author: MaRquette:

text:
    Appeal of Centadrink Filters Co., Inc.
    Docket No. 5214.
    Promulgated March 30, 1927.
    Adjustments in petitioner’s income and deductions for the years involved herein determined.

      Benjannin Mahler, Esq., and Isidore Sehlanger, O. P. A., for the petitioner.

      Benjamin H. Samiders, Esq., and John W. Fisher, Esq., for the Commissioner.
    This appeal is from the determination of deficiencies in income and profits taxes for the years 1911, 1918, 1919, 1920, and 1921, in the amounts of $506.53, $255.50, $5,261.34, $2,430.24, and $2,130.83, respectively, a total of $10,584.44. The petitioner alleges error on the part of the Commissioner (1) in twice adding to income for 1917 an item of $958.53, representing the net increase for that year, in the reserve for past due and doubtful accounts; (2) in failing to allow as deductions from income for the years 1919, 1920, and 1921, the cost of labor and overhead consumed in making installations of cabinets and filters in those years; (3) in adding to income for 1917 and 1918 the sums of $22,424.50 and $29,108.16, respectively, alleged to have been deducted by the petitioner on account of removals of cabinets and filters from customers’ premises; (4) in failing to allow as deductions from income, for all of the years involved in the appeal, the losses incurred in those years as a result of the reinoval of cabinets and filters from customers’ premises; (5) in adding to income for the year 1919 the sum of $31,336.89, alleged to represent the cost of additions to cabinets and filters deducted by the petitioner as expense; (6) in failing to allow adequate deductions from income, for all of the years involved in the appeal on account of depreciation of cabinets and filters installed in customers’ premises; (7) in refusing to allow deductions from income, for all the years involved in the appeal, on account of depreciation of patents acquired at date of organization from the predecessor companies; and in refusing to allow any value for these patents for invested capital purposes; (8) in twice adding to income for 1921 the sum of $24,371.11, representing the deduction taken by the petitioner on account of depreciation of patents acquired from predecessor companies; and (9) in failing to give credit in computing the deficiency for the year 1917, for the additional tax of $381.08 assessed for that year and paid on July 25, 1923.
    FINDINGS OF FACT.
    Petitioner, a New York corporation with its principal office at New York City, was organized in or about the month of February, 1913, and is the outgrowth of the consolidation of the United Centadrink Manufacturing Co. and the New York Centadrink Co. It is engaged in the business of leasing cabinets and filters for supplying cold and filtered drinking water to customers on an annual rental basis, and in the operation of slot machines installed in public places for supplying cold carbonated water to the public.
    At January 1, 1917, petitioner carried on its books of account a reserve for past due and doubtful accounts in the amount of $1,592.73; and at the close of the year 1917, this reserve was carried on the books in the sum of $2,551.26, an increase for the year of $958.53, accounted for as follows:
    Cash collections during the year on accounts previously charged against reserve as uncollectible- $1.22
    By transfer of an account payable in favor of a customer to offset an account receivable charged against the reserve as uncollectible- 14. 80
    By charge against bad debt account- 3, 500. 00
    Total credits to reserve-3, 516. 02
    Less: Bad debts charged against the reserve during year- 2, 557.49
    Net increase in reserve- 958. 53

      The charge of $3,500 against bad debts account was transferred to surplus and deducted in arriving at the net income for the year 1917. The revenue agent in arriving at taxable net income used the book net income as a starting point and added to it the net increase in the reserve for the year. The Commissioner, in the deficiency letter, used the net income computed by the revenue agent as the starting point and added to that figure the net increase in the reserve for that year. The result of the Commissioner’s action is that the net income shown in the deficiency letter twice includes the increase of $958.53 in the reserve.
    All of the parts entering into the construction of the cabinets and filters are purchased by the petitioner. The cost of these parts are charged on the books to a filter material account. During all of the years in controversy the petitioner capitalized the cost of all labor, materials, and overhead consumed in assembling the cabinets and filters and the installation thereof in customers’ premises, by charging such cost on its books to cabinet and filter property accounts. In the deficiency letter the Commissioner ruled that only the cost of the materials used in assembling and installing the cabinets and filters should be capitalized, and that the cost of labor and overhead consumed in the same processes should be deducted as expenses. In accordance with this ruling the Commissioner reduced the income for the years 1917 and 1918 by the sums of $14,802.48 and $15,863.12, respectively, alleged to be the costs of labor and overhead incurred in those years in assembling the cabinets and filters and installing them in customers’ premises. The Commissioner also reduced the income of the years 1920 and 1921 by the sums of $10,217.40 and $41,353.78, respectively, alleged to be the excess of the book values of additions made in those years to the cabinet and filter property accounts over the actual cost of the materials used in making installations in customers’ premises.
    Upon the removal of cabinets and filters from customers’ premises during the years 1917, 1918, and 1919, the accounting procedure was as follows: Cabinet and filter property accounts were credited with the original cost of assembling and installing the removed cabinets and filters. Filter material account, a capital account, was charged with one-half of the cost of assembling and installation, and the other one-half of such cost was charged to cabinet and filter operating expense accounts. This procedure was based upon the assumption that one-half of the cost of assembling and installation of the removed cabinets and filters was recovered in the value of the salvaged materials, and that the other one-half of such cost was un-recovered because of shrinkage in value of salvaged materials and loss of labor and overhead of installation. At the close of each of the above stated years the total charges thus made to the cabinet and filter operating expense accounts were transferred by journal entry to surplus account. The amounts so charged to surplus were as follows: 1917, $12,970.19; 1918, $15,521.67; and 1919, $15,279.58. ISTo part of the charge of $12,970.19 was deducted in arriving at book net income for 1917, which the revenue agent used as the starting point for the purpose of computing the taxable net income of that year. One-third of the charges made against surplus in 1918 and 1919, to wit, $5,173.89 and $5,093.19, respectively, was deducted by the petitioner in the returns for those years, the petitioner assuming that the other two-thirds had been recovered through depreciation deductions in returns of prior years. -In computing net income in the deficiency letter, the Commissioner has allowed as deductions the entire amounts charged against surplus, as losses sustained from removals of cabinets and filters. At the same time the Commissioner has added to the income of the years 1917 and 1918 the sums of $22,424.50 and $29,108.16, respectively, which he alleges were deducted by the petitioner in those years as losses sustained through removals of cabinets and filters from customers’ premises.
    For the years 1920 and 1921, the accounting procedure, as it related to removals of cabinets and. filters, differed from that in effect in the three preceding years. In 1920 and 1921 the accounting procedure was as follows: Cabinet and filter property accounts were credited with the original cost of assembling and installing the removed cabinets and filters. Filter material account, a capital account, was charged with the actual value of the salvaged materials, and the balance of the original cost of installation was charged to cabinet and filters operating expense accounts. At the close of each of the aforementioned years, the total charges thus made to the cabinet and filter operating expense accounts were transferred by journal entry to and charged against the reserve for depreciation; and no part of such charges were deducted from income in the petitioner’s tax returns. ISTeither has the Commissioner made any deductions from income for the years 1920 and 1921, on account of any losses which may have been sustained in these years from removals of cabinets and filters from customers’ premises.
    The Commissioner added to the income of the year 1919 the sum of $31,336.89, which he computed in the following manner:
    Cabinets and filters additions_$34, 090.97
    Net additions per original balance sheet_ 2, 754. 08
    Difference charged against income_ 31, 336. 89
    The Commissioner held that the cost of the materials used in assembling and installing additional cabinets and filters during the year was $34,090.97, and since the balance sheet showed a net increase in the cabinet and filter property accounts for the year 1919 of only $2,754.08, he assumed that the difference of $81,336.89 had been charged against income. The entire cost of assembling and installing additional cabinets and filters during the year, including labor and overhead, as well as materials, was capitalized on the books of account, and no part thereof was deducted, specifically as such, by the petitioner from income. Moreover, in making this adjustment of income the Commissioner failed to take into consideration the fact that the cabinet and filter property accounts had been reduced during the year by crediting thereto the original costs of installation of cabinets and filters removed from customers’ premises.
    For all of the years under consideration, petitioner took deductions from income for depreciation of cabinets and filters installed in customers’ premises. No depreciation was claimed on cabinets and filters on hand but not in use. The deductions which it took for the years 1917 and 1918 were computed on the basis of 10 per cent of the book values, which values included the cost of labor, materials, and overhead used in assembling and installation. The deductions which it took for the years 1919, 1920, and 1921 were computed as follows:

    The deductions which the Commissioner has allowed in the deficiency letter for depreciation of cabinets and filters, for all of the years involved in the appeal, represent 10 per cent of the total cost of materials used in making all installations, of cabinets and filters to the beginning of each year, plus 5 per cent of the cost of materials used in making additional installations during each year. The average useful life of these cabinets and filters is five years.
    Petitioner is the successor to the businesses of the United Centadrink Manufacturing Co., hereinafter referred to as the Manufacturing Company, and the New York Centadrink Co., hereinafter referred to as the New York Company, both of which were New York Corporations. The Manufacturing Company was engaged in the business of manufacturing machines to supply aerated water and the construction of models for the exploitation of patents, and the New York Company in the sale and dispensation of plain, aerated and carbonated beverages. The Manufacturing Company owned approximately 60 per cent of the outstanding capital stock of the New York Company, and all but five shares of the remainder were owned by stockholders of the Manufacturing Company. With one exception, the executive officers of the two companies were the same. Both companies occupied the same office. Employees of each company performed services for the other. The funds of the separate companies were transferred from one to the other as their necessities required. The machines manufactured by the Manufacturing Company were sold exclusively to the New York Company and paid for by the latter at its convenience. The New York Company did not purchase machines from any other source.
    Under date of January 16, 1913, the Manufacturing Company and the New York Company entered into an agreement to consolidate into one corporation. In accordance with the terms of the agreement, the petitioner was organized in or about the month of February, 1913, and immediately took over the businesses and assets of the two corporations, parties to the agreement. Among the assets taken over from the Manufacturing Company were approximately 18 or 20 patents. For the businesses and assets of the two predeccessor companies the petitioner issued its own common capital stock of a par value of $685,000 and preferred stock of a par value of $325,000. The good will and patents acquired from the predecessor companies were carried on the books of account at a lump-sum value of $879,150.86. The Commissioner determined the average tangible assets of the New York Company, for the five-year period 1908 to 1912, inclusive, to be $80,774.12, and the average annual earnings for the same period to be $25,0L3.08. By capitalizing at the rate of 15 per cent, the average annual earnings in execess of 10 per cent of the average tangibles, the Commissioner determined that the value of the good will acquired from the New York Company was $112,904.47, and has allowed this amount as the value of the good will for invested capital purposes. The Commissioner further determined the average tangible assets of the Manufacturing Company, for the five-year period 1908 to 1912, inclusive, to be $77,597.68, and the average annual earnings, for the same period, to be $5,575.88. Since the average annual earnings represented a return of less than 8 or 10 per cent on the average tangibles, the Commissioner has held that the patents acquired by the petitioner from the Maunfacturing Company had no value at the date of acquisition; and accordingly he refused to allow any deduction for the years 1917, 1918, and 1919, for depreciation of these patents, disallowed the depreciation deductions taken by the petitioner in the returns for the years 1920 and 1921 in the amount of $24,371.11 each, and refused to allow any value for the patents for invested capital purposes.

      The total depreciation deduction made by the petitioner in the return for 1921 amounted to $73,382.57, made up as follows:
    Depreciation on plant and equipment_ $811.17
    Depreciation on furniture and fixtures_ 462. 55
    Depreciation on patents_ 24, 371.11
    Depreciation on cabinets and filters_ 47, 737.74
    Total_ 73,382.57
    The Commissioner allowed a deduction for depreciation of patents in the amount of $818.92, representing one-thirteenth of $10,646, which he held to be the total cash expended for development of patents, and added back to income the difference between that amount and $24,371.11, or $23,552.19. He further added to the income for this year the sum of $24,371.11, on the ground that the petitioner had deducted two amounts of $24,371.11, each, for depreciation of patents. The petitioner deducted only one amount of $24,371.11, in its return, for depreciation of patents.
   OPINION.

MaRquette:

The first issue concerns the Commissioner’s action in twice adding to the net income for the year 1917 the net increase for that year of $958.53 in the reserve for past due and doubtful accounts. The manner in which this net increase in the reserve was made is set out in the findings of fact and need not be repeated here. The revenue agent, in computing taxable net income, used book net income as a starting point and added thereto the sum of $958.53, the amount by which the increase in the reserve which had been taken as a deduction exceeded the total debts ascertained to be worthless and charged off during the year, less total collections on accounts previously charged off as worthless. The Commissioner in computing net income in the deficiency letter, used the net income as computed by the revenue agent as the starting point and again added thereto the net increase in the reserve of $958.53. The Commissioner’s action resulted in a duplicate adjustment of income in respect of the same item and was,, therefore, erroneous. The net income determined by the Commissioner in the deficiency letter should be reduced by the amount of $958.53.

During all of the years involved in the appeal, the petitioner capitalized the cost of labor, materials,’ and overhead used in assembling cabinets and filters and in the installation thereof in customers’ premises, by charging such cost on its books to cabinet and filter property accounts. The Commissioner held that only the cost of the materials (cabinet and filter parts) used in assembling and installation should be capitalized and that the cost of labor and overhead should be deducted as expense. In accordance with this ruling the Commissioner reduced the income of the years 1917 and 1918 by the amounts expended in those years for labor and overhead used in assembling and installation. The petitioner, while agreeing with the Commissioner as to the proper accounting treatment of the costs of assembling and installation, complains that the Commissioner has not uniformly applied the same rule in all years, in that he failed to allow as deductions from income of the years 1919, 1920, and 1921, the costs of labor and overhead incurred in those years in assembling and installation. We think the point which the petitioner raises is well taken. If the costs of labor and overhead incurred in assembling and installation are to be treated as deductible expenses, as the parties agree they should be, which,.all circumstances considered, we think is in accord with sound accounting principles, they should be uniformly so treated for all years. For the years 1919, 1920, and 1921, the costs of labor and overhead incurred in assembling and installation were $20,109.68, $23,525.17, and $33,385.55, respectively. The Commissioner reduced the income of the years 1920 and 1921 by the amounts of $10,217.40 and $41,353.78, respectively, which he determined to be the amounts capitalized on the books of account by charges to cabinet and filter property accounts in excess of the actual cost of the materials used in making installations in those years. Thus it appears that the Commissioner has allowed a deduction for a part of the cost of labor and overhead incurred in 1920, and for the year 1921 has allowed a deduction for labor and overhead in excess of the actual cost of labor and overhead incurred in that year. The net income determined by the Commissioner for the years 1919 and 1920 should be reduced by the amounts of $20,109.68, and $13,307.77, respectively, and the net income determined by the Commissioner for the year 1921 should be increased by the amount of $7,968.23.

The third issue concerns the Commissioner’s action in adding to the income of the years 1917 and 1918 the amounts of $22,424.50 and $29,108.16, respectively, which he held the petitioner had deducted from income as losses sustained through removals of cabinets and filters from customers’ premises. The accounting procedure adopted by the petitioner in maintaining the books of account, as it related to removals of cabinets and filters, is set out in detail in the findings of fact. When cabinets and filters were removed from customers’ premises, the cabinet and filter property accounts were credited with the original costs of installation. One-half of the credits so made to the cabinet and filter property accounts were charged to filter material account, a capital account, and the other one-half to cabinet and filter operating expense accounts. These charges to cabinet and filter operating expense accounts were, at the close of the year, transferred to and charged against surplus. No part of the charge made against surplus in 1917 was deducted in arriving at book net income which the revenue agent used as the starting point in computing taxable net income. Of the charge made against surplus in 1918, one-third, or $5,173.89, was deducted by the petitioner in its return. The net income determined by the Commissioner for the years 1917 and 1918 should be reduced by the amounts of $22,424.50 and $23,934.27, respectively.

The fourth issue is that the Commissioner failed to allow as deductions from income, for all of the years involved in the appeal, the losses alleged to have resulted from removals of cabinets and filters from customers’ premises. The fact of the matter is that the Commissioner has allowed as deductions from income of the years 1917 and 1918, the amounts of $12,970.19 and $15,521.67, respectively, which are the amounts charged against surplus in those years as losses occasioned by removals. As outlined in our discussion of the third issue, these charges against surplus represented one-half of the cost of installation of the removed cabinets and filters. It is apparent that these charges to surplus represent either the cost of labor and overhead used in installation, or the cost of labor and overhead plus the difference between the cost of the materials and the value at which they were charged back to the filter material account. We have already held, in agreement with the parties, that the cost of labor and overhead used in installation should be charged to expense and not capitalized; hence, no loss is sustained in this respect upon removal of cabinets and filters. Any shrinkage in value occasioned through physical wear and tear of materials while in use should be taken care of through annual deductions for depreciation. It appears, therefore, that the Commissioner erred in allowing these deductions from the income of the years 1917 and 1918. This is admitted by the petitioner in its brief, so far as it concerns the year 1917, but nothing is said therein so far as concerns the year 1918. As for the years 1919, 1920, and 1921, no evidence was adduced to show that the petitioner sustained any losses in those years as the result of removals of cabinets and filters from customers’ premises. Of the total deduction of $15,521.67 allowed by the Commissioner for the year 1918, $5,173.89 has been disposed of under the third issue necessitating an adjustment of but $10,347.78 under this issue. The net income determined by the Commissioner for the years 1917 and 1918 should be increased by the amounts of $12,970.19 and $10,347.78, respectively.

The fifth issue concerns the Commissioner’s action in adding to the income for the year 1919 an item of $31,336.89, which he held to be the cost of materials used in making installations in that year which the petitioner deducted as expense. From an examination of certain balance sheets submitted by the petitioner, the Commissioner determined that the net increase in the cabinet and filter property accounts, for the year 1919, amounted to $2,754.08. The Commissioner further determined that the cost of the materials used in making installations during the year was $34,090.97. Since the net increase in the cabinet and filter property accounts was $31,336.89 less than the cost of the materials used in making installations during the year, the Commissioner assumed that the petitioner had deducted this amount from income. The evidence is conclusive that no part of the costs of installations made during the year were deducted from income by the petitioner. Furthermore, the comparison which the Commissioner made of gross cost of materials used with net increase in the property accounts is obviously an erroneous one, since it fails to take into account the fact that the property accounts were credited with the costs of installation, including labor and overhead as well as materials, of removed cabinets and filters. The net income determined by the Commissioner for the year 1919 should be reduced by the amount of $31,336.89.

The sixth issue is that the Commissioner failed to allow adequate deductions from income, for all years involved in the appeal, for depreciation of cabinets and filters installed in customers’ premises. The deductions which the Commissioner has allowed represent 10 per cent of the total cost of materials used in making installations to the beginning of each year, plus an additional amount computed at the rate of 5 per cent of the cost of materials used in making installations during each year. The evidence convinces us that the average useful life of petitioner’s cabinets and filters does not exceed five years, and that a rate of 20 per cent should be used in computing the depreciation allowance. Because of the numerous changes in the cabinet and filter property accounts during any year, which are occasioned by additional installations, changes, and removals, the base to which this 20 per cent rate should be applied should be determined by adding together the cost of materials actually in use in installed cabinets and filters at the beginning of the year and at the end of the year and dividing the sum thus obtained by two.

The seventh issue concerns the Commissioner’s action in refusing to allow deductions for the years 1917, 1918, and 1919, for depreciation of patents acquired at the date of organization, in disallowing the deductions which the petitioner took in the returns for the years 1920 and 1921 for depreciation of these patents, and in refusing to allow any value for these same patents for invested capital purposes. The patents in question were taken over from the United Centadrink Manufacturing Co., one of the predecessor companies. Since the average annual earnings of that company for the five-year period immediately proceeding the date of organization of petitioner represented a return of less than 8 or 10 per cent upon the average tangible assets for the same period, the Commissioner held that the patents had no value at the date of acquisition, February, 1913, or at March 1, 1913. He accordingly held that the petitioner was not entitled to deductions for depreciation of these patents, and that no value in respect thereof could be included in invested capital. The petitioner contends that because of the close relationship of the United Centadrink Manufacturing Co. and the Hew York Centadrink Co., and the nature of, and manner in which they carried on their businesses, the Commissioner should have determined upon a value for the patents based upon the combined average annual earnings of the two companies for the five-year period immediately preceding the date of organization of petitioner. All that we have been told about these patents is that there were 18 or 20 of them in number. We know nothing about the inventions covered by these patents, of the stage of development reached at the time they were acquired by the petitioner, of the availability of markets for the products manufactured under them, of the earnings of prior years attributable to them as distinguished from the earnings attributable to good will, of the probabilities as to the earnings which cordd reasonably be expected during the remaining life of the patents, or of the remaining life of the patents from the date of acquisition. Fox aught that has been told us, the whole lot of them may have been entirely obsolete. Ho evidence was introduced relating to their values. In short, we h¡*ve no evidence before us upon which we can base a finding that these patents had a determinable value at the date of acquisition. Under the circumstances, we can not disturb the action of the Commissioner in refusing to allow deductions from income, for all of the years involved in the appeal, for depreciation of patents acquired' from the predecessor companies, and in refusing to allow any value in respect of these patents for invested capital purposes.

The eighth issue concerns the Commissioner’s action in twice adding to the income for 1921 the sum of $24,371.11, representing the deduction taken by the petitioner for depreciation of the patents referred to in the seventh issue. The petitioner deducted only one amount of $24,371.11, in its return, for depreciation of patents; hence, the Commissioner’s action in twice adding this item to income is in error. The net income determined by the Commissioner for the year 1921 should be reduced by the amount of $24,371.11.

The ninth issue is that the Commissioner failed to give credit in computing the deficiency for the year 1917, for the additional tax of $3-81.08 assessed for that year and paid on July 25, 1923. No evidence was submitted in connection with this issue; hence, we are unable to make any finding in respect thereof.

Juág^nent will he entered on 15 days’ notice, under Rule 50.


source: Caselaw Access Project

author: Maequette:

license: Public Domain

text:
    Wyatt Metal & Boiler Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 2415.
    Promulgated March 30, 1927.
    The amount of certain county warrants held, not deductible as worthless.

      J. M. McMillin, Esq., for the petitioner.

      Bruce A. Low, Esq., for the respondent.
    This proceeding is for the redetermination of deficiencies in income and profits taxes for the years 1919, 1920, and 1921, in the respective amounts of $1,140.83; $5,060.28 and $1,887.73.
    FINDINGS OF FACT.
    The petitioner is a Texas corporation engaged in the manufacture of metal parts and boilers, with its principal office at Dallas. Its books of account are kept on the accrual basis.
    In the years 1915 and 1916, petitioner furnished materials to Houston County, Texas, for which it received warrants of the face value of $5,101.90. It assigned these warrants and guaranteed the payment thereof to Austin Brothers, of Dallas, Tex., as follows:
    Warrants of the face value of $1,854 on October 26, 1916.
    Warrants of the face value of $3,906.96 on November 9, 1916.
    On February 27, 1918, Houston County paid to Austin Brothers on one of these warrants the amount of $317, but subsequently refused payment on the other warrants, on the ground that the work and materials for which the warrants were issued were not up to specifications. After the maturity of the warrants, but prior to the year 1920, Austin Brothers instituted suit against Houston County, in the District Court of Houston County, for the payment of these and other warrants held by Austin Brothers. The District Court rendered judgment in favor of the defendant and the case was appealed to the Court of Civil Appeals at Galveston, Tex., which rendered a decision which was unfavorable in part to the plaintiffs, and the plaintiffs then appealed to the Supreme Court of Texas where the case is now pending.

      After the decision of the District Court of Houston County, Texas, was rendered, Austin Brothers, on November 16, 1920, invoiced to the petitioner warrants in the amount of $1,578, which amount was credited to Austin Brothers on the petitioner’s books. On August 25, 1921, Austin Brothers invoiced to the petitioner warrants in the amount of $3,906.96, which amount was also credited to Austin Brothers on the books of the petitioner. On December 31, 1920, the petitioner charged off as a bad debt said warrants in the amount of $1,578, and on December 31, 1921, charged off as a bad debt said warrants in the amount of $3,906.96.
    At the time said warrants were invoiced by Austin Brothers to the petitioner, it was agreed that the petitioner would pay the pro rata portion of the court costs which might subsequently accrue, and that it would share the benefits, if any, which might be derived from the final decision of the courts in the litigation mentioned. However, the petitioner did not become a party to the litigation.
    In the year 1919, the Texas & Pacific Railway Co. constructed for the petitioner a spur track from the railroad right of way to the petitioner’s shops. This spur track was built upon the petitioner’s property and the cost of construction was billed to and paid by the petitioner at the close of each year as follows:
    December 31, 1019_$3,9-13.63
    December 31, 1920_ 1, 898.73
    December 31, 1921_ 5,137. 76
    The petitioner had a contract with the Texas & Pacific Railway Co., which provided that the railroad would maintain the spur mentioned, make all repairs and replacements required to keep it in first class condition, and would bill the petitioner for such maintenance, upkeep and replacements. The first bill from the railroad to the petitioner for such maintenance and replacements was rendered in 1924, and was charged by the petitioner on its books during that year as an operating expense.
    The petitioner, in its income and profits-tax return for the year 1920, deducted from gross income the amount of $1,578, on account of the Houston County warrants charged off as a bad debt on December 31, 1920, and also deducted an amount for the exhaustion, wear and tear of the said spur track computed at the rate of 10 per cent. In its income and profits-tax return for the year 1921, it deducted from gross income the amount of $3,906.96, on account of the Houston County warrants charged off on December 31, 1921, and also deducted an amount for the exhaustion, wear and tear of said spur track computed at the rate of 10 per cent. The respondent disallowed these deductions; those for the exhaustion, wear and tear of the spur track being disallowed on the ground that the petitioner, under the facts hereinabove set forth, is not entitled to any deduction for the exhaustion, wear and tear of the spur track.
   OPINION.

Maequette:

We are of the opinion that the respondent properly refused to allow the petitioner to deduct in 1920 and 1921, as debts ascertained to be worthless and charged off within the taxable years, the Houston County warrants in question. They were in fact charged off, but the record does not establish that they were worthless. They were, in 1920 and 1921, and are still, the subject of litigation in the Texas courts, and whether or not they have any value will not be determined before the final decision therein by the Supreme Court of Texas. That the petitioner did not consider them worthless when they were charged off is evidenced by the fact that it approved of the litigation concerning them and agreed to bear part of the expenses of the litigation. While the pending suit is in the name of Austin Brothers and the petitioner is not a party of record, yet, since it has paid to Austin Brothers the full amount for which it originally assigned the warrants, it is in fact the real party in interest. We think the warrants were not ascertained to be worthless within the taxable years involved herein, and upon this point we approve the action of the respondent.

With reference to the question of whether or not the petitioner is entitled to deductions from gross income as allowances for the exhausfion, wear and tear of the spur track, we are of the opinion that the spur track is depreciable property and that the cost thereof to the petitioner should be capitalized and recovered through allowances for exhaustion, wear and tear spread ratably over its useful life. We are not considering the petitioner’s tax liability for the year 1924, and it is not necessary for us to decide here whether the petitioner erred in charging to expense the amount paid by it in that year to the railroad for the maintenance, repair, and replacement of the spur track. If the property in question is depreciable, the petitioner should be allowed to recover in each year of its useful life an aliquot part of its cost, and this right can not be defeated by the fact that in a subsequent year it may have charged to expense amounts spent for maintenance, repair and replacement.

Although we are of the opinion that the petitioner is entitled to an allowance in each of the years 1920 and 1921, for the exhaustion, wear and tear of its spur track, there is nothing in the record herein from which we can determine what that allowance should be. The petitioner claimed an allowance computed at the rate of 10 per cent, which has been disallowed by the respondent. We are not informed as to the useful life of the spur track, and therefore we can not say what part of the cost thereof should be recovered by the petitioner in each year. In the absence of any evidence as to the life of the property, we must affirm the action of the respondent.

No errors were alleged by the petitioner as to the respondent’s determination of its tax liability for the year 1919.

Judgment will be entered for the respondent.


author: ÁRaNDunr,:

text:
    Edmund W. Wurzburg, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 18399.
    Promulgated March 30, 1927.
    Petitioner, having filed a joint return of income for himself and his wife for the calendar year 1922, is not entitled to have his tax computed on the basis of his separate income. R. Downes, Jr., v. Commissioner, 5 B. T. A. 1029.

      F. E. Seidman, O. P. A., for the petitioner.

      W. F. Gibbs, Esq., for the respondent.
    This proceeding is for the redetermination of a deficiency in .income tax asserted by the Commissioner for the calendar year 1922 in the amount of $839.73. The case was submitted on a stipulation of facts
    FINDINGS OF FACT.
    On July 9, 1905, petitioner was married to Marguerite C. Wurz-burg, and was her husband during the taxable year.
    During the year 1907, Marguerite C. Wurzburg’s father died and as part of his estate left certain shares of stock in the Clark Iron Co., of which Marguerite C. Wurzburg received 1,450J4 shares during that year. The Clark Iron Co. was reorganized in 1914 and on May 15, 1914, Marguerite C. Wurzburg received a new certificate of her holding in that corporation, which certificate she continued to hold during the taxable period.
    From time to time the Clark Iron Co. paid dividends on its stock. The dividend checks were always made to Marguerite C. Wurzburg, and were deposited by her in her account and were subject only to her withdrawal. The stock in the Clark Iron Co. was in the name of Mrs. E. W. "Wurzburg and was her absolute property. The dividends received on this stock during the year 1922 were received by Mrs. Marguerite C. Wurzburg and treated as her absolute property. During the year 1922, Marguerite C. Wurzburg received $18,856.76 as dividends from the Clark Iron Co.

      On March 13, 1923, petitioner filed a joint return of income of himself and his wife for the year 1922, and included therein the taxable portion of such dividends (which he computed to be $8,392.50) received by his wife from the Clark Iron Co.
    In his communication of June 25,1926, the Commissioner increased the taxable portion of the dividends received from the Clark Iron Co. from $8,392.50 to $11,110.40. The Commissioner included these dividends in the gross income, pursuant to an audit of the return filed by Edmund W. Wurzburg as a joint return of income of husband and wife for the year 1922.
   OPINION.

ÁRaNDunr,:

We have heretofore held in R. Downes, Jr. v. Commissioner, 5 B. T. A. 1029, and Germain Cassiere v. Commissioner, 5 B. T. A. 1032, that in a case where a taxpayer has filed a single joint return of the. income of himself and his wife under the provisions of section 223(b) (2) of the Revenue Act of 1921, he is not entitled to have his tax computed on the basis of his separate income. These cases are determinative of the question raised in the instant proceeding, and on their authority the contention of the petitioner must be denied as contrary to the express provision of the law.

Juchjm&nt will be entered for the resfondent.


author: Aiuxndell:

text:
    Edmund W. Wurzburg, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 13644.
    Promulgated March 30, 1927.
    Petitioner, having filed a joint return of income for himself and wife for the calendar year 1923, is not entitled to have his tax computed on the basis of his separate income. It. Doiones, Jr., v. Commissioner, 5 B. T. A. 1029.

      F. E. Seld.man, C. P. A., for the petitioner.

      W. F. Gibbs, Esq., for the respondent.
    This proceeding involves a redetermination of a deficiency in income tax asserted by the Commissioner for the calendar year 1923 in the amount of $131.02. The case was submitted on a stipulation of facts.
    FINDINGS OF FACT.
    On July 9, 1905, petitioner was married to Marguerite C. Wurz-burg, and was her husband during the taxable year.

      In 1907, Marguerite C. Wurzburg’s father died and as part of his estate left certain shares of stock in the Clark Iron Co., the Cicero Timber Co., and the Clark-Nickerson Co., of which Marguerite C. Wurzburg received the following shares, which shares were registered in her name during that year:
    Stock ill— Number of shares.
    Clark Iron Co_1150 14/27
    Cicero Timber Co_ 400
    Clark-Nickerson Co_ 732
    The Clark Iron Co. was reorganized in 1914, and on May 15, 1914, Marguerite C. Wurzburg received a new certificate of her holdings in that corporation, which certificate she continued to hold during the taxable period. She also continued to own the stock in the Cicero Timber Co. received by her from her father’s estate.
    The Clark-Nickerson Co. increased its outstanding stock on April 2, 1923, by the declaration of a stock dividend of 25 per cent, as a result of which Marguerite C. Wurzburg received 244 additional shares from that company on the 732 shares she owned as of that date, making a total of 976 shares.
    From time io time the Clark Iron Co., the Clark-Nickerson Co., and the Cicero Timber Co. declared and paid dividends. The. dividend checks were always made to Marguerite C. Wurzburg and the monies received by her as such dividends were deposited in her account and were subject only to her withdrawal. During the year 1923 she received the following taxable dividends:
    Clark Iron Co-,$10,777.35
    Cicero Timber Co- 150. 00
    Clark-Nickerson Co_ 3, 489. 20
    Petitioner rendered a joint return of income for himself and his wife and included therein the taxable portion of the above described dividends, except that for the Clark Iron Co. the taxable portion was included as $6,054.10 instead of $10,777.35.
    In his deficiency notice of February 26, 1926, the Commissioner increased the taxable portion of the dividends received from the Clark Iron Co. from $6,054.10 to $10,777.35. The Commissioner included these dividends in the gross income pursuant to an audit of the return filed by Edmund W. Wurzburg as a joint return of husband and wife for the year 1923.
   OPINION.

Aiuxndell:

We have heretofore held in R. Downes, Jr., v. Commissioner, 5 B. T. A. 1029, and Germain Cassiere v. Commissioner, 5 B. T. A. 1032, that in a case where the taxpayer has filed a single joint return of the income of himself and his wife under the provisions of section 228 (b) (2) of the Revenue Act of 1921, he is not entitled to have his tax computed on the basis of his separate income. These cases are determinative of the question raised in the instant proceeding, and on the authority of these cases the contention of the petitioner must be denied as contrary to the express provision of the law.

Judgment will be entered for the respondent.


author: Phillips:

text:
    Appeal of S. A. Conover Co.
    Docket No. 3926.
    Promulgated March 31, 1927.
    Petitioner held to be entitled to classiftcalion as a personal service corporation.

      Walter J. Goggin, G. P. A., for the petitioner.

      J. Arthur Adams, Esq., for the Commissioner.
    This is tin appeal from the determination of a deficiency of $2,081.85 in income and profits taxes for the period from May 1, 1920, to December 31, 1920, arising principally by reason of the refusal of the Commissioner to grant personal service classification to the taxpayer. It is alleged in the petition and admitted in the answer that the net taxable income of the taxpayer was overstated in computing the deficiency and that the correct deficiency, if the taxpayer is not a personal service corporation, is $1,544.45.
    FINDINGS OF FACT.
    For about twenty years prior to 1916, S. A. Conover had been engaged in sales promotion and advertising connected with the firm of N. W. Ayer & Sons Co. In 1916 he accepted an offer from L. C. Chase & Co. to furnish them advertising and sales service for which he was to be paid an annual salary and a commission upon their advertising. For some weeks Conover worked in their offices, then having no office of his own. He made a survey of their business, visited their mills and branch offices, and interviewed the trade and the jobbers for the purpose of ascertaining the extent of their market. He devised several trade-marks for use on their goods and changed others previously in use. He prepared sales plans, took photographs of the manufactured products, and later prepared advertisements for use in various publications. During the course of this work Conover gave up his desk in the office of Chase & Company and established his own office.
    On May 1, 1920, the taxpayer corporation was organized to take over Conover’s business, principally for the purpose of permitting three employees to obtain an interest. At that time $15,000 par value of preferred stock was issued to Conover for $13,000 cash, being the accumulated profits of his business, and for furniture and fixtures valued at $2,000. Common stock, having a par value of $†5,000 divided into 3,000 shares of $25 each, was issued to him for good will. Sixty shares of such common stock were issued to former employees of Conover who continued with the corporation, such stock being subject to a trust agreement under which Conover or the company had the right to repurchase at any time. All of the stockholders were actively engaged in the conduct of the business. The only emplojme was a stenographer and bookkeeper who was paid a salary of $100 per month. The stockholders drew salaries in 1920 of approximately $18,000. Conover supervised all of the operations of the taxpayer.
    Taxpajmr had few clients and the placing of advertisements was only a part of the service rendered to them. The services rendered in 1920 were substantially the same as those rendered to Chase & Company by Conover in 1916, which are described above. Before any steps were taken to advertise the business of a new client, an extensive study of the market for its products, as well as a study of its sales force, was made. Frequently changes in the sales force or method of selling were recommended and in some instances Con-over suggested the names of persons to be put in charge of sales or of particular phases of the sales projects. After such study, a report of the result would be submitted to the client, together with suggestions as to the form of advertisements, the medium to be used, the character of the advertising, the amount to be expended, and similar matters. Photographs to be used were prepared and submitted as a part of the proposed advertisements. Frequently, if the advertising were newspaper or magazine advertising, the newspaper or magazine, with name and amount to be expended in each, was fixed. In some instances the service consisted in the preparation of a pamphlet or catalogue. The suggestions submitted by the taxpayer were either approved, rejected, or modified by the client and thereafter orders were placed by the taxpayer for the insertion of the advertising in accordance with the plan adopted, or, if the advertising took the form of catalogues or circulars, orders for these were placed by the taxpayer with the printers.
    Taxpayer’s contracts with its clients provided for a retainer fee and also for 15 per cent upon the amount expended for advertising, printing or other publicity. The only written contract for the service of the taxpayer in 1920 was as follows:
    We authorize you to act as our Advertising Agency from December 1, 1920, and thereafter until three months’ notice is given by either party of their desire lo discontinue this arrangement in accordance with the last paragraph.

      You are to placo all of our advertising, and sucli printing as is necessary. You are to furnish all drawings, plates, composition, pliotos, electros and other material.
    Your compensation on above services is to be the standard Agency Commission of 10% of the gross charges which you bill to us.
    In addition to this, we are to pay you a Service Fee of $100.00 per month. In return for this fee you are to give us the benefit of the experience of your organization in devising ways and means to promote the sale of our products.
    Postage, carriage on electros, drawings, etc., are to be charged us at cost.
    Bills will be rendered to us monthly. We will pay same in full each month, within ten days from date of bill. You are to allow us the actual amounts of Cash Discounts allowed you by the parties with whom you do business on our account.
    At the expiration of three months from the above date, a mutual adjustment in the Service Fee may be made for a future period. This fee is to be based on the volume of work necessary.
    (Dated) November 29, 1920.
    In placing orders for advertising space the name of the client was invariably used. Tlie form in general use by the taxpayer during 1920 was as follows:
    S. A. Conover Company
    24 Milk Street
    Boston, Massachusetts
    Advertising
    (Name of publication)
    Please insert advertising of (name of client) as follows:
    (Here follow instructions with reference to the date of publication, space, position and other instructions with reference to the advertising.)
    S. A. Conover Company.
    The copy for the advertisements was furnished the publication by the taxpayer after it had been prepared by the taxpayer and approved by the advertiser.
    Bills were rendered to the taxpayer for such advertising and for printing, photographing, engraving and other services. In the case of advertising, discounts from the regular rates were allowed taxpayer as a regular agency. Upon receipt by the taxpayer of bills the amount of the deduction allowed to it as an agency was subtracted, arriving at the net amount to be paid and the publisher, printer, photographer or engraver, and the client would be billed for such net amount plus 15 per cent. This procedure was regularly followed whether the hill was for advertising or for printing, or for other expenditures and whether or not a discount was allowed to the taxpayer. Bills were received by the taxpayer upon the first of each month and rendered to its clients shortly thereafter. In most instances payment was received from the client before it was due to the publication or printer, but frequently payments were made by the taxpayer before they were received from its clients. This was done in order to enable the taxpayer to take advantage of f’fl.sli discounts given for prompt payment, usually 2 por cent. A similar cash discount was allowed clients if the bills were paid promptly.
    Gross income from commissions during 1920 was $28,959.69, representing commissions upon approximately $200,000 of business placed during the period from May 1 to December 31, income from retainer fees was $1,750, and from interest $894.34. This last item included $808.70, the difference between the cash discounts received and the cash discounts allowed to clients. The expenses for 1920, ether than salaries, were $2,999.
    The assets and liabilities on May 1, 1920, and on December 31, 1920, were as follows:

    Approximately $26,000 of the accounts receivable were due from Chase & Company.
    Conover was well known to most of the publishers. No publication or association of publications requested taxpayer to furnish any financial statements. When space was desired the order was forwarded in the form quoted above. If the order covered space to be used in the future and the advertiser named in the order did. not use the full space ordered, the amount used was charged at what is known as a “ short rate ” meaning thereby that if there was a differential in rate for the space used and the space contracted for, the space used was charged for at the rate which governed such amount of space, although previously billed at the rate governing the larger space order. The unused space contracted for by one advertiser and not used by him could not be used by another advertiser or client of the taxpayer, or otherwise disposed of by the taxpayer, nor could space be purchased in block or purchased without naming the advertiser in each instance.
   OPINION.

Phillips:

Taxpayer claims that it is entitled to classification as a personal service corporation under the provisions of section 200 of the Revenue Act of 1918. The evidence discloses that all of the stockholders of the appellant corporation were regularly engaged in the active conduct of its affairs and that the only other employee was a stenographer and bookkeeper. The only thing that the corporation had to sell was the service and advice of its stockholders and under the circumstances there can be no doubt that the income is to be ascribed primarily to their activities.

The income was not derived from trading as a principal. The evidence discloses that the corporation, whose principal income was from commissions upon advertising, did not purchase and sell advertising space in bulk but only placed orders for space as directed by its clients, in each case naming the client. Space contracted for but not used by the advertiser named could not be used by another advertiser or disposed of in any way by the advertising agent. It could only be canceled, in which event charge for the space already used would be recomputed upon the basis of the rate for such amount of space, known as the short rate.

We come then to consider the only remaining qualification required under the definition of a personal service corporation, namely: Is capital, (whether invested or borrowed) a material income-producing factor? It is not sufficient to defeat personal service classification that capital be used in the business or that capital be incidental to the production of the income. The capital must be a material factor in producing income. Capital must be of such use that the production of income would be materially lessened without it.

In this connection it is urged that the contract between the publisher and the advertising agent is such that the advertising agent is responsible for the payment of all bills for advertising, that recognition is extended only to agencies having good financial standing and that capital is necessary to obtain recognition as an agency and for use in paying for space used by advertisers.

It is our opinion that the matter of either the theoretical or legal liability, so long as the agent is not a principal dealing in the purchase and sale of space, has little to do with the question which we must decide. In determining whether capital is or is not a material income-producing factor, we must look to the use to which capital is put in the business. One agency, with no legal responsibility to pay the publisher for the advertising of its clients, may follow a consistent practice of making such payments and permitting credit facilities to its clients. This extension of credit may be such as to balance the scales in its favor as against another such agency which will not finance the obligations of its clients. In such a case capital is so used as to be material in securing and retaining income-producing business. Under such circumstances, if used to produce sufficient business, capital becomes a material income-producing factor. Another agency may expressly contract with the publisher to make itself liable for the payment for the advertising of its clients; yet if it so operates its business that collections are promptly made from the clients and it becomes unnecessary to use its capital to perform the obligation it has undertaken, capital has not become a material income-producing factor. The use of capital has been potential only. The fact that a business has capital, or in certain contingencies might require capital, is not sufficient to deny personal service classification, if in fact capital is not used to produce income; the use to which capital is put is the controlling factor.

The evidence here discloses that during a period of eight months the corporation transacted business aggregating over $200,000, or $25,000 per month. The difference between the cash discounts received and the amount allowed to the clients was $808.70, which at the usual cash discount of 2 per cent would indicate that in eight months $40,000 had been paid to publishers prior to payment to the petitioner, an average of $5,000 per month. There were, however, other expenses incurred and paid on behalf of clients and the evidence would indicate the use of from $10,000 to $20,000 in the business. As to the balance sheet at the end of 1920, it appears that the accounts receivable represented the account of Chase & Company, a client who had originally retained Conover on a salary basis and desired his services, not for any credit he could extend, but because it had confidence in his ability.

The net income of the corporation, before payment of salaries, appears to have been $28,803.03. There was paid from this the salary of a stenographer, $100 per month for eight months, leaving $28,000 attributable to the services of stockholders and to capital. Average capital employed, whether invested or borrowed, was less than $20,000. Even this amount appears to have been unnecessary, and its use produced at most only $800 of income. Twice this amount was received from retainer fees, having no reference to the placing of any advertising or the payment of any bills.

In these days of magazines with a national circulation reaching into millions of copies and the cost of advertising space into thousands of dollars per page, the preparation of such advertising and the selection of the proper media in which it is to appear has come to be recognized as a business or profession requiring skill and experience, and it was in such business that the taxpayer was principally engaged. On the whole record we are of the opinion that the primary income-producing factor was tire experience and advice of Conover, that capital was not a material income-producing factor and that such capital as was used was merely incidental to the services rendered in planning and carrying out sales and advertising campaigns.

Derision will be entered for the petitioner on 10 days' notice, under Rule 50.

Milliken and Sterntiacen concur in the result only.


author: Milliken:

text:
    J. S. McDonnell, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 13546.
    Promulgated April 2, 1927.
    1. Tlie 50 per cent fraud penalty asserted for filing a false and fraudulent return with intent to evade tax approved, where the returns filed were admittedly false, grossly understated the income, were filed without reference to readily accessible means of determining income received, and were allowed to stand without amendment until errors were discovered by revenue agents, though petitioner Knew he was under obligation to amend, and where the taxpayer’s explanations for omissions of income items were so conflicting as to be unconvincing.
    2. The 50 per cent fraud penalty is measured by 50 per cent of the amount of tax due in excess of that shown to be due by the return, though a part of the total deficiency had been determined, assessed, and paid prior to the deficiency determination forming the basis for appeal.
    3. The Commissioner's failure to comply with section 1005 of the Revenue Act of 1021, by notifying the taxpayer in writing that an additional examination of boolts was necessary, may not be interposed as a defense invalidating the deficiency based largely upon information derived from other sources, where the examination was conducted without objection by the taxpayer, as the protection afforded by section 1005 was waived by the failure to object.

      M. A. Matloch, Esq., for the petitioner.

      Thomas P. Dudley, Esq., and Robert A. Littleton, Esq., for the respondent.
    This proceeding results from the determination by the Commissioner of deficiencies in tax and the imposition of the 50 per cent fraud penalty for the calendar years 1920,1921, and 1922, in the total amount of $28,405.50. In the original petition filed, three errors are assigned as follows:
    (1) The respondent did not make a legal determination of the deficiencies for the years 1920 and 1921, in that the provisions of section 1005 of the Revenue Act of 1924 were not complied with.

      (2) The respondent committed error in his determination that the petitioner, for the years in question, made a willful and false return with intent to evade the tax or defraud.
    (3) The respondent erred in that he proposed to assert penalties upon deficiencies which do not exist.
    In an amended petition filed at the hearing of this case, petitioner assigned additional errors for all the years involved. For the year 1920 (1) the respondent refused to allow a loss of $1,914.12 sustained in the joint trading account of McDonnell and Matthews and instead charged petitioner with a profit of $919.20 from that source; (2) refused to allow a loss of $355.05, which represents an amount stolen from the safe of the petitioner; (3) failed to allow as a deduction taxes paid to Jefferson and Pulaski Counties, Arkansas, in the amount of $2,000; (4) failed to allow $8,929.73 as a deduction for bad debts. For the year 1921, (1) refused to allow as a deduction state and county taxes paid to Jefferson and Pulaski Counties, Arkansas, in the amount of $2,000; (2) refused to allow as a deduction, a donation of $200. For the year 1922, (1) failed to allow as a deduction, $4,500 as a loss sustained in the trading account of McDonnell and Matthews; (2) failed to allow as a deduction, $2,000 paid to Jefferson and Pulaski Counties, Arkansas, for state and county taxes.
    FINDINGS OF FACT.
    Petitioner is an individual, residing at Altheimer, Ark., and during the years in question, was engaged in the mercantile and cotton business. His income is to be almost entirely attributed to the business in which he was engaged, together with interest received from bonds or other evidences of indebtedness. For each of the years here involved, with the possible exception of 1922, petitioner delayed the preparation and execution of his Federal income-tax return until practically the last day allowed by the statute for filing returns. He then went to the office of the local collector, where his returns were prepared by a deputy collector, who used such figures as were called off to him by the petitioner. His returns for 1920, 1921, and 1922, were prepared and filed on March 15, 1921, March 14, 1922, and February 26, 1923, respectively, and no further returns for those years have since been filed.
    Eevenue Agent John B. Wishendorff made an investigation of the returns filed by the petitioner for the years 1917 to 1921, inclusive, and such records as the petitioner had for those years, submitting his report to the respondent under date of February 20, 1923, said report recommending (and so far at least as the years 1920 and 1921 are concerned there is no dispute as to the correctness thereof) additional taxes in the following amounts:
    1917_1-$1, 773.18
    1918_12, 351. 93
    1919_ 11, 050. 70
    1920_ 3,439.51
    1921_ 1,400. 29
    The respondent, in auditing the l'eport of Agent Wishendorif, found that he had not included in income various items of interest which information returns on file in the office of the respondent indicated the petitioner had received, and accordingly under date of February 12, 1925, the revenue agent in charge was directed by respondent to cause an investigation to be made to clear up this discrepancy. Under date of February 16, 1925, Revenue Agent James F. Shofner was directed by the revenue agent in charge to reconcile the discrepancy and to submit to respondent a supplemental report. Shofner submitted his report under date of May 26, 1925. Except for the items relating to the petitioner’s mercantile business at Altheimer, and his dealings with R. E. Matthews, his report was not based on any books or records of the petitioner. This report was audited by the respondent, and the deficiencies here in question aré based thereon. The income shown on Shofner’s report exceeded that shown on Wishendorff’s report by $15,546.96 for 1920 and $14,902.84 for 1921. The income returned by the petitioner for 1920 and 1921, and the amounts as found by Revenue Agents Wishendorif and Shofner and approved by respondent, are as follows:

    For the year 1922, petitioner reported income of $16,123.70, whereas Agent Shofner in his report dated May 6, 1925, found, and respondent has approved his findings, that petitioner received income in the amount of $55,311.26.
    The principal items of income omitted in the returns filed by petitioner, and resulting in the proposed deficiencies for the years in controversy, relate to the understatement of the amount of interest received, failure to report gains derived from dealing in cotton futures, failure to include in income rents received from real estate, and understatement of income on the books of the mercantile business at Altheimer, Ark. The failure to so report the income from these sources, forms the basis for the penalty asserted by the respondent.
    In the returns filed for 1920, 1921, and 1922, petitioner reported interest received in the amounts of $3,550, $3,625, and $3,675, respectively. Respondent determined, and no error is assigned to such determination, that interest was received by the petitioner in 1920 in the amount of $11,701.07, in 1921 in the amount of $18,694.72, and in 1922 in the amount of $19,526.63.
    Practically the entire amount of interest received during the years in question was received from five sources, namely, the Beal-Burrow Dry Goods Co., Beal-Burrow Realty Co., Pine Bluff Hotel Co., Lula V. Dibbrell, and George W. Donaghey. The reason as signed for failure to report interest received from Beal-Burrow Dry Goods Co. is that the partners of that company had an agreement whereby the treasurer of that concern was to file returns for the partners. The agreement, which petitioner, along with other partners, signed, reads as follows:
    This agreement, made this 4th day of May, A. D. 1920, by and between all the partners doing business as the Beal-Bürrow Dry Goods Company, Wit-nesseth :
    Whereas, Steps have been taken toward perfecting the organization of the Beal-Burrow Bey Goods Company as a partnership unlimited and ordinary, and this has been accomplished, with the result of a substantial saving -of money to the parties hereto because of the necessary reduction of Federal Taxes occasioned by the transformation of the organization from that of a joint stock association, and
    Whereas, the partnership has thereby been financially strengthened by the unlimited liability of the financially responsible partners, whose entire assets are liable for all obligations of the business, and
    Whereas, considerable time, inconvenience and expense will be saved to each of the parties hereto if tlieir income taxes are figured, compiled, returned and paid by the officers of the business,
    Now, Therefore,., in consideration of the premises, the time, inconvenience and expense to be saved and the mutual promises of each of the parties hereto, it is hereby understood and agreed as follows:
    That the Treasurer of the Beal-Burrow Dry Goods Company shall, annually, at the proper time, make and file for each of the parties hereto their Federal Income Tax return showing income from this partnership only, including salary from the partnership to the parties hereto and bonus money, if any is given by the partnership, and the said Treasurer shall pay that amount of Federal Income Taxes which may be legally due from the parties hereto on account of and in proportion only to their income from this business, and all amounts so paid shall he charged to expense of conducting the partnership business, the same as rent and other items, and shall he first paid and take precedence over any other payments to the Federal Government or amounts due or accrued to the parties hereto from said partnership or from any other source, as profit, salary, or otherwise.
    And we each of us hereby ratify and confirm the action of said Treasurer in paying out for the year 1919 our income taxes and charging same to expense of doing business, in the manner above agreed upon.
    Witness our hands and seals this day and year first above written.

      Petitioner did not inquire, during the years here involved, whether returns were being made as provided by the agreement, nor did the treasurer advise him that he was or was not making such returns. The secretary of Beal-Burrow Dry Goods Co. did make returns for some of the partners, but only for those partners who furnished full information as to their income from all sources and all of the deductions claimed.
    Included in the amount of interest not reported for the year 1920 was $4,810 received during that year from bonds of the Pine Bluff Hotel Co., held by the petitioner, and for 1921 a like amount received on those bonds during that year, and for 1922, $4,485 received in 1922.
    Interest payments due the petitioner from the five sources enumerated were made annually or semi-annually to two banks with which petitioner had accounts, and although he kept no books showing interest received, the amount received each year coiild have been ascertained with little difficulty through examination of his bank books. The revenue agents obtained their information of the amount of interest received from these sources, not from the petitioner, but by-checking bank records and records of persons or concerns paying the same.
    No records were maintained by petitioner of his dealings in cotton futures during any of the years in question. Pie dealt in futures with some twelve or fifteen brokers, who rendered statements from time to time, advising him of his profits or losses. When a given transaction was closed, petitioner considered any statements concerning the same of no further use, and they were destroyed. The respondent accepted the findings of the revenue agent and determined that profits from this source amounted to $4,917.32 for 1920, $839.82 for 1921, and $5,493.40 for 1922, and no error is assigned by the petitioner to such determination of income.
    Respondent determined that petitioner received rents from property owned in Pine Bluff, Ark., in the amounts of $531.30 for 1920, $504 for 1921, and $029.05 for 1922. Petitioner returned no income from these sources.
    Petitioner assigns as his reason for failure to return income from his mercantile business at Altheimer, the fact that the books of the business were never maintained in a current manner and from the entries of the books he was unable to ascertain the income received. He employed a bookkeeper to look after these books and made no supervision of them himself to ascertain their accuracy. The petitioner also claims that numerous bad debts and losses were sustained during the years but were not taken as deductions.
    In the year 1920 there was stolen from the safe of petitioner the sum of $355.65, which should be allowed as a deduction income for the year 1920.

      In the year 1921, petitioner paid to the Presbyterian Church of Little Rock, Ark., the sum of $200, which should be allowed as a deduction from income for 1921.
    It was stipulated at the hearing that the following payments were made and losses sustained for the respective years:
    1920. State, county and city tases paid to Pulaski County, Ark_ $647. 30
    State, county and city taxes paid to Jefferson County, Ark_ 519. 77
    Loss sustained from the joint trading account of McDonnell and Matthews-1, 915. 5S
    1921. State, county and city taxes paid to Pulaski County, Ark_ 804. 73
    State, county and city taxes paid to Jefferson County, Ark_ 1,034.24
    1922. State, county and city taxes paid to Pulaski County, Ark_1, 031.82
    State, county and city taxes paid to Jefferson County, Ark_ 676. 83
    Loss sustained in joint trading by McDonnell and Matthews, of $1,030.88, one-half of which was a loss sustained by petitioner- 515. 40
    The petitioner is entitled to deductions for the payments made and losses enumerated for the years specified above.
    It is also stipulated that the books of the joint account of McDonnell and Matthews show a profit for 1923 covering the period from January 1, 1923, to March 30, 1923, of $55.83, which entries were adjustments for trading operations taking place in prior years and do not represent trading in 1923; that the personal account of R. E. Matthews appearing on the books of J. S. McDonnell disclosed a debit balance at December 31, 1922, of $1,629.23; that a charge of $1.10 was made to the personal account of Matthews on January 13, 1923, such charge representing a payment made for a telephone call by Matthews in December, 1922; that the debit balance of the personal account of Matthews was $1,633.33 as of January 31, 1923, and was charged to profit and loss on the books of the petitioner on December 31, 1923. Petitioner and Matthews discontinued their cotton-trading business on or about Christmas, 1922.
    Respondent determined the deficiencies in tax and the penalties for the years in question as follows:
    1920. '
    Total tax assessable-$9,108.29
    Less:
    Tax previously assessed on original return filed_$1, 395. 79
    January, 1924, additional assessment_ 3,439. 51
    - 4,835.30 Deficiency- 4, 272. 99
    Penalty as provided in sec. 250(b), Revenue Act of 1918 ($9,108.29 less $1,395.79=$7,712.50X50%)_ 3.S56.25

      1921.
    Total tax assessable_$8,321.09
    Less:
    Tax previously assessed on original return filed-$3, 003. 69
    January, 1924, additional assessment- 1, 406. 29
    - 4,409.98 Deficiency_ 3, 911.11
    Penalty as provided in sec. 250(b), Revenue Act of 1921 ($8,321.09 less $3,003.69=$5,317.40X50%)_ 2,658.70 1922.
    Total tax assessable- 10, 332.72
    Less: Tax previously assessed on original return- 1,195.09 Deficiency_ 9.137. 63
    Penalty as provided in sec. 250(b), Revenue Act of 1921, of 50%- 4, 508. 82
   OPINION.

Milliken:

Petitioner avers that there has not been a “legal determination” of deficiencies for the years 1920 and 1921 by the respondent, in that the provisions of section 1005 of the Revenue Act of 1924 were not complied with. We are unable to accept his views in the matter. Section 1309 of the Revenue Act of 1921 and section 1005 of the Revenue Act of 1924 contain identical provisions, as follows:

No taxpayer shall be subjected to unnecessary examinations or investigations, and only one inspection of a taxpayer’s books of account shall be made tor each taxable year unless the taxpayer requests otherwise or unless the Commissioner, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.

It is not disputed that the agent of the respondent did not present to petitioner a notification in writing that an additional investigation was necessary. No doubt the petitioner might have refused to permit Revenue Agent Shofner access to his books at Altheimer, Ark., when he conducted his investigation without prior notification to him by the respondent of his intentions to conduct the same, as provided in section 1005. However, that section of the statute merely provides for the relief from unnecessary examinations of a taxpayer’s books and does not propose to provide that any deficiency resulting from such investigation shall be void. Petitioner did not object to the examination of his books at Altheimer, at least we have no evidence to that effect, and his failure so tó do may be taken as a waiver of the protection the statute afforded. It is pertinent to note, also, that petitioner maintained no books or records of that part of his income which forms practically the entire basis for the defi-ciences here in question. The revenue agents determined almost his entire income from deposits at the bank at which petitioner dealt and from the concerns that had paid interest to petitioner during the years involved. He had no books relative to most of these items, and, accordingly, can not set up the defense of a reexamination of something he did not possess. Petitioner is in an anomalous position in objecting to the reexamination of his books, such as he had, for he testified that when filing his returns he knew that they were not true reports of income and that he filed them with the expectation that Government agents would check up his returns and that his true income would be made subject to tax. In relying upon section 1005 as a protection, he is denying to the Government the rig]it to do that which he expected them to do, namely, to check up and ascertain his true income. There might be the interesting question in instances of a false and fraudulent return, where no statute of limitation pertains, as to the applicability of section 1309 and section 1005, but in view of our previous statements no discussion seems necessary.

We next come to the important question presented in the case at bar. Were the returns filed by petitioner for the years 1920, 1921, and 1922, showing an understatement of income, false or fradulent, with the willful intent to evade the tax? Before we can determine if such be the case, the facts and circumstances incident and subsequent to the filing of the returns for the years in question, should, in this case, be weighed. The petitioner is a business man of advanced years, yet active and aggressive. Pie has been in business for over forty-five years, is possessed of considerable wealth, and his affluence is to be ascribed to his own efforts. Pie was fully conversant with the value of a dollar and the necessity in his business for the prompt collection of accounts due from a debtor. Federal income-tax returns were not new to him, for the evidence shows he had filed returns for at least three years preceding the years in question. He knew of his obligation to the Government in this respect. Wo find him, as the time arrives for filing the returns for each of the years in question, dilatory in securing the information upon which the returns wore to be based. He had interest payments for each of the years in question, in substantial amounts, which he knew he had received, for he testified the banks collected the interest payments when due and he had noted their collection on his pass book. The principal payments of interest were not large in number, never exceeding payments from five or six sources in any one year. The payments were made to him on a semiannual or annual basis. He testified that with but little effort he could have ascertained the correct amount of interest in any given year when filing his tax return. He testified that he knew when he filed his returns that the information contained therein was incorrect and his counsel admitted that they were false and petitioner testified he expected to subsequently file a correct return, yet we are unable to find that he made any effort to correctly report his income for the years in question. He also testified he knew it was his duty to correctly report his income and not to delay until the Government agent checked up his accounts, yet we find the petitioner making no effort to divulge to the Government his true income, and doing nothing until approached by the agents of the respondent and then his cooperation was not active, only passive, and the agents of the respoirdent were left to resort to bank statements and data obtained from concerns or persons who paid interest to the petitioner. .The understatement of income does not relate to only one year — it relates to all the three years in question, and to essentially the same kind of income understated. The income understated seems to grow with the years, for in the first year, i. e., 1920, there was an understatement of approximately $33,000, and in 1922 there was an understatement of approximately $39,000. What reasons does the petitioner assign for such understatement? He testified that he sought, to approximate his interest income for each of the years in question by balancing it with the amount paid. At the hearing of this case, petitioner did not submit any proof as to the interest which he paid. His petition has been pending with this Board since April, 1926, and he was given thirty clays’ advance notice of the date of this hearing, which took place on October 8, 1926, and if he had a defense that he had paid sums as interest which would offset the interest received, he has had ample opportunity to present proof thereof, and his reason for the understatement, in this particular, is of no avail. It is not enough that the petitioner should deal in generalities at the hearing of this case, and state that he had paid sums as interest without giving any basis for such statement, or facts or figures in support thereof.

The further reason assigned for his failure to report interest, is that he thought, by the terms of the agreement between the partners of the Beal-Burrow Dry Goods Co., the interest payments from that source would be returned for him. This defense is open to the attack that large sums of interest were received from sources other than the Beal-Burrow Dry Goods Co. and as to which the agreement did not attempt to provide. He testified that he made no inquiries, during any of the years, to ascertain if such reports were being made for him, and also that he was not informed by the treasurer of the Beal-Burrow Dry Goods Co. that reports of hi? income were being made for Mm. The evidence also shows that petitioner reported as income the salary which he received from the Beal-Burrow Dry Goods Co., indicating, further, that he was not depending upon the agreement. He reported this item in the tax returns filed by himself, yet he failed to mention the interest. Counsel for respondent asked petitioner the following question as to why he reported salary from the Beal-Burrow Dry Goods Co. if he was depending upon the agreement, and why he left out interest . from the Beal-Burrow Dry Goods Co.:

Q. Wliy did you put in salary and leave out interest?
A. Because I thought I included all I owed the Government in that block— the sum ot interest there.

If petitioner thought he was including in his return filed the entire amount of interest received from the Beal-Burrow Dry Goods Co., lie could not have, at the same time, been relying upon the agreement recited in the findings of fact, whereby he thought another was going to report it for him.

A large amount of interest from bonds of the Pine Bluff Hotel Co. which petitioner owned was not reported as income, fío error was assigned in the petition to the action of the respondent in adding such interest to his income for the years in dispute. At the hearing the petitioner testified that he had made a gift of some of the bonds prior to the years in question. If the gift was made, proof should have been introduced in support thereof, and we are not warranted in accepting generalities without a definite basis of fact for their support.

Petitioner assigns as his reason for failure to report income from dealing in cotton futures, that he believed that the Government did not tax gains arising from this source, and also for the reason that he had large losses in the years 1923 and 1924. It is obvious that petitioner did not know, when he filed his returns in *March, 1921, March, 1922, and February, 1923, that he would have large losses for the years 1923 and 1924, for, at the time those returns were filed, the years had not passed in which the losses had occurred.

It is true that petitioner is entitled to additional deductions from income because of state, county and city taxes paid during the respective years, and some minor adjustment in the trading account which he maintained. These deductions, however, are of a minor nature when compared with the understatements of income and do not change the force of the fact that no deductions have been proven which would materially offset the large understatement of income from interest received. It may also be that petitioner is entitled to some deductions for bad debts for the year 1920. We have no evidence before us from which it could be determined that the debts were ascertained to be worthless and charged off within that taxable year. Cf. Georgetown Grocery Co. v. United States, 63 Ct. Cls. 160.

This case is not one where a mere clerical error results. in the understatement of income, or where there is a mistaken idea as to some regulation or requirement of the respondent, cf. Cooper v. United States, 9 Fed. (2d) 216; nor is it a case of constructive fraud, see decision of the United States District Court for the Western District of Pennsylvania, in the case of United States v. Whyel, 19 Fed. (2d) 260. Nor docs it represent a case involving a question of fact upon which differences of opinion might reasonably exist, cf. Ohio Farmers' Ins. Co. v. Hard, 59 Ohio St. 248; 52 N. E. 635. Nor have we in this case the fact that the return was hied by the petitioner based upon erroneous legal or accounting advice given him and upon which he honestly relied, cf. Beam v. Hamilton, 289 Fed. 9. Nor do we have in this case the question of a device relied upon to reduce taxes, which device was lawful, cf. United States v. Isham, 17 Wall. 496; Weeks v. Sibley, 269 Fed. 155.

Based iqjon all the facts of record in this proceeding, we are of the opinion that the respondent did not commit error in the imposition of the 50 per cent penalty, pursuant to the provisions of section 250(b) of the Revenue Acts of 1918 and 1921.

We are also of the opinion that no error was committed in the method of computation of the deficiencies and penalty for each of the years, as set forth in the findings of fact.

The deficiencies should be redetermined, making adjustments for the errors stipulated and found, as set forth in the findings of fact.

Judgment will be entered on %0 days' notice, under Rule 50.


text:
    A. W. Hurley, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 7339.
    Promulgated April 2, 1927.
    1. Amounts paid by a national bank on bebalf of its stockholders for taxes assessed against them constitute income to the stockholder, and the amount paid as taxes is deductible from gross income.
    2. Allowance for exhaustion, wear and tear of oil well equipment as determined by the respondent approved.

      Charles H. Garnett, Esq., for the petitioner.

      Robert A. Littleton, Esq., for the respondent.
    This is a proceeding for the redetermination of deficiencies in income taxes for the years 1919 and 1920, in the amounts of $568.96 and $117.68, respectively.

      FINDINGS OF FACT.
    The petitioner was, during the years 1919 and 1920, the owner of certain shares of the capital stock of the Citizens National Bank of Pawhuska, Okla. The laws of Oklahoma taxed the shares with regard to ownership, required the bank to retain so much, of every dividend belonging to the stockholders necessary to pay the tax, and gave the bank a lien on such shares to reimburse it for any taxes so paid. In those years the said Citizens National Bank paid the state and county taxes assessed on the stock of its stockholders. The amount of these taxes applicable to the shares of stock owned by the petitioner was $617.14 for the year 1919, and $547.18 for the year 1920.
    During the years 1919 and 1920, the petitioner was a member of the partnership of Yandervoort & Hurley, which owned two oil leases on which were producing wells. The cost of the equipment on these leases in the year 1917 was $31,849.94. No additional equipment was purchased in 1918 or 1919, but additional equipment was purchased in 1920 at a cost of $20,359.56. The net oil reserve on these leases was 69,850 barrels in the year 1917. Due to additional development in 1920, the reserve was increased in that year by 18,000 barrels. The production for the said leases was 2,206 barrels in 1917, 34,328 barrels in 1918, 13,336 barrels in 1919, and 11,094 barrels in 1920.
    The Commissioner, upon audit of the petitioner’s income-tax returns for the years 1919 and 1920, increased the petitioner’s income for 1919 by the amount of $617.14 and his income for 1920 by the amount of $547.18, on account of the state and county taxes paid by the Citizens National Bank of Pawhuska on the shares of its capital stock owned by the petitioner, but refused to allow any deduction from gross income on account of the taxes so paid. The Commissioner also allowed the partnership of Yandervoort & Hurley an allowance in each of the years 1919 and 1920 for the exhaustion, wear and tear of its oil well equipment, computed at the rate of 10 per cent, and adjusted the petitioner’s income accordingly.
   OPINION.

MaRquette:

The record herein discloses that the petitioner was owner of shares of capital stock of the Citizens National Bank of Pawhuska, and that state and county taxes were assessed thereon, which were paid by the bank. These taxes constituted an obligation of the petitioner and not of the bank. Des Moines National Bank v. Fairweather, 263 U. S. 103.

The transaction was the same in substance as if the bank had paid the petitioner dividend in the amount of the taxes and he had then liquidated his obligation. Stating the transaction in another way the bank paid ihe taxes for the petitioner with the petitioner’s money. If the bank had paid the petitioner a dividend in the amount of the taxes and the petitioner had then paid the taxes, it is clear that he would have been required to include in gross income the amount of the dividend, and that he would be entitled to deduct from gross income the amount of the tax. We are of the opinion that the respondent properly included in the petitioner’s gross income for 1919 and 1920 the amount of the taxes paid by the bank on his shares of stock, but that the respondent erred in refusing to allow the amount so paid to be deducted in computing the petitioner’s net income.

With reference to the deductions to which the partnership of Van-dervoort & Hurley is entitled as allowances for the exhaustion, wear and tear of its oil aycII equipment in the years 1919 and 1920, the petitioner and the respondent are in agreement as to the cost of the equipment, the oil reserves on the leases, and the production in each year. The petitioner, however, contends that the allowances should be computed on the unit of production basis, that is, that the allowance in each year should bear the same ratio to the cost of the equip-' ment that the production in that year bears to the total content of the Avells. The respondent has determined that an allowance in each year computed at a flat rate of 10 per cent is reasonable.

Under section 214 (a) (8) of the Revenue Act of 1918, the partnership is entitled to deduct, in computing its net income for each of the years 1919 and 1920, a reasonable allowance for the exhaustion, wear and tear of the equipment used in connection with its oil leases. However, the petitioner has failed to produce any evidence to show the life of the property in point of time, as related to the life of the resources, or that the unit of production basis of depreciation is properly applicable. Upon the record as made, we see no reason for disturbing the Commissioner’s determination.

Judgment will he entered on 15 days’ notice, wider Bule 50.