*3903 Where it is shown that the true surplus of a corporation is not overstated on the books of a corporation as of the beginning of a year, all of that surplus (whether paid in or earned) must be included in the corporation's invested capital for the beginning of the year.
*1340 This is a proceeding for the redetermination of a deficiency of $793.66 in income and profits taxes for the calendar year 1919. Four errors were alleged, but the petitioner withdrew two of the allegations which left for our consideration the alleged errors of the Commissioner in deducting $30,649.66 from the petitioner's invested capital and in failing to allow any deduction for depreciation.
*1341 FINDINGS OF FACT.
The petitioner is a Wisconsin corporation, organized January 1, 1917, with its principal office at Sheboygan, in that State. The Ross-Sellinger Glove Co. failed in 1916 and went into bankruptcy. The petitioner acquired the assets of the Ross-Sellinger Glove Co., subject to certain liabilities, from some source. The petitioner, at this time, issued*3904 $62,175 par value of its preferred stock and gave its notes having a face value of $26,700. These notes were later exchanged for $26,700 par value of the petitioner's common stock. In connection with this transaction entries were made in the books of the petitioner to show the following:
| Assets acquired: | ||
| Cash | $3,488.37 | |
| Accounts receivable | 30,637.98 | |
| Inventory finished goods | 18,345.48 | |
| Inventory raw materials and supplies | 63,250.57 | |
| Machinery, tools and fixtures | 21,300.00 | |
| Prepaid insurance | 100.00 | |
| $137,122.40 | ||
| Less liabilities assumed: | ||
| Accounts payable | 1,718.00 | |
| Notes payable | 12,000.00 | |
| Accrued pay roll | 2,352.81 | |
| Accrued taxes | 1,526.93 | |
| 17,597.74 | ||
| Net assets acquired | 119,524.66 | |
| Deduct par value of preferred stock and notes exchangeabletherefor: | ||
| Notes (payable Ross-Spiller Glove Co.) | $26,700.00 | |
| Preferred stock | 62,175.00 | |
| 88,875.00 | ||
| Amount set up on books as opening surplus | 30,649.66 |
The Commissioner disallowed this claimed surplus of $30,649.66, computing the petitioner's invested capital as follows:
| Capital Stock, Surlpus and Reserves as shown on Balance Sheet | $158,234.13 | |
| Reductions: | ||
| (a) Excess of net value of assets set up by taxpayer at January 1, 1917, over Par value of preferred stock issued therefor | $30,649.66 | |
| (b) Dividends 1/2 - $1,554.38 - 364 days | 1,550.12 | |
| (c) Additional Federal income taxes on 1917 income | 1,047.59 | |
| (d) Federal income tax on 1918 income - $13,706.37X .4226 | 5,792.31 | |
| 39,039.68 | ||
| Statutory invested capital | 119,194.45 |
*3905 *1342 All of the liabilities assumed by the petitioner on January 1, 1917, were paid before January 1, 1919, and none of the accounts receivable acquired by it at organization were still outstanding on its books on December 31, 1918.
The officers of the petitioner before purchasing the assets of the Ross-Spiller Glove Co. made a thorough inspection of the property to be acquired and took the above inventory of all goods, materials and supplies at cost or market, whichever was lower. All merchandise and material then on hand was promptly manufactured into finished goods. These officer were experienced in the business, were familiar with the machinery, tools and fixtures acquired at this time, and believed that these were worth at least $21,300.
The following is a statement of the petitioner's assets and liabilities as of December 31, 1918, as shown by its books which were kept on an accrual basis:
| Assets | |
| Cash | $3,885.96 |
| Liberty bonds | 801.28 |
| Accounts receivable - trade | 33,590.14 |
| Inventories | 167,492.15 |
| Machinery and fixtures | 20,000.00 |
| Unexpired insurance | 195.95 |
| 225,965.48 | |
| Liabilities | |
| Notes payable | $44,500.00 |
| Accrued State taxes | 2,162.50 |
| Accounts payable - trade | $10,422.09 |
| Accounts payable - officers | 10,173.26 |
| Accrued interest and insurance | 573.50 |
| Reserve for bad debts | 1,000.00 |
| Capital stock - common | 26,700.00 |
| Reserve for taxes - Federal | 13,810.37 |
| Capital stock - preferred | 62,175.00Accrued dividend |
| 1,554.38 | |
| Surplus | 52,894.38 |
| 225,965.48 |
*3906 On the above balance sheet the item of $3,885.96 represents cash belonging to the petitioner and in its bank account on December 31, 1918. The item of $801.26 represents the cost to the petitioner of Liberty bonds owned. The item of $33,590.14 represents amounts due from customers, employees, and officers. At December 31, 1918, no account was over two months past due. The item of $167,492.15 represents goods in process and materials being used in the manufacture of gloves, all recently purchased and carefully inventoried at cost or market, whichever was lower, and includes no merchandise which was on hand on January 1, 1917. The item of $20,000 represents the amount set up at January 1, 1917, as an estimated value for machinery and equipment, less $1,300 which was charged off in 1917. The amount originally was divided into machinery and fixtures at Sheboygan, $20,000, and the smae at Fond du Lac, $1,300. The machinery and equipment at the latter place was sold and charged off in 1919. No other changes were made in this account. One hundred and ninety-five dollars and ninety-five cents represents cost of insurance premiums less amounts charged off up to December 31, 1918.
*3907 The company had no liabilities save those set out above.
*1343 The net income of the petitioner according to its books for the year 1919 was $35,445.69. No depreciation was deducted in 1919. During 1919 no replacement was made of machinery, tools, furniture or fixtures. Repairs were made and charged to expense.
OPINION.
MURDOCK: We have set out above the method used by the Commissioner computing the petitioner's invested capital. The petitioner now concedes that in that computation the reductions lettered "(b)," "(c)" and "(d)" were proper, but contends that the Commissioner erred in reducing invested capital by $30,649.66 for the reason, as stated in his reduction lettered "(a)," that the amount represented an "excess of net value of assets set up by taxpayer at January 1, 1917, over par value of preferred stock issued therefor." The petitioner argues that it is immaterial in this case whether or not such surplus so set up was paid-in surplus for invested capital purposes, because it had on December 31, 1918, an undisputed surplus of $52,994.38 which must have been either paid in or earned and as such should be included in invested capital for 1919.
In order*3908 to prove that this surplus was not overstated on its books the petitioner alleged and attempted to prove, first, that its assets on December 31, 1918, were accorded values which could properly be included in invested capital, and that there were no undisclosed or unascertained liabilities not recorded on the books of account. Its proof on the value of certain of its assets might not be satisfactory if the Commissioner had questioned such value, but he made the reduction for a totally different reason. He does not claim that the accounts receivable contained any bad or doubtful accounts, or that the inventories are incorrect. Under the circumstances we think the proof is sufficient to establish the point made by the petitioner.
The next step in the proof offered by the petitioner was to show that only one of the assets originally acquired and set up on its books on January 1, 1917, remained on its books and was shown as an asset on December 31, 1918, namely, the asset described as "Machinery, Tools & Fixtures," all of the other assets acquired and liabilities assumed on January 1, 1917, having been sold, disposed of, or otherwise accounted for in income before January 1, 1919, as*3909 realized gains or losses. It showed that its accounts receivable as of December 31, 1918, included no account shown as an account receivable on January 1, 1917, that is, that none of its original accounts receivable were still outstanding on December 31, 1918; that all of the goods, materials and supplies in its January 1, 1917, inventory were sold as finished goods before December 31, 1918, and *1344 were not represented in any item on its December 31, 1918, balance sheet, except perhaps in the item of accounts receivable; and that all of its liabilities as of January 1, 1917, were paid before December 31, 1918, so that by its method of keeping its books and reporting its income the petitioner by January 1, 1919, had accounted for any gains or losses on its January 1, 1917, assets and liabilities.
It also proved that the machinery, tools and equipment which it acquired on January 1, 1917, were worth more than $21,300 on that date; that no appreciation on these assets was included in the December 31, 1918, balance sheet; that the only change in the account was that $1,300 was charged off it before December 31, 1918, due to the sale of some of the machinery and fixtures originally*3910 acquired. The Commissioner does not indicate that any adjustment need be made in this asset account because of appreciation and he has made none on account of depreciation. He has never contended that the original machinery, tools, and fixtures acquired by the petitioner were not paid in for stock or shares, or that they did not cost the petitioner $21,300. From the entire record we gather that the respondent raises a question of the excess value of assets paid in for stock over the par value of the stock, rather than one as to whether or not those assets were paid in for stock specifically issued therefor.
We think that it is apparent from the Commissioner's computation that he concedes the right of the petitioner to include in its invested capital as cash or property paid in for stock or shares an amount equal to the par value of its stock outstanding on December 31, 1918, to wit, $26,700, plus $62,175; and that he attacks the petitioner's surplus only. This surplus of $52,994.38 on December 31, 1918, was all surplus (paid in and/or earned) or undivided profits. Therefore the petitioner has proven its case in so far as the question of invested capital is concerned. *3911 The amount of $30,649.66 was erroneously deducted from its surplus in the computation of its invested capital for the year 1919.
An appraiser, whose qualifications, if any, were not satisfactorily shown, stated that appraisers usually used rates of from 3 to 5 per cent for depreciation and that in connection with an appraisal of the petitioner's machinery he had used various rates, but never one in excess of 5 per cent. Evidence such as this does not satisfactorily establish a proper rate for the computation of a deduction for exhaustion of these assets and consequently we must hold that the petitioner has not established its right to such deduction.
Judgment will be entered in accordance with the foregoing opinion on notice of 15 days, under Rule 50.