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November 16, 1966

Mohawk Paper Mills, Inc., Plaintiff,
United States of America, Defendant

Moore, Circuit Judge.

The opinion of the court was delivered by: MOORE

MOORE, Circuit Judge.

The plaintiff, Mohawk Paper Mills, Inc. (Mohawk), brings this tax refund suit to recover taxes paid because of income tax deficiencies assessed against Mohawk for the years 1959, 1960 and 1961 on the theory that Mohawk had accumulated earnings in these years in violation of Section 531, Internal Revenue Code, Title 26. This court has jurisdiction of the suit under 28 U.S.C. § 1346. Mohawk paid under protest accumulated earnings taxes and interest in the sum of $615,829.96 upon alleged excess accumulations as follows: Alleged Excess Tax Year Accumulations Imposed Interest 1959 $ 465,519 $168,225.09 $ 48,193.03 1960 385,571 148,490.80 33,630.11 1961 504,903 186,279.27 31,011.66 $1,355,993 $502,995.16 $112,834.80

 Mohawk's claim for refund was disallowed on February 18, 1965, and this suit was timely filed on February 26, 1965.

 The Applicable Statutes

 The statutes governing the imposition of an accumulated earnings tax are sections 531, 532, 533, 535 and 537 of the Internal Revenue Code of 1954, 26 U.S.C. 1958 ed. and Treasury Regulations, Sec. 1.533-1, 1.533-3, 1.537-1, 26 C.F.R. The facts developed upon the trial must be reviewed against the background of these sections.

 First, the tax* applies to corporations "availed of for the purpose of avoiding the income tax with respect to its shareholders * * * by permitting earnings and profits to accumulate instead of being divided or distributed" (§ 532).

(a) Unreasonable Accumulation Determinative of Purpose.
For purposes of section 532, the fact that the earnings and profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation by the preponderance of the evidence shall prove to the contrary.

 Third, "the term 'reasonable needs of the business' includes the reasonably anticipated needs of the business" (§ 537). Lastly, the Regulations specify certain evidentiary guidelines intended to be helpful in arriving at the conclusion of the existence or non-existence of the proscribed purpose. Despite specific examples in the Regulations, it is fundamental that "Whether or not such purpose was present depends on the particular circumstances of such case." Sec. 1.533-1(a)(2). Factors to be considered are "Dealings between the corporation and its shareholders", "withdrawals by the shareholders as personal loans", "expenditure of funds by the corporation for the personal benefit of the shareholders", "investment by the corporation of undistributed earnings in assets having no reasonable connection with the business", "the extent to which the corporation has distributed its earnings and profits" and "the accumulated earnings and profits of prior years".

 To "justify an accumulation of earnings and profits for reasonably anticipated future needs, there must be an indication that the future needs of the business require such accumulations, and the corporation must have specific, definite and feasible plans for the use of such accumulation".

 The Regulations are also specific as to the extent of the proof to be considered in determining "reasonable anticipated needs". Thus, although "[consideration] shall be given to reasonably anticipated needs as they exist on the basis of the facts at the close of the taxable year", nevertheless "subsequent events may be considered to determine whether the taxpayer actually intended to consummate or has actually consummated the plans for which the earnings and profits were accumulated". Sec. 1.537-1(b).

 Pre-1959 History of Mohawk

 Mohawk operates two mills for the manufacture of paper, one at Waterford, New York, built about 1875, the other at Cohoes, New York, built in 1915-16. The present Mohawk company acquired the properties upon foreclosure in 1931. For some ten years prior thereto, the mills had been in receivership and had been operating at a loss. In fact, it was this situation which accounted for the advent of George E. O'Connor, Esq., and some of his family in the paper business. Mr. O'Connor, a practising lawyer for some years, had been the attorney for the then Mohawk receivers. His father who held a mortgage on both mills was the largest creditor.

 The present Mohawk commenced its existence (1931) with a capitalization of $2,500 (500 shares of no par common stock) owned by Mr. O'Connor, Senior, which shares were given a few years later to Mr. O'Connor, Junior (George E.), who still retains them. For all practical and legal purposes, Mr. O'Connor is the sole proprietor. The original working capital came from a $100,000 mortgage loan and loans from the O'Connor family.

 The financial success (or, better, lack thereof) between 1931 and 1945 fluctuated rather widely. During the Depression years (roughly 1931-40), small profits were realized in two years and losses were incurred in eight years, the net result being a loss of $251,190.65. The next five years saw some improvement; a small loss for one year and an overall profit of $153,272.68.

 Net sales of Mohawk's products from 1932 through 1945 increased from $413,609 in 1932 to $2,731,423 in 1945; in tons of paper correspondingly from 5,140 to 14,120. During this period, $332,347 were added to fixed assets. No dividends were paid. The Mills, both plant and equipment, were obsolete and, as a result of financial reverses, in bad repair.

 After World War II, a marked improvement is noted. For the fifteen years 1946 through 1961, net sales increased from $3,694,887 to $10,777,765 in 1961; tons of paper from 16,895 to 26,881.

 These increases were not fortuitous but reflect managerial policy in discarding unprofitable items and concentrating on profitable specialty items. However, the tonnage increase could not have taken place had not the antiquated machinery been improved by more modern equipment and large sums devoted to repairs and maintenance. From 1931 to date, virtually as the sole owner, Mr. O'Connor has given his ...

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