author: Smith

text:
    Appeal of B. ROSENBERG & SONS, INC.
    Docket No. 4259.
    Decided July 31, 1926.
    Upo.i tile evidence, held, that the taxpayer is not entitled to depreciate its inventory at December 31, 1919, for the purpose of determining its tax liability for 1919.

      Charles Bosen, Esq., for the petitioner.

      J. Arthur Adams, Esq., for the Commissioner.
    Before Littleton, Smith and Teussell.
    This is an appeal from the determination of a deficiency in income and profits tax for the year 1919, the tax in controversy being less than $10,000. All allegations of error made by the taxpayer in its petition were withdrawn at the hearing, except that which relates to an overvaluation of its inventory at December 31, 1919.
    FINDINGS OF FACT.
    The taxpayer is a Louisiana corporation with its principal office and place of business in New Orleans. It was organized on July 1, 1918, as the successor of the partnership of B. Rosenberg & Sons. It is engaged in the wholesale boot and shoe business and also manufactures a certain line of men’s shoes. In order successfully to operate the business it is necessary to carry large stocks at all times. The business is seasonable; that is, it is divided into spring and summer, and fall and winter trade. All purchases of shoes by the wholesalers are made months in advance of the time when the boots and shoes are actually sold. At December 31, 1919, the taxpayer had large quantities of fall and winter goods on hand and in taking its inventory at December 31, 1919, it valued such stocks at cost or market, whichever was lower. Goods which were believed to be of a market value less than cost were priced at what the taxpayer believed was the market price thereof. The prices at December 31, 1919, were extremely high. During the middle of the year 1920, prices declined very rapidly, with the result that when the fall and winter goods were in demand items carried over from the previous year were sold for considerably less than the value at which same had been inventoried at December 31,1919. Owing to changes in styles large quantities in certain lots of shoes included in the inventory taken at December 31, 1919, remained unsold at December 31, 1922, notwithstanding the fact that same were offered for sale at prices ranging from 50 per cent to 75 per cent off cost. The taxpayer sustained a loss of at least $13,900.20 in the sale of certain goods carried in its inventory at December 31, 1919.
   OPINION.

Smith

: The taxpayer took its inventory at December 31, 1919, on the basis of cost or market, whichever was lower. The evidence would indicate that the taxpayer was overstocked with certain lots of women’s boots and shoes and suffered a very large loss upon the sale of certain lots of these goods during 1920 and subsequent years. It is the contention of the taxpayer that it did not actually know the market value of the goods at December 31, 1919, and that it inventoried them on that date above the market. When the taxpayer tried in the .summer and fall of 1920 to sell such inventoried boots and shoes it found very little market for them.

The Commissioner has determined a. deficiency in tax for the .year 1919, without in any way changing the inventory reported by the taxpayer at December 31, 1919. The only evidence which the taxpayer has offered that its inventory was overvalued on that date is the fact that when it tried to sell the goods on hand it found that many of them were obsolete, and it believes that they were obsolete on December 31, 1919.

We are not satisfied from -the evidence of record that the market price of the boots and shoes listed in its inventory at December 31, 1919, was overstated..

Judgment for the Oommissioner.


source: Caselaw Access Project

author: Arundell:

license: Public Domain

text:
    Appeals of ELMER R. WALLINGFORD and C. A. WALLINGFORD.
    Docket Nos. 230, 231.
    Decided July 31, 1926.
    Petitioners formed a partnership in 1920 and took over cattle at their cost to a predecessor partnership. Held, the petitioners may reflect in their 1920 returns the decrease in the value of the cattle which occurred subsequent to their acquisition in 1920.

      Stanley-Spurrier, G. P. A., for the petitioners.

      A. 27. Fast, Esq., for the Commissioner. ,
    These appeals are from determinations of deficiencies in income tax for the calendar year 1920 in the following amounts:
    Elmer R. Wallingford_'-$1, 503. 51
    O. A. Wallingford_-_ 1,195.42
    The only question involved in the appeals is the right of the petitioners to a deduction claimed to represent loss in inventory value of cattle.
    FINDINGS OF FACT.
    The petitioners are individuals, residing at Ashland, Kans.
    C. A. Wallingford has been engaged in' the cattle business since 1895. In September, 1918, he, with two associates, purchased about 500 head of young cows for the purpose, primarily, of feeding and marketing them. In order to make this purchase Wallingford borrowed funds from a local banker.
    The cattle were fed for a while in 1918, but it was decided not to market them that year. Again, in the fall of 1919, they were fed for the market, but it was again decided not to sell them that year. In 1920 there was a great decline in the value of cattle and the banker who had loaned money to Wallingford to purchase the cattle required him to reduce the amount of the loan by more than $13,000. In that year C. A. Wallingford’s brother, Elmer B,. Wallingford, bought out the interests of C. A. Wallingford’s two associates in the enterprise for $17,500.
    The books of C. A. Wallingford were very meagre, consisting principally of a day book or live-stock record. At the time of purchasing the cattle the cost, $35,000, was entered in this record. No change was made in this figure during 1918 and 1919. In the fall of 1920, due to the decline in value of cattle, the value of the cattle was reduced on the live stock record to $22,500.
    In Schedule D of the returns filed for 1920, each of the petitioners list cost of cattle as $17,500, to which is added $6,580, representing cost of feed, and from these items is subtracted $11,250 under the heading “ Sale price or liquidating dividend,” but claimed here to represent reduction in inventory. The Commissioner • refused to allow the claimed reduction in inventory value which gives rise to the deficiencies here involved.
   OPINION.

Arundell:

The petitioners claim the right to deduct from their gross income for 1920 the shrinkage in value of cattle in that year. They seek to take this deduction by subtracting the closing inventory from the opening inventory for the year. The Commissioner contends that, under section 208 of the Revenue Act of 1918, they are not entitled to compute income on an inventory basis, inasmuch as the inventory basis was not used in prior years.

The purchase by Elmer R. Wallingford of a half interest in the cattle in 1920 effected, at the time of the purchase, a dissolution of the partnership which had theretofore owned the cattle and the formation of a neiv partnership of which the petitioners were the members. Thus the ownership of the cattle was vested in a new entity created in 1920 which is privileged to compute its profit or loss without reference to the method of computation used by its predecessor. The income tax returns filed by the petitioners for the year 1920 show that each of them took a half interest in the cattle at $17,500 or a total cost to the partnership of $35,000, which was the same as the cost to the predecessor partnership.

The only witness in this case, C. A. Wallingford, has been engaged in dealing in cattle for thirty years or more, and we believe from his testimony that he is qualified to testify to the value of the cattle which he and his brother owned in 1920. Not only did the cattle decrease in value during 1920 from $35,000 to $22,500, but this decrease was reflected on C. A. Wallingford’s books in that year which carried the joint account of the brothers, and was also shown in the returns filed. Accordingly, we are of the opinion that the petitioners are entitled to the deduction claimed.

Order of redetermination will be entered on 15 days' notice, under Rule 50.


author: Trammell

text:
    Appeal of OPERATORS FUEL AGENCY.
    Docket No. 6349.
    Decided July 31, 1926.

      John B. Brwnot, Esq., for the petitioner. •

      Ward Loveless, Esq., for the Commissioner.
    Before GrattpNer  and Trammell.

       This decision .was prepared during Mr. Graupner’s term of office.

   Trammell

: This is an appeal from the determination of a deficiency in income and profits taxes for the year 1920 in the amount of $2,761.15. The question involved is whether the taxpayer is entitled to have its taxes assessed under the provisions of section 328 of the Revenue Act of 1918.

FINDINGS OF FACT.

The taxpayer is a Pennsylvania corporation having its principal office at Greensburg.

The authorized capital stock was $200,000, of which $90,000 was issued and outstanding during the taxable year. The statutory invested capital of the taxpayer, as determined by the Commissioner, was $79,000. During the taxable year the taxpayer did a gross business in the amount of $6,024,504.85. Its net profits were $138,159.14. The amount of taxes paid for the year was $57,158.94. Approximately 75 per cent of the coal which was sold by the taxpayer was purchased by it from its stockholders.

The Fort Pitt Coal & Coke Co., which was engaged in selling coal during the year 1920, had a gross income of $144,234.92; gross sales of $3,993,154.73; and net income of $58,954.94. The profits tax for that year was $15,370.60 and its total tax was $19,528.55. Its ratio of profits tax to net income was 26 per cent. Its invested capital was $135,927.05.

Judgment for the 0ormnissioner.


author: Phillips:

text:
    Appeal of CLEVELAND, PAINESVILLE & EASTERN R. R. CO. and CLEVELAND, PAINESVILLE & ASHTABULA R. R. CO.
    Docket No. 4927.
    Decided July 31, 1926.

      Arthur B. Foye, G. P. A., for the petitioners.

      M. N. Fisher, Esq., for the Commissioner.
    Before Graupner, Teammell and Phillips.

      This decision was prepared during Mr. Graupner’s term of office.

   Phillips:

This is an appeal from the determination of a deficiency in income and profits taxes of the Cleveland, Painesville & Eastern R. It. Co. for 1917, 1918, and 1919, in the amount of $11,351.37. The deficiency arises from the fact that the Commissioner refused to permit the petitioning corporations to file a consolidated return.

findings of fact.

The Cleveland, Painesville & Eastern ft. R. Co., hereinafter referred to as the Eastern Company, and the Cleveland, Painesville & Ashtabula R. R. Co., hereinafter referred to as the Ashtabula Company, are Ohio corporations, operating an electric interurban railway between Cleveland, Painesville and Ashtabula. The railroad of the Eastern Company extended from Cleveland to Paines-ville, a distance of SO miles, and the railroad of the Ashtabula Company extends from Painesville to Ashtabula, a distance of 26 miles, but trains are operated from Cleveland through to Ashtabula over the tracks of the two companies: The operation of the entire service is from the offices of the Eastern’Company at Willoughby, Ohio. The Eastern Company owned and 'operated repair shops at which repairs were made on the propertjr of both companies, furnished the power which operated the trains of the Ashtabula Company, purchased all supplies and materials for that company, did its bookkeeping, financing and banking, and superintended its operation. At the end of each month there was an adjustment made by billing direct to the Ashtabula Company for all services, material and supplies, office help, etc. The Ashtabula Company paid for nothing direct. Everything was done through the Eastern Company and adjustments made monthly. The Ashtabula Company had no offices, shops or power plant.

During the years involved, the Ashtabula Company was indebted to the Eastern Company in the amount of $240,309.02 on a demand note dated January 1, 1914. The Eastern Company also owned $150,000 of the bonds of the Ashtabula Company of a total issue of $1,000,000, on which interest was in default during 1917, 1918 and 1919. No dividends have been .paid by either company.

The balance sheets of the Ashtabula Company for December 31, 1916, and December of each of the taxable years involved, were as follows:

The Eastern Company owns Y,090 shares of 10,000 shares of stock issued and outstanding, or Y0.9 per cent of the capital stock of the Ashtabula Company.

W. H. Douglas was president and general manager of the-Eastern Company and vice president and general manager of the Ashtabula Company. The same persons are officers of both companies and the directors are the same, except that the Eastern Company has two more directors than the Ashtabula Company.

At the meetings of the stockholders of the Ashtabula Company in 191Y, 1918, and 1919, the following shares were voted:

‘ Shares

1917_7,591

1918_■__ 7, 688

1919____-8, 315

The Eastern Company, through its president and treasurer, in addition to the stock which it owned, voted, in 191Y, 441 shares, in ] 918, 541 shares, and in 1919, 1,187 shares, through proxies, so that, during 1917, 1918, and 1919, the Eastern Company actually voted more than 99 per cent of the stock which was voted at the stock-, holders’ meetings. The Ashtabula Company sent out proxies for the stockholders to sign before the meetings of the stockholders held in the years involved, and as a result the above numbers gave proxies to the president or treasurer of the Eastern Company. During 1917, 2,509 shares of stock were not voted at any stockholders’ meeting. During 1918, 2,412 shares were not voted, and during 1919, 1,785 shares were not voted.

The taxpayers were affiliated during the taxable years involved.

Judgment for the petitioners.

LittletoN dissents.


author: Littleton

text:
    Appeals of B. F. SAUL et al.

    Docket Nos. 3244, 3245, 3652, 3736, 4224, 4826, 4907.
    Decided July 31, 1926.
    A disposition of stock under the circumstances of this appeal hold, to have been a sale under the provisions of section 202 (a) of the Revenue Act of 1918 and not an exchange of stock for stock under the provisions of section 202 (b) of, that Act. Hold, further, that the fair market value of the right to subscribe for stock of another corporation received as a -part Of the consideration for the stock sold should be included in determining the gain or loss upon such sale.

      Laurence Graves, Esq., John F. McCarron, Esq., and John J. Hamilton, Esq., for the petitioners.

      M. N. Fisher, Esq., and L. 0-. Mitchell, Esq., for the Commissioner.
    Before Littleton, Smith, and Teussell.
    These appeals are from determinations of deficiencies in income tax for the calendar year 1919 as follows:
    B. F. Saul-$64, 274.73
    Fanny E. Saul- 795.49
    J. Philip Herrmann_ 6, 253. 45
    Rosina M. May_ 661. 55
    John H. Ruppert,_ 1,932.35
    John J. Hamilton_ 158. 21
    G. Percy McGlue_ 521. 03
    The issue involved arises as the .result of a merger of the Home Savings Bank, a Virginia corporation doing business in the District of Columbia, with the American Security & Trust Co., a District of Columbia corporation, and concerns the question whether the stockholders of the former sold their stock to and purchased certain stock of the latter, or whether the transaction was an exchange of stock for stock.
    FINDINGS OE FACT.
    The taxpayers are residents of the District of Columbia and, at the time the agreement of March 18, 1919, and other transactions hereinafter mentioned, were entered into, they were each the owner of certain shares of the capital stock of the Home Savings Bank, as follows:
    , Shares
    B. F. Saul_479
    Fanny E. Saul_ 30
    J. Philip Herrmann_ 50
    Rosina M. May_ 20
    John H. Ruppert_ 50
    John J. Hamilton_ 4
    G. Percy McGlue_ 10
    They each reported as a profit in their tax returns the difference between the cost, or the March 1, 1913, value of the Home Savings Bank stock, which is not in dispute, and $400 a share, the amount of cash received by them from the American Security & Trust Co. The transaction, hereinafter described in detail, was one in which these taxpayers deposited their stock with trustees to whom the Trust Company, pursuant to the terms of a written contract, paid $400,000, which amount was used by the trustees pursuant to the provisions of the contract in the purchase of 4,000 shares of the capital stock of the Trust Company at par, which they distributed to the taxpayers on the basis of four shares for each share formerly owned by them in the Home Savings Bank.
    The Commissioner held that in substance the transaction was an exchange of stock for stock within the meaning of section 202(b) of the Revenue Act of 1918 and computed the profit accordingly.
    B. F. Saul, president of the Home Savings Bank, hereinafter referred to as the Bank, was approached early in 1919 by the president of the American Security & Trust Co.', hereinafter referred to as the Trust Company, with a proposal to merge the Bank with the Trust Company. This proposal was considered and discussed by the directors of the Bank and negotiations followed which resulted in an offer by the Trust Company to take over the assets of the Bank in consideration of the assumption by the Trust Company of the Bank’s liabilities, other than its liability to its stockholders, which the Trust Company agreed to satisfy by payment to the stockholders of $400,000 and to permit the stockholders of the Bank to subscribe at par for four shares1 of its stock for each share of Bank stock owned by them.
    The Bank had an authorized and outstanding capital stock of $100,000, consisting of 1,000 shares which were owned by less than 50 stockholders. The offer of the Trust Company was made known to each stockholder of the Bank who was advised that under the proposed arrangement he would be paid cash foi his stock at the rate of $400 a share, or, if he so desired, he would be permitted, upon the payment by the Trust Company of the $400 a share, to purchase at par four shares of Trust Company stock for each share of Bank-stock owned. Each stockholder evidenced a desire to acquire the Trust Company stock. Thereafter, on March 18, 1919, a formal written agreement was entered into between the Bank, the Bank' stockholders, and the Trust Company, as follows:'
    This agreement, made this 18th day of March, A. D.'1919, by and between1 the stockholders of the Home Savings Bank, hereinafter referred to as the Stockholders; the Home Savings Bank, a corporation, hereinafter referred to as the Bank; B. Francis Saul, James F. Shea and Howard Moran, as Trustees, hereinafter referred to as the Trustees, and the American Security and Trust Company, hereinafter referred to as the Trust Company; witnesseth:
    1. The Stockholders hereby agree as follows:
    (a) To deposit with the Trustees hereinbefore named at the time of the signing of this contract, certificates of stock in the Bank then owned by them, assigned in blank to said trustees.
    (b) To execute a proxy to the said Trustees to vote the stock so deposited by them at any subsequent meeting of the Stockholders which may be specially called to consider the question of the merger of the Bank and the Trust Company, therein expressly waiving notice of any such meeting, and authorizing said Trustees at such meeting to vote to authorize the Directors of the Bank to pass such resolutions as may be necessary to effect said merger by the transfer of the assets of the Bank, including all of its real and personal property, to the Trust Company.
    (c) To authorize said trustees to hold the stock of the Bank so deposited . with said Trustees until the delivery to the Trustees by the Trust Company of four thousand (4,000) shares of its capital stock and then to hold the stock of the Bank subject to the direction of the Trust Company.
    2. The Bank hereby agrees to call a special meeting of the Stockholders of the Bank for the purposes hereinbefore indicated, and, upon being directed by the Stockholders, to call a special meeting of the Board of Directors, to authorize the transfer of all the assets' of the Bank to the Trust Company for and in consideration of the assumption by the Trust Company of all the liabilities of the Bank, other than its liabilities to its stockholders, and for and in consideration of the satisfaction of the interest of its stockholders by thr payment of the sum of Four Hundred Thousand ($400,000) Dollars to the Trustees.
    3. The said Trustees hereby agree that after said stock of the Bank shall have been delivered to them and after the authorization of the stockholders and Board of Directors of the Bank for the transfer of its assets to said Trust Company and receipt by said Trustees of said sum of Four Hundred Thousand ($400,000) Dollars, and upon delivery by said Trust Company of four thousand (4000) shares of its capital stock to them, they will pay to the Trust Company for said stock the sum of Four Hundred Thousand ($400,-000) Dollars and will hold the stock of the Bank subject to the direction of the Trust Company, and then will thereupon transfer to each stockholder of the Bank four shares of the stock of the Trust Company for each one share of the stock of the Bank delivered by such stockholder.
    4. The Trust Company hereby agrees to call a special meeting of the stockholders of said Company for the purpose of increasing its capital stock from Three Million to Three Million Four Hundred Thousand ($3,400,000) Dollars. If the said increase is authorized by the stockholders, a special meeting of the Board of Directors will then be called for the purpose of the issuance of the four thousand (4000) shares of stock authorized to be issued by the stockholders, and for the purpose of authorizing and directing the merger of the Bank and the Trust Company by the transfer of the assets of the Bank to the Trust Company and the assumption by the Trust Company of all the debts and liabilities of the Bank other than liabilities to the stockholders of the Bank, and of the payment of the sum of Four Hundred Thousand ($400,000) Dollars to the Trustees for the Stockholders, and for the purpose of authorizing the transfer of four thousand (4000) shares of the capital stock of the Trust Company issued as aforesaid to said Trustees for the sum of Four Hundred Thousand ($400,000) Dollars.
    * :U * # $ * ‡
    This agreement was signed by all the stockholders of the Bank, for the Bank by its president, by the trustees for the Bank’s stockholders, and by the Trust Company. Its terms were dictated with the intent and for the purpose of complying with and meeting the requirements of the law of the District of Columbia regulating the issuing of stock by trust companies organized thereunder.

      The fair market value of the stock of the Trust Company on March 18,1919, was $220 a share.
    On April 14, 1919, a meeting of the directors of the Trust Company was held at which a resolution was adopted, the pertinent portions of which were as follows:

      Resolved, That it is the unanimous judgment of the Board that the merger of this Company with the Home Savings Bank in the manner and form provided in the proposed agreement between the stockholders of the Home Savings Bank, the trustees named in said agreement, and this Company, which said proposed agreement has been submitted to this Board by its Executive Committee, will he of great benefit to this Company, and ought, in the best interests of this Company, to be executed;

      Resolved, That the officers of the Company be, and they hereby are authorized and directed to execute said agreement .on behalf of this Company;

      Resolved, further, that * * * a special meeting of the stockholders is hereby directed to be called, * * * on the 14th day of April, 1919, * * * to consider a proposal to increase the capital stock of this Company from three million dollars to three million four hundred thousand dollars with the object and for the purposes stated in the proposed agreement above set forth; to consider and, if in the judgment of the stockholders such action ought to be taken, to approve and ratify the agreement dated the 18th day of March, 1919, above set forth, executed by the officers of the Company, pursuant to the direction contained in these resolutions; and further to consider and adopt such other and further resolutions as may be desirable or expedient in effecting the object and purposes of said agreement; * * *.
    On April 15, 1919, a meeting of the stockholders of the Trust Company was held for the purpose of considering the agreement hereinbefore mentioned and the action of the board of directors relative thereto. At this meeting the stockholders approved and ratified the action of the board of directors and the following resolution was adopted:
    * * * Resolved, that in order to provide capital in amount sufficient and proper to carry into effect the agreement signed on the 18th day of March, 1919, by the stockholders of the Home Savings Bank, the Home Savings Bank, B. Francis Saul,- James F. Shea, and Howard Moran, as trustees, and the American Security & Trust Company, that the capital stock of this company be increased from its present amount of three million dollars ($3,000,000) to three million four hundred thousand dollars ($3,400,000), said increase to consist of four thousand (4000) shares of the par value of $100 each.
    Resolved, that the stockholders of this Company do hereby authorize the said increase in the capital stock of this Company from three million dollars, consisting of thirty thousand shares of the par value of $100 each to three-million four hundred thousand dollars, consisting of thirty four thousand shares of the par value of $100 each.
    Resolved, that the said four thousand shares of stock when issued shall be issued to the trustees named in the above mentioned agreement to carry out the object and purposes of said agreement, upon the payment to this. Company of the sum of four hundred thousand dollars ($400,000).
    *******

      The stock of the Bank was not quoted on any stock exchange. The bid price for this stock on the Washington Stock Exchange was $420 a share for 10 shares in January, 1919, and during the period from January to March 28, 1919, there were offers made through the Washington Stock Exchange to purchase the Bank stock at $420 a share. Between the date of the Trust Company’s offer to acquire the assets and stock of the Bank and before the transaction was consummated the vice president of the Bank purchased from the Bank’s president five shares of stock at $400 a share.
    Between January 10 and April 16, 1919, the following sales of the Trust Company’s stock were made on the Washington Stock Exchange:

    On May 10, 1919, the Trust Company’s stock sold for $289 a share. On May 15, five shares were sold at $240; on June 5, ten shares at $243, and on June 10, two shares at $239.
    The terms of the agreement were carried out and the transaction, as consummated at the close of business on April 19, 1919, was executed in detail as follows:
    The transfer, assignment and conveyance of all the assets of the Bank to the Trust Company, the assumption by the Trust Company of the Bank’s liabilities, the issuance to and the receipt by the trustees on behalf of the stockholders of the Bank of a check issued by the Trust Company for $400,000, the delivery to the Trust Company of the 1,000 shares of the Bank stock by the trustees, the deposit by the trustees of the check for $400,000 in the Biggs National Bank to the credit of their account, the drawing of a check on this account by the trustees for $400,000 payable to the Trust Company, and the issuance and delivery by the Trust Company to the trustees for the stockholders of the Bank of a certificate for 4,000 shares of the Trust Company stock, the same being endorsed by the trustees and returned to the Trust Company with instructions to issue certificates to each of the former stockholders of the Bank. Pursuant thereto, each of the former stockholders of the Bank received a certificate for four shares of Trust Company stock for each share of Bank stock formerly owned by him.

      It was necessary for the Trust Company, being a District of Columbia corporation, to' obtain a certificate from the Comptroller of the Currency that its increased capital stock of $400,000 had been paid in. In a letter dated April 21, 1919, the Trust Company notified the Comptroller of the authorization and issuance of the $400,000 increased capital stock, and furnished him with a copy of the minutes of the meeting of its stockholders held April 14, 1919, in which was incorporated in full the agreement of March 18, 1919. On April 22, 1919, the Comptroller of the Currency issued a certificate that the $400,000 of stock had been issued as required by law, as follows:
    Whereas, satisfactory evidence has been transmitted to the Comptroller of the Currency that the capital stock of the American Security and Trust Company, located in the City of Washington, District of Columbia, has been increased in the sum of Four Hundred Thousand Dollars ($400,000), pursuant to the provisions of the Code of Law of the District of Columbia, and that the whole amount of such increase has been paid in, and that the paid-up capital stock of said company now amounts to the sum of Three Million Four Hundred Thousand Dollars ($3,400,000) ;
    Now, it is hereby certified, that the capital stock of the American Security and Trust Company has been increased in the sum of Four Hundred Thousand Dollars ($400,000) ; that said increase of capital has been paid in as a part of the capital stock; and that the said increase of capital is approved by the Acting Comptroller of the Currency. 1
    In witness whereof, I hereunto affix my official signature and seal of office.
    Each of the stockholders determined the profit or loss upon the sale of the Bank stock as the difference between-the cost, or March 1, 1913, value thereof, and the sales price of $400 a share. The Commissioner held that the transaction was an exchange of stock for stock, within the meaning of section 202 (b) of the Revenue Act of 1918, and determined the fair- market value of the Trust Company’s stock to have been $235 a share, resulting in the deficiencies hereinbefore mentioned.

       The titles and docket numbers of the appeals here decided are: B. F, Saul, No. 3244; Fanny E. Saul, No. 3245 ; J. Philip Herrmann, No. 3652; Rosina M. May, No. 3736; John H. Ruppert, No. 4224 ; John J. Hamilton, No. 4826 ; and G. Percy McGlue, No. 4907.

   OPINION.

Littleton

: Section 202 of the Revenue Act of 1918 imposes a tax upon the gain derived either through a sale of stock, or through an exchange of stock for stock. In the former case it provided that the basis should be the difference between the value on March 1, 1913, and the sales price, if acquired prior thereto, and, if acquired on or after that date, the cost thereof and the sales price, and, in the latter, the difference between the par value of the stock exchanged and that received should the par value of the stock received be in excess of the cost or March 1, 1913, value of the stock exchanged. What should be considered a sale and what an exchange was left to the courts to decide under the facts in each particular case.

The facts in these appeals show that each of the Bank stockholders agreed first to sell his bank stock and, second, to purchase four shares of the Trust Company’s stock. Under- these circumstances, the two transactions can not be combined for the purpose of determining a gain or loss to the Bank stockholders upon the basis of an exchange of stock for stock. Counsel for the Commissioner argued that—

It is perfectly plain that (he ultimate result desired by all parties to the contract was a merger of the two institutions upon the basis of an exchange of four shares for one. It is apparent that without the circumstance of the banking laws the contract would have been shortened by the omission of the part relating to the payment of money. The only effect of the addition of the part relating to the money payment was to provide that a check should be drawn to trustees for the drawer, who should then return it to the drawer. This addition is purely a matter of form. If it made any change it was a change of form only with the real substance of the contract left undisturbed.

It is a general rule of construction'that where a contract is made in performance of a statutory obligation and is susceptible of two interpretations, that construction will be given which is in accord with, and in furtherance of, the statutory obligation in question.

Section 719. subchapter xi of chapter xvra of the Code of Law of the District of Columbia, entitled “Trust, Loan, Mortgage, and certain other corporations ” provides:

* * * That no corporation created and organized under the provisions hereof * * * shall be authorized to transact the business of a trust company, or any business of a fiduciary character, until it shall have filed with the Comptroller of Currency a copy of its certificate of organization and charter, and shall have obtained from him and filed the same for record with the said recorder of deeds, a certificate that the said capital stock of said company has been paid in and * * *.

Section 728 further provides in part:

The capital stock of every such company shall be at least one million dollars, and at least fifty per centum thereof must be paid in, in cash or by the transfer of assets as hereinafter provided in section seven hundred and thirty-five of this subchapter, before any such company shall be entitled to transact business as a corporation, * * *.

Section 735, entitled “Stock to be paid up in money only,”-declares : ' :

Nothing but money shall'be considered as payment of any part of the capital stock, except that in the case of any company now doing business in the District of Columbia in any of the classes herein provided for, or under any act of Congress, or by virtue of the laws of any -of the States, and which company has actually received full payment in money of at least fifty per centum of the capital stock required by this act, * * * all the assets or. property may be received and considered as money at a value to be appraised and fixed by the Comptroller of the Currency: Provided, That all such assets and property are also transferred to and are thereafter owned by the company organized under this act.

Section 743, entitled “Increase of Capital Stock,” reads as follows ;

Any corporation wliieli may be formed under this subchapter may increase its capital stock by complying with the provisions of this subchapter to any amount which may be deemed sufficient and proper for the purpose of the corporation.

It appears from the foregoing provisions of the Code of the District of Columbia that the Trust Company could not have issued its stock for the stock of the Bank in merging the two institutions. In legal effect, the payment by the Trust Company to the trustees of the stockholders of the Bank of $400 a share for the Bank stock was equivalent to the Trust Company having paid that amount to each stockholder and the stockholder having then paid back to the Trust Company the amount received by him for four shares of the Trust Company stock for each share of Bank stock owned by him. The fact that the stockholders of the Bank agreed to purchase at par the stock of the Trust, Company with- the money received in payment for the Bank stock held by them did not make the transaction an exchange of stock for stock, within the meaning of the statute. Each step in the transaction, was one of substance and not of mere form, and the issue must be determined by what was actually done rather than the effect of what, was done. In the Appeal of Anna M. Harkness, 1 B. T. A., 127, the Board said:

It seems to us to be fundamentally unsound to determine income tax liability by wliat might have taken place rather than by what actually occurred. Even though the practical effect may be the same in either case, the resulting tax liability may be quite different.

Strict compliance with acts of Congress relating to. the issuing of stock by Trust Companies organized under the laws of the District of Columbia can not be regarded as a matter of form for the purpose of. bringing a transaction within a particular provision of the Revenue Act inconsistent with such congressional enactments. The $400 a share, when received by the trustees for the Bank stockholders, was deposited in the Riggs National Bank and the relation of debtor and creditor existed until the trustees, acting for the Bank stockholders, purchased 4,000 shares of Trust Company stock. In the Appeal of Edward A. Langenbach, 2 B. T. A. 777, the Board said:

Here the corporation declared and the stockholder received a cash dividend, which, were it not for his voluntary contract, he had under his complete dominion. At thé moment of its receipt he realized income, and what he did with it thereafter, irrespective of how soon, can not change its character at that time. Appeal of Regal Shoe Co., 1 B. T. A. 896; Appeal of E. C. Huffman, 1 B. T. A. 52.
It is our opinion, therefore, that the taxpayer can not' escape tax because the amounts received were incidental to the reorganization.

Neither the fact that the Bank stockholders had agreed to purchase the stock of the Trust Company, nor the fact that the purchase by them of the Trust Company’s stock was near in point of time to the receipt of the $400 a share, changes the character of the transaction. In this respect this appeal is essentially different from the case of United States v. Mellon, 281 Fed. 645, in which the corporation did not intend to pay the cash dividend and was without funds with which to do so. Had the facts in that case shown, as they do here, that the corporation possessed ample funds with which to pay the dividend declared and had, in fact, paid it, and that the stockholders had afterwards under the arrangement purchased certain of its stock, the court doubtless would have held that the dividend was income. Nor is this appeal parallel to the Appeals of Theresa Zellerbach and Isadore Zellerbach, 2 B. T. A. 1076, in which the Board held that the dividend declared by the corporation of which the taxpayers were stockholders, and which they did not actually receive but instead received additional stock, was not income. The facts in that case-show substantially that a dividend was declared but that, under an existing arrangement, stock was issued therefor instead of cash being paid, that this was in accordance with the understanding that no money should be distributed to the stockholders or taken out of the business, and that they should receive only a stock dividend — one share for each three shares held by them.

Although the Board is of the opinion that this transaction was a sale of stock- by these taxpayers, it is not convinced that the profit realized by the stockholders of the Bank was the difference between the cost, or March 1, 1913, value of their stock, and .$400 a share. Under the terms of the agreement hereinbefore referred to, the Bank transferred its business and assets to the Trust Company in consideration of the assumption by the Trust Company of the Bank’s liabilities other than its liability to stockholders. Under this contract the consideration passing from the Trust Company to each Bank stockholder for his Bank stock was $400 a share and the right to subscribe for four shares of the Trust Company stock at $100 a share. Between January 1, 1919, and March 18, 1919, the Trust Company’s stock was selling on the market at prices ranging from $220 a share to $222 a share. Between March 24 and June 10, 1919, the stock of the Trust Company was sold on the exchange at prices ranging from $233 a share to $243 a share. The right of each Bank stockholder to purchase four shares of the Trust Company’s stock at $100 a share was a part of the consideration which the Trust Company agreed to pay for the Bank’s stock, and the value of that right should be considered in measuring the profit realized by the Bank stockholders to the same extent as if it had been cash. The amount received by the Bank stockholders for their stock was, therefore, $400 a share, plus the lvalue of the right to subscribe for four shares of the Trust Company’s stock at par.

Under the provisions of the contract and under all of the evidence submitted, the Board is of the opinion that the fair market price or value of the right received by each Bank stockholder to subscribe to the Trust Company’s stock at par was $120 a share. The result therefore is that the price received by each Bank stockholder for each share of Bank stock sold was $400, plus $480, the value of the right to subscribe for four shares of the Trust Company’s stock, or $880 a share. This amount, less the cost or March 1, 1913, value of the Bank stock, which is not in dispute, is the proper measure of the profit per share of the Bank stock to each of these taxpayers.

Order of redetermination will be entered on 15 days' notioe, under Bule 50.


text:
    Appeal of AMERICAN SEATING CO.
    Docket No. 4772.
    Decided July 31, 1926.
    1. Amounts paid for acquiring title to certain inventions represented by applications for patents and expenses incident thereto are capital expenditures and in the instant proceeding must be treated as elements of invested capital.
    2. The cost of developing and perfecting the manufacture of a newly designed product is a capital expenditure and where such cost was so treated in the year in which it was incurred and was later charged off to surplus the taxpayer is entitled to reinstate the amount in surplus. Appeal of Goodell-Pratt Go., 3 B. T. A. 30.

      Laurence Graves, Esq., and Norman A. Young, G. P. A., for the petitioner.

      Thomas P. Dudley, Jr., Esq., for the Commissioner.
    Before Littleton, Smith, and Tkitssell.
    The taxpayer has petitioned for the redetermination óf a deficiency in income and profits tax for the year 1920, asserted by the Commissioner to be in the amount of $33,892.60. Only such portion of the asserted deficiency is in controversy as results from alleged errors in the computation of invested capital, which alleged errors are as follows:
    (1)' That the Commissioner eliminated from invested capital the amount of $40,500, shown on taxpayer’s books as the cost of certain inventions and application for patents relating to the use of steel tubing in the construction of school desks and seats.

      (2) That the Commissioner eliminated from invested capital the sum of $198,712.37, a part of the claimed cost of developing the use of steel tubing in the manufacture of school seats and desks.
    FINDINGS OF FACT.
    The taxpayer is a corporation organized under the laws of the State of Illinois in the year 1906, and since that time has been continuously engaged in the business of manufacturing and selling desks, chairs, and seats for schools, churches, theatres, and other places of public assembly.
    Prior to 1911 the framework of the desks and seats was made of cast iron manufactured at the taxpayer’s foundry. As early as 1909 it was found that the cast iron frame did not stand up under the hard usage of the school; that it was subject to breakage both in use and in transit, resulting in considerable economic loss.
    In 1909 it was decided to substitute a steel frame for the cast iron one then in use, and the taxpayer’s engineers were put to -work on the problem and continued on the experimental and development work during 1910, 1911, and 1912. The change from the use of the cast iron frame, which was comparatively simple to manufacture, to the steel frame was a radical departure from the methods of production then employed. It required not only additional buildings, machinery, and equipment, new dies, jigs, tools, and patents, but.a complete change in the specifications of the remaining wooden parts, as well as a period of experiment and development during which the imperfections in the plans and specifications must be discovered and corrected and the machinery of operations by which quantity production was to be reached adjusted to meet such changes. This petitioner was the pioneer in the manufacture of the steel standard desk and therefore could not benefit by the experience of others.
    In 1910 new buildings were constructed and machinery and equipment acquired and installed, following which the manufacture of the steel standard desk was started. There was some little production in 1910. Neal production began in 1911. The period of transition from the cast iron frame to the steel frame continued through 1911 and 1912. During this entire transition period the petitioner kept an accurate and detailed record of the cost of changing from the cast iron to the steel frame, and such cost so recorded upon the taxpayer’s books of account on December 31, 1912, amounted to the aggregate of $398,934.39. All of this aggregate was regularly charged on the books of the taxpayer as capital expenditures and none of it was ever charged to ojierating or other expenses.
    When the petitioner entered upon and began the development of the use of steel frames, it opened up on its books of account a capital expenditure account under the designation of “ steel construction.” Into this account were charged many items of cost of material, labor, and superintendence. The transition from cast iron to steel frame resulted in many imperfections in plans, specifications, tools, dies, jigs, etc., with the natural result that a large part of the production of parts, and sometimes of completed desks and seats, were found to be not marketable and were junked, and this, of course, required the junking of all jigs, dies, etc., the making of new ones, and the production of new parts, entering into the construction of a completed and assembled marketable desk. Complete and accurate records of the cost of producing the steel standards were regularly kept from the beginning of the venture until the close of the year 1912. The steel construction account appearing on the company’s ledger for the years 1911 and 1912 is summarized as follows:
    Dr. Cr.
    1911 — January 1 Balance brought forward_$96,446.87
    33 items aggregating--- 37, 707. 08 $600. 00
    Oct. 26 St. Louis contracting acct_ 33, 239. 77
    Dec. 30 Steel operating loss_ 55, 296. 55
    Debit balance_ 222, 590. 27
    1912 — January 1 Balance brought forward_:_ 222, 590.27
    40 items, aggregating- 66,164. 09 118.00
    Dec. 31 — Operating loss_110,180. 05
    Debit balance_ 398, 934. 39
    In the foregoing, items of operating loss for the years 1911 and 1912, summarized from the petitioner’s ledgers, are exhibited as follows :
    Cr. Dr.
    Steel--!---'_ $58, 215. 54
    Finishing material — :_1_"_1_'_ 2,286.75
    Direct supplies_I__ 440. 47
    Non. Prod, supplies: .
    Dept-$5, 693. 72
    H. L. & P___ 1, 363. 60
    General-'- 650. 53 7, 707. 86
    Packing material_■_■_ 433. 85
    Productive labor_1_:_::_-_:_ 45, 511.69
    Non. Prod, labor:
    Dept---$19,323.59
    H. L. & P_ 103.22
    General-,--- 2, 496.17 21, 922. 98
    Fixed charges__ 2, 051. 24
    Iron--- 4, 790. 95
    Packing labor_ 2,230. 70
    Cutting crating_._ 114, 48
    145, 706. 51

      Cr. Dr.

      Brought forward'_$145,706.51
    Shipments — credits-,-$47, 620. 57
    Improvements — credits- 3, 773.41
    Inventory — 12/30/11_ 54, 955. 96
    106, 349.74
    Inventory — 12/31/10- 15, 939. 78
    - 90, 409. 96
    Loss_ 55, 296. 55
    Inventory Jan. 1, 1912 — - 54, 955. 96
    Productive labox*-- 92, 840. 92
    Pro rate (factory overhead, such as supervision, foremen, and all labor in steel plant except productive labor)- 82,148.38
    Stool consumed_ 114,198. 65
    Iron room prod, labor Japanning- 7,405. 82
    Iron room pro rate on above- 5, 549. 00
    Japan material_ 10, 346.24
    Packing steel a/5612 and pro rate- 9,135. 09
    Packing matl. and cut crating labor- 2, 960. 09
    379, 540.15
    School shipments stock and sarnp-$169, 058. 25
    Church shipments_ 252.14
    Opera shipments_ 6, 038.49
    Mise, shipments_ 706. 96
    Transfers Iron Scrap (transferred to another factory) _ 15,884. 68
    Improvements and pro rate- 4, 240.38
    Inventory Jan. 1, 1913-j.- 73,179.20
    - 269,360.10
    Difference loss_ 110,180. 05
    During the years 1911 and 1912 studies were made to determine the cost of producing each unit. From these studies it was determined that the cost of labor, materials, and overhead entering into the production of the salable articles was a certain amount per article. The taxpayer then determined that $55,296.55 of the amount expended during the year in the manufacture of the steel standards was properly chargeable to capital as experimental and development expense. This amount was arrived at in the following manner: To the opening inventory was added productive labor, factory overhead, cost of steel consumed, cost of painting and packing. The total so obtained represented the total cost of constructing the steel standards, sold during the year, junked during the year, and on hand at the end of the year. This total was then credited with (1) the shipments made, valued at a figure which the taxpayer had ascertained from its time studies of cost of production, to be the normal cost of producing a unit, that is, the cost of the material used in producing a unit, the cost of the productive labor necessary for its manufacture as well as the factory overhead cost attributable thereto. (2) Transfers of materials including junk and scrap, and (8) the inventory at the close of the year valued in the same manner as the shipments out as in (1) above. The costs for 1911 so obtained exceeded the credits by $55,296.55, which, in the opinion of the taxpayer, represented the amount expended in the manufacture of steel standards properly attributable to experimental and development expense. This amount reflected the cost of material, labor, factory overhead, tools, jigs, dies, etc., used in manufacturing the units that were junked or scrapped during the year while in the process of construction.
    This $55,296.55 was not charged to expense on the books of the taxpayer but was charged to its capital account “Plant and Properties.” Furthermore, it was not deducted on the Federal excise-tax return filed for the year 1911 showing a net income of $79,207.83 and upon which the tax due was paid.
    The amount charged by the taxpayer to capital account for 1912 for experimental and development expense, determined in the same manner as the $55,296.55 for 1911, was $110,180.05. Likewise, this amount was neither deducted on the taxpayer’s books as an expense nor in the Federal income-tax return filed for that year showing a net income of $51,397.49 upon which the tax due was paid.
    The first contract which the taxpayer procured for the steel standard desk was with the Board of Education of the City of St. Louis, Mo. The first production of the steel standard desk was under this contract. Before the order was completed certain weaknesses evidenced themselves, but under the contract delivery was guaranteed by a certain date. The desks were accordingly shipped, delivered and installed. Later on, and in 1912, it became necessary to manufacture new desks to replace the defective ones theretofore installed. The defective ones were junked. The cost in 1912 of replacing the desks junked was $33,239.77, which the taxpayer considered as representing the experimental and development expenses properly attributable to this particular contract. This $33,239.77 was therefore charged to capital by the taxpayer as experimental and development expense and not charged to expense on the books or in the income-tax returns filed for that year, which, as previously stated, showed a net income of $51,397.49 upon which tax was paid.
    After having deducted from the total cost of manufacturing the steel standards sold, junked, and on hand at the end of the years 1911, and 1912, the $55,296.55 and $110,180.05, respectively, for experimental and development expenses, the percentage of factory costs to school sales, that is, the cost of the complete marketable desk,including the steel standard as well as other parts, was a greater percentage of the sales price than in the years prior and subsequent to the experimental period 1910 to 1913, inclusive, as is shown by the following tabulation:

    The $398,984.39 charged to the taxpayer’s capital account “ Plant and Properties,” on account of experimental and development expense during the period in which the steel standard desk was being-developed and perfected, remained in the “Plant and Property” account until 1914, when, upon the recommendation of accountants ' engaged in auditing the taxpayer’s books, it was eliminated from that account and surplus account was charged with a like amount. This was a surplus adjustment, not an income adjustment, and the income for 1914 as shown by the books for that year was not affected in any manner by the adjustment, nor did the income shown by the Federal income-tax returns filed for that year reflect the adjustment.
    Later on, and in 1919, the entries made in 1914 charging off against surplus the $398,934.39 of experimental and development, were reversed upon the recommendation of accountants and the amount was restored to the “ Plant and Property ” account as well as to surplus, where it remains today.
    On or about the 3d day of March, 1911, the petitioner entered into a so-called agreement of license with the Welded Steel Products Co., a Delaware corporation, which recited that the said Welded Steel Products Co. is the “ owner of inventions for certain new and useful improvements for which patents have not yet been issued or applied for but for which it is intended to make application for letters patent as soon as possible,” and further, that “ such inventions comprise a method of steel construction particularly applicable in and adapted to the manufacture of seating furnishings and fittings for schools, educational institutions, places of amusement or congregation, opera houses, theatres, temple halls, churches or places of worship,” and further, the said agreement in the usual and proper language granted to the petitioner and its assigns full and exclusive license and authority to manufacture and sell all kinds of seatings, furnishings, and fittings, for schools, etc., embodying or containing, or made in accordance with, the methods of such inventions, and in consideration of such grant of license the petitioner undertook to pay to the licensor certain specifically described royalties upon all articles manufactured and sold under such inventions.

      Thereafter, and on or about August 3, 1915, the petitioner and the Welded Steel Products Co. entered into another written agreement which contained, among other things, recitals as follows:
    Whereas, under date of tlie 3d day of March, A. D., 1911, the parties hereto entered into a certain agreement oe license with reference to certain inventions for certain new and useful improvements, for which patents at said date of March 3, 1911 had not been issued or applied for, but for which patents upon a part of said inventions have subsequent to said March 3d, 1911 been applied for,
    * ijs * * * * *

    Whereas, the parties to said agreement of license have, subsequent to the execution and delivery thereof, been operating, manufacturing, selling and governed thereunder by said agreement of license, and certain sums of royalty have been paid by the Seating Company to the Products Company under said
    AGREEMENT OF LICENSE, * * *.
    Now therefore it is now and heeeby agreed between' the parties as follows:
    (1) -..The parties hereto agree and certify that they have had between them an accounting under said agreement of license of March 3d, 1911, 'and have struck a balance in the matter thereof and found nothing due from either to the other, and each party, for a mutual consideration received, releases, discharges and acquits the other of any claim or demand of any kind or nature whatsoever growing out of said agreement of license of March 3d, 1911, or any acts or things done thereunder or with reference to the matters and things therein provided for.
    * h* * * * # *
    (3) : For and in consideration of the sum of twenty-five thousand dollars ($25,000.00) in hand paid by the Seating Company to the Products Company (receipt whereof is now and hereby acknowledged) and of the covenants and agreements herein contained, the Products Company hereby sells, assigns, transfers and sets over to the Seating Company, all its rights, title and interest in and to said inventions and applications for patents thereon, or patents, if issued. It is further understood and agreed that the Products Company in no way guarantees the validity of any patent or inventor’s rights in the matter of said inventions.
    On or about the said 3rd day of August, 1915, the petitioner, pursuant to the agreement last above referred to, purchased the patents and inventions in said agreement described and thereupon paid to the Welded Steel Products Co. the sum of $15,000 in settlement and adjustment of all royalties due under the contract of March 3, 1911, and the further sum of $25,000, the purchase price of said inventions and patents as agreed to in the agreement of August 3, 1915; and at or about the same time the petitioner paid to its legal counsel a fee of $500 for legal services in connection with the making of said contract and counsel and advice relating thereto, and on December 3, 1915, it caused to be made journal vouchers as follows:
    Debit. Credit.
    9540 73 Plant & property (exp. and del.)-$500.00,
    34 Sheridan Wilkerson & Scott_ $500.00
    Legal advice in connection with purchase from the Welded Steel Products Co.

      9541 73 Plant & property (exp. and del.)-$40,000.00
    34 Welded Steel Products Co_$40, 000.00
    In full for all royalties under contract dated March 3,
    1911_$15,000.00
    In full for all rights, title and interest in inventions and applications for patents thereon, or patents if issued, owned, and to be owned by the Welded Steel Products Co. as per contract dated Aug. 3, 1915- 25, 000. 00
    40, 000. 00
    The entire amount of $40,500 so paid was considered by the petitioner as its cost in acquiring the patent and was then charged to its capital account, “Plant and Properties,” and not to expense, and the whole amount of said sum has at all times remained in the petitioner’s capital account and it so remains at this time.
    In auditing the petitioner’s income and profits-tax return for the year 1920, the Commissioner eliminated from invested capital the items of $40,500 charged as cost of patents and inventions. Pie also eliminated the item of .development expense relating to the so-called St. Louis contract, $33,239.77, and the so-called operating loss items of $55,296.55 for the year 1911, and $110,180.05 for the year 1912, aggregating $198,712.37.
   OPINION.

Smith

: Moneys paid for patents or for the exclusive right to use designs and inventions, whether patented or not, have been so generally recognized as capital expenditures that any argument or citation of authority in support thereof would seem to be superfluous. In 1911 the petitioner acquired by written contract exclusive license to use certain unpatented designs and inventions and agreed to pay and apparently did pay royalties for such use. In 1915 it acquired title to such inventions then held under applications fór' patents and paid therefor a purchase price of $25,000, together with counsel fees in connection with the acquirement of such title in the amount of $500. It appears that no one can question the fact that these payments, aggregating $25,500, are capital expenditures and immediately upon such payments being made become a part of the invested capital of the petitioner.

The payment of $15,000 by the petitioner to the Welded Steel Products Co., at or about the same time that it purchased title to the inventions, appears from the record to have been the sum of three payments made in settlement of the petitioner’s obligations under the contract of 1911 for the payment of roj^alties. It is not clear why the petitioner capitalized this amount. It may be that this $15,000 represents royalties upon manufactured articles which proved to be defective and were ‘therefore junked, and if such facts were shown the petitioner’s assignment of these payments as capital expenditures might under the circumstances have been warranted, but the testimony offered does not prove that the $15,000 was anything other than the usual royalty payments under the contract of 1911. We are, therefore, of the opinion that that amount can not under the circumstances be treated as a capital expenditure.

The petitioner, who had up to 1909 been engaged in the manufacture of school desks and seats with cast iron frames, determined in 1909 to substitute steel frames for the cast iron frames. This was a new and at that time untried business venture. The petitioner was in possession of no designs, patterns,, tools, .or machinery fitted for the manufacture of such steel frames and it could not procure them from other manufacturers. It was therefore under the necessity of employing skilled engineers and mechanics to develop designs, patterns, tools, and machinery, and, according to the testimony in this case, such development covered a transition period from 1909 until after the close of 1912. By the close of the period the petitioner had an established business of comparatively large proportions and had had a number of years experience in such business. Apparently, its management was in the hands of business men of experience and ability and its engineers and accountants were as capable as the going rates of wages and salaries could command. It had a thoroughly efficient cost accounting system by means of which it was able at all times to keep itself informed -as to the true cost of every article manufactured and sold. When it determined to venture into the field of manufacturing steel frames for school desks and seats it set up, in accordance with approved accounting methods, a capital account in which it entered material, labor, and overhead cost of developing the new business of making such desks and seats with steel frames. It is universally recognized in such cases that much capital must be put into development costs, and the record in this proceeding shows that in this case thousands of dollars worth of material and labor were expended in the production of designs, patterns, tools, and machinery which failed at first to produce results; that in the early days in the production of desks and seats with steel frames many such articles manufactured were found to be defective and were necessarily junked. The charging of all of these costs of experimentation, of materials lost, and of labor employed, as capital expenditures was apparently done in accordance with sound business judgment and approved accounting methods. So far as the record shows, the three items of development cost capitalized by the petitioner and eliminated by the Commissioner were just as much entitled to classification as capital expenditures as were the items which the Commissioner has allowed as capital expenditures.

In the ordinary conduct of a manufacturing business the differentiation of capital expenditures and operating expense disbursements is largely a matter of sound discretion and experienced business judgment. The dividing line between the two classes can not be defined by statute and, so far as has come to our attention, no court has ever yet attempted to make a definition that can apply to any case except the one under review. We are thus led to the conclusion that on December 31, 1912, the amount of the petitioner’s capital which had been expended in developing and perfecting the business of producing school desks and seats with steel frames was the sum of $396,884.13, and that that amount, constituting a part of $398,934.39, was then properly carried on its books as a capital asset.

The, taxpayer has continued to manufacture school desks and seats with steel frames. Its expenditures during the years 1910 to 1912, inclusive, in the development of a process of such manufacture were as much a capital item in 1920 as they were in 1913 or 1914. The taxpayer has lost none of the benefit of its capital outlay during these years. The charging off of the capital outlay in 1914 to surplus did not change the character of the expenditure so far as the computation of invested capital is concerned. Invested capital does not depend upon the manner in which the taxpayer’s books are kept. At most the books are only evidentiary. We conclude that the taxpayer is entitled to reinstate in its surplus account $396,884.13 of the $398,934.39 charged off to surplus in 1914. The Commissioner has allowed the reinstatement in surplus of $198,167.16. The balance of the $396,884.13 should also be restored. Appeal of Goodell-Pratt Co., 3 B. T. A. 30.

Judgment will he entered on 15 days1 notice, vmder Rule 50.


text:
    Appeals of HERBERT J. GERST et al.

    Docket Nos. 3879, 3888, 5365, 5366, 5367.
    Decided July 31, 1926.
    Deductions for exhaustion, wear and tear of machinery and equipment, and the profit upon the sale of real estate determined from the evidence.

      I). N. Burnham, O. P. A., for the petitioners.

      B. G. Simpich, Esq., for the Commissioner.
    Before LittletoN, Smith, and Trussell.
    These appeals involve determinations of deficiencies in income tax in the amount of $1,189.92 for the years 1919, 1920, and 1921 as to Herbert J. Gerst, a deficiency of $1,001.07 for the years 1919 and 1920 and an overassessment of $27 for the year 1921 as to Maurice G. Long, and a deficiency of $3,177.28 for the years 1920 and 1921 as to the estate of Albert Gerst.
    FINDINGS OF FACT.
    During the years 1919 to 1921, inclusive, Albert Gerst, who died October 27, 1924, Maurice G. Long, and Herbert J. Gerst were partners doing business under the firm name of Gerst & Long, operating the Crystal Laundry at Norfolk, Va., in which their interests were 50 per cent, 35 per cent, and 15 per cent, respectively.
    A portion of the deficiencies is predicated upon the refusal of the Commissioner to allow this partnership to deduct the amount claimed for exhaustion, wear and tear, and obsolescence of laundry machinery and equipment and a motor boat. These individuals were also partners during the years 1920 and 1921 in the purchase and sale of certain real estate in the City of Norfolk, Va., under the firm name of Gerst, Long & Gerst, in which each had a one-third interest, and the deficiencies for 1920 were predicated in part upon the profit determined by the Commissioner to have been received upon the sale on January 10, 1920, of certain real estate.in Norfolk, designated as the NixdorfE property.
    In addition,- Albert Gerst was a partner with one A. S. Rosen-krans in the sale of certain real property, designated as 26th & Granby Streets, Norfolk, in which he had a one-third interest, and 14th & Granby Streets, Norfolk, in which he had a one-half interest, and the deficiency asserted against him for the year 1920 is predicated in part upon these profits.
    From 1902 until June, 1918, one A. S. Rosenkrans was engaged in the operation of the Crystal Laundry in Norfolk, Va. During this period certain of the machinery and equipment was replaced. On the last-mentioned date this laundry was purchased and thereafter operated by the partners of Gerst & Long, composed of the individuals hereinbefore mentioned. At that time approximately 75 per cent of the machinery was considerably worn and in a bad state of repair. Approximately all of the machinery had once been replaced by Rosenkrans during the period of his operations. During the years 1919 to 1921, inclusive, the laundry was operated twelve hours instead of the usual period of ten hours a day. Certain of the machinery was replaced during this period, partly with new machinery and partly with old machinery from other plants. The cost of the machinery, plus additions, as determined by the Commissioner and agreed to by the taxpayers, was $23,240.33 at December, 1919, $23,415.33 at December, 1920, and $23,476.90 at December, 1921. The Commissioner computed the deduction for exhaustion, wear and tear for the years upon the basis of 10 per cent.
    During the taxable j^ears the partnership owned certain delivery equipment, consisting of Dodge, Ford, and other automobiles, and wagons, the cost of which, plus the cost of additions, was $3,005.25 in 1919, $5,342.95 in 1920, and $8,299.55 in 1921. The Commissioner computed the deduction for exhaustion, wear and tear of this equipment upon the basis of 25 per cent.
    In July, 1920, the partnership purchased a motor boat and installed. therein a new motor at a total cost of $2,946.05. This boat was used in calling for and delivering laundry to, ships lying in the harbor, from the date of purchase until the latter part of 1923. It was sold in 1925 for approximately $200. The Commissioner computed the deduction for exhaustion, wear and tear of this boat upon the basis of 10 per cent.
    In 1919 the partnership of Gerst, Long & Gerst purchased certain real estate in the City of Norfolk, designated as the Mxdorff property, for the following consideration:
    Cash_$16, 000
    Assumption of deed of trust, 1 year- 10, 000
    Assumption of deed of trust, S years- 37, 500
    Assumption of deed of trust, 5 years- 37, 500
    Total___ 100,000
    On January 10,1920, the partnership sold this property to Creech, Hough, et al., for a total consideration of $125,000, made up of cash in the amount of $25,000, promissory notes paid May 31, 1920, $15,000, and the assumption of the above-mentioned trust notes which the sellers endorsed with recourse. The Commissioner determined a profit of $25,000 in the year 1920.
    On November 14, 1919, Albert Gerst and others purchased certain real estate, designated as 26th & Granby Streets, Norfolk, for the following consideration:
    Cash__$12,000.00
    Assumption of 1st deed of trust_ 4, 000. 00 .
    Assumption of 2nd deed of trust__ 38, 834. 38
    Assumption of miscellaneous charges 'against property- 201.16
    Total_ 55, 035. 54
    On January 1, 1920, this property was sold to one E. L. Simpson for the following consideration:' •
    Cash___‘-.-$15,000.00'
    Gave 3rd deed of trust — :_•- 9, 800. 57'
    Assumed 1st deed of trust-'- 4, 000. 00'
    Assumed 2nd deed of trust--- 38, 834. 38'.
    Assumed miscellaneous charges against property- 365. 05'.
    Total. 68,000. 00)

      Albert Gerst’s interest in this property was one-third. The third trust note given by the purchaser had a market value of 40 per cent of its face value.
    On May 31, 1919, Albert Gerst and others purchased certain real estate in Norfolk, designated as 14th and Granby Streets, for which the consideration was as follows:
    Cash--$10,034 65
    Assumption of 1st deed of trust_i_ 10, 000.00
    Assumption of 2nd deed of trust_ 11, 000.00
    Assumption of 3rd deed of trust_ 16, 360. 00
    Assumption of miscellaneous charges against property_ 374. 86
    Total_ 47, 769. 51
    On January 1, 1920, Albert Gerst, who owned a one-half interest, and his associates sold this property to one D. Pender for a consideration of $59,251.40, made up as follows:
    Cash_i_$6,367.00
    Assumption 1st deed of ti ust_ 10, 000. 00
    Assumption 2nd deed of trust_ 11, 000. 00
    Assumption 3rd deed of trust- 16, 360. 00
    Gave 4th deed of trust__ 15, 200.00
    Assumption of miscellaneous charges_ 324. 40-
    Total-:_ 59,251.40
    The fourth trust notes had a market value of 40 per cent of their face value.

       The following appeals were heard with the above-named appeal and are decided herewith : Maurice G. Long, No. 3888; Maurice G. Long, No 5365 ; Herbert J. Gerst, No. 5366; and Herbert J. Gerst, Co-administrator of Estate of Albert Gerst, No. 5367.

   OPINION.

Littleton

: The petitioners placed in evidence the reports of the Commissioner’s field agents for the purpose of showing the total cost, including the cost of additions, of the property upon which the amount of the deductions for exhaustion, wear and tear is in controversy.

Certain witnesses testified that, at.the time the machinery was acquired in June, 1918, it had been in use for some time and was in a bad state of repair; that, due to the fact that during the taxable years it was operated twelve hours a day, exhaustion, wear and tear thereof was greater than when operated the usual ten hours a day, and that the ordinary useful life of machinery of this character is eight years.

The evidence is somewhat indefinite as to the period of time the machinery had been in use and as to the additions and replacements made prior to June, 1918, the date on which the entire plant was purchased by Gerst & Long; also as to the extent of the additions and replacements between June, 1918, and December 31, 1921. There is credible evidence, however, showing that the machinery purchased in June, 1918, had been in use for some years and that at that time at least 75 per cent thereof was considerably worn and in a bad state of repair. The petitioners were entitled to a deduction for exhaustion, wear and tear of the machinery at such a rate as may reasonably be expected to return to them the cost thereof oyer the period of its useful life in the business. We are convinced from all of the evidence submitted that the deduction for exhaustion, wear and tear of machinery during the taxable years should have been computed at the rate of 12 per cent, instead of 10 per cent, as allowed by the Commissioner.

The petitioners claim that the partnership should have been allowed a deduction for exhaustion, wear and tear of delivery equipment at the rate of 50 per cent per annum, instead of 25 per cent, as allowed by the Commissioner. The evidence before the Board upon this question is not sufficient to sustain the contention made.

It is claimed that the cost of the motor boat should have been exhausted over a period of four years from July, 1920, the date on which it was purchased, upon the ground that its use was discontinued within that time and it was of no further use in the business. The fact that the use of the boat was discontinued within four years after its purchase has no necessary relation to the amount which may be deducted for the jshysical exhaustion thereof. The Commissioner computed the deduction for exhaustion at the rate of 10 per cent per annum, and we believe his action in this regard should be approved.

On the question of whether the petitioners were correct in reporting the profit upon the sale of the real estate by allocating the percentage of profit to the cash received and the extent to which the trust notes endorsed by the petitioners with recourse were discharged within the year, we are not convinced from the evidence that the Commissioner’s determination that the profit upon the sale should have been reported in the year in which the sale was made should be reversed. The petitioners were, of course, secondarily liable upon the trust notes endorsed with recourse. It has not been shown to our satisfaction that the amount of the notes could not have been collected out of the property and from the person or persons primarily liable thereon.

As to the fair market value of the third trust notes totaling $9,800.57, given to Albert Gerst and his associates by E. L. Simpson as part consideration for the 26th and Granby Street property, and the fourth trust notes totaling $15,200, given by D. Pender as part consideration for the 14th and Granby Street property, the evidence satisfactorily shows that the fair market value of these notes was not in excess of 40 per cent of their face value. One of the partners in these transactions testified that the makers of these notes were not financially responsible and that the value of the particulár property on which they were given was not sufficient to. give these notes a value in excess of 50 per cent of their face amount. He further testi-fled that during the year 1920 he sought a purchaser for these notes and was offered 25 cents on the dollar, but declined this offer for the reason that he regarded the notes as being worth more than that amount.

Order of redetermination, will J>e entered on 15 days’ notice, under Rule 50.


author: GRben

text:
    Appeal of PHILIP KOBBE CO., INC.
    Docket No. 3308.
    Decided July 31, 1926.
    Net Loss ; operation op business requearly carried on by the taxpayer. — Where, in order to further its regular business, a petitioner operating an advertising agency purchased stock in another corporation which subsequently became worthless, held,, that the loss thus sustained on the purchased stock should be included among other losses in the computation of the statutory net loss under section 204(a) (1) of the Revenue Act of 1918.

      Blount Ralls, Esq., for the petitioner.

      B. H. Saunders, Esq., for the Commissioner.
    Before Marquette, MoRRis, GREEN, and Love.
    The petitioner appeals from a deficiency in income and profits taxes for the year 1918 in the sum of $2,194.70. It alleges-as error the determination of the Commissioner that a certain loss, admittedly sustained in 1919, should not be included in its net loss for that year with the consequent reduction of its 1918 net income.
    FINDINGS OF FACT.
    The petitioner is a domestic corporation with its principal office in New York City. It was incorporated in 1916 and since that time has engaged in the advertising business. It solicits and procures advertising accounts and contracts; prepares the copy for the advertisements; does the necessary art work; secures the necessary plates and type matter.; arranges for the publication of the advertisement in the various publications; and in general cares for and looks after advertising for its various clients.
    In 1917 an effort was made to procure the advertising business of the West Electric Hair Curler Co. of which a Mr. Short was president. Short, who was also president of the A-l Manufacturing Co. and the Chase-0 Manufacturing Co., agreed with the representatives of the petitioner that all of the advertising business of the three companies would be given to the petitioner if it would purchase stock in the Chase- 0 Manufacturing Co. of the par value of $30,000 for a cash consideration of $15,000. These three companies advertised extensively and their business was valuable. ■ The petitioner accepted the offer, purchased the stock, and secured all of the advertising -business of the three companies. It was known at the time o £ the purchase that the stock of the Chase-0 Manufacturing Co. was of little value, and the purchase was made for the purpose of securing the business of the three companies. It is stipulated that the stock became worthless in 1919 and that the petitioner had an “ ordinary,” as distinguished from “ statutory,” net loss of $7,622.15 in that year.
   OPINION.

GRben

: The parties agree that a. loss was sustained in 1919 and agree upon the amount. The issue is whether such a loss, arising as above set out, may be included in the computation of the statutory net loss for the taxable year. The Commissioner’s contention is that the loss is not within the provisions of section 204(a) (1) of the Revenue Act of 1918, which section reads, in part, as follows:

Sec. 204(a) That as used in this section the term “net loss” refers only to net losses resulting from either (1) the operation of any business regularly carried on by the taxpayer, * * *.

To us it appears that the business regularly carried on by the taxpayer was that of advertising, and that in furtherance of such business it purchased the stock of the Chase-0 Manufacturing Co. The evidence shows that scant, if any, consideration was given to the value of the stock and that it was purchased only for the purpose of procuring valuable advertising contracts. We are of the opinion that the loss is within the provisions of section 204(a) and that the Commissioner erroneously excluded it in his computation of the statutory net loss.

Judgment for the petitioner..