author: Littleton :

text:
    Alpin J. Cameron, William P. Denegre, and Alpin W. Cameron, Petitioners, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 9686.
    Promulgated September 19, 1927.
    1. When in 1920 one partnership is succeeded by another partnership and the interests of the members continue substantially as before with the exception of a gift by one of the partners of his partnership interest to a new partner and a change in the distributive shares of the partnership income, no new basis for computing the allowance for exhaustion, wear and tear to the partnership arises.
    2. The March 1, 1913, value of depreciable assets determined upon the basis of cost less accrued depreciation instead of upon' the basis of a retrospective appraisal made in 1926 of cost of reproduction new less an estimated amount for depreciation.
    3. Depreciation previously claimed by the partnership of which petitioners are members and allowed by the Commissioner in com- ■ puting the taxable income for prior years must be taken into consideration in arriving at the capital costs which are yet subject to recovery through a depreciation allowance for the years 1920 and 1921.

      J. Robert Sherrod, Esq., and B. E. Hinton, Esq., for the petitioners.

      M. N. Fisher, Esq., for the respondent.
    The Commissioner determined deficiencies in income taxes as follows: Alpin J. Cameron, $21,665.31 for 1920 and $13,904.16 for 1921; William P. Denegre, $15,203.16 for 1920 and $29,019.91 for 1921; and Alpin W. Cameron, $10,921.17 for 1920 and $6,860.40 for 1921.
    FINDINGS OF FACT.
    The business of A. J. Cameron & Co. was begun prior to 1891. In that year a new partnership was organized composed of Alpin J. Cameron and William P. Denegre, trading as copartners under the name of A. J. Cameron & Co. With various changes of location, this partnership continued until January 1, 1920, when, by oral agreement, Alpin W. Cameron, son of Alpin J. Cameron, was admitted to a share in the partnership earnings, the distributive shares after this time being: William P. Denegre, 40 per cent; Alpin J. Cameron, 35 per cent; and Alpin W. Cameron, 25 per cent. At this time, Alpin J. Cameron made a gift to his son, Alpin W. Cameron, of $250,000 which was accomplished by a transfer from the capital account of the former on the books of A. J. Cameron & Co. to a similar account of the latter on the same books. No change was made at this time of the asset values on the books of A. J. Cameron & Co.
    The business of the partnership is that of a wool-spinning plant, producing yarn and tops.
    In 1903 the partnership erected a three-story mill building of the type known as “ slow-burning construction,” with stone foundations, heavy brick walls, wood interior, and slag roof, at a cost of $115,-880.66. Capital expenditures on this building in 1910 of $3,282.41 added to the original construction cost made a total cost on March 1, 1913, of $119,163.13. The greater part of the machinery installed in this building was purchased new in 1903, though a small part was transferred from buildings previously rented by the partnership. The books of account show a total cost of machinery at March 1, 1913, of $310,525.93, which includes additions from 1903 to 1913. The total plant account on March 1,1913, was $429,689.06 — buildings, $119,163.13, and machinery, $310,525.93.
    In 1915, another mill building and a warehouse of the same type of construction as the first building, were erected at a cost of $87,-736.40, which, with certain other later costs of $278.77, constituted total building costs subsequent to 1913 and prior to December 31, 1919, of $88,015.17. No additional building costs were incurred in 1920 and 1921. Machinery and equipment were acquired after March 1, 1913 as follows:

    Depreciation was computed by the partnership at a composite rate for each of the years prior to 1920 as follows:
    Per cent
    1903 to 1912, inclusive_ 6
    1913 to 1915, inclusive- 8
    1916_10
    1917 to 1919, inclusive_20
    The depreciation allowance as determined at the above rates was used in computing net income on the partnership books. The total depreciation reserve on the partnership books at December 31, 1916. was $374,567.15 and the total cost of depreciable assets to this date was: buildings, $207,178.30, and machinery and equipment, $410,-853.14. The rate of 20 per cent as shown for 1917 to 1919, inclusive, was reduced by the Commissioner in determining the taxable income for these years, the result being an allowance of depreciation deductions as follows: 1917, $56,690.74; 1918, $78,126.49; and 1919, $81,-382.13. The rates of 8 per cent from 1913 to 1915 inclusive and 10 per cent for 1916 were not disturbed by the Commissioner for these years. The depreciation set up on the partnership books to December 31, 1916, together1 with depreciation allowed by the Commissioner for the three subsequent years, made a total of depreciation to December 31, 1919, of $590,766.51. The cost of depreciable assets to December 31, 1919, was $684,772.56 — buildings, $207,178.30; machinery and equipment, $477,594.26.
    The Commissioner, in his determination, segregated the total depreciation reserve at December 31, 1916, of $374,567.15 which appeared on the books in a lump amount as applicable to the plant account and showed $107,019.19 as applicable to buildings and $267,-547.96 as applicable to machinery and equipment. To these amounts was added the depreciation allowed by him on these two classes of assets in three succeeding years which produced the following depreciation reserves at December 31, 1919; buildings, $132,594.12, machinery and equipment, $458,172.38. The Commissioner, in com- - puting allowable depreciation for 1920 and 1921, eliminated $464,-607.67 from the machinery and equipment account on account of acquisitions made prior to December 31, 1916, which he considered fully depreciated before the end of 1920, the allowance on these assets in 1920 being the unextinguished balance at January 1, 1920. No depreciation was allowed on these assets in 1921, though depreciation was allowed on additions which were made subsequent to January 1, 1917. The depreciation thus allowed by the Commissioner in 1920 and 1921 was as follows:

    The plant and the machinery were at all times kept in first-class condition, the partners being unusually thorough in making inspections of the plant and seeing to it that necessary repairs were made. At least annually all machines were taken down, reassembled and placed in proper alignment in order that a high state of operating efficiency might be maintained. A machine shop, with a greater number of mechanics than is normally employed by similar plants, was maintained, its function being to repair and replace defective or worn parts of machinery and equipment.
    A high state of operating efficiency maintained in the plant was reflected in a product which was of such character that no advertising as such was necessary for its sale, the only advertising being derived from the location of the plant near the main line of the Pennsylvania Railroad into Philadelphia, on which plant was placed the name “A. J. Cameron and Company ” and title of the business in large letters, and from the character of the product manufactured.
    The buildings at the time of construction were the most advanced mill type and are still entirely suitable for the purpose for which they are used. They receive unusual care in the way of pointing-up the masonry and making such repairs as are possible to arrest deterioration. Obsolescence is a negligible factor. The useful life of the buildings so maintained is not less than 50 years.
    The machines used by the partnership are still modern and up-to-date. Practically all machines installed in 1903 and subsequent thereto were in use in 1926. There has been little, if any, change in the design and construction of wool-spinning machinery since prior to 1903, the only improvements in machinery of this type being by way of attachments designed to be placed upon existing machines of the type used by A. J. Cameron & Co. The fast-moving and rapidly depreciating parts have been and are being repaired and replaced continually. Such repairs and replacements are charged to expense by the partnership and taken as a deduction in computing taxable income. Obsolescence has been of minor consequence in connection with wool-spinning machinery and equipment of this type. The average useful life of the machinery maintained in the high state of repair peculiar to this taxpayer would not be less than 33% years.
    The sales, invested capital, depreciation used in computing net income, and the net income of the partnership for the nine years next prior to January 1, 1913, were as follows:

      The average net taxable income of the partnership for the five years next preceding January 1, 1920, was $476,997.82 on an average invested capital as shown by the books of $1,415,544.87.
    No salaries were drawn by the partners or used in computing net-income until 1917, when a salary of $7,000 for each of the two partners was arrived at on the basis of the saving in tax for 1917 which would be effected by such salaries.
   OPINION.

Littleton :

The primary error assigned in this proceeding is the failure of the Commissioner to allow adequate depreciation for the years on appeal.

As the basis for this claim, the petitioners contend, first, that since the partnership which was formed in 1891 was dissolved and a new partnership came into existence on January 1, 1920, when A. W. Cameron was admitted to membership, there should be a revaluation of the assets of the partnership on January 1, 1920, for depreciation purposes in determining the distributive income of the partnership.

Granting that there was a new partnership created on January 1, 1920, should there be a revaluation of assets on this date for the purpose of determining the partnership income which is taxable to the partners ?

Section 218 (d), Revenue Act of 1918, provides the basis for determining partnership income as follows:

The net income of the partnership shall be computed in the same manner and on the same basis as provided in section 212 except that the deduction provided in paragraph (11) of subdivision (a) of section 214 shall not be allowed.

The exception mentioned above, section 214 (a) (11), refers to charitable contributions, etc., which are not material to a decision of the question at issue.

Section 212, Revenue Act of 1918, provides, in part that:

(a) That in the case of an individual the term “ net income ” means the gross income as defined in section 213, less the deductions allowed by section 214.

Section 214, Revenue Act of 1918, provides in part that:

(a) That in computing net income there shall be allowed as deductions:
* * # * * * >k
(8) A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence.

Under the foregoing provisions the depreciation allowable to a partnership should be determined on the same basis as for an individual. The transaction which petitioners claim gave rise to a new basis for depreciation, occurred after March 1, 1913, and, therefore, we have only the question to consider of whether a new cost arose on January 1, 1920, which may be used as a basis for depreciation. In other words, would the dissolution of the partnership which existed prior to January 1, 1920, and the creation of a new partnership on January 1, 1920, under the circumstances of this case, give rise to a new cost for depreciation purposes?

Two partners constituted the partnership prior to January 1,1920, and these same partners continued to be members of the partnership which existed after a third partner had been admitted on January 1, 1920. No additional funds were paid in at this time, the capital account of the new partner being created by a transfer from the capital account of one of the old partners, Alpin J. Cameron. The other partner, Denegre, continued with the same investment as before. The change of consequence for all the partners at the time was that the income would thereafter be distributed on the basis of 40 per cent to W. P. Denegre, 35 per cent to Alpin J. Cameron and 25 per cent to A. W. Cameron.

There was no sale or transfer by the old partnership to the new partnership of the assets of the old partnership. Unlike a corporation, a partnership does not for tax purposes exist separate and apart from the partners. There is nothing to indicate that there were any transfers of any kind with respect to the ownership of the property here in question, such as would have been necessary had a corporation been succeeded by a corporation or by a partnership. The old partners had an interest in a partnership and this interest continued without interruption when the new partnership was created — at least this was true as far as Denegre was concerned. Not only did the old partnership sell nothing, but also the same was true of Denegre. The other old partner, Cameron, gave a part of his interest to his son, but in so far as the remaining part was-concerned, there was no change of ownership whatever.

The status of a partnership under the Revenue Act of 1913, is defined in United States v. Coulby, 251 Fed. 982, which would be equally applicable under the Revenue Act of 1918, since in both instances a partnership is not taxed as such. The court said:

This law, therefore, ignores for taxing purposes the existence of a partnership. The law is so framed as to deal with the gains and profits of a partnership as if they were the gains and profits of the individual partner. * * * The law looks through the fiction of a partnership and treats its profits and its earnings as those of the individual taxpayer. Unlike a corporation, a partnership has no legal existence aside from the members who compose it. The Congress, consequently, it would seem, ignored, for taxing purposes, a partnership’s existence, and placed the individual partners share in its gains and profits on the same footing as if his income had been received directly by him without the intervention of a partnership name.

The conclusion reached by the district court was later affirmed by the circuit court of appeals in United States v. Coulby, 258 Fed. 27. See also, J. H. Goadby Mills, 3 B. T. A. 1245, in which the Board said :

In the enactment of section 218 (a) Congress ignored for taxing purposes the existence of the partnership and framed the law so as to treat the gains and profits of the partnership as if they were gains and profits of the individual partners. Unlike a corporation, a partnership has no legal existence aside from the members who compose it; consequently, in order that the profits of the partnership might not escape taxation, Congress provided that its income should be taxed to the individual partners, the same as if they had received it direct without the intervention of the partnership.

The Board is of the opinion that for the purpose of 'determining income of a partnership under the Revenue Act of 1918 the partnership must be viewed from the standpoint of the individual partners who compose it, and not as a legal entity of itself.

When considered in this manner, we fail to see where there can be any new basis of depreciation for the interests of the partners which existed in the old partnership and continued in the new partnership. These partners neither bought nor sold anything at this time. There was no new cost to them and, consequently, no new basis for depreciation which has for its purpose the recovery of capital outlay before taxing income.

With respect to the new partner who received a gift on January 1,1920, of an interest in the partnership business of $250,000, we are unable to determine a different depreciation allowance thereon other than the allowance which the Commissioner has made in computing the net income of the partnership, for the reason that we do not know what depreciable assets, if any, he acquired. In Abraham B. Johnson, 7 B. T. A. 820, we held that the basis for depreciation in the case of a gift was the fair market value of the depreciable property at the date of the gift. Assuming the most favorable position for this petitioner, namely, that he constructively received $250,000 from his father and this was used to purchase an interest in the partnership, we would still be unable to provide a basis for the return of this capital to him for the reason that we do not know that this amount was invested in depreciable property alone. We only know that after January 1, 1920, he was entitled to receive 25 per cent of the future earnings of the partnership. Was it an acquisition of depreciable tangible property alone or was it an interest in the entire business, including both depreciable and nondepreciable assets % The evidence fails to show what dejoreciable assets, if any, were acquired and, therefore, we must deny any deduction for depreciation on account thereof.

In view of the above conclusions, it becomes unnecessary to determine the value of the assets on January 1, 1920.

The next issue relates to the March 1, 1913, value of assets for the purpose of computing the allowance for depreciation. The evidence with respect to the March 1, 1913, value, consisted almost entirely of a retrospective appraisal made in 1926 upon the basis of cost of reproduction less an estimated amount for depreciation, which was explained in some detail by the men who did the greater part of the work in its preparation. At the same time there was presented testimony relating to a similar appraisal for the purpose of showing the value of the plant in question on January 1, 1920, and the greater portion of the evidence of value, outside the two appraisals, was directed at showing the increase in value from March 1, 1913, to January 1, 1920, and the value on January 1, 1920. What evidence we have tends to show small, if any, increase in value over cost from 1903 and intervening years to March 1, 1913.

One witness for the petitioners testified that there was no fluctuation in prices during the period 1903 to 1913, and another that 1913 was a normal year with prices “ slightly less ” in 1903 than in 1913. Upon further questioning, the latter stated that in his opinion 1903 prices were about 90 per cent of 1913 prices. This same witness, who holds an important position with the appraisal company which prepared the appraisals, though he was not connected with the making of appraisals here in question, placed a fair market value on de-preciable assets of the partnership of $397,000, which is only $62 in excess of the net replacement cost fixed by the appraisal itself. The gross replacement cost fixed by the appraisal, represents an increase over original cost of approximately 32 per cent.

While it was shown at the hearing that the partnership made an inventory of its assets at the end of 1912 for the purpose of determining the assets on hand at that time, this inventory was neither availed of by the appraisers for the purpose of checking the correctness of the inventory which they made in 1926 as to March 1, 1913, by working back an inventory made in 1926, through a process of additions and eliminations, nor was it introduced in evidence to enable the Board to make a check. One of the difficulties which frequently arises in the making of a retrospective appraisal is the determination of the assets which were on hand at a much earlier date than that on which the appraisal is being made — in this instance 13 years. Obviously, the percentage of error may be high for many reasons.

In this proceeding we are not dealing with a situation where there is any contention made that the costs of assets on hand at March 1, 1913, are not reflected by the books; on the contrary, at the hearing much stress was laid on the accuracy with which the books were kept and the detail shown therein. The basic contention appears to be that replacement cost at March 1, 1913, less depreciation to March 1, 1913, both as determined by the retrospective appraisal, should be accepted in lieu of costs as reflected by the partnership books for the purpose of computing depreciation.

Upon a consideration of all the evidence, we are not convinced that the March 1, 1913, value as determined by the retrospective appraisal, represents as nearly accurate fair market value as that which is represented by cost of the depreciable assets as reflected by the partnership books, less proper depreciation to March 1, 1913. This case is easily distinguishable from Paducah Water Co., 5 B. T. A. 1067, to which we are referred by the petitioners, as many of the corroborative factors which led to the acceptance of a retrospective appraisal in that instance are not present here.

The cost of the depreciable assets to the partnership from 1903 to March 1, 1913, was $429,689.06 and we are satisfied from the evidence that a reasonable reserve for depreciation at this date would be $128,906.72. This results in a depreciated cost on March 1, 1913, of $300,782.34, which we believe from a consideration of all of the evidence should be accepted in this case as the best evidence of the fair market value on this date.

The next question is whether, in determining the depreciation allowance for 1920 and 1921, the Commissioner was in error in eliminating depreciable assets (machinery and equipment) from the partnership’s plant account in 1920 and 1921, to the extent of $464,-607.67, on the ground that assets to this extent had been fully depreciated on the partnership books. At January 1,1917, the partnership had on its books a depreciation reserve of $374,567.16, which had been set up from 1904 to 1916 by the use of composite rates ranging from 6 per cent from 1904 to 1912, and 8 per cent from 1913 to 1915, to 10 per cent in 1916. The depreciation thus determined was used in computing income on the partnership books and at least for the last four years was claimed and allowed as a deduction in determining taxable income. The Commissioner segregated this depreciation reserve as between buildings and machinery and equipment, and added to the two reserves the depreciation which he allowed on these classes of assets for 1917, 1918, and 1919. Since the total of the depreciation reserve for machinery and equipment at January 1, 1920, was only slightly less than the costs incurred for machinery and equipment prior to January 1, 1917, as determined by him, only the remainder was allowed as a deduction for depreciation in 1920 on these assets, and no depreciation was allowed on such costs for 1921.

The evidence adduced at the hearing was conclusive to the effect that not only were practically all these assets on hand and in use in 1920 and 1921, but also that they were in use and rendering satisfactory service in 1926. Further, we have found as a fact that a composite rate of 3 per cent, or a life of 33% years, was reasonable for these assets, under the maintenance policy pursued by this partnership. This rate, on the evidence, is reasonable when the unusual repair and maintenance policy of the partnership and the expert testimony offered by the petitioners are considered. It is, therefore, apparent that an elimination of these assets, because their useful life had expired in 1920, would not be justified.

On a consideration of this question, the Board is of the opinion that the fact of the existence of the assets and their continued use in the business is not alone sufficient to justify a depreciation allowance in the taxable years, but that due regard must also be had to the extent to which recovery has already been had of their value on March 1, 1913, of assets acquired prior thereto, and of costs of assets acquired subsequent to this date. Depreciation at best is an estimate. Pierce-Arrow Motor Car Co., 2 B. T. A. 396. Its purpose is to provide a return of capital before taxing income. Richmond Dairy Lunch, 1 B. T. A. 876; Gladding Dry Goods Co., 2 B. T. A. 336; United States v. Ludey, 274 U. S. 295. Under the Revenue Act of 1918, a taxpayer’s capital which he is entitled to recover before taxing income is the value as it existed on March 1, 1913, of assets acquired prior to this date, if such value is greater than cost, and cost of assets acquired subsequent to March 1, 1913. Even Realty Co. 1. B. T. A. 355; J. J. Gray, Jr., 2 B. T. A. 672. In this proceeding we have determined the fair market value at March 1, 1913, in an amount not less than cost after adjustment for depreciation to this date. This amount the petitioners are entitled to have recovered to them as well as subsequent costs before taxing income, but in no greater amount than the sum total of the March 1, 1913, value and subsequent costs. As we said in Even Realty Co., supra, “The Constitution certainly does not entitle a taxpayer to recover any part of his cost more than once, before becoming accountable for taxes upon his gain.”

We have found that the value on March 1, 1913, is represented by a cost on this date of $429,689.06 less a depreciation reserve of $128,906.72. From March 1, 1913, to December 31, 1916, depreciation was claimed by the petitioners and allowed by the Commissioner in the computation of taxable income in the approximate amount of $162,200.27. (This amount is referred to as “ approximate ” since only the rates claimed and allowed were furnished, though the application of the rates to cost furnishes this amount, which is a close approximation to the difference between the depreciation reserve on the books at December 31, 1916, and the depreciation computed on the books prior to March 1,' 1913.) By adding to the latter amount the depreciation reserve on March 1, 1913, we arrive at a depreciation reserve on December 31, 1916, of $291,-106.99. The Commissioner made a segregation as between buildings and machinery and equipment of the total reserve on the books at this time on a basis which appears reasonable, and which, when applied to the foregoing total, produces the following result: buildings, $83,178.43, machinery and equipment, $207,933.56. For 1917, 1918, and 1919, a composite rate of 20 per cent was claimed for depreciation, though this was reduced by the Commissioner to the extent that a total was allowed on buildings in those years of $25,574.93 and on machinery and equipment of $190,624.42. When these amounts are added to the depreciation reserve as previously shown at December 31, 1916, we find accumulated reserves at December 31, 1919, as follows: buildings, $108,748.36, machinery and equipment, $398,557.98. Costs of buildings at December 31, 1919, were $207,178.30 and of machinery and equipment, $477,594.26.

When returns for the years 1913 to 1919 were filed, an amount was claimed as representing a reasonable allowance for depreciation under the provisions of the statutes then in force, and in all cases the allowances made by the Commissioner were no greater than those claimed by the petitioners — in 1917, 1918, and 1919 they were substantially less. In those years the petitioners knew as well as they now know the conditions surrounding the property, its useful life in the business, and what would be a reasonable allowance for the exhaustion, wear' and tear thereof. All we know is that for the years 1917, 1918, and 1919 when the tax rates were high, the partnership claimed and insisted upon an allowance of 20 per cent for depreciation. What evidence was presented, or ■ upon what consideration the parties acted to determine the reasonableness of the allowances finally made we do not know. The fact is that the parties arrived at allowances which both accepted then as reasonable, and from the evidence before us we can not say that it was unreasonable or excessive, notwithstanding it is now shown that the machinery had a useful life greater than the period of usefulness in the business upon which the allowances in 1917, 1918, and 1919 were made. The Board will not lightly conclude that deductions from gross income in prior years through allowances for exhaustion, wear and tear of property used in the trade or business were unwarranted and excessive, and direct adjustment thereof so that a taxpayer may in subsequent years secure the benefit of a greater deduction from income for exhaustion, wear and tear than to which he would otherwise be entitled. We have held that we will not permit the Commissioner to adjust invested capital for taxable years upon the ground that the taxpayer has taken inadequate depreciation in prior years, in the absence of a clear showing that the depreciation charged upon the books or claimed in the returns was inadequate. Russell Milling Co., 1 B. T. A. 194; Cleveland Home Brewing Co., 1 B. T. A. 87; Rub-No-More Co., 1 B. T. A. 228. And, when a taxpayer claims that the Board should go back and redetermine the useful life of the property and recompute the depreciation allowance over a long period of years long since barred by the statute of limitation, so that he may obtain a greater deduction from income in the taxable year, and in fact obtain the benefit of a double deduction from income, he must satisfy the Board by clear and convincing evidence that he is in justice entitled to such adjustment. The allowance of the deduction from income for exhaustion, wear and tear of property is for the benefit of the taxpayer and when he has been given a liberal allowance in prior years, when the tax rates were high, he should not be heard to say upon a mere showing that in the taxable years the property is still in use and giving good service, that the depreciation claimed and allowed after a full consideration of the facts in prior years should be disregarded and an allowance made which will permit of the exhaustion of the same or a portion of the capital investment the second time. Our allowance for the years involved will, therefore, be predicated on the proposition that the allowances from 1913 to 1919 were reasonable, and that recoveries of capital to this extent have been made which will not again be permitted in a later year.

There is no controversy between the Commissioner and the petitioners as to buildings, the controversy arising on account of an elimination from the capital account of machinery and equipment which the Commissioner considered fully depreciated and the consequent disallowance of depreciation thereon. As shown above, the depreciation reserve for machinery and equipment at March 1, 1913, plus the depreciation asked for and granted from this date to December 31, 1919, leaves an unextinguished balance in this account at December 31, 1919, of $79,036.28. The evidence before us is insufficient to show that specific assets were actually depreciated out and, therefore, would be subject to elimination, since a composite rate was used by the partnership for all assets. On the other hand, we have found that under the circumstances of this case, a composite rate of 3 per cent, or a life of 33ys years would be reasonable for these assets. On a weighted-average basis, there would be an unexpired life as applicable to the assets on hand on December 31, 1919, of approximately 22 years. An allowance of 3 per cent on the total cost of assets would extinguish the assets long before the expiration of their useful life. The Board is, therefore, of. the opinion that a revision of the basis of computing depreciation should be made to the end that the unextinguished balance may be spread over its remaining life. When this is done, there is found a depreciation allowance for the years on appeal less than that already allowed by the Commissioner after making the elimination in question. Since other factors may have entered into such an allowance, we are willing to give the petitioners the benefit of the doubt in this instance and not disturb the deductions as allowed by the Commissioner.

Reviewed by the Board.

Judgment will be entered for the respondent.


source: Caselaw Access Project

author: Phillips :

license: Public Domain

text:
    Symington-Anderson Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 4918.
    Promulgated September 19, 1927.
    1. Evidence helé not to establish that a contract with the Government to manufacture 3-inch' artillery guns on the basis of cost plus a fixed sum per gun, which contract could be canceled by the Government at any time, had a fair market value.
    2. Profit from such contract held to have been derived on a cost-plus basis, within the provisions of subdivision (d) of section 327 of the Revenue Act of 1918.
    3. The assets paid in to the corporation on organization were acquired by the owners without cost. Held that under section 331 of the Revenue Act of 1918 petitioner had no invested capital at the time of organization.
    4. Assessment under section 328 denied.

      Robert P. Smith, Esg., for the petitioner.

      Joseph K. Moyer, Esq., for the respondent.
    This is an appeal from the determination of a deficiency in income and profits tax for the calendar year 1918 in the amount of $76,174.96, arising from the denial of a claim for the abatement of a jeopardy assessment in that amount. It is alleged that the respondent erred in determining the tax liability of the petitioner for the year 1918 in (1) determining that more than 50 per cent of the income received by petitioner in 1918 was derived from cost-plus Government contracts and refusing to compute the tax under the provisions of sections 327 and 328 of the Revenue Act of 1918; (2) failing to determine any statutory invested capital under the provisions of section 326 of the Revenue Act of 1918, and in computing the tax under section 302 of said Act instead of section 301 or 328; (3) failing to allow as a deduction from income, depreciation or a deduction in lieu thereof of the value of Contract G. C. 102.

      FINDINGS OF FACT.
    The petitioner is a Maryland corporation with its principal offices at Baltimore, Md. It was organized on or about July 21, 1917, with 10,000 shares of stock without par value. It was formed for the purpose of the manufacture of ordnance. On April 19, 1917, L. M. Vauclain, the Chairman of the Artillery Committee of the Council of National Defense, wrote to T. H. Symington Co. as follows:
    The Government of the United States desires a large number of small calibre Field and Naval Guns, ranging from 3” in diameter to 6” in diameter, the greater number will naturally be of the smaller size, namely 3”. The length of these guns will range from the Army Field Guns, about 85" long, to the Anti-aircraft Guns, about 170" long.
    The Government will provide an ample supply of gun forgings, rough machined and heat treated, to meet their requirements, delivery of the same beginning in about ninety days.
    It is desired to create a capacity for machining and completing these guns ready for service. It is further desired that you create such additional facilities as you may require in addition to those you now possess to perform a percentage of the total work required.
    The Committee will, therefore, be pleased to receive from you a proposition:
    Fikst For doing all the work that may be required to finish each gun completely and ready for service.
    Second For doing all the work as above excepting the breech manufacture.
    Thibd Omitting such other details of the gun manufacture as in your judgment might be unwise for you to undertake.
    Inasmuch as this matter is of the utmost importance and must be decided promptly, a personal interview is desired within the next ten days. Will you kindly telegraph when you may be expected. An early reply to the Secretary, Mr. Benedict Crowell, Boom 956, Munsey Building, Washington, D. C., will be appreciated.
    In response to this letter Symington went to Washington and had an interview with Vauclain. He informed Vauclain that the T. H. Symington Co. could not undertake any further work, and was told that they were interested in him, rather than his company, on account of his experience and abilities and financial standing.
    T. H. Symington was a mechanical engineer and a manufacturer of many years’ experience. In 1917 and for some years prior thereto, he had been engaged in manufacturing special machinery for the production of artillery ammunition and also in the manufacture of such ammunition. He had sold machinery to most of the large ammunition manufacturers in this country and had equipped two arsenals in Russia; one in Italy, and one in Australia. He had manufactured shrapnel for the allies under subcontracts for the Bethlehem Steel Co. and also for the Eddystone Ammunition Co., of which Vauclain was president. He was interested in various manufacturing companies and had had an extraordinary experience as a manufacturer of ordnance. This experience was known to Vauclain.

      Vauclain urged that Symington undertake a contract to manufacture guns at a fixed price, but Symington refused and suggested that a contract on the basis of cost, plus a fixed profit per gun, was better for both parties. It was agreed that the contract would be of this nature. Symington further conferred with Major C. 0. Jamieson in charge of the production of guns and with Colonel Rice in charge of the production of field artillery gun carriages.
    There was associated with Symington, one M. H. Anderson as vice president of the Symington Machinery Corporation. Anderson had formerly been employed by the Bethlehem Steel Co. as superintendent of shops, in charge of the manufacture of shrapnel and guns. Anderson was a practical man who had had about 7% years’ experience in manufacturing ordnance. He had resigned from the Bethlehem Steel Co. in March, 1917, and was employed by Symington in April, 1917, on account of his experience in organization and the manufacture of ordnance. He was selected by Symington to take charge of the manufacture of guns under the contract being negotiated with the Government. Early in the negotiation he accompanied Symington to Washington where he was interviewed by Vau-clain relative to his ability to handle the work and was found to be satisfactory.
    On May 28, 1927, the War Department telegraphed Symington as follows:
    Mr. T. H. Symington,
    T. H. Symington Company,
    Maryland Trust Bldg.,
    Baltimore, Md.
    How soon can you give us rough estimate of your expenditures for plant and equipment necessary for machining three inch field guns four per day please rush answer.
    Benedict Crowell Secretary Committee on Army and Navy Artillery.
    On June 11, 1917, the following telegram was sent to Symington by Jamieson:
    T. H. Symington,
    Barnum Leighton and Crouch St.,
    Rochester
    Will be glad to go into three inch gun question Wednesday.
    C. C. Jamieson.
    On June 15, 1917, the Chief of Ordnance wrote Symington and Anderson as follows:
    This Department will enter into a contract with you, as soon as appropriations become available, for machining and assembling three thousand 3-inch field guns, Model of 1916, delivery to begin within six months, and the contract to be completed by November 1, 1918, under the following general conditions:
    1. The United States will pay the cost of the necessary land rental, buildings and equipment to manufacture these guns at an estimated rate of ten guns per day; the sum to be expended therefor to be agreed upon between you and the Ordnance Department.
    2. The plant to remain the property of the United States subject to removal at its option at the end of the contract or such subsequent contracts as may be entered into, such option to be exercised within thirty days after completion of final contract and actual removal to be completed within six months thereafter.
    3. The United States to pay all cost of the manufacture of these guns, such cost to be determined by a firm of competent certified public accountants, or by some other method equally satisfactory to the contracting parties. The estimated unit cost of these guns machined and assembled, exclusive of land leased, plant, machine tools, jigs, fixtures and gauges for the purpose of estimating a fair fixed profit per gun is assumed at $2625.00, based on a cost of 74 cents per pound for the forgings.
    4. The United States agrees to pay $390 per gun as profit under the assumption that the cost, including forgings as above, exclusive of land rental, plant, machine tools, jigs, fixtures and gauges is not more than $2025.00.
    In case the cost as shown by the records is less than $2625, the saving or reduction in cost shall be divided between you and the United States on the basis of 33%% of such saving to 5rou, and 06% to the United States. In case the cost is greater than $2625.00, 20% of such excess cost shall be deducted from the fixed profit of $390, provided always that the fixed profit after such deduction shall not be less than $340. per gun delivered, it being understood that in ease of excessive cost, the United States shall have the right to terminate the contract.
    If after a reasonable time the daily output reached indicates that the contract will not be completed by November 1, 1918, the number of guns called for in the contract may be reduced to such number as will probably be completed by the date named.
    The United States will make prompt monthly payment on account for all expenditures made, so as not to tie up your capital.
    This Department would like further to have the option of placing an additional order for one thousand similar guns within sixty days, the rate of output to be increased in that case to twelve or more guns per day.
    This letter is being mailed to you in duplicate, and in case a contract embodying the terms set forth above is satisfactory to you, your signed acceptance on one copy mailed to us will constitute a preliminary agreement.
    On June 17, 1917, Jamieson telegraphed Symington as follows:
    T. H. Symington,
    T. H. Symington Co.,
    Rochester
    There will be some delay before letter can be signed and some modifications may be necessary. Will write fully tomorrow. Am returning to. Washington to-night.
    C. C. Jamieson
    On July 6,1917, Symington wrote Jamieson as follows:
    We have placed firm orders of approximately $500,000 for machinery for finishing guns, and will only be enabled to hold the secured deliveries by advising the machine tool builders of a number that will identify our work for the Government.

      If consistent, can you wire me at Baltimore a number that can be given to our prospective order, so that the demand of the machine tool people can be met?
    Please understand that this number that you will give me will in no sense commit your Department beyond its intention to place this contract with me; and please further understand that your non-compliance with the above will satisfy me that it is not possible for you to meet my request.
    Xou will doubtless be interested to know that I have gotten together our complete working organization, and we are making excellent progress towards the manufacture of our gauges, jigs and fixtures.
    If your present problem could be solved by our deeding to the Government, without reservation, a piece of land suitable for our purpose, I am ready to proceed.
    On July 10, 1917, Jamieson replied by telegram as follows:
    T. H. Symington,
    Baltimore, Md.
    Have reserved order number G. 0. one hundred and two
    Ckozieb, Chief of Ordnance
    C. C. J.
    On July 9, 1917, Jamieson wrote Symington as follows:
    I am directed by the Chief of Ordnance to inform you that the Honorable Secretary of War has rendered a decision on the various questions involved in the execution of contracts which require the erection of buildings and extension to plant equipments for the production of the material called for therein.
    This decision is such that this department is now in a position to proceed with definite orders for the machining and assembly of 3” guns under discussion with your Company, and you are therefore entirely safe to proceed with the purchase of the necessary machine tool equipment, and with the preparation for the purchase of land for the erection of buildings for this purpose. A definite order in anticipation .of the execution of the formal contract will be given you during the present week.
    In order that this office may have definite information as to the estimated expenditure involved, we have already asked you for a list of the machine tools which it is anticipated will be required with the prices which you expect to pay for them. We also desire to examine this list in order to advise you whether the equipment is properly balanced for the production of the number of guns 'which you propose to manufacture.
    It has been decided that such buildings as it shall be necessary to erect for the execution of contracts are to be temporary in character. By this is meant that they should be no more permanent than necessary for their purpose, and of a character that will not permit of a just charge of permanency.
    For your information we are enclosing a definition of what we regard as temporary construction. This definition you will note leaves the actual details with reference to the construction very largely to the contractor, but we will appreciate receiving a sketch of your proposed construction.
    On July 19, 1917, Jamieson wrote Symington as follows:
    In connection with order from this office, G. C.-102 for 3-inch Field Guns, you are authorized to proceed with the construction of buildings in accordance with plans submitted this day and approved by the undersigned; also to proceed with the purchase of machinery and equipment in accordance with your letter of July 19tb and the exhibits attached thereto, dated July 17th and 18 th.
    On July 27, 1917, Lieutenant Colonel Hoffner of the office of the Chief of Ordnance wrote Symington as follows:
    1. Referring to previous correspondence with you on the subject and to the provisions of section 120 of the Act of Congress relating to National Defense, approved June 3, 1916, and other laws of the United States and the Executive Orders of the President of the United States, or heads of its departments under which the requirements of advertisements for proposals are dispensed with, X am directed by the Chief of Ordnance to hereby give you an order to erect temporary buildings and purchase equipment which will enable you to machine and assemble three thousand (3,000) 3-inch field guns, at the rate of ten guns per day of twenty-four hours. Specifications for these guns will be furnished in connection with an order to be placed with you as soon as funds become available.
    2. The cost of buildings and equipment, including small tools, jigs, fixtures and gauges, is not to exceed two million two hundred thousand dollars ($2,200,000). This plant, at the termination of the contract, or any subsequent contract which may be entered into with you, is to remain the property of the United States, subject to removal at its option.
    3. Payment of at least ninety percent (90%) of the cost of buildings and equipment is to be made you monthly as incurred. Payment for the remainder to be made upon completion of buildings and installation of equipment.
    4. In accepting this order you are also to agree to accept an order for the following, which -will be placed in sufficient time to permit you to mate deliveries as stated below. This order will be placed under the provisions of section 120 of an act of Congress relating to National Defense, approved June 3, 1916, under which the requirements of advertisements for proposals are dispensed with, an extract copy of which is enclosed herewith:
    Machine and assemble three thousand (3,000) 3-inch field guns, Model of 1916, in accordance with Ordnance Office drawings Nos. 52-76-1 to 10, inclusive, revisions of June 14, 1917. Spare parts as listed below to be in accordance with Ordnance Office Drawing No. 27-8-1, revision of May 21, 1917, copies of which drawings are attached hereto. Forgings for gun body and breech block to be supplied you by the United States at such times as will enable you to make deliveries:

      Spare Parts

    750 Breech mechanisms complete.
    3000 Firing pins.
    3000 Firing pin springs.
    3000 Firing spring shoes.
    3000 Hand fuze setters with covers.
    3000 Sears.
    3000 Sear springs.
    3000 Trigger arms — should read “ Firing Arms ” in drawing.
    3000 Trigger shaft detents with split pins.
    3000 Catch springs.
    3000 Closing springs.
    6000 Extractor Plun. springs.
    3000 Latch springs.

      5. The serial numbers of the guns referred to herein will be 619 to 3618, inclusive.
    6. Delivery, f. o. b. cars your plant, Rochester, N. Y., of the guns referred to herein is to be made at the rate of ten (10) guns per day, beginning on or before January 1, 1918, the entire order to be completed by March 1, 1919. If, after a reasonable time the daily output indicates that the order will not be completed by March 1, 1919, then it may be reduced to such number of guns as will be completed by that time.
    7. The order referred to herein is to carry with it an option of placing at any time during the life of said order, and up to within sixty (60) days of its completion, an additional order for guns. If, after completing said order, the United States wishes to continue the manufacture of guns, you are to continue to operate • the plant;
    8. The guns referred to herein will be subject to inspection and acceptance before delivery.
    9. Payment for the entire cost of machining and assembling these guns will be made as follows: At least ninety percent (90%) to be paid you monthly as incurred. The remainder and your profit to be paid you on completion and delivery of the guns and to be included in the next monthly payment after such completion and delivery. The term “ cost ” whenever used in the order referred to herein is understood to mean cost as defined in the “ Definition of ‘ Cost ’ Pertaining to Contracts ”, issued by the Chief of Ordnance, United States Army, June 27, 1917, copy of which is enclosed herewith.
    10. The estimated cost per gun with forgings, at seventy-four cents (740) per pound, and including cost of spare parts and preparation for shipment, is two thousand six hundred twenty-five dollars ($2625). On this basis you will be paid a fixed profit of three hundred ninety dollars ($390) per gun. If the cost is less than the above estimate, you are to be paid an extra profit of 33% percent of the difference between the estimated cost and the actual cost, but a reduction in the cost of forgings is not to benefit you in this extra profit plan.
    11. You will be supplied, by this Department, with one set of master gauges; all working gauges, inspection gauges, and star gauges to be provided by you.
    12. It is agreed that, if owing to a cessation of hostilities or the termination of the war, or for any other reason, it should develop that the United States will not require all or any of the articles or material herein contracted for, then upon due notice the United States may cancel this agreement. It is further agreed that in the event of such cancellation the United States shall reimburse the manufacturer for all authorized expenditures incurred, and obligations outstanding in connection with this contract, up to the date of such notice. It is also agreed that the United States shall pay the fixed profit on all articles completed and accepted, and a profit upon the cost of the work done on those articles in process of manufacture which shall be based on the same percentage as the profit on completed articles. It is further agreed that all unfinished articles, other material, the plant and equipment, shall remain the property of the United States subject to removal at its option.
    13. A formal contract covering the order referred to herein will be prepared in this office and forwarded to you for execution. It will contain a paragraph to the effect that the Eight Hour Act, approved June 19, 1912, will apply, subject to the modifications contained in the Executive Order of March 24, 1917, copy of which is enclosed herewith, and such other usual provisions as may be required by the Chief of Ordnance, United States Army. It is suggested that if you have any doubt as to the acceptability of these provisions, you make inquiry to this office in regard thereto.
    14. Notification of your acceptance of this order is requested.
    Such letter was improperly addressed to the T. H. Symington Co., having reference to the negotiations theretofore conducted with Symington personally. •
    At the first meeting of the incorporators and board of directors of The Symington-Anderson Co., on August 2, 1917, T. H. Symington was elected president and M. H. Anderson vice president and general manager. The minutes of this meeting recited in part as follows:
    Mr. T. H. Symington submitted to the meeting the following letter from Major Jamieson:
    Mr. T. H. Symington,

      Rochester, N. T.

    Dbab Sir:—
    Subject: Contract for 3-inch field Guns. G. C.-102
    In connection with order from this office, G. C.-102 for the manufacture of 3-inch field guns, I am directed by the Chief of Ordnance to authorize you to proceed with the construction of buildings in accordance with plans submitted this day and approved by the undersigned; also, to proceed with the purchase of machinery and equipment in accordance with your letter of July 19th and the exhibits attached thereto, dated July 17th and 18th.
    Very truly yours,
    Chas. C. Jamieson,
    ‘ Major, U. 8. Army, Ret’d.

    and offered to sell and assign all his rights under the contract referred to in said letter to the Company in return for the issue to him or his nominees of ten thousand shares of its capital stock.
    On motion, the offer was unanimously accepted.
    A form of contract, intended to assist in securing the best possible organization, was then submitted, unanimously approved, and ordered signed and spread on the minutes of this meeting. It is as follows:
    Agreement made at Bochester, N. Y., this 2nd day of August 1917, between x The Symington-Anderson Co., party of the first part, T. H. Symington, of Bochester, N. Y., party of the second part, and M. H. Anderson, of South Bethlehem, Pa., party of the third part.
    Whereas, The Symington-Anderson Co., through T. H. Symington, has secured from the United States Government an order for the erection at Boches-ter, N. X., of a plant to machine and assemble 3,000 75 m/m Field Guns;
    And Whereas, in the opinion of all the parties to this agreement, it is essential, in order to secure the most competent men and so secure the best results for the Government, that the organization of the Company should have the incentive of an interest in the business in addition to their regular salaries;
    This Agreement Witnesseth, that The Symington-Anderson Co. hereby agrees with the other parties hereto to distribute among the organization of the Company twenty (20) per cent, of the net profits from said order for 3,000 Field Guns, and an equal percentage of the net profits from all future orders placed with the Company by the Government, to such individuals and in such proportion as may be fixed by unanimous agreement of a committee consisting of T. H. Symington, M. H. Anderson and C. H. Lynn, any vacancy occurring in said committee, for whatever cause, to be filled by- agreement of its two remaining members.
    Seventy-five hundred shares of stock were issued to T. H. Syming-ton and twenty-five hundred shares were issued to M. H. Anderson as nominee. Anderson was selected by Symington as his nominee for what was considered his unusual ability and fitness to perfect an organization and get results. Five thousand shares of the stock originally issued to Symington were assigned by him to the T. H. Symington Co. for the financial assistance it had given and was to give.
    Before the organization of the Symington-Anderson Co. there was an agreement between Symington and Anderson that Anderson was to perform certain duties in obtaining men and getting together an organization to perform this contract, and, if and when the company was formed, Anderson was to receive a certain percentage of the stock for his services.
    Prior to August 2, 1917, plans for the buildings required to house the equipment had been prepared; lists of requirements in machine tools, jigs, templets, and equipment had been made out; the working organization had been gotten together and commitments of approximately $500,000 for machinery for finishing guns .had been made. During this time Anderson, who was actively engaged in.the work, received a salary as vice president of the Symington Machinery Corporation.
    A formal contract for the construction and equipment of the plant was executed by and between the Symington-Anderson Co. and the contracting officer for the Government August 31, 1917. The number assigned to it was G. C. 102.
    An order to machine and assemble three thousand 75 m/m guns, dated November 23, 1917, was addressed to the Symington-Anderson Co. by the Ordnance Department of the United States Army. The number assigned to this order was G-964-34-1-C. It was performed in part by petitioner and deliveries of guns thereunder were made in 1918. No formal contract for this order was executed. With the exception of some later drawings this order was substantially the same as the draft contained in letters of June 15, 1917, and July 27, 1917. It provided for payment to the contractor as follows:
    8. You will be paid tbe entire cost of producing tbe guns herein ordered plus a fixed profit of three hundred and ninety dollars ($390.00) for each gun accepted by the United States and delivered by you.
    4. This fixed profit may be added to in the following manner. Adding the cost of materials furnished by the United States, which is hereby fixed at Nine Hundred and Sixty dollars ($960.00), the estimated cost of spare parts, the estimated cost of preparation for shipment and the estimated cost of machining and assembling, the estimated average cost per gun is Two Thousand Six Hundred and Twenty-five dollars ($2,625.00). On completion of this order the actual average cost per gun will be determined by adding to the actual cost of machining and assembling and the actual cost of the spare parts and preparation for shipment, the sum of Nine Hundred and Sixty dollars ($960.00) per gun, and if the actual average cost is less than the estimated average cost, you will receive in addition to the fixed profit provided for in paragraph three of this order, one third of the difference between the actual average cost and the estimated average cost.
    5. Payments will be made as follows:—
    (a) The cost as incurred, of producing the guns will be paid from time to time but at least monthly.
    (b) Ninety-five per cent (95%) of the fixed profit will be paid monthly for all guns accepted and delivered the previous month or months.
    (c) The remainder of the fixed profit and any additional profit which may be due under the provisions of paragraph four of this order will be paid at the completion of this order.
    After production of guns had begun the order was changed to provide for the manufacture of the French 75 m/m gun in place of the American gun. This resulted in additional expense and slowed down production. Six hundred eighty-seven guns were manufactured by petitioner under this order in 1918. Petitioner’s net income in 1918 was $324,874.85 without allowance for any deduction for exhaustion of its contract. Claim for loss on account of cancellation was made by the Symington-Anderson Co. under the provisions of the Act of Congress approved March 2, 1919, entitled, “Act to provide relief in case of contracts connected with the prosecution of the war and other purposes.”
    The Commissioner determined no invested capital for the petitioner, refused to compute the profits tax under section 328 of the Revenue Act of 1918, refused to allow any deduction for exhaustion of the Government contract, and computed the profits tax under section 302 of the Act.
   OPINION.

Phillips :

Petitioner contends that upon organization it acquired, in exchange for its capital stock, a contract to manufacture 3,000 guns which had a fair market value of $1,000,000, that this represented the cost to it of such contract, and that it is entitled to a deduction for the exhaustion of such cost at the rate of $333.33 per gun manufactured. The respondent contends that all that was assigned to the corporation at organization was a contract to construct a building and install suitable machinery to produce guns, that at that time no order for guns had been placed with Symington and that such order was thereafter placed directly with the petitioner; further, the Commissioner contends that if we hold there was a contract to manufacture guns, it cost the petitioner nothing.

Without determining whether there was in fact any contract, we are of the opinion that no value or cost has been established. Although both Symington and Anderson testified that the contract had a value of $1,000,000 when transferred to the corporation, it appears from other testimony given by them that this was merely another way of stating that if all the guns were manufactured, the minimum profit would be $1,000,000. It appears, however, that the Government reserved the right to cancel at any time, and did in fact cancel after the Armistice, after only about one-third of the guns called for had been finished. In the case of cancellation, the profit stopped, except as to the work already done. Anyone considering the purchase or sale of such a contract could not fail to recognize that the estimated profit was uncertain.

It is contended that the provision of the contract giving to petitioner one-third of the saving resulting from a cost less than $2,625 per gun gave added value to the contract. It is in evidence that guns were produced for less than this amount, despite a costly change from American to French 75 m/m guns. No doubt the officers of petitioner hoped, through the unusual mechanical skill of Symington and Anderson, to realize on this clause, but the possibility at the time the contract was under negotiation does not seem to have been very encouraging, for Symington testifies:

Q. Were you told by the Government’s Agent at Washington, with whom you dealt, what the Arsenal cost of manufacturing similar guns was?
A. I was told that that was the estimate based on cost and studies in the production of that gun, and I was further told that the cost of $2625 was made after due consideration was given to the fact that a large number of guns could be produced at a much less cost than a few guns, so that my inpression was and I so told them that they had made a very low figure for me to shoot at, to which they agreed.

It was because Symington and Anderson were known to be capable of carrying out the contract that it was awarded to them. We do not question for a moment that, combined with their financial standing, their skill and their ability to secure and hold an adequate organization, the contract promised to be valuable. Standing alone as a contract, we doubt if there was any considerable value, for the contract had just been negotiated in a transaction between two parties dealing at arm’s length. The Government was seeking such production and presumably any one who could have assured the officials of his ability to perform such a contract might have obtained one. It is not to be assumed, and we believe that Symington and Anderson would be the last to ask us to assume, that they obtained something from the Government that others could not have obtained if able to perform. The principal asset the petitioner possessed was, we are convinced, the services of these two men and the organization they developed. It was this which led the officials to give them the contract and, with such a situation existing, the petitioner would undoubtedly have been in a position to obtain such a contract direct, had there been none to assign to it.

We are of the opinion that the petitioner is not entitled to any deduction for exhaustion of the contract.

We come then to consider the claim for assessment under the provisions of sections 327 and 328 of the Revenue Act of 1918. Section 327 provides as follows:

Sec. 327. That in the following cases the tax shall be determined as provided in section 328:
(a) Where the Commissioner is unable to determine the invested capital as provided in section 326;
(b) In the case of a foreign corporation;
(c) Where a mixed aggregate of tangible property and intangible property has been paid in for stock or for stock and bonds and the Commissioner is unable satisfactorily to determine the respective values of the several classes of property at the time of payment, or to distinguish the classes of property paid in for stock and for bonds, respectively;
id) Where upon application by the corporation the Commissioner finds and so declares of record that the tax if determined without benefit of this section would, owing to abnormal conditions affecting the capital or income of the corporation, work upon the corporation an exceptional hardship evidenced by gross disproportion between the tax computed without benefit of this section and the tax computed by reference to the representative corporations specified in section 328. This subdivision shall not apply to any case (1) in which the tax (computed without benefit of this section) is high merely because the corporation earned within the taxable year a high rate of profit upon a normal invested capital, nor (2) in which 50 per centum or more of the gross income of the corporation for the taxable year (computed under section 233 of Title II) consists of gains, profits, commissions, or other income, derived on a cost-plus basis from a Government contract or contracts made between April 6. 1917, and November 11, 1918, both dates inclusive.

The Commissioner denied that petitioner fell within this section, claiming that more than 50 per cent of its income was derived from cost-plus contracts. Petitioner asserts that the contract here involved contemplated a fixed profit per gun and a share in the savings, is not a cost-plus contract as such term is generally used, that there are abnormalities of income and invested capital which bring it within subdivision (d) of this section and that in any event it falls within subdivision (a). In his brief the Commissioner contends that if there is a cost-plus contract, petitioner can not have his tax computed under section 328. In this he is clearly in error, since the provision relating to cost-plus contracts is contained only in subdivision (d) of the section and by its express provisions is confined in its operation to that subdivision. The other subdivisions are free of any such limitation.

Section 331 of the statute provides as follows:

In the case of the reorganization, consolidation, or change of ownership of a trade or business, or change of ownership of property, after March 3, 1917, if an interest or control in such trade or business or property of 50 per centum or more remains in the same persons, or any of them, then no asset transferred or received from the previous owner shall, for the purpose of determining invested capital, be allowed a greater value than would have been allowed under this title in computing the invested capital of such previous owner if such asset had not been so transferred or received: Provided,, That if such previous owner was not a corporation, then the value of any asset so transferred or received shall be taken at its cost of acquisition (at the date when acquired by such previous owner) with proper allowance for depreciation, impairment, betterment or development, but no addition to the original cost shall be made for any chaise or expenditure deducted as expense or otherwise on or after March I, 1913, 'in computing the net income of such previous owner for purposes of taxation.

None of the assets, either tangible or intangible, which were paid in to the corporation either for stock or otherwise cost Symington anything. Under the limitations of this provision the corporation apparently had no invested capital when organized. The invested capital can therefore be determined as nonexistent, and the petitioner does not fall within subdivision (a).

In the petition, it is alleged that the Commissioner erred in determining that the contracts in question were cost-plus Government contracts, apparently because petitioner wished to argue that it fell within subdivision (d) of the Act. In its brief, the whole argument is with respect to subdivision (a) and we are without any help in determining what Congress meant by the words “cost-plus.” Reference to standard and law dictionaries and to the committee reports on the Act throw no light on their meaning. Texts on accounting, however, use this phrase to distinguish from the “ lump-sum ” basis. Here the petitioner was to recover its costs in any event and, in addition, a further amount. The word “plus” indicates addition, and the phrase “ cost-plus ” would ordinarily include what we have here; a provision for the payment of cost and something additional. We conclude that the income was derived on a cost-plus basis from a Government contract made between April 6, 1917, and November II, 1918, and that the petitioner is not entitled to have its tax computed under section 328 by reason of any abnormal conditions affecting its income or capital.

It is not contended that petitioner falls within either of the other subdivisions of section 327.

Reviewed by the Board.

Decision will he entered, for the respondent.


text:
    Textile Mill Supply Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 10382.
    Promulgated September 19, 1927.
    1. In determining whether current dividends, ior the purpose of computing invested capital, are paid from current earnings or from surplus existing at the beginning of the year, current earnings should not be reduced by a tentative income and profits tax for the current year.
    2. Claim for assessment under sections 327 and 328 of the Revenue Act of 1918 denied.

      Theodore B. Benson, Esq., for the petitioner.

      P. J. Bose, Esq., for the respondent.
    This proceeding arises from the determination by the Commissioner of a deficiency of $5,374.73 in income and profits taxes for the fiscal year ended May 31, 1920.
    It is alleged that the respondent committed error (1) in deducting a pro rata part of the income and profits tax due for 1919 in determining the amount of invested capital for excess-profits-tax purposes, (2) in reducing current earnings by deducting therefrom a tentative tax in determining the extent to which dividends were paid therefrom, (3) in refusing to determine the tax liability under the provisions of section 328 of the Revenue Act of 1918.
    The first assignment of error was waived by petitioner at the-hearing and is not here in issue.
    FINDINGS OF FACT.
    The petitioner is a corporation organized and existing, under the laws of the State of North Carolina with principal office at Charlotte. During the taxable year in question it was affiliated with the Charlotte Manufacturing Co., also a North Carolina corporation, having the same principal office and place of business, and a consolidated return for both companies was filed. In computing the deficiency the Commissioner reduced the invested capital as of the beginning of the year by current dividends alleged to have been paid from sources other than current earnings. In computing current earnings available for dividends, the Commissioner reduced the earnings by the amount of á tentative tax computed thereon. The computation made by the Commissioner was as follows:
    Invested capital for year_$220,185.18
    Net income for year_ 111, 439. 85
    Tentative tax_ 37, 395.35
    Net income available for dividends_ 74,044.50

    The Commissioner reduced petitioner’s invested capital as it existed at the beginning of the year by $8,341.54, and determined the correct tax liability of the two corporations to be $37,824.21.
    The business engaged in by the petitioner consisted of buying and selling textile mill supplies, such as bobbins, spools, shuttles, shaft-ings, pulleys and bangers. Ninety per cent of the stock of the petitioner was owned by four men, Crampton, Ferris, Glover, and McMahon; these men were officers of petitioner. They gave their entire time to petitioner’s business and, in addition to acting as executives, Glover had charge of buying and Crampton and McMahon were principally engaged in selling, and traveled from Virginia to Texas. In addition to the officers two salesmen were employed. The salaries they received were less than was paid to the officers. Sales were promoted principally through personal contact of the officers. There was some advertising in textile publications, and circular letters and pamphlets were mailed to customers. The total amount expended by petitioner for advertising in the taxable year was $903.55.
    The gross sales of petitioner in the taxable year amounted to $1,172,777.65, ajjd' the consolidated gross sales were $1,278,055.77. The consolidated net income was $107,231.46. The consolidated invested capital was $211,676.12. The excess-profits tax of the affiliated corporations was determined by the Commissioner to be $30,438.73.
    The compensation paid the officers of petitioner was as follows:

      H. J. Crampton, president_$5,100
    IT. B. Perris, vice president- 5, 000
    P. W. Glover, secretary- 6, 000
    P. L. McMahon, treasurer_ 6, 000
    Compensation paid its officers by the affiliated company was as follows:
    P. B. Perris, president_$500
    P. L. McMahon, vice president_ 500
    P. W. Glover, secretary and treasurer_ 800
    A. L. Crampton_ 500
    B. L. Spratt_ 500
    The Commissioner computed petitioner’s profits tax for the previous year, ended May 81, 1919, under section 328 of the Revenue Act of 1918. The rate of profits tax to net income for the last five months of the fiscal year ended May 31, 1919, which fell in the calendar year 1919, as determined by the comparatives used by the Commissioner, was 26.72 per cent. This rate was used in the determination of the profits tax.
   OPINION.

Phillips :

The first assignment of error was waived by petitioner at the hearing and is not here in issue.

In determining what earnings were available for payment of dividends, the Commissioner first computed a so-called tentative tax on the earnings of the year, reduced the earnings by such tentative tax and prorated the resulting figure over the year. We have heretofore had occasion to consider this question in the Appeal of L. S. Ayers & Co., 1 B. T. A. 1135, where we reached the conclusion that such a reduction of the earnings was not justified. The invested capital and the deficiency should be recomputed accordingly.

The petitioner claims the right to have its profits tax computed under the provisions of section 328 of the Revenue Act of 1918, contending that the Commissioner determined that it was entitled thereto in a prior year and that salaries paid were so small as to result in an abnormality of income. The first ground urged seems to us untenable. That the Commissioner may have permitted special relief in one year can not control other years when the question is raised before the Board. If, for example, the Commissioner erred with respect to such year, must such error be perpetuated indefinitely? Furthermore, we do not know on what basis the Commissioner based his determination as to the preceding year. The fact that net income and invested capital are similar in both years would be insufficient to establish that the situation with respect to the factors entering into their computation were the same in each year.

There is nothing from which we may determine whether the salaries paid to the officers were abnormally low, or otherwise. We know that the business earned a substantial net income during the taxable year, but this is not sufficient to enable us to say either that these officers should have commanded larger salaries or that any abnormality exists. The law in section 327 expressly provides that the relief claimed shall not apply to the case where the tax is high merely because the corporation earned a high rate of profit upon a normal invested capital

On the record before us we see no basis for the application of sections 327 and .328 of the Act.

Reviewed by the Board.

Decision will be entered on 15 days' notice, under Rule 50.


author: LaNSdoN : MillikeN :

text:
    Cushman Chuck Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 7812, 11480.
    Promulgated September 22, 1927.
    1. Redetermination of profits taxes under section 328, Revenue Act of 1918 denied.
    2. Redetermination under section 328, Revenue Act of 1918, of profits taxes determined under section 326 of said Act granted for the years 1919 and 1920.

      Barry MoJmn, Esq., for the petitioner."

      A. George Bouchard, Esq., for the respondent.
    These appeals are from deficiencies in taxes asserted by the respondent against the petitioner for the years 1918, 1919, and 1920 amounting, respectively, to $46,678.95, $27,846.51, and $26,608.56. The two appeals were consolidated for hearing.
    The petitioner alleges that the respondent erred in determining the former’s profits taxes for the year 1918 under section 327 and 328 of the Revenue Act of 1918 in that he failed both to select representative corporations and to employ the ratio between the average tax and the average net income of corporations selected as required by section 328 (a) (b) of the Revenue Act of 1918, and also in that he refused to allow the petitioner the benefit of assessment under sections 327 and 328 in the computation of its taxes for the years 1819 and 1920.

      FINDINGS OK FACT.
    Petitioner’s entire business consists of the manufacture of lathe chucks, face plate jaws, and drill chucks. Less than 2 per cent consists in the making of drill chucks. The lathe chuck was invented by John Fairman, whose daughter Harriet was the wife of Austin F. Cushman. Cushman learned his trade as a mechanic before specialization became a necessity. In 1862 he borrowed money of Samuel Woodruff with which he bought a lathe. ' This he rigged with foot power and set up in a hall bedroom of his tenement in the City of Hartford, Conn., and there worked from 10 to 15 hours a day making lathe chucks 3 or 4 inches in diameter, which he took to New York City in dozen lots and sold. In four years he was employing in the business approximately five journeymen mechanics and as many boys. In 1881 the number of employees had increased to approximately 24 men and the annual output of the factory to $25,000. Both of these doubled during the ensuing 4 years and the net profits at that time were at least 25 per cent of the gross income.
    In 1885 Austin F. Cushman and his son, Eugene L., incorporated the business as Cushman Chuck Co., under the laws of Connecticut, with a capital stock of $80,000, divided into 800 shares, of which the two Cushmans took 799 and had one share issued to Adrian P. Sloan, superintendent of the Cushman Company shops, to enable him to hold the office of director, and thus complete the organization. Payments in full were made for all the stock — 25 per cent in cash, 6214 in tangible property of a cash value equal to the par value of the stock and six letters patent of an ascertained actual cash value of at least $10,000. The total number of shares has not been changed since the organization of the company. The factories and office of the corporation are at Hartford.
    The incorporation did not produce any change in the conduct of the business. No stockholders’ or directors’ meetings were held and the founder continued to direct all the activities of the business as fully as he had previously done. But, while Adrian P. Sloan performed no active duties as director, he was given full opportunity to increase the output and salability of the manufactured articles. To this end, he made numerous labor-saving improvements in the machinery. Some of these were patentable, but no patents were applied for. The management kept the inventions as trade secrets.
    Like, and more notable, benefits were derived from the inventions of Harry E. Sloan, son of Adrian, who was employed in the factory when a school boy during vacations and remained there after completing his school work. In 1902 he became foreman of the gear and scroll department, employing approximately 50 men. In 1915 he was promoted to the position of superintendent of the factory, and is now vice president of the corporation. About 1905, he invented a jaw-slotting machine which produced an annual saving to the company of approximately $2,500 per year. Within a dozen years, he had added four other inventions which, with the first, produced an annual saving in labor and better product of approximately $98,500 per year. None of these were patented nor was application made for patents for any of them.
    The elder Cushman died in 1914. Beginning some 20 years prior to his death, he had at sundry times promised Adrian P. Sloan that he would provide in his will a substantial bequest of stock in recognition of the latter’s services on behalf of his employers. But it was discovered after his death that he had left no will. His son, Eugene L. Cushman, inherited all his property. Mr. Sloan then brought the matter to the attention of the son, with the result that the latter transferred to him 100 shares and to Harry E. Sloan 25 shares of the capital stock. These shares had at the time an earning capacity of approximately $85 each per year and an actual value of at least $500 each.
    The respondent determined petitioner’s excess-profits taxes for 1918 by the use of comparatives, under the requirements of sections 327 and 328 of the Bevenue Act of 1918, and for 1919 and 1920 under section 301 of that Act. The petitioner alleges that because of the inability of the respondent to determine its invested capital as provided in section 326, he should have determined its profits taxes for 1919 and 1920 under the provisions of section 328 of the Act, and also that he used inapplicable comparatives in determining such taxes for 1918. It further alleges that there are but three companies in the United States which meet the requirements for such comparatives and that these three are the Skinner Chuck Co. of New Britain, Conn., the Westcott Chuck Co. of Oneida, N. Y., and E. Horton & Son Co. of Windsor Locks, Conn.
    The respondent has ascertained the invested capital and net income of the petitioner and the three certain companies proposed by the latter as comparatives and determined the profits taxes and the petitioner has computed therefrom the ratio of tax to net income of each to be as follows:

    The inventions made by Adrian P. and Harry E. Sloan increased the company’s net earning capacity $100,000 per year and they were productive of approximately that amount during each of the years 1918, 1919, and 1920. * A comparison of the net income of the four companies for the three years involved is as folloAvs:

   OPINION.

LaNSdoN :

With the exception of “ Eatio of Tax to net income,” “ Comparative percentage ” and “ Cushman Company’s excess,” the tabulated statements in the findings of fact are all taken from exhibits submitted at the hearing and are the respondent’s findings. Those relating to net income are not disputed and the petitioner uses them for illustrative purposes in its brief. They indicate very clearly that the Cushman Company had an immense advantage over its three competitors named either in the production or the sale of its products, and probably in both. No suggestion has been made of any reason for this other than that it is due to the inventions made by the Sloans, and inferentially to the mechanical and executive ability of the Cushmans.

The trade secrets invented by the Sloans, while proven at the hearing to have been of great value, do not appear to have been assigned any value in the computation of the taxes, further than as they gave rise to the claim advanced by the petitioner, that the conditions affecting its capital and income were abnormal and that without the benefit of section 328 of the Eevenue Act of 1918, this abnormality would “work upon the corporation an exceptional hardship evidenced by gross disproportion between the. tax computed without benefit of this section and the tax computed by reference to the representative corporations specified in section 328.”

The reason for such abnormality is not far to seek. These secret processes were intangible property. Section 325(a), Eevenue Act of 1918. .They had a clearly defined actual value of at least $100,000 per year, and possessed such value for a number of years, and there was nothing to indicate that the margin of value was decreasing. True, the corporation’s net income had decreased almost 39 per cent from 1918 to 1919 and more than 46 per cent from 1919 to 1920; but that of its direct competitors had decreased to such an extent that none of them had any excess-profits tax for the year 1920. It is not unreasonable to presume that without these inventions, its net income and that of these competitors would have been practically the same. The largest of these, the Skinner Company, had in 1920 a net income of $17,693.70. If the other two averaged $15,000, the total for the three would have been, say, $48,000, the total of the four companies $244,000, and the average $61,000, showing an advantage in net income of $135,000 in favor of the Cushman Company attributable to its trade secrets and other undisclosed causes, and an actual difference in its favor of $177,977.87 over its nearest competitor — more than ten to one.

This working capital forms no part of the corporation’s invested capital within the comprehension of the statute. It has not been “ paid in for stock.” It is not “ paid in or earned surplus,” nor can it be claimed as “ undivided profits,” Herald-Despatch Co., 4 B. T. A. 1096; Shope Brick Co., 5 B. T. A. 1042; J. M. and M. S. Browning Co., 6 B. T. A. 914. In Herald-Despatch Co., at page 1105, we said:

It would be absurd construction indeed which would permit the inclusion in invested capital, under very arbitrary limitations, of intangibles paid in for a consideration, and at the same time permit the inclusion of intangibles paid in as a gift to the full extent of their actual cash value. * * * Reading together subdivisions (a) (3) and (a) (4) of the sections above quoted, we feel constrained to hold that the petitioner is not entitled under the Revenue Acts of 1917 and 1918, to include in invested capital, as paid-in surplus, intangibles acquired by way of gift.

In Shope Brick Co., supra, we held the above quoted language controlling, and in the Browning Company case, at page 926, speaking of certain contracts acquired by that company, we said:

It may also be stated * * * that regardless of the value of the several contracts on January 2, 1915, the date they were acquired by the petitioner, it is not entitled to include that value or any part thereof in its invested capital for the year 1918. The contracts were paid in to the petitioner corporation by the Brownings without any consideration therefor except the nominal consideration of one dollar, and under the decision of this Board in the Appeal of Herald-Despatch Co., 4 B. T. A. 1096, they may not be included in invested capital under section 326 (a) (3) of the Revenue Act of 1918.

It has cost the corporation nothing more than the small expense pertaining to the development of the devices and yet measured by its earning capacity, it is the largest asset or single line of assets the business possesses. As testified by the inventor of the principal improvements, now vice president of the corporation: “It gave us a jump on our competitors, and also was just simply vital to the business.” According to this witness, the five principal inventions made by him saved the company in time and labor $98,500 per year. The minor inventions increased this amount to approximately $100,000. If this increased earning capacity could be considered as invested capital and used in the computation of the profits taxes it would result in a saving to the petitioner of approximately $36,000 in such taxes for the year 1919 and approximately $25,000 for 1920 if computed without benefit of comparatives. This abnormal condition works “ upon the corporation an exceptional hardship ” which should be eliminated if practicable by according to it the computation of its taxes by means of comparatives, as provided by section 328 of the Revenue Act of 1918.

The profits taxes for 1918 were computed by means of comparatives. As to what corporations were used as comparatives, neither the taxpayer nor the Board has any information. These taxes are 62.6 per cent of the net income. Whether this be excessive can not be determined from the facts before us. We know that for the West-cott Chuck Co., engaged in a like business, having a net income of approximately 26 per cent of that of the petitioner, the respondent computed a tax equal to approximately 24 per cent of that assessed against the petitioner — a rate of 62.6 per cent against the petitioner and 57.2 per cent against the other corporation. The seeming disparity may be due to differences in facts relating to comparatives necessarily used. We must and do impute to the respondent good faith and therefore do not deem it just or proper to require that he ascertain again the accuracy of the facts on which he has based certain conclusions unless there be ample reasons submitted to warrant such requirement. In our opinion such reasons are not to be found in the record of this case.

The petitioner states that the three corporations, the Skinner Chuck Co., the Westcott Chuck Co., and E. Horton & Son Co., are the only companies in the United States, except the petitioner itself, engaged exclusively in the manufacture of chucks, and are therefore the only companies which properly can be used as comparatives under section 328 of the Revenue Act of 1918 and should be used as such. Admitting the facts to be as stated we are unable to agree with its conclusions, first, because the companies named are not proper comparatives for 1919 and 1920 or either of these years, and, second, because we deem it possible that there are other companies which may meet all the requireme&ts of comparatives. We pause to consider the former of these reasons.

These comparatives are used only for the determination of excess-profits taxes; and such taxes when determined must bear the same ratio to the net income of the corporation for which they are determined as the average tax of the comparatives to their average net income. For the year 1920, the net income of the Cushman Chuck Co. was $195,671.51; that of its nearest proposed comparative was $17,693.70, not quite 9 per cent as great. As to the second nearest comparative we have no information and the third suffered an actual loss. None of these three paid any profits tax. Consequently the average tax to be considered under section 328 (a) was zero and the ratio of the tax to the net income of the three was as zero to an indeterminate amount, possibly more, possibly less than zero. The petitioner expresses it thus—

Westcott Chuck Co_No information.
Skinner Chuck Co- 00.00
El. Horton & Son Co_ 00.00
Average ratio of profits tax to net income of comparative corporations whose profits tax has been finally determined under section 301_ 00.00

It is obvious from the evidence that the petitioner has shown only that the other three companies were in a similar business. The remaining factors of similarity required by the statute are absent. Clearly the gross income, the net income, profits per unit of business, and employed capital, are not comparable with those of the petitioner.

In view of the foregoing, judgment for the respondent will be entered for the year 1918. For the years 1919 and 1920 the petitioner has. proved that it comes within the provisions of section 327 of the Revenue Act of 1918 and therefore is entitled to the computation of its tax liability for such years under the provisions of section 328 of the same Act.

Reviewed by the Board.

Judgment will he entered on 15 days’ notice, under Rule 50.

MillikeN :

I concur in the result concerning the years 1919 and 1920 and dissent as to the decision concerning the year 1918.

       Sec. 328 granted.

       Not determined.

       Not computed.

         No information.

       Loss.

       Not determined.

       No information.