*3329 1. From the evidence, held that $25,000 paid at the beginning of a lease in adjustment of the liability for the restoration of alterations to the leased premises is a capital expenditure, which is properly exhaustible over the life of the lease or the life of the building, whichever is shorter.
2. Additional construction costs incurred solely for the purpose of obtaining early occupancy of a building should be exhausted over the life of the building.
3. From the evidence, held that petitioners sustained a loss on the sale of certain stock in the fiscal year ended January 31, 1921.
*1 In these proceedings, which have been consolidated for hearing and opinion, the petitioners seek a redetermination of their income and profits taxes for the fiscal years ended January 31, 1919, to January 31, 1921, inclusive, for which years the respondent has determined deficiencies as follows:
| Frank & Seder Co., January 31, 1919 | $27,726.07 |
| Frank & Seder (Inc.), January 31, 1919 | 28,354.14 |
| January 31, 1920 | 31,909.86 |
| January 31, 1921 | 44,209.41 |
*3330 The respondent, by his answer, has admitted that Frank & Seder Co., of Philadelphia, and Frank & Seder, Inc., of Pittsburgh, are affiliated.
There remain the following questions:
1. Whether an obligation in the sum of $25,000 incurred by Frank & Seder Co. to its Philadelphia landlord in the fiscal year 1919, of *2 which $5,000 was paid to that landlord in that year and the remainder in the amount of $20,000 paid in the succeeding year, was a capital payment or a deductible expenditure, and if a deductible expenditure, whether the entire $25,000 should be deducted in the year ended January 31, 1919, or whether $5,000 thereof should be deducted in that year and the remaining $20,000 in the following fiscal year.
2. Whether certain payments made by the petitioners in the fiscal year ended January 31, 1919, in connection with the erection of its new building in Pittsburgh after a fire had destroyed the old building, were capital items or deductible expenses.
3. Whether a loss suffered by Frank & Seder, Inc., in the fiscal year ended January 31, 1921, on the sale of certain stock should be deducted.
4. Whether the amount of the deduction from invested capital*3331 of Frank & Seder, Inc., for inadmissible assets for the fiscal year ended January 31, 1921, was overstated by the respondent.
FINDINGS OF FACT.
The petitioners herein are both Pennsylvania corporations. The respondent has admitted that they were affiliated for the years under consideration.
In 1917 the Frank & Seder Co., which operated a department store, was in occupancy of the premises at 1033 Market Street, Philadelphia, under a sublease expiring on December 31, 1918. This lease contained a provision that the lessees should not make any alterations, improvements or additions to said premises, other than those specified in the plans and specifications previously agreed upon, without first obtaining the consent in writing from the lessor.
The alterations authorized in the plans and specifications did not include the right to remove either the east wall or the north wall of said premises.
A new lease between the lessors and the Frank & Seder Co. was entered into on February 13, 1917, whereby the premises were again leased for a term of nine years, commencing on January 1, 1919, for an annual rental of $26,875, and this lease provided for the removal of the east wall. *3332 The lessee furnished a bond in the sum of $5,000, conditioned upon the restoration of the said east wall at the expiration of the lease.
Subsequent to the making of the last mentioned lease, the petitioner also obtained a lease of additional property fronting North 11th Street and Commerce Street, which property was in the rear and to the north of 1033 Market Street. The petitioner spent a substantial amount in making improvements to the additional property and desired to break through the north wall of the 1033 Market *3 Street property for the purpose of connecting the two properties and operating the two as one single department store unit.
Negotiations were entered into with the owner of the Market Street property which resulted in the cancellation of the lease dated February 13, 1917, and the accompanying supplemental agreement and the making of a new lease dated August 16, 1918, for a term of 19 years, commencing on January 1, 1919, at a rental of $26,875 per annum for the first 9 years and of $31,875 for the remaining 10 years. The new lease contained provisions similar to those in the previous leases as to alterations and restorations.
In the negotiations*3333 relative to the making of an opening in the north wall, an agreement was reached whereby the petitioner was to pay $25,000 in lieu of liability for restoration. The agreement which was made provided for $5,000 to be paid at the time of signing and the balance of $20,000 to be paid on February 1, 1919, provided however, that the petitioner should have the right to an extension for the payment of $10,000 of such amount until May 1, 1919. Five thousand dollars was paid at the time of signing, $10,000 on February 1, 1919, and $10,000 on May 1, 1919.
Five thousand dollars had previously been agreed upon as the amount required to restore the east wall and $20,000 was shown to have been the approximate cost of the restoration of the north wall.
The cost of making the alteration, as distinguished from the payments thus made in lieu of an obligation to restore, were charged to capital on the petitioner's books. The $25,000 in controversy was charged to expense on the books of the petitioner and none of it was charged to any improvement account. Some part of this account has heretofore been claimed as a deduction for the fiscal year 1919 and disallowed by the respondent.
The record*3334 does not disclose whether the books of the petitioner were kept on the cash receipts or accrual basis.
2. In February, 1917, the petitioner, Frank & Seder, Inc., operated a department store at Fifth Avenue and Smithfield Street, Pittsburgh, Pa. The building was totally destroyed by fire in the latter part of said month, necessitating a complete suspension of business.
Architects who were familiar with the requirements of the business were immediately retained to prepare plans and specifications for a new building.
The necessity for haste was apparent, and, before the plans were ready, a contract was made with James L. Stuart to act as construction engineer and general contractor. Stuart was to have entire charge of the work under the supervision of the architects. He was to receive a fixed fee of $40,000, plus an additional fee of $10,000 if the *4 building was ready for occupancy by the petitioners by February 1, 1918. The contract with Stuart provided that he was to finish the building on February 1, 1918, with a bonus of $10,000 for completion before December 1, 1917, and liquidated damages of $500 per day after February 1. There was a further provision that*3335 if Stuart should be delayed in completion by strikes, fires, acts of God or other causes beyond his control, then the respective dates of completion should upon application by Stuart be extended for a period equivalent to the time lost by reason of the said causes.
A bid of $101 per ton was received for the structural steel from a reliable firm, which was unwilling to commit itself to anything more than delivering after a reasonable time after delivery from the rolling mills. The contract was awarded to another firm at $116 per ton which bound itself to make deliveries of the material on specified dates. The higher price was paid solely in the interest of expedition. The deliveries were made within the dates specified in the contract. The petitioner, to secure prompt deliveries, thus paid $44,024 more for the steel work than it would have paid had it accepted the contract without a guarantee as to the dates of delivery.
During the progress of the work, in order to expedite completion, orders were given to the subcontractors to work the mechanics and laborers overtime. The total charges for overtime and above the regular rates were $26,331.
Stuart drove the work to completion*3336 with dispatch, but it was delayed by strikes that were not confined to this building. He applied for and received extensions of time, so that the extended date for the earning of his $10,000 bonus became May 1, 1918, by which date the building was completed. If the additional amounts had not been expended, the building would not have been completed prior to January 1, 1919. The bonus was paid to him for his speeding up the work.
In order to speed up the work to obtain the early occupancy of the building, the following additional expenses were incurred:
| Extra cost of steel | $44,024.00 |
| Overtime | 23,331.00 |
| Bonus to Stuart | 10,000.00 |
| Additional percentage payments to architects | 4,017.75 |
| Making a total of | 84,372.75 |
At least one of the foregoing items was claimed as a deduction by the petitioner and disallowed as such by the respondent.
3. Prior to 1920, the petitioners had acquired 1,402 1/2 shares of preferred stock and 3,005 shares of common stock of Perry Dame & Co., at a cost of $261,516. Perry Dame & Co. was a New York corporation engaged in the catalogue-mail-order business. Its business *5 had not been profitable and three assessments were*3337 made on its stock. The amount of these assessments is included in the cost found above.
In 1920, the petitioner and Isaac Seder, its president, had an opportunity to acquire another department store in Philadelphia. It was necessary to provide additional cash for this transaction. Seder visited New York for the purpose of attempting to dispose of the Perry Dame stock for cash. He found a purchaser in one Friedberg, a member of the firm of Levay & Friedberg, which firm was engaged in the manufacture of ladies' skirts. Seder and Friedberg agreed upon a price of $50,000 for the stock.
The record intimates that Friedberg was influenced to make the purchase in part by the consideration that the ownership of a substantial block of stock in Perry Dame & Co. would give him an effective entree to that concern in selling some of his firm's output, Perry Dame & Co. being a purchaser of that commodity.
Seder, although three assessments had been paid on the Perry Dame & Co. stock, was still optimistic as to the business future of the concern. He accordingly bargained for and obtained an option from Friedberg for the repurchase of the stock by the petitioner within a period of three*3338 years upon the following terms. In the first year the petitioner had an option to repurchase for the sum of $52,500, together with an additional sum computed at the rate of 10 per cent per annum on $50,000 from the date of the sale to the date of the exercise of the option; in the succeeding year the option price was $55,000, together with an additional sum computed as above, and finally in the third year the option price was $57,500, together with an additional sum computed as aforesaid. If the option was not exercised within the first year the petitioner was required to pay $5,000 to keep it alive thereafter, and if not exercised within the second year it was required to pay a further sum of $5,000 to keep it alive, the said sums to be credited against the purchase price of the stock if the option to repurchase was exercised, but to belong absolutely to Friedberg if the option was not exercised.
In return for this option, Friedberg, who apparently realized the possibility of a continuing depression in the Perry Dame & Co.'s business, insisted on an option to himself whereby he could limit his loss on the stock. He accordingly bargained for and obtained an option to resell the*3339 stock to the petitioner at any time during the period of the petitioner's option for the sum of $25,000, together with an additional amount equal to 6 per cent on the sum of $50,000 from the date of the exercise by him of the option to resell to the petitioner.
The contract for the sale and purchase and the above-mentioned options were executed December 15, 1920, and thereupon the petitioner *6 delivered the stock of Friedberg and the latter paid to the petitioner the sum of $50,000. The stock was transferred on the books of Perry Dame & Co.
In September, 1921, the petitioner was about to incorporate as a separate corporation under the name of Frank & Seder Co. of Detroit. Friedberg was desirous of obtaining an opportunity to invest in the stock of this new corporation. Seder, who persisted in his optimistic hopes for Perry Dame & Co., saw an opportunity to extend the option which the petitioner had to repurchase the Perry Dame & Co. stock for a longer period, but also in the event that it exercised the option, an opportunity to do so without the payment of a profit to Friedberg. A new agreement in writing was entered into between the petitioner and Friedberg in September, *3340 1921, whereby the petitioner was given a five-year option to repurchase the Perry Dame stock for the sum of $50,000, or at its option to deliver to Friedberg in payment for said stock 500 shares of preferred stock and 675 shares of common stock of the new Michigan corporation, while Friedberg in turn was given a five-year option to purchase from the petitioner the stock in the Michigan corporation by paying $50,000 in cash or at his option by delivery of the Perry Dame & Co. stock.
By the close of 1922, it became apparent that the Michigan corporation was an assured success while Perry Dame & Co. was continuing to lose money. Friedberg exercised his option under the September, 1922, agreement by demanding that the petitioner deliver to him 500 shares of preferred stock and 675 shares of common stock in the Michigan corporation in exchange for the 1,402 1/2 shares of preferred stock and 3,005 shares of common stock of Perry Dame & Co.
The transfers were made on January 2, 1923. Upon that date two entries were made in the petitioner's journal. It showed that the transaction was regarded as a sale of the Michigan corporation's stock to Friedberg for $50,000 and a purchase of*3341 the Perry Dame stock from him for an equal amount.
The petitioner deducted the loss in its return for the fiscal year 1921, which loss the respondent disallowed.
4. The respondent ruled that the sale of the Perry Dame & Co. stock was not bona fide, and treated that stock as if it had been held by the petitioner up to the end of the fiscal year, and computed the deduction from invested capital for that inadmissible asset accordingly.
OPINION.
GREEN: The four questions raised in these proceedings will be discussed in the order in which they have been previously stated.
1. The $25,000 obligation incurred during the fiscal year ended January 31, 1919, in connection with the petitioner's liability for the *7 restoration of altered leased premises should be treated as advanced rent, since the amount paid was part of the consideration flowing from the lessees to the lessors under the lease, and the recovery of said amount by the petitioners would necessarily have to be out of the profits which it anticipated it would make from its business, during the life of the lease. If, however, the remaining life of the building upon which the expenditure was made is less than*3342 the life of the lease, the shorter period may be used.
2. The second question is whether certain payments made by the petitioner in the fiscal year ended January 31, 1919, in connection with the erection of its new building in Pittsburgh, after a fire had destroyed the old building, were capital expenditures or deductible expenses.
We are of the opinion that the respondent was correct in treating the expenditures incurred to expedite the construction as capital expenditures to be exhausted over the life of the building. In the ordinary case the material and labor costs are not only reflected in the value of the completed building, but that value subject to exhaustion remains throughout the life of the building. Regarding the expenditures here in question, the value of them did, to some extent, remain or inure to the petitioner throughout the life of the building.
3. The sale by the petitioner to Abraham Friedberg of 1,402 1/2 shares of preferred stock and 3,005 shares of common stock of Perry Dame & Co. on December 15, 1920, was held by the respondent not to be a bona fide sale and not to constitute a closed and completed transaction, and he accordingly held that the loss*3343 thereon of $211,516 was not deductible in the fiscal year ended January 31, 1921.
There can be no doubt that the sale by the petitioner to Friedberg of the Perry Dame & Co. stock on December 15, 1920, was occasioned by business considerations alone, and that the subsequent reacquisition of that stock by the petitioner in no way affected the motive of the original sale, which was the result of purely business considerations.
We are of the opinion that the contract for sale and purchase, and that relating to the options are separable, and that the option contract, and its subsequent renewal in another option contract which was ultimately exercised, in no way affects the bona fides of the sale made on December 15, 1920. Accordingly, the respondent erred in not allowing as a loss for the fiscal period ending January 31, 1921, the loss sustained on the Perry Dame & Co. stock.
4. From our conclusion as to the loss in the Perry Dame & Co. stock, it follows that in computing the average deduction from *8 invested capital for inadmissible assets the cost of that stock should be eliminated as of December 15, 1920.
Reviewed by the Board.
Judgment will be entered under*3344 Rule 50.