*2867 1. The respondent's determination of the petitioner's invested capital and the amount of deductions to which the petitioner is entitled on account of wear and tear of its plant and equipment for the years 1917 to 1920, approved.
2. The respondent's disallowance of deductions claimed by the petitioner on account of alleged additional compensation to its president for the years 1917 to 1920, inclusive, sustained.
*380 This proceeding is for the redetermination of deficiencies in income and profits taxes which the respondent has asserted, together with penalties in the amounts of $2,920.38 for the year 1917; $12,185.64 for the year 1918 and a delinquency penalty of 25 per cent of the total tax for that year; $6,828.64 for 1919 and a delinquency penalty of 25 per cent of the total tax for that year; and $6,249.59 for the year 1920. The petitioner alleges that the respondent erred: (1) In disallowing as deductions from gross income for the years 1917 to 1920, inclusive, certain amounts paid to its president as additional*2868 compensation for those years; (2) in excluding from invested capital for each of the years 1917 to 1920, inclusive, the amount of $49,387.09; and (3) in reducing the petitioner's plant account by the amount of $49,387.09 and thereby reducing the basis for computing the allowances for exhaustion, wear and tear of the plant and equipment during the years 1917 to 1920, inclusive.
FINDINGS OF FACT.
The petitioner is an Ohio corporation organized in February, 1915, with a capital stock of $150,000 divided into 1,000 shares of common stock and 500 shares of preferred stock of the par value of $100 each.
On and prior to March 6, 1915, there was in existence on Ohio corporation known as the Cyclone Drill Co., the outstanding capital stock of which consisted of 1,151 shares of the par value of $100 each, *381 and which was engaged in the manufacture of well-drilling machinery at Orrville, Ohio. There was and had been for some time dissension among the stockholders because the company had not paid dividends, and because of that fact, and the further fact that they, the larger stockholders, were financially embarrassed, the larger stockholders desired to dispose of their interest*2869 in the corporation.
On or about March 6, 1915, the petitioner (1) either purchased all of the assets of the Cyclone Drill Co., subject to its liabilities, for $86,325, said purchase price being paid part in cash and part in shares of the petitioner's capital stock, or (2) it purchased 1,120 1/2 shares of the capital stock of the Cyclone Drill Co. for $75 per share, paying therefor cash in the amount of $38,252.90 and 461.7575 shares of the petitioner's capital stock, and immediately thereafter dissolved the Cyclone Drill Co. and took over its assets, subject to its liabilities. The book value of the assets so acquired as shown by the books of the Cyclone Drill Co. was $218,172.89 and the liabilities of that company, exclusive of capital stock and surplus, were $37,383.38, making a net book value of $180,789.51. From the net value of the assets as thus determined, the petitioner deducted the amount of $86,325, leaving the amount of $94,464.55, which it entered on its books as a liquidating dividend from the Cyclone Drill Co. under the head of "Unearned Surplus." The balance sheet of the Cyclone Drill Co. as of February 28, 1915, and the opening balance sheet of the petitioner, *2870 are as follows:
| Assets | |
| Cash | $395.79 |
| Bills receivable | 16,999.49 |
| Accounts receivable | 15,643.58 |
| Inventories | 88,352.45 |
| Real estate and buildings | 34,325.21 |
| Machinery and tools | 39,946.16 |
| Office fixtures | 4,122.90 |
| Patterns, blue prints, etc | 12,988.27 |
| Patents | 3,114.51 |
| Deferred expenses | 2,284.53 |
| 218,172.89 | |
| Liabilities | |
| Unpaid labor | $862.38 |
| Bills payable | 23,457.08 |
| Accounts payable | 13,063.92 |
| Capital stock | 115,100.00 |
| Surplus | 65,689.51 |
| 218,172.89 |
| Assets | |
| Cash | $121.11 |
| Bills receivable | 16,999.49 |
| Accounts receivable | 15,643.58 |
| Inventories | 88,352.45 |
| Real estate and buildings | 34,325.21 |
| Machinery and tools | 39,946.16 |
| Office fixtures | 4,122.90 |
| Patterns, bue prints, etc | 12,988.27 |
| Patents | 3,114.51 |
| Deferred expenses | 2,284.53 |
| Capital stock subscriptions - common | 20,470.00 |
| 238,125.99 | |
| Liabilities | |
| Unpaid labor | $862.38 |
| Bills payable | 23,457.08 |
| Accounts payable | 13,063.92 |
| Cyclone Drill Co., Stock Purchase Account | 6,711.35 |
| Capital stock - common | 34,530.00 |
| Capital stock, preferred | 44,566.75 |
| Capital stock - common subscribed | 20,470.00 |
| Unearned surplus | 94,464.51 |
| 238,125.99 |
*2871 *382 Certain stockholders of the Cyclone Drill Co. who owned 30 1/2 shares of its capital stock and who either objected to the sale of the company's assets to the petitioner, or who refused to accept $75 per share as the true value of their stock, instituted an action in the Court of Common Pleas of Wayne County, Ohio, against the Cyclone Drill Co. They obtained a judgment, which was affirmed by the Supreme Court of Ohio. (.) The Supreme Court held that in making the sale of its assets the Cyclone Drill Co. had not fully complied with the statutes authorizing it to make such a sale, and that the purchaser took the corporate property subject to the rights of the stockholders not consenting thereto. The petitioner subsequently settled with said stockholders on the basis of $110 per share, a total amount of $3,355.
All accounts receivable and bills receivable which the petitioner acquired from the Cyclone Drill Co. were later collected by the petitioner. All of the other assets, consisting of plant, machinery, tools, patterns, blue prints, office furniture, etc., were continued in use by the petitioner and only ordinary repairs were required. There*2872 was no general replacement necessary at the time the petitioner acquired these assets.
The net fair market value of the assets that the petitioner acquired from the Cyclone Drill Co. was not to exceed $131,402.42. The fair market value of the real estate, buildings, machinery and tools, office fixtures, patterns and blue prints, which were included among the assets so acquired, was not to exceed $41,995.45.
R. R. Sanderson was, during the years 1917 to 1920, inclusive, and had been since the petitioner was organized, president and general manager thereof. All of the business of the petitioner was conducted by Sanderson practically as a one-man concern so far as the selling and production were concerned, but he gave little or no attention to the office management or the records. Article VI of the petitioner's by-laws provides:
The president shall receive no compensation whatever.
The general manager shall receive such compensation as may be fixed by the board of directors.
At the first meeting of the board of directors, held on February 8, 1915, the salary of the general manager was fixed $125at per month for the ensuing year. This salary was never changed by any action*2873 of the board of directors. No regular meetings of either stockholders or directors were held after March 28, 1917. R. R. Sanderson was the owner of only one share of the common stock of the petitioner. The preferred stock had no voting rights.
*383 At the time the petitioner was organized, R. R. Sanderson and the subscribers to the petitioner's capital stock, entered into an agreement which provided that:
* * * WHEREAS, R. R. Sanderson, the president of said corporation, Sanderson Cyclone Drill Company, agrees to assign unto said corporation as soon as same is organized, options covering all of the outstanding stock of the Cyclone Drill Company, which options are taken at a price which will make the total cost of the Cyclone Drill Company to Sanderson Cyclone Drill Company less than $87,500.00, which $87,500.00 or what less amount shall be paid, shall be payable 50% or less in cash and balance in proferred stock, and
WHEREAS, the said R. R. Sanderson further agrees to assign to Sanderson Cyclone Drill Company an option covering the manufacturing plant, consisting of buildings, and real estate and known as the Wonder Manufacturing Company plant, located at Washington*2874 Court House, Ohio, which option permits of the plant being purchased at $10,000 and paid for in the common stock of the Sanderson Cyclone Drill Company, which stock will be accepted at its full par value of $100 per share, and
WHEREAS, the said R. R. Sanderson further agrees to assign to the Sanderson Cyclone Drill Company all patents and designs covering new and improved well drilling machinery now owned by him.
NOW, THEREFORE, the undersigned in consideration of their mutual promises and agreements do severally agree to and with each other and with R. R. Sanderson, the promoter of the Sanderson Cyclone Drill Company, that of the 450 shares of Common Stock placed in the treasury as hereinbefore mentioned, one share of the same is to be transferred to and become the property of said R. R. Sanderson, as soon as the said corporation, the Sanderson Cyclone Drill Company, is organized and the 449 shares of common stock remaining in the treasury after the one share has been transferred to the sair R. R. Sanderson shall be kept therein until the net earnings upon all of the outstanding capital stock of the company, both common and preferred, shall amount to 10% per annum and thereupon*2875 there shall be transferred to the said R. R. Sanderson such portion of the 449 shares so set apart as may be done without diminishing the 10% per annum net earnings upon all of the stock outstanding and when the net earnings of 10% per annum, or all stock outstanding will not be diminished by the transfer of the 449 shares of common stock so set apart, then the whole of the said 449 shares of stock shall be transferred to the said R. R. Sanderson.
In the early part of 1917, Sanderson, after consulating his father and other persons, decided to waive the foregoing agreement as to capital stock and instead to take additional compensation for his services. No action was taken by the board of directors, but Sanderson's father and one J. J. Hidy, neither of whom was a director, said "they would take it up with the boys down there and fix it up all right." (Meaning Washington Court House, where the majority of the stockholders lived.) Nothing was done with regard to any additional salary until early in the year 1921. By that time Sanderson's salary account, carried on the basis of $1,500 per year, was overdrawn and entries were then made as of December 31, 1920, crediting his account*2876 with additional salary in the amounts of $4,000 for 1917; $6,000 for 1918; $7,500 for 1919; and $8,500 for 1920. These amounts *384 were never authorized by the directors but were arbitrarily fixed by Sanderson after consulting with his father and friends as being what he considered fair and proper compensation.
The petitioner, in its income and profits-tax returns for the years 1917 to 1920, inclusive, included in invested capital the amount of $94,464.55 heretofore mentioned, claimed by it to have been received as a liquidating dividend from the Cyclone Drill Co. The respondent allowed $45,077.42 of this amount but excluded $49,389.09 thereof and reduced the petitioner's plant account by the same amount. He also computed wear and tear of the petitioner's plant and equipment on the value thereof as so adjusted, and reduced the petitioner's allowances for exhaustion, wear and tear of the plant and equipment by the amounts of $5,566.02 for 1917; $5,553.93 for 1918; $4,128.72 for 1919; and $3,708.60 for 1920.
In its original income-tax return for 1917 the petitioner deducted $1,500 as salary or compensation paid to R. R. Sanderson. In an amended return for 1917 the amount*2877 claimed as a deduction on account of salaries paid to Sanderson was $5,500. In its returns for 1918 and 1920 the amounts claimed as deductions on account of salaries paid to Sanderson were $7,500 and $9,000, respectively. For 1920 the amount claimed was a deduction of $10,000. For each for these years the respondent disallowed as deductions on account of salaries paid to Sanderson all amounts in excess of $1,500.
OPINION.
MARQUETTE: The petitioner contends that it acquired from the Cyclone Drill Co. assets of the net value of $180,789.51, which it is entitled to include in invested capital for the years 1917 to 1920, inclusive, and that $91,382.54 represents the value of the plant and equipment included in such assets, which value should be used as a basis for computing the allowances for wear and tear of the plant and equipment during the taxable years involved. The respondent has reduced the petitioner's invested capital claimed on account of said assets by the amount of $49,387.09, but has allowed its claim in the amount of $131,402.42. He also reduced the value of the petitioner's plant account by the amount of $49,387.09, and thereby reduced the basis for computing*2878 the allowances for exhaustion, wear and tear of the plant and equipment.
The record in this case is confusing and entirely unsatisfactory. The petition alleges and the answer admits, that the petitioner purchased 1120 1/2 shares of the capital stock of the Cyclone Drill Co. for $75 per share and immediately thereafter liquidated that company and took over its assets, and that it thereafter paid for the 30 1/2 shares of stock of the Cyclone Drill Co., which it had been unable *385 to acquire, at the rate of $110 per share. On the other hand, the minutes of the Cyclone Drill Co., which were introduced in evidence, show that the petitioner purchased the assets of that company, subject to its liabilities, for $86,325, paying 40 per cent in cash and 60 per cent in shares of the petitioner's preferred stock. Also, the opinion of the Supreme Court of Ohio in ; , which was an action brought by certain stockholders of the Cyclone Drill Co., and arising from the transaction under consideration, indicates that it involved the sale by the Cyclone Drill Co. of its assets, to which certain of its*2879 stockholders had not consented. If the petitioner purchased the assets of the Cyclone Drill Co. for $86,325, it is not entitled to include them in invested capital or as a basis for computing depreciation allowances at any greater amount than it paid for them. If the petitioner purchased the capital stock of the Cyclone Drill Co. and subsequently liquidated that company and took over its assets, it would be entitled to include the assets in invested capital and to compute depreciation allowances thereof on their fair market value at the date of acquisition. However, we are unable to understand how the owner of only part of the capital stock of a corporation can dissolve the corporation and take over its assets in liquidation to the exclusion of the other stockholders.
The petitioner has attempted, by the testimony of several witnesses, to establish a value for the plant and equipment greater than that allowed by the respondent. However, we are of opinion that the evidence falls far short of showing that the plant and equipment had any greater value when the petitioner acquired it than the respondent has allowed. On this point we must affirm the action of the respondent, although*2880 the evidence before us indicates that he may have erred in including the property in question in the petitioner's invested capital at more than $86,325.
With respect to the petitioner's claim that it is entitled to deduct from gross income for the taxable years 1917 to 1920, inclusive, the amounts credited in 1921 to Sanderson as additional salary for those years, we must be governed by section 12(a) of the Revenue Act of 1916, which was in force during 1917, and by section 234(a) of the Revenue Act of 1918. The 1916 Act provides for the deduction from gross income of:
* * * First. All the ordinary and necessary expenses paid within the year in the maintenance and operation of its business and properties, * * *.
The 1918 Act allows as deductions:
(1) All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered, * * *.
In *386 our opinion the respondent's determination on this point was correct and the deductions claimed should not be allowed. The additional salaries were neither paid nor incurred*2881 during the taxable year. Sanderson, the recipient of the salaries in question, overdrew his salary account in each of the years 1917 to 1920, inclusive, but the petitioner's directors, who were the managers of the petitioner's property and business, had never authorized the additional salaries, nor did they cause the bookkeeping entries to be made crediting Sanderson's account with the amounts thereof. The additional salaries were arbitrarily fixed by Sanderson himself in 1921 and the bookkeeping entries were directed by him in that year. See , and cases cited; .
Judgment will be entered under Rule 50.