Court Opinion

ID: 4485105
Source: CourtListenerOpinion
Date Created: 2020-01-16 21:17:10.978879+00
Date Added: 2024-06-11T08:49:15.023025
License: Public Domain

Fay, J., dissenting: I respectfully dissent. In my view, the majority is taking a much too restrictive and inflexible view of section 1348. This Court has always treated the issue before us as a question of fact, and we have consistently held that the distinction must be made between income earned by capital and income earned by personal effort. Gaudern v. Commissioner, 77 T.C. 1305 (1981); Rousku v. Commissioner, 56 T.C. 548, 551 (1971); Lewis v. Commissioner, 42 T.C. 885 (1964). It is precisely the relative values of these components that must be considered, and where gross income of the business consists principally of compensation for personal services, capital is generally not a material income-producing factor. Sec. 1.1348-3(a)(3)(h), Income Tax Regs. Thus, where the value added by personal effort is so substantial in comparison to the value added by the employment of capital, capital will not be deemed a material income-producing factor. United States v. Van Dyke, 696 F.2d 957 (Fed. Cir. 1982).1 And in my opinion, the unique facts of this case support a conclusion that the value added by the personal efforts of petitioner and his employees is so predominant that capital will not be deemed a material income-producing factor. What truly makes this case unique is the lack of any significant capital invested in petitioner’s business. 'Lest anyone be misled by visions of smokestacks and assembly lines, petitioner’s business was a very small concern with only a minimal investment in capital, certainly not the kind of investment associated with a "manufacturing” business. Petitioner started the business over 23 years ago and continues to operate it out of the same structure his father originally built to repair farm equipment. It is the size of a four-car garage. In the beginning, petitioner made his own tools. As of the year in issue, his tools included two metal cutters, four welders, and an assortment of handmade tools. His adjusted basis in these tools was only $19,040. He also kept a stock of unworked iron rods and bars which are reflected by a 1978 closing inventory of $11,066. Yet, despite this minimal capital investment, his business generated $476,178-in gross receipts and $196,046 in net profits. When the regulations speak of "a substantial investment in inventories, plant, machinery, or other equipment,” I cannot imagine they had in mind this business.2 Sec. 1.1348 — 3(a)(3)(ii), Income Tax Regs. The business generates its income through a labor-intensive process whereby raw materials in the form of crude iron rods are transformed into custom-made ornamental iron products. Petitioner visits the location, discusses various designs and plans with each customer, and takes measurements. After receiving the specifications and measurements, an employee removes the iron rods from stock and cuts, bends, welds, and paints them to create the finished product. Then petitioner installs it. The efforts, skill, and hours of labor that petitioner and his employees devote to the production of these ornamental products are what account for the business’s income. The fruits of their efforts are just as much "earned income” as is a doctor’s or lawyer’s fee. The majority points to the fact that petitioner’s customers paid for a finished product. As the majority states, "petitioner sold goods not services.” I agree that in the vast majority of cases where a tangible product is sold, capital is necessarily a material income-producing factor. For instance, in cases where the taxpayer is a retailer or wholesaler of goods, this Court has recognized that the business income is attributable to the markup in the product itself.3 But this is not such a case. To be sure, petitioner’s customers were buying iron products, but this does not place him in the same category as a wholesaler or retailer. It is not the value or markup in the raw materials that contributed to the business’s income. As I have, noted, the skill and effort that went into transforming such raw material into the finished product are what produced the income. To simply say petitioner sold goods and not services oversimplifies the problem. And for this reason, I do not place controlling significance on the cost of the raw materials.4  In effect, the majority sets a standard which makes it literally impossible for any manufacturing or production concern to qualify for the 50-percent maximum tax rate, for any manufacturing concern is going to sell a product and is going to have a significant cost of material that goes into whatever is being produced. If all net profits of a business such as petitioner’s do not qualify, I fail to see how any production concern can qualify. Congress could have easily excluded manufacturing or production concerns, but it did not. The regulations speak of businesses with "substantial investments] in inventories, plant, machinery, or other equipment.” Sec. 1.1348-3(a)(3)(ii), Income Tax Regs. (Emphasis added.) Clearly then, businesses with insubstantial investments in such items must at least be eligible. Furthermore, this Court has held that capital was not a material income-producing factor in a business that manufactured eyeglasses upon prescription from oculists. Innes-Behney Optical Co. v. Commissioner, 7 B.T.A. 982 (1927). Similar to the crude iron rods in this case, a supply of lenses and frames was kept on the premises to produce the eyeglasses. In holding that capital was not a material income-producing factor, we found that it was essentially the ability of the optometrists and opticians to fit eyeglasses to the individual needs of its customers which produced the business income. We noted— lenses and frames [like crude iron rods in the instant case] were not kept for sale as such and had little value until made up as eyeglasses through the services performed upon them * * * [Innes-Behney Optical Co. v. Commissioner, supra at 985] Thus, despite the fact that the business manufactured and sold eyeglasses, we held the income was primarily attributable to the efforts and skills of the individuals involved. I see no meaningful distinction between this case and the case before us.5  Innes-Behney was decided under section 200 of the Revenue Act of 1918 which related to personal service corporations. However, the statutory test is the same, namely, whether capital is a material income-producing factor. This Court has consistently applied principles of cases interpreting this test, notwithstanding the fact that it arises in the context of different Code sections. See Bruno v. Commissioner, 71 T.C. 191, 200 (1978); Miller v. Commissioner, 51 T.C. 755 (1969); Lewis v. Commissioner, 42 T.C. 885 (1964). Moreover, I find no suggestion those same principles should not apply herein. I also find support in both the legislative concern and purpose for enacting section 1348. The concern was over the 70-percent tax bracket and its propensity to breed abusive tax shelters. S. Rept. 94-938 (1976), 1976-3 C.B. (Vol. 3) 57, 115. The express purpose of section 1348 was to encourage the "work effort.” S. Rept. 94-938, supra. Certainly, petitioner’s strong work ethic cannot be doubted. Given the posture of this case, I am influenced by express congressional purposes.6  My views are shared by the newly created Federal Circuit Court of Appeals. On facts even more favorable to the Government, the Federal Circuit considered this same issue with respect to a taxpayer engaged in the manufacture and production of taxidermy supplies and held capital was not a material income-producing factor. United States v. Van Dyke, 696 F.2d 957 (Fed. Cir. 1982), affg. an unreported case (Ct. Cl. Trial Div. 1982, 49 AFTR 2d 82-556, 82-1 USTC par. 9156).7 His operation was nearly twice the size of petitioner’s. I see no basis, as the majority does, for distinguishing this case. Indeed, respondent does not attempt to distinguish the case. He argues United States v. Van Dyke, supra, was decided incorrectly. Although it recognizes petitioner’s efforts played a vital role in his business, the majority effectively pays lip service to this role. Instead, it focuses on the fact that petitioner operates a "manufacturing” concern, that he sells a product and not services, and that the cost of raw materials is significant. Without so stating, the majority excludes the benefits of section 1348 from anyone who sells a product. The majority lays down an extremely difficult standard, and in my view, this inflexible view is unwarranted. The statute is not limited to net profits generated by commissions and fees of professionals; it extends to income generated by personal effort, skill, and labor even if it results from the production and sale of a tangible item. I cannot imagine capital would be deemed a material income-producing factor in the production of an oriental rug through hours and hours of manual labor even though the rug is sold as the final product or there is a substantial cost of wool incorporated into the product. I, too, have serious doubts many production concerns can qualify. But I cannot rule out all of them, and this happens to be one I cannot rule out. This case is unusual in that, even though petitioner generated substantial net profits, he did so by using only a few tools. As this Court has stated, "Few modern businesses are conducted without the use of capital in some form or other, and it cannot be assumed that Congress intended such a narrow reading of the term 'capital’ under section 1348.” Bruno v. Commissioner, 71 T.C. 191, 201 (1978). Congress has given us a general standard to apply, and we must draw the line on the particular facts of each case. As the majority points out, this "is a matter largely of approximation.” Yet, the majority sets a standard, admittedly easier to apply, that goes too far. In my opinion, Congress did not intend such a far-reaching result, and I believe the record in this case supports a finding in favor of petitioner. Sterrett, Wiles, Kórner, and Cohen, JJ, agree with this dissent.  Although sec. 1348 recognizes that both capital and services may be income-producing factors, the majority holds "that the relative value of petitioner’s services is not the question.” It further states that the statute "does not permit the courts to compare the relative materiality of the capital and personal service components.” I submit that for the issue before us, it is precisely the relative values of these components that must be considered. Indeed, once a determination is made that capital is a material income-producing factor, the statute, as it read during the year in issue, mandated the 30-percent figure and no further inquiry into the relative values could be made. But the statute did not preclude such an inquiry in the initial determination of whether capital is a material income-producing factor, and that is precisely the issue presented in this case.   Other businesses where this Court has held capital to be a material income-producing factor are marked by a substantially greater capital investment which played a significant role in the production of income. See Smith v. Commissioner, T.C. Memo. 1983-93, and Nelson v. Commissioner, T.C. Memo. 1982-361 (painting businesses featuring blasting equipment); Wilson v. Commissioner, T.C. Memo. 1982-289 (egg-producing business); McGowan v. Commissioner, T.C. Memo. 1982-65 (sanitary landfill operation); Novikoff v. Commissioner, T.C. Memo. 1980-330 (movie theater business).   See Gaudern v. Commissioner, 77 T.C. 1305 (1981) (seller of bowling supplies); Moore v. Commissioner, 71 T.C. 533 (1979), and Jones v. Commissioner, T.C. Memo. 1982-612 (retail grocery stores); Rousku v. Commissioner, 56 T.C. 548 (1971) (automobile body repair business where a substantial portion of the income was from the direct sale of automobile parts); Pilkington v. Commissioner, T.C. Memo. 1983-111 (a lounge business where the principal source of income came from the sale of beer and liquor).   Moreover, I note the gross income of a business does not include the cost of goods sold. Sec. 1.61-3(a), Income Tax Regs. See Winkler v. United States, 230 F.2d 766 (1st Cir. 1956), holding that this concept ultimately rests on constitutional grounds.   In 1919, the business had gross receipts of $26,491.05. Opening inventory for the lenses and frames was $2,632.68. At the end of the year, the cost value of the assets, consisting of merchandise inventory, furniture and fixtures, and tools and machinery, was $8,445.48. No figures were given for the costs of materials.   In later years, Congress further expressed its dissatisfaction with the limitations on earned income. The 30-percent limitation was removed for years after 1978 by Revenue Act of 1978, Pub. L. 95-600, sec. 442(a), 92 Stat. 2878. Finally, sec. 1348 was repealed for taxable years beginning after Dec. 31, 1981, when the highest marginal rate for all types of income was reduced from 70 percent to BO percent. Economic Recovery Tax Act of 1981, Pub. L. 97-34, sec. 101(c)(1), 95 Stat. 183.   In United States v. Van Dyke, 696 F.2d 957 (Fed. Cir. 1982), the taxpayer owned and operated a taxidermy supply business in which he produced and sold artificial eyes, forms, wood panels and plaques, and other supplies to both commercial and museum taxidermists. He employed over 20 people on a full-time or a part-time basis. Gross sales, expenses, and the cost of business assets were as follows: 1972 1973 Gross sales . $713,917 $866,039 Materials . 162,496 222,630 Labor . 180,516 218,577 Cost of physical assets . 40,86T 105,237