste material.

During the years in issue, petitioners were subject to a variety of Federal, State, and local laws and regulations governing the levels of certain substances in the waste waters discharged from their plants into sewers or elsewhere (environmental regulations). The environmental regulations classified silver as a “toxic pollutant,” and required petitioners to reduce significantly the concentration of silver thiosulfate in photo-finishing solutions before disposing...

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