MEAD'S BAKERY, INC. v. Commissioner
| Decision Date | 22 April 1964 |
| Docket Number | Docket No. 94027. |
| Citation | 23 TCM (CCH) 607,1964 TC Memo 104 |
| Parties | Mead's Bakery, Inc. v. Commissioner. |
| Court | U.S. Tax Court |
Donald L. Wilson and Kenneth G. Tarlton, for the petitioner. Harold D. Rogers, for the respondent.
Memorandum Findings of Fact and Opinion
The respondent determined deficiencies in petitioner's income tax, as follows:
Fiscal Year Ended Deficiency
April 30, 1956............... $ 41,735.30
April 30, 1957............... 104,768.46
April 30, 1958............... 57,226.14
Respondent made a number of adjustments in petitioner's taxable income for each of the years in question, which adjustments petitioner has conceded. The principal issue remaining for decision is whether petitioner is subject to tax under section 5311 with respect to all or any part of the earnings retained by it in any of the years involved herein.
Some of the facts have been stipulated, and the stipulations of facts, together with the exhibits attached thereto, are incorporated herein by this reference.
Petitioner is a Delaware corporation with its principal office in Amarillo, Texas. It maintains its books and records and files its Federal income tax returns on the basis of a fiscal year ended April 30. For its taxable years 1956 through 1958, it timely filed its income tax returns, prepared on the accrual method, with the district director of internal revenue at Dallas, Texas.
Shortly after its incorporation on April 27, 1955, petitioner, in a tax-free reorganization, acquired the assets and assumed the liabilities of the following corporations, which were then dissolved:
Name Date of Incorporation
Mead's Bakery, Inc., Amarillo
Texas....................... May 18, 1946
Mead's Bakery, Inc., Lawton
Oklahoma.................... June 5, 1946
Mead's Fine Bread Company of
Big Spring, Big Spring, Texas Oct. 7, 1946
Mead's Fine Bread Company of
El Paso, El Paso, Texas..... Mar. 20, 1948
(These corporations will hereinafter sometimes be referred to as the predecessor corporations.) Petitioner's stock was then distributed to the stockholders of the predecessor corporations. At all times relevant hereto, E. P. Mead, petitioner's president, owned approximately 60 percent of the outstanding stock in petitioner. Similarly, Ed V. Mead, petitioner's vice-president and the son of E. P. Mead, owned approximately 31 percent of petitioner's outstanding stock. The remaining stock in petitioner was held by other members of the Mead family during the period in question.
The Mead family has been engaged in the business of manufacturing and distributing bread on a wholesale basis in the southwestern part of the United States since at least 1938. From that time to date, their activities in this business reflect sustained growth, expansion and diversification. Starting out originally as a sole proprietorship and later conducting their business in the form of the four predecessor corporations which petitioner absorbed in 1955, the Meads acquired 21 bakery plants between 1938 and May 1, 1955. Fourteen of these plants were acquired between 1946 and May 1, 1955. In 1950, petitioner's four predecessor corporations employed a total of 524 persons. In 1955, petitioner had 1,037 employees. During the years in issue, the course pursued by petitioner with regard to expansion remained the same.
As of May 1, 1955, the equipment in many of petitioner's plants was obsolete, worn out, and in need of replacement. The acquisition of the 14 plants by the predecessor corporations between 1946 and May 1, 1955, had depleted their earnings and adversely affected their ability to add to and replace equipment during the period from 1946 to 1955. Thus, for example, in March 1955, shortly before the reorganization occurred, one of the predecessor corporations acquired a large bakery plant in Oklahoma City, Oklahoma. Petitioner's management estimated as a rule of thumb that in the acquisition of new plants it would incur losses approximately equal to acquisition cost before being able to place the new plants on a profitable basis. Between the time the Oklahoma City plant was acquired and April 30, 1958, petitioner, in fact, lost $423,644.89 in connection with its operation.
The capital stock and earned surplus of the predecessor corporations before the May 1, 1955, reorganization and that of petitioner immediately subsequent thereto, were as follows:
Before Reorganization After Reorganization
Capital Stock........ $1,265,000.00 $2,593,115.20
Earned Surplus1. 1,328,115.20
_____________ _____________
$2,593,115.20 $2,593,115.20
Petitioner's average cash balance for the four weeks ended July 21, 1955, was $150,293.76.2 Petitioner found this amount of cash insufficient for purposes of conducting its business. Thus, it was forced to borrow funds to obtain the requisite working capital. Throughout its entire existence, petitioner has experienced great diffculty in obtaining adequate credit and financing. On September 12, 1955, petitioner borrowed a total of $400,000 from two banks. In order to obtain these loans, it was required (1) to give a chattel mortgage on all of its trucks and baking equipment, and (2) to agree that it would not acquire or construct any additional bakeries or related buildings or facilities without prior permission from the banks. These loans proved unduly restrictive. On February 1, 1956, petitioner refinanced them with a $600,000 loan from The Penn Mutual Life Insurance Company (hereinafter referred to as the Penn Mutual loan).
Although the terms of the Penn Mutual loan were somewhat less stringent than those of the bank loans, nevertheless, petitioner found them confining. The Penn Mutual loan contained restrictions against petitioner's incurring any indebtedness other than (1) the Penn Mutual loan, (2) indebtedness incurred in connection with the purchase of equipment, but not to exceed an aggregate of $150,000 at any time outstanding, and (3) unsecured bank loans maturing within 12 months and not exceeding $400,000. Petitioner was unable to borrow from banks on unsecured loans. Thus, petitioner was, in effect, prevented by the terms of the Penn Mutual loan from expanding by means of debt financing. This loan also prohibited petitioner from acquiring any new corporations or assets by merger, or in return for the issuance of its stock. The loan agreement also prevented petitioner from acquiring any subsidiaries in addition to Mead's Angus Mesa, Inc. Thus, for the period during which the Penn Mutual loan was outstanding, the only means by which petitioner could finance the acquisition of new plants, diversification into new lines of business, or the purchase of equipment to any substantial extent was by the retention of earnings.
Petitioner's average four week cash balances for the fiscal year ended April 30, 1956, was $360,283.37. The major portion of this amount consisted of $281,000 representing proceeds from the Penn Mutual loan. Its average cash balance for the four weeks ended March 1, 1956, excluding the Penn Mutual loan from proceeds, was $40,733.86. This amount would have been insufficient to enable petitioner to conduct its operations for one day.
As previously indicated, during the years in issue, petitioner steadily expanded its activities in the bakery business. Between May 1, 1955, and April 30, 1956, it added some 41 new delivery routes to service Oklahoma City, Ada, and Tulsa, Oklahoma. The initial expense of adding a new route is $5,000, which includes a truck and a 12-week training period for the delivery man. Development costs for the new route, including additional consumption of supervisor time and more stale, unsold bread to be picked up from the stores on the route, result in losses of approximately an additional $5,000 per route for the first year of operation. Because of the large growth of population in the cities in which petitioner's principal bakeries were located, new routes had to be continuously developed to meet competition.
In order to keep up with its competition, rising costs and the increasing population of the areas it served, petitioner was forced to expend considerable sums for replacing old equipment and purchasing new equipment. During the years in issue petitioner spent a total of approximately $1,400,000 for additions to its existing plants and equipment. The cost of these additions exceeded depreciation allowed during this period by approximately $170,000.
The bakery business has been subject to dramatic innovations. Some of those which influenced petitioner's management to retain its earnings in order to be able to produce or utilize these innovations were: (1) "Brown and Serve" rolls; (2) "diet bread"; (3) "round bread"; and (4) the use of plastic "end seals" in wrapping loaves of bread. Thus, the use of such new products and devices required petitioner to spend substantial amounts for advertising and new equipment such as pans and other machinery.
One of the most significant innovations in the baking industry in recent years has been the development of the continuous mix method of making bread. This is an automated process which produces bread of a better texture and quality at a cost of approximately 10 to 15 percent less than the conventional methods. In 1953, E. P. Mead made a trip to New Jersey to inspect a bakery plant that had converted to the continuous mix method of manufacturing bread. Although the basic equipment for this process did not become available in the areas in which petitioner's plants were located until some time in 1958, petitioner had, by 1956, made definite plans to begin converting its ten largest bakery plants to the...
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