*1614 1. Special assessment denied.
2. Where income is reported on a completed-contract basis, no part of the lump-sum payment on a certain contract should have been reported before the completion of the contract as damages on a previous unfulfilled contract with the same customer.
3. Income was derived in 1919 from a Government contract or contracts made between April 6, 1917, and November 11, 1918.
*627 The Commissioner determined deficiencies in income and profits taxes as shown below:
| Docket No. | Year | Deficiency |
| 21205 | 1917 | $2,001.13 |
| 21817 | 1918 | 22,876.20 |
| 21206 | 1919 | 24,880.30 |
However, he now concedes that the collection of these deficiencies is barred by the statute of limitations, except for certain amounts which were timely credited and which have been covered by a stipulation. The petitioner contends that a favorable decision on the merits will show that it has overpaid its taxes for these years.
*1615 The issues presented for our decision are:
1. Is the petitioner entitled to special assessment for each year?
2. Has an item of $53,500, or any part thereof, alleged to represent a payment for the cancellation of a contract, been erroneously included in income for 1918 when it should have been reported in income for 1917?
3. Has an item of $161,091.29, which was properly reported in income for 1919, been erroneously taxed at 1918 rates as income derived from a Government contract?
The proceedings were consolidated.
FINDINGS OF FACT.
The petitioner is a Pennsylvania corporation having its principal office at Pittsburgh. It was incorporated on May 11, 1896.
Its original authorized capital stock consisted of 1,000 shares of common, each share having a par value of $100. Nine hundred and thirty shares were issued to three individuals for $3,000 in cash and a plant, machinery and equipment at Canonsburg, Pa. The remaining 70 shares were issued to Herman R. Blickle and Theodore A. Straub for $7,000 in cash. These two individuals organized a partnership, either late in 1894 or early in 1895 and engaged in the engineering and contracting business, designing and*1616 constructing bridges and buildings. The assets of this partnership, consisting of about 30 contracts for work, a small rented plant and some small machinery and tools, were turned in to the petitioner, but no stock was issued for them. The capital account on the petitioner's books has never *628 included any value for good will or contracts of the partnership, and invested capital as reported by the petitioner and as determined by the respondent for the years in controversy does not reflect any value for good will, contracts, or other assets of the partnership which might have been turned in to the petitioner by the partners.
The principal part of the petitioner's business has always been the designing and fabricating of steel for office buildings, bridges, coal tipples, power houses, mill buildings and similar structures. It sometimes contracts to erect the steel which it has fabricated. It frequently enters into competitive bidding for contracts, but it sometimes obtains contracts without bidding and sometimes makes sales upon open purchase orders. Its contracts are usually completed in less than twelve months, but some contracts require a longer period for completion. *1617 It always has uncompleted contracts on hand at the end of the year. The average length of time required to complete the contracts handled in the three years here involved was about six months. It handled between 234 and 380 contracts in each year.
During these three years the petitioner had nineteen contracts on a cost-plus basis. It also had some contracts where it was to be compensated in a lump sum. Most of its contracts and orders, however, provided for compensation on a unit-price basis, that is, so much per pound for materials fabricated and delivered, with an additional amount added if the petitioner was to erect the structure. Customers were usually billed for materials as shipments were made and for the erection of the work monthly on the basis of completed work.
Under the method of accounting regularly employed in keeping the petitioner's books from 1896 to the present time, no gain or loss on a contract or order was computed or accounted for until the job was completed. A separate account was kept for each contract and order, to which were charged all raw materials in process of fabrication, other materials and supplies directly chargeable to the job, including*1618 cost of drafting, direct labor and expenses, and the overhead apportioned to the job. Materials and supplies returned to stock for which a customer had been billed, were credited to the account, as were the various billings to the customer. The balance in the account was carried forward and reflected in a controlling asset account until the job was completed, at which time the contract account was closed and the balance, representing either gain or loss, was transferred to profit and loss. The net income reported by the petitioner in the returns for the taxable years in controversy was computed in accordance with the method of accounting regularly employed in keeping the books, i.e., on the basis of completed contracts. This method clearly reflected its income.
*629 The petitioner has never inventoried work in process on uncompleted contracts at the end of a year as it did its raw materials and supplies, but, instead, identified such work in process under a "contract control account" which it carried forward from year to year at the book value thereof, without regard to fluctuation of market prices, as shown by the analytical statement below. The table also shows the*1619 year in which the contracts were completed and the amount of profits realized.
The petitioner's books show the following in regard to uncompleted contracts:
| 1916 | 1917 | 1 1918 | |
| CHARGES | |||
| Materials | $648,023.00 | $1,008,285.04 | $462,408.68 |
| Labor | 149,888.87 | 157,456.67 | 115,934.95 |
| Drafting | 40,045.19 | 58,377.99 | 43,772.61 |
| Freight and hauling | 35,322.84 | 40,987.01 | 14,865.55 |
| Overhead | 22,934.88 | 38,006.45 | 17,508.54 |
| Miscellaneous | 80,685.82 | 85,603.13 | 72,370.84 |
| Total | 976,900.60 | 1,388,716.29 | 726,861.17 |
| Add: Profits taken | 47,300.00 | ||
| Total charges | 1,024,200.60 | 1,388,716.29 | 726,861.17 |
| CREDITS | |||
| Billed to customers, etc | 748,609.85 | 1,105,576.15 | 547,520.15 |
| Book value of uncompleted contracts at close of year | 275,590.75 | 283,140.14 | 179,341.02 |
| Year in which completed | 1917 | 1918 | 1919 |
| Profits realized | $171,596.39 | $281,065.05 | $172,576.21 |
The respondent has accepted, without change, the inventory values reflected by the petitioner's books for the years in controversy, as follows:
| Item | Dec. 31, 1916 | Dec. 31, 1917 | Dec. 31, 1918 | Dec. 31, 1919 |
| Pig iron | $4,875.00 | $10,695.00 | $7,960.00 | $4,901.74 |
| Cast scrap | 4,855.22 | 3,701.86 | 1,748.58 | 1,369.40 |
| Steel scrap | 33,055.24 | 20,628.97 | 4,733.72 | 3,935.55 |
| Merchandise inventories | 388,004.42 | 202,342.24 | 182,962.30 | 214,873.28 |
*1620 Under the petitioner's system of accounting it cometimes happens that contracts are carried over from one year to another and the profits reported in the latter year, where a majority of the charges for the contracts have been made in the earlier year and the final deliveries of materials have been made within the first two or three months of the following year.
At the plant at Canonsburg, Pa., and at the Pittsburgh office, the petitioner kept running book inventory accounts for raw materials and supplies. Among these was one termed "Stock Steel Account." *630 At January 1, 1917, this account shows on hand 13,045,698 pounds of steel, valued at $306,953.92. The total purchases of steel charged to stock steel account in 1917 amounted to 14,117,387 poinds, at a cost of $485,990.83. There were charged back to stock steel account 2,472,224 pounds, valued at $81,674.56, which previously had been charged against specific contracts but not used. Expenses charged to stock steel account amounted to $1,695.86. Credits to the account, for steel charged out to contracts and sundry jobs, amounted to 23,564,355 pounds, valued at $795,070.92. At the close of 1917 the stock steel*1621 account at the Pittsburgh office was reduced by 54,345 pounds to make that account conform with the stock steel account at the plant. After making that adjustment, the account showed 6,016,609 pounds of steel on hand, valued at $81,244.25. As of December 31, 1917, by appropriate journal entries properly posted to the ledger, fuel, cast scrap, scrap, and stock steel accounts were charged with the amounts of $1,993.79, $4,765.59, $2,451.76, and $39,380.92, respectively, amounting in all to $48,592.06. As of the same date, inventory adjustment account was charged with $48,592.06, and pig iron, rivet stock, and store supplies accounts were credited with the amounts of $4,158.69, $42,048.69, and $2,384.68, respectively. After these entries were made, the stock steel account showed a book value of $120,625.17 for the steel on hand at the close of 1917.
The total purchases of steel charged to stock steel account in 1918 amounted to 7,198,124 pounds, at a cost of $225,266.42. There were charged back to stock steel account, 92,593,684 pounds, valued at $2,750,907.71, which previously had been charged against specific contracts. Expenses charged to stock steel account amounted to $1,164.21. *1622 Credits to the account, for steel charged out to contracts and sundry jobs, amounted to 95,686,817 pounds, valued at $3,189,578.51. At the close of 1918 the stock steel account at the Pittsburgh office was increased by 59,145 pounds to make that account conform with the stock steel account at the plant. After making that adjustment, the accounts showed 10,180,745 pounds of steel on hand and a credit balance of $91,615. As of December 31, 1918, by appropriate journal entry properly posted to the ledger, stock steel account was charged and contracts account was credited with the amount of $193,422.45. After this entry was made, the stock steel account showed a book value of $101,807.45 for the steel on hand at the close of 1918.
The total purchases of steel charged to stock steel account in 1919 amounted to 18,507,488 pounds, at a cost of $485,314.19. There were charged back to stock steel account 2,128,381 pounds, valued at $43,202.76, which previously had been charged against specific contracts but not used. Expenses charged to stock steel account amounted to *631 $7,452.66. Credits to the account, for steel charged out to contracts and sundry jobs, amounted to 22,581,590*1623 pounds, valued at $521,718.40. At the close of 1919 the stock steel account at the Pittsburgh office was increased by 1,279,584 pounds to make that account conform with the stock steel account at the plant. After making that adjustment, the account showed 9,514,608 pounds of steel on hand, valued at $116,058.66. As of December 31, 1919, by appropriate journal entry properly posted to the ledger, stock steel account was charged with the amount of $26,660.46. After this entry was made, the stock steel account showed a value of $142,719.12 for the steel on hand at the close of 1919.
The petitioner maintains an estimating and engineering department at the main office in Pittsburgh, for the purpose of conceiving and designing engineering work and making estimates for bids on contracts. That department, consisting of five engineers, prepares the designs for proposed structures, estimates the weights of the structures, the kinds and quantities of materials required, and computes the cost of the work on the basis of the estimates. The petitioner also maintains a drafting department at the Canonsburg plant composed of an undisclosed number of engineers and draftsmen, the duties of*1624 which are to make detailed drawings, compute stresses and strains, and prepare specifications for the fabrication of materials for all contracts.
When a bid is accepted, the designs are sent to the drafting department for preparation of the detailed drawings. These drawings and the specifications show the dimensions of the materials, the spacing of the field and shop rivets, the arrangement of the dimension lines, and all necessary details for cutting and fabricating the steel and for making up the trusses, columns, struts, spans, girders, etc.
The estimate of cost, the bid and the contract price always include an amount to cover the cost of designs, drawings and patterns, and when the cost of designs, drawings and patterns for each job is determined, or as such cost is incurred, it is charged against the account of the contract to which it relates, as a part of the cost or expense of that contract, to be taken into consideration in computing gains and losses upon completion of the contract.
When contracts are completed, the designs, detailed drawings, specifications, bills of materials, and all other data relating to costs, are placed together and filed under separate index*1625 numbers in a fireproof storage vault at the plant. Designs and estimates prepared for bidding on work which the petitioner fails to obtain are indexed and filed at the Pittsburgh office. A record of these designs and drawings is kept in the drafting department, showing the index *632 number and a sufficient description of each to readily identify it as relating to a particular class of work.
At December 31, 1916, the petitioner had accumulated 25,328 detailed drawings, with related designs and cost data, pertaining to contracts completed prior to that date, and between 400 to 500 designs and estimates for contract work which the petitioner failed to obtain. Many of these detailed drawings are duplicates, and many others differ only in minor details. Some of them are used over again, sometimes with minor modifications, in extension work and additions to mill plants. The principal use of these drawings, after the completion of the contract for which they were prepared, is for reference in preparing estimates and drawings for current new work. By reference to these drawings and related data, the engineer and draftsman are enabled to apply to current work the tested ideas*1626 and experiences of past performances, particularly in relation to costs and the factors of loadings, weights, stresses and strains. This results in a saving of time, expense and labor in preparing new estimates and drawings.
During the years in controversy, the petitioner obtained nineteen contracts for extensions and additions to work previously done. On these jobs the petitioner was able to use 159 old drawings, prepared prior to the taxable years, and had to make only 38 new drawings.
The following statement shows, for each year, the number of estimates prepared, the number of contracts obtained, the number of drawings made and their cost:
| Year | Number of estimates | Number of contracts | Number of drawings | Cost |
| 1917 | 917 | 233 | 2,301 | $62,817.30 |
| 1918 | 651 | 237 | 1,046 | 43,220.72 |
| 1919 | 867 | 237 | 1,030 | 88,197.24 |
| Total | 2,435 | 707 | 4,377 | 194,235.26 |
Of the 25,328 drawings on hand at December 31, 1916, 7,339 were made during the period 1896 to 1905, inclusive. The actual cost of these 7,339 drawings can not be determined. The remaining 17,989 were made during the period 1906 to 1916, inclusive, at a total cost of $467,374.69.
The entire cost*1627 of the 25,328 drawings was treated on the books as a part of the cost of the contracts to which the drawings related, and no part of such cost has ever been restored to capital accounts. The drawings, except for a few blueprints of originals which were delivered to customers, are made on linen, and are in good condition. Not more than 10 per cent of these drawings were entirely out of date in the taxable years in question. The respondent has not included any *633 value for these drawings in computing invested capital for the years in controversy.
At December 31, 1916, the petitioner had on hand 2,092 patterns which had been made by experienced pattern makers in its employ. Sometimes old patterns can be used for new work after alterations, modifications and repairs. They were used during the years here involved to the following extent: 78 in 1917, 26 in 1918, and 6 in 1919. The entire cost of these patterns was treated on the books, when incurred, as a part of the cost of the contract work for which they were made, and when used again on a new job they are treated, except in cases of close competition, as part of the cost of that job at their original cost.
The petitioner*1628 returned and the respondent has determined the following amounts as received by the petitioner from gross sales from operations, the costs of such goods, and deductions for ordinary and necessary expenses:
| Item | 1917 | 1918 | 1919 |
| Gross sales as returned | $4,377,857.56 | $7,475,151.31 | $3,149,202.43 |
| Gross sales as redetermined | $4,377,857.56 | $7,475,151.31 | $3,149,202.43 |
| Cost of goods as returned | 2,621,933.55 | 5,744,640.79 | 2,086,048.57 |
| Cost of goods as redetermined | 2,605,813.55 | 5,744,640.79 | 2,086,048.57 |
| Expenses as returned | 1,298,185.98 | 355,705.25 | 275,886.20 |
| Expenses as redetermined | 1,296,930.98 |
The net income and invested capital for each year, as determined by the Commissioner, and the percentage of net income which the profits tax determined represents, are as follows:
| Year | Net income | Invested capital | Profits tax percentage of net income |
| 1917 | $401,834.43 | $1,067,174.97 | 28.8 |
| 1918 | 1,148,329.97 | 1,338,602.66 | 70.2 |
| 1919 | 572,974.71 | 2,025,434.24 | 32.0 |
The petitioner did not have any Government contracts providing for compensation on a cost-plus basis during the years in controversy.
The Commissioner has held that*1629 the petitioner is not entitled to special assessment for the years here involved.
In April, 1917, the petitioner entered into a contract with the Firestone Tire and Rubber Company (hereinafter referred to as the Firestone Company), for fabricating, delivering and erecting complete the structural steel, amounting to 2,500 tons, for a proposed power station, pump house and approach coal trestle, at Akron, Ohio, for the price of 7.40 cents per pound. The work was to be completed by September 15, 1917.
*634 In July, 1917, the Firestone Company decided not to carry out its plan for the building contemplated by this contract and asked the petitioner to submit a proposition of settlement for cancellation of the contract. The petitioner in a letter dated July 18, 1917, submitted three alternative propositions of settlement, as follows:
(1) In consideration of the payment of Seventy-five Thousand Dollars ($75,000) by you to us, we will consider the contracts closed without any further obligation on your part or on our part.
(2) In consideration of the payment by you to us of Sixty Thousand Dollars ($60,000) at this time and a further payment by November 1st, 1917, for the*1630 payment of all plain material which would still be remaining on our hands at the rate of Five and Three-Quarter Cents (5 3/4??) per pound plus loading charge f.o.b. cars our Works, Canonsburg, Pa., it being understood that we would attempt to dispose of this material in the interim, so as to have as little remaining as possible by November 1st, 1917.
(3) In case you wish us to fabricate some 500 tons of this work and cancel the remaining tonnage, we would charge you Seven and Fifteen Hundredths Cents (7.15??) per pound f.o.b. Akron, Ohio, for the fabricated tonnage and cancel the remaining tonnage in consideration of an additional payment by you to us in the amount of Fifty-three Thousand Dollars ($53,000) under the conditions of proposition No. 2, or payment of Sixty-eight Thousand Dollars ($68,000) under the conditions of proposition No. 1.
On July 21, 1917, the petitioner advised the Firestone Company that it accepted cancellation of the contract, on the following conditions:
For the lump sum of One Hundred Twenty-five Thousand Dollars ($125,000) we will furnish you the fabricated grillage f.o.b. cars Akron, Ohio, and also an additional tonnage amounting to 500 tons, as*1631 outlined by your Mr. Myers as that portion of the Power Plant which you desire fabricated supporting two boilers, f.o.b. cars Akron, Ohio. It has been assumed that the portion of the steel work you desire amounts to approximately 500 tons. Any variation within 100 tons of this amount as shown finally as having been shipped will be either added to or deducted from the above lump sum at the rate of Seven and Fifteen Hundredths Cents (7.15??) per pound.
If you should desire us to do the erection of this assumed 500 tons, more or less, at the time same is being delivered by us at Akron, Ohio, we will do this erection at the rate of Seventeen Dollars ($17.00) per ton of 2000 pounds. The grillage, however, is to be set in place by you.
Due to the cancellation and the final re-adjustment of this work, we are to have the privilege of delaying the shipment of this 500 tons to enable us to take advantage of any possibility we might have of fabricating some of the cancelled 2000 tons. This delay, however, to be reasonable and to be consistent with your requirements on this 500 tons, and in case you need it fast shipment of material to be made not later than October 15th, 1917.
Terms*1632 of payment: $25,000 to be paid us by August 20th, 1917; $7500 to be paid us thirty (30) days after grillage has been shipped; $21,000 to be paid us October 1st, 1917, and the balance to be paid as invoiced thirty (30) days after date of invoice.
These terms and conditions of the petitioner's letter of July 21, 1917, were accepted by the Firestone Company, and incorporated*635 in a formal written agreement dated July 21, 1917. A pertinent part of this contract is as follows:
Art. 1. The contractor shall and will provide all the materials and perform all the work for the fabrication and delivery f.o.b. cars Akron, Ohio, of all grillage and in addition approximately Five Hundred (500) tons of structural steel for that company's Power House Building, being such portion as the Owners may immediately require and all to be in accordance with all of the terms as outlined in the contractor's letter dated July 21st, 1917, and accepted by the Owner on July 21st, 1917, and as shown on the drawings and described in the specifications prepared by THE OSBORN ENGINEERING COMPANY OF CLEVELAND, OHIO, ENGINEERS, which drawings and specifications are identified by the signature of the parties*1633 hereto, and become hereby a part of this contract.
The three payments, aggregating $53,500, due between August 20 and October 1, 1917, under the provisions of the above quoted letter relating to "Terms of payment," were received on the due dates thereof, in 1917.
The petitioner kept a separate account for the Firestone Company contract. The total charges to this account in 1917 for materials, labor, and other costs and expenses, amounted to $45,869.97. These charges were made in May, 1917, and each month thereafter in 1917. The three payments, aggregating $53,500, received from the Firestone Company were credited to the account in 1917. Billings made to the Firestone Company for materials shipped were also credited to the account. Total shipments of materials under this contract in 1917 amounted to 205,120 pounds billed at $13,400.53. The first material was delivered in December, 1917. At the close of 1917, the account showed a credit balance of $21,030.56. No profit was accounted for in 1917 pending completion of the contract. During 1918 the total charges to this account for materials, labor, etc., amounted to $8,767.89, and the total credits thereto, representing*1634 billings made to the Firestone Company for materials in the amount of 887,914 pounds, amounted to $63,485.85. The contract was completed in March, 1918, at which time the credit balance in the account of $75,748.52 was transferred to profit and loss account, as the gain realized from this contract; and the entire amount of the gain accounted for was included in income as returned by the petitioner and determined by the Commissioner for 1918.
On March 7, 1918, the petitioner entered into a contract with the Signal Corps, United States Army, under which it undertook to furnish "the material described in Order No. 50263," for a total consideration of "Eight hundred fifty-five thousand dollars ($855,000.00) more or less as per order." This contract was identified as No. 3047. Order No. 50263 required the furnishing of "Necessary structural steel and miscellaneous iron fabricated for 200 buildings, job 106-A-3, * * * at $0.057 per lb."
*636 The Bureau of Aircraft Production, War Department, advised the petitioner by a letter dated June 25, 1918, that Order No. 50263 "is amended to cover material for 155 additional Hangars." These hangars were designed with interchangeable*1635 sections so that, while all were of the same width, they could be made to practically any length desired.
The office of the Director of Military Aeronautics wrote the following letter to the petitioner on September 24, 1918:
Subject: Job 106-B C
1. It is requested you furnish and fabricate structural steel and accessory material required for the construction of 21 hangars 110 X 160, in accordance with Bill of Material #143, copy of which is enclosed.
2. It is understood this material is to be invoiced by you at 5.7?? per pound, f.o.b. cars your plant.
3. This is a preliminary order and your order 50,263 will be amended to cover this material.
4. This material must not be shipped until receipt of Government Bills of Lading, which will be furnished by the Traffic Department, and shipping instructions, which will be furnished you by this office and confirmed by the Traffic Department.
5. It is requested, however, that arrangements be made to fabricate this material immediately and have ready for shipment as soon as definite location is decided upon.
The Bureau of Aircraft Production, War Department, advised the petitioner, by a letter dated September 27, 1918, that*1636 the preliminary order of September 24, 1918, was confirmed.
On November 12, 1918, the petitioner received a telegram as follows:
SR DASH ONE HUNDRED THIRTY SEVEN CANCEL ENTIRELY AND STOP FURTHER ACTIVITY ON JOB ONE HUNDRED SIX B C COVERING TWENTY ONE HANGARS ONE HUNDRED TEN BY ONE SIXTY BILL OF MATERIAL ONE FORTY THREE ADVISE DEPARTMENT PRESENT STATUS OF ORDERS AND CANCELLATION CHARGES IF ANY.
KENLY DIRECTOR MILITARY AERONAUTICS
The above telegram was confirmed by a letter from the office of the Director of Military Aeronautics, dated November 14, 1918, which was as follows:
1. Confirming telegram dated Nov. 12th requesting you to cancel all orders and further activity on the above job relative to 21 hangars 110 X 160 in accordance with Bill of Material #143. It is the understanding of this office that no materials have as yet been shipped.
2. It is requested that you advise this office, the status of this order regarding its cancellation together with a full statement regarding any charges accruing through cancellation.
3. There has been shipped out of this 21 set of Buildings, one Building for the Navy at the Washington Navy Yard, one Building at Dayton, Ohio*1637 and one Building at Austin, Texas.
*637 The petitioner acknowledged receipt of the telegram of November 13, 1918, on November 14, 1918, and also stated in the communication to the Government:
Regarding the status of the remaining Hangars of Job 106-BC, would advise that all plain material has been rolled and considerable fabricated. We will make up a statement of cancellation charges and advise you later.
The office of the Director of Military Aeronautics, War Department, advised the petitioner by a letter dated November 16, 1918, as follows:
1. You are directed to crease any activity and work on any orders now in your possession for buildings of the above type issued to you by the Supply Section, Department of Military Aeronautics in the past and prevent the accruing of any cancellation charges, if it is deemed advisable to cancel.
2. At the present writing it is to be understood this does not cancel these orders, but precaution is being taken at this time, by general orders issued, to prevent further accruing of these charges until a careful survey can be made of the entire Military situation and decision reached as to the proper method of handling existing*1638 orders and just what materials will be needed for the demobilization or reconstruction work.
3. There is a great probability all orders now in your possession for materials for above buildings being necessary and needed for other purposes than Military Service.
4. This office quite appreciates the possible disturbance caused by this action in the matter of labor and your shop arrangements, but finds it necessary, under general instructions issued, to have you observe these instructions and every effort will be made to reach a decision, which should reach you in several days.
5. In the meanwhile it is requested that a complete schedule of materials, with full itemizations and lists be prepared, showing cancellation charges and losses as of the date of this communication.
6. The above instructions apply to all orders, excepting those for the Navy and the 47 hangars for the French Government.
On November 19, 1918, the petitioner advised the Director of Military Aeronautics as to the status of the 21 hangars added to Order No. 50263 by the amendment of September 24, 1918, as follows:
21 - 110'X160' buildings, your job 106 - BC, preliminary order dated September 24th, *1639 1918, material all on hand or rolled and considerable fabricated. No fabricated material has been shipped and we have suspended fabrication complying with instructions in your telegram of November 13th, 1918, and letter of November 14th, 1918.
The petitioner has made no claim against the Government for damages by reason of the telegram of November 12, 1918, and its confirmation.
The Director of Military Aeronautics, on the dates shown, directed the petitioner to make immediate shipment of structural steel and accessory materials required for the construction of a total of 16 *638 hangars and for miscellaneous material as the following statement shows:
| December, 1918 Date | Material |
| 12 | 1 hangar 110 X 140 |
| 20 | 1 hangar 110 X 120 |
| 1 hangar 110 X 140 | |
| 2 hangar 110 X 160 | |
| 4 hangar 110 X 200 | |
| 3 hangar 110 X 240 | |
| 21 | 4 hangar 110 X 200 |
| 27 | miscellaneous material for hangars |
The materials for these hangars and the miscellaneous material were to be shipped from that ordered for 21 hangars "110 X 160" on Order 50263 which had already been fabricated, and 5.17 cents per pound was to be the price.
In its return for 1919 the petitioner reported net profits*1640 of $161,091.28 derived from sales of materials to the War Department under these orders. The respondent has correctly held that these net profits were derived in 1919 from a Government contract or contracts made between April 6, 1917, and November 11, 1918, and has determined the profits tax thereon under the provisions of section 301(c) of the Revenue Act of 1918.
OPINION.
MURDOCK: The petitioner assigned a number of errors which were either waived or supported by no evidence. They were not urged and will entitle the petitioner to no relief in this proceeding. The Commissioner has conceded that the statute of limitations bars collection of the deficiencies except for certain items which have been properly credited against the assessments. We have, therefore, made no findings of fact in regard to the statute of limitations and see no reason to discuss the question. The respondent made certain claims, by amendment to his answer, alleging that the deficiency for 1917 should be increased if any income reported in 1918 were transferred to 1917, and that, in case the Board holds that expenditures made for designs and drawings should have been capitalized, there should be added*1641 to income for each year certain amounts heretofore allowed as deductions representing the cost of the designs and drawings plus an amount for overhead expenses.
The petitioner's principal contention is that its profits taxes should be computed under section 210 of the Revenue Act of 1917 and section 328 of the Revenue Act of 1918. The former section is applicable to 1917 income only where a taxpayer's invested capital can not be satisfactorily determined. Section 327 authorizes special *639 assessment for the years 1918 and 1919 not only where invested capital can not be determined, but it also provides:
Where upon application by the corporation the Commissioner finds and so declares of record that the tax if determined without benefit of this section would, owing to abnormal conditions affecting the capital or income of the corporation, work upon the corporation an exceptional hardship evidenced by gross disproportion between the tax computed without benefit of this section and the tax computed by reference to the representative corporations specified in section 328. This subdivision shall not apply to any case (1) in which the tax (computed without benefit of this*1642 section) is high merely because the corporation earned within the taxable year a high rate of profit upon a normal invested capital * * *.
The petitioner attempts to make the following points in support of this contention:
1. Valuable assets received from a predecessor partnership have not been and can not be considered in computing invested capital.
2. Old designs, drawings and patterns of great value have not been and can not be considered in computing invested capital.
3. Due to an improper accounting system known as the completed-contract method, the reporting of profits has been delayed one year, with a consequent reduction of surplus, but it is now impossible to reconstruct a proper surplus on a proper accrual basis.
4. The bookkeeping system has resulted in certain abnormalities such as (a) the deferring and shifting of income, (b) the inflation of current income caused by an incorrect method in the stock steel account, and (c) inaccuracy in income due to the absence of a proper work in process inventory.
The petitioner claims that it received valuable assets in 1896 from the partnership of Straub and Blickle which have not been considered in computing its*1643 invested capital. Good will, contracts, plant leases and equipment are mentioned in this connection. These assets were not turned in for stock or shares and must come into invested capital, if at all, as surplus. But had this young firm any good will? Had the good will, the contracts, the lease, and the equipment any value when turned in? If they had, why can not that value be determined and included in invested capital? Special assessment is not to be applied where the petitioner does not exhaust reasonable means to show its true invested capital. . Both partners were witnesses, yet these assets were not shown to have had any value. On the contrary, there is evidence that they had no particular value. Furthermore, if they had value, it must have been translated into profits in the intervening twenty years and thus reflected in invested capital by 1917 through earned surplus under the petitioner's method of accounting.
*640 A great number of old designs, drawings, and patterns were in the possession of the petitioner during the years involved in this proceeding. Each of these had been made for the purpose*1644 of some particular contract in years gone by and the cost had been charged to expense. The actual cost of those prepared prior to 1906 can not be accurately determined at this time. The petitioner contends that all or some indeterminable part of these designs, drawings, and patterns were capital assets; they cost approximately $1,100,000; they have suffered little depreciation or obsolescence; and some part of their cost should but now can not be reflected in invested capital.
We do not agree that any part of the cost of these designs, drawings and patterns was ever a proper item to be set up as a capital account in the petitioner's business. The testimony shows that the petitioner referred to and made use of some of these drawings in various ways after the completion of the job for which they were prepared. We do not know how many were thus used or how valuable they were for these purposes, but it is quite apparent that in the petitioner's business the principal use made of each design, drawing, and pattern and the principal value of each was in connection with the job for which it was made. After that, further use was problematical and uncertain and their principal value*1645 was exhausted. They should not be carried as an asset at their cost in a proper system of accounting for this business. This is particularly true here where the drawings and patterns had been paid for by the customers.
Every new contract requires the preparation of designs, drawings and sometimes patterns. Materials have to be applied in different ways. The draftsman and the pattern maker must give expression to the peculiarities of the particular job. No set of drawings, no design, and no pattern can be prepared with the idea or assurance of future or continued use in the business after the job is completed for which it was first prepared. At least the evidence indicates the truth of the above statement. The situation is unlike that of a plant turning out a more staple product. Cf. ; . Out of the many thousands of old drawings on hand, the petitioner used only 159 in the three years before us in extending old work. The use of old patterns was even less and they had to be altered for such use as they were put to. In addition to the above, some undisclosed number of the*1646 old designs and drawings were used for reference in current work. They no doubt had some value for this purpose. But we can not tell from the record the extent of this use or the value which the drawings had for this purpose except that it was not great in proportion to the value of the drawings incident to the contracts for which they were originally prepared.
*641 The question of whether or not designs, drawings, and patterns should be charged to expense or capitalized depends, in each case, upon the nature of the particular business and the use to which they are put in that business. The experience of the company and the judgment of those in charge are important factors. The petitioner's practice creates a reasonable inference that it thought the cost should be charged to expense, it still uses that method, and the Commissioner has approved it. Furthermore, we believe it did quite right in charging the entire cost of these items to expense. ; ; *1647 ; . The case is distinguishable from such cases as , where inability to allocate an expenditure between capital and expense was the ground for special assessment. Here the expense characteristics so predominate and the capital features are so uncertain and relatively unimportant that the whole may be charged to expense with propriety. Cost of patterns and drawings was but a small part of the cost of goods sold in the years before us. The possession of the old drawings was not a substantial income-producing factor. This item does not constitute an abnormality. Furthermore, all similar concerns may have been in the same situation for all we know. Cf. .
The accounting system employed by the petitioner is the completed-contract system. It is a modification of a strict accrual method and differs in the one respect that items of income and expense, though recorded in primary accounts when accrued or incurred, are not carried into profit and loss as earnings*1648 of the business until the contract to which they relate is completed. A separate account is kept for each contract. Any debit balance in the amount represents the investment in the contract and any credit balance represents unearned income until the completion of the contract. A characteristic of this system is that income earned in one accounting period may not be accounted for until a later period. It is peculiarly adapted to a business fulfilling contracts which lap over accounting periods where the ultimate gain or loss can not be accurately determined until the completion of the contract. It may be used even though the contracts call for payment on the basis of a certain price per pound. The contracts need not run for more than a year. The Commissioner's regulations permit its use. It has been approved, for tax purposes, by the courts and by this Board. ; ;; ; *1649 ; affd., . Its use is no reason for *642 special assessment. Furthermore, we do not know what the petitioner's income would amount to on any other basis and without the net income the tax could not be computed under the special assessment sections.
For about 35 years the petitioner has consistently kept its books on this system. Its business has been extensive and successful. Competition has no doubt been keen. The bookeeping system has been advantageous, adequate, and satisfactory to the petitioner. It is still in use. The Commissioner approves of it too. But the petitioner now claims in respect to a short period, when income was large and taxes were exceptionally high, that the system was antiquated, inaccurate, and improper for profits-tax purposes. The principal support for this claim comes from the testimony of an accountant who apparently was employed for the purpose of this case only and first attacked the system. His figures are accurate enough, but we disagree with most of his conclusions, and we think there is some reasonable explanation of certain "defects" which he has*1650 sought to prove. For example, according to his testimony, the stock steel account was hopelessly inaccurate and improper from an accounting standpoint; it contained arbitrary adjustments; it was forced to balance; and the average price at which steel was charged out to contracts exceeded the average at which steel was carried in this amount, thus inflating income for the current year. He was content merely to disclose these phenomena without attempting any explanation. Averages are frequently puzzling and meaningless. Here apparently, steel was charged to contracts at about the current price as disclosed by recent purchases. Officers of the corporation were present when this witness gave his deposition. The books were there. These intelligent officers were responsible for and familiar with the entries in this amount. We have no doubt that they could have explained them. Special assessment is not gained except by a full disclosure of the facts so that it satisfactorily appears that there is an abnormality or that invested capital can not be determined.
Another alleged defect in the accounting system is that it provided no inventory of work in process at the end of the year. *1651 This contention seems to conflict with that made above, because without such inventory it is difficult to see how the current income could be inflated by excessive charges to contracts. However, the failure to inventory work in process leads nowhere, since such an inventory is not necessary under the method of accounting employed by the petitioner. The method clearly reflects income without it and hence this is no ground for special assessment.
*643 Considering the petitioner's contentions separately and collectively, we can see therein no cause for applying the special assessment provisions of either act here applicable.
The petitioner contends, in connection with the second issue, that $53,500 of the total of $125,000 mentioned in the contract of July 21, 1917, with the Firestone Company was paid to it in cash in 1917 as damages for breach of the earlier contract and was erroneously reported as income in 1918 instead of in 1917. In 1918, when the contract was completed, $75,748.52 was reported as the profit on the contract. In support of this contention it claims that the original contract was for approximately 3,700 tons of fabricated steel, on which it expected*1652 to make a profit of $54,094, or about $15 a ton. Even if these figures were correct, there would be some reduction of the damages on account of the steel delivered under the later contract. But the evidence, although conflicting, shows that the tonnage contracted for originally amounted to only 2,500 tons. Two thousand tons of this were canceled. Five hundred tons were contracted for under the final adjustment contract of July 21, 1917. Furthermore, there is evidence that the estimated profit on the original contract was only $13.60 a ton, or .68 of a cent per pound. Counsel for the petitioner argue that the contract of July 21, 1917, called for only 500 tons of steel. In so doing they overlook the fact that the agreement calls for "all grillage and in addition approximately Five Hundred (500) tons of structural steel." The petitioner's offer of the same date stated, "we will furnish you the fabricated grillage * * * and also an additional tonnage amounting to 500 tons." It also stated that the petitioner would erect the 500 tons for a certain amount, but the Firestone Company was to erect the grillage. Thus, it is clear that two products were contracted for, 500 tons of steel*1653 and an undisclosed amount of grillage. We can not tell from the record how much steel or grillage was actually furnished, or the price at which the latter was furnished. The petitioner's offer of July 21, 1917, mentions "fabricated" grillage and "additional" tonnage. These terms may mean that the grillage had already been fabricated before work ceased on the original contract. Perhaps costs incident to the original contract have been carried forward into 1918.
We are satisfied that the "lump sum" of $125,000 should not be divided into $71,500 for 500 tons of steel at 7.15 cents per pound and $53,500 for damages for breach of the prior contract. This leaves nothing for the grillage. The record indicates that damages in some amount were paid under the contract of July 21, 1917, but we can not say that the amount was in excess of $27,200 (2,000 tons at a *644 profit of $13.60 per ton). It may have been less, depending upon the price of the grillage. This really disposes of the question, for, even if this amount were shifted from 1918 to 1917, the deficiencies would not be wiped out. It does not appear, however, that any amount should be shifted to income of 1917. The*1654 contract was for a lump sum. The petitioner's method of bookkeeping and of reporting income treated the contract as a whole. The profit was all accounted for and reported in 1918, when the contract was completed. At the end of 1917 the books showed a credit balance in the contract account of only $21,030.56 and the contract uncompleted. We think that the income as reported should not be disturbed in this connection.
The third issue relates to whether or not a profit of $161,091.29 should be taxed as provided in section 301(c) of the Revenue Act of 1918. It is conceded that the amount of this profit is correct and that it was properly reported in income for the taxable year 1919. Section 301 is in part as follows:
(c) For the taxable year 1919 and each taxable year thereafter there shall be levied, collected, and paid upon the net income of every corporation which dervices in such year a net income of more than $10,000 from any Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive, a tax equal to the sum of the following:
(1) Such a portion of a tax computed at the rates specified in subdivision (a) as the part of the net*1655 income attributable to such Government contract or contracts bears to the entire net income. In computing such tax the excess-profits credit and the war-profits credit applicable to the taxable year shall be used.
The contract for the fabrication of material for the construction of 21 hangers was a Government contract made between April 6, 1917, and November 11, 1918. The income eventually realized from furnishing the 16 hangars and certain material was derived in the year 1919 and was more than $10,000. Was it derived from or attributable to the Government contract relating to 21 hangars? This is the only question on this issue. The petitioner contends that the contract for 21 hangars was canceled by the Government through the telegram of November 12, 1918; the orders for the 16 hangars and the miscellaneous material were new contracts distinct from the old and accepted by the petitioner on that basis; therefore, the gain was derived from the latter contracts and is not taxable as provided in the above quoted section. However, it nowhere appears that the petitioner ever agreed to allow the Government to cancel the contract for the 21 hangars or indicated that it would make*1656 no claim for damages in case the Government refused to take and pay for the material already fabricated. Considering all of the circumstances, we do not think that the telegram referred to served to *645 rescind the original contract. See Willston on Contracts, section 1826; ; . This is true even though the petitioner's letter dated November 14, 1918, acknowledging receipt of the telegram stated: "We will make up a statement of cancellation charges and advise you later." Two days later the petitioner received assurance that the Government did not care to cancel the contract, but merely desired to save additional expense by having all work cease, and the petitioner learned in that same letter that there was great likelihood that the Government could eventually use the hangars. Shortly thereafter, the Government notified the petitioner to ship certain of the material originally fabricated for the 21 hangars, and in less than two months after the armistice it had directed the petitioner to ship 16*1657 hangars and certain miscellaneous material. All of this material was to be shipped from material already fabricated on Order No. 50,263 which was ordered for the construction of 21 hangars "110 X 160." The price was that originally agreed upon, in other words, the war-contract price. The total length of the 16 hangars finally taken by the Government was greater than the length of 19 1/2 of the hangars originally ordered. Thus, the petitioner failed to deliver the material for less than 1 1/2 hangars, and, so far as we know, this material had never been fabricated. The evidence does not indicate that the orders for the 16 hangars were new contracts separate from the earlier war contract, but, on the contrary, it strongly indicates that the Government, under the war contract, was taking certain fabricated material which it needed and was under obligation to pay for. The material and the price were the same as that provided for in the war contract, so that the source of the gains was in the original war contract. The gain must be regarded as income derived from or attributable to that contract. The petitioner cites *1658 , but we think ; ; , affirmed on this issue in , are cases more in point.
Reviewed by the Board.
Judgments of no deficiency and no overpayment will be entered.
MCMAHON did not participate in deciding this proceeding after the hearing had in the first instance.
Footnotes
1. Government contracts excluded. ↩