author: Milliicen:

text:
    H. C. Walker, Jr., Petitioner, v. Commissioner of Internal Revenue, Respondent. Mrs. H. C. Walker, Jr., Petitioner, v. Commissioner of Internal Revenue, Respondent. Elias Goldstein, Petitioner, v. Commissioner of Internal Revenue, Respondent. Mrs. Elias Goldstein, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 8266, 8267, 8268, 8269.
    Promulgated April 29, 1927.
    1. A donation by a husband to his wife of his interest in an oil and gas lease which was community property under the laws of Louisiana, vests in the wife the husband’s then interest in the lease as her separate property and gain resulting from a subsequent sale by the wife should be taxed as her gain.
    2. The right of the husband under the laws of Louisiana to revoke a donation to his wife is a mere power and until exercised the title to the property donated remains in the wife.
    3. Where the owners of an interest in an oil and gas lease sold and transferred their interest for a certain sum of money they are not entitled to a depletion allowance against any gain resulting from the sale, even though the consideration for the sale was payable solely out of royalties.

      Elias Goldstein, Esq., for the petitioners.

      Robert A. Littleton, Esq., for the respondent.
    By agreement these proceedings were consolidated. They involve deficiencies in income taxes for the years 1920 and 1922. In the case of H. C. Walker, Jr., the total deficiency for the two years amounts to $46,104.83, of which the petitioner concedes that $21,900 is due, leaving in controversy, $24,204.83. In the case of Mrs. H. C. Walker, Jr., the total amount of the deficiencies is $48,131.65, of which the petitioner concedes that approximately $23,900 is due, leaving in controversy approximately $24,237.65. In the case of Elias Goldstein, the total amount of the deficiencies for the two years amounts to $39,044.27, of which the petitioner concedes that approximately $15,500 is due, leaving in controversy the sum of $23,544.27. In the case of Mrs. Elias Goldstein, the total amount of the deficiencies for the two years is $45,490.41, of which the petitioner concedes that approximately $21,000 is due, leaving in controversy $24,490.43.
    These deficiencies arise from the refusal of the Commissioner to recognize the gift made by the petitioners, II. C. Walker, Jr., and Elias Goldstein, to their respective wives, and by his refusal to permit the deduction of any allowance for depletion arising from a transaction between the petitioners and Foster, Looney & Wilkinson.

      FINDINGS OF FACT.
    Prior to June 20, 1919, H. C. Walker, Jr., and his wife, and Elias Goldstein and his wife, were the owners in community of certain oil leases, among them being one covering the south half of the northeast quarter of section 24, less the west 30 acres thereof, township 21 north, range 8 west, containing 51 acres more or less, in the Parish of Caddo, State of Louisiana. These leases stood in the name of Walker. On June 20, 1919, Walker together with one Muslow, executed and delivered to George O. Baird, the following instrument:
    Before me, the undersigned authority, personally came and appeared Henry C. Walker, Jr., and Isaac Muslow, residents of Caddo Parish, Louisiana, who declared that they do by these presents transfer, sell, set over, assign and convey unto George O. Baird, husband of Estelle Mitchell, a resident of Caddo Parish, Louisiana, those certain oil and gas leases owned and held by them affecting land in Claiborne Parish, Louisiana, in so far as said leases cover and apply to the following described land, to-wit:
    The South half (S %) of the Northeast Quarter (NE U,) of Section Twenty Pour (24), less the West thirty (30) Acres thereof, Township Twenty one (21) North, Range Eight (8) West, containing Fifty one (51) Acres, more or less; that is to say, the said Henry C. Walker, Jr., transfers in so far as it affects the above described land that certain oil and gas lease executed by Len Langston to Len T. Langston, and by the said Len T. Langston assigned to the said Henry C. Walker, Jr.; and the said Isaac Muslow transfer in so far as' it affects the above described land those certain oil and gas leases executed in his favor by George W. Shaw, Tutor, et al, and by Mrs. Lena Brown, which said leases and assignments are of record in the office of the Clerk and ex-official [sic] recorder of Claiborne Parish, Louisiana, and made part hereof by reference.
    The consideration of this assignment is the sum of Four Thousand ($4000.00) Dollars cash, receipt of which is hereby acknowledged; and other valuable considerations.
    Whereas the lease assigned by the said Henry C. Walker, Jr., purports to cover the entirety of the title to said land, and
    Whereas the leases, the interest in which as to the above described land is assigned by the said Muslow, cover and applies to an undivided one-half interest therein, it is agreed that the obligation Geo. O. Baird, is restricted to the payment of a royalty of one-eighth (%) of the oil; that is to say, one-half (%) of the royalty of one-eighth (%) of the oil is to be delivered in any event to the lessor of the said Walker, his successors or assigns, and the remaining royalty of one-half (%) of one^eighth (%) is to be paid either to the lessors of the said Muslow, their successors or assigns, or to the said Walker’s lessor, his successors or assigns, according to the result of the final determination of the suit involving the title to said undivided one-half interest, now pending in the Third Judicial District Court of Claiborne Parish, Louisiana, between the lessor of the said Walker and the lessors of the said Muslow.
    Executed at Shreveport, Louisiana, in the presence of the undersigned competent witnesses and before me, Notary Public, on this the 20th day of June, 1919.

      ' On the same day Baird executed and delivered to Walker the following instrument in writing:
    Before me, the undersigned notary public in and for Caddo Parish, Louisiana, duly commissioned and qualified, came and appeared George O. Baird, husband of Estella Mitchell, a resident of Caddo Parish, Louisiana, who declared that:
    Whereas on June 20th, 1919, H. 0. Walker, Jr.,- and Ike Muslow, both residents of Caddo Parish, Louisiana, transferred and assigned to him the said George O. Baird certain oil, gas and mineral leases granted by Len Langston and by George W. Shaw, Tutor, et al, and by Mrs. Lena Brown, in so far as they affected the property described in the aforesaid assignment, the description of the aforesaid leases being more fully set forth in the aforesaid assignment ; and
    Whereas the aforesaid assignment recites a consideration of four thousand ($4000.00) dollars and other valuable considerations and is an assignment of the entire interest in the aforesaid leases in so far as they affect the aforesaid property; and
    Whereas the aforesaid leases were owned exclusively by the said H. O. Walker, Jr., in so far as they affect the land described in the aforesaid assignment; and
    Whereas the aforesaid assignment does not fully set forth the agreement between the said H. C. Walker, Jr., and the said George O. Baird;
    Now, therefore, the said George O. Baird declares and acknowledges that he is the owner of only an undivided three-fourths (%) interest in the aforesaid leases in so far as they affect the aforesaid fifty-one (61) acre tract described in the aforesaid assignment and that the aforesaid H. C. Walker, Jr., is the owner of the remaining one-fourth (%) interest therein.
    The said George O. Baird further declares and acknowledges that as part of the consideration for the execution of the aforesaid assignment to him he has bound and obligated himself to drill at his own expense a well for the production of oil on the aforesaid tract in event that the well now being drilled by the Standard Oil Company on the Loewenberg tract immediately north and adjacent to the aforesaid fifty-one (51) acre tract should produce oil or gas in paying quantities. If the aforesaid Standard Oil Company’s well does not produce oil or gas in paying quantities and the said George O. Baird should elect nevertheless to drill a well for the production of oil or gas on the aforesaid fifty-one (51) acre tract, such well shall be drilled entirely at his own expense. The expense of drilling all subsequent wells, if any, on the aforesaid fifty-one (51) acre tract shall be borne by the said George O. Baird and H. C. Walker, Jr., in the proportion of their respective interests in the aforesaid leases.
    The said George O. Baird further declares that he has bound and obligated himself at any time upon demand of the said H. C. Walker, Jr., his heirs or assigns, to execute a conveyance to him of the aforesaid undivided one-fourth (%) interest in the aforesaid leases, subject to and in accordance with the terms of this counter-letter.
    This done and signed in the presence of me, notary, and of the undersigned competent attesting witnesses, on this the 20th day of June, 1919.
    (Signed) Gao. O. Baird
    Witnesses :
    Elias Goldstein
    S. L. I-Ierold,
    (Signed) J. A. Thigpen,

      Notary Public in and for Gaddo Parish, Louisiana.

      George O. Baird at this time was a member of and represented the partnership composed of himself, J. A. Thigpen, E. G. Palmer, R. T. Lane, and subsequent to his death, his widow, and Sydney L. Herold. The George O. Baird partnership proceeded to develop the properties by sinking gas wells. The first well was brought in on August 2,1919, and the second well two days thereafter. In all, four wells were sunk prior to November 1, 1919, which developed first-flow capacity of 50,000 barrels daily.
    In this state of affairs an option was given by Baird to one J. C. Pugh. At -what date this option was given does not appear, but it is stipulated that it -was given prior to November 1, 1919. Realizing that the gains from a sale of the lease -would result in a large amount of income tax, and for the admitted purpose of avoiding the payment of such tax, the petitioners, H. G. Walker, <Tr., and Elias Goldstein, each, on November 1, made a donation of his one-eighth interest to his wife. These donations -were executed and recorded on the same dates and with the exception of the difference in names, are precisely alike. The donation of Walker to his wife is in words and figures, as follows:
    Before me, the undersigned authority, a ¿Notary Public, in and for Caddo Parish, Louisiana, duly commissioned and qualified, came and appeared Henry C. Walker, Jr., a resident of Caddo Parish, Louisiana, who declares that,
    Whereas, he is the owner of an undivided one eighth (%) interest in and to a certain oil, gas and mineral lease granted by Len Langston to Len T. Langston and by Len T. Langston assigned to Henry C. Walker, Jr., and also of an undivided one-eighth (%) interest in and to a certain oil, gas and mineral lease granted by George W. Shaw, tutor, and others to Isaac Muslow, in so far as the aforesaid leases affect and apply to
    South half of the Northeast quarter (S % of NE %) Section (24) less West 30 acres (W 30 A) thereof Township 21 North, Bango 8 West, Claiborne Parish, Louisiana, containing- 51 acres, more or loss, the record title to which leases in so far as they affect the above described tract of land being in George O. Baird, and the interest of the said H. C. Walker, Jr., being covered and set forth in a counter letter not of record, executed by the said George O. Baird, and
    AVhereas, he the said Henry C. Walker, Jr., desires that his wife, Mrs. Lurline Graham Walker should possess an independent fortune of her own.
    Now, therefore, because of his love and affection for his said wife, he, the said Henry C. Walker, Jr., does by these presents grant, assign, convey and donate unto his wife, Mrs. Lurline Graham Walker, the aforesaid undivided one-eighth (%) interest, being all of the interest owned by him, in the aforesaid leases in so far as they affect and apply to the above described tract of land.
    And hereunto appears the said Mrs. Lurline Graham Walker, for the purpose of accepting this donation.
    This done and signed before me, Notary and in the presence of the undersigned competent witnesses on this 1st day of Nov. 1919.
    These donations have not been revoked. Each husband administers his wife’s affairs.

      In December, 1919, tbe exact date not appearing, Pugh negotiated a sale of the lease to J. Roger Flannery, of Pittsburgh, Pa. The consideration for this sale was $2,500,000, of which Mr. Flannery paid prior to January 1, 1920, $500,000, and obligated himself to pay a further sum of $300,000 in January, 1920. When $800,000 was paid, Baird was to execute a deed conveying the lease, taking five notes of Flannery in the sum of $300,000 each, due on or before 30, 60, 90, 120, and 150 days, respectively, after the date of the deed, and one note of $200,000 due on or before 180 days after the date of the deed.
    Flannery did not pay the $300,000, or anj*- part thereof, which became due in January, 1920, nor did he make any further payments after paying the $500,000 above mentioned, and the contract between the George O. Baird partnership and Flannery was rescinded.
    The sale to Flannery was made on the following basis: The commissions of Pugh and his associates were to be deducted from the purchase price, leaving a net purchase price of $2,162,000. Of this, it was estimated that $100,000 had been expended by the partnership in the drilling of wells, and the making of other improvements, and $62,500 was the approximate value of oil tanks which had been contracted for and which were to be placed on the property, leaving the net amount of $2,000,000, which was to be divided between the owners of the lease in proportion to their respective shares.
    In December, 1920, Mrs. Walker and Mrs. Goldstein sold their interests in the lease to the remaining members of the George O. Baird partnership, for the sum of $250,000 each, or for what would have been their proportionate share of the total purchase price which would have been paid by Flannery had the sale not been rescinded.
    The value of the shares of Mrs. Goldstein and Mrs. Walker, on November 1, 1919, the date of the donation, was $500,000, or $250,000 for each share.
    The transactions between the petitioners and Foster, Looney & Wilkinson appear from an agreement entered into between them, dated June 23, 1920, which reads:
    Before Me, the undersigned authority, a Notary Public in and for Caddo Parish, Louisiana, duly commissioned and qualified, came and appeared George West, husband of Missouri Kimbell, a resident of Claiborne Parish, Louisiana, Henry C. Walker, Jr., husband of Lurline Graham, Elias Goldstein, husband of Fannie Levy, both residents of Caddo Parish, Louisiana, hereinafter referred to as vendors, and James M. Foster, a single man, Frank L. Looney, husband of Adeline Leonard, and W. A. Wilkinson, husband of Annie Carter, all residents of Caddo Parish, Louisiana, hereinafter referred to as vendees, who declared; that,
    Whereas, there is pending in the United States District Court, for the Western District of Louisiana, a suit entitled Lillie G. Taylor, vs. George West, which suit is numbered 1235 on the docket of the aforesaid Court, and involves the title to:

      All of the Southeast Quarter of the Southeast Quarter (SE % of SE A4), Section Eighteen (18) Lying South of the Minden and Sykes Ferry road; the Northeast Quarter of the Northeast Quarter (NE A4 of NE %), Section Nineteen (19) ; and all of the Northwest Quarter of the Northeast Quarter (NW % of NE %), Section Nineteen (19), except that part thereof known as a part of the Len Langston Farm; and the Northwest Quarter of the Northwest Quarter (NW % of NW %) Section Twenty (20) Township Twenty one (21) North Range Seven (7) West, Claiborne Parish, Louisiana, being 91 acres, more or less; and:
    Whereas, the aforesaid vendees have acquired from the aforesaid Lillie G. Taylor an interest equal to an undivided one-half {%) interest in the minerals in and under the aforesaid tract of land subject to the leases granted by the said Lillie G. Taylor, which interest, being one-half (%) of the entire royalty reserved by the said Lillie G. Taylor under the lease granted by her, amounts to an undivided one-sixteenth (fg) of the oil, gas and other minerals produced and to be produced from the aforesaid premises; and,
    Whereas, the aforesaid George West having granted an oil, gas and mineral lease affecting the above described tract of land and other lands, to the said Henry C. Walker, Jr., and the said H. C. Walker, Jr., having assigned the said lease to the Gulf Refining Company of Louisiana, reserving to himself and in his favor an undivided one-twenty-fourth (s^i) of all the oil, gas and other minerals produced from the aforeaid land; and,
    Whereas, the parties hereto desire and have agreed to compromise the aforesaid law suit in so far as it relates to the interest above described, together with one-sixth (%) of the royalty reserved by the said George West under the aforesaid lease to H. 0. Walker, Jr., which one-sixth (%) is equivalent to one-forty-eighth (5V) of the oil, gas and other minerals produced from the aforesaid lease; and,
    Whereas, all of the parties hereto have agreed that such compromise shall be effected by the sale by-the said H. C. Walker, Jr., and the said Elias Gold-stein, to the said Vendees of the said one-twenty-fourth (A) interest, and by a sale to the same parties by the said George West of an undivided one-forty-eighth (Ag-) interest in the oil, gas and other minerals produced from the aforesaid land (including one-sixth (%) of the total royalty reserved by the said George AVest under the aforesaid lease) ;
    The consideration of this sale is the sum of Two Hundred Thousand ($200,000.09) Dollars, to be paid entirely out of the oil produced from the above described tract of land, either by the lessees of the said George West and their assigns, or by the lessees of the said Lillie G. Taylor and their assigns and accruing to the credit of the undivided one-sixteenth (N) interest that is vested in the said vendees by reason of the purchase above referred to by them from the said Lillie G. Taylor on the one hand, and by reason of their purchase from the said vendors under this contract on the other hand.
    Immediately upon the execution of this contract the said vendees shall be entitled to withdraw and receive from the Gulf Refining Company of Louisiana, all sums accruing to the credit of the interest hereby transferred to them by the said vendors, up to June 1st, 1920, which sums shall be retained by them free of any claim on the part of these vendors; but all sums hereinafter accruing to the credit of the aforesaid one-sixteenth (ig) interest shall be paid by the lessees under the leases granted by the said Qeorge West and by Lillie G. Taylor, their heirs and assigns to the City Savings Bank & Trust Company of Shreveport, Louisiana, hereinafter referred to as the bank, which bank is hereby made the agent of all the parties hereto for the purpose of receiving such royalty, acknowledging receipt thereof and holding and distributing the sums in accordance with the provisions of this contract.
    The sums received by the said bank under this contract shall be deposited to the credit of an account to be known as “ Escrow Account, George West, H. 0. Walker, Jr., and Elias Goldstein”, and shall be paid out by the said Bank as follows:
    On the 2nd day of January, 1921, 1922, 1923, and 1924, the aforesaid bank shall withdraw from the said account the sum of Fifty Thousand ($50,000.00) Dollars, and shall credit same to the said vendors in the proportion of one-third (%) to each. In the event that there should not be sufficient funds to the credit of the aforesaid account to make such payment at the due date thereof, the said bank shall pay to the said vendors the entire amount to the credit of the said account, and shall continue to make payments from month to month as sums are received by it to the credit of the said account until the deficiency in the payment shall have been made up.
    If the full sum of Two Hundred Thousand ($200,000.00) Dollars shall not have boon received by the aforesaid bank on or before the 2nd day of January, 1924, then and in that event the royalties accruing to the credit of the aforesaid one-sixteenth (h?) mineral interest shall continue to be paid to the said bank until it shall have received the full sum of Two Hundred Thousand ($200,000.00) Dollars; it being the intent of the parties to this contract that the said vendors shall receive Two Hundred Thousand ($200,000.00) Dollars out of the royalties accruing to the credit of the aforesaid undivided one-sixteenth (A) interest before the said vendees shall receive any further income from the aforesaid royalties or become entitled to any portion thereof.
    Now, therefore, the said H. O. Walker, Jr., and Elias Goldstein do sell, transfer and convey unto the aforesaid vendees the excess royalty of one-twenty fourth (A) of all the oil, gas and other minerals reserved by them under the aforesaid lease granted by George West and assigned to the Gulf Refining Company of Louisiana in so far as same affects and applies to the above described tract of land; and the said George West sells, transfers and conveys to the said vendees an undivided one-forty-eighth (A) interest in the oil, gas and other minerals in and under the aforesaid land, including an undivided one-sixth (%) of the royalty reserved by him under the aforesaid lease in so far as same affects and applies to the above described tract of land under the following terms and conditions, and for the consideration as hereinafter set forth.
    This sale is made without warranty of any kind even as to the return of the purchase price; and the execution of this instrument by the parties hereto shall not be regarded as a recognition by any of the vendees hereunder of the title of the said vendors to the interest herein conveyed or any part thereof, and shall not be construed as a recognition by the said vendors of any title or interest in the said Lillie G. Taylor and said vendees in and to the aforesaid land, and shall be entirely without effect upon the aforesaid suit now pending in the United States District Court, except with regard to the interest conveyed.
    Subsequent to the execution of the above contract, the taxpayers acquired the interest of George West, but the amount of the consideration does not appear.
   OPINION.

Milliicen:

The first question presented is the effect of the donations made by the petitioners Goldstein and Walker, to their respective wives of their then interests in the Baird oil lease. If the donations had the effect of vesting in the wives the then interests of their husbands and this was accomplished before the accrual of any gain, it is immaterial what was the motive that impelled the donors to make the gifts, even though that motive was to avoid the payment of taxes. Cf. United States v. Isham, 17 Wall. 496.

At the outset it should be observed that the sale to Flannery was not consummated until after the donations had been made, and further, that the sale to Flannery was rescinded after he had paid only one-fifth of the purchase price. The sale, which is the source of the controversy, was not the sale to Flannery, but a sale to the remaining members of the George O. Baird partnership, which was made a little over a year after the Flannery sale, and after Flannery had defaulted on his contract. It is clear, therefore, that if the donations were valid, the subject matter of the gift was not the gain from a sale, but was the donors’ interests in the lease itself.

It should be further noted that there was no concealment or secretiveness about these donations. They were recorded in the proper office and are public records.

Articles 1746 and 1749 of the Civil Code of Louisiana provide:

1746. — One of the married couple may, either by marriage contract or during the marriage, give to the other, in full property, all that he or she might give to a stranger.
1749. — All donations made between married persons during marriage, though termed inter vivos, shall always be revocable.
The revocation may be made by the wife, without her being authorized to that effect by her husband, or by a court of justice.

The respondent contends that the donations were void and in support of his contention cites Kelly v. Kelly, 131 La. 1024; 60 So. 671. This case involved what the court held to be a gift from a husband to his wife of practically all that he possessed, and after quoting article 2446 of the Civil Code with reference to contracts of sale between husband and wife, held the gift void. The gist of the decision is found in the following excerpts:'

It concerns the state that a donor should not pauperize himself.

Again:

In this case the evidence shows that the transfer of the lot and house in dispute was without legal consideration and left the husband without means of subsistence.

No such question arises in this proceeding. The respondent cites Hanby v. Texas Co., 140 La. 189; 72 So. 933; and Shaw v. Watson, 151 La. 893; 92 So. 875, to the effect that the interests of the taxpayers in the oil lease in controversy fall within the category of immov-ables. He then refers to article 2404 of the Civil Code. The question raised by respondent was before the Supreme Court of Louisiana in Snowden v. Cruse, 152 La. 144; 92 So. 764. In that case the court held a donation by a husband to a wife of his interest in community real estate was valid. The court said:

This is a partition suit. The defendants, five in number, are the uterine brothers and sisters of plaintiff. The real estate to be partitioned was purchased by plaintiff’s father after his marriage to the mother of all the parties, and was donated by him to her during the marriage. The only issue involved is as to the proportions in which the property shall be divided; i. e., shall plaintiff receive one-half the property as sole heir of his father, and one-sixth of the other one-half as one of the six heirs of his mother; or shall each of the parties receive one-sixth of the whole property as equal heirs of their mother. And that involves the validity vel non of the donation made by the father to his wife; if the donation was void, then the property remained to the community, and must be divided in the proportions first stated; if the donation was valid, then the property belonged exclusively to the mother, and must be equally divided between her six children.
1.
The contention of plaintiff is that the donation was void because in contravention of the Civil Code, art. 2404 (2373), reading in part as follows:
“ * * * He [the husband] can make no conveyance inter vivos, by a gratuitous title, of the immovables of the community, nor of the whole, or of a quota of the movables, unless it be for the establishment of the children of the marriage. * * * ”
This limitation on the right of the husband, as head and master of the community, to do as he pleased with the effects of the community, was first introduced into our law by the Code of 1825, and is taken verbatim from the Code Napoleon, art. 1422.
The French authors, and the French jurisprudence, from the very first time the question arose before the Court of Cassation in 1850, have been unanimous and uniform that this provision concerns the wife alone, and hence if she joins her husband in the donation, it is valid as to her, and consequently as to all other persons. These authorities are gathered in a long list, to be found in Baudry-Lacantinerie, vol. 16, p. 612, note 2; and in Dalloz Code Annotee, art. 1422, Nos. 61-67.

After citing several cases, the court proceeds:

And it follows a fortiori that if the donation be made to the wife herself, the donation is all the more valid. Fuzier-Herman, vol. 3, p. 1010, art. 1422, No. 46.

The opinion concludes:

The proposition that the donation, even if valid, and no longer reducible, yet left the property in the community, is simply to say that the donation produced no effect, which is but to say in another form that the donation was void. This has already been considered.

We must, therefore, conclude that the donations of November 1, 1919, were valid under the law of Louisiana, and that the interests in the lease donated became the separate property of the donees under article 2334 of the Civil Code, which in part declares:

The property of married persons is divided into separate and common property.
Separate property is that which either party brings into the marriage, or acquires during the marriage with separate funds or by inheritance, or by donation made to him or her particularly.

The remaining question with reference to these donations, is whether the power of revocation, in article 1749 of the Civil Code, makes these donations merely colorable transactions, or, in other words, what effect, if any, does the power of revocation have on the ownership of or title to property donated.

Under the rule laid down in Snowden v. Cruse, supra, the property donated passed in each case from the community and became the wife’s separate estate. The title to the donor’s interest in the lease vested in the donee. The effect on the title to property granted of a power to revoke the grant and appoint to other uses is thus stated in Jones v. Clifton, 101 U. S. 225:

The powers of revocation and appointment to other uses reserved to the husband in the deeds in question do not impair their validity or their efficiency in transferring the estate to the wife, to be held by her until such revocation or appointment be made.

And, again:

The title to the land and the policies passed by the deeds; a power only was reserved. That power is not an interest in the property which can be transferred to another, or sold on execution, or devised by will.

Compare Newhall v. Casey, 18 Fed. (2d) 447, decided by the District Court of the United States for the District of Massachusetts, March 22, 1927.

The gifts have not been revoked. The title to the donors’ interest in the lease passed by the donation to their respective wives, and the proceeds of the sale, which in this case involved no gain, went with the right of ownership. Dillon v. Freville, 129 La. 1005; 57 So. 316; Sharp v. Zeller, 110 La. 61; 34 So. 129. The proceeds of the sale of the interests donated were the separate property of the donees. Since the donors had at the time of the sale no title, no right of ownership, nothing except, a power of revocation, they can not be held to have had any right to the proceeds arising from the interests donated, nor can they be taxed upon any gain arising therefrom.

That the contract of sale to Flannery was made in good faith, is shown by the fact that before he defaulted, Flannery had paid $500,000 on the purchase price. This contract of sale, which was made by a willing seller to a willing buyer, and which was consummated shortly after the date of the donations, and under an option granted just prior to that date, is the best evidence of the value of the donees’ interests in the lease donated at the time the donations were made. The value thus established is also borne out by the testimony of the witnesses, two of whom, E. G. Palmer and George O. Baird, are experienced oil men. The amounts received by Mrs. Walker and Mrs. Goldstein from the George O. Baird partnership, for the interests given them by their husbands, are precisely what they would have received if the Flannery sale had not been rescinded. It is clear,.therefore, that the amounts received by the donees for so much of their interests in the lease as they received by virtue of the donations were not greater than the value of the interests at the date of the donation.

The remaining question is whether the petitioners should be permitted to take as a deduction a depletion allowance against the gain made by them in the transaction with Foster, Looney & Wilkinson.

The contract between the petitioners and West on one side, and Foster, Looney & Wilkinson on the other, refers to the petitioners and West as “vendors” and to Foster, Looney & Wilkinson as “ vendees,” which term we adopt for the purpose of this opinion. It recites that in consideration of $200,000, to be paid entirely out of the oil produced on the tract of land described in the contract “ the said FI. C. Walker, Jr., and Elias Goldstein do sell, transfer and convey unto the aforesaid vendees the excess royalties of one twenty-fourth (1/24) of all the oil, gas and other minerals reserved for them under the aforesaid lease * * *.”

Petitioners claim that we should disregard the words used in the contract and look to its substance, and that when so viewed it was not a contract of sale but that under it their rights as lessors were continued until they had received $200,000 out of the oil and that by the contract the petitioners and George West were recognized as the owners of the one-sixteenth royalty interest which was the subject of the contract. These contentions are not borne out by the recitals and the provisions of the contract. It clearly appears that the vendors and vendees were claiming under adverse titles, and that the purpose of the agreement was not to recognize the rights of each other, but to settle the controversy by a compromise of that which had theretofore been contested. The sum of $200,000 was “ to be paid entirely out of the oil produced from the above described tract of land, either by the lessees of the said George West and their assigns, or by the lessees of the said Lillie G. Taylor and their assigns and accruing to the credit of the undivided one-sixteenth (1/16) interest that is vested in the said vendees by reason of the purchase above referred to by them from the said Lillie G. Taylor on the one hand, and by reason of their purchase from the said vendors under this contract on the other hand.”

It thus appears that the $200,000 was not payable to the petitioners and West out of their interest in the oil, but was payable out of the interest of the vendees, which they had acquired from Lillie G. Taylor, and from the petitioners and West.

Putting aside the fact that the contract uses the words “ sell, transfer and convey,” and the words “ vendors ” and “ vendees,” and looking to the substance of the contract alone, the conclusion can not be escaped that the contract was a contract of sale which divested the taxpayers and West of all interest in the property therein referred to, and vested eo instanti the title thereto in the vendees for the consideration of $200,000, payable out of the royalties the contract for which was assigned to the vendees. Such being the case, the respondent did not err in refusing to allow the petitioners a deduction for depletion.

Judgment will be entered in accordance with the above decision, on W days’ notice, under Rule 50.


source: Caselaw Access Project

author: Smith: Murdoch and GreeN

license: Public Domain

text:
    Kleeson Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 7050, 19116.
    Promulgated April 30, 1927.
    Where a corporation acquired without cost in 1919 a contract for the hire of convict labor, held, that the value, if any, of such contract may not be included in invested capital. Seld, further, that the evidence does not warrant a finding that the contract had a value at the date of acquisition, the exhaustion of which may be spread over the life of the contract and an aliquot part of which may be deducted from gross income in income-tax returns.

      Robert McNeill, Esq., and James A. Councilor, Esq., for the petitioner.

      W. E. Gibbs, Esq., for the respondent.
    This is a proceeding for. the redetermination of deficiencies in income and profits tax for the fiscal years ended April 30, 1920, 1921, and 1922 in the respective amounts of $21,874.38, $4,800.13, and $14,-050.51. The appeal entered under Docket No. 7050 relates to the years 1920 and 1921, and the appeal entered under Docket No. 19116 relates to the year 1922. The issues in each appeal being identical, the appeals were consolidated for the purpose of this proceeding. The petitioner alleges that the Commissioner erred in not including in its invested capital for each of the years involved $150,000 as the value of a contract under which it operated and in not allowing as a deduction from gross income for each of the years involved an aliquot part of the value of said contract representing exhaustion thereof.
    FINDINGS OF FACT.
    John A. Bloyd, a resident of Moundsville, W. Va., was from 1897 to 1913, one of the managing directors of the penitentiary in Moundg-ville. The board of directors consisted of five individuals appointed by the Governor. Bloyd was resident director and treasurer of the penitentiary. As such director he had much to do with the letting of contracts for the employment of convicts in the penitentiary during his term of office. During such term three contracts similar to the one mentioned below were let and were renewed at the end of each five years. One was the J. C. Bardol contract, one the Kraft Manufacturing Co. contract, and the other the Joseph Klee’s Sons contract. Two of these were in existence at the time Bloyd became managing director, and one, the Kraft contract, was let by him and his associates. These contracts were let to the highest bidders after due advertisement had been made. The renewals were also made upon bids received in response to advertisements. Under the Bardol contract the pay for the convict labor hire was originally 62 cents per day and was increased until in 1919 it was 90 cents per day. The price paid for convict labor under the other two contracts ranged from 52 or 55 cents to 72 cents per day. The Klee’s Sons contract or renewals thereof had been in effect for about 25 years prior to 1919. This contract called for the employment of 200 convicts in a pants factory located in the penitentiary grounds. In 1913, 62 cents per day for convict labor was paid under this contract. In 1913 the letting of the contracts was taken over by the State Board of Control, which was then given charge of all the penal and eleemosynary institutions of the State.
    The so-called Klee’s Sons contract was let to two brothers, the sons of Joseph Klee, one of whom lived in New York and one at Wheeling, W. Ya. These brothers had married wealthy women and were reputed to have accumulated a considerable fortune from the operation of the prison contract. They desired to retire from the business in 1919, at Miich time their then contract had two years to run. They had been closely associated with Bloyd for a number of years and offered to sell their contract to him provided he would pay them $10,000 for machinery and equipment and pay the invoice price of the merchandise on hand, and provided he would permit M. Bachenheimer, who had been the manager of the factory and had been in their employ for a period of 20 years, to acquire an interest in the business and be contimied in employment. Bloyd learned from the State Board of Control that it would be willing that he should be substituted for the Klee brothers as contractor and would be willing to execute a new contract for a period of five years on approximately the same terms as the contract then held by the Klee sons. The State Board of Control was not required to advertise for bids before the contract was let. If in their opinion the letting of the contract was for the best interests of the State the same could be entered into. Bloyd knew the intimate workings of the different contracts for the employment of convict labor and he believed that the contract could be operated profitably.
    On March 26, 1919, the State Board of Control, party of the first part, entered into an agreement with J. A. Bloyd and Marcus Bachen-heimer, parties of the second part, whereby the party of the first part agreed on behalf of the State to furnish the parties of the second part certain convict labor at a stipulated per diem hire for the purpose of operating the pants factory within the state penitentiary at Moundsville. The parties of the second part were also to have the use of certain factory buildings on the premises rent free in which the work was to be performed. The contract was to run for a period of five years beginning July 1, 1919. Material parts thereof read as follows:
    This Agreement, Made and entered into this 26th day of March,- 1919, by and between the State Board of Control of West Virginia, a corporation, party of the first part, hereinafter called “State Board of Control”, and John A. Bloyd and M. Bachenheimer, parties of the second part, hereinafter called “ Contractors.”
    Witnesseth, That for and in consideration of the covenants and agreements of the Contractors, hereinafter contained, the State Board of Control hereby agrees to hire and let to the Contractors for the term of five years from and including the first day of July 1919, the labor and services of two hundred (200) male convicts in the West Virginia Penitentiary, with the privilege of as many more as may mutually be agreed upon, such men to be what are generally denominated able bodied men, who shall then or may thereafter be confined in the said Penitentiary, to be employed by the Contractor in the manufacture of pantaloons, overalls, and other articles of men’s clothing, except shirts and underwear.
    And the said party of the first part hereby covenants with the Contractors, not to permit any other contract for the same kind of business within the Penitentiary during the life of this contract.
    For the puri>ose of carrying on the business herein named the Contractors shall have and be permitted to occupy all of the shop room that is now being used by the Joseph Klee’s Sons Company, * * * and the said Contractors
    agree to pay to the State Board of Control for fire protection $500.00 per year, or $41.66% per month, to be paid monthly as above provided for payment of electricity.
    * * * * * * *
    The daily tasks to be performed by the convicts is to be fixed by the Warden and the Contractors by mutual agreement, subject to confirmation by the State Board of Control. The Contractors agree to pay for all overtime done by any convict at the same rate per day as that paid for the daily task of the convicts; and to pay for said overtime monthly in cash to the Warden on or before the tenth day of the month following that in which the work is done. * * *
    It is further understood and agreed between the parties hereto that the Contractors are to pay the sum of seventy-two cents (72Í) per day for each convict so employed under this agreement, payments for said labor to be made on or before the tenth day of each month for the previous month’s labor, and in the form and manner as prescribed by law.
    If for any cause there should be a deficiency in the number of convicts available for labor, and thereby the State Board of Control should he unable to furnish the Contractors with the labor of the full number of convicts called for herein, then the Contractors shall accept the same proportion of the whole number hereinbefore specified as may he furnished other contractors employing convict labor in said Penitentiary, and in such event the Contractors shall pay for the labor of only such convicts as are actually employed by it, but shall not be entitled to any damages or other compensations on account of such deficiency.
    It is understood and agreed that should the National Government pass laws inimical to the sale of prison made goods to such an extent as to make unlawful the sale of goods manufactured under this contract, or should a majority of the following states pass such laws, namely; Massachusetts, New York, New Jersey, Pennsylvania, Ohio, Indiana, Illinois, Maryland, Texas, California, Michigan, Missouri, and West Virginia, then the Contractors may cancel this contract by giving sixty (60) days notice in writing of its intention so to do to the State Board of Control.
    The Contractors have filed with the State Board of Control, their bond in the penalty of Twenty Thousand Dollars ($20,000.00) conditioned for the faithful performance of its duties hereunder, and the payment to the State Board of Control of all money due under the provisions hereof.
    Bloyd and Bachenheimer originally intended to operate the business by themselves, believing that the capital which they had, approximately $100,000, was sufficient therefor. After the contract-had been secured, however, they found that their capital was inadequate and that the business would require a capital of at least $200,-000. Accordingly, it was decided to incorporate a company, the xie-titioner, for the purpose of taking over and operating under the above described contract. The petitioner was incorporated on August 16, 1919, with an authorized capital of $300,000 of which amount it was contemplated that $200,000 should be immediately paid in. Bloyd was elected president and has been president of the corporation ever since. Bloyd and Bachenheimer subscribed for slightly less than one-half of the total stock. Business friends of BI03M subscribed for the balance of $200,000 stock being induced thereto by the statement of Bloyd that in his opinion the contract itself had a value over and above the amount to be paid to the Klee brothers for machinery and merchandise of $150,000.
    On or about April 22, 1919, a meeting of the stockholders of the corporation was called at which the corporation agreed to accept from Bloyd and Bachenheimer an “ assignment of an agreement made by them with the State Board of Control of West Virginia, dated March 26, 1919, for the hire and let of the labor of 200 convicts, with other rights and privileges, and for the compensation therein fixed, and that the company assume the obligations and duties therein imposed by John A. Bloyd and Marcus Bachenheimer in their place and stead, and that the president be and hereby is authorized to execute on behalf of this company a contract bearing the date of the 26th day of March, 1919, with the State Board of Control of West Virginia, for the hire and let of the labor of 200 convicts, with the same other rights and privileges and for the same compensation as provided in the above agreement.”
    On May 1, 1919, the State Board of Control entered into a contract of like tenor and effect as the contract entered into with Bloyd and Bachenheimer on March 26, 1919, in which the Kleeson Company was named as party of the second part in place of J. A. Bloyd and M. Bachenheimer.
    Under the contract no rental was chargeable to the petitioner for the nse of the factory buildings which it occupied on and after July 1, 1919. The two buildings mentioned in the contract were furnished petitioner free of rent. They were of brick construction about 40 feet wide by 200 feet long and occupied for factory purposes. One was a three-story building with a central heating 'and lighting plant occupying one end of the ground floor. The buildings were kept in repair and heated without cost to the contractor but the petitioner was charged for the electricity used.
    In addition to the stipulated amount of 72 cents per day which was to be paid to the State for the services of each convict, the petitioner also paid to the individual convicts a bonus computed on a piece work basis for all work performed over a specified quantity, known as “ the task.” During the years 1920 to 1924, inclusive, the petitioner, operating under the contract, paid to the State and to the individual convicts the following amounts:

    The average total paid to each convict was approximately 95.5 cents per day. The average minimum hire for free labor of approximately equal value would have been about $2 per day.
    During the same period, the petitioner operated another pants factory in the City of Moundsville, in conjunction with the one within the penitentiary, using free female labor. On a comparative basis, the production per person was substantially higher in the prison factory than in the outside factory. The cost of labor in the outside factory per unit of production was approximately double that in the prison factory.

      The net income and net tangible investment, exclusive of the contract here in question, of the Kleeson Company for the five years covered by the contract were as follows:

    In the year 1923 one Isadore Gordon, who had a similar contract with the State Board of Control (formerly the Kraft Manufacturing Co. contract) calling for the hire of 400 male and female convicts," sold his contract, then having a remaining life of four years, together with the entire business for the sum of $200,000. Of this amount $125,000 was paid in cash, $25,000 by note, and $50,000 in stock of the purchasing company. Under this contract Gordon was manufacturing shirts for a New York company which furnished the material and paid a stipulated price per dozen for the manufacturing.
   OPINION.

Smith:

The issues to be considered are (1) whether the value, if any, of the contract above described may be included in the petitioner’s invested capital; (2) what amount, if any, of such value representing exhaustion thereof, may be deducted from income for each of the years involved; and (3) the actual cash value of the contract at the time acquired by the petitioner.

The petitioner contends specifically (1) that the total value of the contract should be included in invested capital as representing tangible property; or in the alternative, (2) that the value of the leasehold contained in the contract should be included in invested capital as tangible property in an amount equal to the total value claimed for the contract; (8) that the contract had a fair market value when acquired of at least $150,000; (4) that the entire value of the contract should be exhausted ratably over the five years of its life.

The statutory definition of invested capital is found in section 326 of the Revenue Act of 1918, which reads as follows:

Seo. 326. (a) That as used in this title the term “invested capital” for any year means (except as provided in subdivisions (b) and (c) of this section) :
(1) Actual cash bona fide paid in for stock or shares;
(2) Actual cash value of tangible property, other than cash, bona fide paid in for stock or shares, at the time of such payment, but in no case to exceed the par value of the original stock or shares specifically issued therefor, unless the actual cash value of such tangible property at the time paid in is shown to the satisfaction of the Commissioner to have been clearly and substantially in excess of such par value, in which case such excess shall be treated as paid-in surplus: Provided., That the Commissioner shall keep a record of all cases in which tangible property is included in invested capital at a value in excess of the stock or shares issued therefor, containing the name and address of each taxpayer, the business in which engaged, the amount of invested capital and net income shown by the return, the value of the tangible property at the time paid in, the par value of the stock or shares specifically issued therefor, and the amount included under this paragraph as paid-in surplus. The Commissioner shall furnish a copy of such record and other detailed information with respect to such eases w'hen required by resolution of either House of Congress, without regard to the restrictions contained in section 257;
(3) Paid-in or earned surplus and undivided profits; not including surplus and undivided profits earned during the year;
(4) Intangible property bona fide paid in for stock or shares prior to March 3, 1917, in an amount not exceeding (a) the actual cash value of such property at the time paid in, (b) the par value of the stock or shares issued therefor, or (c) in the aggregate 25 per centum of the par value of the total stock or shares of the corporation outstanding on March 3, 1917, whichever is lowest;
(5) Intangible property bona fide paid in for stock or shares on or after March 3, 1917, in an amount not exceeding (a) the actual cash value of such property at the time paid in, (b) the par value of the stock or shares issued therefor, or (c) in the aggregate 25 per centum of the par value of the total stock or shares of the corporation outstanding at the beginning of the taxable year, whichever is lowest: Provided, That in no case shall the total amount included under paragraphs (4) and (5) exceed in the aggregate 25 per centum of the par value of the total stock or shares of the corporation outstanding at the beginning of the taxable year * * *.

Since the contract here in question was acquired by the petitioner as a gift, the question of whether its value in any amount may be included in invested capital as intangible property comes squarely within our ruling in the Appeal of Herald-Despatch Co., 4 B. T. A. 1096, and must therefore be decided adversely to the contentions of the petitioner.

The 1918 Act defines intangible property and tangible property as follows:

The term “ intangible property ” means patents, copyrights, secret processes and formulae, good will, trade-marks, trade-brands, franchises, and other like property;
The term “ tangible property ” means stocks, bonds, notes, and other evidences of indebtedness, bills and accounts receivable, leaseholds, and other property other than intangible property. [Sec. 325. (a).]

It is not clear to us that contracts generally are so like or unlike the properties enumerated as intangible property and tangible property as to fall very readily into either class. We may conjecture that because of their divergency of character contracts were considered incapable of satisfactory classification. It is stated in the Commissioner’s [Regulations 45, article 811, that a contract should be treated as intangible property unless it is shown that it relates to rights in tangible property to such an extent that its value arises chiefly therefrom. If the contract here had been simply for the hire of convict labor, we would have no difficulty in finding that it was intangible property. There is certainly no element of tangibility in unperformed labor. We are asked to find, however, that the leasehold embodied in the contract had itself a value in excess of the value claimed for the entire contract. We are unable to arrive at this conclusion. The evidence as well as the construction of the contract itself indicates that the convict labor was the chief element of value. Since the work could not be performed without the confines of the penitentiary, it was a matter of necessity that the use of the buildings be offered for factory purposes as an inducement for bids for the convict labor. The buildings would of course have had no value apart from the convict labor; so that whatever value the leasehold in itself may have had, it was a part of and indistinguishable from the value of the labor feature of the contract.

It is now well recognized that under section 234(a)(7) of the 1918 Act, deductions may be taken by a corporation for exhaustion of contracts and like property where the cost or the March 1, 1913, value of such property constituted capital of the corporation. Kaufman-Straus Co. v. Lucas, 12 Fed. (2d) 774; Appeal of Atlantic Carton Corporation, 2 B. T. A. 380; Appeal of General Equipment Co., 2 B. T. A. 804; Appeal of Automatic Fire Protection Co., 3 B. T. A. 1267; and Appeal of National Film Publicity Co., 4 B. T. A. 118. In Appeal of J. M. Browning, 6 B. T. A. 914, we allowed a deduction for the exhaustion of intangibles paid in without cost, or at a nominal cost of $1, on the basis of their proved value at the date acquired by the corporation. Under that decision the contract here in question should be exhausted over the period of its life at its actual value when acquired by the petitioner.

The petitioner claims that the value of the contract set up on its books at date of organization at $150,000 was understated; that the true value more nearly approximated $450,000. It asks us to determine the value of the contract and to permit the deduction from the gross income of each of the taxable years of an aliquot part of such value.

The evidence indicates that the contract was a fair contract as between the State and the contractor for the employment of convict labor. The petitioner was paying as much for the labor of its convicts as was paid by other contractors of convict labor at Mounds-ville, with the exception of the Bai’dol contract where, by reason of the character of the work and for other reasons, a larger per diem amount was paid. The petitioner was paying as much as was paid for convict labor under the Gordon contract and it appears that upon a renewal of the Gordon contract by the Reliance Manufacturing Co., a smaller per diem was paid for convict labor. Bloyd was clearly of the opinion that the contract had a very great value. He believed that it could be operated profitably. He told his business associates that in his judgment the contract had a value to the Kleeson Company of $150,000. The basis for this value was testified to by him as follows:

There' are very few outside people who would know anything about prison contracts. I mean outside business people. There are only a few of them and people don’t know. But from the time I served on the Board there, I studied the conditions of those contracts, studied them, and I became acquainted with the value of them, and after the Klee people decided to move to New York, there came conditions there they thought, on account of legislation and one thing and another, that their contract might not be so valuable, but those things changed around. Then, another thing; the last few years they did not manage their factory economically. They were wasting thousands a year there in trimmings that ought not to be wasted. They had twice as many outside — what we call free help — as they would have to have. I knew that from the conditions. I told our people that when I took over the contract that I would eliminate $1,000 a month on this outside help, which I did. As soon as I took over the contract I went to work and cut off just $12,000 a year there; and I went out in the trimming department, where they were using so much more trimming than was necessary, and the first year, well, not the first year, but it was in a couple of years only — we eliminated a waste of over $27,000, and those things I knew.

As we stated in Rockford Malleable Iron Works, 2 B. T. A. 817, “Value is what the property is worth. It is what it would bring in the open market if offered for sale by an owner willing, but not compelled, to sell to a purchaser willing, but not compelled, to buy.”

The petitioner claims that by virtue of the contract it had the use of the prison buildings free of rent, the rental of which was worth $30,000 per year. This, however, appears to be a characteristic of all contracts for the employment of convict labor. That was only one of the elements that made it profitable for persons to bid for the employment of convict labor.

The petitioner also claims that the sale of the Gordon contract in 1923, calling for the employment of 400 male and female convicts for a price of $200,000 serves to establish a value for a contract of the character of that possessed by the petitioner. We think, however, that the sale of that contract in 1923, without more information than is contained in the record, furnishes little evidence of the value of the Klee’s Sons contract in 1919. In our opinion the evidence does not warrant a finding that the contract acquired by Bloyd and Bachenheimer from the State Board of Control on March 26, 1919, and turned over to the petitioner as a gift to it had a value (in excess of the amount paid by Bloyd and Bachenheimer for machinery and merchandise to the Klee brothers) which may be the basis of a deduction for exhaustion in the tax returns of the petitioner for the years 1920, 1921, and 1922.

Judgment will be entered for the respondent.

Murdoch and GreeN

dissenting: We can not agree with that portion of the prevailing opinion which holds that the evidence does not warrant a finding that the contract had any value when turned over to the corporation by Bloyd and Bachenheimer. In 1919, these contracts for prison labor were no longer let upon competitive bids and there is nothing in the evidence which would preclude a finding that this contract had a value. On the contrary the findings of fact clearly indicate to our minds that the contract had a substantial value, which amounted to $150,000 at least.


author: Littleton:

text:
    Phoenix Glass Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 8570, 16798.
    Promulgated April 30, 1927.
    The Board is not warranted from the evidence in this proceeding in holding that the Commissioner erred in his determination of a reasonable allowance for exhaustion, wear and tear, and obsolescence of the property used in the petitioner’s business.

      Ben JenJdns, Esq., for the petitioner.

      John D. Foley, Esq., for the respondent.
    The Commissioner determined deficiencies in income and profits tax for the fiscal years ended June 30, 1920, and June 30,1922, in the amounts of $27,911.65 and $2,403.38, respectively.
    The errors assigned by the petitioner are: (1) The failure of the Commissioner to make a reasonable allowance for depreciation on machinery and equipment, 8 per cent being allowed by the Commissioner and 12% per cent being claimed by the petitioner, and (2) the failure of the Commissioner to restore to petitioner’s invested capital certain amounts which were charged off by the petitioner on account of obsolescence, but which deductions were disallowed by the Commissioner and not restored to invested capital for the succeeding year or years.
    FINDINGS OE FACT.
    The petitioner is a West Virginia corporation with its principal office at Pittsburgh, Pa., and is engaged in the manufacturing of illuminating glassware at Monaca, Pa., where it occupies a plant covering eight acres along the Ohio River.

      Upon the books of the petitioner there is no segregation of the values of the various classes of machinery and equipment, but the Commissioner fixed a value of $506,361.99 as at January 1, 1917, which, with subsequent additions and retirements, furnishes the values upon which depreciation was computed for the years involved, and this has been accepted by the petitioner.
    The petitioner, during the years involved, operated its factory on a union basis, i. e., four shifts of from four to four and one-half hours each, with a short time intervening between each shift, but making a total of approximately 17 hours per day. The heat of the furnaces is maintained at 2,500 degrees unless it is determined to close down for a period of several weeks.
    The silicates used in the manufacture of glass are particularly abrasive, as the edges of the crystals have not been worn smooth. This abrasion accelerates the depreciation of the batch-mixing machines used in mixing the raw materials.
    From the batch-mixing machines, the raw material is transferred to the furnaces, where it is melted under a heat of 2,400 degrees Fahrenheit. The molten glass is then blown by hand-mold and machine-mold processes. These molds are of cast iron and are heated before being used. From the mold, the glass is placed in the lehr where it is annealed under a heat of from 950 degrees to 1,150 degrees Fahrenheit. In these lehrs certain machinery moves the ware through the length of the oven.
    From the lehrs the glassware goes to the grinding machine where the rough edges are removed, carborundum being used as the abrasive. From these machines some of the glassware goes to sand-blasting machines where sand is the abrasive, being discharged against the ware under high pressure. There is a dust from these sandblasting machines which accelerates depreciation of machinery and equipment with which it comes in contact, affecting particularly the sand-blasting machinery, air compressors and fans.
    The “ hard ” quality of the water used in boilers tended to decrease their normal life.
    During the fiscal year ended June 30, 1920, the petitioner made many changes in its plant, installing new and, what it considered, improved machinery and adding new units of equipment.
    In the three years preceding the fiscal year ended June 30, 1920, depreciation was allowed on machinery and equipment by the Commissioner at the rate of 8 per cent. No depreciation was taken on petitioner’s books prior to 1917, though when the Commissioner sought to adjust asset values at the beginning of the first year in which invested capital was involved, at the same rates as for 1917 and subsequent years, this was protested by the petitioner and a lower rate was finally allowed.
   OPINION.

Littleton:

The principal question on which the petitioner presented evidence was as to the correct rate of depreciation for the machinery and equipment. The assistant general manager, who has charge of construction and maintenance work was the only witness as to this feature. He has been with the petitioner since 1915 and showed a detailed knowledge of the principal feature of the plant and of the factors which enter into depreciation.

No segregation could be furnished of the depreciable assets which entered into the total on which a depreciation rate of 12% per cent was claimed, though he testified as to his opinion of the life of various units and machines. On several major items he testified that their average life was 8 years, though this was qualified in some instances by the statement that new machines, e. g., batch-mixing machinery installed in 1920 were still in use and, therefore, no accurate estimate of their probable life could be given. In the case of furnaces an average life of 8 years was given, but this was qualified by the statement that the principal factor was obsolescence. In many other instances, obsolescence was considered as an important factor, since new machinery was continually being perfected which made it necessary to discard the old machinery'. No evidence was furnished, however, to the effect that the date when it would be necessary to abandon equipment could be anticipated.

Other units were given a life of from 10 to 15 years, and two items, molds and air-compressor equipment, were given a life of 5 years. Molds are manufactured in the plant and the witness stated that they represented a value of not less than $85,000.

We are of the opinion that the above evidence is insufficient to overcome the Commissioner’s determination of a rate of 8 per cent. We are satisfied that there are units among the petitioner’s machinery and equipment, the useful life of which is shorter than 12% years, and, likewise, some the life of which is much longer. Our difficulty lies in determining with any approximate degree of certainty the probable life of the various units and, even if we had the probable life, our problem is further complicated by the fact that we have no segregation of assets to which we could apply the respective rates to determine whether the depreciation as allowed by the Commissioner was reasonable.

We are also satisfied that obsolescence is an important factor in determining the commercial usable life of the assets in question. On more than one class of these assets the witness stated that the assets were discarded because they were obsolete and not because their useful life was exhausted due to wear and tear. But again petitioner’s evidence is insufficient on which to give consideration to this factor. We said in the Appeal of Columbia Malting Co., 1 B. T. A. 999:

In order that the taxpayer may be entitled to the obsolescence deduction in the years involved, there must have been substantial reasons for believing that the assets would become obsolete prior to the end of their ordinary useful life, and second, it must have been known, or believed to have been known, to a reasonable degree of certainty, under all the facts and circumstances, when that event would likely occur. The purpose of the statute is to permit the capital invested in assets to be returned to a taxpayer out of earnings over the life of the property in the business. A reasonable deduction is allowed on account of the exhaustion, wear, and tear of property. This includes obsolescence, if the property is becoming obsolete, so that by the time it reaches that state the entire cost thereof will be restored. While it is known that physical property is ordinarily subject to exhaustion, wear, and tear from use in the business, it may not be known that it is also becoming obsolete. Whether it is, is a question of fact in each case. When it is found that property is becoming obsolete, a deduction on that account can only be determined by ascertaining, as accurately as possible, when the property may be expected, under the circumstances, to be no longer commercially useful notwithstanding its physical condition. In the case of a deduction on account of exhaustion, wear and tear of property used in the business, if it can not be determined that the property is subject to wear, tear, and exhaustion, or what the approximate life of the property, under all the facts and circumstances, is, there is no basis for determining the deduction. With respect to obsolescence, if it can not be determined that the assets will become obsolete prior to the estimated date of the physical exhaustion thereof, or if a reasonably definite date can not be ascertained, there are no means of determining what is a reasonable allowance on that account.

See also Appeal of Crown Margarin Co., 1 B. T. A. 1110, and Corsicana Gas & Electric Co. v. Commissioner, 6 B. T. A. 565.

In testifying as to furnaces, the witness said: “ It would be, it seems to me, very fair to strike an average of about eight years for the life of a furnace. That would be about the average. You can’t say that definitely for one style or another. You never know when something is going to come along making it necessary to change your style of furnace.” Without more definite information, the factor of obsolescence can not be given much weight.

Another feature which can not be overlooked is the fact that the petitioner took no depreciation on its books prior to 1917 and that when the Commissioner attempted to apply the rate of 8 per cent in determining the depreciation reserve, protest was made by petitioner on the ground that this rate was excessive and it finally convinced the Commissioner of that fact, and in computing the depreciation reserve the Commissioner finally allowed a lower rate than 8 per cent. True, depreciation is a question of fact and must be determined in the light of facts known and existing in the years under consideration, but we feel that this is an evidentiary fact that should be considered in arriving at a decision of the issue presented since the witness who testified based his conclusions on the history of the plant from 1915 to the present time.

We are of the opinion, based on the entire record in the case, that insufficient evidence has been introduced to warrant a finding that a greater rate of depreciation has been suffered on the petitioner’s machinery and equipment than that allowed by the Commissioner and his determination in this regard is therefore approved. •

A further contention advanced by the petitioner is that when the Commissioner made certain disallowances of items which it charged off on account of obsolescence, he failed to restore these items to invested capital for the year or years affected thereby. The Commissioner concedes that if this has not been done, it should have been done and, therefore, it becomes a question of fact as to what was done.

The first item is $10,287.64 for obsolescence of molds which was disallowed as a deduction from -income in the fiscal year ended June 30, 1919. We do not find where this specific item was restored to invested capital for the subsequent year, but we do find an increase of approximately this amount from 1919 to 1920 in a restoration entitled “ Restoration to assets due to amounts being arbitrarily written off on account of appraisal.”

The second item is $64,887.66, similarly disallowed in 1920, and no restoration of this specific amount to the invested capital for 1921, though we do find an increase in the account referred to under the previous item of but little less than the amount charged off. The difference in each instance might be accounted for by depreciation.

Since it may be a mere coincidence that other items which were restored were almost identical in amount with those in question and since the deficiency letters do not specifically show the restoration of these items, this matter will be determined under Rule 50, since both parties agree that if the amounts in question have not been restored to the invested capital of the appropriate years such restoration should be made.

Judgment will be entered on 10 days' notice, under Rule 50.


author: Littleton :

text:
    Charles H. Haynes, Executor, Estate of R. R. Haynes, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 9584.
    Promulgated April 30, 1927.
    Amounts expended for ordinary and necessary repairs to property were proper deductions from gross income.

      Jolm L. Elliott, Esq., for the petitioner.

      W. F. Wattles, Esq., for the respondent.
    The Commissioner determined a deficiency in income tax for the calendar year 1921 in the amount of $362.02. The executor claims that the Commissioner erred in disallowing a deduction of $2,455.38 as an ordinary and necessary expense alleged to represent repairs to property owned by the estate of It. E. Haynes.
    FINDINGS OF FACT.
    Charles H. Haynes, Executor of the Estate of E. E. Haynes, is a resident of Cliffside, N. C., and was appointed executor of said estate in 1917.
    The estate is and has been since 1917 engaged in the business of operating farms, grocery stores, and renting property owned by it near Henrietta, N. C. During the calendar year 1921 the estate owned 193 buildings of rather cheap frame construction, consisting of farm and tenement houses, and outhouses, storehouses, warehouses, barns, cribs, and blacksmith shops. These buildings have been in use from ten to twenty years. During the year 1921 the estate, through the executor, expended a total of $2,455.38 in keeping these buildings in repair and in cleaning out wells and in repairing well tops. No additions or replacements of a major character were made to premises.
   OPINION.

Littleton :

The Board is of the opinion from a consideration of the evidence submitted that the expenditures totaling $2,455.38 were for ordinary repairs and upkeep of the properties of the estate and, as such, represent an ordinary and necessary business expense. The amount is therefore a proper deduction from gross income for the year 1921.

Judgment <wül be entered on 15 days notice, wider Rule 50.