*1757 Claim for special assessment denied.
*1179 Proceedings for the redetermination of deficiencies of $2,712.27 and $432.16 in income and profits taxes for the respective years 1918 and 1920. The issue is whether petitioner is entitled to special assessment. In the alternative petitioner asks that its invested capital be increased. On motion of respondent and without objection by petitioner the proceedings were dismissed in so far as they related to 1917, no deficiency having been determined for that year. The proceedings were consolidated for hearing. Upon motion the hearing was limited in the first instance to the question of whether petitioner is entitled to special assessment.
FINDINGS OF FACT.
The petitioner, a Washington corporation, has been engaged in the manufacture of paper and paper products at Everett, Wash., since 1892. Its main products in the taxable years were book and label papers.
In addition to paper and pulp mills, in the taxable years petitioner operated a*1758 supercalendering department, a plant for making paper tablets, a plant for the printing of tablet covers, a plating department for linen finishing of papers, a factory for the manufacture of packing boxes, two limekilns, and, in connection with the pulp mill, a drag-saw and splinter plant for cutting logs into pulpwood.
In 1896 five or six acres of petitioner's plant site were practically a swamp. By dumping thereon dirt obtained from leveling other portions of the plant site to make way for expansion of the plant and also by dumping thereon cinders and sawdust produced and refuse accumulated, the swampy ground was sufficiently reclaimed to permit the piling thereon of cordwood. This served to give petitioner needed storage space. The filling in of this ground was carried on *1180 over many years and as the land continues to sink it is still being filled in.
Petitioner's site fronting on the Snohomish River was unprotected except for a small dock where steamers landed, and the land had been washed away from four to twenty feet. To protect the water front from the current at high water and to secure the additional space, the petitioner erected a bulkhead about 500 feet*1759 long at the meander line. The piles used were driven by a pile-driving company and the work of putting in timbers and filling in was done gradually between 1896 and 1918. A small amount of work was done after 1918. The material used was the same as that used to fill in the swamp. The wages of the men employed in the work of filling in the swamp and erecting the bulkhead were charged to expense.
The production of petitioner's plant was gradually increased from 15 tons of paper per day in 1896 to 35 tons per day in 1916, operating 24 hours a day. In order to increase the production of the plant to that quantity petitioner installed the necessary machinery and equipment to meet the new production and enlarged its plant. Some of the work was contracted and considerable of it was done gradually by petitioner's employees. The plans for the changes and additions were drawn by the master mechanic under the general supervision of the officers. The cost of the pipe used and the labor involved in making the changes in and additions to the piping system was charged to expense.
Prior to 1918 many of the piles supporting petitioner's plant became decayed for a depth of from 1 1/2 to*1760 4 feet, causing a settling of the buildings. The decayed sections of the piles were replaced by concrete piers. The work was done gradually by petitioner's employees under the supervision of its master mechanic. The buildings of petitioner's plant in 1896 had clapboard siding. They were thereafter sided with cedar or spruce siding. This work was done at odd times by regular employees, assisted occasionally by outside help. The payroll of petitioner was charged to expense.
It was petitioner's practice to capitalize the cost of new assets, work done under contract, and additions, replacements and renewals of the items were large. The smaller items, especially when the work was done by their own crew, were charged to expense. This was the practice in the industry. The items charged to capital account between 1906 and 1916 did not include any sum for overhead.
Commencing in 1904 materials purchased were recorded on cards, and the cost thereof was charged to a "stores" account. As the material was used the stores account was credited and a charge was made either to capital or expense. In deciding whether an item of equipment should be charged to expense or capitalized, *1761 its useful life was not considered. The cards on which the materials were reported accumulated rapidly and were destroyed from time to time.
*1181 At the close of each month petitioner's bookkeeper made up a summary showing amounts charged to repairs of the different departments during the month. If the amount shown exceeded the total for other months in the current and prior year, an explanation was given for the increase. These sheets contained only a portion of the items charged to repairs each month. These summary sheets are the only records in existence showing the items charged to repairs from 1906 to 1916, inclusive.
The policy of petitioner was to write its plant account down to a minimum figure. Other concerns in the paper industry did likewise. On December 31, 1909, petitioner charged off $93,532.48 of its plant account to reduce the account to about $500,000. Arbitrary credit entries were made in the account in December, 1910 and 1912, to keep it at this figure.
In 1920 a certified public accountant spent from three to six months examining the records and accounts of petitioner for the purpose of restoring to invested capital items of a capital nature*1762 which had been charged to expense. In the preparation of his report he used an appraisal inventory made in 1920, analyzed the plant account, checked from the bookkeeper's summary of repairs hereinbefore before referred to and consulted petitioner's plant superintendent to ascertain whether the items were still being used. The accountant was able to make an analysis of about 80 per cent of the items by number, but as to some of these was not able to ascertain the cost of labor and material used to install the machinery included therein, or freight or overhead. He was unable to ascertain the cost of any of the remaining items.
Respondent determined petitioner's plant account to be in the amount of $676,596.19 as of December 31, 1916. In so determining he restored to the account the sum of $279,287.35, less depreciation thereon of $21,685.84, for capital items previously charged to expense. For the year 1917 respondent made an additional allowance of $32,192.79 for capital items charged to expense, less adjustments for depreciation and abandoned items. The plant account so adjusted was included in petitioner's invested capital for the taxable years. These allowances were made*1763 strictly in accordance with data submitted by petitioner in connection with a claim filed for an increased invested capital. Respondent did not check the data in the schedules forming the basis of his allowances. In 1919 he made a further allowance of $6,758.47.
For the respective taxable years respondent determined petitioner's invested capital to be in the amounts of $1,800,354.53 and $2,209,568.72. In reaching the amount for 1918 he made an additional allowance of $20,848.84 for capital plant items erroneously charged to expense and an adjustment for the arbitrary write-down *1182 made in the account in 1909 and 1910. He also made adjustments for depreciation on the restored items and inadequate depreciation taken and capital items abandoned.
In and prior to 1896 petitioner was manufacturing low grades of paper out of a mixture of soda pulp and sulphite pulp produced from Douglas fir and cottonwood, and spruce. The Douglas fir and cottonwood pulp was produced in petitioner's soda plant and the spruce pulp in its sulphite plant. In the soda process of producing pulp the wood fibre is cooked in cylindrical steel digesters in a solution of caustic soda. In the sulphite*1764 process the fibre is cooked in a solution of sulphuric acid.
In the manufacture of print paper it is necessary to use the soda process. This process had been used generally in the industry for years, but not in the production of woodpulp out of Douglas fir. In connection with the commercial manufacture of the pulp petitioner made various experiments with each "cook" by changing the temperature or steam pressure in the digesters, increasing or decreassing the usual period for cooking the wood, or changing the mixture of the woods or solution used in the process, first one and then another, until a satisfactory formula was perfected. After numerous tests made in this manner a formula was developed which enabled to produce satisfactory pulp from Douglas fir and cottonwood by the soda process. Petitioner never attempted to patent the formula and, in fact, one other paper manufacturer made use of it, being assisted to that end by employing some of petitioner's former employees. Petitioner did endeavor to keep the formula a secret. The salaries of the plant superintendent, chemist, and plant foreman, the only employees of petitioner who performed any service in connection with the*1765 prefection of the formula, were charged to expense.
During the taxable years William Howarth was president and general manager of petitioner and A. H. B. Jordan was vice president and plant superintendent. Each received as compensation for his services an annual salary of $12,000.
Howarth entered petitioner's services in about 1892 as an auditor, and in 1895 became its general manager. Afterwards he was elected president. As president and general manager of petitioner he devoted practically all of his time to sales and finances, and, with Jordan, determined matters of policy. He also had charge of petitioner's books. During its history, petitioner's losses on account of bad debts were nominal.
Jordan became plant superintendent of petitioner in 1896. During the taxable years he was also vice president. As plant superintendent and vice president, in the taxable years he devoted practically all of his time to supervising manufacturing activities and attending *1183 to personnel matters. During the taxable years petitioner had about 275 employees. It has never experienced any labor troubles.
The stock of petitioner was held as follows during the taxable years: *1766
| Stockholders | Common stock | Preferred stock |
| Shares | Shares | |
| William Howarth | 930 1/3 | 186 2/3 |
| A. H. B. Jordan | 1,866 2/3 | 373 1/3 |
| Leonard Howarth (brother of Wm.) | 1,866 2/3 | 373 1/3 |
| Margaret Howarth (wife of Wm.) | 933 1/3 | 186 2/3 |
| William J. Pilz | 1 | |
| Augustus Johnson | 1 | |
| J. A. Coleman | 1 | |
| Total | 5,600 | 1,120 |
The gross sales and net income of petitioner from the manufacture and sale of paper, and the dividends it paid in the taxable years, were as follows:
| Item | 1918 | 1920 |
| Gross sales | $2,021,549.41 | $3,044,799.74 |
| Net income | 761,319.19 | 1,270,572.71 |
| Dividends | 160,160.00 | 428,400.00 |
Prior to his determination of the deficiencies involved herein respondent considered petitioner's claim for special assessment for 1917 and 1918. In his 30-day letter for 1918, respondent, in denying the claim, advised petitioner that the "audit disclosed no exceptional hardship evidenced by gross disproportion between the tax computed without benefit of the above sections and the tax computed by reference to the representative corporations specified in Sections 210 and 328." The notice of deficiency for 1918 contains no statement regarding action*1767 taken on petitioner's claim for special assessment for that year.
In his notice of deficiency for 1920 respondent stated that petitioner's application for special assessment for 1920 had been properly denied "for the reason that no abnormality affecting either your capital or income has been disclosed which would bring your case within the scope of Paragraph (d) of Section 327."
OPINION.
ARUNDELL: The petitioner asks us on the record made to hold that the facts warrant the determination of petitioner's taxes under sections 327 and 328 of the 1918 Act instead of at the statutory rates. The grounds alleged are that the invested capital can not be determined and, furthermore, that there is an abnormality within the meaning of subdivision (d) of section 327 of the Revenue Act of 1918.
*1184 We suppose all will concede, where the statute provides for the determination of the tax under the provisions of section 328 in a case where the invested capital can not be determined, that it does not mean that every penny must be definitely traced. If this be so, the determination of the tax under section 328 would be the usual rather than the unusual method. It is a well known*1768 fact that before the incidence of the income tax strictly accurate accounting records were seldom to be found. Especially was this true in the case of small or closely held corporations such as petitioner, where it was not important whether or not certain items were charged to capital account or to expense. Congress was conversant with this fact, but it certainly did not intend because of the difficulty of the proof, or where the irregularity in the accounting method was not substantial, that such an extraordinary method as section 328 should be resorted to.
Section 326 of the Revenue Act of 1918, defines invested capital as, "Actual cash bona fide paid in for stock or shares; actual cash value of tangible property, other than cash, bona fide paid in for stock or shares, at the time of such payment * * *; paid-in or earned surplus and undivided profits * * *." The Commissioner has determined what he says is petitioner's invested capital, but petitioner disputes the Commissioner's ability to make the determination, because it claims that its earned surplus may not be determined by reason of the fact that certain so-called plant items were charged to expense which should have been*1769 capitalized, and it is now impossible to correct the errors so made. The determination by the Commissioner of petitioner's invested capital as we understand it is not challenged except as it relates to the plant account. For the year 1918 the Commissioner determined a total invested capital of $1,800,354.53, in reaching which figure he determined petitioner's plant account to be $723,635.66. For the year 1920 the total invested capital was determined by the Commissioner to be $2,209,568.73, and petitioner's plant account was fixed at $735,319.78. In reaching the figure that he did for the plant account in 1918 and again in 1920, the Commissioner made various adjustments which served to correct the plant account as recorded on petitioner's books, chief among which was to restore to the capital account $93,532.48, an amount arbitrarily charged out of petitioner's plant account on December 31, 1909, and to restore to invested capital the sum of $279,287.35, less depreciation thereon of $21,685.84, covering capital items previously charged to expense. A further allowance was made of $32,192.79, less adjustments for depreciation and abandoned items, which had been improperly charged*1770 to expense. The restoration resulted altogether from the research efforts of accountants employed by petitioner to that end, a matter about which we will speak further on in this opinion.
*1185 In support of its contention that its invested capital can not be determined, petitioner approaches the matter from several angles. It appears that in 1920 the American Appraisal Company appraised petitioner's property. With this appraisal as a guide, an accountant was employed who attempted to trace the cost of the several items included therein and was able to locate 80 per cent of the items, though as to some of them he could not determine such incidental costs as freight, installation charges, and overhead chargeable to the items. As to 20 per cent of the items he could not trace or identify their cost. The identified items weres restored to invested capital by the Commissioner in the amounts requested by the petitioner, after adjustments for depreciation and abandoned items were made. The record is absolutely silent as to the nature of the items constituting the 20 per cent the cost of which the accountant did not determine. The appraisal was not offered in evidence. The*1771 ease with which large items may be traced compared with minor ones in our opinion warrants the inference that the items the cost of which could not be determined were minor rather than major items. Nor was there any evidence offered as to the number or nature of the items the installation, freight costs, and overhead of which could not be located. We are left to conjecture where we might have been advised.
Various exhibits were presented which listed large numbers of items which it was claimed should have been capitalized, but which were in fact charged to expense. These items ranged in cost from one dollar to several hundred dollars. While we do not understand that the lists were intended to be complete, but rather typical of items improperly charged to expense, we are nevertheless impressed with the fact that they represent a careful combing of the expense account for items which it may have been proper to capitalize. How many of these items so listed were ones which were later restored to capital account by the Commissioner as a result of the accountant's work we do not know. In the early years of petitioner's life it appears that the charges were made purusant to specific*1772 instructions of Howarth, the general manager, and after 1904 all outside purchases and labor charges were capitalized and all labor costs of their employees, if they be related to such items, were likewise capitalized. The testimony of Jordan, the plant superintendent, and one of the three controlling interests, was to the effect that the custom in the industry was to charge all but large items to expense.
As examples of work performed, the cost of which was charged to expense and which it is now said to be impossible to trace, were the filling in of five or six acres of marshy ground, replacement of rotting piling, installing of various water pipes, the re-siding of *1186 certain buildings, etc. The labor for this work was largely performed by various employees, at odd times when their services were not otherwise needed and over a period of twenty years. The marshy ground was reclaimed by filling in dirt from land that had been leveled for building purposes and by dumping sawdust, cinders and plant refuse thereon. We have no idea of the amount and value of the sawdust used. While the enlargement of the water system would appear at first blush as a capital item, the*1773 manner of making the change a little at a time over a long period of years makes it difficult to definitely stamp it one way or another. This same comment we believe apropose to the re-siding of the buildings, and the other items mentioned in this paragraph. Not even an approximate cost was suggested as to the items as a whole or any one of them.
The testimony discloses that in 1920 petitioner installed a new system of books which it claims clearly reflects its operations by capitalizing what properly should be so treated and charging the balance to expense. It is interesting to note that plant repairs during 1920 were in the amount of $82,234.80, which figures does not compare unfavorably with the sums charged to expense in prior years.
Our conclusion is that petitioner has failed to sustain its burden that its invested capital may not be determined.
In support of its claim that there is an abnormality of income within the meaning of section 327(d), petitioner asserts that salaries to officers were low and that petitioner had developed a formula of value for the production of wood pulp.
It is not enough that salaries paid officers be low. To come within the provisions*1774 of section 327(d) it must be shown that the salaries paid are abnormally low in comparison with other corporations. ; .
The evidence fails to convince us that a reasonable annual salary for Jordan and Howarth would have been $50,000 each, the amount suggested by petitioner. Jordan frankly admitted that the petitioner would not have brought two outsiders into the organization and paid them $50,000 apiece. The salaries paid these two officers certainly were not nominal, even although the business might have justified paying more. Nothing was offered to show the salaries paid by other similar corporations for like services. We can not say that the salaries paid created an abnormal condition.
The formula used by petitioner, as we understand it, was the application of the soda process to the production of pulp from Douglas fir. The soda process had been used generally in the industry *1187 for years. There is no secret about it and there is no patent. Where the wood out of which pulp is made varies the formula has to be varied and so to get the best results from Douglas fir*1775 petitioner watched each "cook" and varied the solution, or the temperature as experience dictated until it was getting good results. The field was open to other paper manufacturers having available a supply of Douglas fir. Jordan concedes this though he thinks a new company would have "grief" until it learned from experience the best formula. In fact another paper company did use this very formula, though it hired away some of petitioner's employees to help them get started. Other paper companies on the Pacific Coast used Douglas fir, but in making pulp from it they use the sulphite process which is cheaper. Petitioner uses the soda process because its product is print paper which requires the soda process to make.
We are not persuaded that there is an abnormality in petitioner's income warranting the application of the special assessment provisions.
There remains for consideration one other matter, which relates solely to the year 1918. The gist of petitioner's argument in this particular is that the statement made by respondent in his so-called thirty-day letter to the effect that a comparison with representative corporations showed no relief, creates a prima facie presumption*1776 that respondent determined petitioner's right to special assessment and that the Board should hold without further proof that it is so entitled to have its profit computed under section 328. We think petitioner's argument is without merit. The proceedings before the Board are bottomed on the notice of deficiency and not on preliminary action taken by the respondent. The deficiency notice contained no admission or concessions, but denied flatly petitioner's right to special assessment. Nor do we believe that respondent's thirty-day letter carries with it the broad implications urged by the petitioner. But even if we are wrong in this particular, our conclusion would be the same, as respondent can not be held to a preliminary action taken by him in the course of the consideration of a case.
Petitioner asks, if its claim for special assessment be denied, that it be granted an increase in its invested capital over that allowed by the respondent. Petitioner's counsel, in the course of the trial of the case and at the time the pleadings were amended so as to raise this issue, frankly stated he was not optimistic enough to believe that this prayer could be granted. We agree with*1777 counsel. The proof is insufficient.
Decision will be entered for the respondent.