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Electric Regulator Corp. v. Commissioner of Internal Revenue

decided: August 11, 1964.


Author: Moore

Before LUMBARD, Chief Judge, and MOORE and SMITH, Circuit Judges.

MOORE, Circuit Judge:

Electric Regulator Corporation (petitioner) petitions for a review of a decision of the Tax Court of the United States, 40 T.C. 757 (1963), sustaining the Commissioner's determination of deficiencies in income tax for its fiscal years 1957 and 1958 in the amounts of $81,751.01 and $25,944.69. These deficiencies resulted from the Commissioner's imposition of an accumulated earnings tax pursuant to Internal Revenue Code of 1954, ยง 531*fn1 for each of the years in question. The Tax Court found that petitioner permitted its earnings and profits to accumulate beyond the reasonable needs of its business*fn2 and that it was availed of during the years in question for the purpose of avoiding the income tax with respect to its two shareholders by permitting earnings to accumulate instead of being divided and distributed.*fn3 Upon the facts and the law, we think the determination of the Tax Court clearly erroneous and therefore reverse.

Petitioner was organized as a New York corporation in 1945 and since then has been successfully engaged in the manufacture of electric regulating devices. The history of its growth and the use of its earnings to achieve that growth is important to a proper disposition of this case. In its early years (1945-1948), petitioner occupied only 400 square feet of floor space in New York City, from 1948 to 1950, 1200 square feet, and from 1950 to 1952, 7500 square feet. In 1952 petitioner moved from New York to Norwalk, Connecticut, where it now maintains its principal business location. The size of the Norwalk plant, originally 16,000 square feet, was substantially increased in 1958 to 29,000 square feet. As reflected in its balance sheets, the investment in petitioner's plant, machinery and equipment (before depreciation) had grown steadily from $9,172 in 1948 to $469,347 at the end of the 1958 fiscal year.

Petitioner's principal product over the years, 1945-1957, had been its patented electromechanical voltage regulator, called "Regohm." Because of its size (about two inches on all sides), weight (three or four ounces) and other features, many sizeable motor manufacturers favored the Regohm over competing devices and it has enjoyed considerable commercial success. Petitioner's cost for Regohm's component parts was seven or eight dollars. The manufactured product was sold for approximately thirty-five dollars. Technological advances led to the gradual decline in the demand for the Regohm, however, and as a result, early in 1955 petitioner began to develop the "Magohm" to market along with the Regohm. The newer product, a static type regulator, measured about one cubic foot and weighed approximately thirty-five pounds; the component parts cost about $100 and it was sold for $350. Naturally, the Magohm called for far greater inventories and manufacturing space than did the Regohm, a major factor in the 1957 decision to substantially increase plant facilities. Sales of Magohm devices accounted for only $6,000 of $1,462,000 sales in fiscal 1956. However, in fiscal 1957 $238,000 of $2,624,000 sales were attributable to Magohm and by 1958 it had accounted for $639,000 of $2,016,000 sales. Petitioner also developed two other products, the "Teleregister" and the unsuccessful "Rotojet."

Since its inception, petitioner's sole shareholders have been Arthur M. Cohen, President and Chief Engineer, and Paul W. Fink, Treasurer and Chief Fiscal Officer. Their only contribution to the capital of petitioner was their initial investment of $2,180 in 1945. Two thousand dollars in preferred stock was subsequently retired, thus leaving a capitalization of $180 in common stock. In 1952 and again in 1957, however, the capital stock account was increased, first to $50,000, then to $540,000.In each case earned surplus was reduced by the appropriate amount and a non-taxable dividend in common stock was declared. The salaries of petitioner's officers, Cohen and Fink, from 1955 through 1959 were:

Fiscal Year Cohen Fink

1955 $40,000.00 $11,000.00

1956 67,949.01 26,966.01

1957 65,000.00 43,500. 00

1958 63,607.15 27,404.77

1959 56,029.45 22,352.97

No taxable dividend has ever been declared or paid by petitioner.

During the fiscal years 1957 and 1958, petitioner held no investments in securities or other assets not directly related to its business. And during these years it made no loans to shareholders or members of their families with the exception of one $3,000 loan to Fink which was promptly repaid.

Petitioner's profit and loss statements for the fiscal years 1955 through 1959 reveal net income, after taxes and profit-sharing, in the following amounts: $52,543 (1955); $83,884 (1956); $261,524 (1957);*fn4 $89,027 (1958); $73,017 (1959). Balance sheet assets figures for the same years were: $694,478 (1955); $833,417 (1956); $1,423,701 (1957); $1,138,195 (1958), $1,156,285 (1959). Reflected in these balance sheet figures are the following amounts which are of particular importance:

Year Fiscal ...

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