author: Geaupner:

text:
    Appeal of Estate of SAMUEL P. SCHWING, J. L. HORTENSTINE, Coadministrator.
    Docket No. 3633.
    Submitted November 16, 1925.
    Decided February 13, 1926.
    1. Transfer of stock by decedent about fourteen months prior to bis death, where promissory notes equal to the par value of the stock were given in payment, the stock certificates being attached to the notes as security, held to have been a bona tide sale for a fair consideration.

      2. The decedent a few days before bis death surrendered the notes to the makers thereof, with instructions to destroy them. Helé, the unpaid balance of the notes was a gift made in contemplation of death.
    3. Deduction claimed as fee paid to a physician for services rendered the decedent disallowed for lack of evidence.

      G. A. Ruhl, G. P. A., for the taxpayer.

      John F. Greaney, Esq., for the Commissioner.
    Before GraupneR, Trammell, and Phillips.
    This is an appeal from the determination of a deficiency in estate tax for the year 1921 in the amount of $2,694.98, of which $2,579.87 is in controversy. The disputed portion of the deficiency arises from the inclusion by the Commissioner, in the gross estate of the decedent, of certain shares of stock which had been transferred by the decedent to his son and daughter. The value of the stock is also in controversy, the taxpayer contending that unrealized appreciation should not be used in determining the value. The petition further alleged error on the part of the Commissioner in disallowing a doctor’s fee and one-half the amount of the executor’s fee. The allegations with respect to the executor’s fee were withdrawn.
    FINDINGS OE EAOT.
    1. Samuel P. Schwing died on February 19, 1921, at an age in excess of 60 years, and J. L. Hortenstine and Samuel P. Schwing, Jr., were duly appointed administrators of his estate.
    2. The decedent was educated and licensed as a physician, but did not follow his profession. For a number of years he was president of the Schwing Lumber & Shingle Co., of Plaquemine, La., and looked after the logging and timber part of the business. His brother, Edward B. Schwing, was secretary and treasurer of the company, and some time prior to the transaction' hereinafter described the brothers had agreed that they would gradually work their sons into the business, so that they would be able in time to take charge of it.
    3. On December 19, 1919, the decedent surrendered 1,163 shares of stock which he held in the company, and, at his direction, the secretary issued certificates for 580 shares thereof to Samuel P. Schwing, Jr., 580 shares to Carrie B. Schwing Hortenstine, who was a daughter of the decedent, and 3 shares to the decedent. At or about the same time the son and daughter each gave the decedent a promissory note in the amount of $58,000 in payment for the stock at $100 per share and attached the stock certificates to the notes as collateral security. The notes and stock certificates were placed in a safe deposit box in a New Orleans bank, which the decedent and his wife held jointly.
    4. At the time this transfer was made the decedent contemplated retiring from the business in about five years and so expressed his intention.
    5. Dividends in the amounts of $5,800 and $11,600, representing 10 per cent and 20 per cent dividends, were paid on January 6, 1920, and January 10, 1921, respectively, by the company to each of the transferees of the stock here involved. The dividend checks were endorsed by the payees and turned over to the decedent to be applied against the purchase price of the stock as evidenced by the note.
    6. In December, 1920, decedent and his brother made a trip to Havana, Cuba, where they were entertained and kept late hours. On their return from Havana they went to Chicago. The decedent was quite active while in Chicago, but while in New Orleans on his way home from Chicago he spent a short time in a hospital, and at that time advised members of his family that he had high blood pressure. Until the time of the illness which preceded his death, he never expressed any alarm as to his condition. On January 26, 1921, Mrs. Schwing insisted upon knowing the condition of the health of her husband and was informed by a physician that he was in the last stages of Bright’s disease.
    7. On or about February 7, 1921, Mrs. S. P. Schwing, at the direction of her husband, secured the stock certificates and notes from the safe deposit box. The decedent thereupon delivered to his son and daughter the certificates standing in their names and the notes they had executed, stating that the balance due on the notes was canceled and directing them to destroy the notes.
    8. At the time the stock certificates and the notes above mentioned were delivered by decedent to his son and daughter there was due on the notes $81,200, after crediting the dividends received. One-half of this amount, or $40,600, was included in the estate-tax return, in accordance with the community property law of Louisiana, as a transfer made in contemplation of death. The Commissioner decreased the gross estate by the amount of $40,600 and increased it by adding thereto $121,220, representing one-half the value of 1,160 shares of stock at $209 per share. This increase was made on the theory that the stock was transferred in contemplation of death and to take effect in possession and enjoyment at or after death.
    9. The book value of the stock of the Schwing Lumber & Shingle Co., as disclosed by its balance sheet of December 31, 1920, which did not include appreciation of timber, was $137 per share. The value of $209 per share was determined by the Commissioner by including appreciation of the value of timber'. The valuation of the timber was the subject of conference in the Bureau of Internal Revenue at the time the Commissioner’s answer in this appeal was filed. The timber questionnaire filed by the company in 1920 shows the unrealized appreciation in value of the timber to be $358,429.95, equal to $71.68 per share.
    10. In 1923, 260 shares of stock were sold at $140 per share; in 1924, 80 shares at $140; and in 1925, 150 shares at $130.
    11. The decedent was attended in his final illness by a physician who gave the decedent constant attention during the last 30 days and. even slept at his home. In accordance with the custom of the medical profession, this physician never rendered a bill to the estate for his services. However, relatives of the decedent later mailed the physician a check for the services he had rendered.
    DECISION.
    The deficiency should be computed in accordance with the following opinion. Final determination will be settled on 10 days’ notice, under Rule 50.
   OPINION.

Geaupner:

The principal question for determination is whether the transfer of 1,160 shares of stock by the decedent to his son and daughter in December, 1919, was a bona -fide sale for a fair consideration or a transfer made in contemplation of death, within the meaning of section 402(c) of the Revenue Act of 1918.

The evidence is that the transferees gave the decedent their notes, each in the amount of $58,000, and deposited the stock certificates as security. The notes were therefore valuable to the extent of the value of the stock given as security, which, from the evidence, was not less than the face of the notes. This, in our opinion, constituted a bona fide sale of the stock, and the transaction is accordingly removed from the operation of the presumption created by section 402(c) of the 1918 Act.

The taxable amount was that of the unpaid balance of the notes which was canceled by the decedent early in February, 1921,'within two weeks prior to his death. The decedent forgave the indebtedness amounting to $81,200, one-half of which, or $40,600, in accordance with the community property law of Louisiana, should be included in the gross estate of the decedent.

In view of this holding, it is unnecessary to determine the value of the stock here involved at the time of the decedent’s death.

The deposition of the physician who attended the decedent discloses that he received a check for services rendered, but there - is no evidence' of the- amount of the. check, and the disallowance by the Commissioner of the amount claimed as' a doctor’s fee is approved.


source: Caselaw Access Project

author: Phillips:

license: Public Domain

text:
    Appeals of R. H. SOAPER and JAMES E. RANKIN, Sr.
    Docket Nos. 2517, 2518.
    Submitted October 15, 1925.
    Decided February 13, 1926.
    Upon the evidence, held, that tbe Commissioner’s determination of the fair market value of the capital stock of a corporation as of March 1, 1913, should not be disturbed.

      John G. Worsham, Esq., for the taxpayers.

      J. W. Fisher and B. A. Littleton, Esqs., for the Commissioner.
    Before Graupner, Trammell, and Phillips.
    The taxpayer, R. H. Soaper, appeals from the determination of a deficiency of $32,142.10, income tax for 1920. The taxpayer, James E. Rankin, Sr., appeals from the determination of a deficiency of $1,734.71, income tax for 1920. Each- of these appeals involves the determination of the fair market value of the capital stock of Henderson Cotton Mills on March 1, 1913. The two appeals were consolidated.
    FINDINGS OP PACT.
    1. The taxpayer, R. H. Soaper, is a citizen and resident of Henderson, Ky. Prior to March 1, 1913, Soaper acquired 711 shares of the capital stock of the Henderson Cotton Mills. In April, 1920, said stock was sold by him for $300 per share. In his income-tax return for 1920, he reported said sale and computed and reported a profit thereon upon the basis of a fair market value on March 1, 1913, of $194.59 per share. The Commissioner determined the fair market value of said stock, as of March 1, 1913, to be $150 per share, increased Soaper’s income accordingly, and determined the deficiency here in issue.
    2. The taxpayer, James E. Rankin, Sr., is a citizen and resident of Henderson, Ky. Prior to March 1, 1913, Rankin acquired 151 shares of the capital stock of the Henderson Cotton Mills. In April, 1920, said stock was sold by him for $300 per share. In his income-tax return for 1920, he reported said sale and computed and reported a profit thereon upon the basis of a fair market value on March 1, 1913, of $194.59 per share. The Commissioner determined the fair market value of said stock, as of March 1, 1913, to be $150 per share, increased Rankin’s income accordingly, and determined the deficiency here in issue.
    3. The Henderson Cotton Mills was a Kentucky corporation, with its principal place of business at Henderson. It was organized in 1885 with a capital stock of $400,000. Operations were begun in 1886. The capital stock was increased to $450,000 in 1896 and to $500,000 in 1901. The par value of the stock was $100 per share. During the period of its existence the corporation was engaged in the manufacture of cotton goods at Henderson.
    4. From the date of organization in 1886 to March 1, 1913, the average earnings were over 12 per cent of the capital and surplus disclosed by the books of the corporation. The earnings of the corporation from April 1, 1897, ’to March 1, 1913, before depreciation, were $966,852.09. During the same period the corporation charged off depreciation of $573,220.56 and paid dividends of $520,500. Depreciation was not entered on the books at regular intervals, but from time to time lump sums were charged off as depreciation. The average capital and surplus for the same period, as shown by the books, was approximately $616,000. For the years 1908 to 1912, inclusive, the earnings of the corporation before deducting any depreciation, the dividends paid, and the capital and surplus, as shown by the books, were as follows:

    1 In 1911, $53,402.28 depreciation previously written off was restored on the books.
    5. On March 1,1913, the book value of the stock was approximately $119 per share.
    6. From March 1, 1913, to May 20, 1920, the earnings of the corporation were $1,169,160.90, after allowing for depreciation and for payment of taxes. The average capital and surplus during the same period approximated $800,000. Dividends during the same period amounted to $375,000. On December 31, 1919, the capital and surplus of the corporation, as shown upon its books, was $1,060,963.94. The earnings, dividends, and capital and surplus, as shown by the books of the corporation, from 1915 to May 20,1920, were as follows;

    7. Except for. the year 1911, when no dividends were paid, the corporation has regularly paid dividends since 1887, varying, prior to 1913, from 4 per cent to 12 per cent per annum. For the 10 years prior to 1913 the dividends averaged 6.8 per cent per annum.
    8. The stock of the corporation was closely held and there was no active or recognized market for it. The increase of $50,000 in 1901 was sold at $151 per share. In 1917, five shares of the stock were sold by an estate for $135 per share.
    DECISION.
    The determinations of the Commissioner are approved.
   OPINION.

Phillips:

These appeals present solely the question of the fair market value on March 1, 1913, of the stock of Henderson Cotton Mills. There was no market establishing sales prices on or about March 1, 1913, and taxpayers are forced to rely upon other evidence of its value on that date.

The taxpayers assert that the actual value of the assets of the corporation on March 1, 1913, was greatly in excess of the book values, and that, based upon such actual values, the stock was worth $194.59 per share on March 1, 1913. In support of such contention the taxpayers offered in evidence an appraisal of the plant of the company as of March 1, 1913. This appraisal is “ based on the total replacement cost on that date less accrued depreciation.” While such an appraisal may have many legitimate uses, it can be of little assistance in solving the question presented to us. Appeal of Stokes Milling Co., 2 B. T. A. 1284. The statute specifies that the fair market value of the stock shall be the test. The taxpayer contends that, in the absence of actual sales, the fair market value of the stock is equal to the fair market value of the assets of the company. Even though we were to accept this contention, the fair market value of the assets is entirely different from the replacement cost, less accrued depreciation. The statute does not ask what it would cost to replace the assets in their worn condition, but what price could be obtained for them in a fair market. The testimony indicates that on March 1, Í91S, the cotton manufacturing business was in a depressed condition which had continued for a period of several years. Under such conditions, it can not be assumed with any hope of accuracy that the replacement cost of a cotton mill represents its fair value on the market. There are other objections to the appraisal which it is unnecessary to discuss in this appeal.

The corporation had good earnings and dividend records. It appears that from the date of organization to March 1, 1913, the average annual earnings were approximately 12 per cent of the capital and surplus invested. The book value of the stock on March 1, 1913, was approximately $119 per share, excluding any value to be attributed to the good will or earning capacity of the corporation or any appreciation in value of its assets over cost less depreciation written off. Under such circumstances, it might well be contended that the stock had a value in excess of $150 per share on March 1, 1913, except for the fact that the years immediately preceding that date were the least successful in the entire history of the company. In 1908, 1910, and 1911, the corporation sustained losses. In 1909 there was a profit comparing favorably with the average profit of prior years. In 1912 there was a profit of over $100,000 from the operation of the business. The testimony, however, is to the effect that on March 1, 1913, the depression in the business still continued.

At the time of the sale in April, 1920, the stock had a book value, based on the balance sheet of December 31, 1919, and, disregarding the substantial profits subsequent to that date, of $212 per share. For the five years preceding, the corporation had earned profits exceeding 30 per cent upon its capital and surplus as shown by its books. At that time there was good demand for the products manufactured by the taxpayer.

Considering the conditions which existed in March, 1913, and which had existed for several years prior thereto, we reach the conclusion that the value of $150 assigned to the stock by the Commissioner should not be disturbed. Comparing the situations which existed in 1913 and in 1920, we fail to find any discrepancy between a value of $150 in 1913, when the stock had a book value of $119 and its earning capacity was impaired, and the sales price of $300 in 1920, when the stock had a book value of more than $212 and a record of exceptional earnings for the preceding years.


text:
    Appeal of THE AGUILAR LAND ASSOCIATION.
    Docket No. 3718.
    Submitted November 3, 1925.
    Decided February 13, 1926.

      Robert B. Honeyman, Esq., for the taxpayer.

      Benjamin H. Saunders, Esq., for the Commissioner.
    Before James, Littleton, Smith, and Teussell.
    This is an appeal from the determination' of a deficiency, in income and profits tax for the calendar years 1919 and 1920 in the amounts of $1,100.80 and $930.39, respectively. The issue presented relates to invested capital and concerns the actual cash value of a total of 1,540 acres of mining property paid in for $200,000 par value of stock of each, the taxpayer and its subsidiary, The Green Canyon Land Co., in 1897 and 1902, respectively. The taxpayer claims a value of $400,000 — the par value of the stock. The Commissioner allowed a value of $81,695.
    FINDINGS OF FACT.
    The Aguilar Land Association is a Colorado corporation, organized in 1897 with a capital stock of $200,000, divided into 2,000 shares of the par value of $100 each. The Green Canyon Land Co. was similarly incorporated in 1902, with a capital stock of $200,000, divided into 2,000 shares of the par value of $100 each. The latter company was at all times herein mentioned a subsidiary of the taxpayer, the stock of both corporations being owned by A. G. and Henry C. Broadhead, or their estates or heirs.
    A. G. and Henry C. Broadhead were experienced mining engineers and geologists, specializing in the coal industry. They devoted their efforts to the acquisition and development of coal lands, with a view of leasing the same upon a royalty basis. Their activities extended to various parts of the United States, but principally to the coal fields in Pennsylvania and Colorado. During the period from 1893 to 1902, they investigated, prospected, and tested certain coal lands in Colorado, known as the Trinidad District, as a result of which they gradually acquired by purchase approximately 3,500 acres in this district, including portions of the Gonzales and Vasquez Canyons. This land was situated in a known and proven coal district. They not only acquired the land immediately available for the mining of coal but, as a precaution, secured certain adjoining upland and surrounding sites for the purpose of assuring a steady supply of coal for future operation and for the purpose of preventing possible interference to transportation and obstructions to large operations by adverse ownership. The tract thus secured was the result of exhaustive and thorough tests and careful analysis from engineering and geological standpoints. *

      From this tract 1,080 acres were transferred in 1897 to The Aguilar Land Association for $200,000 par value of stock, and in 1902 460 acres were transferred to The Green Canyon Land Co. for $200,000 par value of stock. Under the land in question were several proven seams of coal. The seams underlying the Aguilar property were as follows:

    There was a total average of 14 feet of coal underlying 1,000 of the 1,080 acres transferred to The Aguilar Land Association.
    The seams underlying The Green Canyon Land Co. property were as follows:
    Name of seam. Tliickness.
    Broadhead No. 3, upper_4 feet.
    Broadhead No. 4, upper_4 feet.
    Broadhead No. 3, lower_I
    Broadhead No. 4, lower_J ee ‘
    It was estimated that there was an average total of 20 feet of workable coal underlying 400 of the 460 acres transferred to The Green Canyon Land Co. •
    It was not practicable to extract coal from the upper and lower coal seams at the same time. At the time of the transfer the principal output of the Aguilar property, which was being operated by the Broadheads, was from the Welsen seam through a shaft about 250 feet deep. No coal had been removed from the Robinson seam. There had been some development of the Broadhead seams 3 and 4 through the removal of coal outcroppings.
    The Green Canyon property had not been operated when it was paid in to the corporation. Two entrances of about 150 feet each, however, had been made at outcroppings for the purpose of showing the character of coal, thickness of the vein, and character of the roof and bottom to aid in the leasing of the property.
    The shaft upon the Aguilar property was constructed in ■ 1895 at a cost of approximately $50,000, and in 1896, 30,000 tons of coal were extracted. During the year 1897 approximately the same amount was removed.
    Prior to the transfer of the properties to the two corporations mentioned, the Broadheads expended for the shaft, railway facilities, and other improvements at least $130,000. As a result of these expenditures, together with other sums of money expended by them in developing these properties and the losses sustained by them in their attempted operation, they became heavily in debt. It was for this reason that the two corporations were organized and the property transferred to them with the hope that, in the event of bankruptcy, they might save the loss of the coal lands.
    In 1902, just prior to the transfer of the property to The Green Canyon Land Co., Henry C. Broadhead leased to John Connell 420 acres of the 460 acres thereafter paid in to The Green Canyon Land Co. for stock. This lease provided for the removal of a minimum of 25,000 tons of coal for the year 1908 at a royalty of 8 cents a ton, a minimum of 45,000 tons for the year 1904 at a royalty of 9 cents a ton, and for each year thereafter the removal of a minimum of 60,000 tons at a royalty of 9 cents a ton.
    Geological formations indicated at the time of the transfer of the property to the corporations that there were probably 22,000,000 tons of coal underlying the same, determined by applying the universally accepted estimate that a seam 1 foot thick contains 1,000 tons of coal per acre, as follows:
    Tons.
    Aguilar, 1,000 acres, 14 feet, 1,000 tons_ 14, 000, 000
    Green Canyon, 400 acres, 20 feet, 1,000 tons_ 8,000, 000
    Total_ 22, 000, 000
    Coal mines in the district in which the property in question is located were subject to risks of encountering faults, dikes, lavic intrusions, gas explosions, and flooding. These properties were known to contain these difliculties. The amount of recoverable coal was uncertain, but it was much less than the above estimate of total coal content.
    The property transferred to The Aguilar Land Association and The Green Canyon Land Co. was purchased by A. G. and Henry C. Broadhead over a period from about 1893 to 1896 in small parcels, ranging from 40 to 60 acres, at a cost ranging from less than $20 to $40 an acre.
    In 1902 an experienced coal operator familiar with the coal lands in this territory made an offer to purchase the property transferred to the two corporations for $250,000 in bonds, and his agreement was to expend at least $200,000 in development. This offer was declined.
    The actual cash value of the entire property paid in to The Aguilar Land Association and The Green Canyon Land Co. for stock was $150,000 — the value of the 1,080 acres acquired by the former being $100,000 and that of the 460 acres acquired by the latter company being $50,000.
    Since the dates of the transfers of the properties to The Aguilar Land Association and The Green Canyon Land Co., up to and in-eluding 1924, a total of 3,540,671 tons of coal had been removed by lessees upon a royalty basis. From 1913 to 1918 mining on the Green Canyon property was suspended on account of strikes. There was also a suspension of operations by the lessees on the Aguilar property for a number of years between 1898 and 1924, on account of explosions, strikes, and flooding.
    For the purpose of computing invested capital, the Commissioner determined that the actual cash value of the property at the time of transfer to The Aguilar Land Association was $57,775, and that the actual cash value of the land at the time it was transferred to The Green Canyon Land Co. was $23,920. He calculated that 337 acres out of the 1,080 acres of The Aguilar Land Association property would produce 1,718,000 tons of coal, and that 120 acres out of the 460 acres transferred to The Green Canyon Land Co. would produce 960,000 tons of coal, or a total of 2,678,000 tons. He estimated the royalties of the Aguilar property at 8 cents a ton and those of the Green Canyon at 9 cents a ton, and discounted these royalties at 10 per cent for a period of 40 years. His computation follows:
    Aguilar:
    229 acres coal, Temple-'-tons__ 916, 000
    108 acres coal, Royal-do_• 802, 000
    337 1, 718,000
    8 cents discounted at 10 per cent lor 40 years gives a rate of 1.956 cents.
    1,718,000 tons, at 1.956 cents_ $33, 600
    1,080 acres surface, at $10_ 10, 800
    44, 400
    121 shares for machinery_ 2, 860
    Value of railroad (part of improvements acquired with land)— 10,515
    57, 775
    Green Canyon Co.:
    120 acres, 960,000 tons, 9 cents discounted at 10 per cent, 40 years gives a rate of 2.2 cents.
    960,000, at 2.2 cents_ $21,120
    280 acres grazing land, at $10_ 2,800 23,920
    Total:
    Aguilar_ 57, 775
    Green Canyon. 23,920
    81, 695
   DECISION.

The deficiency should be computed in accordance with the foregoing findings of fact. Final determination will be settled on 15 days’ notice, under Hule 50.


author: Smith

text:
    Appeal of KANSAS MILLING CO.
    Docket No. 2835.
    Submitted July 15, 1925.
    Decided February 13, 1926.
    The taxpayer’s books of account showed payments for additions and improvements as expenses. By reason thereof the reserve set up for depreciation was less than the amount of depreciation actually sustained. Seld, that, upon all the evidence, the invested capital shown by the taxpayer on its books should not be adjusted either for capital additions or depreciation in prior years. Appeal of Cleveland Some Brewing Co., 1 B. T. A. 87.

      P. J. Barnes, G. P. A., and O. B. Abel, O. P. A., lor the taxpayer.

      Arthur H. Fast, Esq., for the Commissioner.
    Before Littleton, Smith, and Tetjssell.
    This appeal is from the determination of a deficiency in income and profits tax for the year 1917 in the amount of $63,080.82.
    FINDINGS OF FACT.
    The taxpayer is a Kansas corporation, with its principal office at Wichita. It was organized in 1907 and is engaged in the manufacture of flour and grist mill products. It is a close corporation, its stock having always been held by a small group of individuals. Two flour and grist milling plants are operated by the taxpayer, one of which is located at St. John, Kans., and the other at Wichita.
    During the period 1907 to and including the year 1916, certain sums expended for additions, betterments, renewals, and replacements, but not all such expenditures, were charged to current operating expenses rather than to capital accounts. However, depreciation, specifically as such, was not charged off on the books uniformly at stated periods, it being the opinion of the directors and officers that the additions, betterments, renewals, and replacements, which were annually being charged to current operating expenses, were sufficient to offset any depreciation which was taking place.
    On December 31, 1916, the plapt and all other fixed assets, exclusive of land, appeared on the taxpayer’s books at an aggregate value of $364,894.87. • Against this value there appeared a reserve for depreciation in the total sum of $19,324.19.
    As the result of an examination of the taxpayer’s books of account by a revenue agent and the recommendations of that officer, the Commissioner, for the purpose of computing the taxpayer’s invested capital, increased the book values of the plant and fixed assets by the aggregate amount of $47,172.69. This latter sum represented the aggregate cost of additions, betterments, renewals, and replacements, which the revenue agent was able to identify as such, which bad been charged to current operating expenses from 1907 to 1916, inclusive. At the same time and for the same purpose, the Commissioner increased the reserve for depreciation, as it appeared on the books, from $19,324.19 to $98,681.59, an increase of $79,357.40. Thus the Commissioner has reduced the surplus as shown by the books, for the purpose of computing invested capital, by the net amount of $32,184.71.
    The reserve for depreciation as computed by the Commissioner, in the sum of $98,681.59, results from an application of the straight-line theory of depreciation from 1907 to the end of 1916.
    In computing the deduction from gross income to which this taxpayer is entitled on account of. depreciation of physical assets, the Cómmissioner failed to provide for any depreciation sustained with respect to the physical properties comprising the plant at Saint John, Kans. This appears to be an inadvertence, brought about by the fact that the properties comprising this plant are not carried in the regular property accounts, but are carried in a separate account on taxpayer’s books denominated “ St. John Investment Account.” The nature of this account was not made known to the revenue agent whose depreciation schedules were made the basis for the Commissioner’s allowance for depreciation.
    The property comprising this plant and the cost thereof are as follows:
    Ice plant-$11,000
    Manager’s residence_ 3, 000
    Machinery- 46,000
    Building- 15,000
    Total-•-$75, 000
    The ice plant had a useful life of 10 years; the manager’s residence, 20 years; the machinery 10 years, and the building 20 years.
    DECISION.
    The deficiency should be computed in accordance with the following opinion. Final determination will be settled on 15 days’ notice, in accordance with Eule 50.
   OPINION.

Smith

: In its petition the taxpayer alleges that the deficiency is predicated, in part, upon the following errors:

(a) That the Commissioner has arbitrarily reduced the invested capital shown on the taxpayer’s books of account, without adducing affirmative evidence that such books of account overstated the amount of invested capital within the meaning of the tax statutes.

(5) That the Commissioner has not allowed the taxpayer a reasonable allowance for the exhaustion, wear and tear of property arising out of its use or employment in the business.

(e) That the Commissioner erred in computing its excess-profits-tax liability for the year 1917 under the provisions of section 201 of the Eevenue Act of 1917, whereas, in view of existing circumstances, such determination should have been made under the provisions of section 210.

The first allegation of error is directed toward the Commissioner’s action in rejecting, for invested capital purposes, the reserve for depreciation as shown by • the taxpayer’s books and substituting therefor a reserve of a considerably greater amount, thereby materially reducing taxpayer’s invested capital.

The evidence before us indicates that at January 1, 1917, the taxpayer had accrued on its books a reserve for depreciation in the sum of $19,324.19; that, in addition to this reserve, the taxpayer from 1907 to the close of 1916, had charged as current operating expense certain capital expenditures in lieu of charging off depreciation, specifically as such, annually at uniform rates; that of the capital expenditures charged to operating expense the revenue agent was able to identify items totaling $47,172.69, and this amount the Commissioner restored to the asset accounts and to invested capital; and that, by the application of a mathematical formula to property costs, based upon the straight-line theory of depreciation, going back to the date of taxpayer’s organization, the Commissioner has determined that the reserve for depreciation at the beginning of the taxable year 1917 should be stated in the sum of $98,681.59.

We can not approve the Commissioner’s action in this respect. It appears from the facts that, from 1907 to the end of 1916, the taxpayer took depreciation upon its books as such in the amount of $19,324.19, and in addition thereto expended at least the amount of $47,172.69 in betterments and additions which were not capitalized. The question here involved is the determination of the invested capital of this taxpayer as of January 1, 1917. For that purpose the Commissioner has, on the one hand, added the above amount of $47,172.69 to capital items, and, on the other hand, has applied straight-line depreciation to the taxpayer’s assets from 1907 to 1917. The facts are thus .not substantially different from the facts in the Appeal of Cleveland Home Brewing Co., 1 B. T. A. 87. In that appeal we said (p. 91):

Depreciation, we have already said, is a question of fact. Congress has allowed taxpayers “ a reasonable allowance for * * * wear and tear of property used in the trade or business ” as a deduction from income, to make whole tbeir capital investments before levying a tax upon that income. The Oommissioner in this case asks us to accept a readjustment of taxpayer’s invested capital upon a mere assumption that the property of this taxpayer was reasonably depreciable at certain arbitrary rates and in equal annual amounts over a period of 11 completed years. No evidence is offered that the alleged depreciation has actually occurred. None is even offered that property of the kind here in question usually deteriorates at approximately the rates used in the computations of the examining agent. Upon the record so made, we must sustain the position of the taxpayer.

The evidence before us discloses that the amount charged off its books, by the taxpayer against its physical assets, both in the reserve and in capital expenditures charged to expense, was substantial. There is no evidence before us that such assets suffered any greater depreciation than the amount so charged off, or that the Commissioner’s computation is more nearly correct than the taxpayer’s. In these circumstances, we are of the opinion that no change should be made either in the asset accounts or in the depreciation reserve as they stand in the taxpayer’s books as of January 1, 1917. Appeal of Cleveland Home Brewing Co., supra; Appeal of Russell Milling Co., 1 B. T. A. 194; Appeal of Rub-No-More Co., 1 B. T. A. 228; Appeal of City National Bank, 2 B. T. A. 623.

As pointed out in our findings of fact, the deduction for depreciation which the Commissioner has allowed the taxpayer for the year 1917 does not include any allowance for depreciation of the physical properties comprising the plant located at St. John, Kans. Any part of the deficiency occasioned by the failure of the Commissioner to make such an allowance is in error. The costs of the properties comprising this plant are set out in our findings of fact. We conclude that those costs should form the basis for the determination of a reasonable allowance for depreciation, computed at the following rates: Ice plant, 10 per cent; manager’s residence, 5 per cent; machinery, 10 per cent; building, 5 per cent.

In support of its allegation of error, that the Commissioner erred in determining its excess-profits tax under the provisions of section 201 of the Revenue Act of 1917, when, under the existing circumstances, such determination should have been made under the provisions of section 210, the taxpayer contends that its invested capital can not be satisfactorily determined. We are unable to find, from any evidence which has been presented to us, that the invested capital is not susceptible of accurate ascertainment, or that the invested capital as determined by the Commissioner, subject to adjustment in accordance with this opinion, is not correct.


author: Phillips

text:
    Appeal of IMPERIAL DEVELOPMENT CO.
    Docket No. 4183.
    Submitted November 11, 1925.
    Decided February 13, 1926.
    A foreign corporation was in existence during 1911, 1912, and 1913, and during each of those years sustained a net loss in the operation of its business. Held, that such corporation is not entitled to have its profits taxes computed under section 205 (a) (1) of the Eevenue Act of 1917.

      Frank G. Butts, O. P. A., for the taxpayer.

      Ward Loveless, Esq., for the Commissioner.
    Before Phillips and Trammell.
    Taxpayer appeals from the determination of a deficiency of $5,387.97 income and profits taxes for 1917.
    FINDINGS OP FACT.
    1. Taxpayer is a foreign corporation, organized and operating under the laws of Mexico.
    '2. During the years 1911, 1912, and 1913, and each of them, the taxpayer sustained net losses.
    3. The Commissioner determined the invested capital of the taxpayer for 1917 to be $1,056,547.33, allowed 7 per cent of that amount as the war-excess-profits-tax deduction under Title II of the Revenue Act of 1917, and determined the deficiency upon that basis.
    DECISION.
    The determination of the Commissioner is approved.
   OPINION.

Phillips

: The Commissioner determined taxpayer’s profits tax for 1917 under the provisions of section 203 (a) and (c) of the Revenue Act of 1917. Taxpayer claims that such tax should have been computed under the provisions of section 205, on the ground that the taxpayer had no net income from the trade or business during the pre-war period. Section 205 (a) (1) refers specifically to domestic corporations, while taxpayer is a foreign corporation. Taxpayer claims, however, that it falls within section 203 (d), in that it is impossible satisfactorily to determine the average amount of the annual net income of the trade or business during the pre-war period, and that, in such a case, a foreign corporation may fall within the provisions of section 205 (a) (1). Without passing upon the question raised by the taxpayer, it is sufficient to point out that there is a marked difference between inability to determine the average amount of the annual net income of the trade or business during the pre-war period and the determination that during the pre-war period the taxpayer had no net income from the trade or business. The taxpayer has not shown that its average net income for the pre-war period can not be determined, and it does not fall within the provisions of section 203 (d).


author: Teammell

text:
    Appeal of L. W. GUNBY CO.
    Docket No. 4952.
    Submitted November 7, 1925.
    Decided February 13, 1926.
    On the evidence, held, that the invested capital of the taxpayer should be reduced by the amounts of promissory notes given to its president.

      K. N. Parkinson, Esq., and PL. A. Walburn, O. P. A., for the taxpayer.

      Pilis W. Manning, Esg., for the Commissioner.
    Before Phillips and Trammell.
    This is an appeal from a determination of a deficiency for the calendar year 1919 in the sum of $10,324.88. The deficiency arose from the action of the Commissioner in eliminating from invested capital the sum of $294,049.28, on the ground that it represented borrowed capital.
    FINDINGS OP FACT.
    1. The taxpayer is a corporation, organized on February 3, 1903, under the laws of Maryland, and is engaged in selling hardware and machinery. Prior to incorporation, the business had been owned and operated as a sole proprietorship by one L. W. Gunby. At the time of incorporation the taxpayer issued 1,500 shares of stock of the par value of $100 each, as follows:
    Shares. Per cent.
    L. W. Gunby- 1,370 91.33
    Graham Gunby, son_ 501
    Donald Graham, brother-in-law_ 40 l 8. 66
    F. L. Smith, employee_ 40 j
    2. At that time, the said L. W. Gunby was in ill health and, preparatory to a trip abroad, he desired to adjust his business affairs and to place a greater responsibility on his son and to reward a few employees. At the date of incorporation, the value of the net assets of the individual business owned by L. W. Gunby exceeded the par val'ue of the stock issued therefor by the amount of $27,531.16, and such excess amount was left in the business. The sum was evidenced by a promissory note in words and figures as follows:
    $27,631.16 Salisbm-y> Md. February 3rd, 1903.
    On Demand, after date — Tbe L. W. Gunby Company of Salisbury Md. promises to pay to tbe order of L. W. Gunby Twenty-seven Thousand Five Hundred and Tbirty-One and 16/100 Dollars at The Farmers and Merchants Bank . or Salisbury, Maryland, value received without offset. Tbe makers and endorsers each hereby waive the benefit of the Homestead and all other statutory exemptions as to the debt evidenced by this note with interest at 5% per annum.
    The L. W. Gunby Co. of Salisbury, Md.
    By (Signed) Donald Graham — Treas.
    By (Signed) Graham Gunby- — Vice-President.
    3. The business of the taxpayer from the date of incorporation continued to grow and prosper. L. W. Gunby later resumed active control of the business as president and manager, and practically treated the business as his own. Few formal directors’ meetings were held; occasionally he would consult his son, Graham Gunby, and the secretary, both of whom were directors, about the amount of the dividends, but they always accepted his judgment. No formal declaration of dividends was made by the directors or entered upon the minutes of directors’ meetings, but each year there was credited, as dividends, a certain amount to each stockholder, as determined by the president. The said L. W. Gunby left in the business his dividends and credits. In addition to the dividends, he put in the business other spare money and returns from other investments, all of which were credited to his account and included in the amount of the note. From time to time the taxpayer would issue notes to L. W. Gunby, similar in form to the first note, representing the balance of Gunby’s credit, and would cancel the prior notes. The additions of money left in the business by the taxpayer accumulated until, by January 1, 1917, there was a balance of $294,049.28, which balance remained through the taxable year 1919. The notes issued bore interest at 5 per cent, except the last note, on which the provision for interest was marked out. The totals of the notes issued were as follows:
    Per cent.
    Feb. 3, 1903 $27, 631.16 5
    Jan. 1, 1908 119,545. 64 5
    Jan. 1, 1909 175,116. 00 5
    Jan. 1, 1910 194, 637. 62 5
    Jan, 2, 1911 225,318.41 5
    Jan. 1, 1912 250, 975. 35 5
    Jan. 1, 1913 282,095.55 5
    Jan. 1, 1914 302, 836.99 5

      Per cent.
    Jan. 1, 1915 329, 611. 54 5
    Jan. 1, 1916' 274,741. 22 13, 737. 06
    Jan. 1, 1917 294, 049.28
    The amount of each note included the principal and interest of the preceding note, the annual dividend, and other credits due L. W. Gunby for the preceding year. The last note so issued was in words and figures as follows:
    $194,049.28. Salisbury, Md. January 1, 1917.
    Twelve Months after date We promise to pay to the order of L. W. Gunby, the sum of Two Hundred Ninety Four Thousand Forty-Nine and 28/100 Dollars at The Salisbury Building, Loan & Banking Association, Salisbury, Md. Value received without offset. The maker and endorser each hereby waives the benefit of the Homestead Exemption and all right to exemption from execution, as to the debt evidenced by this obligation, and if default be made in the payment hereof at maturity, hereby covenants to pay ten per cent additional as collection fee; and hereby authorizes and empowers any attorney of record, to confess judgment against me, us or it, for the above sum and the cost of suit, with ten per cent collection charges. And the maker and endorser each hereby waives demand, protest and notice of nonpayment hereof.
    L. W. Gunby, Pres. (Signed) L. W. Gunby Co.,
    Graham Gunby, Treas.
    It is this sum of $294,049.28 which the taxpayer claims as invested capital and which was disallowed by the Commissioner.
    4. The by-laws of the taxpayer, in respect to the control and management of the corporation, provided as follows:
    See. 1 (Control & Management).
    The general control and management of the property, business and concerns of this company, and the power to choose its officers, and agents, and fix their compensation, with the right to fill any vacancy therein, or, in their own number, shall (except as hereinafter delegated to the President), be vested in a Board of Seven Directors, (of whom four shall be a.quorum — ), to be chosen by its shareholders at their annual meeting, and they shall hold office until their successors are elected, and qualify.
    The minutes of the directors’ meeting, dated March 20, 1919, are as follows:
    Record of Directors Meeting of the L. W. Gunby Company held at office on the 20th day of March 1919 at 10.30 o’clock A. M.
    Those present L. W. Gunby, Graham Gunby, Mary S. Lowe. This meeting was held after deputy Collectors Popp and Findley advised us the amount of money left in the business of L. W. Gunby Co. by L. W. Gunby could not be used as invested capital in computing our income tax returns.
    At this meeting L. W. Gunby turned over to L. W. Gunby Co. the demand note which the said L. W. Gunby Co. had given him causing this amount left in tlie business of $294,049.28 and authorized the Secretary to credit said amount of $294,049.28 on the books of L. W. Gunby Company to Surplus Account said amount of $294,049.28 to be left in the Surplus Account and used by L. W. Gunby Co. as part of its invested capital until January 1st 1920 when the said L. W. Gunby Co. shall issue preferred stock to Ij. W. Gunby for same.
    L. W. Gunby Co. is not to pay to L. W. Gunby any interest on this amount of $294,049.28.
    The minutes of the directors’ meeting held on February 23, 1920, refer to the indebtedness of the corporation to Gunby and to the intention of satisfying it by the issuance of stock.
    The minutes of directors’ meeting held in April, 1916, contain a waiver of notice of directors’ meeting signed by three directors. At that meeting the resignation of one director was accepted and another was elected. The minutes of that meeting also refer to the indebtedness due Gunby.
    The note payable to Gunby, representing the indebtedness due him, was signed by the corporation by its treasurer, and also by Gunby as president.
    The taxpayer claims the total amount left in the business by L. W. Gunby was really surplus or undivided profits, for the reason that the dividends were not declared according to law and that there was no authorization for the execution of the said notes. The Commissioner treated this sum as borrowed capital and refused to include it in invested capital.
    DECISION.
    The determination of the Commissioner is approved.

       Interest on *274,741.22.

   OPINION.

Teammell

: We are fully convinced that the accumulated credit to L. W. Gunby was borrowed capital and can not be included as invested capital. Even a casual examination of the notes in question and the methods of doing business fully disclose that L. W. Gunby considered the taxpayer as using his money as borrowed capital. He not only caused the amounts due him to be credited on the books, but took the precaution of having executed to him interest-bearing negotiable notes. The taxpayer contends that the notes merely represented memoranda, but, if so, they were memoranda of indebtedness. They indicated that the corporation owed Gunby money. Up to January 1,1917, the credits included 5 per cent interest on the amount of the note of the preceding year, which interest, over a period of 15 years, constituted no mean portion of the balance due.

The taxpayer raised the point that the dividend and the execution of the notes on behalf of the corporation were not authorized by a formal meeting of the board and were illegal, and therefore the amounts remained a part of surplus. While it is true that there may not have been a strict technical compliance with its by-laws in this respect, corporations may, and close corporations frequently do, distribute' earnings and profits without formal action.

The notes were given as obligations of the corporation and there is no evidence that they were not. The indebtedness was acknowledged by the directors at formal meetings. Where the rights of third persons are not impaired, the distribution of profits of a corporation among its stockholders, without any formal action on the part of the corporation, but by consent and agreement of the stockholders, is the equivalent of a dividend. Ratcliff v. Clendenin, 232 Fed. 61; Smith v. Moore, 199 Fed. 689; Spencer v. Lowe, 198 Fed. 961.

It appears that, without any objection on the part of any stockholder or director, the profits of the corporation from the date of its organization had always been distributed without any formal action.


author: TRAmmell

text:
    Appeal of ACME BOX & LUMBER CO.
    Docket No. 4472.
    Submitted December 2, 1925.
    Decided February 13, 1926.
    A contract to buy stock does not in itself vest a control thereof in the purchaser.

      Henry J. Richardson, Esq., for the taxpayer.

      M. N. Fisher, Esq., for the Commissioner.
    Before Graupner, Trammell, and Phillips.
    This is an appeal from a deficiency in income and profits taxes for 1920 in the amount of $3,629.32. The deficiency arises from the action of the Commissioner in refusing to permit the taxpayer and the Folding Box Co., another corporation, to file a consolidated return for 1920.
    FINDINGS OE PACT.
    The Acme Box & Lumber Co. is an Ohio corporation, having its principal place of business at Cleveland. During 1919 it had outstanding capital stock in the amount of $60,000, having a par value of $100 per share. On September 17, 1919, the owners of all the outstanding stock gave an option for the. purchase thereof to one Edward O. Young. The option was to be exercised on or before November 15, 1919. This option was, for a valuable consideration, assigned and transferred to the National Folding Box Association, a Delaware corporation, on October 16, 1919. The National Folding-Box Association, for a valuable consideration, assigned the same to the Folding Box Co. on October 20, 1919. This option was extended to December 15, 1919, again to March 15, 1920, and again to July 15, 1920, all of which extensions were endorsed on the option.
    The price per share for the said stock, as set out in the option, was $375, and was payable as follows: One-half of the $375 per share was agreed to be paid on or before November 15, 1919, upon the transfer and delivery to the Broadway Savings & Trust Co. of Cleveland in escrow of certificates evidencing 40 per cent of the capital stock of the company, said certificates to be assigned in blank but to have no voting power. The remaining 60 per cent of the stock was to be delivered to the Broadway Savings & Trust Co. upon payment of the remaining one-half of the amount stated, which amount was to draw interest at the rate of 6 per cent from November 15, 1919, at which time the original option provided that all of the stock duly assigned should be delivered to the person or persons exercising the option, or their nominees, and further provided that the remaining one-half should be paid on or before February 15, 1920, and, in default of such payment of said certificates of stock, 600 shares should revert to and become the property of the vendors, and the amount of the first payment should be regarded as liquidated damages.
    The option also provided that all of the stock must be purchased or none of it.
    Payments were made from time to time until July 15, 1920. The first payment made under the option was made on November 15, 1919, in the amount of $1,000. Another payment was made on January 7, 1920, in the amount of $5,000; another payment was made on January 14, 1920, in the amount of $14,000; another payment was made on January 22, 1920, in the amount of $10,000; and another payment was made on February 10, 1920, in the amount of $10,000, making a total of $40,000 received in cash up to February 10, 1920.
    The stockholders of the Acme Box & Lumber Co. received $75,000 in stock of the Folding Box Co. as part payment in lieu of cash. It was agreed in the latter part of 1919 that this could be done, and the stock was issued to them in February, 1920. The balance of principal and interest was paid to them by a note for $120,000 on July 15, 1920, and the amount of $465 was paid in cash, making a total consideration, including the amount of stock received in the Folding Box Co., the note received and cash, of $235,465.
    The payments were not made according to the terms of the option, and there is no evidence that the terms of the-option with respect to the deposit of the stock in escrow were carried out. The stock of the Acme Box & Lumber Co. was not acquired by the Folding Box Co. until July, 1920. Prior to that time it did not own or control substantially all of the stock of the Acme Box & Lumber Co.
    DECISION.
    The determination of the Commissioner is approved.
   OPINION.

TRAmmell

i The question as to whether the Folding Box Co. owned or controlled substantially all the stock of the Acme Box & Lumber Co. is one of fact. It did not own any of the stock prior to the date it acquired that referred to in the option. An examination of the option agreement does not disclose any provision which could be interpreted as vesting a control of the stock in the purchasers unless or until the stock was actually acquired. A witness on the stand was asked if the owners of the stock followed the provisions of the contract as to the delivery of the stock. He answered, “ I guess we did.” But the option contract provided that only 40 per cent of the stock would be deposited in escrow when 50 per cent of the purchase price had been paid and the remaining 60 per cent was to be delivered when final settlement was made. There is no positive evidence that the provisions of the option as to deposit of the stock in escrow were carried out, and even if it were so deposited that amount was only 40 per cent. There is nothing of record to indicate that the purchasers would have had any control over the stock even if it had been deposited in escrow. While the first payment under the option was made in November, 1919, the contract appears to have been executory and had not been executed. The sellers did not sell their stock but retained it until the final settlement was made. The option gave the purchasers merely the right to buy the stock. The acceptance of the payments by the sellers bound them to convey according to the option, but a contract to buy which is binding on the seller to sell does not itself give the buyer a control of the stock. The taxpayer could not have voted it, nor could it have directed or influenced the voting of that stock. Nor did the taxpayer even claim that it could have done so. Until the contract had been executed and the stock bought, the control remained in the owner.


author: Tettssell

text:
    Appeal of ROTHHOLZ EXAMINING & SHRINKING CO., INC.
    Docket No. 4844.
    Submitted December 7, 1925.
    Decided February 13, 1926.
    A corporation taxpayer carrying on a business and using during the year shop and delivery equipment of the average book value of $11,713.62, held not a personal service corporation under the provisions of the Revenue Act of 1918.

      II. Earlton Hanes, Esq., for the taxpayer.

      J. A. Adams, Esq., for the Commissioner.
    Before Smith, Littletoh, and Trussell.
    This is an appeal from the determination of a deficiency for the year 1921 in the sum of $835.08. The deficiency arose from the refusal of the Commissioner to classify the taxpayer as a personal service corporation and to allow it to set up additional salaries in an amended return.
    FINDINGS OE PACT.
    1.The taxpayer is a New York corporation, with its principal place of business at Rochester, with a capitalization of $5,000, held as follows:
    Per cent.
    J. A. Bakrow, president_ 45
    F. M. Rothholz, secretary and treasurer_ 45
    H. A. Friedman_ - 10
    2. The taxpayer is engaged in the business of examining, shrinking, and waterproofing cotton and woolen goods, and its income is derived from services performed upon such goods. The said Rothholz and Bakrow, the principal stockholders, devoted all their time to the business of the taxpayer. Rothholz ivas an expert in waterproofing and sponging and the secret processes used therein. He ivas the only one connected with the taxpayer’s business who had knowledge of this and personally supervised the operations. Bakrow was an expert in examining woolens, and he, together with Rothholz, personally examined each piece of goods worked upon. The goods worked upon were brought in by clothing manufacturers and returned after the treatment by the taxpayer.
    3. The taxpayer operated a large plant and employed other labor to assist in the work. The wages paid for 1921 were $17,996.64. The value of the plant and equipment was as follows:

      The gross income for the year 1921 was $47,401.61, deductions, including salaries of members, $41,863.31, and net income $5,538.30.
    4. The balance sheet of the taxpayer as of January 1, 1921, and January 1, 1922, is as follows:

    o. The officers drew salaries for 1921 as follows:
    J. A. Bakrow, president_$5.145. 00
    S1. M. Bothholz, secretary-treasurer_ 5,145. 00
    Total_ 10,290.00
    They made further withdrawals as follows:
    Bakrow_$3, 342. 43
    Bothholz_ 2, 067. 05
    Total withdrawals by officers- 15, 699. 48
    The Commissioner, for the prior year (1920), allowed officers’ salaries of $15,700.
    In the original return for 1921, filed by the taxpayer as a personal service corporation, the total officers’ salaries were $10,290. Upon the Commissioner’s refusal to classify the taxpayer as a personal service corporation, it filed an amended return for the taxable year 1921, showing officers’ salaries in the sum allowed by the Commissioner for the prior year.
    DECISION.
    The deficiency should be computed in accordance with the following opinion. Final determination will be settled on 15 days’ notice, pursuant to Rule 50.
   OPINION.

Tettssell

: The business of examining, shrinking, and waterproofing cotton and woolen goods is a part of the manufacturing processes by which such goods are converted into clothing and other articles suitable for the use of the wearers and users of such articles. In this process the element of personal service does not appear to materially differ from that of other manufacturing businesses in which the services of experienced men are required. The taxpayer’s business needed and employed shop equipment, office furniture, and delivery equipment of an average depreciated value during the year in question of $11,713.62. This is capital, and it surely can not be said of this business that such capital did not materially contribute to the production of income. We are, therefore, of the opinion that this taxpayer was not, during the year 1921, entitled to classification as a personal service corporation.

In the course of its business during that year, the taxpayer authorized and paid to two of its principal officers salaries of $5,145 each, which amounts, in view of the figures of gross and net income, seem to be reasonable compensation for the services of such officers.


text:
    Appeal of WALTER J. SALMON.
    Docket No. 3115.
    Submitted October 12, 1925.
    Decided February 13, 1926.
    Value of a leasehold on March 1, 1913, determined.

      Albert M. Barnes, Jr., Esq., for the taxpayer.

      M. N. Fisher, Esq., for the Commissioner.
    Before Smith, Littleton, and Trussell.
    This is an appeal from the determination of a deficiency in income tax for 1919 and 1920 in the aggregate amount of $19,253.23. The question in issue is the value on March 1, 1913, of a leasehold in which the taxpayer owned a one-half interest acquired in 1902,
    FINDINGS OF FACT.
    The taxpayer is a resident of New York City. In 1902 he acquired a 20-year lease beginning May 1, 1902, and ending April 30, 1922, on a building known as the Bristol Building, situated on the northwest corner of Fifth Avenue and Forty-second Street, New York City. The lot fronted 74½ feet on Fifth Avenue and 125 feet on Forty-second Street, and was improved with a seven-story building which had theretofore been used as a hotel. The agreed rental was $55,000 a year, which amount was to be net to the lessor, the lessee agreeing to pay all taxes, insurance, repairs, and all operating charges.

      The first floor of the building consisted of 10 stores, which were soon rented for varying periods. The corner store was leased for the full term of the lease of the building, the sublease expiring April 30, 1922. The second floor was known as the mezzanine floor, and was used for tailoring shops, showrooms, etc. There were six upper floors that were rented for offices. All of the subleases carried provisions whereby they might be canceled on payment of certain stipulated bonuses. On March 1,1913, the entire building might have been cleared of tenants on the payment of such bonuses in the amount of $128,850.
    The rentals collected, the operating costs, including taxes, insurance, etc., and the profits to the lessee for the full period of the lease were as follows:

    1 Loss.
    For many years prior to 1910, the retail business section in New York City had centered around Sixth Avenue and Twenty-third Street. The establishment of manufacturing industries in that section made it undesirable for retail businesses; they first located at Twenty-third Street and Broadway and moved up first to Thirty-fourth Street between Broadway and Fifth Avenue and spread north to Fifth Avenue up to Forty-second Street, and certain of the specialty shops moved up between Forty-second Street and Forty-eighth Street. In 1911 Stearn abandoned his location on Twenty-third Street and located at Forty-second Street and Sixth Avenue.
    All of these factors centered the attention of the real estate interests in New York City upon the locality of Forty-second Street and Fifth Avenue. Tenants on that street, in the vicinity of Fifth Avenue, were offered good bonuses for their leases. There were many deals pending in 1913 and 1914, and long-term leases on desirable properties were in great demand.

      In his income-tax returns for 1919 and 1920, the taxpayer reported the fair market value of the lease on the Bristol Building on March 1, 1913, to have been $652,641.32, and that the amount deductible from gross income by the lessees for each of the years 1919 and 1920 was $70,555.82, half of which was claimed by the taxpayer.
    The fair value of the leasehold on the Bristol Building at March 1, 1913, was $262,025.82. A reasonable amount for the exhaustion of the taxpayer’s interest in the leasehold for each of the years 1919 and 1920 was $14,192.31.
    DECISION.
    The deficiency should be computed in accordance with the following opinion. Final determination will be settled on 10 days’ notice, in accordance with Eule 50.
   OPINION.

Smith

: The taxpayer had a one-half interest in a leasehold which was acquired in 1902, the lease expiring April 30, 1922. The leasehold had a large cash value at March 1, 1913. The taxpayer is entitled to deduct from gross income for each of the years 1919 and 1920 an amount representing the annual exhaustion of the leasehold. Appeal of Grosvenor Atterbury, 1 B. T. A. 169.

In his income-tax returns for the years 1919 and 1920, the taxpayer claimed that the fair market value of the leasehold on March 1, 1913, was $652,641.32; that this value should be spread ratably over the 9 years and 2 months that the lease had to run from March 1, 1913, to the date of expiration, April 30, 1922; that the exhaustion deduction allocable to each of the years 1919 and 1920 was $70,555.82; and that the taxpayer, having a one-half interest in the leasehold, was entitled to a deduction for exhaustion of $35,277.91 for each year.

In support of this appeal the taxpayer has placed in evidence appraisals of the leasehold by two real estate experts of New York City. One expert has given the leasehold a value on March 1, 1913, of $800,496, based on the fair market value of the land and buildings, and of $739,203, based on the fair rental value of the property as follows:

Fair market value of land-$3, 000, 000
Fair market value of building_ 225, 000
Allowing 5 per cent interest on land and 6 per cent interest on the building and applying the Inwood formula, the estimated value of the leasehold is_ 800,496
Fair annual rental from entire building- 258, 750
Less-40 per cent for operating, taxes, insurance, etc- 103,500
Less $55,000 annual rental of lease_ 55,000
Net annual income from property_ 100,250
Value of leasehold on March 1, 1913_ 739,203

The appraised value of the leasehold was placed by the other expert at $793,000 as of March 1, 1913. Both appraisals were made in 1925.

In the light of the actual earnings, we thinii that the appraisals made by the expert appraisers of the value of the leasehold in question as of March 1, 1913, are much too high. In the determination of the value of the leasehold at March 1, 1913, one of the appraisers has stated that the fair annual rental from the entire building as of March 1, 1913, was $258,750. This was greatly in excess of the rentals collected for the fiscal year ended January 31, 1913, or for any year prior to that ended January 31, 1920. There was a gradual increase in the total rentals collected, a portion of which increase was reflected in the profit- from the leasehold, but we do not think that it was possible in 1913 to foresee the greatly increased rentals of the years subsequent to 1919. The lessees’ profits were subject to the hazards of business. Even though the rentals might increase in amount, the proportionate part of such increase which would be reflected in profits was uncertain. It is noted that from February 1, 1910, tó January 31, 1916, the average annual profit from the lease was $49,611.06. In our opinion, it was impossible for the lessees to foresee on March 1, 1913, a greater profit per year from the operation of the property for the period March 1, 1913, to April 30, 1922, than $49,611.06. We are of the opinion that, in the determination of the cash value of the leasehold, it should be considered that it would earn only $49,611.06 per year for nine years and two months. The then cash value of such a leasehold is $262,025.82, which we have found as a fact to be the cash value of the leasehold on March 1, 1913. The amount of the exhaustion allocable to each year is $28,-584.63, one-half of which, or $14,192.31, is a legal deduction from the annual gross income of the taxpayer in his income-tax returns.