1929 BTA LEXIS 2927">*2927 1. Exclusion of good will from invested capital by the Commissioner approved for lack of evidence to show that the petitioner acquired good will with shares of capital stock, and the value thereof, at date of acquisition, if any such were acquired.
2. Additions to reserve for cash discounts, in excess of the cash discounts actually allowed within the year, are not deductible from income.
3. The Commissioner's action in excluding the reserve for cash discounts, as it appeared on the books at the beginning of the year, from invested capital approved for lack of evidence to show that such reserve is a part of earned surplus.
4. Determination of profits-tax liability under setions 327 and 328 of the Revenue Act of 1918 denied for lack of evidence showing the existence of any abnormalities affecting income and capital.
15 B.T.A. 64">*64 These are proceedings for the redetermination of deficiencies in income tax asserted by the Commissioner for 1919 and 1923, in the amounts of $6,274.68 and $223.80, respectively. In Docket No. 20461, petitioner asserts1929 BTA LEXIS 2927">*2928 the following errors in the Commissioner's determination for 1919: (1) That the Commissioner disallowed as a deduction from income the actual cash discounts granted to customers during the year, and allowed in lieu thereof the addition to the reserve for cash discounts; (2) that the Commissioner refused to include any value for good will in invested capital; (3) that the Commissioner failed to include in invested capital, the reserve for cash discounts at the beginning of the year, amounting to $25,244.79; and (4) that the Commissioner refused to compute the profits-tax liability in accordance with the provisions of sections 327 and 328 15 B.T.A. 64">*65 of the Revenue Act of 1918. In Docket No. 30364, petitioner alleges error on the part of the Commissioner in disallowing as a deduction from income of 1923, the addition to the reserve for cash discounts made during the year, and in allowing, in lieu thereof, the deduction of the actual cash discounts granted to customers during the year. The proceedings were consolidated for hearing and decision.
FINDINGS OF FACT.
Petitioner, an Ohio corporation with its principal office at Cleveland, was organized on November 24, 1896, and since1929 BTA LEXIS 2927">*2929 that date has been continuously engaged, at Cleveland, in manufacturing and selling ladies' wearing apparel.
The business in which petitioner is engaged was established in 1875, and, until 1880, was carried on by Jacob Landesman as a sole proprietorship. In 1880 the business passed to the partnership of Landesman and Hirschheimer, and was conducted by that firm until succeeded, in 1883, by the partnership of Landesman, Hirschheimer & Co., petitioner's immediate predecessor.
Petitioner's authorized capital stock, at date of organization, consisted of 250 shares of common of the par value of $1,000 each. On December 23, 1902, the authorized capital stock was increased to 325 shares of the par value of $1,000 each. At March 3, 1917, petitioner had issued, and there was outstanding, capital stock of the total par value of $325,000.
The following is a list of persons who, on December 7, 1896, subscribed to petitioner's capital stock, the number of shares for which each subscribed being set opposite their respective names:
| Shares | |
| Jacob Landesman | 63 |
| Felix Hirschheimer | 63 |
| Isaac Levi | 63 |
| Harry New | 15 |
| Benjamin New | 10 |
| Benjamin Lowenstein | 25 |
The minutes1929 BTA LEXIS 2927">*2930 of the meeting of petitioner's board of directors, held on December 7, 1896, show the adoption of the following resolution:
WHEREAS, Messrs. Landesman, Hirschheimer and Levi have each subscribed for sixty-three shares of the capital stock of this Company of the par value of $1000.00 each, aggregating 189 shares of the par value of $189,000, and Messrs. Benj. Lowenstein, Harry New and Benj. New have subscribed for 25, 15, and 10 shares, respectively, of said capital stock of this Company, aggregating fifty (50) shares of the par value of Fifty Thousand Dollars; and,
WHEREAS, all of said subscribers have agreed to pay for said stock so subscribed by them at such times and in such manner as this Board shall require.
THEREFORE, RESOLVED, That the said subscribers be, and they hereby are, required to pay for said capital stock so respectively subscribed for by them, as follows, to wit:
1st. That Messrs. Landesman, Hirschheimer and Levi pay their said subscriptions at par by delivering to the Company on or before January 2, 1897, 15 B.T.A. 64">*66 the stock of goods of the firm of Landesman, Hirschheimer & Co., of Cleveland, Ohio, a partnership composed of said Landesman, Hirschheimer1929 BTA LEXIS 2927">*2931 and Levi (engaged in the business which this corporation is organized to carry on) at cost price of said goods, as shown by an inventory to be taken between this date and January 2, 1897; that any balance that may remain unpaid on their said subscriptions, after the inventory price of said stock of goods has been credited thereon, shall be paid by said Landesman, Hirschheimer & Levi in cash on said January 2, 1897;
2nd. That Messrs. Benjamin Lowenstein, Harry New and Benjamin New pay their said respective subscriptions at par in cash on January 2, 1897;
3rd. That upon the payment in full of said respective subscriptions as above provided, The President and Secretary of this Company be, and they are hereby, authorized and directed to issue to said persons, as fully paid up, certificates for the shares of stock of this Company respectively subscribed for by them as hereinbefore set forth.
On or about January 2, 1897, petitioner took over the assets of, and succeeded to, the business of the partnership of Landesman, Hirschheimer & Co., and issued to each of the three partners, in exchange for such business and assets, 63 shares of its common capital stock of the par value of1929 BTA LEXIS 2927">*2932 $1,000 each, a total of 189 shares of a par value of $189,000. Included among the assets of the partnership were certain investments, having an aggregate book value of $148,787.89, which were entirely unrelated to the business of manufacturing and selling ladies' clothing, and which were not taken over by the petitioner.
The following are the closing balance sheet of the partnership and the opening balance sheet of petitioner, as of the date of the change of ownership of the business:
| Closing balance sheet of partnership | |
| Assets | |
| Cash and checking accounts | $55,860.99 |
| Accounts receivable | 173,604.53 |
| Bills receivable | 5,183.31 |
| Merchandise | 47,181.32 |
| Furniture and fixtures | 2,850.00 |
| Prepaid expenses | 722.15 |
| Business assets | 285,402.30 |
| Savings deposits | 60,000.00 |
| Bank and other stocks | 46,900.00 |
| Real estate | 41,887.89 |
| Investments | 148,787.89 |
| Total | 434,190.19 |
| Liabilities | |
| Accounts payable | $966.67 |
| Reserve for discount | 8,829.04 |
| Total liabilities | 9,795.71 |
| Net worth | 424,394.48 |
| Net worth represented by: partners accounts - | |
| J. Landesman | 139,053.41 |
| F. Hirschheimer | 144,812.66 |
| I. Levi | 140,528.41 |
| 424,394.48 |
| Opening balance sheet of petitioner | ||
| Assets | ||
| Cash | $43,857.58 | |
| Accounts receivable | 149,567.19 | |
| Bills receivable | 5,183.31 | |
| Due from employees | 2,167.37 | |
| Stock subscriptions receivable | 21,817.29 | |
| Merchandise (inventory) | 47,181.32 | |
| Furniture and fixtures | 2,850.00 | |
| Prepaid expenses: | ||
| Incorporation fee | $250.00 | |
| 1897 credit services | 163.38 | 413.38 |
| Prepaid insurance | 308.77 | |
| Total assets | 273,346.21 | |
| Liabilities | ||
| Landesman, Hirschheimer & Co. (excess of assets turned in over stock issued therefor) | $15,907.13 | |
| Reserve for discounts on accounts receivable | 7,439.08 | |
| Stock accounts: | ||
| Jacob Landesman | $63,000.00 | |
| Felix Hirschheimer | 63,000.00 | |
| Isaac Levi | 63,000.00 | |
| Benjamin Lowenstein | 25,000.00 | |
| Harry New | 15,000.00 | |
| Ben New | 10,000.00 | |
| Sam Gross | 3,000.00 | |
| Joseph Frankel | 3,000.00 | |
| Louis Goodman | 2,000.00 | |
| Joseph Loehnert | 2,000.00 | 249,000.00 |
| Total liabilities | 273,346.21 |
1929 BTA LEXIS 2927">*2933 15 B.T.A. 64">*67 There was no written contract of sale, or other instrument conveying the assets and business of the partnership to the petitioner.
At the time of organization of petitioner, Benjamin Lowenstein, a brother-in-law of Felix Hirschheimer, was residing at Canton, and was engaged in a merchandising business with retail stores at Akron, Canton, and Mansfield, all in the State of Ohio. Prior to the organization, it ws represented to him, by Landesman and Hirschheimer, that a corporation was to be formed which was to take over and succeed to the assets and business of the partnership, that the assets and business were of considerable value, and that the business would cotinue to be conducted as theretofore. Lowenstein sold his home at Canton, moved to Cleveland, and disposed of his business interests at Akron, Canton, and Mansfield, in order to devote his entire time to the petitioner's business. He subscribed for 25 shares of petitioner's capital stock, par value $1,000 per share, and paid for the same with cash at par.
Harry and Benjamin New had been the most successful of the salesmen employed by the partnership, and they continued in the petitioner's employment in1929 BTA LEXIS 2927">*2934 similar capacities, until their deaths which occurred in 1921 and 1927, respectively.
Samuel Gross had been employed by the partnership as bookkeeper for nine years. It was represented to him by Isaac Levi, a partner, that a new corporation was to be formed which would take over the entire business and assets of the partnership, exclusive of the investments, and that the business would continue as it had in the past. Gross subscribed for three shares of petitioner's capital stock, and paid for the same with cash at par.
Joseph Loehnert had been employed by the partnership in the manufacturing department for approximately 11 years, and he has continued to be employed by the petitioner to the present time, in 15 B.T.A. 64">*68 the same capacity. It was represented to him by Landesman, a partner, that the entire assets and business of the partnership were to be transferred to a corporation, and that no change would be made in the management or in the affairs of the business. Loehnert subscribed for two shares of petitioner's capital stock, and paid for the same with cash at par.
Following the transfer of the assets and business to the petitioner, Hirschheimer and Levi, former partners, 1929 BTA LEXIS 2927">*2935 retired from active participation in the affairs of the business, while Landesman, the other partner, continued for about a year and a half to exercise an active part in petitioner's affairs. Both Hirschheimer and Levi, however, continued as members of petitioner's directorate. Each was alloted desk space in petitioner's office, which they made their headquarters for the balance of their lives, and they rendered such counsel and advice in connection with the affairs of the business as, from time to time, was sought of them. Neither of these three individuals became interested in any competitor business following the transfer of the partnership business of the petitioner.
The entire organization of the partnership business, including all manufacturing and selling personnel, was taken over and continued by the petitioner. There were no substantial changes in business policies by the petitioner. The customers of the partnership, generally, continued their business relations with the petitioner. No change was made, or has since been made, in the location of the business.
The following is a statement of the net tangible assets of the partnership on January 1 of each of the years1929 BTA LEXIS 2927">*2936 1892 to 1897, inclusive, and of the partnership earnings for the years 1892 to 1896, inclusive:
| Year | Net tangible assets on Jan. 1 | Earnings for the year |
| 1892 | $426,102.22 | $127,970.17 |
| 1893 | 474,849.36 | 56,365.85 |
| 1894 | 442,210.75 | 92,618.33 |
| 1895 | 431,062.51 | 106,833.44 |
| 1896 | 443,531.15 | 67,433.99 |
| 1897 | 424,394.48 | |
| Total | 2,642,150.47 | 451,221.78 |
| Average | 440,358.41 | 90,244.36 |
Included in the net tangible assets of each year, as listed above, are investments which were wholly unrelated to the business carried on by the partnership; and the income from such investments is included in the annual earnings as shown above. The book value of such investments and the income derived therefrom are as follows:
| Year | Book value of investments Jan. 1 | Income from investments |
| 1892 | $86,481.95 | $5,123.77 |
| 1893 | 135,037.89 | 1 3,239.10 |
| 1894 | 119,587.89 | 4,501.87 |
| 1895 | 164,587.89 | 10,774.18 |
| 1896 | 129,887.89 | 8,463.89 |
| 1897 | 148,787.89 | |
| Total | 784,371.50 | 21,624.61 |
| Average | 130,728.60 | 4,324.92 |
15 B.T.A. 64">*69 The partnership earnings for the years 1892 to 1896, inclusive, are arrived at without deduction of any charges for salaries1929 BTA LEXIS 2927">*2937 to partners. A reasonable salary for each of the three partners, during the period stated, would have been $5,000 per annum.
The following is a statement of the net tangible assets and of the earnings of the business for the first six years after the acquisition thereof by the petitioner:
| Year | Net tangibles | Earnings |
| 1897 | $249,000.00 | $86,002.74 |
| 1898 | 335,002.74 | 72,992.81 |
| 1899 | 346,840.95 | 114,485.68 |
| 1900 | 398,826.63 | 111,308.40 |
| 1901 | 434,544.42 | 83,472.24 |
| Total | 1,764,214.74 | 468,261.87 |
| Average | 352,842.95 | 93,652.37 |
No specific shares of capital stock were issued by the petitioner for the good will of the predecessor partnership. Such good will as may have been acquired from the partnership was not recorded on petitioner's books of account at the time, nor at any time since.
In 1902 all of petitioner's stockholders, with the exception of Jacob Landesman, agreed not to dispose of their stock without first giving to petitioner's board of directors an option to purchase said stock at its then book value, and further agreed, for themselves and in behalf of their estates, that upon severing their relations with the petitioner, either through retirement, 1929 BTA LEXIS 2927">*2938 leaving petitioner's employ, or through death, that the board of directors should have an option to buy their stock at its then book value. This agreement has continued in effect and was in force throughout the year 1919.
During 1919 petitioner's capital stock was held as follows:
| Name | Number of shares |
| Harry New, vice president and treasurer | 60 |
| Benjamin Lowenstein, president | 50 |
| Ben New, salesman (secretary) | 35 |
| Samuel Hartman, salesman | 23 |
| Frank D. Fulmer, salesman | 23 |
| Samuel Gross, salesman | 23 |
| Harry P. Fisher, salesman | 23 |
| Joseph Loehnert, managing director | 23 |
| Mrs. I. Landesman, widow of Jacob | 17 |
| Joseph Frankel, factory superintendent | 17 |
| Benjamin Lowenstein and Harry New | 13 |
| Joseph A. Matthews, salesman | 11 |
| Rudolph C. Hess, credit manager | 7 |
| Total | 325 |
15 B.T.A. 64">*70 In its original return for 1919, petitioner claimed a deduction of the total amount of cash discounts actually allowed to its customers during the year. Subsequently, it filed an amended return in which it claimed, in lieu of the deduction taken in the original return, the amount added to the reserve for cash discounts during the year. The cash discounts allowed to customers during1929 BTA LEXIS 2927">*2939 the year amounted to $62,030.18; the addition to the reserve for cash discounts was $58,402.40. The invested capital claimed in the amended return did not include the reserve for cash discounts at the beginning of the year, which amounted to $25,244.79. The tax shown on the original return, amounting to $101,630.27, was paid in 1920, and the additional tax of $2,941.12, shown on the amended return, was paid on September 7, 1923.
In his deficiency determination for 1919, the Commissioner allowed the deduction for cash discounts claimed in the amended return, that is, the amount added to the reserve for cash discounts during the year. The invested capital for 1919, determined by the Commissioner in the deficiency notice is $1,129,544.95, which does not include the reserve for cash discounts at the beginning of the year, amounting to $25,244.79.
During 1923 petitioner allowed cash discounts to its customers in the total amount of $45,361.77. In the same year petitioner added to the reserve for cash discounts the sum of $49,201.89. In his deficiency determination, the Commissioner allowed a deduction of $45,361.77, representing the actual discounts allowed during the year.
1929 BTA LEXIS 2927">*2940 On or about February 13, 1925, petitioner filed with the Commissioner a consent agreement extending the time for the assessment of any taxes found for 1919, to December 31, 1925. This time was further extended to December 31, 1926, by a consent agreement filed on or about November 21, 1925.
On or about May 12, 1925, petitioner, in a protest filed with the Commissioner, made claim that it was entitled to have its profits-tax liability for 1919 determined under the provisions of sections 327 and 328 of the Revenue Act of 1918. In the deficiency notice, the Commissioner held that petitioner was not entitled to have its profits taxes so determined, on the ground "That no abnormality affecting either your capital or income has been disclosed that would bring your case within the scope of Paragraph (d) of section 327."
OPINION.
LITTLETON: Petitioner alleges error on the part of the Commissioner in refusing to include in invested capital for 1919, any value for good will, subject to the limitations applicable to intangibles imposed by section 326(a)(4) of the Revenue Act of 1918. It contends 15 B.T.A. 64">*71 that the good will was acquired from the predecessor partnership of Landesman, 1929 BTA LEXIS 2927">*2941 Hirschheimer & Co., in 1897, when it succeeded to the partnership business; that such good will was bona fide paid in by the members of the predecessor partnership, for shares of its capital stock; that the actual cash value of such good will, at the time paid in, was not less than $304,000; and that it is entitled to include this good will in invested capital, subject to the limitations applicable to intangibles. The Commissioner does not deny that when petitioner succeeded to the business of the predecessor partnership, it came into the ownership of any good will which may have attached to the business. He contends, however, that no stock was issued by the petitioner specifically for good will, and, that being the case, petitioner is not entitled to include such good will in invested capital, because section 326(a)(4) of the Revenue Act of 1918 permits the inclusion of only such intangibles as have been bona fide paid in for shares of stock.
The Commissioner places his chief reliance in this controversy upon the express language of the resolution adopted at the meeting of petitioner's board of directors held on December 7, 1896. This resolution provided that the shares of stock1929 BTA LEXIS 2927">*2942 issued to Landesman, Hirschheimer, and Levi should be paid for "at par by delivering to the Company on or before January 2, 1897, the stock of goods of the firm of Landesman, Hirschheimer & Co., of Cleveland, Ohio, a partnership composed of said Landesman, Hirschheimer and Levi (engaged in the business which this corporation is organized to carry on) at cost price of said goods, as shown by an inventory to be taken between this date and January 2, 1897; that any balance that may remain unpaid on their said subscriptions, after the inventory price of said stock of goods has been credited thereon, shall be paid by said Landesman, Hirschheimer and Levi in cash on said January 2, 1897." The manner of payment for the capital stock issued to the members of the predecessor partnership, required by this resolution, the Commissioner contends precludes any possibility of conclusion that good will was paid in for shares of stock.
Whatever may be the answer to this controversy, we deem unimportant at this time. The fact is the petitioner has failed to prove the premise of its contention - the existence of any good will at the date it took over the assets and business. When we found as a fact1929 BTA LEXIS 2927">*2943 that the business to which petitioner succeeded was the manufacturing and selling of ladies' wearing apparel, we stated substantially all that had been given to us as to the history of the business. No evidence whatever was introduced as to the character, quality, or standard of goods which were being produced by the business, the reputation of such products in the markets in which they were being 15 B.T.A. 64">*72 disposed of, the extent of development of markets for its products, the standing of the business in the industry, its reputation for fair dealing, and other factors of importance in determining the existence and value of good will. Evidence was introduced as to the earnings of the business before and after it was taken over by the petitioner. It is true that these earnings are far in excess of a reasonable return on the average net tangible assets employed in the business. Nevertheless we can not assume from that situation the existence of any good will. Excess earnings may be attributable to many other factors. The petitioner, for aught we know, may have enjoyed a virtual monopoly in the marts in which it disposed of its products. Its large earnings may have resulted from1929 BTA LEXIS 2927">*2944 an extortionate policy of securing for its products whatever the traffic would bear. The meagre evidence afforded by the record in this case offers no basis for a conclusion that the petitioner acquired valuable good will from its predecessor. Such being the case we shall not disturb the Commissioner's action in excluding good will from invested capital for 1919.
The petitioner complains of the inconsistent manner in which the Commissioner has dealt with cash discounts, as deductions from income, for 1919 and 1923. For 1919 the Commissioner allowed as a deduction the addition to the reserve for cash discounts, which was $3,627.78 less than the actual discounts allowed to customers during the year. For 1923 he allowed as a deduction the actual discounts allowed during the year which were $3,840.12 less than the addition to the reserve for cash discounts made in that year. Petitioner contends that the Commissioner can not be right in both instances. It concedes that the Commissioner's determination in respect of cash discounts for 1923 is correct, but contends that his determination for 1919 is wrong. We think that petitioner's contentions in this matter are correct. They1929 BTA LEXIS 2927">*2945 are supported by the decisions of this Board in , and the several cases cited therein. Accordingly, we hold that the net income determined by the Commissioner in the deficiency notice for 1919 should be reduced by $3,627.78, and we approve the Commissioner's determination as to the deduction for cash discounts for 1923.
The next assignment of error is that the Commissioner failed to include in invested capital for 1919 the reserve for cash discounts at the beginning of the year, amounting to $25,244.79. We have no evidence before us which establishes error on the part of the Commissioner in this respect. Ordinarily true reserves, the additions to which are not deductible from income for income-tax purposes, are regarded as a part of earned surplus and included in invested capital as such. But we have no evidence before us which shows that the 15 B.T.A. 64">*73 reserve of which petitioner speaks belongs to that class of reserves which are in reality merely an appropriation, or a part of the earned surplus. We can not assume the nature of a book account merely from its nomenclature. Even though we have held that the1929 BTA LEXIS 2927">*2946 Commissioner erred in allowing the deduction of the addition to the reserve for cash discounts made in 1919, we are not necessarily led to the position of having to conclude that the reserve for cash discounts at the beginning of the year constituted a part of petitioner's earned surplus. Without knowing from what source the reserve at the beginning of the year was set up, we can not say that it constitutes a part of the earned surplus to be properly included in invested capital.
Finally, the petitioner alleges that the Commissioner erred in refusing to compute its profits-tax liability for 1919 under the provisions of sections 327 and 328 of the Revenue Act of 1918. Petitioner contends that it acquired a mixed aggregate of tangible and intangible properties with shares of its capital stock, the respective values of which properties the Commissioner is unable to ascertain satisfactorily and, therefore, it is within the provisions of section 327(c) of the Act. The answer to that contention is that petitioner has failed to prove, as we have previously stated, that it acquired any valuable good will from its predecessor with shares of stock. If it acquired any intangibles from1929 BTA LEXIS 2927">*2947 any other source, with shares of stock, there is no proof thereof in the record. The petitioner further contends that the exclusion from invested capital of all good will value in excess of the statutory limitation creates such an abnormality affecting its capital as to bring it within the provisions of section 327(d) of the Act. The answer to this contention is the same as to the preceding one. Two other conditions are set out in the brief as constituting such abnormalities affecting capital and income as to bring the petitioner within the provisions of section 327(d). They are as follows:
First, the fact that the company's capital stock was closely held, all of the stockholders excepting one being actively employed in the company's business and their shares being tied up under an arrangement whereby, upon their leaving the company either through voluntary cessation of employment or by death, their shares were subject to purchase by the Board of Directors of the company for the benefit of other stockholders, and,
Second, the fact that the company, which for the year 1919 had an invested capital in excess of $1,100,000.00 for tangibles only, much of which had been accumulated1929 BTA LEXIS 2927">*2948 prior to March 3, 1917, through failure normally to capitalize its surplus and issue stock therefor prior to March 3, 1917, was subject to the 25 per cent limitation imposed by Section 326 computed on only $325,000.00 of capital stock outstanding on March 3, 1917; had the company normally capitalized its surplus prior to March 3, 1917, the amount of Good Will which might be included in invested capital under Section 326 would have been much in excess of the figure of $81,250.00.
15 B.T.A. 64">*74 It is argued that the first of these conditions resulted in the production of income wholly disproportionate to the actual investment. This is merely theorizing. It is true that in 1919 all but one stockholder were actively engaged in some capacity in the business. It is to be presumed, however, in the absence of evidence to the contrary, that they were compensated in proportion to the value of the services which they rendered. We do not know what the stockholder's investment in the business is. It has been stipulated that the Commissioner determined the invested capital to be $1,129,554.95. The deficiency notice shows a net income of $366,338.33, a return of approximately 30 per cent on1929 BTA LEXIS 2927">*2949 invested capital. If this income is abnormally high and disproportionate to the investment, in a business of the character in which petitioner is engaged, such facts, and the causes thereof, have not been established by proper proof.
As to the second condition, we must hold that it presents no abnormality affecting capital, because the petitioner has failed to establish its right to include any good will in invested capital.
Judgment will be entered under Rule 50.
Footnotes
1. Loss. ↩