author: Lansdon:

text:
    Appeals of J. A. Bentley and E. W. Zimmerman.
    Docket Nos. 2512, 2513.
    Decided October 30, 1926.
    1. A corporation wbicb was legally organized in 1908, but which never issued any shares of stock or received any assets of any description, or transacted any business whatever, derived no income from a business operated by a partnership, which, at the time the corporation was formed, it was intended the corporation should take over and carry on.
    2. A taxpayer is entitled to deduct from gross income in his income-tax return his proportionate share of any net loss actually sustained by a partnership of which he was a member within the same taxable year as a result of the embezzlement of moneys by an employee of the partnership, unless such loss has been included in the computation of the distributive income of the partnership, but the amount of the deduction to which such partnership is entitled in computing net income on account of the embezzlement is limited to the amount of the loss actually sustained within the taxable year; and, where the embezzlements have covered a series of years and the amount thereof can not be determined, the partnership is limited to the deduction of a loss in the year under review of the amount of the embezzlement proven for that year.
    3. Where individuals on January 2, 1919, sell to a corporation organized on December 31, 1918, certain assets in exchange for shares of stock of the corporation, any loss sustained upon the transaction is deductible from the gross income of the year 1919 and not of the year 1918.
    4. The depreciated cost or cost of reproduction of property on March 1, 1913, is not evidence of the fair market price or value of the property on the same date.

      Albert L. Hopkins, Esq., R. S. Doyle, Esq., and L. Dana Latham, Esq., for the petitioners.

      (J. II. Gurl, Esq., for the Commissioner.
    The Commissioner found deficiencies in income taxes of J. A. Bentley for the years 1917, 1918, 1919, and 1920, in the respective amounts of $24,586.31; $109,184.94; $10,488.44; and $17,819.54, a total of $162,079.23; and of E. W. Zimmerman for the same taxable years, in the respective amounts of $8,375.26; $30,306.58; $3,853 and $7,148.14, a total of $49,682.98. The issues pleaded by the taxpayers being identical, a motion to consolidate the appeals for hearing and decision was granted.
    The issues pleaded in behalf of the taxpayers are:
    (1) The Commissioner erroneously determined a taxable net income of the Hotel Bentley Co., a partnership, in 1917, in the amount of $16,887.08, and added to the gross income of the taxpayers their respective shares of such distributive income.
    (2) The Commissioner refused to allow the taxpayers to deduct from their respective gross incomes, in their income returns for 1917, their proportionate shares of a net loss in the amount of $142,588.69, which the Hotel Bentley Co. is alleged to have sustained in that year.
    (3) In computing the net income of the Hotel Bentley Co. for the year 1918, the Commissioner disallowed as a deduction from gross income the amount of $311,998.86, alleged as a loss sustained in that year by the partnership in the sale of all its assets to the Hotel Bentley Co., Inc.
    (4) The Commissioner refused to allow the taxpayers to deduct from their respective gross incomes, in their income-tax returns for 1918, their proportionate shares of a net loss in the amount of $295,307.49, which the Hotel Bentley Co. is alleged to have sustained in that year.
    At the hearing the Commissioner amended his answers to the taxpayers’ petitions, denied that the Hotel Bentley Co. was a partnership during the years 1917 and 1918, or at any other time, and asserted that it was in fact a corporation during such years. The taxpayers presented no evidence to support their allegations that the deficiencies for 1920 were erroneously determined, leaving only the years 1917,1918, and 1919 in controversy.
    FINDINGS OF FACT.
    On or about January 1, 1907, J. A. Bentley, of Alexandria, La., and E. W. Zimmerman, of Zimmerman, La., partners in the J. A. Bentley Lumber Co., of Alexandria, decided to build a high class hotel at Alexandria. The town of Alexandria, in Rapides Parish, is the center of a rich lumber district and at that time had a population of about 11,000. There was then no first class hotel in the town. The agreement between Bentley and Zimmerman for the construction of the hotel was oral, but the parties agree that Bentley was to have a three-fourths interest and Zimmerman a one-fourth interest therein. Pursuant to the agreement, Bentley purchased two tracts of real estate in Alexandria in 1907, at a total cost of $40,000. The title to each tract was taken in the names of Bentley and Zimmerman.
    The construction of the hotel was begun in 1907. Bentley had first contemplated building a hotel with 100 rooms, at a cost of not to exceed $300,000, and had gone ahead with plans for that for some time, but later decided upon a building with 168 guest rooms. He thought that a hotel of such size would take care of the needs of the town for many years to come, and that there was little likelihood that such a hotel would be superseded by a larger and better building. It was built on a cost plus 10 per cent basis. It was built of stone, steel reinforced concrete, and brick, and, as nearly as possible, was fireproof. It was elaborately built; the lobby is unusually large. The furnishings are of fine quality and the hotel compares favorably with first class hotels of much larger cities. The total cost of the land, buildings and improvements was from $650,000 to $700,000. The cost was paid partly by Bentley and partly by Zimmerman. The J. A. Bentley Lumber Co., in which Bentley and Zimmerman were partners, advanced a part of the money for the construction. The amounts thus advanced were charged to Bentley’s and Zimmerman’s individual accounts. The checks drawn by Zimmerman, by Bentley, and by the J. A. Bentley Lumber Co. were deposited in the First National Bank of Alexandria in the name of the Hotel Bentley. Paul Lisso, an officer of the bank, signed the checks in payment of construction costs as treasurer of the Hotel Bentley The hotel was opened for business on or about April 1, 1908.
    Subsequent to the completion and opening of the hotel, Bentley and Zimmerman contemplated the formation of a corporation to take over and operate the property. Articles of incorporation were drawn up and executed in the office of Louis J. Hakenyos, Bentley’s attorney, and duly recorded with the local recorder of Rapides Parish on August 15, 1908. The name of the corporation is designated in the articles of incorporation as Hotel Bentley Co., Ltd. All of the formalities of incorporation required by the statutes of Louisiana were complied with, except that a copy of the articles of incorporation was not filed in the office of the Secretary of State. The charter stated that the capital stock of the corporation shall consist of 7,000 shares of a par value of $100 each, of which 4,666 were subscribed for by J. A. Bentley, 2,333 by E. W. Zimmerman, and 1 by Paul Lisso. The Hotel Bentley Co., Ltd., never acquired title to the real estate or other hotel property held by Bentley and Zimmerman. ' No stock was ever issued or paid for. The corporation never operated the Hotel Bentley nor did it at any time have any money or any bank account.
    At the request of the Commissioner, corporation excise-tax returns were filed for the hotel for the years 1909 to 1912, inclusive, and corporation income-tax returns were filed for the years 1913 to 1915, inclusive. The return filed for the year 1909 was executed by J. A. Bentley, president, and by Paul Lisso, treasurer. Returns for subsequent years purport to have been signed by J. A. Bentley, president, by one Barnes, the manager of the hotel, who was authorized to sign Bentley’s name to checks in connection with the financial operations of the hotel. The Rapides Parish tax assessment rolls show that taxes for the years 1909 to 1913, inclusive, were assessed against Bentley Hotel Co., Ltd. For the years 1914 to 1918, inclusive, the taxes were assessed against J. A. Bentley, individually. The change was made at the instance of Bentley, who advised the assessor that the taxes should be assessed against him. The excise and income-tax returns filed for Hotel Bentley Co., Ltd., for the years 1909 to 1915, show net losses as follows:
    1909-$28, 938.90
    1910 - 23, 637.44
    1911- 7. 560.48
    1912- 12, 527.20
    1913- 14. 006. 85
    1914- 21, 790.21
    1915- 14, 318.67
    123. 679.84
    The first manager of the hotel resigned in 1911 and was succeeded by T. L. Barnes, who brought with him one George Lawrence, a bookkeeper. Barnes and Lawrence remained as manager and bookkeeper, respectively, until May 1, 1917. Barnes was married and his wife was employed as housekeeper of the hotel. Throughout. the period of his employment Barnes received a salary o f $150 per month, plus room and board; his wife received $75 per month, plus room and board; and Lawrence received $100 per month, plus room and board. Barnes was given a free hand in the operation of the hotel during all this period. At stated intervals and at the end of each year Barnes reported to Bentley, who from the date of the opening of the hotel occupied a suite of rooms at the hotel, the results of operation. He usually informed Bentley that the hotel was about breaking even, although several times he called upon Bentley to advance money for the payment of taxes and other bills.
    In April, 1917, Bentley’s suspicions as to the honesty of Barnes and Lawrence was aroused by the fact that representatives of Armour & Company and Swift & Company came to him asking him personally to guarantee current bills for supplies furnished the hotel. They had been unable to make collections in regular course and, not understanding whether Bentley was personally responsible, approached him upon the subject. At about the same time he also learned of the extravagant habits of Barnes, and at the suggestion of a business associate he called in a public accountant by the name of Robinson to make an audit of the books of account. At about this time Bentley had words with Lawrence, who suddenly disappeared. As soon as Robinson was called in, Barnes destroyed a great many vouchers and records relating to the finances of the hotel. After Robinson had made a preliminary investigation he formed the opinion that the moneys and other property of the hotel were being embezzled. A few days after the investigation was begun, and after he had been informed that he would be discharged as manager, Barnes committed suicide.
    The accountant completed an audit from the inaccurate and incomplete records which he could obtain. This audit showed, among other things, that the hotel had operated at a loss from January 1 to April 30, in 1917, the estimated amount being $14,933.33, and that the total deficit resulting from operations from the date of its opening to April 30, 1917, was $164,036.93. This audit report is dated June 22, 1917. Employees in the hotel and others having knowledge of the circumstances told the auditor of considerable waste and misappropriation of the hotel’s supplies and liquors by Barnes and Lawrence.
    Hotel checks made by Barnes in 1917 for payment of personal debts were found, but there was no record that they had ever been charged to his personal account. The following is a list of these:
    Wolf Shirt Co., Kansas City_ $650.00
    Simon Bros, (hardware merchants, Alexandria, La.)- 800.00
    Winberg’s Livery Stable, Alexandria, La- 130. 00
    House in Olathe, Kans_ 6, 200.00
    Conrad Beauty Parlor, Alexandria, La_ 1, 000.00
    Total_ 8, 780. 00
    In 1917, Barnes sold certain billiard tables belonging to the hotel for $1,500 and did not account for the cash in the hotel receipts.
    Shortly after Barnes’ death and as soon as Robinson’s audit was completed, Bentley and Zimmerman undertook to collect from Barnes’ estate any amounts they could lay their hands on. It was not clear, however, that Lawrence embezzled anything. The assets of Barnes’ estate consisted of wearing apparel, jewelry and other personal effects, insurance policies payable to his widow, and a house in Olathe, Kans., valued at about $5,000. Barnes’ widow offered to pay Bentley and Zimmerman $5,010, the value of the house in Olathe, which they, on advice of counsel, accepted in full settlement of their claims against Barnes’ estate. The charge made by Robinson for his services in auditing the books was $1,000.
    Robinson opened a new set of books f$r the Hotel Company as of May 1, 1917. The books of account for the balance of the calendar year were kept under his direction. He made an audit of such books shortly after the close of the year 1917, and in his report to the partnership, dated February 14, 1918, he reported that the earnings of the hotel for the last eight months of the year amounted to $17,-946.69. In this audit he also adjusted the estimated operating deficit for the first four months of the year 1917 and found that the actual loss for such period was $15,441.78. He computed the net loss of the partnership for the calendar year 1917 as follows:

      Deficit to April 30, 1917_$164, 036.93
    Error in computing such deficit- 508. 45
    Audit expense- 1, 000.00
    - $165, 545.38
    Erom Barnes’ estate- 5, 010.00
    Earnings May 1 to Dec. 31- 17, 946.69
    - 22, 956.69
    Net loss for year. 142, 588.69
    In making up this net loss the accountant assumed that approximately the entire amount of the deficit existing at April 30, 1917, was attributable to the defalcations of Barnes and Lawrence. The taxpayers have allocated all the defalcations to the year 1917.
    Balance sheets set up by Robinson at April 30, 1917, and December 31, 1917, read as follows:
    ASSETS.
    Apr. 30,1917. Dec. 81,1917.
    Cash_ $350.00 $11,276.22
    Accounts receivable_ 35. 00 3, 991. 81
    Storeroom inventory-._ 1,742.12 3,446.27
    Wine and liquor inventory. ._ 2, 935.43 11,212.33
    Beal estate and building— 540,454.44 540,454.44
    Furniture and fixtures_ ._ 62, 545. 56 63, 874.01
    Linen_ ._ 8,000.00 8,135.45
    Glassware and crockery_ ._ 7, 000. 00 7,024.88
    Silverware-7,200. 00 7, 891.46
    Licenses, etc., prepaid-1,270. 00 _
    631, 532. 55 657,306. 87
    Less reserve for depreciation. 8, 533. 33 25, 599. 81
    622,999.22 631,707.06
    Deficit 164, 036. 93 142, 588.69
    787,036.15 774,295.75
    LIABILITIES.
    Accounts payable-$26,744. 59 $11,890.53
    Notes payable-60, 000. 00 45,000. 00
    Payroll-1, 509.17 2, 207. 65
    Reserve for taxes-1,625.00 5, 054.18
    J. A. Bentley — personal-71, 590. 72 84, 576.72
    E. W. Zimmerman — personal. 366. 67 366.67
    J. A. Bentley — capital_ 468,900.00 468,900.00
    E. W. Zimmerman — capital— 156,300. 00 156, 300.00
    787, 036.15 774,295.75
    In computing the income of the hotel for the year 1917 the accountant deducted from gross income $25,599.81 for depreciation, which amount included $15,000 for depreciation of the hotel building. In the audit of the taxpayers’ returns for 1917 the Commissioner disallowed $4,990.91 of the depreciation claimed on the hotel building in computing the income of the partnership.
    In 1918 it was suggested to Bentley that a corporation should be organized to take over the hotel; that a corporation could manage the hotel to better advantage, and that the stockholders would thereby be saved from personal losses. Acting upon this suggestion, the charter of Hotel Bentley Co., Inc,, was drawn up and executed under date of December 31,1918. The capital stock of this corporation was fixed at $200,000. The charter provided that capital stock might be paid up in property, but if so paid up the property should be appraised. For this purpose an appraisal of the hotel property and other assets of the partnership was made. Such appraisal was made by J. A. Bentley and P. F. Appel under date of January 1,1919. The assets were appraised at a total of $250,000. On January 2, 1917, Bentley and Zimmerman transferred all of the Hotel Bentley property to the newly organized corporation, in accordance with the oral agreement entered into with the subscribers at the date the articles of incorporation were drawn up. The charter was placed on record in the office of the recorder in Rapides Parish, La., on January 10, 1919. It designates J. A. Bentley as president, E. W. Zimmerman as vice president, and P. F. Appel as secretary and treasurer. The stock of the new corporation was subscribed for as follows:
    Shares. Amount.
    J. A. Bentley of Alexandria, La_ 1, 200 $120, 000
    E. W. Zimmerman of Alexandria, La. per .1. A. Bentley- 400 40, 000
    O. G-. Zoder of Alexandria, La- 20 2, 000
    H. O. Collier of Alexandria, La- 20 2, 000
    H. H. Furby of Alexandria, La- 50 5,000
    P. F. Appel of Alexandria, La- 50 5, 000
    F. M. Friel of Alexandria, La_ 50 5,000
    Gus Gelir of Alexandria, La- 50 5,000
    H. D. Foote of Alexandria, La_ 50 5, 000
    W. D. Hill of Alexandria, La_ 50 5, 000
    L. J. Haclienyos of Alexandria, La_ 50 5, 000
    W. O’Shee of Alexandria, La- 10 1, 000
    The subscribers were for the most part employees of the hotel and business associates of Bentley in Alexandria. Rone of the stock was paid for in cash. Certificates of stock were issued to the subscribers who endorsed them in blank and turned them over to Bentley, together with interest-bearing promissory notes, in payment therefor. The certificates, together with the promissory notes attached thereto, were held by Bentley. None of these notes has as yet been paid, nor has any interest been collected on them.
    The fair market price or the value of the land on which the Hotel Bentley was located on March 1, 1913, was $40,000. The original cost of the hotel building was approximately $000,000. The depreciated cost at March 1, 1913, was $540,000. The depreciated cost of the furniture, fixtures and equipment at March 1, 1913, was $52,000, The cost of reproduction of the Hotel Bentley building on the same date was approximately $540,000..
   OPINION.

Lansdon:

In his amended answers, filed at the hearing, without objection from the taxpayers, the Commissioner denied that the Hotel Bentley was owned and operated during the years 19TT and 1918 by a partnership composed of J. A. Bentley and E. W. Zimmerman, with respective interests of three-fourths and one' fourth therein, and alleged that such hotel was erected, owned and operated during the years 1917 and 1918 by the Hotel Bentley Co., Ltd., a Louisiana corporation organized in 1908. The issue so raised must be decided before any consideration of the other matters in controversy.

The record discloses that the charter of a corporation designated as the Hotel Bentley Co., Ltd., was recorded in the office of the recorder of the Parish of Rapides, State of Louisiana, on August 15, 1908. There is conclusive evidence, however, that such corporation never issued any stock; never acquired the property known as the Hotel Bentley from the owners thereof, Bentley and Zimmerman; never had any bank account, and that it never operated the Hotel Bentley either as owner or lessee of such property. If such a corporation had any legal existence during the years 1917 and 1918, it was a mere shadow without substance or function. The corporation-excise and income-tax returns for the years 1909 to 1915, inclusive, made in the name of the Hotel Bentley Co., Ltd., were without authority or legal effect, since they were the returns of a corporation which was not engaged in the business the income and expenses of which they purported to show. The gains and losses of the Plotel Bentley, with which we are concerned here, were not the gains and losses of the shadow corporation which never issued any stock, acquired any property or at any time operated this hotel. We "are fully persuaded that all such gains or losses were the gains or losses of the partnership composed of Bentley and Zimmerman.

The second issue presented for our consideration is the determination of the true tax liability of these taxpayers, resulting from the operation of the Hotel Bentley during the year 1917. The taxpayers aver that the hotel was operated during such year at a loss of $142,588.69, and in their income-tax returns each of them deducted his proportionate share of such alleged loss from his gross income for that year. The Commissioner disallowed these deductions, held that the partnership realized a net income in the amount of $16,887.08, and added three-fourths and one-fourth of such amount to the respective gross incomes of Bentley and Zimmerman.

Some time in 1911, Bentley, presumably with the consent of Zimmerman, employed one T. L. Barnes as manager of the hotel. In April, 1917, Bentley became suspicious of the integrity of Barnes and employed a certified public accountant to audit the accounts and books of the hotel and to make a report of the result of such audit. The accountant discovered gross discrepancies between the cash collections reflected in the books of the various cashiers and the record of such collections in the regular books of account kept by one Lawrence under the direction of Barnes. He also found that many of the earlier books and records relating to the hotel had been lost or destroyed, and that many of the vouchers and invoices relating to the business of the hotel for the time immediately preceding the audit had been destroyed by Barnes.

From all the data available the auditor reached the conclusion that the hotel should have been operated at a profit and that Barnes and Lawrence, in collusion with each other, had embezzled hotel funds and property in the amount of at least $175,000. The report of the auditor dated June 22, 1917, showed an operating deficit from the opening of the hotel in 1908 to April 30,1917, in the amount of $164,036.93, of which $14,983.33 was ascribed to the period from January 1 to April 30, 1917. At the close of the year 1917 the same accountant made an audit covering operations from April 30 to December 31, 1917, and reported net operating earnings for that period in the amount of $17,946.69. He then made some minor adjustments, assembled the results of his audits and determined that the net operating deficit at that date was $142,588.69.

Upon the theory that the entire operating deficit resulted from the alleged peculations of Barnes and Lawrence and was a loss sustained in 1917 because it was ascertained in that year, the taxpayers deducted proportionate parts of such deficit from their respective gross incomes in their income-tax returns for such year as losses sustained during the year. The Commissioner disallowed all the alleged loss from defalcation, except the amounts proved to have been embezzled within the taxable year, disallowed part of the depreciation taken on the building, and determined a net income for the Hotel Bentley for the year 1917 in the amount of $16,887.08.

The taxpayers have not convinced us that the entire amount of $142,588.69 is a deductible loss of the Hotel Bentley for 1917. There is no conclusive evidence that the entire deficit resulted from the peculations of Barnes and Lawrence. On the other hand, there is proof that the hotel lost much money before Barnes was employed, and there is good reason to believe that it was not meeting its operating expenses during the earlier years of such employment. In any event it is not enough for the taxpayers’ purpose in this proceeding to prove that the entire deficit resulted from the alleged embezzlement. In order to sustain their claim for deductions on this account they must show in what years and in what amounts their property was embezzled. This they have not done except as to the comparatively small amounts traced to Barnes in 1917 and in part recouped by a payment of $5,000 by Mrs. Barnes after the death of her husband. In the case of United States v. Cleveland, Cincinnati, Chicago & St. Louis Ry. Co., U. S. Dist. Ct., So. Dist. Ohio, February 23, 1916 (not reported) the court said:

The time of the discovery of a loss bears no relation to the loss sustained. The loss 'was sustained when the theft occurred, although the defendant did not know at the time of the depletion of its assets. As each embezzlement occurred, the defendant was poorer to the extent of it. It then sustained a loss.

Inasmuch as the proved defalcations are included in the operating deficit of the hotel for the period from January 1, 1917, to April 30, 1917, they require no separate consideration in computing the net income of the taxpayers for the year 1917. The evidence shows that from January 1 to May 1, 1917, the estimated operating deficit of the Hotel Bentley was $14,933.33 and that the actual deficit for that period was later ascertained to have been $15,441.78. The net-operating earnings as reflected by the books and reported by the auditor for the period from May 1 to December 31, 1917, was $17,946.69. It is obvious, therefore, that the net income of the hotel for the year 1917, which is the taxable period, was'$2,504.91, unless errors in the computations of the petitioners are established. In computing the net income of the hotel for 1917, a deduction on account of depreciation of the building was taken in the amount of $15,000. The Commissioner disallowed this in part and allowed depreciation at the rate of 2 per cent. We are of the opinion that 2½ per cent should be allowed on a valuation of $540,000 ai March 1, 1913.

The third issue for our consideration is whether the partnership sold the assets of the Hotel Bentley Company, on December 31, 1918, or at some date in the year 1919. The taxpayers contend that all the material steps in this transaction were taken in 1918 and that the partnership, by virtue of an oral agieement to form a corporation and convey the hotel assets thereto when formed, parted with the beneficial title to such property at the date of the agreement to incorporate and from that time became a trustee for the stockholders of the proposed corporation, even though its legal ownership continued until the date of the actual transfer by deed. The evidence that any agreement to transfer the assets was entered into in 1918 is not convincing. If there was such an agreement, it was oral and we are not fully informed as to its terms. It is true that the charter of the Hotel Bentley was executed December 31, 1918, but the assets to be exchanged for stock were not appraised as the law of Louisiana requires until January 1, 1919, and the deed transferring the assets was not executed until January 2, 1919, on which date such assets were formally proffered to the corporation and formally taken over by appropriate corporate action, as. disclosed by the official minutes of the Hotel Bentley Co., Inc.

In support of their contention the taxpayers cite African M. E. Church v. Conover, 27 N. J. Eq. 157, wherein the court holds:

Where a purchase [of land] is made by several persons representing a voluntary association * * * for the common benefit of all the persons composing the association, and the purchase money is paid, and possession of the land given, equity raises a promise by the vendor to make a title, either to the persons making the payment, or to the corporation, if one be created.
In such case, the vendor, as to the title, becomes a trustee for the purchasers; and they being the mere agents of the voluntary association, the moment the association is incorporated, it has a right to a conveyance from the vendor.

We are not convinced that the authority relied on by the taxpayers sustains their contention. The facts are easily distinguished. Our question is whether these taxpayers sold their property to the Hotel Bentley Co., Inc., in 1918, or, by their agreement to form a corporation and their execution of the charter of the proposed corporation, so obligated themselves that from the date of such agreement and execution they ceased to be, and the corporation became, the benefical owner of the property. Inasmuch as the proposed incorporation was not concluded in 1918, and no offer of sale was made in that year, we are of the opinion that the sale of' the property to the Hotel Bentley Co., Inc., was made in 1919 and that such sale does not affect the tax liability of the taxpayers for 1918.

The only remaining question relating to the deficiencies asserted for 1918 is the correct rate of depreciation of the hotel building, which we have held as to 1917 should be 2½ per cent on a basic value of $540,000. The income of the taxpayers for 1918 should also have the benefit of the increased rate of depreciation which we have allowed.

We must now determine the gain or loss resulting to the partnership from its sale of its hotel assets to the corporation in 1919. For such assets the corporation issued its stock of the par value of $200,000 and assumed liabilities of the partnership In the amount of $89,955.44. The taxpayers contend that the fair market value of the stock received was not in excess of $289,955.44. It is in evidence that, at or about the date of the transfer, shares of stock were sold at par in the amount of $40,000, that a profitable department of the hotel’s business had just been abandoned on account of Federal prohibition, and that except during the war there had been small profits, if any, from the operation of the property. We are convinced that $289,955.44 was the fair market value of the stock received for the hotel property at thé date of its transfer to the corporation.

The partnership received $289,955.44 for its assets after January 1, 1919. Did it sustain a loss or realize a profit? To answer this question the law requires us in the case of property acquired prior to March 1, 1913, to determine the fair market price or value of the assets at that date. In this case, the market price can not be determined from any offers or sales. We must therefore resort to some other method for determining its fair market value at the basic date.

There are two elements of the composite value of the hotel property at March 1, 1913, that are not in dispute. The site cost $40,000 in 1908 and was not less valuable in 1913. The hotel equipment cost $75,000 and there is ample evidence that this value was maintained, less an annual depreciation of 10 per cent, and that it had a fair market value of $52,000 at March 1, 1913.

We have found that the depreciated cost of the building at March 1, was $540,000. The taxpayers contend that in the absence of an established market price the depreciated cost represents the fair market value. With this contention we can not agree. It is in evidence that when constructed the Hotel Bentley was in advance of the needs of the town and that with due consideration for the losses that may have resulted from embezzlements it had not been operated at a profit prior to the basic date. Admitting these adverse conditions, we believe that this building had a very substantial value at March 1, 1913. Alexandria was and is a rapidly growing city, situated in the heart of a rich lumbering and farming district, ' The Bentley was the only good hotel in the city or in that immediate territory. At March 1, 1913, there was no reason to believe that the property would not soon become profitable. The evidence convinces us that from such date it might have been operated at a profit but for the peculations of Barnes and Lawrence. To sustain their contentions of value the taxpayers introduced opinion evidence by many witnesses qualified to pass on the value of such property. These witnesses testified to reproductive values of the property at March 1, 1913, ranging from $550,000 to $650,000. It is our opinion that the fair market value of the hotel building at March 1, 1913, was $450,000; of the land, $40,000; and of the furniture and equipment, $52,000, or a total of $542,000, and this amount should be used as the basis for determining the loss sustained by the partnership when it sold the property to the corporation in 1919. It follows therefore that each of the taxpayers is entitled to deduct his proportionate share of the loss so sustained and computed from his gross income for 1919.

Judgment will be entered on 15 days’ notice, under Bule 50.


source: Caselaw Access Project

author: Teussell:

license: Public Domain

text:
    Julia Anna Schroth, Executrix, Estate of Joseph Schroth, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 3914.
    Decided October 30, 1926.
    Valuation of bank stock for estate tax. — In valuing the stock of a bank which is closely held and of which few sales have ever occurred, consideration must be given not only to the earnings of the bank but also to the established dividend rates and the book or liquidation value of the bank’s assets.

      Boy Massena, Esq., for the petitioner.

      L. 0. Mitchell, Esq., for the respondent.
    This is a proceeding for the redetermination of a deficiency in estate tax of the estate of Joseph Schroth, deceased, in the amount of $911.74.
    The petitioner alleges that the Commissioner erred in valuing certain stock at $300 per share at the time of decedent’s death, instead of $175 as valued by the estate.
    FINDINGS OF FACT.
    Julia Anna Schroth, residing at Blue Island, Ill., is the executrix of the estate of Joseph Schroth, deceased.
    Joseph Schroth died on November 27, 1923. At the time of his death he owned 180 shares of the capital stock of the Commercial Bank of Blue Island, now known as the First National Bank of Blue Island.
    The book value of the said stock on November 27, 1923, was $189 per share. The stock of this bank has always been held by very few persons, chiefly by its active officers, and there have been but few sales. In 1916 there was a sale of some of the stock at $175 per share. At that time the dividend rate was 16 per cent. The book value is not shown by the record. On or about March 5, 1918, there was a sale of 10 shares at $250 per share. On July 1, following this sale, the outstanding capital stock was $100,000 and the surplus and undivided profits were $110,311.76. The dividend rate for 1918 is not shown in the record. The rate for 1917 was 16 per cent, and the rate for 1919 was 20 per cent. The net earnings of the bank for the five years 1919 to 1923, inclusive, are in an unbroken ascending scale, and for the five years average $60,647.26. The dividend rate for 1920, 1921, and 1922, upon an outstanding capital of $100,000, was 24 per cent. In January, 1928, $100,000 of undivided profits was transferred to capital account and distributed to the then stockholders as a stock dividend. The dividend paid during 1923 upon the $200,000 of outstanding stock was 15 per cent.

      At the time of the decedent’s death the bank’s condition was thoroughly sound, both in respect to its assets and its management. The executrix valued the decedent’s stock at $175 per share. The Commissioner valued it at $300 per share.
   OPINION.

Teussell:

The Internal Revenue Bureau’s Estate Tax Regulations No. 68, article 13, respecting the valuation of stocks and bonds, provides :

Stock in a close corporation should he valued upon the basis of the company’s net worth, earning and dividend-paying capacity, and all other factors having a bearing upon the value of the stock.

While this exact language was not contained in the Bureau regulations issued under the Revenue Act of 1921, it appears to us that this provision expresses the latest and the best judgment of the Treasury Department respecting the valuation of stocks and other securities, under conditions similar to those existing in the instant case, and we believe that this regulation is substantially fair and just. This regulation means that, in valuing stocks under the conditions prevailing in this case, consideration must be given to all of the elements mentioned and not to any one of them exclusive of the others. Boyd v. Heiner, 5 Am. Fed. Tax Rep. 6069. The Commissioner’s deficiency letter indicates that he fixed the value of the decedent’s stock on the basis of the earning capacity only, ignoring the dividend payments and the book value or net worth of the stock. We are therefore unable to agree with his valuation.

The figures of net worth or book value, taken alone, would produce ⅝ valuation of $189. Considering the dividend rates of 1923 of 15 per cent, it may be observed that, if a dividend rate of 8 per cent would establish a par value of stock, a dividend rate of 15 per cent would establish a value of $187.50. Referring to the sale of March 5, 1918, it will be found that at or near the time of this sale the dividend rate of 16 per cent might be taken as establishing a value for the stock of $200, while the net worth would produce a value of $210, and the purchaser paid $250. The purchaser paid an amount equivalent to 25/21 of the book value. This ratio applied to the book value of 1923 would produce a selling value of $225 per share, and we therefore have found that the decedent’s 180 shares of stock in the Commercial Bank of Blue Island had a value, at the date of his death, of $225 per share.

Order of redetermination m accordance with the foregoing findings of fact and opinion wUl he entered on 15 days' notice, under Bule 50.


author: Ceben : Phillips,

text:
    Humble & Gulf Coast Oil Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 1078.
    Decided October 30, 1926.
    1. Proof relative to certain deductions for losses claimed by the petitioner and disallowed by the Commissioner, considered and held, insufficient to establish error.
    2. Proof relative to an alleged error in the computation of invested capital held insufficient to establish error.

      J. E. Niday, Esq., for the petitioner.

      John D. Foley, Esq., for the respondent.
    In this proceeding the petitioner seeks a redetermination of a deficiency in income and profits taxes for the year 1920 in the sum of $2,688.91. The errors alleged are, first, the disallowance as deductions of certain alleged losses; and, second, the failure to allow the excess profits credit in the computation of invested capital.
    FINDINGS OF FACT.
    The petitioner is a trust association acting under a declaration of trust made pursuant to the laws of the State of Texas and filed in Harrison County of that State.
    On its income and profits-tax return for the year in question, the petitioner claimed, among others, the following losses, all of which were disallowed:
    (1) $7,000 paid for Hardin lease of two acres, Burkburnett townsite.
    (2) $107,000 loss on sale of Kansas leases.
    (3) $30,118.22 loss on equipment.
    (4) $540 loss due to personal Injuries to workman.
    (5) $70,075.13 development and promotion expense.
    On January 24, 1919, Hardin and his wife, in consideration of $1,000 paid on the execution of the lease, leased to the petitioner certain property for a term of five years. The rental stipulated was one-eighth of the oil produced and saved, and a monthly cash payment out of the proceeds of the sale of gas and casing-head gas. It was provided that the lease should terminate if drilling was not commenced on the land on or before May 24, 1919, unless the lessee on or before that date paid the lessors the sum of $1,000. Upon such payment, the period within which a well should be drilled was extended four months. At the end of such four-month period the drilling might again be similarly deferred upon the payment of $1,000, and so on until the expiration of the term. It was further provided that, if the first well drilled proved to be a dry hole, a second well should be commenced within twelve months from the expiration of the last rental period for which the reinal had been paid, unless before the expiration of such twelve-month period the rental payments had been resumed.
    The petitioner drilled a well in 1919 which proved to be a dry hole. The record is silent as to rental payments subsequent to the drilling of such well and as to a declaration of forfeiture or abandonment.
    In the year 1918 the petitioner purchased certain leases covering 969 acres of land in Neosho County, Kansas. Upon the land so leased were nine or ten producing oil wells. The leases were sold in the year 1919. Neither the purchase nor the selling price of the leases is in evidence.
    The petitioner owns an oil well in the Burkburnett oil field. On this property were numerous items of personal property, 'such as a derrick, tanks, etc., all of which were destroyed by fire. The record does not disclose the year of the fire, the cost of the property destroyed, nor the insurance or salvage, if any.
    In 1919 one of the employees was injured and in 1920 the matter was adjusted by a payment to him of $540. The Commissioner denied the deduction, apparently upon the theory that the petitioner kept its books upon the accrual basis. There is nothing in the evidence to indicate whether its books were kept upon the cash or the accrual basis.
   OPINION.

Ceben :

The first assignment of error relates to the disallowance of five deductions claimed by the petitioner in its return.

The first deduction in controversy is an alleged loss resulting from the Hardin lease. It is obvious from an examination of the lease that the petitioner herein might, upon the making of certain payments specified therein, remain in possession during the full term of the lease. As was set forth in the findings of fact, there is no evidence as to the rental payments or as to a declaration of forfeiture or abandonment. We can not tell from the records whether the lessee’s rights were ever terminated, and, consequently, we must hold that there was no loss in the year 1920.

The second deduction in controversy is an alleged loss on the Kansas leases. . The petitioner, while admitting that the loss was sustained in 1919, contends that because it failed to deduct it in that year that it is entitled to deduct it in 1920. There is no provision of the statute under which such a shifting of -losses is permissible, and, consequently, we must approve the action of the Commissioner as to this loss.

The third deduction in controversy is an alleged loss on equipment destroyed by fire. The petitioner has failed to prove the cost of the property destroyed, the insurance or salvage, if any, and the year in which the fire occurred. Under such a state of proof, we must affirm the Commissioner.

The fourth deduction in controversy is a loss due to personal injuries to an employee. In the disallowance of this we believe the Commissioner was in error. So far as the evidence discloses there was nothing to accrue in the year 1919, and, consequently ( having paid the loss in 1920, the petitioner is entitled to a deduction for the amount thereof in that year, regardless of whether it was on a cash or on an accrual basis.

The petitioner abandoned its deduction as to the expenditure of $70,075.13 which it claims the right to deduct as development and promotion expense.

The second assignment of error relates to the computation of invested capital. It is contended that the proposed excess profits tax of $1,849.26 can not be correct, since the net income was determined by the Commissioner to be $12,246.31. This contention is apparently based upon the misapprehension that the excess-profits credit is computed by taking 8 per cent of the outstanding capital stock. Such is not the law. Section 301(b) of the Revenue Act of 1918 requires the tax in the first bracket to be 20 per centum of the amount of the net income in excess of the excess-profits credit. Section 312 of the same Act provides that such credit shall consist of a specific exemption of $3,000 plus an amount equal to 8 per cent of the invested capital.

The record is wholly silent as to the invested capital of the petitioner. We do not know what was claimed or what was allowed. It is apparent that the Commissioner did not allow an invested capital equal to the par value of the outstanding capital stock, but there is nothing to indicate that his determination in this regard was erroneous.

Judgment will be entered after 15 days’ notice, under Rule 50.

Phillips,

dissenting: I dissent so far as a deduction is allowed in 1920 for an amount paid in that year to an employee for injuries sustained by him in 1919. It is the intention of the statute to tax the true earnings of each year as income for that year. Necessarily, this involves the deduction within the year of any expense connected with the production of the income of that year. It can not be logically contended that the amount paid in 1920 in settlement for injuries to an employee in 1919 has any relationship to the earnings for 1920, for the liability existed regardless of whether or not the company operated in 1920. If deducted in 1920, the true income is distorted to that extent. In these circumstances, it is my opinion that the amount paid was properly chargeable against 1919 income and was a deduction in computing the net income of that year. United States v. Anderson, 269 U. S. 422; 46 Sup. Ct. 131; 5 Am. Fed. Tax Rep. 5674.

Although it may be doubted whether there is any method by which net income from the operation of a business may be computed to the last cent, the statute lays down a rule by which taxpayers are to compute net income and should be so interpreted as to reflect the true net income as accurately as may be. This statute provides for numerous deductions from the gross income of a trade or business, among which are (1) all the ordinary and necessary expenses paid or incurred during the taxable year, (2) losses sustained in the taxable year and not compensated for by insurance or otherwise. The first of these deductions is general in its terms and the second specific. Under familiar rules of statutory interpretation, losses would be governed by the second provision, not by the first, and if, as the prevailing opinion indicates, the deduction is to be taken as a loss, it must be taken in the year in which sustained, regardless of the year in which it may have accrued or been paid. Martin Veneer Co. v. Commissioner, 5 B. T. A. 207.

The prevailing decision can only be justified upon the ground that the deduction claimed can not be classified as a loss, but must be treated as an ordinary and necessary business expense which is deductible when paid or incurred. If it should be so regarded, I can not consider this payment as more than the adjustment of a liability incurred in 1919, in which year the casualty occurred and the liability to compensate the employee arose. All that happened in 1920 was the determination and measurement of the previously existing liability. No new liability was incurred in that year.

It may be said that this presents a difficulty in administration, since the income can not be accurately determined at the end of the year. This is not unusual; witness the fact that the courts and this Board are constantly called upon at the present time to determine the correct income of periods ten years and more in the past. We might even be permitted the thought that this was one of the reasons for the provisions in the various taxing statutes allowing several years in which the Commissioner may make additional assessments and taxpayers may file claims for refund.


author: Mokris :

text:
    Appeals of Northeastern Oil & Gas Co.
    Docket Nos. 2231, 3525.
    Decided October 30, 1926.
    1. Amount of reduction of invested capital for the year 1918 by reason of exhaustion of franchises determined.
    2. Deduction claimed by the taxpayer for the years 1918 and 1920 for exhaustion, wear and tear, and obsolescence approved.
    3. Value of certain mineral and gas rights, and leaseholds determined for invested capital purposes.
    /. W. Reavis, Esq., and H. H. MiMlls, G. P. A., for the petitioner.

      A. H. Fast, Esq, for the Commissioner.
    Separate appeals involving different taxable years have been consolidated by consent. One appeal is from the determination of a deficiency in income and profits tax for 1918 in the sum of $43,986.25, and the other is from the determination of a deficiency in income and profits tax for 1920 in the sum of $2,391.64. The taxpayer alleges error on the part of the Commissioner in (1) reducing invested capital $77,400.95 for the year 1918, because of alleged depreciation sustained by the taxpayer prior to the year 1918 in addition to that charged off its books; (2) reducing the deduction claimed by the taxpayer for exhaustion, wear and tear, and obsolescence during the years 1918 and 1920 and thereby increasing the taxable income for those years; (3) eliminating from invested capital for 1918 the value of certain leaseholds and mineral and gas rights shown upon the taxpayer’s books in the aggregate sum of $84,027.93; and (4) refusing to grant special relief for 1918 under the provisions of sections 327 and 328 of the Revenue Act of 1918.
    FINDINGS OF FACT.
    1. The taxpayer is an Ohio corporation engaged in the business of distributing natural gas to a number of municipalities and townships in Ashtabula County, Ohio. It was organized in the year 1901 with a capital stock of a par value of $300,000. On December 1, 1913, all the stock of the taxpayer was purchased by one M. B. Daly for $570,000, the approximate net worth of the assets as shown by its books, the exact net worth so shown being $563,994.87. The taxpayer was operated by the said Daly at a profit for a number of years, but, owing to a shortage of the supply of natural gas, was forced to give up the franchise. On December 30, 1920, he sold the stock for $245,-000, which sum rejiresented the book value of the assets at that date.
    2. While the taxpayer obtained some of its natural gas from its own wells in Ohio, the principal source of supply was from the-Clarion Gas Co., in Pennsylvania. At the time of the acquisition of the stock by Daly, the taxpayer had a 20 year contract with the Clarion Gas Co. to supply sufficient gas for its needs at the Ohio state line. From this point the taxpayer built its own pipe lines and distributed the gas to its customers at the various municipalities and townships. The taxpayer had approximately 12,000 customers in 20 towns and townships. Until the year 1916, the supply oí gas from the Clarion Gas Co. was ample, but commencing in 1916 the supply decreased in spite of constant and repeated demands for more gas. From 1916 on, the Clarion Gas Co., on account of exhaustion of its own gas fields, was unable to furnish sufficient gas to the taxpayer, and finally, in 1918, notified the taxpayer by letter that it would be necessary for the taxpayer to seek a supply elsewhere, as it was unable to supply the gas. In 1918 a new contract was entered into by the Clarion Gas Co. and the taxpayer, by the terms of which the old contract was canceled and the Clarion Gas Co. was only required to furnish sufficient gas to supply the Town of Andover, which was near the state line. The taxpayer thereupon took up the remaining pipe line connecting with the Clarion Gas Co. and sold it. The declining gas supply of the Clarion Co. is illustrated by the following records of gas supplied by it:
    Year. Cubic feet of gas.
    1914- 689,147,732
    1915- 514, 927,034
    1916-518, 391, 011
    1917- 95,121,242
    1918- 54, 587,473
    1919 - 43, 083,127
    3. The taxpayer, foreseeing the exhaustion of the supply of the Clarion Gas Co., on June 30, 1916, eiltered indo a contract with the Commercial Oil & G-as Co., by the terms of which the taxpayer assigned certain of its leaseholds from which the Commercial Oil & Gas Co. was to develop and sell natural gas to the taxpayer. This gas field was from local wells in Ohio and was a limited supply. The experience of the Ohio gas fields in this vicinity was that the gas wells would be brought in at a high pressure but in a few years become depleted to a low pressure insufficient for commercial use. The entire local field was becoming exhausted and it was known that this source would not be available in a few years. The gas received from this source was as follows:
    Tear. CuMe feet of gas.
    1916___ 69, 767,000
    1917_ 976,001, 000
    1918_ 1,174,575,100
    1919_ 987, 516„ 399
    1920_ 334,784,135
    1921_ 187, 898, 000
    1922_ 125, 819,000
    1923 _ 85, 045, 931

      4.The taxpayer also obtained some natural gas from its own wells in the Ohio gas field. This source was also diminishing. It drilled five wells in 1911 and five more in 1919, but all were dry holes. The pressure in its producing wells was also decreasing to a point below commercial usage. This experience in producing gas is illustrated by the following statistics:

    5.The taxpayer, for the first time, in 1916, realized that the supply of natural gas available for its customers would terminate in a few years, and thereupon commenced to write off of its books depreciation, including obsolescence of its physical assets, as follows:
    1916_$24,296.87
    1917_ 34,694.18
    1918_ 73, 688. 92
    1919_ 80, 000. 00
    1920_ 70,926.67
    Total_ 283, 606. 54
    The Commissioner conceded the total amount, but allocated the same as follows:
    1914_$34,299. 51
    1915_I_ 34,229. 51
    1916- 34, 229. 51
    1917_ 34,229. 51
    1918_ 34,220.51
    1919_ 34,229. 51
    1920- 34,229. 51
    239, 606. 57
    Exhaustion of franchise prior to 1914_ 44, 000. 00
    ' Total_ 283, 606.57
    Included in the assets listed by the taxpayer in its balance sheet as of December 1, 1913, were franchises valued at $100,000. The Commissioner determined the life of these franchises, at the date of acquisition, to be 25 years, of which 11 years had expired prior to 1914.
    6.In the year 1920, it appearing that the taxpayer was not obtaining sufficient natural gas to supply its customers, the Public Utilities Commission of the State of Ohio granted permission to the taxpayer to discontinue service to seven municipalities and twelve townships and required it to continue service to but one municipality. This service was thereupon discontinued by the taxpayer. Daly then sold his stock for $245,000, the book value of the depreciated assets. The stock was purchased by certain citizens of one municipality as a matter of civic pride, and the company thereafter distributed artificial gas to that community.
    7. The officials and the original organizers of the taxpayer and those having cognizance of its early transactions have since died, and the early books and records of transactions at that time were incomplete or unavailable. The balance sheet of the taxpayer as of December 1, 1913, is as follows:

      Balance Sheet

    ASSETS
    Mineral & Gas Eights_ $17, 500.00
    Franchises_ 100, 000.00
    Lands in Fee_ 3, 250. 00
    Leaseholds_ 66, 527.93
    Buildings_ 1, 908.25
    Tools over $25_ 2,282. 50
    Office Furniture & Fixtures — Geneva- 261.38
    “ “ “ “ —Jefferson_ 368.41
    “ “ “ “ —Oonneaut_ 1,224.32
    “ “ “ “ —-Andover_ 2.95
    Gas Eeceivers & Regulators_ 1, 737. 50
    Gas Wells_ 14, 061.36
    Gas Meters_ 38, 568.35
    Pipe Lines — Main_ 409, 500. 85
    “ “ —Field_ 11,029.80
    Inventory — Oonneaut_ 2, 613.25
    “ —Markham_ 8,792.56
    “ —Geneva_ 785.16
    “ —Andover_ 415. 38
    Acct. Rec. A. W. Lewis_ • 59.92
    “ “ L. G. Anderson_ 1.00
    “ “ B. Simmons_ 13.00
    “ “ Oonneaut_ 7,052.37
    “ “ Geneva_ 8, 830.18
    “ “ Jefferson_ 2,252.23
    “ “ Ashtabula Gas Co_ 7,911.67
    Petty Cash Fund — Hunter_ 10Ó. 00
    “ • “ “ —Reed_ 250.00
    “ “ « —Webb_ 200.00
    “ “ “ —Cole_ 100.00
    Monongahela National Bank- 1,311. 71
    Total_$703,912.01

      LIABILITIES
    Unclaimed Vouchers___ $20.00
    Worth Oil & Gas Oo_ 1, 740.68
    Loan Account_ 186,924.83
    Meter Deposits_ 6.00
    Vouchers Payable_ 2, 336.63
    Capital Stock_ 300, 000.00
    Surplus_ 238, 612.23
    Current Profit & Loss (Detail attached)_ 25,372.64
    Total_$703,912.01
    NET WORTH-DEO. 1, 1913
    Capital stock_$300, 000. 00
    Surplus- 23S, 612.23
    Current Profit & Loss_ 25, 372. 64
    Total_$503, 884. 87
    In computing invested capital for the year 1918, the Commissioner disallowed the above item of $17,600 for mineral and gas rights, and $66,527.93 for leaseholds, on the ground of insufficient evidence of the cost. As to the two said items, the taxpayer has submitted the original vouchers as proof of the $17,500 item, and vouchers totaling $25,913.85 of the $66,527.93 item. The taxpayer had acquired leaseholds on approximately 8,000 acres of land and still had an equal amount in the year 1918. The taxpayer on its books had always carried the above items in the amounts as above set forth, both prior to December 1, 1913, and subsequently, and they wore included as assets in its balance sheet of December 31,1920.
    8. The major portion of the physical assets of the taxpayer consisted of cast iron pipe lines, and immediately after the purchase of the stock of the taxpayer by Daly the pipe lines were put into a better state of repair and sums of money greatly in excess of normal maintenance were expended in improving the same. While the normal maintenance for prior years was approximately $7,000 per year, the taxpayer in 1914 spent $19,341.03, and in 1915, $29,998.74, in bettering this equipment. On account of these improvements, the taxpayer did not charge off depreciation for 1914 and 1915, but the Commissioner charged off $34,229.51 for each of those years, or a total of $68,459.02, which he deducted in computing invested capital for the year 1918. The Commissioner for the year 1916 also charged off depreciation in excess of that taken by the taxpayer, which resulted in a further decrease of invested capital for the said year 1918.

       Items In controversy.

   OPINION.

Mokris :

The total depreciation charged off by the taxpayer on its books to December 31, 1917, amounted to $58,991.05. The Commissioner has determined that the total depreciation sustained to the same date amounts to $136,918.04, and, therefore, he has reduced the taxpayer’s invested capital by the amount of $77,926.99 (the amount set out in the petition is $77,400.95), because of depreciation alleged to have been sustained in years prior to 1918, and which the taxpayer failed to write off on its books of account. The total depreciation of $136,918.04, which the Commissioner alleges was sustained to December 31, 1917, was determined by him in the following manner:

Total depreciation deducted on the books to December 31, 1920_$283, 606.54
Deduct: Depreciation on franchises 1903 to 1920, 18 years at $4,000 per annum- 72,000.00
Depreciation sustained from 1914 to 1920, 7 years_ 211,606.54
Annual depreciation deduction (1/7 of $211,606.54_ 30, 229.51
Add: Annual deduction for amortization of franchises_ 4, 000.00
Total annual deduction_ 34,229.51
Total depreciation sustained 1914 to 1917, 4 years_ 136, 918.04

It will be noted from the foregoing that the Commissioner has arbitrarily spread the total depreciation allowance charged off on the taxpayer’s books, to the end of 1920, ratably over the seven-year period 1914 to 1920, inclusive, although the proven facts are that the depreciation was not actually sustained in equal annual amounts and that no depreciation was sustained in the years 1914 and 1915. The taxpayer charged off no depreciation in the years 1914 and 1915, because of the large amounts it had spent in those years in bettering its equipment and which it had charged to expense on the books of account. While, in years prior to 1914, its average annual expenditure for betterment and maintenance of equipment was approximately $7,000, in the years 1914 and 1915 it expended for these purposes the sums of $19,341.03 and $29,998.74, respectively. The taxpayer considered that the expenditure of these amounts and the charging thereof to expense was sufficient to take care of any depreciation sustained during those years, and, hence it charged off no depreciation specifically as such in those years. In 1916 the impending shortage and approaching end of the source of supply of natural gas became apparent to the taxpayer. That the shortage was imminent and the time of suspension of operations could be foreseen, was not mere guesswork but was based upon experience, statistics, figures and facts from both private and public sources. From that year on, the taxpayer charged off annually increasing amounts to take care of not only the actual wear and tear suffered by its physical assets, but also the impending obsoleteness which was overtaking these assets and extinguishing their value before the expiration of their normal useful life. Thus it is apparent from these facts that any arbitrary spread of the total depreciation taken on the taxpayer’s books, during the period 1916 to 1920, inclusive, ratably over the period 1914 to 1920 as the Commissioner has done, is unwarranted and not in consonance with the actual facts.

However, it appears that the taxpayer had not, prior to 1916, charged off on its books any depreciation of franchises. These franchises were acquired in 1903 and had a value, at the date of acquisition, of $100,000. The Commissioner has determined that the life of these franchises at the date of acquisition was 25 years, and this has not been rebutted by the taxpayer. It is apparent, therefore, that at the close of the year 1915, 13 years of the life of these franchises had expired. By the very nature of these franchises, they are invariably subject to exhaustion because the life thereof is of limited duration. Unlike exhaustion in the case of such items as machinery and equipment, which may be arrested through better-ments and replacements, exhaustion in the case of franchises is definite and certain and can not be stayed. The passing of each year means the franchises have one year less of life to run and marks a proportionate loss of the capital invested in them. In the case of the franchises under consideration, the annual loss of capital occasioned by exhaustion is $4,000, and the accumulated exhaustion from 1903 to the close of 1915, a period of 13 years, was $52,000, which must be reckoned with in the computation of invested capital. Whether provision was made for exhaustion of franchises in the depreciation written off by the taxpayer for the years 1916 and 1917, we do not know. The Commissioner offered no affirmative evidence that the depreciation written off in those years was not sufficient to take care of such exhaustion; and, certainly, the method he adopted in determining the allowances to be made for depreciation in those years, affords no proof of the reasonableness or the adequacy of the deductions made by the taxpayer.

The foregoing leads us to the conclusion that the Commissioner was justified in reducing taxpayer’s invested capital for the year 1918 to the extent of $52,000, because of inadequate depreciation charged off by the petitioner on its books, through failure to make provision for exhaustion of franchises; and, since the reduction made by the Commissioner for inadequate depreciation is $77,926.99, the invested capital, as he has determined it to be, should be increased $25,926.99.

For the years 1918 and 1920, taxpayer claimed deductions in its returns for depreciation in the respective amounts of $73,688.92 and $70,926.57. The Commissioner has allowed a depreciation deduction for each year in the amount of $34,229.51, determined in the manner heretofore outlined, disallowing the amounts in excess thereof, thereby increasing the net income of the years 1918 and 1920 by the amounts of $39,459.41 and $36,697.06, respectively. The taxpayer contends that the allowances made by the Commissioner are clearly the result of an arbitrary mathematical allocation with no consideration of the facts and conditions as they existed at the time. It is further pointed out that the Commissioner has given no consideration to the impending obsoleteness, first ascertained in 1916, which was overtaking the physical assets and extinguishing their value before the expiration of their normal useful life. We are of the opinion that the evidence clearly sustains the contentions of the taxpayer in this respect. It seems more logical and more in harmony with the proven fact that the greater losses in value obtained with the impending shortage and approaching end of the source of supply of natural gas. As we have heretofore pointed out, the taxpayer, because of experience, statistics, figures and facts, from both private and public sources, was in a position definitely to foresee the imminent shortage of natural gas and the suspension of operations. The beginning was in 1916, when the principal source of supply of the Clarion Gas Co. of Pennsylvania commenced to fail and forced the taxpayer to rely on local gas fields, the limit of which it already knew through experience with its own gas wells, and the end was officially determined by the Public Utilities Commission of the State of Ohio, which recognized the physical impossibility of obtaining natural gas and permitted the taxpayer to give up its service. The Commissioner has offered no logical basis for the computation of the allowances for depreciation which he has made for these two years. The amounts do not purport to be based upon the useful life of the property; while no consideration whatever has been given to the above related facts. He has simply taken the total depreciation charged off on the petitioner’s books over the period 1916 to 1920, and ratably spread the same over the period 1914 to 1920* Upon the evidence before us, we are of the opinion that the depreciation deductions claimed by the petitioner for the years 1918 and 1920, arc reasonable in the light of the conditions obtaining and we are not disposed to disturb them in the absence of affirmative evidence to the contrary.

The taxpayer claims that the Commissioner erroneously excluded from invested capital for 1918, the following items:

Mineral and gas rights_$17, 500. 00
Leaseholds_ 66, 527.93
Total_ 84, 027.93

The taxpayer was unable to furnish the Commissioner affirmative proof of the cost of these assets. At the hearing, however, the taxpayer succeeded in producing the original voucher for the $17,500 item and other Touchers covering $25,913.85 of the $66,527.98 item. These items appear to have been carried upon the books of the taxpayer continuously at their full face value. They show up in the balance sheet of December 1, 1913, as shown in our findings of fact, and they appear in the balance sheet of December 31, 1920, as an asset and are included in the value of the assets of the taxpayer when the stock was sold by Daly. Though the taxpayer was unable to specify the precise assets they represented, it was undisputed that it had in fact leaseholds of approximately 8,000 acres of land and numerous gas and mineral rights. In view of the fact that these assets have always been taken at their full value by all parties dealing with the taxpayer and it has always without controversy carried them upon its books, and the further fact that original vouchers have been discovered covering a portion of the full amounts, we are disposed to give full credence to the entries on the books as to the cost of these assets and allow them as invested capital, subject to reduction for any accumulated exhaustion.

The taxpayer petitions that for the year 1918 it be given special relief under section 328 of the Revenue Act of 1918. It has failed to show the existence of any abnormality affecting capital or income that would bring it within section 327(d). Its contention that invested capital can not be satisfactorily determined is not supported by the evidence. The Commissioner determined invested capital from the taxpayer’s books of account, and it has not been shown that the books do not correctly reflect the invested capital.

Judgment will he entered on 10 days’ notice, under Rule 50.

Sternhagen dissents in part.


author: Green :

text:
    Co-operative Publishing Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 8606.
    Decided October 30, 1926.
    1. Value of tangible assets as of March 1, 1913, determined for depreciation purposes.
    2. Gain or loss on sale of capital assets determined.

      H. O. Hammonds, G. P. A., for the petitioner.

      Robert A. Littleton, Esq., for the respondent.
    This is a proceeding for the redetermination of deficiencies in income taxes for the years 1920, 1921, 1922, and 1923, in the total sum of $1,333.55.

      In the petition the following errors are alleged:
    (1) Failure of the Commissioner to allow petitioner’s claim of fair market value of property as of March 1, 1913, for purposes of depreciation and loss and gain on sale of assets.
    (2) Failure of the Commissioner to allow petitioner depreciation rates on its property units for the years 1920 to 1923, inclusive, on the schedule promulgated by the Commissioner for the year 1919 and prior thereto.
    (3) Failure of the Commissioner to allow as a deduction for the year 1920 the net loss sustained in 1919, said net loss having been previously determined by the Commissioner.
    (4) Failure of the Commissioner to allow as a deduction from income for the years 1922 and 1923 the net loss of 1921, as claimed by petitioner.
    (5) Erroneous determination by the Commissioner of net profit realized from the sale of capital assets in the year 1921.
    FINDINGS OP PACT.
    The petitioner herein is an Oklahoma corporation with its principal place of business at Guthrie. It was organized by five individuals to take over from them certain property which they owned as partners. The property just mentioned consisted of a lot in the City of Guthrie, a three-story building situated thereon, and the machinery and equipment necessary for the operation of a printing plant.
    All of the property above referred to originally belonged to the State Capital Co. This organization went into bankruptcy and the holders of the first mortgage on the property instituted foreclosure proceedings and at the foreclosure sale purchased the property for $8,000. The five partners were employees of the State Capital Co. and as such were thoroughly conversant with the property and business of the company. When it became bankrupt they leased the property from the receiver and carried on the business until the foreclosure sale. After the foreclosure sale the partners offered the purchasers $15,000 for the property, to be paid by a $3,000 cash payment and notes for the balance. This offer was accepted and on January 4, 1913, the purchase and sale was completed. Shortly thereafter the petitioner was organized and the property thus acquired was transferred to it in exchange for shares of stock having a total par value of $15,000.
    The State Capital Co. owned several linotype machines. These were damaged by fire in 1902. Thereafter they were in part repaired and one placed in a usable condition. Two of them were sold in 1921.

      In the year 1910, the capital of the State of Oklahoma was moved from Guthrie to Oklahoma City. This change materially affected business conditions and property values in Guthrie and had a considerable effect upon the business of the petitioner’s predecessor.
    The petitioner, immediately after its incorporation, opened a set of books and, among other entries, were the following:
    Building and site-$12, 000
    Machinery and type_ 7,000
    Furniture and fixtures- 2,000
    Total_ 21,000
    The Commissioner, after making such additions to the plant and equipment account as he deemed warranted by reason of subsequent expenditures, placed upon the property the following valuations:

    For the various years the Commissioner allowed depreciation on the various classes (if property as follows: building, 3 per cent; machinery and equipment, 10 per cent; furniture and fixtures, 10 per cent; automobiles, 33½ per cent; electric sign, 5 per cent.
   OPINION.

Green :

The first allegation of error relates to the March 1, 1913, valuation of the depreciable property as determined by the Commissioner for the purpose of computing depreciation thereon and the gain or loss on the linotype machines resulting from their sale.

In addition to the facts found above, the evidence shows the cost to the State Capital Co. of the assets or property the value of which on March 1, 1913, is in controversy. A substantial portion of the property was purchased by that company in 1902 and there is no proof of purchases immediately prior to the bankruptcy proceeding. The transactions from which these costs are derived are too remote to serve as a measure of the March 1,1913, value.

The evidence also shows that prior to their purchase, the five partners made an inventory and appraisal of the property and that the value thus determined by them is substantially in excess of the price paid at the foreclosure sale or by the five partners. We do not knoAv what sort of value the five were endeavoring to ascertain, but it is clear that it was not market value, and we therefore conclude that the appraisal is no evidence of the March 1, 1913, value.

It seems to us that the two sales are the best evidence of value; and we therefore find the value of the property at the date of its acquisition by the petitioner to have been $15,000. There is no evidence of appreciation between that date and March 1, 1913.

The second allegation of error is based upon the theory that the Commissioner having once fixed the rates of depreciation applicable to specific units of depreciable property, must thereafter allow a deduction for depreciation at the rate thus fixed. We know of no precedent which holds that the Commissioner’s determinations are, as to him, res adjudicaba,, and this Board has repeatedly held to the contrary.

The third allegation of error relates to a net loss which the petitioner alleges it sustained in 1919, and which it seeks to deduct from its net income for the year 1920. The tax for the year 1919 is not considered in the deficiency letter. It appears that in its return for 1919 the petitioner showed a net income of $405.25, and that the Commissioner determined the net income for that year to be $1,550 and that he proposed an additional assessment for that year. It does not appear whether an assessment of the additional tax was made or a claim for refund filed. The proof by which the petitioner seeks to establish the net loss is wholly inadequate. Because of this inadequacy, we are not- called upon to determine whether, under the statute, as a matter of right, it is entitled to have determined by this Board a net loss for a year not involved in the deficiency letter where such net loss is still a matter of controversy between the Commissioner and the petitioner.

There is no evidence upon the issue presented by the fourth allegation of error. Apparently it is based upon the theory that a net loss for 1921 would be established as the result of increasing the basis and rates for depreciation. Our conclusion as to the proper basis has already been stated and there is no evidence warranting a change in the rates fixed by the Commissioner.

The evidence offered in support of the fifth allegation of error leaves us in doubt as to how many linotype machines the petitioner had, their cost to petitioner, their value on March 1, 1913, and as to which machines were sold. It also appears that some of the machines were in part dismantled to secure parts for others. We are therefore unable to ascertain whether the Commissioner’s computation of gain is correct or erroneous.

Judgment will he entered for the Oonwmsioner,


author: SteRnhagen:

text:
    Appeal of G. Trevor Dunham, Inc.
    Docket No. 5654.
    Decided October 30, 1926.
    A corporation which conducted an insurance agency and financed, partly with its own funds and partly with funds of a trust company, the purchase of automobiles upon which it wrote insurance, is not within section 303, Revenue Act 1918.

      F. W. MoBeynolds, Esq., for the petitioner.

      John D. Foley, Esq., for the Commissioner.
    Deficiencies of $3,052.49 and $7,433.61 income and profits taxes for the calendar years 1919 and 1920, respectively, arising in part from the refusal of the Commissioner to grant partial personal service classification under section 303 of the Revenue Act of 1918.
    FINDINGS OF FACT.
    The petitioner is a Delaware corporation with its principal place of business at 246 North Broad Street, Philadelphia, Pa. It conducted an insurance agency business, financed automobile sales on its own account, and acted as agent in the financing of automobile sales with funds of the First Peoples Trust Co., of Boston, Mass.
    The corporation was organized primarily for the purpose of taking over and increasing the insurance agency business originally conducted by C. Trevor Dunham personally. It was desired to build up good will among his insurance clients and only those who had insurance with him were invited to invest money. It was desired to eliminate competition to the extent that those having an investment in the company would place their own insurance with the company and influence the business of their friends.
    Of a total capital stock of $39,832.15 outstanding as of January 1, 1919, $33,387.50 was held as follows:
    O. T. Dunham_$24,447.50
    H. Freeman_ 6, 000. 00
    G. O. Krick- 1, 000. 00
    H. W. Kunzig_ 30. 00
    R. T. Martin_ 410. 00
    F. White- 1, 500. 00
    Of a total capital stock of $60,552.50 outstanding as of January 1, 1920, $48,832.50 was held as follows:
    O. T. Dunham-$26,662.50
    H. Freeman- 2, 000. 00
    G. O. Krick- 1,900.00
    H. W. Kunzig- 180.00
    R. T. Martin- 1,000.00
    F. White- 4, 500. 00
    B. Lever- 1,300.00

      P. Scblosser_ §2, 000. 00

      G. S. Myers_ 400.00
    B. B. Davis_ 2,500.00
    J. W. Hemplor_ 1,000.00
    33. Pilkington_ 490. 00
    A. Miller_ 1,450. 00
    C. G. Spite_ 450.00

      G. Waterhouse_ 1,000.00
    E. <3. Sproules_ 500. 00
    J. S. Vertner_ 500.00
    J. P. Eubank_ 600.00
    W. P. Lurker_ 500. 00
    C. Trevor Dunham was the treasurer and general manager of the company. H. W. Kunzig was the secretary of the company. Both devoted their entire time to and were actively engaged in the conduct of the business.
    Dunham and Kunzig were the only stockholders who drew salaries.
    The other stockholders listed above were engaged in other businesses and professions. They placed their own insurance with the company, recommended the company to their friends, and when they learned of persons who were prospects for insurance, reported the fact to Dunham or Kunzig, who would endeavor to secure the insurance. Occasionally these stockholders would accompany Dun-ham or Kunzig to the prospects so secured and assist them in the active solicitation of the insurance. A majority of the calls made by Dunham and Kunzig were by appointment with prospective customer friends of the stockholders.
    The stockholders received no compensation for their services other than the return on their investment in the company.
    The corporation paid 10 per cent dividends on its stock in 1919 and 1920.
    Originally the petitioner was principally concerned with the securing of insurance, mainly on automobiles. It was found, however, that occasionally certain insurance could not be written unless the company would finance the purchase of the automobile on which the insurance was to be written. While the petitioner did not solicit this type of business during the years involved in this appeal, it accepted it as it presented itself and it steadily increased in volume.
    Fire, theft and casualty insurance was required by the petitioner to be placed with it in all transactions involving the financing of the purchase of automobiles, and in the majority of cases liability and property insurance were also required. This was exacted solely to build up the company’s insurance business. Occasionally a customer would take out insurance in excess of these requirements.
    The demand upon the petitioner for funds with which to finance such transactions increased to such an extent that, foreseeing the possibility of greatly increasing its insurance business, it made arrangements in January of 1920 with the First Peoples Trust Co., of Boston, Mass., to provide such funds. The trust company dealt only with Dunham and he acted as its agent in investing the funds. For this service the trust company paid a 2 per cent commission on all disbursements. This commission was turned over by Dunham to the petitioner, which collected all loans for the trust company as they became due and paid all expenses in connection with the financing transactions, retaining the profits for itself. The First Peoples Trust Co. was responsible for and assumed all losses from bad loans.
    During 1920 the commissions received from the First Peoples Trust Co. amounted to $50,582.04.
    During the years 1919 and 1920 there was income in an undetermined amount from miscellaneous insurance — fire, burglary, liability, property damage, etc., not connected with automobiles.
    The petitioner allocated the expenses between an assumed personal service part of the business and an assumed non-personal service part in proportion to an assumed gross income received from those parts, with the exception of commissions paid for insurance, which were charged directly to the so-called personal service part, and bad debts on leases, which were charged against the non-personal service part. Separate books were not kept for the two different classes of business.
    The petitioner’s business required the extension of credit to its insurance customers. In a great majority of cases it paid its insurance agencies before it received the money from its customers. The investment of capital with it by its stockholders enabled it to handle larger and bigger accounts.
    O. Trevor Dunham was a notary public during the years involved. The fees received by him were turned in to the corporation. In 1919 these fees amounted to $1,543.26. In 1920 they were $1,519.58. In both years the petitioner included these amounts in its income.
   OPINION.

SteRnhagen:

The petitioner seeks to prove itself within section 303, Revenue Act of 1918, which is as follows:

That if part of the net income of a corporation is derived (1) from a trade or business (or a branch of a trade or business) in which the employment of capital is necessary, and (2) a part (constituting not less than 30 per centum of its total net income) is derived from a separate trade or business (or a distinctly separate branch of the trade or business) which if constituting the sole trade or business would bring it within the class of “ personal service corporations,” then (under regulations prescribed by the Commissioner with the approval of the Secretary) the tax upon the first part of such net income shall be separately computed (allowing in such computation only the same proportionate part of the credits authorized in sections 311 and 312), and the tax upon the second part shall be the same percentage thereof as the tax so computed upon the first part is of such first part: Provided, That the tax upon such second part shall in no case be less than 20 per centum thereof, unless the tax upon the entire net income, if computed without benefit of this section, would constitute less than 20 per centum of such entire net income, in which event the tax shall be determined upon the entire net income, without reference to this section, as other taxes are determined under this title. The total tax computed under this section shall be subject to the limitations provided in ‘section 302.

The evidence indicates clearly enough that the activities of petitioner are so closely related one to the other and each to the whole that there is neither a separate trade or business nor a distinctly separate branch of the trade or business. As an automobile insurance agent it found a means of increasing its business by financing the purchase of the automobiles upon which it negotiated insurance, and as a further step in this financing it arranged to place loans for the trust company. No one of these was distinct. The costs of the entire business were undividedly applicable to all and the attempt of petitioner’s accounting representative to segregate and allocate expenses was not satisfactory. The entire personnel of the business was, so far as the evidence shows, devoted to all its activities, and the only clearly separate factor was the commissions received from the trust company.

Judgment will lye entered for the Commissioner.