*3934 1. If the petitioner's predecessor were still in existence, its invested capital could not reflect any greater amount on account of good will built up by it than the cost of that good will and therefore, since section 331 of the Revenue Act of 1918 applies, the petitioner's invested capital can not reflect any greater amount on account of this same good will than the cost of that good will to the predecessor.
2. Patents, or rights to patents, paid for by a royalty measured by the profits from articles manufactured under the patents during each year, can not affect invested capital of the manufacturer which pays the royalty.
3. Commissioner's disallowance of a deduction for exhaustion approved.
*1202 The taxes in controversy are income and profits taxes for the calendar years 1918 and 1920, in the respective amounts of $11,973.70 and $18,385.76. Errors are alleged as follows:
(a) The Commissioner has reduced taxpayer's invested capital for each of the tax years 1918 and 1920, by the sum of*3935 $165,155.50, on the ground that the same represents intangibles of no value.
(b) The Commissioner has failed to allow as part of taxpayer's invested capital for the tax years 1918 and 1920, the value of certain valuable patents which taxpayer then owned and employed in its business.
*1203 (c) The Commissioner has failed to allow a reasonable amount of depreciation on the said patents as a deduction from gross income in the years 1918 and 1920.
FINDINGS OF FACT.
The Rome Merchant Iron Mill was incorporated under the laws of New York State on July 10, 1868, for a term of existence of fifty years. It immediately began business at Rome, New York, and continued this business until sometime in the month of April, 1917, when the corporation was dissolved by the voluntary consent of its stockholders.
Originally, the capital stock of the organization was of the par value of $75,000. At the beginning of 1870, the authorized capital stock was increased to $135,000 par value. In 1884 the 1,350 shares representing $135,000 par value of the stock were called in and the company issued 850 consolidated shares of the par value of $100 each, thus reducing the capital stock to*3936 $85,000 par value.
On June 30, 1884, the corporation showed on its balance sheet a surplus of $78,521.86. On its next balance sheet, that of June 30, 1885, the corporation showed capital stock in the amount of $85,000 and a surplus of $141,128.99, which included $50,000, the reduction in the par value of the capital stock above referred to.
Thereafter and up to January 1, 1911, the corporation showed a profit on its books for each year's business. Its practice was to charge amounts expended for construction, maintenance and repair to expense.
On January 1, 1911, the profit and loss account of the corporation showed a surplus balance of $234,011.44, after deduction of dividends declared up to that date. From the year 1884 up to January 1, 1911, dividends were charged off the profit and loss account in the following amounts:
| Year | Amount |
| 1884 | |
| 1885 | |
| 1886 | $2,550 |
| 1887 | 5,100 |
| 1888 | 52,640 |
| 1889 | 45,050 |
| 1890 | 85,000 |
| 1891 | 72,250 |
| 1892 | 55,250 |
| 1893 | 85,000 |
| 1894 | $59,500 |
| 1895 | 17,000 |
| 1896 | 29,750 |
| 1897 | 17,000 |
| 1898 | 29,750 |
| 1899 | 12,750 |
| 1900 | 85,000 |
| 1901 | 46,750 |
| 1902 | 42,500 |
| 1903 | 34,000 |
| 1904 | $72,250 |
| 1905 | 8,500 |
| 1906 | 59,500 |
| 1907 | 55,250 |
| 1908 | 25,500 |
| 1909 | 38,250 |
| 1910 | 85,000 |
| 1911 |
*3937 On April 1, 1911, there was a complete change in the ownership of the capital stock of the corporation. The new owners increased the authorized capital stock of the corporation from $85,000 to $350,000 par value, and in connection with this increase the minutes *1204 show that at a stockholders' meeting on April 5, 1911, the following took place:
Mr. Flodine presented the following resolutions for increase of capital stock and its disposition to be incorporated in the minutes and it was so ordered:
Whereas, the value of the assets of Rome Merchant Iron Mill, exceeds the par value of the present capital stock of Eighty-five Thousand Dollars, by more than One Hundred and Fifteen Thousand Dollars, making a total value of Two Hundred Thousand Dollars; and
Whereas, the stockholders have unanimously consented and agreed to increase the capital stock to Three Hundred and Fifty Thousand, divided into Thirty Five Hundred shares:
Resolved, that when the capital stock is increased, One Hundred and Fifteen Thousand Dollars thereof, or, Eleven Hundred and Fifty shares, be divided and distributed ratably among the holders of the stock in proportion to their present holdings, and*3938 that the balance of said increased stock, or, One Hundred and Fifty Thousand Dollars, divided into Fifteen Hundred shares, be sold by the Directors, at not less than the par value.
The minutes also show that at a special meeting of the board of directors on May 11, 1911, the following motion was duly made, seconded, and unanimously carried:
WHEREAS, at a meeting held at the office of Mr. J. S. Coffin at 30 Church Street on April 5th, 1911, at 2:30 P.M., the Stock Holders of the Rome Merchant Iron Mill did unanimously consent to the increase of the capital stock of the said company from $135,000 to $350,000 and did authorize the declaration of a stock dividend equal to the Company's present surplus (i.e. $115,000).
AND WHEREAS, the said increase has been duly authorized by the Secretary of the State of New York.
Now IT IS RESOLVED that a stock dividend of $115,000 be and hereby is declared and the proper officers are authorized and directed to issue the same pro rata and without further consideration to stockholders of record as of May 12th, 1911.
There was spread upon the minutes of a meeting of the board of directors on August 2, 1911, the following financial statement*3939 as of July 1, 1911:
| ASSETS | |||
| Cash on hand and in banks | $39,836.58 | ||
| Accounts receivable | 27,341.97 | ||
| Bills receivable | 12,000.00 | ||
| Inventory, as follows: | |||
| Finished product | $8,155.56 | ||
| Semi-finished product | 32,678.75 | ||
| Stock of materials | 21,304.77 | ||
| 62,139.08 | |||
| Insurance and taxes | 352.73 | ||
| Office furniture and fixtures | 286.70 | ||
| Building improvements | 677.54 | ||
| New rolls | 740.30 | ||
| Miscellaneous property | 940.11 | ||
| Machinery and equipment | 1,374.75 | ||
| Plant | 300,000.00 | ||
| $445,689.76 |
| LIABILITIES | |||
| Accounts payable | $9,298.70 | ||
| Jim Stevens | 25,066.10 | ||
| E. M. Zehnder | 1,250.00 | ||
| Mortgage | 95,000.00 | ||
| Capital stock issued | 310,050.00 | ||
| $440,664.80 | |||
| Net earnings for the period | 5,024.96 | ||
| 445,689.76 |
The $150,000 par value of capital stock to be sold, mentioned in the above resolution of April 5, 1911, was sold for cash at par between April 5, 1911, and May 20, 1912. On July 1, 1911, capital stock of the par value of $310,000 was issued and outstanding. On December 31, 1911, $335,050 par value of capital stock was issued and outstanding.
Thereafter, the authorized capital stock of the Rome*3940 Merchant Iron Mill was increased to $500,000 and the additional $150,000 par value of the capital stock was sold for cash at par, so that at the time of its dissolution the corporation had authorized and outstanding capital stock of the par value of $500,000, divided into 5,000 shares.
The corporation's statement of its assets and liabilities on April 30, 1917, was as follows:
| Assets | ||
| Cash | $58,925.39 | |
| Accounts receivable | 179,429.54 | |
| Bills receivable | 11,000.00 | |
| Stock material | 89,172.18 | |
| Manufactured stock | 115,092.14 | |
| Stores | 10,911.32 | |
| $464,530.57 | ||
| Contracts, good will, and trade names | 165,155.50 | |
| Property | 419,180.50 | |
| Improvements | 7,598.28 | |
| Horses and wagons | 1,075.00 | |
| Office furniture and fixtures | 2,058.75 | |
| Insurance | 976.82 | |
| Water | 93.95 | |
| Demurrage | 71.79 | |
| Reserve for extraordinary maintenance | 8,830.84 | |
| Reserve for bond and extraordinary interest | 1,734.61 | |
| Reserve for organization expense | 1,700.00 | |
| Reserve for surety bond | 80.20 | |
| Patents | 2,168.92 | |
| Investments | 1.00 | |
| Sundry prepayments | 417.07 | |
| Claims | 660.94 | |
| 1,076,334.74 |
| Liabilities | ||
| Capital stock | $500,000.00 | |
| Mortgages | 65,000.00 | |
| Accounts payable | 53,768.97 | |
| Bills payable | 185,000.00 | |
| $803,768.97 | ||
| Taxes | 1,280.00 | |
| Legal expense | 55.00 | |
| Liability insurance | 1,133.90 | |
| Reserve for auditing | 800.00 | |
| Reserve for income tax | 2,129.67 | |
| Reserve for inventory adjustment | 922.74 | |
| Undivided earnings | 261,144.70 | |
| Commissions | 5,099.76 | |
| 1,076,334.74 |
*3941 The petitioner was incorporated under the laws of the State of New York, in April, 1917, with an authorized capital stock of $2,000,000, divided into 20,000 shares of the par value of $100 each. Its principal office is in New York City. As of April 30, 1917, it acquired the assets subject to the liabilities of the Rome Merchant Iron Mill, and as consideration therefor issued 15,000 shares of its capital stock to the former stockholders of the Rome Merchant Iron Mill in proportion to their stock holdings in that corporation.
On September 28, 1917, the authorized capital stock of the petitioner was changed from $2,000,000, divided into 20,000 shares of the par value of $100, to 20,000 shares without nominal or par value, and the 15,000 par value shares issued as aforesaid were called in and canceled and the nonpar stock issued in their stead, share for share.
On July 13, 1913, the board of directors of Rome Merchant Iron Mills passed a resolution to open an account under the name of "Contracts, Good Will, and Trade Names" as of June 30, 1913, in the amount of $375,000. On that corporation's statement of accounts as of December 31, 1914, under capital assets there appeared*3942 the following item:
| Contracts, good will, and trade names as at January 1, 1914 | $375,000.00 |
| Loss: Amount charged off by transfer of surplus a/c | 209,844.50 |
| 165,155.50 |
On subsequent statements this item appeared as an asset in the amount of $165,155.50. In statements of the petitioner it was always called "Patents" instead of "Contracts, Good Will, and Trade Names." On the petitioner's statement of December 31, 1918, the following appeared:
| Capital assets: | |
| Patents | $165,155.50 |
| Less: Reserve for depreciation | 10,735.11 |
| 154,420.39 |
*1207 Thereafter the item always appeared as "Patents - 165,155.50."
The Rome Merchant Iron Mill had at all times enjoyed a good reputation in the trade. Its product was high grade and was used extensively by locomotive manufacturers and by wagon and carriage manufacturers. It established certain brands and systematically advertised these brands in trade journals.
From 1915 to 1926, both years inclusive, the two companies spent over $80,000 for advertising. During this time the amount spent in any one year did not vary materially from the amount spent in any other year.
On the return filed by the*3943 petitioner for the taxable year 1918, in Schedule A, as a deduction opposite "18. Exhaustion, wear, and tear (including obsolescence) (from Schedule A 18)," the figure "68,010.30" appears. There was no Schedule A 18 attached to the return for 1918 when introduced in evidence in this case. On the return filed by the petitioner for the taxable year 1920, in Schedule A, as a deduction opposite "18. Exhaustion, wear, and tear (including obsolescence) (from Schedule A 18)," the figure "72,357.22" appears. There was no Schedule A 18 attached to the return for 1920 when introduced in evidence in this case. Attached to the 1919 return, which was introduced in evidence in this case, the following appears under Schedule A 18:
A-18:
| Amount of depreciation charged off | |||||
| Kind of property. (If buildings state the material of which constructed) | Date acquired | Cost or fair market value as at Mar. 1, 1913, if acquired prior thereto | Probable life after acquirement | This year | Previous years |
| Buildings and equipment | May 1, 1917 | $422,314.25 | $37,512.03 | $60,325.13 | |
| Patents | do | 165,155.50 | 5 to 33 years. | 10,735.11 | 10,735.11 |
| Obsolescence | do | 21,347.07 | 20,833.03 | ||
| Total | 587,469.75 | 69,594.21 | 91,893.27 |
*3944 In 1916 the superintendent of the Rome Merchant Iron Mill made application for patents on two inventions relating to the design and manufacture of hollow iron. While the applications were pending he entered into an agreement with the Rome Merchant Iron Mill transferring to it all of his rights, title and interest in and to the said inventions in consideration of which the corporation agreed to pay him, his heirs or assigns, after the issue of the letters patent, an amount equal to 10 per cent of the net profit accruing to the company from the manufacture in the United States of hollow stay bolt iron manufactured under the patents, such net profit not to exceed $20,000 in any one year. The payments were to continue only *1208 during the life of the patents. All costs and expenses theretofore incurred or thereafter to be incurred in connection with securing or protecting the patents were to be deducted as part of the cost of manufacture in determining the net profits out of which the 10 per cent was to be paid. On April 30, 1917, the petitioner succeeded to the rights and liabilities of the Rome Merchant Iron Mill under this agreement.
In September , 1916, the Rome Merchant*3945 Iron Mill had authorized the expenditure of a total of $4,000 for the purpose of carrying on experiments in the making of hollow stay bolt iron and on October 24, 1916, its board of directors authorized the expenditure of "$40,000 for the purpose of erecting a structure, building a furnace therein, and securing and setting up the necessary machinery, etc. for the making of hollow stay bolt iron." Up to April 30, 1917, no one connected with the company knew what these inventions and applications for patents thereon were worth.
The two patents above mentioned were granted on the 3rd day of July, 1917. Thereafter, up to 1921, royalties were paid to the inventor by the petitioner as follows:
| 1917 | $12,439.19 |
| 1918 | 3,538.63 |
| 1919 | |
| 1920 | 2,128.66 |
| 18,106.48 |
In the calculation of the net profits on which these royalties were paid, Federal income and profits taxes were not considered as an expense of the business.
The Rome Merchant Iron Mill did not enter any amount upon its books to represent the value of these applications for patents. Nor did the petitioner at the time it acquired the assets of the Rome Merchant Iron Mill enter any amount on its books to represent*3946 their value.
The Commissioner computed the petitioner's invested capital for the year 1918, as follows:
| Invested capital | |||
| Capital stock | $500,000.00 | ||
| Surplus as shown in R.A. R | $171,502.13 | ||
| Adjustment for depreciation in prior years | 54,038.28 | ||
| 225,540.41 | |||
| Reserve for income tax | 37,579.85 | ||
| Total | 763,120.26 | ||
| Add: | |||
| Sale of stock | 16,666.65 | ||
| March 19, 1918, prorated for 288 days | 13,150.67 | ||
| 776,270.93 |
| Deduct: | |||
| Income tax for period May 1, 1917, to Dec. 31, 1917, $58,735.21, prorated for 200 days | $32,183.68 | ||
| Additional for period ended Apr. 30, 1917, not reflected in surplus - | |||
| Tax due | $2,616.09 | ||
| Tax paid | 1,833.59 | ||
| 782.50 | |||
| Additional depreciation allowed 1917 | 5,861.78 | ||
| $38,827.96 | |||
| Adjusted invested capital before deducting inadmissibles | 737,442.97 | ||
| Inadmissibles | .72 | ||
| Adjusted invested capital | 737,442.25 |
The Commissioner computed the petitioner's invested capital for the year 1920, as follows:
| Adjustments to invested capital | ||
| Capital stock | $516,666.65 | |
| Surplus, revenue agent's report | $185,081.49 | |
| Depreciation adjustment, prior years | 54,038.28 | |
| 239,119.77 | ||
| Reserves | 46,558.25 | |
| Total | 802,344.67 | |
| Additions: | ||
| Payment due period ended Apr. 30, 1917 | 782.50 | |
| Payment due period ended Dec. 31, 1917 | 27,238.94 | |
| Additional tax for 1918 | 11,973.70 | |
| 39,995.14 | ||
| Amount used by agent in balance sheet | 42,413.78 | |
| Corrections to adjustments for additional taxes prior years | 2,418.64 | |
| Total | 804,763.31 | |
| Deductions: Additional depreciation allowed 1917 to 1919, inclusive | 11,211.42 | |
| 793,551.89 | ||
| Less: Inadmissibles per cent, 0.000001016 | .81 | |
| Invested capital adjusted | 793,551.08 |
*3947 The deficiency notice states that for the year 1918, "the calculations set forth in Bureau letter dated May 28, 1925, are sustained." Attached to the Bureau letter of May 28, 1925, is a statement which sets forth among other things the following:
| Computation of tax | ||
| Net income shown in R.A. R | $139,677.15 | |
| Less: | ||
| Additional depreciation - | ||
| Amount claimed | $39,125.31 | |
| Allowed in R.A. R | 36,442.16 | |
| 2,683.15 | ||
| Adjusted net income | 136,994.00 |
*1210 OPINION.
MURDOCK: In its brief the petitioner states that the petitioner raised the point that the Commissioner has not made a proper allowance for invested capital because "the difference between surplus on January 1, 1911 ($234,011.44) and $115,000 capital stock issued and distributed as a stock dividend and by error not thereafter reflected on the books of the company, to wit: the sum of $119,011.44 was not allowed." We have set forth verbatim in our opening statement the allegations of error contained in the petition, and it is apparent that they do not raise any such point as is claimed in the brief. Neither are any facts alleged in the petition to support an error of this kind. The petition*3948 has never been amended. We are unable to tell from the deficiency notice or from the evidence whether or not the Commissioner has taken into account the amount of $119,011.44 in his computation of invested capital for the years before us so that the issue has not been properly raised, and even if it had been properly raised, we do not know what the Commissioner has done. Furthermore, the evidence does not show that $119,011.44 should be included in the petitioner's invested capital for the years in question. If the Rome Merchant Iron Mill had a real surplus of $119,011.44 which was erroneously wiped off its books, there might be merit in this contention of the petitioner, but there is nothing in the evidence to indicate that any real surplus was eliminated from the books. The resolutions which we have set out in our findings of fact indicate only that there was sufficient surplus to take care of the stock dividend and no more. Surplus in excess of this amount theretofore carried would seem to have been deliberately written off the books by the new owners of the company. If it were true, as the petitioner contends, that the Rome Merchant Iron Mill had a surplus of $119,011.44*3949 after the declaration of its stock dividend of $115,000, then the 1,500 shares thereafter offered for sale would have had a value of about $134 each. Yet we know that this stock was offered for sale at par and even at par was not all sold until about a year had elapsed. We think that the weight of the evidence indicates that the Rome Merchant Iron Mill had no real surplus in excess of the $115,000 stock dividend which it declared and we know of no reason to make any change in the Commissioner's determination as to this item.
The first error assigned is that the petitioner's invested capital for each of the years 1918 and 1920, has been reduced by the Commissioner in the amount of $165,155.50, on the ground that the amount represents intangibles of no value. The Commissioner has never indicated or admitted that he made such a reduction and the petitioner has failed to prove that such a reduction was in fact made. The same can be said in regard to the other two errors alleged. So *1211 far as we know the questions before us may be merely moot questions which we need not answer.
The petitioner claims that it had an asset of good will worth $165,155.50, or, at least, *3950 $150,123.53, which the Commissioner eliminated from his calculation of the petitioner's invested capital. The petitioner further claims that it had two patents worth $150,284.96, which the Commissioner eliminated from his calculation of the petitioner's invested capital and on which he allowed no deduction for exhaustion. We have just pointed out that we do not know what the Commissioner did in regard to these two alleged assets, but were we to assume that he did what the petitioner claims he did, we can not say that his action was erroneous.
There is an allegation in the petition that the item called "Contracts, Good Will and Trade Names" in the amount of $165,155,50, represents good will only. This allegation was admitted in the answer. And yet on the books and statements of the petitioner this item was always called "Patents" and, in relation to this so-called patent asset, depreciation has been deducted by the petitioner on its financial statements, and deductions for depreciation have been claimed on its returns. Despite these deductions later statements still include $165,155.50 as the value of the assets. We are unable to reconcile the admitted allegation with the other*3951 evidence. It would seem that the petitioner has proven error in its own allegation and that the $165,155.50 item really represents, not good will but patents. If the item represents patents, the value of which became less each year, it is paradoxical to claim that the value remained the same year after year. The two items of good will and patents have been so confused that we are unable to understand what claims have been made in the returns as to each, what allowances have been made on those claims, and what should have been allowed.
The petitioner does not contend that the Commissioner should have allowed a greater amount in invested capital on account of cash or property paid in for stock or shares, but contends that the error occurred in the computation of earned surplus and undivided profits. Only parts of the Commissioner's computations of the petitioner's invested capital for 1918 and 1920 are before us. In each, an item appears identified as surplus shown by the revenue agent's report. This report is not before us and we do not know what the surplus as terein shown reflected. The petitioner admits being a corporation resulting from the reorganization of a predecessor*3952 in which the control of the business remained in the same persons and which, under section 331 of the Revenue Act of 1918, is entitled for invested capital purposes to no greater value of the assets transferred than the predecessor corporation would have been entitled to, but claims that the predecessor, if in existence during the taxable years, would *1212 have been entitled to include in its invested capital an amount representing the value of its good will at the beginning of each year, and an amount representing the value of the patents at the time they were acquired. The argument of the petitioner is that the Revenue Act of 1917, in section 207, specifically recognized good will as earned surplus, but made an unjust proviso that the good will of a corporation could only be included in invested capital if it had been paid for in cash, tangible property, or shares; that the Revenue Act of 1918 rectified this injustice in section 326(a)(3) by using the words of section 207 of the 1917 Act to describe what may be included in invested capital, but omitting the proviso; that under the 1918 Act, earned good will constituted earned surplus, otherwise the words "earned surplus" *3953 would have no meaning in the Act, inasmuch as the words "undivided profits" take care of other earnings of a corporation.
If such were the intent of Congress, good will and other assets would have to be revalued each year. We do not agree that Congress so intended. The Supreme Court of the United States in , held that under the 1917 Act, no annual revaluation of assets for invested capital was intended, and we think that the same reasoning applies to the 1918 Act, despite the fact that it does not contain the proviso mentioned. Good will of the Rome Merchant Iron Mill should not be reflected in its invested capital in an amount exceeding the cost of that good will. No satisfactory evidence of this cost was introduced. We can not conclude that the cost of advertising was the equivalent of the cost of good will. An unknown portion of the cost of advertising, which we are unable to segregate, may have been allocable to current expense. . Likewise, the depreciated cost, or the unexhausted portion of the cost of patents might under some circumstances*3954 be reflected in invested capital, inasmuch as in the assets of the purchaser the patents take the place of the money which was paid for them. But in this case the purchaser of the patents was to pay for them on a royalty basis and the royalties to be paid would be ordinary and necessary expenses of the business for the year in which paid, and the patents purchased would not take the place of an asset represented by the money paid for them; because the part paid for had been exhausted during the year; so it is difficult to see how their cost could ever be reflected in invested capital.
The petitioner is entitled to a deduction for exhaustion of a portion of the cost to it of the rights to the inventions or to the patents. It happens in this case that the petitioner exchanged its stock for the assets of a predecessor corporation so that the cost to the petitioner of the assets acquired was the value of the assets acquired, since the *1213 stock had the same value as the assets. Included among the assets acquired were the rights to the inventions or to the patents in question. To determine the cost of this particular asset we would have to know among other things its actual*3955 cash value at the time acquired by the petitioner. This value is not measured by the royalties to be paid, but is rather the value of the asset to the petitioner over and above the royalties to be paid by the petitioner. The evidence shows that no one knew what that value was and on the evidence before us we are unable to determine what it was. The patents were not granted until July 3, 1917, and the agreement provided that from that date a percentage was to be paid to the inventor, so we do not know any earnings prior to that date. The petitioner in later years derived profits as a result of the rights which it then acquired, but we are at a complete loss to say to what extent those profits reasonably could have been or were foreseen at the date the petitioner acquired the rights. The evidence would seem to indicate that for 1918 the petitioner claimed and was allowed exhaustion on these patents. For 1920 we can not tell what was allowed. For neither year can we say that the action of the Commissioner was erroneous.
Judgment will be entered for the respondent.