author: SteeNiiageN :

text:
    Appeal of Coburn Heirs, Inc.
    Docket No. 1131.
    Promulgated June 16, 1927.
    1. The aggregate of unit prices for stumpage or merchantable timber held not to represent the value of an entire tract of timber in computing depletion.
    2. A valuation of exhaustible property such as timber based upon future income must recognize the discount applicable to such income.
    3. The statement that the Commissioner’s valuation of timberland used in determining depletion was based upon information in his files which he was forbidden to disclose in a public proceeding is entitled to no weight as evidence of value.
    4. The value on March 1, 1913, of timber located on two tracts in Maine determined in the light of all the numerous facts and circumstances in evidence.

      William R. Pattamgdll, Esq., and Carter B. Keene, Esq., for the petitioner.

      Ward Loveless, Esq., and Benjamin H. Saunders, Esq., for the Commissioner.
    Deficiencies in income and profits taxes for the years 1919 and 1920, aggregating $7,909.67, resulting from the Commissioner’s reduction of the petitioner’s deductions for timber depletion. The issue for determination is the fair market value on March 1, 1913, of two certain timber tracts in Maine.
    FINDINGS OF FACT.
    Petitioner, a Maine corporation with its principal office at Skow-hegan, was organized in May, 1911, for the purpose of taking over and holding certain timberlands located in the Kennebec Valley in Maine and selling timber under stumpage permits.
    In 1919 the Coburn estate owned approximately 200,000 acres of timberlands. Differences arose between the two groups of heirs as to the proper business policies and management of the estate, find a division of the properties was agreed upon. The tracts were listed and each group made a sealed bid, a give or take offer, on each separate tract of timber. The amount thus bid was the price at which the bidder was willing to buy or to have the other group pay for the tract. Only one bid was opened on each piece of property. Neither group knew, prior to the actual opening of the bid, just_ when a bid upon a particular piece of property would be reached, nor which group’s bid would be opened. As each bid was drawn the adverse group had the choice of buying or selling at the price bid. It was desired that after the division of the properties had been completed the holdings of the two groups, as represented either by the value of the properties which each acquired or the equivalent thereof in cash, should be in direct proportion to their respective interests in the estate; so that it was agreed that any adjustment necessary should be made by the payment of cash. The group of heirs who subsequently incorporated as the Cobum Heirs, Inc., the petitioner in this proceeding, and who owned approximately a 56 per cent interest in the estate, secured about 120,000 acres of timberland at a total auction price of $1,143,825. The-other group of heirs, subsequently organized as a Massachusetts trust known as the Cobum Lands Trust, who owned approximately a 44 per cent interest in the estate, secured about 80,000 acres of timberlands at a total auction price of $871,-787. The adjustment to maintain the proportionate interests of the two groups was effected through the payment of $25,000 cash to the Cobiirn Lands Trust group by the Coburn Heirs group.
    Among the tracts purchased by the Coburn Heirs group were the Jackman tract and a 41/128ths interest in the Spencer Bay tract involved in this proceeding. The Jackman tract was purchased on a Coburn Lands Trust group bid of $80,000. The 41/128ths interest in the Spencer Bay tract was purchased on a Coburn Heirs, group bid of $46,000. The bid of the Coburn Lands Trust group for the Spencer Bay tract, if opened, would have been $25,000. These tracts were owned by the petitioner on March 1, 1913, and during the years in controversy.
    Jackman is a tract pf 10,726 acres, of which, on March 1, 1913, 9,716 were covered by merchantable timber and young growth (timber not yet merchantable). The petitioner on its return claimed a fair market value for this property as of March 1, 1913, of $365,719. The Commissioner allowed a value of $131,926.
    The fair market value on March 1, 1913, was as follows:

      Jackman

    Spencer Bay is a tract of 11,161 acres, of which 9,164 were covered by merchantable timber and young growth on March 1, 1913. The interest in this tract owned by the petitioner was a 41/128ths undivided interest in the whole. The petitioner claimed a fair market value for a 100 per cent interest in the whole tract, as of March 1, 1913, of $266,922. The Commissioner allowed a value of $140,061.
    The fair market value on March 1,1913, was as follows:

      Spencer Bay

      The value of petitioner’s interest at March 1, 1918, was 41/128 X $165,025=$52,860.
    No separate valuation on hardwoods was made by the Commissioner either by species or tracts, but a lump sum was allowed to cover the hardwoods on all the petitioner’s properties.
    In its return the petitioner claimed depletion deductions of $71,-655.37 for the year 1919, and $75,732.35 for the year 1920. The Commissioner determined the total March 1,1913, value of all of petitioner’s timber properties to be $1,400,000, and since this amount is 47 per cent of the total March 1,1913, value claimed by the petitioner, he has allowed as deductions 47 per cent of the amounts claimed by the petitioner for depletion, or $33,678.02 for 1919 and $35,594.20 for 1920.
    The petitioner claimed depletion based on a March 1,1913, value of the Spencer Bay tract based on ownership of 58.98 per centum interest, whereas it owned only a 41/128ths or 32.03 per centum interest on that date.
    An additional interest of 77/288ths (or 26.736 per centum) was purchased in 1919 for $44,790, making a total ownership of 58.766 per centum. The total timber acquired by this purchase was approximately 10,069,110 feet as reflected by the timber remaining after deducting timber cut from the estimate at March 1, 1913. This cost is apportioned as follows:

   OPINION.

SteeNiiageN :

The deficiencies arise from the Commissioner’s dis-allowance of a substantial part of the deductions taken by the petitioner for timber depletion. The parties are agreed as to the quantity cut in the years in question and as to the approximate quantities owned on March 1, 1913; and this leaves the value on that date of the quantities owned as the only matter to be determined. This issue is further narrowed because the parties have confined the dispute to the value of the timber on the tract of 10,726 acres in Jackman township and the petitioner’s undivided interest of 41/128ths in the tract of 11,161 acres in the township of Spencer Bay.

As to these valuations the parties are far apart, not only as to the amounts of value but also as to the methods by which such valuations should be made and the data which may or should be considered. The petitioner’s contention is that the Commissioner’s method does not take into consideration or make allowance for unusual conditions existing in the timber market in Maine. It contends there is no regular market for timborlands; that those owning such lands are holding them and selling them only when circumstances compel them to do so ^ that even such sales are few; and that the prices so obtained are consequently not indicative of the true value. Its theory is that the fair market value is best obtained, under such circumstances, by ascribing to each unit of value in the property an amount representing or approximating the price which would be obtained for that unit if sold about March 1,1913, and then adding these unit values to arrive at the total value of the property as a whole. Specifically, it claims a value for the property equivalent to'the price which could be obtained for the merchantable timber if it were to be sold on a stumpage or permit basis, plus a value for the soil equivalent to the price which could be obtained for cut-over land with young growth thereon. The values thus claimed are $365,719 for Jackman and $266,922 for a 100 per cent interest in Spencer Bay. The Commissioner held these values to be too high, and, claiming to act in accordance with information in his files which he was forbidden to disclose in a public proceeding, and upon the special experience of a valuation expert, found that a so-called en bloc or wholesale value of each tract was between 40 and 60 per cent of the so-called retail value used by the petitioner. The values thus determined by the Commissioner are $131,926 for Jackman and $140,061 for a 100 per cent interest in Spencer Bay. As indicative of the fairness of the values which he has’fixed, the Commissioner points to the prices at which the petitioner secured these properties in the division between the two groups of heirs in 1910, the action of the petitioner’s board of directors in voting, on March 29, 1912, to give to a prospective purchaser of its entire timber properties an option to purchase at $15 per acre, and the sale by the petitioner, in 1914, of a tract of timberland in Holden township said to be comparable to Jackman and Spencer Bay tracts.

At the outset it should be said that we have given consideration to the entire evidence and have excluded nothing. Depositions of numerous witnesses to substantial length have been taken. The testimony in some of these has but a remote significance. It has nevertheless been considered. We give no weight to the statement that the Commissioner’s valuations were based upon information in his files which he was forbidden to disclose in a public proceeding.

The petitioner’s valuation of its timber properties is based on the aggregate of stumpage or permit prices for merchantable timber at March 1, 1913. We do not, under the circumstances in this case, believe that this represents the true value. Assuming that the prices claimed by petitioner are the actual prices prevailing at March 1, 1913, for timber to be removed under stumpage permits; and that the risks and burdens inherent in the ownership of property of this character, such as taxes, insurance, losses from fire, bug, wind, and storm, will be taken care of by future'growth, as petitioner contends, the aggregate value claimed would be equivalent to the gross proceeds which the petitioner could on March 1, 1913, have expected to receive during future years. This fails to take into account the fact that the income from the sale of the timber through stumpage permits would only be realized over an extended period of years. At March 1, 1913, there were no operations of any consequence on the Jackman tract. The General Forest Industries Questionnaire which the petitioner filed with the Bureau of Internal Revenue shows that in. the years 1913 to 1917, inclusive, only 208,000 feet of timber were removed from this tract. The first major operation apparently commenced during the logging season of 1917-1918. Operations had commenced on the Spencer Bay tract in the logging season of 1912-1913, under a stump-age permit. On March 1, 1913, Jackman had a timber stand of 48,200,000 feet and Spencer Bay a stand of 44,500,000 feet. At the close of the logging season of 1920-1921, or eight years later, but 25,334,495 feet, or approximately 52 per cent of the March 1, 1913, stand, had been cut from Jackman and at the close of the logging season of 1922-1923, or' ten years later, but 15,798,313 feet, or approximately 36 per cent of the March 1, 1913, stand had been removed from the Spencer Bay tract. At these rates of cutting and removing the timber, it would’have required approximately 16 years and 27 years, respectively, to cut and remove the timber from the Jack-man and Spencer Bay tracts. Any method of valuation of exhaustible properties such as timber, based upon expected future income, which fails to give recognition to the principle of discounting such income, is obviously unsound. Frances J. Eaton, 5 B. T. A. 100. There are, of course, numerous other factors which should be considered.

The division of the properties between the two groups of heirs was made in 1910, and the prices are, therefore, not determinative of their values at March 1, 1913, approximately three years later. But they are a fair measure of value in 1910, and, if taken together with all of the other evidence; are helpful in determining the fair market value at March 1, 1913, of the properties in question. There were two adverse groups. Each held different views from the other as to proper business policies and management of the estate. A division of the properties between the two groups appeared to be the only way out of the situation. Each group was called upon to place a price on each piece of property. Neither party knew whether it would be forced to buy or sell at its own price. The group later incorporated as the petitioner, and the group now known as the Coburn Lands Trust had approximately 60 per cent and 40 per cent interests, respectively, in the estate, and approximately three chances and two chances, respectively, out of five, to act upon each other’s bid. Neither group knew just when a bid upon a particular piece of property would be reached, nor which group’s bid would be opened and acted upon. Under the circumstances, if the bid of one group was too high, that group stood the chance of being forced to buy at its own high price, or if too low it stood the chance of being forced to sell a desirable piece of property at a low figure. Each group must have known that a separation of its interests from those of the other group and a division of the properties between the two would necessarily limit the income of each group thereafter to that derived from the properties which each secured in the division. If one group secured the most desirable properties its income thereafter would be enhanced while that of the other group would be adversely affected. Roy L. Marston, petitioner’s treasurer and general manager, who represented the group which incorporated the petitioner company at the division, testified that the other group was in possession of all of the data which he had compiled after several years of investigation of all of the properties. Therefore it is apparent that the Coburn Lands Trust group was in a position to know the properties as well as the group which incorporated the petitioner company.

Furthermore there was the chance that one of the two groups might be required to make a substantial payment in cash to effect any adjustment necessary to maintain the proportionate interests of the two groups. The extent to which the Coburn Lands Trust group was influenced by this factor is indicated by the testimony of a witness who represented that group at the division. Upon cross-examination by counsel for the petitioner, he testified as follows:

Q. Assuming that your division resulted in your group retaining about the same percentage of ownership that it had in common and unidentified, so long as the price agreed upon for the various pieces of property were relative, it did not matter particularly whether they were full market value or not, did it?
A. Why, I did not feel that we were safe in taking any such view as that. Inasmuch as any balance must be paid in cash, it would bo plain that if we inflated the values one hundred per cent, some one would make double the cash payment.
Q. And if you kept them fairly well down the cash payment would not be large?
A. But I would equally wish that cash balance to be fair, because at the time I did not know which one of us would pay it.

The division of the properties in 1910 was made between the parties as a business matter, and in our opinion the prices at which the properties in question were secured by the petitioner and the relation of those prices must be given due consideration in arriving at the fair market value of the properties at March 1, 1913.

The Commissioner put in evidence the minutes of a meeting of petitioner’s board of directors held on March 29, 1912, which contains a resolution granting to one Northrop an option to purchase its entire timber holdings at the price of $15 per acre, subject to the approval of one Harry C. Turner. The option was never exercised.

The sale in 1914, upon which the Commissioner relies as tending to prove the values fixed by him, involved the transfer of a tract of 11,967 acres in Holden township, of which tract 11,632 acres were covered by merchantable timber and young growth. This tract was acquired by the petitioner in the 1910 division at a bid price of $263,000. It was sold by the petitioner for the sum of $375,000, of which $100,000 was paid in cash and the balance represented by notes. It is contiguous to Jackman on the north. The Spencer Bay tract lies some, distance to the east of it, the two tracts being separated by four townships. All three tracts contained approximately the same acreage. Jackman and Holden were about equally accessible, and both were subject to full local taxation. Spencer Bay is not as accessible as Jackman and Holden, but it is subject to only a nominal tax.

Petitioner’s witness, Marston, testified that the selling price of Holden was not a fair indication of its value or that of adjacent tracts; that the selling price was fixed at less than actual value in order to establish a largo mill in the vicinity of Jackman which would be a market not only for timber owned by the petitioner, but for that of neighboring ¿wners of timberlands, and which would give employment to people residing in Jackman; and that the selling price was fixed on the basis of $8 per thousand feet of spruce. There are, however, other facts to be considered in connection with the sale of Holden tract. In the General Forest Industries Questionnaire, for years prior to 1919, executed by the witness on behalf of the petitioner company, it is stated that the sale of Holden was made “ in order to secure a large amount of money which was desired by a majority of the stockholders,” and that “the price is actually what a willing buyer and a willing seller determined upon in 1913.” It further appears from his testimony that the sales to the purchaser of this property, after the mill was established thereon, did not amount to more than a few hundred thousand feet, and that such sales as were made were of a casual nature. The spruce stand on Holden was 61,269,000 feet, and on the basis of $8 per thousand feet for the spruce, the selling price would have amounted to $490,152. The selling price was $375,000, which is equivalent to $6.12 per thousand feet of spruce; and if the selling price was based upon the spruce stand alone, it was undoubtedly not the actual value of the spruce but a composite figure intended to taire in the value of the other 16,987,000 feet of soft woods and some quantity of hard woods, besides the young growth and soil.

Weighing all of the evidence bearing upon the sale of Holden, we think that the sale of this tract is indicative of the value of Jackman and Spencer Bay tracts, at March 1, 1913, if due consideration be given to the difference in the general characteristics of the three tracts. Counsel for the petitioner in their brief say' that “it was a bona fide business sale near enough in point of date and character of property to be almost controlling as to values.”

The comparison of Holden with Jackman and Spencer Bay tracts, for the purpose of determining the values of the two last mentioned, is made difficult because of lack of definite information as to the quantity of the hardwood stand on Holden. The record shows only the details of the softwood stand, although the evidence is clear that there were mature hard woods on the tract. However, there is evidence of the probabilities as to the hardwood stand.

Jackman is contiguous to Holden on the south, and the township of Thorndike, comprising 22,680 acres, of which 22,052 acres are covered with merchantable timber and young growth, which is also owned by the petitioner, is contiguous to Holden on the east. These two tracts, Jackman and Thorndike, form the boundaries of Holden on two sides. By comparison of the three tracts, the probabilities as to the hardwood stand on Holden can be fairly determined.

The Jackman and Thorndike tracts had approximately 26 per centum of hard woods. The Holden tract had a much heavier stand of soft woods than either of these tracts, which circumstance would presumably result in a lesser per centum stand of hard woods. Accordingly it is estimated that the Holden tract reasonably had 17 per centum of hard woods, or 16,000,000 board feet.

- Having available the quantities of soft woods from data contained in the Forest Industries Questionnaire, we can compute the amount which the Holden tract should have sold for at March 1, 1913, if the petitioner’s unit rates were applied. This results in a total of $613,-179.50 for spruce, fir, cedar, and pine; adding to this an amount for hard woods estimated at $2 a thousand, gives $645,179.50.

Assuming a ratable increase from 1910 to 1914, and allocating $1 an acre to land and 50 cents an acre to young growth in 1910, and one dollar an acre to young growth in 1914, the March 1, 1913, value of the merchantable timber on the Holden tract woud be $324,850. This value is approximately 50 per centum of $645,179.50, the amount previously computed. Therefore, from the evidence furnished by this sale, the fair market value at March 1, 1913, of timber en bloc in this district allocated to species, would be as follows:

M board feet
Spruce saw logs_$4.25
Spruce pulp logs- 3. 50
Fir saw logs- 3.50
Cedar_ 3. 50
Pine_ 4. 25

The values per thousand board feet claimed by the petitioner and those allowed by the Commissioner as compared to these rates, are shown as follows:

It is noted that the rates computed from the Holden sale represent almost an average of the rates allowed by the Commissioner on these species; the difference could easily be due to local conditions and quality of timber. Accordingly, the rates determined by the Commissioner appear reasonable. The small amount of hemlock, which in 1913 was not used for pulpwood, and which, according to testimony, had practically no value for barb, does not justify a rate in excess of $2. There appears to have been a fair stand of poplar on both tracts in question. This wood was salable in 1913 and could have been easily taken out; accordingly a rate of $2 per thousand is considered reasonable. The balance of the hard woods were of very little value at March 1, 1913, both because of the location as to markets and the difficulties of transportation. The Commissioner has admitted a value of from 75 cents to $1 a thousand for hard woods and various witnesses have testified as to stumpage rates.

It has been brought out by the testimony and evidence that hard woods were cut and sold from petitioner’s lands in. 1912, 1913, and later years, but only in small quantities. It is therefore evident that the demand was small or that difficulties of logging and marketing prevented active operations, therefore a long period would be required to realize a return on all the hard woods. In view of this feature, a value of $1 a thousand at March 1, 1913, is considered reasonable.

Various witnesses testified that land was worth $1 an acre and young growth $2 an acre. In the computation of the March 1, 1913, value of the Holden tract, $1 an acre was used for land and $1 an acre for young growth. This produced a value remaining for merchantable timber which resulted in the rates previously given. Any increase in value of young growth would result in reducing the value remaining for merchantable timber and would result in lower rates. Accordingly $1 an acre for land and $1 an acre for young growth is considered a fair valuation.

Judgment will be entered on 15 days’ notice, wider Rule 50.


source: Caselaw Access Project

author: Love :

license: Public Domain

text:
    W. N. Stokes, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 251.
    Promulgated June 16, 1927.
    In computing gain or loss on the sale of real property, petitioner claimed as part of cost an amount spent in litigation involving tax liens and to remove cloud on title. Part of the taxes accrued after petitioner acquired the property. Held, expenditures on account of such taxes are not a part of cost. No segregation was made of these expenditures from the others, and the latter may not be included in the cost because of lack of evidence of the amount.

      Harry G. Weeks, Esq., for the petitioner.

      Bruce A. Low, Esq., for the respondent.
    This is a proceeding for the redetermination of a deficiency in income tax for the year 1920 in the amount of $189.71.
    It appears from the petition that the year 1919 is also involved, but that year is not involved in evidence and statements at the hearing ; neither the amount of deficiency, if any, for 1919, nor the facts relative to such deficiency, if any, are disclosed. There is only one assignment of error, as follows:
    The Gommissioner erred in charging to the taxpayer $1,187.50 as profit from the sale of three-fourths (%) of Block Fifty-one (51) South Addition to the town of Vernon, Wilbarger County, Texas.
    FINDINGS OF FACT.
    The petitioner is an individual, and is engaged in the practice of law in Vernon, Tex.
    In 1912, he and F. L. Massie purchased from E. L. McHugh all of Block 51 in the town of Vernon, paying therefor $700. When McHugh acquired the property the title to the same was defective. At January 1, 1913, five years’ adverse possession under deed duly registered had been maintained, which, under the limitation statutes of Texas, matured the title by limitation.
    About the year 1913 the town of Yernon extended its street improvements alongside of this property, which resulted in the levy of an improvement tax against it. Its owners refused to pay this tax as was claimed because they wanted a suit brought and a sale under execution for the purpose of further strengthening their title, and suit was instituted. In that suit the owners of the property were subjected to some expense and the payment of the tax, the amount of which payments is not disclosed.
    In order to further strengthen their title, they procured a number of quit claim deeds from alleged heirs of persons then deceased who appeared, from the records, to own s<3me interest in the property. In order to procure such quit claim deeds they, in some instances, had to pay a consideration and in all cases had to pay expenses incident to execution of deed. The amount so expended is not disclosed by the record.
    It was discovered at some time after 1913 and prior to 1919 that state and county taxes were delinquent on that property for twenty or thirty years prior to about 190G. Suit was filed to enforce payment of those taxes. That suit was formally contested by the owners, but in fact rather invited by them in order to further strengthen their title. A compromise judgment was rendered in that suit. The owners had to pay off that judgment or buy in the property at execution sale (just which procedure was followed is not disclosed) the amount of such payment being undisclosed. Some time prior to 1919, it was deemed advisable by the owners to bring a suit to remove the cloud from the title, this character of suit being provided for by the statutes of Texas and technically known as “ suit against unknown heirs,” the object and purpose of which suit is to establish by record the title claimed by the plaintiff, usually title by limitation. The expenditures incident to this suit are not disclosed. It is not disclosed who were made defendants in any of the suits above set out.
    The petitioner testified at the hearing that he and Massie, after their purchase of the property from McHugh, expended for the purposes above indicated not less than $2,250, and the Board finds that for those purposes petitioner and Massie spent $2,250, one-half by each.
    On March 1, 1913, the value of the property was $1,500. The property was sold in 1919 for $4,500. The petitioner claims a profit of $1,000 was thereby realized, one-half of which inured to him and the other one-half to Massie. The Commissioner claims that the petitioner realized a profit of $1,187.57, based on his refusal to allow as part of the costs of the property, the alleged expenditures of $2,250.
   OPINION.

Love :

There are some of the items going into the list of expenditures, the aggregate amount of which the petitioner seeks to include as cost of the property, which clearly are not capital expenditures, for example, the taxes paid, which accrued subsequent to date of purchase by Stokes and Massie.

We have no evidence by which we may segregate those expense items from the capital expenditures, if any, and hence, for the want of such evidence,

Judgment will be entered for the respondent.

Phillips dissents.


author: Moeeis:

text:
    Appeal of Star Brewing Co., Inc.
    Docket No. 374.
    Promulgated June 16, 1927.
    1. The evidence is insufficient to warrant deduction for obsolescence of tangible property.
    2. Deduction for obsolescence of good will disallowed. Manhattan Brewing Co., 6 B. T. A. 952.

      Paul F. Myers, Esq., for the petitioner.

      Jolm D. Foley, Esq., for the Commissioner.
    This is an appeal from the determination of deficiencies in income and profits taxes for 1918 and 1919 amounting to more than $10,000. The deficiencies result from the disallowance of deductions taken in each of the years for obsolescence of (a) tangible assets, and (b) good will because of prohibition. Paragraphs numbered (1) to (8), inclusive, of the findings of fact were stipulated by the parties.
    FINDINGS OP PACT.
    (1) The Star Brewing Co. Inc., was organized in July, 1895, under the laws of the State of West Virginia, to engage in the manufacture and sale of malt liquors. Its principal office was at No. 69 Shirley Street, Boxbury, Mass.
    (2) The two main products of the company in pre-prohibition days were “ Star Banner Ale ” and “ Star Prize Lager.” The estimated maximum capacity of the plant was 100,000 barrels.

      (3) If there be adopted the third method described in A. R. M. 34 for computing the March 1, 1913, value of good will, the computation would be as follows:
    Average tangible assets for the five-year period prior to March 1, 1913 ; i. e., the calendar years 1908 to 1913, inclnsive-$560,107.60
    10% of the average tangible assets for this period- 56,010.76
    Average earnings for this period- 82,457.03
    Surplus earnings — the excess of the actual average earnings over a 10% return on the average tangible assets- 26,446.27
    Capitalizing this amount on the basis of a five years’ purchase— x5
    Value of the good will as of March 1, 1913- 132,231. 35
    (4) On December 31,1919, the plant and equipment accounts on the books of the company disclosed an undepreciated balance of $177,-365.95. The salvage or scrap value of the plant and equipment totaled $32,700, leaving a difference of $144,665.95. These values were practically the same as of October 28, 1919, inasmuch as there was little difference, if any, between the values on that date and December 31, 1919. A statement showing the undepreciated balance of the plant and equipment accounts as of December 31, 1919, and the salvage value of plant and equipment as of that date is as follows:

    (5) In the latter part of 1919 the company had a large quantity of malt liquors in process of manufacture. There also were on hand brewing materials. It then commenced the manufacture of a cereal beverage containing one-half of one per cent of alcohol. The company sustained operating losses in 1920 and 1921, when ojierations ceased, in the amounts of $42,721.12 and $50,249.44, respectively.

      (6)The number of barrels produced per year from 1913 to 1917, inclusive, follows:
    Barrels
    1913_*_ 95,445
    1914_ 90,375
    1915_71,760
    1916_ 68,000
    1917- 80,485
    The number of barrels of cereal beverage produced during 1920 and 1921 follows:
    Barrels
    1920- 6,100
    1921_ 5,005
    (7) Upon the commencement of the manufacture of cereal beverages in 1920, only a portion of the plant and equipment was used, and the balance was abandoned. The total floor space of the brewery buildings (excluding the brick annex upon which obsolescence has been allowed) was 29,497 square feet. The floor space of the brewery buildings unused after December 31, 1919, due to prohibition legislation, (excluding the brick annex upon which obsolescence has been allowed) was 20,977 square feet.
    (8) The net asset value of the annex and equipment abandoned in 1919, at the time of its abandonment, was $48,594.45, and this amount has been allowed as a deduction from gross income by the Income Tax Unit of the Internal Revenue Bureau in computing the tax liability of the company for 1919 as a loss on account of obsolescence.
    (9) On December 31, 1919, the company had on hand brewing materials consisting of about 6,000 bushels of malt,-2,000 pounds of sugar, between 5,000 and 6,000 pounds of hops and about 6,000 barrels of ale, porter and lager, but principally ale.
    (10) The plant was properly equipped in every respect for the manufacture of cereal beverage, but it was incomplete for its sale as it did not have a bottling and Pasteurizing plant, which was subsequently purchased and operated.
    (11) The manufacture of cereal beverage was discontinued because the product on hand had been used up and the business continued to show greater losses.
   OPINION.

Moeeis:

The appeal presents two issues for our determination, whether deductions should be allowed for obsolescence of (1) tangible property such as machinery, equipment and buildings and (2) intangible property such as good will.

The right to take a deduction for obsolescence of tangible property is provided for by section 234 (a) (7) of the 1918 Act. Having the right, the only question remaining is the specific amount of the deduction. It is the contention of the petitioner that it is entitled to an additional deduction on account of obsolescence of tangible property of $96,071.50. That amount represents the difference between the undepreciated balance of the plant and equipment accounts on December 31, 1919, as shown on the books and the salvage value of the plant, less $48,594.45 which was allowed by the Commissioner as a deduction for obsolescence for the year 1919. The facts show, however, that a part of the assets represented by that amount was actually used by the petitioner during the years 1920 and 1921. This precludes the allowance of the total deduction herein contended for. See Appeal of Yough Brewing Co., 4 B. T. A. 612.

The petitioner contends that, if the Board can not allow the deduction in toto, a proportionate part should be allowed, based on the percentage of the floor space of the brewery buildings unused after December 31, 1919, to the total floor space. The application of such a percentage is purely arbitrary and not warranted. We do not know the character of the floor space abandoned or what specific assets were not used in the manufacture of cereal beverages and their depreciated cost. A percentage such as that suggested has no relation to the cost of the assets not used after the taxable years in question nor does it assist in the determination of what those assets are. We must therefore deny the claimed deduction for obsolescence of tangible property.

The remaining question is controlled by our decision in Appeal of Manhattan Brewing Co., 6 B. T. A. 952, where we held that a deduction for obsolescence of good will is not allowable. See Red Wing Malting Co. v. Willcuts (C. C. A.), 15 Fed. (2d) 626; certiorari denied, 273 U. S. 763.

Judgment will be entered for the Commissioner on 15 days'1 notice, under Bule 50.


author: MoeRis :

text:
    Superior Pocahontas Coal Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 5377.
    Promulgated June 16, 1927.
    1. The cost of certain items of mining equipment should be capitalized and not deducted as ordinary and necessary business expenses.
    2. A contribution made under the present facts is deductible as a business expense.

      Ward Loveless, Esq., for the petitioner.

      J. Marry Byrne, Esq., for the respondent.
    This proceeding is for the redetermination of deficiencies in income and profits taxes for 1919 and 1920, in the respective amounts of $339.58 and $18,890.66. The only questions at issue are whether expenditures made in 1919 and 1920 for certain items are deductible, and whether a contribution of $1,000 in 1920 for the reconstruction of a church is deductible.
    FINDINGS OP PACT.
    The petitioner is a West Virginia corporation engaged in coal mining. It operates four mines at Davy, McDowell County, W. Va., hereinafter referred to as Mine Nos. 1, 2, 3, and 4.
    In 1919 the petitioner encountered an unusually hard slate rock formation in Mine No. 3 which required the use of a power drill. Accordingly a rock power drill was purchased at a cost of $1,002.48. The use of the rock drill did not increase the production, but without its use, production in Mine No. 3 would have decreased.
    During the same year the working faces had progressed so far from the tipple in Mine No. 4 that the owners were confronted with the problem of buying additional mine motors and locomotives or' laying heavier steel rails and increasing the speed on the trips. The owners decided it would be cheaper to lay heavier rails and speed up transportation. New steel rails were therefore laid between the tipple and the mine and also inside the mine between the tipple and the main side track. The cost of the steel rails was $1,502.63.
    For the year 1919 the petitioner charged to two accounts known as “ Boarding Ho’use Fixtures ” and “ Hotel Fixtures,” the cost of certain items in the amounts of $609.15 and $513.51, respectively. The additions to these accounts were turned in monthly by the company store. The company store was burned in July, 1924, destroying the records containing the itemized accounts. The accounts included items such as cheap rugs, electric light bulbs, dishes, mattresses, window blinds, etc. The policy of the company has always been to charge similar items to expense, and the records prior and subsequent to those destroyed showed such items as those listed above in these two accounts.
    In 1920 it became necessary to install new fans in Mines No. 2 and No. 3 because of the lack of proper ventilation. The old fans were crude homemade affairs and had been in use since 1910. As the working faces progressed away from the mine openings the demand on the air current increased. Some of the former openings which helped ventilate the mine had been closed by the extraction of coal, thus increasing the need for mechanical ventilation. The fan installed in Mine No. 2 in 1920 cost $1,432.13; the fan in No. 3 cost $1,894.72. The old fans were scrapped after the new ones were installed. The new fans were installed near the location of the old in both mines, the installation being made without stopping operations.

      During 1920, due to a break in the roof of Mine No. 3, approximately one-third of the working faces were cut off by water which flooded one of the main haulways. Petitioner purchased a pump to meet the emergency at a cost of $510, and shortly thereafter purchased an additional pump at a cost of $485. The two pumps were continuously in use until the water could be ditched and drained out of the mine by gravity. Petitioner ordinarily keeps several pumps on hand to take care of the water that gathers in the mines. The break in this particular case was unusual and a large quantity of water flooded a portion of the mine.
    Petitioner also purchased an additional gathering locomotive for Mine No. 4 during 1920. This purchase became necessary because of increasing length of the hauls as the working faces receded from the side track. The locomotive was of the electrical type, costing $5,551.96 and is still in use.
    Late in 1919 or early in 1920 the Methodist Church at Davy _burned down. Davy had two churches, a Methodist and a Baptist, but only the former had a regular minister. The population of Davy was approximately 1,500 and 90 per cent of its wage earners were employed by petitioner. The employees of the petitioner comprised 75 to 90 per cent of the Methodist congregation. The president of the petitioner on the recommendation of the minister donated $1,000 to help rebuild the church, which constituted the only community or social center in Davy. The donation was considered by both officers as an expense item to the corporation and it was anticipated that certain benefits would result to the petitioner therefrom. One of the employees of the petitioner assisted the regular minister in conducting the services and often filled the pulpit himself. At the present time this employee is the regular minister and is paid $50 per month for his welfare work in addition to his salary as an engineer. The church property is owned by the board of trustees of the church.
    The petitioner deducted the cost of the above items and its contribution to the church as ordinary and necessary expenses, which deductions were disallowed by the Commissioner.
   OPINION.

MoeRis :

The mine equipment and the additions to the plant which were purchased in either year, are in our opinion capital expenditures, and as such should be depreciated over their useful life. The rock power drill was a permanent addition to the mining equipment, and the same is true of the mine fans installed in Mines Nos. 2 and 3 in the year 1920. The two pumps purchased in 1920 became a part of the regular mining equipment. One of the witnesses testified that the petitioner kept a number of pumps on hand at all times as water was constantly accumulating in the mine, which required the use of pumps. The mere fact that these two- particular pumps were purchased to meet an emergency situation does not justify the charging off of the expenditures as ordinary and necessary business expenses. The electric locomotive which was purchased in 1920 is still in use, clearly indicating that it was a capital addition. See Appeal of Union Collieries Co., 3 B. T. A. 540; Appeal of Kirk Coal Co. 3 B. T. A. 755.

The cost of steel rails was held to be an ordinary and necessary expense in the Appeal of Bruin Coal Co., 1 B. T. A. 83, but since that case was promulgated, the Appeals of Union Collieries, supra, and Kirk Coal Co., supra, have expressly disallowed the cost of steel rails as a business expense, holding that such expenditures were capital items and expressly overruling the Appeal of Bruin Coal, Co., supra, in this respect.

Although, due to the destruction of certain books by fire, a detailed statement of the items charged to “Boarding House Fixtures” and “Hotel Fixtures” was not available, the testimony shows that such items as cheap rugs, mattresses, dishes, window shades and electric light bulbs comprised the list, and that the cost of such articles was uniformly charged to expense by the petitioner. We are satisfied that the petitioner is entitled to the deduction of $609.15 and $513.51 as claimed.

The remaining question relates to the contribution to the Methodist Church. If this contribution had a reasonable relation to petitioner’s business, it is allowable as a business expense, Appeal of Thomas Shoe Co., 1 B. T. A. 124. That it had such a relation can not be doubted in view of the particular facts under which the contribution was made. In our opinion the contribution may well be considered as an ordinary and necessary business expense. See Appeal of Poinsett Mills, 1 B. T. A. 6; Appeal of Holt-Granite Mills Co., 1 B. T. A. 1246; Elm City Cotton Mills v. Commissioner, 5 B. T. A. 309; Hibbard, Spencer, Bartlett & Co. v. Commissioner, 5 B. T. A. 464.

Judgment will be entered on 15 days’ notice, under Bule 50,


author: LittletoN :

text:
    Commercial Reference Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 9420.
    Promulgated June 17, 1927.
    Personal service classification denied upon the grounds that the earnings are not to be ascribed primarily to the activities o£ the principal stockholders and that capital was a material income-producing factor.

      Albert E. James, Esq., for the petitioner.

      J. Artlmr Adams, Esq., for the respondent.
    The Commissioner determined a deficiency in income and profits tax for the calendar years 1920 and 1921 in the respective amounts of $2,920.86 and $2,742.79, as a result of his refusal to classify the petitioner as a personal service corporation. He determined an overassessment of $36.59 for 1922.
    FINDINGS OF FACT.
    The petitioner is a Pennsylvania corporation with its principal place of business in Philadelphia. It was organized in 1909 by consolidating the Pennsylvania Credit Co., Ltd., and the Consumers Mercantile Agency, Inc., both credit agencies, and thereafter carried on the business on the same basis.
    The petitioner issued capital stock of a par value of $30,000, $3,000 of which was issued for cash, and $27,000 for the plant, good will, files and records of the two companies mentioned.
    The organizers of petitioner were Robert O. Cowan, J. S. Freeman, Allen C. Middleton and Robert R. Dornan. Middleton had been the attorney and owner of the Consumers Mercantile Agency, Inc., and Dornan the manager thereof. Freeman was an attorney and was associated with Cowan in the Pennsylvania Credit Co.
    After the consolidation, Cowan became the president and Dornan the secretary and treasurer of petitioner. Upon Dornan’s death in 1917, Sarah W. Cowan, sister of Robert O. Cowan, became secretary and treasurer and there was no change in such officers during 1920 and 1921.
    During the taxable years 1920 and 1921, the petitioner was engaged in the business of supplying credit information to its customers or subscribers and annually published a rating book known as the. “ Red Book,” which was furnished to subscribers under lease of contract. Petitioner’s customers consisted mainly of those engaged in the retail mercantile business in Philadelphia. Upon special requests therefor, petitioner furnished specific credit information in greater detail than given in the “ Red Book ” and received compensation for same, on the basis of $1 for each credit statement so furnished. Petitioner obtained information through its employees known as investigators and reporters. From 300 to 400 such information reports were daily prepared. Employees engaged as investigators or reporters were not stockholders of petitioner, nor was any stockholder engaged in serving as an investigator or reporter. The information procured by reporters was also utilized in keeping petitioner’s “ Eed Book ” up to date. During each of the years 1920 and 1921, petitioner served approximately 500 customers, either by renting them a “ Eed Book ” or furnishing them with information reports or both. The information contained in the “ Eed Book ” rented to customers was obtained principally from information contained in the files which were acquired by petitioner at the date of organization from the two corporations consolidated and from subsequent reports of its investigators and reporters.
    The “ Eed Book,” during the years 1920 and 1921, was largely compiled or prepared by employees not stockholders of petitioner and under the supervision of Miss Dorothea C. Peterson, who also was not a stockholder.
    The amounts expended by petitioner in preparing and publishing the “ Eed Book ” were charged on its books to expense. The “ Eed Book ” increased in value from year to year, resulting from the addition of names and information.
    Some of the stockholders of the petitioner were actively engaged in petitioner’s business, but others were not so engaged. The names of the owners of shares which were active and those not active, and the number of shares held by each during the taxable years, are as follows:

    After September 15,1921, to the end of said taxable year, there was no change of ownership or activity in shares, except that the 10 shares standing in the name of Archibald Dornan were transferred to Edna M. Dornan.
    The average holding of stock of the active stockholders and nonactive stockholders on the basis of the number of days during which they owned shares for the year 1920 was for active stockholders, 47.1 per cent and for nonactive stockholders, 52.9 per cent.
    In 1921, the percentage of stock held by active stockholders was 70 per cent and of nonactive stockholders, 80 per cent.
    The gross income for the year 1920 was $60,410.76, derived as follows:
    Prom special information reports_$31, 824.56
    Subscriptions- 28, 391. 00
    Interest_ 195.20
    In that year, there was paid as compensation or salaries to employees :
    Nonstockholders_$23,475. 58
    Stockholders_ 8, 922. 50
    Foreign correspondents_ 4, 793. 27
    The gross income for the year 1921 was $67,683.22, derived as follows:
    Prom special information reports_$34,141.19
    Subscriptions_•_ 32, 728. 75
    Interest_ 813.28
    In 1921 there was paid as compensation or salaries to employees:
    Nonstockholders_$25, 006. 69
    Stockholders- 12, 480. 00
    Foreign correspondents_ G, 921.30
    The balance sheets of the petitioner at January 1 and December 31, 1920 and 1921 show the following assets and liabilities:

   OPINION.

LittletoN :

The petitioner contends that its income for the years 1920 and 1921 is ascribable primarily to the activities of its principal stockholders who were regularly engaged in the active conduct of its affairs; that the capital employed in its business is not a material income-producing factor and that it is, therefore, entitled to classification as a personal service corporation and to exemption as such, certainly from and after September 23, 1920.

Respondent claims that this contention is not well founded for the reason that petitioner’s income can not be ascribed primarily to the activities of its principal stockholders and because capital was a material income-producing factor.

No error other than respondent’s refusal to allow such classification is alleged to have been committed in connection with his determination of the deficiencies involved in this proceeding.

Failure to comply with any one of the requirements of the statute, section 200, Acts of 1918 and 1921, is fatal to a claim that a corporation is a personal service corporation.

Since the petitioner is seeking to overturn the determination of respondent, the burden is upon it clearly to establish by competent and satisfactory evidence that it comes within the class of corporations referred to. As stated by the court in Matteson Co. v. Willcuts, 12 Fed. (2d) 447:

There is constant temptation to urge that particular corporations, with no right to such favor, be accorded classification as personal service corporations, and the requirements necessary thereto must be substantially observed.
* * * * * * a
Every corporation has full control of its own activities. * * * If it does not fairly observe and keep within the requirements of the law, it should not claim the benefits which the law confers. To nearly comply with the law, or to come within hailing distance thereof, is not enough.

In this case, the evidence indicates that during the taxable years in question only two stockholders were active in the business affairs of petitioner. During 1920, such stockholders owned less than 50 per cent of its outstanding stock and in 1921, 70 per cent thereof. From 16 to 25 employees, clerks and reporters, rendered very valuable services to petitioner in the carrying on of its business; they did so much of its work and work of such a character, that the income of petitioner was very materially increased thereby. The reporters employed by petitioner procured practically all the information embraced in the special reports and these reports furnished customers, produced in 1920 and in 1921, slightly more than one-half of the entire gross income of petitioner in each of those years.

The assets acquired from the two credit companies consolidated, and for which $27,000 par value of stock was issued by petitioner, were very valuable and were a substantial factor in producing the income of petitioner. The rating or “ Red Book ” and the right to continue publishing the same, acquired from the Consumers Mercantile Agency, Inc., and the names of the customers and the files of the Pennsylvania Credit Co., Ltd., secured by petitioner, were very valuable and undoubtedly, from the nature of petitioner’s business, continued to be valuable and material income-producing factors in petitioner’s business.

In the preface to the “ Ned Book ” leased to customers in 1920 and 1921, substantially the same as the “ Ned Book ” used in 1922, and in evidence, it is stated:

We herewith present the 1922 Edition of the Red Book of Individual Ratings, upon which we have spent considerable more time and money than any other publication we have ever issued.
Since the last issue a capable corps of compilers and reporters has been steadily engaged in gathering information on new risks, obtaining lists of credit customers and 'experience from many merchants and revising former ratings, enabling us to present the most complete book of Individual Ratings Eve» Published.

During each of the years 1920 and 1921, the petitioner served approximately 500 customers by leasing them the “ Ned Book ” or furnishing them credit information reports, and the large income derived therefrom indicates their income-producing character.

The president of petitioner had been connected with the Pennsylvania Credit Co., Ltd., and the evidence indicates no different method of conducting petitioner’s business from that of the Pennsylvania Credit Co., Ltd.; neither is there any evidence indicating that there was any change made in the forms used by petitioner from those prepared and used by the Pennsylvania Credit Co., Ltd. It is shown in the evidence that the files and “ Ned Book ” described were used by petitioner and were necessary to enable it to render the services from which it received its income. While the investigators and reporters were subject to the instructions of the officers of the corporation who were stockholders, it can not be said that the income of the petitioner resulting from the services of such investigators and reporters was primarily due to the activities of the stockholders.

The Board is of the opinion that during the taxable years the capital invested by petitioner was a material income-producing factor and also that the income of petitioner can not be ascribed primarily to the activities of the principal stockholders who were regularly engaged in the active conduct of its business affairs. Matteson Co. v. Willcuts, 12 Fed. (2d) 447; Record Abstract Co., 2 B. T. A. 628; Home Insurance Agency, 5 B. T. A. 1020; Patterson-Andress Co., 6 B. T. A. 392; Cuyahoga Abstract Title & Trust Co., 7 B. T. A. 95.

Judgment will be entered for the respondent.


author: Trammell:

text:
    Wm. Fleischaker, Petitioner, v. Commissioner of Internal Revenue, Respondent. Fleischaker’s, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 6432, 3369.
    Promulgated June 17, 1927.
    Under the facts in tills case, petitioners’ income should be determined on the accrual basis.

      Milo A. Lang,• Esq., for the petitioners.

      John D. Foley, Esq., for the respondent.
    The petitioners in the above-entitled proceedings are seeking the redetermination of deficiencies in the amount of $245.71 in the case of Fleischaker’s for 1917, and in the amounts of $608.33 for 1918, and $1,903.90 for 1919 in the case of Wm. Fleischaker. The two proceedings were consolidated for the purpose of hearing and decision. The question raised in both proceedings is whether the petitioners correctly reported their income upon the basis of cash receipts and disbursements.
    findings of fact.
    The petitioner, Fleischaker’s, is a partnership with its principal office in Joplin, Mo.. During 1917 the partners were William Fleis-chaker, the petitioner, and Isadore Fleischaker.
    Fleischaker’s filed its return for 1917 on the basis of cash receipts and disbursements. The respondent, upon a reaudit of the return, determined the tax liability upon the accrual basis, which increased the tax liability resulting in the deficiency.
    During 1918 and up until July 1, 1919, William Fleischaker was a member of the partnership operating as Fleischaker’s, and from July, 1919, until the end of that calendar year, he operated as an individual.
    The partnership of Fleischaker’s was engaged in the merchandise business operating a ladies’ ready-to-wear store in Joplin, Mo. Isa-dore Fleischaker was also a member of other partnerships operating stores in other places.
   OPINION.

Trammell:

The respondent held that the partnership of Fleisch-aker’s should have reported its income upon the accrual. basis and determined its tax liability upon that basis. Testimony was introduced by the petitioner for the purpose of showing that the books of account of Fleischaker’s were kept upon the basis of cash receipts and disbursements. There was introduced in evidence a check book showing the stubs of checks written, a cash book showing cash received and paid out, and a book showing' the sales between the different partnerships in which Fleischaker was interested and identified. William Fleischaker was a witness at the hearing but was not asked, and did not testify, whether the books and records introduced in evidence constituted all the books and records kept and maintained by the partnership during the years involved. Counsel for the petitioners admitted that inventories were kept of merchandise on hand and that resort was had to these inventories for the purpose of determining taxable income, but they were not offered in evidence. A revenue agent’s report was introduced in evidence by the petitioner for the purpose of showing the basis used by the respondent in determining the deficiency. This report indicates that the cost of goods sold during the year was determined by the partnership by the use of inventories. The revenue agent’s report makes allowance for bad debts charged off during the taxable year and also shows as liabilities accounts payable. It is not disclosed from what books or records the revenue agent obtained these accounts. It would indicate, however, that other books and records were kept than those introduced in evidence by the petitioner and that the accrual basis of reporting income was used.

The presumption is that the determination of the respondent is correct, and the evidence introduced by the petitioners does not overcome that presumption.

In the petitions filed in these proceedings it was alleged that Fleischaker’s was a partnership composed of William Fleischaker and Isadore Fleischaker. This allegation in each of the petitions was admitted in the answers of the respondent. Testimony, however, was introduced to the effect that the partnership was what was called a working partnership and that William Fleischaker owned the assets and Isadore Fleischaker performed services for which he was to receive a portion of the profits. In the brief filed the petitioners contend that Fleischaker’s was not a partnership. The pleadings, however, were not amended to raise the issue of the partnership and for that reason we do not consider the question. If we were called upon to decide the question, the testimony is too uncertain, indefinite, and unconvincing to warrant us in finding that the allegations made in the petitions and admitted in the answers are not true.

Judgment will be entered for the respondent. The deficiency for 1917 in the case of Fleis choker's is $Z^S.71, and in the ease of Wm. Fleischaher the deficiency for 1918 is $608.33, and for 1919 is $1,908.90.


author: Littleton :

text:
    R. E. Thompson, Petitioner, v. Commissioner of Internal Revenue, Respondent. Clark W. Kelly, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 6523, 6524.
    Promulgated June 17, 1927.
    Income and deductions are determined upon an annual basis and, in the circumstances of those proceedings, items of income received in 1920 may not be deferred to a subsequent year. The cost of land and amounts expended for other items of a major character are not proper deductions from gross income for the year in which such expenditures are made.
    /S'. Leo Ruslander, Esq., for the petitioners.

      John W. Fisher, Esq., for the respondent.
    These proceedings were consolidated for the purpose of hearing and decision. They involved deficiencies in income tax for the year 1920 in the amount of $1,162.06 as to It. E. Thompson and $178.99 as to Clark W. Kelly. The deficiencies are due to an increase by the Commissioner in the income of the Fern Hollow Gas & Oil Co., a partnership, in which the petitioners were two of the four partners.
    FINDINGS OF FACT.
    The Fern Hollow Gas & Oil Co., an ordinary Partnership, and hereinafter referred to as the partnership, was formed in 1920 under the Fictitious Names Act of Pennsylvania and was originally composed of four partners, namely, the two petitioners and Messrs. Brown and Temple. The purpose of the partnership was to acquire certain land and drill oil and gas wells thereon.
    In order to secure funds for carrying out the project, the prospective income from the property was divided into 600 shares, represented by certificates, each holder of such a certificate to be entitled to one six-hundredth part of whatever net earnings should be derived from the production, less a one-eighth interest in such earnings retained by the partnership, of any oil or gas which might be found in paying quantities in the two wells to be drilled. The certificate in question reads as follows:
    In consideration of the sum of $100.00, to it in hand paid, the Fern Hollow Gas and Oil Company, of Braddock, Pa., a partnership composed of R. E. Thompson, Clark W. Kelly, Ralph J. Brown and Miner E. Temple, does hereby sell, assign, transfer and set over unto - heirs and assigns, the one six-hundredth (l-600th) part of the net earnings derived from the production — less the Company’s one-eighth (l-8th) royalty — of any oil or gas which may be found in paying quantities in the two wells to be drilled by the Company, through the Speechley sand on a four-acre tract of land situate in Nine Mile Nun Hollow, Fourteenth Ward, City of Pittsburgh, Pa., unless oil or gas is found in paying quantities at a lesser depth.
    This Assignment is executed by the Company and accepted by the Assignee — ■, subject to the following terms and conditions:
    1 — This share is non-assessable and the Assignee is not liable for any debts contracted by the Company, hence the relationship between the Company and the Assignee, created by this assignment, is not one of partnership, but one of agency for the distribution of any production, as evidenced by any net earning.
    2 — The Company, as the owner of the property and said wells, shall have absolute and exclusive charge of the drilling- and management of the wells and the sale of any production therefrom, and upon the completion of both wells and the payment to the Assignee, of his or her proportionate share, of any net earnings, shall have discharged every obligation due the Assignee.
    3 — In the event the company drills other wells on said tract, the Assignee will be given a seven-day option of purchasing one more share.
    During the year 1920, 578 of these certificates were sold for $57,800, the remaining 22 certificates being retained by the partners. The two wells referred to were drilled in the same year by contract under which payment of $37,697.70 was made to the contractor for drilling and for equipment furnished to the contractor.
    Gas production continued from 1920 to 1924 when the wells ceased production and the entire property was disposed of. The amount received by the partnership from all sources from 1920 to 1924 exceeded the amount disbursed for all purposes, including the cost of land and drilling expenses, by $8,373.58.
    The partnership kept no books of account, and filed its returns for 1920 on the receipts and disbursements basis. In this return it showed a net income of $13,903.04, which amount was increased $7,198.05 by the Commissioner on account of the disallowance of a part of the depletion claimed. Such increase was allocated to the respective partners in accordance with their pro rata share of the profits, thus increasing the income of the two petitioners.
    The receipts and disbursements of the partnership for 1920, exclusive of the cost of land and withdrawals by the partners, were as follows:
    Receipts:
    From sale of metered gas_$4, 408. 56
    From sale of 578/600 of % of prospective production_ 57, 800. 00
    Rentals derived from old buildings on property_ 13.00
    Miscellaneous receipts_ 340.15
    Interest on daily bank balances- 454. 57
    Total receipts-63, 016. 28

      Disbursements:
    Payments to owners of 578/600 of % of prospective production— $2, 658. 80
    Mortgage interest payments- 315. 00
    Payments to contractor for drilling wells and furnisliing necessary equipment- 37, 697. 70
    Other expenses incidental to drilling- 378.88
    Postage, printing, advertising, etc- 353.77
    Repairs to old buildings on property- 64.66
    Commissions paid for sale of interests in production- 1, 050. 00
    Local taxes- 159. 67
    Safe deposit box rental- 4.00
    Court costs and revenue stamps- 43.25
    Traveling expenses_ 47.24
    Sundry expenses- 271. 85
    Pire insurance_ 174.25
    Lumber_ 897.00
    Survey of property- 176.18
    Tubing of wells- 395.00
    Total disbursements- 44, 687.25
    Cash receipts over disbursements- 18, 329. 03
    The cost of the land, which does not appear in the foregoing disbursements, was $11,000, and the partners’ withdrawals for 1920 were $3,645.71.
   OPINION.

Littleton :

The deficiencies in this case arose as the result of the disallowance by the Commissioner of a part of the depletion claimed in the partnership return filed by the Fern Hollow Gas & Oil Co. for the calendar year 1920, which resulted in an increase in the partnership income and correspondingly an increase in the taxable income of the petitioners, who were two of the partners in the enterprise.

The action of the Commissioner, however, in disallowing depletion is not the issue raised before the Board, it apparently being conceded by petitioners that the foregoing was correct. The error here assigned is, broadly, that the Commissioner has determined the income of the partnership for 1920 to be in excess of what it really was when effect is given to all proper items of income and all allowable deductions.

The problem then is to determine the correct income of the partnership. The parties are, in effect, in accord as to the amounts which were received and disbursed by the partnership during the year 1920, the question being how the various items should be treated for tax purposes.

In order to determine taxable income, it is necessary in any given case to decide first the basis on which income is to be computed, since very different results follow when a receipts and disbursements basis is being used as compared with the use of the accrual basis. Section 212(b), Eevenue Act of 1918, provides:

The net income shall be computed upon the basis of the taxpayer’s annual accounting period (fiscal year or calendar year, as the case may he) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income. If the taxpayer’s annual accounting period is other than a fiscal year as defined in section 200 or if the taxpayer has no annual accounting period or does not keep books, the net income shall be computed on the basis of the calendar year.

In this case, no books of account (as the term is ordinarily understood) were kept by the partnership, the information for its 1920 return being compiled from check books, canceled checks, pass books, memoranda, etc. This return reflected income on the basis of cash received and disbursed, and also included deductions from gross income on account of depreciation and depletion, the former being allowed in total by the Commissioner and the latter being almost entirely disallowed by him. Similarly, the petitioners’ amended statement of income of the partnership is prepared on the basis of cash received and disbursed, capital items such as purchase of land being taken as a deduction and no depreciation or depletion being claimed.

The petitioners contend in the first instance that income of the partnership should be computed on the receipts and disbursements basis which they have used, wherein capital expenditures are taken as deductions from gross income or, in the alternative, that an accrual method should be followed and the income of the partnership determined upon the basis of the operation of the partnership from the date of its organization in 1920 to the end of its existence in 1924.

Considering, first, the situation with respect to the alternative method. It is not argued by the petitioners that there was sufficient information available in 1920, or any books kept, on which a return could have been prepared on an accrual basis which would have reflected even an approximation of the income which the partnership ultimately produced over its period of operation. It is readily apparent that such a method does show what ultimately resulted from the venture into which the petitioners and the other partners embarked in 1920, in a similar manner that would be true in considering the entire life of any business undertaking. It is, however, peculiar to our Federal revenue laws that the accounting period generally recognized is one year and the income and deductions must be determined upon an annual basis. In effect, what the petitioners ask is stated in these words by one of the petitioners in his testimony that “ Our maintenance is now, that we are taking it on the whole to show the amount of profit made in the entire deal.” In other words, the petitioners contend that the Board should consider the operations of the partnership over the period from 1920 to 1924 in determining whether any income was derived in the year 1920 and defer as income of the partnership amounts received in 1920 from the sale of the rights to share in prospective earnings.

Not only are we of the opinion that no statutory authority exists for following this proposal, but also that the accrual method on an annual basis would not result in an allowance of the petitioners’ contention. The principal item which gives rise to the income in question is $51,800 received from the sale of certificates entitling the holders thereof to an interest in the future net earnings, if any, of the partnership. These holders were unlike stockholders in a corporation in that they were merely entitled to share in anticipated net earnings and beyond this they had no voice in the business or right or interest in the property of the partnership prior to or upon dissolution, every obligation of payment to them being discharged when payment was made to them of their share of the net profits when earned and if none were earned they lost entirely. Whatever net earnings may have been derived and distributed in years subsequent to 1920 were deductible from the earnings of the partnership in determining the partners’ distributable shares in such years. It is difficult to conceive of a basis upon which the amount of $57,800 might be deferred over the succeeding years. There was no investment by the partners of the amount of $57,800 nor was there any obligation that they should return this amount or any part of it to the purchasers of the certificates.

That an obligation rested upon the partners to pay out a part of the net profits as earned and that this obligation arose on account of the receipt of the amount of $57,800 from the sale of certificates, is certainly true, but it certainly is not of such a definite character that a reserve could be set up to provide for its amortization over future operation. Concerning the setting up of reserves for contingencies, the Board in the Appeal of Consolidated Asphalt Co., 1 B. T. A. 79, said:

It is quite true that not all amounts received constitute income; but when a taxable corporation in the course of its business of making profits receives contractual compensation for work done and material furnished; it can not contend that a part of the amount received is not income because the taxpayer is subject to a collateral obligation the fulfillment of which may require it to spend some of the amount. This is in substance what we said in the Appeal of William J. Ostheimer, 1 B. T. A. 18, and as we there said, this result is not changed because in the light of general experience the taxpayer feels reasonably certain of the necessity to expend the amount and is impelled by business prudence to set up a reserve therefor. In this instance good accounting and the statute may not be in strict accord, since Congress may with entire fairness tax what a very conservative and prudent business man may wish to hold in reserve.

See also Appeal of Uvalde Co., 1 B. T. A. 932, and Appeal of Morrison-Ricker Mfg. Co., 2 B. T. A. 1008.

The second difficulty which arises in the use of the accrual method is that no books of account were kept by the partnership. In the Appeal of John A. Brander, 3 B. T. A. 231, the Board said:

He had no method of accounting, for he kept no books, and, except in an extraordinary case, which does not now come to mind, an accrual method without accounting records is an anomaly. Such a method is inherently an accounting system whereby one is 'enabled not merely to record receipts and payments after they take place but to keep track of his financial rights and obligations under a credit system. Even a simple practice of accruals would require systematic accounting and some sort of bookkeeping. Without records it may generally be concluded that the cash method is being used.

The Board is, therefore, of the opinion that the accrual method is not applicable in determining the income of the partnership and that the entire amount of $57,800 received from the sale of certificates was properly included by the partnership in its return filed and by the Commissioner in his determination as a part of gross income.

Our next consideration is whether the deductions from income contended for by petitioners on the receipts and disbursements basis can be sustained. Under this theory, the material difference between the parties is that the petitioners consider all items of disbursements as deductions from gross income, regardless of their nature, and whether for land, permanent improvements, or additions, whereas the Commissioner contends that capital items are not proper deductions from gross income even on a receipts and disbursements basis. The principal item in controversy here is $11,000, representing the cost of the land. That the amount paid for such an item was a capital expenditure and therefore not deductible from gross income, either on the receipts and disbursements or the accrual basis, is too well established to admit of questioning. (See section 215 (b) of the Kevenue Act of 1918.) In fact, petitioners do not specifically contend that this item and the item of $37,697.70 hereinbefore mentioned were not of a capital nature. The testimony shows that in the item of $37,697.70, the amount paid the contractor for drilling the wells and for equipment, there were certain items of a capital nature which were likewise not deductible from gross income.

In our findings of fact, there is shown an excess of receipts over disbursements of $18,329.03, exclusive of the amount paid for land. Included, however, in the deductions which give rise to the foregoing net amount are capital items which are not allowable deductions, and no amount is shown among the deductions for depletion or depreciation to which the partnership is apparently entitled. In the original return as considered by the Commissioner certain capital items here claimed as deductions were not so included and depreciation and depletion were allowed as deductions.

The evidence is insufficient to show whether by the proper exclusion of the capital item and the allowance of the depreciation and depletion to which the partnership is entitled the income of the partnership would be more or less than that determined by the Commissioner.

Judgment will be entered for the respondent.

Arundell, GiíeeN, and Phillips dissent.


text:
    Indianapolis Street Railway Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 8787.
    Promulgated June 17, 1927.
    The petitioner corporation, which was the result of a consolidation on June 80, 1919, of two other Indiana corporations, pursuant to the provisions of the statutes of the State of Indiana, took over the assets and assumed the liabilities of such other corporations and issued its stock for the stock of such other corporations, and, among such liabilities of such corporations, were certain mortgage bonds which the petitioner purchased in 1923 for sinking-fund purposes at less than par and less than the amount for which such constituent corporations had theretofore sold them. Held that petitioner received no taxable income from such purchase.

      Harry A. Fellows, Esq., and Will H. Latta, Esq., for the petitioner.

      M. N. Fisher, Esq.', for the respondent.
    The Commissioner notified petitioner of his determination of deficiencies in income and profits tax for 1922 and 1923 in the amounts of $8,869.21 and $4,983.57, respectively. Only the deficiency for 1923 is in controversy. Petitioner was incorporated on June 30, 1919, to take over all of the assets and assume all of the liabilities of two other Indiana corporations and issued its stock in exchange for stock of such other corporations. Among outstanding liabilities assumed by petitioner were certain mortgage bonds of the constituent corporations, which bonds petitioner purchased for sinking-fund purposes in 1923 at less than par. Petitioner claims that the Commissioner erred in holding that upon the purchase of these bonds it derived a taxable gain. The facts are stipulated.

      BINDINGS OP PACT.
    Petitioner is an Indiana corporation organized June 30, 1919, by the consolidation of the Indianapolis Street By. Co. and the Indianapolis Traction & Terminal Co., pursuant to a statute of the State of Indiana in force on and after March 3, 1899, and as amended in 1903, being sections 5685, 5686, 5687, 5688, 5689 and 5690 of Burns’ 1914 Bevised Annotated Statutes of the State of Indiana.
    Prior to June 30, 1919, the Indianapolis Traction & Terminal Co. was lessee under a lease executed by the Indianapolis Street By. Co. upon all of its street railway properties in the City of Indianapolis. Each of the said companies owned certain street railway properties in the City of Indianapolis, which properties were joined and'connected and by the lease were operated by the Indianapolis Traction & Terminal Co. as one property. The property of said companies physically connected, intersected, joined, and united each with the other and formed continuous lines of street railway lying within the City of Indianapolis.
    Prior to consolidation the constituent, Indianapolis Street By. Co., had issued $105,000 par value of its first mortgage bonds and had received upon the issuance thereof the sum of $93,257.49. Prior to the consolidation, the Indianapolis Traction & Terminal Co. had issued $66,000 par value of its first mortgage bonds and had received at the time of issuance thereof the sum of $64,036.50.
    Upon organization petitioner took over all of the properties of the Indianapolis Street By. Co. and the Indianapolis Traction & Terminal Co. and assumed their debts, issuing $5,000,000 par value of its capital stock for that amount of the par value of the capital stock of the Indianapolis Street By. Co. and $2,000,000 of its capital stock for $5,000,000 par value of the capital stock of the Indianapolis Traction & Terminal Co. The stock of the constituent corporations was thereupon canceled.
    In the year 1923, petitioner “ paid over by acquiring for sinking fund purposes the mortgages under which the same were issued, the following bonds, hereinbefore referred to: $105,000 par value of said constituent, Indianapolis Street Bailway Company, first mortgage bonds issued for a consideration hereinbefore stated, by payment of $68,038.33; $66,000 par value of said Indianapolis Traction & Terminal Company, first mortgage bonds issued for a consideration hereinbefore stated, by payment of $59,261.70.”
   OPINION.

Littleton :

The Commissioner held that the petitioner derived a taxable gain in 1923 when it purchased the bonds of its predecessor companies which it had assumed when it took over their assets, at less than par. Petitioner contends that no taxable gain resulted from such purchase. The Board has heretofore had occasion to consider this question and has held that the retirement by a corporation of its bonds at less than par does not result in taxable gain. Independent Brewing Co. of Pittsburgh, 4 B. T. A. 870; New Orleans, Texas & Mexico Ry. Co., 6 B. T. A. 436. See also Kerbaugh-Empire Co. v. Bowers, 300 Fed. 938; Bowers v. Kerbaugh-Empire Co., 271 U. S. 170; Meyer Jewelry Co., 3 B. T. A. 1319. It is accordingly held that the Commissioner erred in his determination that the petitioner derived a taxable gain upon the retirement of the bonds involved in this proceeding.

Judgment will be entered on IS days'1 notice, under Rule 50.


author: Littleton:

text:
    Geo. H. Bowman Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 9961.
    Promulgated June 17, 1927.
    Tbe cost of permanent improvements voluntarily made to leased premises by a tenant at will, wbicli continued to occupy tbe premises beyond tbe taxable year in which such expenditures were made, was not deductible in its entirety within the taxable year as an ordinary and necessary expense.

      Chester A. Gwinn, Esq., and Adrian G. Humphreys, Esq., for the petitioner.

      W. Frank Gibbs, Esq., for the respondent.
    The Commissioner determined a deficiency of $7,669.66 in income and profits tax for the fiscal year ending January 31, 1921. The petitioner assigns a number of errors, all of which were withdrawn except the claim that the Commissioner erred in refusing to permit it to deduct in the taxable year as an ordinary and necessary business expense the sum of $7,084.79 representing the cost of permanent improvements made to leased premises.
    Petitioner contends that inasmuch as its tenancy of the premises was from month to month the total expenditure was a deductible expense within the taxable year.
    The position of the Commissioner is that the cost of improvements was not an ordinary and necessary business expense within the year and since the petitioner’s tenure was indefinite in duration the cost of improvements should be exhausted in the taxable year upon the basis of the useful life thereof. The facts are found as stipulated.
    FINDINGS OF FACT.
    The petitioner is a corporation organized and existing under the laws of the State of Ohio with its principal office at Cleveland. Its business is that of manufacturer, importer, wholesaler and retailer of chinaware, glassware, and kindred articles, and, as such, requires considerable storage space to carry its stock in trade.
    During the fiscal year ended January 31, 1921, petitioner rented for storage purposes a five-story building, 50 by 100 feet, known as the Eagle Street Warehouse, owned by Augusta B. Bowman, who is a stockholder of the petitioner to the extent of owning 490 shares out of the total 5,067 shares of stock issued and outstanding. Augusta B. Bowman is the wife of George H. Bowman, who, during the taxable year, owned more than 50 per cent of the outstanding issued capital stock of the petitioner corporation.
    The petitioner has not and did not have during the taxable year a lease on the Eagle Street Warehouse but occupied the same as a month-to-month tenant, paying therefor a monthly rental of $1,750. There is not now and there has never been any definite arrangement as to the duration of the petitioner’s tenancy of said warehouse nor for the reimbursement of the petitioner for any amounts expended by it for repairs, improvements or betterment of said Eagle Street Warehouse.
    During the fiscal year ended January 31, 1921, the petitioner, in order to better adapt the building to its needs as a storehouse, made certain improvements such as erecting partitions, installing an elevator, etc., more specifically described as follows:
    W. J. Rossborough, elevator equipment_ $90. 00
    Do- 490. 00
    Do- 138. 00
    Chafer Co., plumbing_ 214. 50
    Do- 160. 31
    Do- 93.24
    Do- 129. 07
    Reister & Thesmacher, fire cloors_ 200. 00
    Jas. B. Hatton, plumbing_ 208. 00
    Do- 260. 00
    Cleveland buildings, brick and sand_ 215.96
    Supply Co., brick and sand- 120. 50
    W. F. Hyde Co., partitions_ 99. 74
    A. J. Hanson, contractors_ 1,290. 86
    A. J. Hanson, work_ 1, 925.39

    Do-1- 1, 449.12
    Total_ 7, 084. 69
    All of the foregoing improvements are of a fixed nature and can not be economically removed by the petitioner upon vacating the building but must be regarded as forming a part of the realty. The improvements were necessary in carrying on petitioner’s business.
    In its income and profits-tax return for the fiscal year ending January 31, 1921, the petitioner deducted from gross income “Improvements, $1,084.69,” on account of the improvements to the building in question as set forth above. This deduction was disallowed by the Commissioner and the deficiency results in part from such action.
   OPINION.

Littleton:

Petitioner occupied the Eagle Street Warehouse and used it in carrying on its business without having a lease for any stated period of time; its tenancy was indefinite, no arrangement being made between it and the owner of the property as to such occupancy, other than that petitioner should pay monthly rental of $1,150 which apparently had no relation to the improvements in question. The owner of the building was a stockholder of the corporation and her husband owned more than 50 per cent of petitioner’s outstanding stock but, regardless of this fact, we think under the facts in this proceeding that the Commissioner was correct in allowing petitioner a deduction in the taxable year of only a reasonable allowance for the exhaustion of the cost of improvements on the basis of the useful life. The additions and improvements in question had a useful life in petitioner’s business of more than a year and were of a capital nature. In order, therefore, for petitioner to become entitled to a deduction in the taxable year on account of the expenditure in question of an amount in excess of a reasonable allowance for the exhaustion, wear and tear thereof, it must be clearly shown that the use of such improvements in petitioner’s business will terminate prior to the end of their ordinary useful life. This has not been shown. The duration of petitioner’s tenancy .of the building was indefinite and indeterminable. It occupied the premises at the will of the lessor and until it appears that petitioner’s tenancy will end at some definite time, it is entitled to a deduction in the taxable year of no more than a reasonable allowance for the exhaustion of the cost of improvements over the useful life thereof. If petitioner’s tenure extends over the period of the useful life of the improvements it will have recovered its cost through the annual allowance for exhaustion; if the tenure should for any reason terminate prior to the useful life of the improvements petitioner will then be entitled to a deduction from gross income of the unextin-guished cost of such improvements. In either event petitioner will have obtained the deduction to which, under the statute, it is entitled. Walle & Co., Ltd., 1 B. T. A. 1064. Sentinel Publishing Co., 2 B. T. A. 1211. Thatcher Medicine Co., 3 B. T. A. 154. William Scholes & Sons, Inc., 3 B. T. A. 598. William Greilich & Sons, Inc., 3 B. T. A. 1333.

Judgment will be entered for the respondent.