*2764 1. A reserve set up by the Commissioner in the amount of depreciation deductions claimed and allowed in prior years but not reflected in the books, held prima facie correct and the reserve affirmed where the evidence failed to establish that replacements and repairs, charged to expense, adequately offset depreciation sustained.
2. Special assessment denied upon the evidence.
*910 These proceedings, which present identical questions and were consolidated for hearing and decision, result from deficiencies in income and profits taxes asserted for the years 1920, 1921, and 1922 in the respective amounts of $7,204.72, $5,317.53, and $1,303.24. Error is alleged in respondent's action in setting up a depreciation reserve for the years 1909 to 1916, in the amount of depreciation deductions taken in those years, which reserve (1) reduced depreciable capital account for all the years in question, and (2) decreased surplus in invested capital for the years 1920 and 1921. Petitioner's contention is that the cost of additions and betterments erroneously*2765 charged to expense during such prior years was equivalent to and served to offset depreciation sustained. Error is also alleged in respondent's refusal to grant special assessment for the years 1920 and 1921 under sections 327 and 328, Acts of 1918 and 1921. By motion granted under Rule 62, the hearing was confined, so far as concerned the issue of special assessment, to the question whether petitioner is entitled to have its tax computed under section 328.
*911 FINDINGS OF FACT.
Petitioner is an Illinois corporation with its office and place of business at Highland Park, Ill., where it is engaged in the business of operating a hotel. It was organized in 1900 with a capital stock of $35,000, divided into 350 shares [which is approximately the present capitalization], to operate the hotel then being erected as an investment on a tract of land near Chicago, Ill., and bordering on Lake Michigan. The land was then owned by Cassie Cushing, the wife of Fred W. Cushing. The hotel began operations in June, 1900, and sustained losses during the first year. To avert a receivership, Fred W. Cushing, who originally held but 20 shares of stock, purchased the remainder of the*2766 capital stock from outside interests, paying them what they had put into the corporation, and took over the active management of the corporation. His ownership of all the stock and his management of the hotel has continued through the years in question. The ownership of the land still remains in the Cushing family, having passed to the heirs of Cassie Cushing at her death in 1918.
The original building was a large, three-story brick veneer structure of the colonial type, and contained about 140 rooms. In 1903 an addition known as the East Annex was built, and a South Annex was added in 1910. The hotel was at first run as a summer hotel, keeping open four months in the year until 1907, when it began full-year operation. It is and has been from the beginning a family hotel in the sense that families live there for several months at a time, especially during the summer season. The enterprise was ahead of the demand for a hotel of that character and was forced to cater to a cheaper class of people in the earlier years to get started. Since that time and before the period in question the hotel has been converted into a high-class hotel charging $2.50 to $3 per day, European plan.
*2767 The petitioner leased the hotel and furnished it and the additions thereto when made. No depreciation (aside from the amount charged off on January 1, 1913, as set out in the table below) was ever charged off on petitioner's books down to and including the year 1916. Replacements of furnishings were, however, charged to expense as made. Replacements which were made from time to time were of better quality as the years progressed. The extent of replacements, asset account and additions thereto during the prior years in question may be summarized and tabulated as follows:
| Replacements | Additions during | Ledger balance at | |
| charged to | calendar year | end of calendar | |
| expense | year | ||
| Balance, Dec. 31, 1901 | $32,764.56 | $32,764.56 | |
| 1902 | 3,767.75 | 36,532.31 | |
| 1903 | 1,341.30 | 37,873.61 | |
| 1904 | 1 $3,000.00 | 1,587.53 | 39,461.14 |
| 1905 | 1 4,000.00 | 1,284.26 | 40,745.40 |
| 1906 | 1 5,000.00 | 884.46 | 41,629.86 |
| 1907 | 1 4,000.00 | 1,698.91 | 43,328.77 |
| 1908 | 1 4,000.00 | 1,554.15 | 44,882.92 |
| 1909 | 1 5,000.00 | 3,159.61 | 48,042.53 |
| 1910 | 1 4,000.00 | 16,871.06 | 64,913.59 |
| (May 1, 1910 to Dec. 31, | |||
| 1910) | 1 6,000.00 | ||
| 1911 | 5,417.58 | 7,926.94 | 72,840.53 |
| 1912 | 7,183.04 | 4,892.88 | 77,733.41 |
| Jan. 1, 1913 - 10 per | |||
| cent depreciation | |||
| credited direct to asset | |||
| account | 7,773.33 | 69,960.08 | |
| 1913 | 3,362.99 | 1,444.68 | 71,404.76 |
| 1914 | 3,832.57 | 299.88 | 71,704.64 |
| 1915 | 5,066.99 | 488.92 | 72,193.56 |
| 1916 | 5,200.02 | 961.49 | 73,155.05 |
*912 Repairs of whatever nature were made by petitioner's employees and treated as pay-roll expense. This item amounted to approximately $10,000 annually, of which approximately 50 per cent represented repairs to furnishings owned by petitioner.
Petitioner claimed and was allowed depreciation deductions aggregating $31,390.29 in its tax returns for the years 1909 to 1916, inclusive, which depreciation was never set up on its books. The respondent, when petitioner's books were first examined in 1922 (respecting the year 1917) reduced surplus to the extent of such aggregate depreciation by setting up a reserve therefor, which served to reduce invested capital for the years 1920 and 1921, and reduced depreciable capital account for all the years in question. Until the year 1907, when the hotel began year-round operation, depreciation did not exceed 10 per cent, and between 1907 and 1917 depreciation was sustained at the rate of about 15 per cent.
The petitioner corporation and the property which it occupied was owned entirely by members of the Cushing family. Fred W. Cushing's salary*2769 as president of the corporation and manager of the business was $2,000 per year until 1917 when it was increased to $4,000, the amount paid him during all the years in question. In addition to such salary he was furnished board and room for which he added $1 per day to his income in making out his personal tax return. He was the active manager of the properties during the period in controversy. His duties included attending to correspondence, determining matters of policy, purchasing the equipment needed, and employing the help. He had no other interests requiring any substantial portion of his attention, and devoted all his time, save for three or four months annual vacation taken during the winter, to the affairs of the corporation. His first assistant, a Mr. Larke, was paid $3,600 up to 1917, $4,800 during the years in question, *913 and his salary has since been increased to $6,000. He has been offered a salary of $12,000 per year to go elsewhere.
The land and buildings occupied by petitioner corporation steadily increased from 1900. In 1918 it was appraised at $485,000 for inheritance-tax purposes. During the years at issue it was worth between $500,000 and $600,000*2770 and is probably worth $1,000,000 at the present time. The annual rent paid by petitioner as lessee amounted to $35,000 during the years in question. There was also an obligation on the part of petitioner to keep the buildings in repair. A fair annual rental to a stranger - i.e., one not connected with the Cushing family - would have been between $40,000 and $50,000 for each of the years in question.
No good will asset was ever entered upon the books. The books prior to 1911 were destroyed as of no further use. The respondent allowed special assessment for the year 1919. Petitioner reported income for the years 1920, 1921, and 1922 in the respective amounts of $13,568.73, $11,474.99, and $12,117.14. The respective incomes for such years as adjusted by respondent in computing the deficiencies were $31,747.71, $23,777.24, and $22,543.03. Invested capital as allowed by respondent was $32,918.93 for 1920 and $58,166.47 for 1921.
OPINION.
SIEFKIN: Respecting the respondent's reduction of petitioner's surplus due to setting up a reserve for depreciation for years prior to 1917, the essential facts to the controversy lend themselves to brief restatement. To the close of 1916*2771 petitioner had never taken any depreciation on its books, excepting a charge-off as of January 1, 1913, in an amount equal to 10 per cent of its asset account. In such prior years it had, however, charged all replacements and repairs to expense. In addition to thus offsetting depreciation petitioner had, during the years 1909 to 1916, inclusive, claimed and was allowed depreciation deductions aggregating $31,390.29, which were never charged off on the books. The respondent set this amount up as a reserve for depreciation. Petitioner alleges such action was erroneous as depreciation sustained was adequately offset by charging to expense the cost of replacements and repairs.
Petitioner earnestly urges that its books are presumed to be correct and that the respondent must bear the burden of proving the propriety of his action in setting up the reserve in disregard of book entries, citing and relying on ; ; *2772 ; ; ; and .
*914 We think the cases cited fall far short of applying the rule which, it is claimed, they establish. A similar contention has been made heretofore in a number of cases and has been rejected by us in unmistakable terms. In , we affirmed such an adjustment made by the Commissioner in the absence of evidence and pointed out that a taxpayer who challenges the adjustment must produce evidence. In , we said:
The petitioner can not rebut the prima facie case by the mere production in evidence of statements setting forth what the books show as to amounts charged off in prior years. As we stated in , "A line of reasoning which concluded that the presumption of the correctness of the Commissioner's determination is rebutted by the correctness of the very evidence which the Commissioner examined*2773 and found to reflect an unreasonable allowance and so found not from the books themselves, but from the surrounding circumstances, would be most peculiar." And in , we said: "In every appeal in which the Board has reversed the action of the Commissioner on issues similar to this, the petitioner has proved that the amount of depreciation written off was, in view of all the facts, a reasonable allowance for the exhaustion, wear and tear of assets." There is no evidence upon which we can base findings of fact adverse to the determination of the Commissioner.
Other cases in which we have approved such adjustment in the absence of evidence include ; ; .
We have in a number of cases held that like any other fact found by the respondent it is prima facie correct in the absence of evidence tending to show otherwise. *2774 ; ; ;; ; .
On the other hand, in a number of cases, where the taxpayer had introduced evidence tending to show that depreciation had been considered in prior years and allowances, which apparently were approximately adequate, were made by charges to depreciation or the equivalent thereof, we have refused to disturb such allowances without affirmative evidence from the Commissioner, ; ; To the same effect . That, of course, is very different from saying the burden of proof is on the Commissioner. It amounts only to requiring the Commissioner to assume the ordinary burden of going forward with the evidence*2775 when that burden is shifted to him by the production of evidence overcoming *915 the prima facie correctness of his determination and tending to show that depreciation allowances made by the taxpayers were adequate. Our consistent refusal to accept the result of a computation by the Commissioner on a straight line basis as warranting his action where the evidence has overcome his prima facie case is a matter of weighing the evidence, and has nothing to do with the burden of proof. See , and , as well as the cases last cited above.
We have consistently held depreciation to be a matter of fact. Proof of the books is proof only that depreciation was taken in the amounts thus shown, and such evidence must be supplemented by proof of the adequacy of such amounts in their relation to depreciation sustained. See , and , in which we held proof of depreciation and its equivalent as shown by petitioner's books was not sufficient to overcome the prima facie correctness of respondent's determination. *2776
In the instant case, then, respondent's determination is prima facie correct. The petitioner has the burden of showing that determination to be erroneous, i.e., of proving the depreciation in fact sustained was in some amount other than that fixed by the respondent. It attempted to prove the amount shown by the books was adequate and that, therefore, the adjustment thereto should not have been made. The fact that it had currently claimed depreciation in prior years in the amount determined by the respondent, instead of that shown by the books, handicaps the petitioner at the outset, as such fact is pertinent and weighty, though not conclusive, evidence of the amount of depreciation actually sustained. That is, petitioner is now attempting to show that the depreciation deducted was excessive to the extent it exceeded the amount recorded on the books, despite the fact that the deductions, presumptively, represent petitioner's best judgment currently exercised during the years under discussion.
The evidence of record tends to confirm rather than overcome the action complained of. In drafting the findings of fact upon this point full credence has been given the testimony of*2777 Cushing and the records, produced largely by the taxpayer. Cushing's testimony is that annual depreciation sustained after 1907 amounted to 15 per cent. That, of course, means that the assets would be fully depreciated over a seven-year period. Accordingly, assets purchased prior to 1910 would be fully depreciated by the close of 1916, and may, therefore, be disregarded in determining the undepreciated asset balance as of the close of 1916. The undepreciated balance as of 1916 may be roughly computed as follows:
| Year | Replacements | Additions | Total | Annual depreciation at 15% | Accumulated depreciation (to 1916) | Undepreciated balandance Dec. 31, 1916 |
| 1910 | $10,000.00 | $16,871.06 | $26,871.06 | $4,030.66 | $24,183.96 | $2,687.10 |
| 1911 | 5,417.58 | 7,926.94 | 13,344.52 | 2,001.67 | 10,008.39 | 3,336.13 |
| 1912 | 7,183.04 | 4,892.88 | 12,075.92 | 1,811.39 | 7,245.56 | 4,830.36 |
| 1913 | 3,362.99 | 1,444.68 | 4,807.67 | 721.15 | 2,163.45 | 1,644.22 |
| 1914 | 3,832.57 | 229.88 | 4,062.45 | 609.37 | 1,218.73 | 2,843.72 |
| 1915 | 5,066.99 | 488.92 | 5,066.99 | 833.39 | 833.39 | 4,233.66 |
| 1916 | 5,200.02 | 961.49 | 6,161.51 | 6,161.51 | ||
| 40,063.19 | 32,815.85 | 72,390.12 | 10,007.63 | 45,653.48 | 25,736.70 |
*2778 *916 The above computation is inaccurate in that it makes no allowance in any year for depreciation of assets purchased within that year, but such error is in favor of the petitioner. The undepreciated balance thus reached is considerably less than the book balance minus the reserve set up by the respondent. The computation likewise disregards the $7,773.33 depreciation charged off on the books as of January 1, 1913. The probability that such charge-off had to do in large part at least with assets purchased prior to 1910 need hardly be pointed out. However, even if that charge-off be entirely restored to the asset balance, the result would be less than the balance allowed by the respondent.
Petitioner urges that its practice of charging off the cost of all repairs to expense also was equivalent to taking depreciation or served to compensate for failure to do so. The record is silent as to the extent of capital repairs or of the portion of such total repair costs which is properly allocable to capital account. Without such fact we are unable to determine that any of such costs should be added to the 1916 asset balance. It follows that the prima facie correctness of*2779 respondent's determination has not been overcome. The setting up of a reserve is affirmed.
In reaching such conclusion we have not overlooked the fact that an appraisal made in 1906 showed the replacement value of the assets at that time to be greater than the then asset balance. Aside from serious objections as to the weight of such evidence, it proved nothing, due to the assets concerned having been fully depreciated before the close of 1916. Nor have we overlooked petitioner's contention that, the statute of limitations having run against such prior years, the respondent may not examine or reopen the records pertaining thereto. The statute relied upon imposes limitations only upon the assessment and collection of taxes. It does not purport to relate to examinations or investigations of years past to ascertain the correct tax liability of years for which assessment and collection is not yet barred.
There remains the question whether petitioner is entitled to special assessment for the years 1920 and 1921. The grounds alleged are *917 (1) low salary paid Fred W. Cushing, president and manager; (2) advantageous rental terms; (3) good will not reflected in invested*2780 capital, and (4) invested capital can not be determined because capital items erroneously charged to expense in prior years can not now be segregated from items properly charged to expense.
There is some evidence tending to show that Cushing's salary was below a fair compensation. On the other hand the facts given us for determining what a fair salary would be deal only with the salary paid to an assistant and an offer made to him to go elsewhere. It must also be borne in mind that Cushing had under him a first-class assistant. Also, he took an annual vacation of about three months which might well affect adversely the value of his services and be reflected in his salary allowance if it were fixed by a stranger in interest. On the whole we are unable to find as a matter of fact that Cushing's salary was below a fair figure.
Nor is the evidence satisfactory as to the alleged low rent. Petitioner had the burden of keeping up the building, at least in part, which, according to Cushing's estimate, required an expenditure of $5,000 annually. It paid a yearly rental of $35,000 and Cushing estimated a fair rental to be between $40,000 and $50,000 per year. If the repair costs*2781 be added to the rent paid, the total rental would equal the $40,000 estimate, and we have no reason to believe that such addition should not be made.
No evidence was introduced respecting the other two grounds alleged. There is little in the record indicating any substantial good will asset or its value, if any. We have, due to lack of proof permitting a segregation of capital expense items, rejected petitioner's contention that replacement and repairs offset depreciation sustained. There is no direct evidence upon the point and it does not necessarily follow that invested capital could not be determined because of inability to so segregate, as failure of proof and impossibility of proof are not synonymous.
Reviewed by the Board.
Judgment will be entered for the respondent.
MILLIKEN, concurring in the result: I concur in the result reached in this case with respect to the depreciation reserve for invested capital purposes. I am of the opinion, however, that too narrow an interpretation has been placed on the cases of Cleveland Home Brewing Co.,1 B.T.A. 87">1 B.T.A. 87; Russell Milling Co.,1 B.T.A. 194">1 B.T.A. 194; Rub-No-More Co.,1 B.T.A. 228">1 B.T.A. 228;*2782 City National Bank,2 B.T.A. 623">2 B.T.A. 623; Marigold Garden Co.,6 B.T.A. 368">6 B.T.A. 368.
PHILLIPS concurs in the above.
Footnotes
1. Estimates for year ending Apr. 30, except as indicated otherwise for 1910. ↩