Before MARIS, GOODRICH and HASTIE, Circuit Judges.
This is a petition to review a decision of the Tax Court. Petitioners are, and were during 1952, the taxable year involved, husband and wife and filed a joint income tax return for that year.
Prior to 1951, petitioners lived in New York where Gordon operated a printing plant and also had engaged in the sale of plastic products. About 1950, Gordon became interested in a method for the manufacture of plastic molding compounds known as urea formaldehyde molding compounds. The method was radically different from conventional manufacturing methods then in use. Urea and paraformaldehyde were the basic materials to be used, and the proposed method of manufacture was supposed to dispense with the need for certain expensive items of equipment used in conventional manufacturing methods of the material, with costs supposed to be far below those under the conventional manufacturing methods. One of the factors inducing Gordon to go into the business was the fact that the demand at that time for urea formaldehyde molding compounds was so great that manufacturers were rationing their products among their customers, and requiring them to wait twelve to sixteen weeks for deliveries.
Gordon's previous business had been conducted as a proprietorship and he therefore first considered operating this enterprise in the same manner. However, after conferring with friends and upon the advice of counsel, Gordon decided that in view of the hazardous nature of the proposed new manufacturing operation, he would form a corporation to conduct the manufacturing operation. Accordingly, in April 1951, before the business began, Gordon Chemicals, Inc., a Delaware corporation, was formed, and a selling organization was set up by Gordon individually under the name Gordon Chemical Co. The corporation was created to engage merely in manufacturing the material and selling its output to Gordon and Gordon was to develop a market for the product and sell the same to the trade.
Gordon's estimate of the corporation's capital requirements was $35,000 or $40,000. His entire resources amounted to $20,000, all of which he invested in capital stock of the corporation. He arranged to borrow the additional estimated funds and to lend that borrowed money to the corporation.
On April 28, 1951 the corporation and Gordon entered into a written contract whereby the corporation agreed to sell its entire output to Gordon at 107% of the corporation's manufacturing costs, the amount of those costs to be determined as set forth in the contract. This price was to be paid monthly on an estimated basis and within three months after the end of each calendar year the exact amount payable by Gordon in respect to purchases during the preceding year was to be computed, and the account settled between the corporation and Gordon. Under the contract Gordon assumed all financial and other responsibility for sales.
From the time the corporation and Gordon began business, and throughout the year 1952, both the corporation and Gordon functioned in accordance with the contract. Each had separate books of account. The books were kept by an accountant who was engaged on a parttime basis. The accountant was given a copy of the contract between the corporation and Gordon and he was instructed to keep the records in accordance with the contract.
Due to delays in delivery of certain portions of the equipment, the corporation did not begin operations for a number of months after the contract was signed. During the period of delay deliveries were made to the corporation of certain basic materials which had been ordered some time before, and those materials were stock-piled. Gordon borrowed money and loaned it to the corporation to enable payment to be made for those purchases. It was expected that these loans would be repaid within a short time. However, the corporation experienced unanticipated difficulties in making the new method work. Substantial additional amounts of money were found to be needed. When, finally, salable material was developed about the middle of 1952 the manufacturing costs were found to be higher than had been estimated, because the equipment did not perform with the anticipated efficiency.
The material manufactured and sold to Gordon during the second half of 1952 was marketed by Gordon for the total sum of $9,969.25, against which $2,219.95 was deducted for material returned and other credits in connection therewith, leaving net sales by Gordon of $7,749.30. His expenses for the year were $305.34, and discounts allowed to customers totalled $71.45.
The corporation's books show periodical debits during the year for sales to Gordon in the total amount of $9,969.25, and credits for merchandise returned of $2,219.95, and also an additional debit to Gordon in December of $21,720.93, explained on the corporation's books as follows: "This adj. to bring sales in line with contract".
The purchases account in the books of Gordon show, similarly, a December debit in the amount of $21,720.93, which entry, along with the other debits, was duly entered on the accounts payable.
The corporation's books also show credits to Gordon during 1952 amounting to about $3,000.00 on the amounts owed to the corporation for products purchased from it, so that, at the close of 1952, the books of the corporation showed an account receivable from Gordon of $25,904.23. Correspondingly, the books of Gordon showed the same amount owing by him to the corporation as an account payable.
By the end of 1952 Gordon had loaned $92,000.00 to the corporation, all but $3,000 of which had been borrowed by Gordon; and the respective payable and receivable accounts of the corporation and Gordon reflected this ...