FISHER, Judge:
Respondent determined deficiencies in the income tax of petitioner as follows:
Year Amount
1952 .............................. $47,723.95 1953 .............................. 48,239.61 ___________ 95,963.56
The only issue presented is whether or not the compensation paid by petitioner to its two principal officer-shareholders exceeded a reasonable allowance for their respective services, and if so, the amount of such excess.
FINDINGS OF FACT.
Some of the facts have been stipulated and are incorporated herein by this reference. Some of the testimony and exhibits received in the case of Huckins Tool and Die, Inc. (in which case Memorandum of Findings of Fact and Opinion was filed on October 14, 1959), have been incorporated in the instant case by agreement and reference.
Adams Tooling, Inc., formerly Adams E.D.T., Inc., by a change of name only, effective October 22, 1954, was organized under the laws of the State of Indiana on May 31, 1926, with an authorized capitalization of 100 shares, common stock with a par value of $100 per share.
Petitioner filed timely Federal income tax returns for its taxable years ending December 31, 1952, and December 31, 1953, with the then director of internal revenue for the district of Indiana at Indianapolis.
The plant of petitioner in the taxable years under consideration, and its principal place of business, was located at 1702 West Washington Avenue, South Bend, Indiana.
Ownership of the issued and outstanding shares of stock as of December 31, 1952, and December 31, 1953, were as follows: Number of shares 1952 1953 C. R. Adams ...................................... 33 30 Lillian M. Adams ................................. 31 28 R. C. Adams ...................................... 33 33 Linda E. Adams ................................... 2 4 Conrad R. Adams .................................. 2 Linda Lee Adams .................................. 2 making an aggregate of 99 shares outstanding. Petitioner and all its facilities during the years in question was engaged in the business of a tool and die job shop.
During the years in question the officers of petitioner were as follows:
1952 Conrad R. Adams — President. Robert C. Adams — Vice president and general manager. Edwin B. Hampel — Vice president and works manager. Richard Kazmierzak — Secretary-treasurer.
1953 Conrad R. Adams — President. Robert C. Adams — Vice president andgeneral manager. Edwin B. Hampel — Vice president and works manager. Richard Kazmierzak — Treasurer. Fred Binder, Jr. — Secretary.
Petitioner specializes in designing and building tools for the aircraft industry and more especially in jet engine parts. These jobs are rather large in scope and rather difficult from an engineering standpoint.
A shop of this character has no fixed or standard product, and is to be distinguished from shops in which end products are manufactured and assembled. The complexities of design and fabrication were such that highly skilled labor was required and technical skill was necessary to manufacture tools and dies, where tolerances must, in some instances, be held to a range of no greater than 0.0001 of an inch.
In the course of its operation, petitioner usually received what is known as a "part print," from its customers. This part print consisted of a printed sketch or diagram of the end product which the customer wished to make. From this part print petitioner designed and built the tools or machines which made the end product. The design of petitioner's product required an imaginative effort on the part of the tool designers. When new metals were introduced by the manufacturer to be used in a product, petitioner had to design new types and methods to accommodate such new and untried metal. It was necessary for petitioner to try out these metals to find out what would happen to them under varying circumstances.
Conrad Robert Adams was the president of petitioner during the years in question and had over 50 years experience in the tool and die business, the last 30 years being with petitioner. He was born in Great Britain in 1881 and since has become an American citizen. He attended Chelsea Polytechnic in London being graduated with a degree in mechanical engineering. His career and achievements have been noted in the National Cyclopedia of American Biography, as follows:
1898-1903 — Apprenticeship, R. W. Monroe Mechanical Engineers, London England.
1903-1905 — Experimental Work, Keene Auto Co., London, England.
1905-1907 — Tool, gauge and die maker, Pope Mfg., Pratt Whitney of Hartford, Connecticut, and E. R. Thomas Co., Buffalo, New York.
1907 — Tool Designer, Automobile Department, St. Louis Car Co., St. Louis, Missouri.
1908-1910 — Charge of tool design, tool room and maintenance, Goodman Mfg. Co., Chicago, Illinois.
1911-1913 — Assistant Superintendent of Assemblies, Pierce-Arrow Motor Car Co.
1914 — Production Engineer, F.I.A.T. Motor Co.
1915-1916 — Assistant Engineer, Chandler Motor Car Co.
1916-1926 — Factory Manager, Sibley Machine and Foundry Corp., South Bend, Indiana.
1926 to Date — President and General Manager, Adams Engineering Tool Die Co., Inc.
1944 — National War Labor Board, Member of Industries.
Conrad R. Adams is an honorary life member of the Society of Mechanical Engineers. In addition to his activities in the tool and die field, he has been active in civic affairs in the community wherein he resides.
Robert C. Adams, Conrad's son, was born in 1911 and began work in the tool and die field during the summer vacations while still in high school. Upon graduation from high school, he attended Purdue University for 2 years. Before entering Purdue he had made certain special tools which permitted him to receive credit for machine shop work at the university without having to take the required course.
When Robert left Purdue in 1933, he accepted employment with Bendix Products, Corp., South Bend, as an apprentice tool — and die-maker. He completed his apprentice training after 8,000 hours of apprentice work which included approximately 800 hours on every important machine in the tool and die shop. Upon completion of the apprentice program, he worked on the bench as a journeyman for petitioner. He remained on this job for 2 years.
In 1938, Robert went on the road as a sales representative for petitioner. In 1941, he was transferred to the design room, although he also did a considerable portion of the sales work during the years in question. In the design room, he supervised an average of 10 or 12 tool and die engineers who did the designing work for petitioner.
During World War II, Robert took the job as factory manager. This included plant layout, machinery maintenance and repair, the purchase of new equipment, the purchase of supplies for the tool crib, priorities, and other associated work. He devoted most of his time to the quoting of bids and processing of work. In addition, he also worked on the budget and financing of petitioner. He has also done a considerable amount of work in the area of labor relations. This includes the negotiation of annual or biennial contracts, as well as relations at the plant level where grievances were processed and the problems of the shop committee discussed. Robert also handled customer contacts by telephone and also entertained customers.
Conrad Adams formulated the overall business and operational policies of petitioner, although both executives worked more or less as a pair or team and consulted one another on all problems.
During the years in question, Conrad and Robert devoted their time exclusively to the business of petitioner and were not employed by any other concern.
During the years under review, the plant was operating at full capacity and ran two shifts with the employees working from 55 to 65 hours per week. Robert usually worked until at least 7 o'clock in the evening 6 days a week. Conrad usually left the plant a little earlier than that.
During the years in question, approximately 90 per cent of the work brought into petitioner's shop came as a result of estimates and bids submitted by and under the direction of the executives here involved, and represented work obtained from competitive bids. In determining a bid price, an estimate was made in terms of the hours which the estimator believed would be necessary to complete the design and build the tool.
In 1951 and during the years in issue the General Electric Company of Lynn, Massachusetts, was building experimental jet aircraft engines and needed tools with which to produce the after-burner for this engine. Due to the extreme heat generated by this engine, it was necessary to develop special alloys and metals for the part exposed to such intense heat. The work characteristics of the metals used were unknown and the industry was without experience as to the type of tooling necessary to produce parts from such metals. The General Electric Company requested at least three tool and die shops to quote a fixed price to engineer and build experimental tools for this job. The tool and die shops in question were located in Buffalo, Cleveland, and Dayton. Such other tool and die shops declined to build tools for General Electric's requirements on a fixed price basis. Shortly before the period here under review, petitioner decided to undertake the job and quoted a firm price. Petitioner successfully produced the tools ordered by the General Electric Company.
General Electric subsequently established a production plant at Lockland, Ohio. This production plant was unsuccessful in contracting with a tool and die shop to build the necessary tools for the production of parts for jet engines. Upon inquiry as to where experimental tools had been built, General Electric was referred to petitioner, which contracted to produce the necessary tools. The Lockland, Ohio, plant was a relatively new plant in this work and not fully coordinated. Petitioner assisted with the engineering to the extent of establishing manufacturing tolerances. Petitioner also assisted the Lockland, Ohio, plant in the processing for the particular machine which they had available in their plant to produce the jet engines. When the plans, drawings, and specifications for the jet parts were given to petitioner, they were in the form of drawings for subassemblies of the jet engine. As a result, petitioner, during the years in question, had to design the necessary part prints so that the ultimate parts produced would fit together. It was necessary for petitioner to do the process engineering as well as the design engineering.
Petitioner was a closely owned corporation, the stock being owned by members of the Adams family. During the period here significant, Conrad R. Adams and Robert C. Adams (father and son) each owned approximately one-third of the stock and were in control of the corporation.
By the beginning of 1946, petitioner went into a period of transition from war work to civilian endeavors. Under date of January 2, 1946, it entered into employment contracts with Conrad Adams (as general manager), Robert Adams (as general sales manager), and Horace W. Wentsell (as works manager). Each contract was for a 5-year period and provided for a basic salary to each of $200 per week plus one-fifth of petitioner's net profits. Wentsell did not own any stock in the company. Wentsell's employment ceased in November of 1948. His compensation from 1946 to and including November 1948, was as follows:
1946 ................................... $15,687 1947 ................................... 10,480 1948 (to November) ..................... 8,800
On June 2, 1947, petitioner entered into a written contract with Edwin B. Hampel as sales manager whereby petitioner agreed to pay him a weekly salary of $110 with the understanding that the employer would increase the employee's salary from time to time in such amounts as may be mutually agreed upon. As a further incentive to Hampel, petitioner agreed to pay him a bonus of 5 per cent of the net earnings of petitioner before Federal income and excess profits taxes, with the further understanding that the incentive bonus would be increased to 10 per cent of the net earnings of petitioner before taxes beginning with the earnings for the year 1952. Hampel did not own any stock in petitioner.
During the years 1946 to 1957, inclusive, petitioner's books and Federal income tax returns reflected gross sales, gross profits, net income before taxes, Federal income tax paid, compensation paid to Conrad R. and Robert C. Adams, net income after taxes, earned surplus (end of year), and net worth (end of year), as follows: Year Gross Gross Net Federal sales profit income income before tax taxes paid 1946 ......... $251,637 $62,127 $10,619 $2,342 1947 ......... 229,548 50,862 3,854 809 1948 ......... 273,684 61,189 3,692 775 1949 ......... 281,463 78,187 3,382 710 1950 ......... 612,390 158,682 29,086 8,241 1951 ......... 1,643,709 454,853 137,284 87,864 1952 ......... 1,493,908 490,410 124,196 81,068 1953 ......... 1,427,619 488,203 120,904 79,693 1954 ......... 955,435 322,739 58,162 24,744 1955 ......... 555,625 135,232 (50) 0 1956 ......... 1,024,060 245,480 45,083 17,738 1957 ......... 717,175 168,528 24,977 7,493 Officers' Year Net compensation Earned Net income paid to surplus worth after C. R. Adams end of end of taxes and year year R. C. Adams 1946 ......... $8,277 $31,374 $11,637 $66,029 1947 ......... 3,045 20,950 11,375 65,766 1948 ......... 2,917 23,400 13,222 67,613 1949 ......... 2,672 18,850 13,817 68,209 1950 ......... 20,844 36,000 31,119 85,511 1951 ......... 49,420 126,003 75,268 129,660 1952 ......... 43,128 128,177 109,318 163,700 1953 ......... 41,211 128,913 144,646 199,037 1954 ......... 33,418 80,340 172,205 226,597 1955 ......... (50) 33,800 170,674 225,066 1956 ......... 27,345 69,866 192,326 246,717 1957 ......... 17,484 32,225 197,450 251,841
During the taxable years 1946 to 1957, inclusive, the compensation paid petitioner's officers was as follows: Conrad R. Adams, President Year Basic Contingent Total 1946 .......... $15,687 0 $15,687 1947 .......... 10,480 0 10,480 1948 .......... 15,900 0 15,900 1949 .......... 9,425 0 9,425 1950 .......... 10,650 $7,350 18,000 1951 .......... 13,080 49,921 63,001 1952 .......... 14,410 49,678 64,088 1953 .......... 16,095 48,361 64,456 1954 .......... 16,965 23,205 40,170 1955 .......... 16,900 0 16,900 1956 .......... 16,900 18,033 34,933 1957 .......... 15,325 0 15,325 Robert C. Adams, Vice President General Manager 1946 .......... $15,687 0 $15,687 1947 .......... 10,480 0 10,480 1948 .......... 15,900 0 15,900 1949 .......... 9,425 0 9,425 1950 .......... 11,625 $6,375 18,000 1951 .......... 13,080 49,921 63,001 1952 .......... 14,410 49,678 64,088 1953 .......... 16,095 48,361 64,456 1954 .......... 16,965 23,205 40,170 1955 .......... 16,900 0 16,900 1956 .......... 16,900 18,033 34,933 1957 .......... 16,900 0 16,900 Edwin B. Hampel, Vice President Works Manager 1951 .......... $9,750 $12,480 $22,230 1952 ......... 10,600 24,839 35,439 1953fn1 ......... 12,100 24,180 36,280 1954 .......... 13,000 11,602 24,602 1955 .......... 13,000 0 13,000 1956 .......... 13,000 $9,016 22,016 1957 .......... 13,000 0 13,000 Fred Binder, Secretary 1953fn1 ......... $8,462 $750 $9,212 1954 .......... 9,100 750 9,850 1955 ......... 9,100 236 9,336 1956fn2 ......... 9,100 0 9,100 1957fn2 ......... 9,100 0 9,100 Richard Fortenbacher, Secretary-Treasurer 1946 .......... $4,305 0 $4,305 1947 .......... 4,570 0 4,570 1948 .......... 5,135 0 5,135 1949 .......... 1,085 0 1,085 Richard Kazmierzk, Secretary-Treasurer 1950 .......... $4,421 0 $4,421 1951 .......... 6,429 0 6,429 1952fn1 ......... 6,199 0 6,199 1953fn1 ....... 6,366 0 6,366 1954fn3 ......... 6,700 0 6,700 During the taxable years ended December 31, 1951, through December 31, 1954, petitioner had total sales and renegotiable sales as follows: Taxable year Total sales Renegotiable sales 1951 .............. $1,643,809 $1,608,000 1952 .............. 1,493,908 1,219,000 1953 .............. $1,427,619 $679,000 1954 .............. 955,435 473,000 Petitioner's corporate books and records were examined by the Renegotiation Board of the United States and in each of the taxable year 1951 to 1953, clearance letetres were granted to the corporation.
Petitioner had the following increase in capital accounts in each of the taxable years 1950 through 1953, inclusive: Year Machinery Improvements Total acquisition to building acquisition 1950 ........ $19,822.86 $1,192.87 $21,015.73 1951 ........ 41,652.02 27,421.90 69,073.92 1952 ........ $63,835.50 $14,224.61 $78,060.11 1953 ........ 36,103.78 36,103.78 No cash dividend was ever declared or paid by petitioner.
Petitioner had no pension plan, or definitive plantwide profit-sharing plan, or any other form of deferred compensation during the years in question.
The following table discloses the wages earned by some of the paid employees in petitioner's shop who were under the direction and control of the officers and executives of petitioner. Year and amount Name 1952 1953 R. Clark .................................. $8,614 $11,290 J. D. Fair ................................ 9,432 12,530 R. Groppler ............................... 9,030 11,647 S. Wroblewski ............................. 9,460 11,524 J. Kovach ................................. 10,498 10,555 C. Cochran ................................ 7,871 10,017 Wm. Floyd ................................. $9,504 $10,848 U. Ernsberger ............................. 9,737 10,048 C. Schrader ............................... 10,499 J. Krislofeski ............................ 9,475 10,522 J. Cierpial ............................... 9,243 The business activities of the tool and die industry are cyclical in nature and tend to fluctuate over the years.
Petitioner had a large volume of sales during the years 1952 and 1953. Its increase in sales and earnings was due in substantial measure to the war economy engendered by the Korean conflict. The substantial increase in production and sales added to the burdens and responsibilities of the executives, but not to an extent commensurate with the increase in production, sales, and income.
During the years in question the efficiency of petitioner's management as compared with the tool and die industry in general, was above average.
Respondent determined that the salaries paid to Conrad and Robert Adams (who were the only persons listed as officers in the income tax returns filed by petitioner) were unreasonable and excessive and disallowed the following amounts: Amounts Amounts Year claimed disallowed 1952 ................................... $128,177 $68,177 1953 ................................... 128,913 68,913 The effect of the foregoing was to allow deductions in the total amount of $60,000 for both executives for each of said years.
Reasonable compensation, and compensation in excess of reasonable, as to each of said executives for each of the years involved were as follows: CONRAD R. ADAMS In excess Year Reasonable of reasonable 1952 .................................. $51,288 $12,800 1953 .................................. 51,656 12,800 ROBERT C. ADAMS In excess Year Reasonable of reasonable 1952 .................................. $51,288 $12,800 1953 .................................. 51,656 12,800
OPINION.
Respondent allowed to petitioner corporation a total deduction of $60,000 for each of the taxable years 1952 and 1953, as compensation paid to Conrad R. Adams and Robert C. Adams, father and son, who were the chief executives of petitioner, a family-owned corporation. The same executives owned, together, approximately two-thirds of petitioner's stock, and clearly dominated the corporation. The salaries to said executives disallowed for the respective years totaled the following: 1952 — $68,177; 1953 — $68,913.
The problem before us is to determine what is a reasonable allowance for salary or other compensation to each of the two executives for each of the years in question under the provisions of section 23(a) (1) (A) of the Code of 1939.
The actual services performed by each of the two executives are summarized in our Findings of Fact. Suffice it to say here that each executive was thoroughly trained and experienced, possessed a high degree of intelligence and technical knowledge, worked skillfully and efficiently for long hours; rendered very valuable services to the petitioner; and was entitled to substantial compensation.
We think there is nothing to be gained by a detailed discussion of each of the contentions presented by the parties, all of which we have fully considered in conjunction with a careful examination of the entire record. We mention only one with particularity. Petitioner relies upon Regulations 118, section 39.23(a)-6(b)(3), for the proposition that since the disputed compensation was paid in accordance with written contracts, the reasonableness of the compensation in 1952 and 1953 must be determined upon the basis of the reasonableness of the agreement when entered into (1946). We think the quotation relied upon by petitioner on brief is taken somewhat out of context. We accordingly set out all of the provisions of section 39.23(a)-6 (Compensation for personal services) in our footnote 1.fn1
A perusal of the provisions of the regulation seems to leave no doubt that in using the word "contract," a free bargain or arm's-length transaction was contemplated rather than, as here, one in which the contracting employees controlled the corporation. Any other view would give a closely held corporation and its controlling executives the tactical and practical opportunity from the tax perspective of adhering to and relying upon the contract as long as it might be advantageous for them to do so, or causing the execution of a new contract or arrangement if and when it better served their purposes.
On the broader horizon, it is also clear that the regulation was not designed (and could not be taken) to lessen or minimize the test supplied in the statute by the word "reasonable."
Upon the record as a whole, we have no difficulty in finding that the salary allowances determined by respondent are inadequate, but we likewise think it clear that the deductions taken by petitioner for compensation paid to the two executives for each of the years in question are in part in excess of reasonable.
It is apparent on the record that the marked increases in sales and profits were due in substantial degree to the fortuity of Korean war conditions. The compensation of the executives was geared largely to profits and reflected in substantial measure the chance benefits of the war economy but, in our judgment, without commensurate increase in the duties and responsibilities of the executives or in the value of their services although their burdens and responsibilities no doubt became somewhat heavier.
It may be trite, but nevertheless true, in a case of this type to say that to draw the line between what is reasonable and what is excessive is a difficult undertaking. We do not think it possible in this case to draw a precise line to the dollar. We must, under the circumstances, use our judgment, after weighing all the evidence, to reconcile and integrate the elements material to our ultimate conclusions. Our Findings of Fact reflect our determinations. We implement them into this opinion by reference, since it would add nothing to repeat them here.
We need only add, for completeness, that the difference between the amount of the deduction allowed for each of the years in question is attributable to the fact that the salaries are in part based upon contingent compensation, and also to the fact that there was a small increase in basic compensation for 1953, which we see no reason to disturb. The disallowances are rounded off. No more precise answer is practicable.
Decision will be entered under Rule 50.