*3911 1. Evidence examined and value of tangible property paid in for capital stock determined as of September 1, 1912, for invested capital purposes.
2. Where the taxpayer, owing to a change in business conditions, discarded a dry press brick plant in 1918 and never used same thereafter, there should be deducted from the gross income for that year the difference between the depreciated cost of the plant and the salvage value thereof, if any.
3. A liability to respond in damages for the breach of a contract occurring in the regular course of the taxpayer's business is a liability incurred at the time of the breach, and an approximately accurate estimate of such damages set up on the taxpayer's books to meet such damages may properly be claimed as a deduction from gross income for the taxable year in which the breach occurred, although the exact amount required to liquidate such damages may not be determined until a later period. When the exact amount is ascertained only that amount may be deducted.
*1253 The amended petition alleges that the*3912 taxes in controversy are income and profits taxes for the years 1917, 1918, 1919 and 1920. The respondent did not assert a deficiency for the years 1918 and 1920. At the hearing, the proceedings relative to 1918 and 1920 were dismissed for the reason that the respondent had not asserted a deficiency for said years.
The respondent determined a deficiency of $1,069.30 for 1917 and $5,338.80 for 1919.
The petitioner assigns as errors in the determination of the deficiencies: (a) Failure of the respondent to allow paid-in surplus at the date of the incorporation of the Fraser Brick Co., September 1, 1912, in the sum of $84,446.53; (b) failure of the respondent to allow depreciation for the calendar years 1917, 1918, 1919 and 1920, on petitioner's depreciable assets on the basis of cost, which was the fair market value as of March 1, 1913; (c) failure of the respondent to allow a deduction for 1917 of a loss resulting from liability arising by reason of a guarantee by the petitioner of certain work by another corporation, where the work failed to satisfy the guarantee and the corporation whose work was guaranteed was insolvent; (d) failure of the respondent to allow the deduction*3913 for depreciation or obsolescence for the year 1919 on a certain dry press brick plant owned by petitioner, use of which was discontinued in 1918; (e) the statute of limitations bars the assessment and collection of the deficiency for the year 1917.
At the hearing, counsel for petitioner waived the last mentioned assignment of error.
FINDINGS OF FACT.
The petitioner is a Texas corporation engaged in the manufacture and sale of brick and hollow tile. Its principal office is located at Dallas, Texas. For several years prior to September 1, 1910, the business was conducted as a partnership composed of W. B. Fraser and Chas. A. Myers. On September 1, 1910, J. H. Payne became *1254 a partner by purchasing a 5 per cent interest for $5,000 and each of the others retained a 47 1/2 per cent interest. In June, 1912, Myers sold his 47 1/2 per cent interest to Fraser for $40,000 and on September 1, 1912, the petitioner was incorporated with a capital stock of $50,000 par value, which was issued in payment for the entire assets of the Fraser-Myers Brick Co., the partnership above mentioned.
At the time of the incorporation of the petitioner the net worth of the assets of the*3914 preceding partnership was set up on its books at $134,446.53, and the same amount was used by the petitioner in opening its books at the beginning of business September 1, 1912. The balance sheet was as follows:
| FRASER BRICK COMPANY, SEPTEMBER 1, 1912. | ||
| Property Account | $8,433.55 | |
| Mines Devel. (This charged off) | ||
| Brick Stock Account (Inventories Frt. out etc.) | 17,138.86 | |
| Water Supply | 3,536.09 | |
| Works Cash Dep | 58.50 | |
| Stiff Mud Plant | 75.00 | |
| Office Furniture | 828.44 | |
| American Exch. Nat'l Bank | 4,044.29 | |
| Property Development | 6,031,28 | |
| Harris Royalty | 281.13 | |
| Houses Acct | 9,877.07 | |
| Brick Plant Constn. Acct | 61,628.89Accts. Receivable as per memo Folio #251-2 | 25,945.99 |
| First Nat'l Bank "E" | $1,963.99 | |
| As per memo Folio #252 Accts. Payable | 1,468.57 | |
| Capital Stock | 50,000.00 | |
| Surplus | 84,446.53 |
The partnership preceding the petitioner began business about 1905. It was engaged in the manufacture of brick of various kinds and became the owner of 181 acres of clay bearing land upon which it erected buildings, machinery, kilns, a railroad switch, and other facilities necessary for the purposes of its business and the housing of its employees.
The figures*3915 set up on petitioner's balance sheet as of September 1, 1912, represented the cost of its assets, and it was the policy of the partnership and petitioner to maintain said assets at the highest state of efficiency by repairs, replacements, and betterments, which were charged to expense. The actual cash value of petitioner's assets as of September 1, 1912, was $134,446.53. The March 1, 1913, value was cost less depreciation sustained to that date.
In August, 1917, the Tennessee Farm Dairy, a corporation, entered into a contract with the Dallas Paving Co., a corporation, for the *1255 erection of a silo, for which the petitioner was to furnish the building material. As security, the Tennessee Farm Dairy required the petitioner to guarantee the silo for a period of ten years against defects resulting from faulty design, material or workmanship. When filled with silage, the silo collapsed in October, 1917, damaging the silo and its contents, whereupon, before the close of 1917, the petitioner acknowledged its liability to the Tennessee Farm Dairy, and entered upon its books as an estimated liability the sum of $4,000. Before the close of 1917, it ascertained that the Dallas*3916 Paving Co. was insolvent and the $4,000 was charged off as a loss on December 31, 1917. The liability of petitioner was finally settled in the spring of 1918 for $3,000. The books of account of petitioner were kept and maintained upon an accrual basis.
In the prosecution of the business, the partnership and petitioner used what is known in the record as the "dry press brick plant." Owing to a change in business demands and methods of manufacture, the use of this dry press brick plant was discontinued in 1918, and a new plant for a different process was erected in 1918 and used thereafter. The old or "dry press brick plant" was not junked, but was never used again by petitioner in the business.
OPINION.
MILLIKEN: The principal issue relates to the claim for a paid-in surplus in the amount of $84,446.53. No question is involved concerning the right to the same for the years in question. We are concerned with only the amount. Respondent in his determination has allowed a paid-in surplus in the amount of $34,210.
The respondent as a basis for his action resorted to the sale in 1912 by one of the partners of a 47 1/2 per cent interest as establishing the actual cash value*3917 of the assets acquired by petitioner at date of incorporation. Such a sale standing alone would no doubt be a sufficient index to support the conclusion reached. Petitioner, however, placed both Fraser and Myers on the witness stand and their testimony reveals that the sale was akin to a forced sale and quite without regard to the real value of the assets involved. Myers did not desire to continue in the business and was prepared to and did offer his interest to his relative and co-partner at a price below its actual cash value. Prior to his connection with the partnership he was engaged in the newspaper business and desired to return thereto. In 1912 he had found such an opportunity requiring capital and he made an offer to sell to Fraser his interest, which was promptly accepted without further negotiations; Myers being *1256 satisfied with a quick sale and Fraser accepting what he considered a bargain. Testimony was also introduced concerning the actual cash value of each of the assets.
An examination of the balance sheet of the petitioner of September 1, 1912, shows that it had in bank $4,044.29 and cash at its manufacturing plant of $58.50. These items were clearly*3918 worth par and were allowed by the respondent.
The brick stock account or inventory showed manufactured products on hand of the value of $17,138.86. The evidence is to the effect that this stock was inventoried at cost, and that the fair market price or value was perhaps 25 per cent in excess of same. The respondent allowed this item in the amount of $17,138.86, which we think was correct and his action is approved.
Water supply was set up at $3,536.09. This consisted of a deep well costing $1,600, pump, pipes and lines to dwelling houses and manufacturing plant, comprising a water works system essential to the carrying on of the business of the petitioner and for the comfort of its employees. The president of the petitioner testified that the cost of said system was $3,536.09, that it had been kept in the best of condition by repairs and replacements, and that its actual cash value was $3,536.09. This should be allowed in full.
Expenditures for stiff mud plant $75, and for office furniture $828.44, should be allowed in full, as should also accounts receivable $26,227.12, as the evidence showed all accounts were collected in full and were worth the face amount on September 1, 1912.
*3919 Deductions made by the respondent were mainly as follows: Property account from $8,433.55 to $3,354.78; property development from $6,031.28 to $2,399.18; houses from $9,877.07 to $3,929.00, and brick plant construction account from $61,628.89 to $24,514.84. The evidence of record does not support the action of the respondent concerning the values so determined.
Relative to the property account of $8,433.55, it appears from the evidence that the petitioner's predecessor purchased 181 acres of land in 1905 for $8,433.55 and it has been carried on the books ever since at the original cost, which is $46.55 per acre. It is shown in the evidence that this land is underlaid by clay beds of fine quality of an average thickness of 14 feet, running about 27,000 tons acre of the value of 2 cents per ton, or $540 per acre. There is other evidence to the effect that this land on September 1, 1912, had a fair market value of $250 per acre. In view of the same, we must disapprove the respondent's determination on this item and hold that the property account should be allowed in full.
*1257 The property development account of $6,031.28 represents a $3,020 expenditure for a steam*3920 shovel 10 1/2 months before the incorporation of the petitioner, five-eighths of a mile of railroad rails, ties and switches, and small tool houses.
The items of this account were put down at cost and according to the only evidence relative thereto the railroad switch and steam shovel were kept in the very best of condition, and at the date of incorporation were of the actual cash value carried on the books. The respondent only allowed $2,399.18 on this account, which is $620.82 less than the cost of the steam shovel alone which had been purchased only a short while before the incorporation. This account should be allowed in full.
The houses account of $9,877.07 was reduced by the respondent to $3,929. It appears from the evidence that in order to furnish living quarters for its employees, petitioner's predecessor built 34 frame residences with brick foundations, and a brick store. The residences were of two, three and four rooms. The average cost was $282 and the actual cost only was carried on the books. The Federal Trade Commission in making an audit and examination of the petitioner in 1918 fixed the cost of these houses at $11,784.95. In view of all the evidence we*3921 think that $9,877.07 is a very conservative charge for these houses and this should be allowed without reduction.
The remaining account is that of brick plant construction, $61,628.89, which comprised the power plant consisting of boiler, engine, pumps, water heater, the dry press brick plant, eight kilns, oil burning equipment, factory buildings and other miscellaneous facilities. The principal item in this account is the dry press brick plant $40,434.29. It appears from the evidence that only the actual cost of the items comprising this account was charged and that the values fixed were very conservative. Our opinion is that this also should be allowed in full.
The controversy concerning depreciation relates to the basis for the computation rather than the rate. Petitioner accepts the rate determined and used by respondent in the determination of the deficiencies for the years in question. We find no occasion to change the rate. Invested capital and deductions for depreciation should be computed in accordance with the basis set forth in our findings of fact.
The petitioner and its predecessor used in the manufacture of brick what is known in the record as the "Dry*3922 Press Brick Plant." Owing to a change in business demands avd methods of manufacture the use of this plant was discontinued in 1918, and it was replaced *1258 by different and more modern machinery and methods. It was not junked but remained standing on the company's grounds. The respondent contends that deduction therefor should be made from the gross income for 1918, while the petitioner submits that 25 per cent thereof should be deducted yearly for the years 1918, 1919, 1920 and 1921. It is significant that, in making its return for 1918, petitioner stated that the dry press brick plant had been abandoned and scrapped. Based upon the evidence we are satisfied that the loss occurred in the year 1918, and the respondent's action is approved. .
In August, 1917, the Tennessee Farm Dairy, a corporation, entered into a contract with the Dallas Paving Co., a corporation, for the construction by the latter of a large silo upon the property of the former. The petitioner was to furnish the necessary brick and as security the Tennessee Farm Dairy required the petitioner to guarantee the silo for a period of ten years against*3923 defects resulting from faulty design, workmanship or material used therein, which the petitioner did.
When the silo was first filled with silage in the early fall of 1917, the silo collapsed, causing great damage to the silo and its contents of 850 tons. The petitioner admitted its liability, but as the exact amount of damage could not be immediately ascertained, it estimated that its possible liability was $4,000, which it entered on its books as such during 1917. Before the close of the year 1917, it ascertained that the Dallas Paving Co. was hopelessly insolvent, its claim against the Paving Co. worthless and it therefore charged off the item as a loss in and for 1917.
The loss was actually settled in June, 1918, by the petitioner paying the Tennessee Farm Dairy $3,000, with no reimbursement from the Dallas Paving Co.
The Commissioner insists that the loss should be deducted from 1918 income, while the petitioner contends that it is entitled to the deduction from 1917 income. We are of the opinion that the facts of this case bring it within the rule laid down in *3924 , that the petitioner is right and that the deduction should be allowed from 1917 income, but for only $3,000, the amount actually paid.
Judgment will be entered on 15 days' notice, under Rule 50.