*3398 1. The release by a corporation of an employee from a debt in consideration of the retention of his services held deductible from gross income under section 12(a) of the Revenue Act of 1916.
2. Cost of assets for the purpose of restoring surplus to invested capital and fair market value of assets as of March 1, 1913, determined.
*1165 This proceeding involves deficiencies in income and profits taxes for the calendar years 1917 and 1918, in the respective amounts of $879.89 and $99,144.13.
Petitioner asserts the following errors: (1) Refusal of respondent to allow as a deduction from gross income for the year 1917 ordinary and necessary expenses of carrying on its business; (2) refusal of respondent to allow as a deduction a reasonable allowance for exhaustion, wear and tear of property used in its business; (3) refusal of respondent to allow as invested capital the total amount of cash and property paid in for stock for earned surplus and undivided profits; (4) rejection by respondent in determining invested capital*3399 of an appraisal of its properties submitted by petitioner; and (5) deduction by respondent of prorated income and profits taxes for the preceding year from invested capital for the current year, for the *1166 purpose of computing excess-profits tax for the years 1917 and 1918. At the hearing petitioner abandoned errors (3) and (5).
FINDINGS OF FACT.
Petitioner is a corporation engaged in the manufacture of pipe fittings, pipe-threading tools, valves and oil well supplies. The business was started by two Jerecki brothers in 1852. Petitioner was organized in 1897 with a capital stock of $1,000,000, 92 per cent of which was held by the Jerecki family at the date of the hearing. It is and has always been a family affair. Up to 1918 its method of accounting was inadequate and incomplete. About that date a new system was installed. The system installed did not attempt to reconstruct the old books for the reason that the condition of the old books rendered such a course impracticable. Petitioner had no cost system and its books did not clearly disclose its financial condition. A large part of its machinery and equipment did not appear upon its books and the books did*3400 not always reflect the total cost of that which did appear thereon. On August 3, 1915, there was a flood in a creek which flowed under the accounting rooms. These rooms were submerged to a depth of about 10 feet. Some of the records were lost and such as remained were watersoaked and covered with mud. A revenue agent who examined these books in the summer of 1920 was compelled to use a microscope. Respondent, in computing petitioner's invested capital for the years involved, while making adjustments of various accounts, adopted these books as the basis for his determinations. Respondent made no determination of the value of the assets as of March 1, 1913. Recognizing the incompleteness of the books, the examining agent, whose report was the basis of respondent's determinations, advised petitioner's officers to have an appraisal of its properties made by disinterested parties and to submit such appraisal to respondent. Thereupon, in the latter part of 1920, petitioner employed an appraisal company to make an appraisal of all its fixed assets at Erie, Pa. This company sent about ten men to Erie to make an appraisement. These men spent 260 1/2 working days on the job. Petitioner*3401 had two plants at Erie, one known as the Ninth Street Plant, or Brass Foundry, and the other as the Twelfth Street Plant, or Iron Foundry. Employees of the appraisal company measured every building, made a plan showing the relation of such buildings to the others, made ground plans, made cross sections, determined the amount, character and cost of various materials used therein, and, in short, made a complete bill of specifications of all that went into their construction. Every machine was located, numbered, fully described. The same was done with reference to all other equipment. A complete list was made of *1167 all the fixed property of petitioner situated in Erie. The appraisers were assisted by a former appraisal made by the same company in 1902, when all the then fixed assets, except patterns and lands, were appraised. The appraisers carefully noted the condition of each machine or item of equipment and from its then condition and its past history and use determined its remaining useful life. The date of acquisition of each piece of property, machine or other item appraised, was ascertained from the books, if that source indicated such date. If this date could*3402 not be found in the books, such item was taken in connection with some other item or factor with which it was coordinated. The memories of the old employees were tested and then they were questioned as to such date of acquisition. about two-thirds of the items appraised were acquired by petitioner prior to 1902. There was little change between 1897 and 1902. There was little change in petitioner's art and quite old machines were still in active use in 1920. When the date of acquisition was determined the books were searched for cost, and wherever that appeared it was used to determine cost. If the cost did not appear on the books, price lists of similar articles published as of date of acquisition were used. Petitioner made some of its machinery and nearly all, if not all, its patterns. The books contained meagre information on the cost of such articles. Sometimes the labor directly involved would appear; sometimes the cost of the materials; and in some cases both the cost of such labor and material. Sometimes total but not individual cost appeared. In such cases the appraisers used contemporary price lists of similar machines or they determined the cost by taking into consideration*3403 the cost of the material and the cost of the labor directly used, and added thereto an overhead charge which did not contain taxes, interests, or similar carrying charges.
When the future useful life of each machine or other asset was determined and also the date of acquisition, the part of its life applicable to the past was spread over the previous years. Each machine or other item was treated separately and individual cost and life determined. Obsolescence, renewals, and repairs were taken into consideration. Where all items had been renewed, its original cost only was used. When all this was done the items were classified and a weighted rate of depreciation was applied to the class. In this way the depreciated cost of all the property, as of March 1, 1913, was determined.
The appraisal company also determined the fair market value of all such property at Erie as of March 1, 1913, by applying to each asset its reproductive cost as of that date, depreciated in the same manner and at the same rates as were applied to actual cost.
*1168 The cost of petitioner's property at the Ninth Street Plant, which it owned on March 1, 1913, and its fair market value as of*3404 said date are as follows:
| Cost | Depreciated costs | |
| and fair market | ||
| value | ||
| Land | $22,958.78 | $22,958.78 |
| Buildings: | ||
| Construction | 223,014.84 | 170,927.71 |
| Plumbing | 2,240.42 | 1,525.50 |
| Heating | 6,097.51 | 5,754.83 |
| Electric lighting | 2,629.34 | 1,570.08 |
| Fire protection piping | 124.49 | 94.10 |
| Sprinkler system | 6,769.22 | 6,495.90 |
| Building elevators | 3,223.00 | 1,864.93 |
| Building fixtures | 24.62 | 21.42 |
| Fees | 16,378.76 | 12,583.84 |
| Total of buildings | 260,502.20 | 200,829.31 |
| Equipment: | ||
| Machine foundations | 2,183.88 | 1,538.86 |
| Steam power plant | 13,520.00 | 9,235.15 |
| Electric power plant | 4,993.45 | 4,033.35 |
| Power piping | 2,540.15 | 2,080.30 |
| Motors | 3,545.22 | 3,089.21 |
| Power feed wiring | 1,016.83 | 930.61 |
| Machinery | 247,904.30 | 139,521.84 |
| Multiple core and drying boxes | 4,804.80 | 3,123.12 |
| Forges and furnaces, including pyrometer system | 3,925.46 | 2,844.57 |
| Cranes and hoists | 4,263.75 | 3,817.63 |
| Dust collector system | 284.61 | 167.93 |
| Blower system | 211.12 | 124.56 |
| Tanks | 670.80 | 627.61 |
| Manufacturing piping and fitting | 2,834.68 | 1,960.52 |
| Machine pulleys | 2,324.21 | 1,476.75 |
| Machine belting | 7,463.62 | 5,081.03 |
| Transmission | 9,225.79 | 5,162.53 |
| Factory furniture and fixtures | 14,200.74 | 9,422.23 |
| Scales | 1,306.92 | 915.00 |
| Trucks | 613.30 | 398.61 |
| Fire protection equipment | 1,053.05 | 684.45 |
| Tools and perishable equipment | 161,545.83 | 111,282.68 |
| Plating equipment | 166.40 | 106.50 |
| Totals of equipment | 490,598.91 | 307,625.04 |
| Patterns | 88,192.02 | 60,053.82 |
| Flasks | 420.22 | 266.66 |
| Jigs and fixtures | 10,164.96 | 7,128.88 |
| Administration equipment: | ||
| Office furniture and fixtures | 2,242.75 | 1,569.94 |
| Factory office furniture and fixtures | 273.68 | 103.97 |
| Service equipment, including fire alarm system | 1,458.50 | 1,007.89 |
| Totals of administration equipment | 3,974.93 | 2,681.80 |
| Delivery equipment: | ||
| Horses and mules | 1,650.00 | 1,650.00 |
| Wagons and harness | 967.50 | 802.26 |
| Totals of delivery equipment | 2,617.50 | 2,452.26 |
| Unused equipment | 9,288.05 | 4,762.68 |
| Grand totals | 888,717.57 | 608,759.23 |
*3405 *1169 The cost of petitioner's property at the Twelfth Street Plant, which it owned on March 1, 1913, and its fair market value as of said date, are as follows:
| Cost | Depreciated costs | |
| and fair market | ||
| value | ||
| Land | $30,000.00 | $30,000.00 |
| Railroad siding | 1,084.10 | 477.00 |
| Buildings: | ||
| Construction | 96,428.92 | 67,976.81 |
| Plumbing and sewerage | 1,886.43 | 1,357.18 |
| Heating system | 1,509.64 | 781.35 |
| Electric lighting system | 485.68 | 404.00 |
| Fire protection piping and fittings | 30.48 | 18.89 |
| Sprinkler system | 10,216.63 | 6,801.57 |
| Building elevators | 680.00 | 529.00 |
| Foundations for building fixtures | 69.47 | 35.40 |
| Architects' and engineers' fees | 7,021.75 | 4,936.35 |
| Totals of buildings | 118,329.00 | 82,840.55 |
| Machinery and equipment: | ||
| Machine foundations | 1,247.15 | 788.17 |
| Power plant | 7,076.35 | 4,173.47 |
| Power piping and fittings | 1,489.00 | 773.06 |
| Power feed wiring | 171.37 | 119.96 |
| Machinery | 20,292.39 | 14,807.53 |
| Core plates and dryers | 4,112.34 | 3,517.86 |
| Forges and furnances | 21,168.11 | 16,781.81 |
| Cranes and hoists | 6,975.00 | 5,168.27 |
| Dust collector system | 390.38 | 216.22 |
| Blower system | 1,173.48 | 666.83 |
| Tanks | 76.00 | 54.94 |
| Manufacturing piping and fittings | 1,801.34 | 937.93 |
| Machine pulleys | 295.50 | 184.28 |
| Machine belting | 1,042.78 | 746.69 |
| Transmission | 2,255.99 | 1,462.65 |
| Factory furniture and fixtures | 3,615.06 | 2,539.62 |
| Scales | 635.40 | 423.28 |
| Trucks | 451.19 | 307.46 |
| Fire protection equipment | 467.75 | 390.17 |
| Tools and perishable equipment | 1,481.89 | 948.77 |
| Totals of machinery and equipment | 76,218.47 | 55,008.97 |
| Patterns | 250,597.82 | 184,377.62 |
| Flasks | 8,987.55 | 6,653.12 |
| Administration equipment: | ||
| Factory office furniture and fixtures | 267.87 | 202.60 |
| Service equipment | 456.33 | 305.75 |
| Totals of administration equipment | 724.20 | 508.35 |
| Delivery equipment: | ||
| Wagons | 235.00 | 158.25 |
| Unused machinery | 5,647.06 | 2,426.47 |
| Grand totals | 491,823.20 | 362,450.33 |
*3406 The additions to and deductions from the property of petitioner at the Ninth Street Plant during the period from March 1, 1913, to *1170 December 31, 1913, and during 1914, 1915, 1916, and 1917, are as follows:
| Mar. 1 to Dec. 31, 1913 | 1914 | |||
| Additions | Deductions | Additions | Deductions | |
| Land | $2,000.00 | |||
| Buildings: | ||||
| Construction | $18.12 | 746.89 | ||
| Heating | 15.71 | |||
| Sprinkler system | 2,188.96 | 8,435.51 | ||
| Building fixtures | 813.09 | |||
| Architects' and engineers' fees | 1.27 | 53.38 | ||
| Totals of buildings | 2,208.35 | 10,064.58 | ||
| Equipment: | ||||
| Motors | 256.85 | |||
| Machinery | 4,051.10 | $127.00 | 6,221.01 | $13,430.00 |
| Forges and furnaces, including | ||||
| pyrometer system | 222.50 | |||
| Cranes and hoists | 191.84 | |||
| Machine pulleys | 26.64 | 39.43 | ||
| Machine belting | 151.22 | 246.37 | ||
| Transmission | 114.90 | |||
| Factory furniture and fixtures | 1,377.09 | |||
| Scales | 5.13 | |||
| Totals of equipment | 4,228.96 | 127.00 | 8,675.12 | 13,430.00 |
| Administration equipment: | ||||
| Office furniture and fixtures | 255.50 | |||
| Factory office furniture and | ||||
| fixtures | 68.85 | |||
| Service equipment, including | ||||
| fire alarm | 65.00 | 1,566.00 | ||
| Totals of administration | ||||
| equipment | 65.00 | 1,890.35 | ||
| Unused equipment, including | ||||
| unused machinery, unused | ||||
| shaft and pulleys | 23.85 | |||
| Totals of Ninth Street plant | 6,502.31 | 127.00 | 22,653.90 | 13,430.00 |
| 1915 | 1916 | |||
| Additions | Deductions | Additions | Deductions | |
| Buildings: | ||||
| Construction | $781.26 | $5,300.81 | ||
| Plumbing and sewerage | 75.92 | .36 | ||
| Heating | 40.10 | 16.32 | ||
| Electric-lighting system | 8.03 | 10.44 | ||
| Sprinkler system | 20.79 | |||
| Architects' and engineers' fees | 63.37 | 372.96 | ||
| Totals of buildings | 989.47 | 5,700.89 | ||
| Equipment: | ||||
| Steam-power plant | 166.80 | |||
| Power-feed wiring | 112.52 | |||
| Machinery | 582.20 | $1,015.00 | 2,978.85 | $2,492.00 |
| Cranes and hoists | 217.20 | |||
| Blower system | 31.52 | 179.00 | ||
| Machine pulleys | 11.39 | 17.20 | ||
| Machine belting | 57.18 | 81.49 | ||
| Transmission | 29.37 | 285.85 | ||
| Factory furniture and fixtures | 43.07 | |||
| Totals of equipment | 711.66 | 1,015.00 | 4,081.98 | 2,492.00 |
| Administration equipment: | ||||
| Office furniture and fixtures | 255.50 | 1,078.79 | ||
| Factory office furniture and | ||||
| fixtures | 154.94 | |||
| Service equipment, including | ||||
| fire alarm | 1,710.00 | 200.00 | ||
| Totals of administration | ||||
| equipment | 255.50 | 2,943.73 | 200.00 | |
| Totals of Ninth Street plant | 1,956.63 | 1,015.00 | 12,726.60 | 2,692.00 |
| 1917 | ||
| Additions | Deductions | |
| Buildings: | ||
| Construction | $1,200.28 | |
| Plumbing and sewerage | 2,349.94 | |
| Building elevators | 8,710.00 | $1,780.00 |
| Architects' and engineers' fees | 248.52 | |
| Totals of buildings | 12,508.74 | 1,780.00 |
| Equipment: | ||
| Motors | $460.00 | |
| Machinery | 7,266.40 | 6,746.00 |
| Forges and furnaces, including pyrometer system | 1,082.00 | |
| Tanks | 575.00 | |
| Machine pulleys | 213.25 | |
| Machine belting | 302.63 | |
| Transmission | 4,133.39 | |
| Totals of equipment | 14,032.67 | 6,746.00 |
| Administration equipment: | ||
| Office furniture and fixtures | 307.55 | |
| Welfare equipment | 200.56 | |
| Totals of administration equipment | 508.11 | |
| Totals of Ninth Street plant | 27,049.52 | 8,526.00 |
*3408 *1171 The additions to and deductions from the property of petitioner at the Twelfth Street plant during the period from March 1, 1913, to December 31, 1913, and during 1914, 1915, 1916, and 1917, are as follows:
| March 1-December 31, 1913 | 1914 | |||
| Additions | Deductions | Additions | Deductions | |
| Buildings: | ||||
| Construction | $ 103.21 | $19.62 | ||
| Architects' and engineers' fees | 7.22 | 1.37 | ||
| Totals of buildings | 110.43 | 20.99 | ||
| Machinery and equipment: | ||||
| Machine foundations | $38.24 | |||
| Machinery | 1,823.79 | $610.00 | 2,273.50 | 332.00 |
| Pyrometer system | 310.20 | |||
| Machine pulleys | 10.38 | 2.69 | ||
| Machine belting | 18.30 | 8.70 | ||
| Transmission | 57.08 | 113.79 | ||
| Totals of machinery and | ||||
| equipment | 1,947.79 | 610.00 | 2,708.88 | 332.00 |
| Totals of Twelfth Street plant | 1,947.79 | 610.00 | 2,819.31 | 352.99 |
| 1915 | 1916 | |||
| Additions | Deductions | Additions | Deductions | |
| Buildings: | ||||
| Construction | $114.07 | $328.85 | $26.75 | |
| Plumbing and sewerage | 702.66 | |||
| Architects' and engineers' fees | 7.98 | 72.21 | 1.87 | |
| Totals of buildings | 122.05 | 1,103.72 | 28.62 |
| March 1-Dec. 31, 1915 | 1916 | |||
| Additions | Deductions | Additions | Deductions | |
| Machinery and equipment: | ||||
| Machine foundations | $12.95 | |||
| Machinery | $168.00 | 861.44 | ||
| Forges and furnaces | 1,240.32 | |||
| Cranes and hoists | 240.22 | 1,348.81 | ||
| Machine pulleys | 1.53 | |||
| Machine belting | 27.80 | |||
| Transmission | 61.46 | 48.87 | ||
| Totals of machinery and | ||||
| equipment | 499.01 | 3,512.39 | ||
| Administration equipment: | ||||
| Factory office furniture and | ||||
| fixtures | 39.00 | |||
| Total of administration | ||||
| equipment | 39.00 | |||
| Totals of Twelfth Street plant | 621.06 | 4,655.11 | 28.62 |
| 1917 | ||
| Additions | Deductions | |
| Buildings: | ||
| Construction | $4,534.78 | $531.56 |
| Plumbing and sewerage | 987.26 | |
| Electric lighting system | 29.88 | |
| Architects' and engineers' fees | 388.63 | 37.21 |
| Totals of buildings | 5,940.55 | 568.77 |
| Machinery and equipment: | ||
| Machinery | 472.00 | 145.00 |
| Multiple core drying boxes | 16,173.30 | |
| Transmission | 130.51 | |
| Factory furniture and fixtures | 56.73 | |
| Totals of machinery and equipment | 16,832.54 | 145.00 |
| Administration equipment: | ||
| Factory office furniture and fixtures | 75.00 | |
| Welfare equipment | 684.48 | |
| Totals of administration equipment | 759.48 | |
| Totals of Twelfth Street plant | 23,532.57 | 713.77 |
*1172 The following statements show the cost value on the books as of January 1, 1917, and January 1, 1918, as shown by the revenue agent's report. The rate of depreciation and the amounts of depreciation allowed for said years by respondent are as follows:
| Assets | Book costs, | Rate (per | 1917 de- |
| Jan. 1, 1917 | cent) | preciation | |
| Erie buildings | $165,275.51 | 2 1/2 | $4,265.39 |
| Machinery and tools | 336,012.80 | 5 | 17,067.11 |
| Iron foundry | 244,231.87 | 5 | 12,212.13 |
| Brass foundry | 32,208.88 | 5 | 1,610.44 |
| Patterns | 107,381.86 | 10 | 10,739.19 |
| Erie office furniture and fixtures | 7,803.59 | 5 | 390.18 |
| Branch office furniture and fixtures | 345.02 | 5 | 17.25 |
| Team and wagons | 1,231.75 | 10 | 123.18 |
| Sprinkler system | 13,533.83 | 2 1/2 | 338.35 |
| Erie autos and trucks | 7,739.64 | 20 | 1,547.93 |
| Branch autos and trucks | 2,731.97 | 20 | 1,034.61 |
| Branch store buildings | 6,136.81 | 16 2/3 | 1,311.80 |
| Real estate | 56,602.48 | None. | None. |
| Patents | 3,423.62 | 5.8825 | 201.39 |
| 984,659.63 | 50,858.95 |
*3410 Additions during 1917 were depreciated at half rate.
| Assets | Book costs | Rate (per cent) | 1918 de- |
| Jan. 1, 1918 | preciation | ||
| Erie building | $175,955.56 | 2 1/2 | $4,476.69 |
| Machinery and tools | 186.623.79 | 5 | 9,758.45 |
| Iron foundry | 70,373.43 | 5 | 3,252.40 |
| Brass foundry | 10,467.88 | 5 | 485.89 |
| Patterns | 106,327.83 | 10 | 10,632.78 |
| Erie office furniture and fixtures | 5,629.69 | 5 | 281.48 |
| Branch office furniture and fixtures | 617.68 | 5 | 30.88 |
| Team and wagons | 612.50 | 10 | 61.25 |
| Sprinkler system | 13,533.83 | 2 1/2 | 338.35 |
| Erie autos and trucks | 7,739.64 | 20 | 1,820.08 |
| Branch autos and trucks | 7,614.12 | 20 | 1,839.51 |
| Branch store buildings | 5,233.95 | 16 2/3 | 872.32 |
| Real estate | 74,902.48 | None. | None. |
| Patents | 2,528.48 | 5.8825 | 148.74 |
| 668,160.80 | 33,998.82 |
*1173 Additions during 1918 were depreciated at half rate.
E. A. Weart, who had been in petitioner's employ for over thirty years, was during the year 1916 and prior thereto the manager of its branch office at Pittsburgh. He was a valuable employee and a very important man in petitioner's business. He was not an officer, director or stockholder of petitioner. As such manager he paid to*3411 himself his salary and expenses with checks drawn by himself on a local bank account. He rendered an account to petitioner at the end of each year. Whenever such account showed that he had overdrawn his salary and expenses, such overdraft went into accounts receivable. During the year 1916 he drew $15,297.21 in excess of the amount he was entitled to draw. This overdraft was reported by Weart to petitioner at the end of 1916 and was entered on petitioner's books as an account receivable. There was a controversy between petitioner and Weart over this overdraft. This controversy continued into the year 1917. Petitioner demanded that it be paid and Weart threatened to leave petitioner's service, stating that he had received several good offers for his services from other concerns. In 1917 petitioner consented to charge off the account in order to keep Weart in its employ. In that year the account was charged off as a bad account and the amount thereof credited to Weart's account. Weart continued in petitioner's service until his death, which occurred in 1926.
OPINION.
MILLIKEN: Briefly stated, three questions are presented, which are: (1) whether petitioner is entitled*3412 to deduct from its gross income for 1917 the amount of the overdraft of its employee, Weart; (2) what was the cost of petitioner's fixed assets at Erie for the purpose of computing invested capital; and (3) what was the fair market value of such assets on March 1, 1913, for the purpose of computing depreciation.
*1174 The first question is controlled by sections 12(a) and 13(d) of the Revenue Act of 1916. Section 12(a) provides for the deduction from gross income of a corporation of:
All the ordinary and necessary expenses paid within the year in the maintenance and operation of its business and properties * * *.
Section 13(d) reads:
(d) A corporation, joint-stock company or association, or insurance company, keeping accounts upon any basis other than that of actual receipts and disbursements, unless such other basis does not clearly reflect its income, may, subject to regulations made by the Commissioner of Internal Revenue, with the approval of the Secretary of the Treasury, make its return upon the basis upon which its accounts are kept, in which case the tax shall be computed upon its income as so returned;
Under the facts presented by the record petitioner*3413 could not have accrued in 1916 this overdraft as a liability, for the reason that the overdraft was not then a liability but an asset. Petitioner was under no obligation to pay Weart this amount. On the contrary, he owed it to petitioner. He continued to owe it until he was released and the amount credited to his account. This occurred in 1917 and the sole issue presented is whether the amount released constituted an ordinary and necessary business expense for the year 1917. The cancellation of the account was not in the nature of a gratuity. It was based upon a valuable consideration and that consideration was that petitioner retained the services of its valuable employee. In the judgment of petitioner's officers it was a good business proposition to pay this amount rather than lose its employee's services. If we had the right, we would hesitate to substitute our judgment for that of those who were fully cognizant of the needs of the company and presumably able to determine what was best for it. We have not here the question that arises under the Revenue Act of 1918 and subsequent revenue acts - whether the salary was "reasonable." There is no such provision in the Revenue*3414 Act of 1916. In United States v. Philadelphia Knitting Mills Co.,273 Fed. 657, the Circuit Court of Appeals for the Third Circuit had before it the question of the allowance as a deduction of salaries of corporate officers who were also directors and stockholders under the provisions of the Corporation Excise Tax Act of 1909, which contained a provision similar to section 12(a) of the Revenue Act of 1916. There the court said:
Whether services were rendered and whether also they were commensurate with the salary paid are matters of judgment and discretion reposed by general law in the board of directors of the corporation. As the board of directors is charged with the duty and clothed with the discretion of fixing the salaries of the corporation's officers, the Government has no right (until expressly granted by statute) to inquire into and determine whether the amounts thereof are proper, that is, whether they are too much or too little. But, while the amount of salary fixed by a board of directors is presumptively valid, it is not conclusively *1175 so, because the Government may inquire whether the amount paid is salary or something else. Admittedly*3415 the Government has a right to collect taxes on net income of a corporation based on profits after all ordinary and necessary expenses, including salaries, are paid. It has a right, therefore to attack the action of a board of directors and show by evidence, not that a given salary is too much, but that, in the circumstances, the whole or some part of it is not salary at all but is profits diverted to a stockholding officer under the guise of salary and as such is subject to taxation.
The Court of Claims in Gray & Co.v.United States, decided June 6, 1927, quoted from the above opinion and applied it to section 12(a) of the Revenue Act of 1916.
Weart was not a stockholder and received nothing in the nature of a distribution of profits. Under these circumstances we are satisfied that the release of Weart from his debt to the company in 1917 constituted a proper and necessary business expense of the corporation for that year, and it is therefore deductible in that year from gross income.
With respect to the second and third issues, it was stated by petitioner's counsel at the hearing that all that was submitted for decision was the respective bases for the computation*3416 of invested capital and depreciation. The question of proper rates for depreciation was not presented.
In computing invested capital, respondent accepted, subject to certain adjustments, the capital and surplus shown by petitioner's books. In computing depreciation, he also relied upon the books. He made no determination of value as of March 1, 1913. Petitioner insists and we in effect have found that these books were wholly unreliable for either of these purposes. Cf. Union Metal Manufacturing Co.1 B.T.A. 395">1 B.T.A. 395; Rockford Brick & Tile Co.,4 B.T.A. 313">4 B.T.A. 313; and Donaldson, Iron Co.,9 B.T.A. 1081">9 B.T.A. 1081. Many of petitioner's records were lost in the flood of 1915. Such as were left could be read only by the use of a microscope. The books, such as they were, did not disclose the existence of a large part of petitioner's machinery and equipment. Often such cost as was shown was not the whole cost. There was no cost account on the books. Capital items were often charged to expense. There is nothing peculiar in this when we remember that this was purely a family affair. The business was begun by two brothers in 1852, and at the date*3417 of the hearing 92 per cent of its outstanding stock was held by their respectively families. The strict method of accounting which prevails in those corporations whose stock is held by persons who have no tie except corporate success is not to be expected of corporations whose stock is held by close kindred. So it was here. Neither could these people, prior to the adoption of the Sixteenth Amendment, have foretold that March 1, 1913, would be the most important date in the history of *1176 their corporation, nor that the peculiar statutory concept of invested capital would become an important element in its taxation.
Our findings as to the unreliability of the books are amply borne out by the testimony adduced at the hearing. Petitioner's president testified that he showed the revenue agent, whose report is the foundation of respondent's findings, three large machine tools valued at $15,000 or $20,000 apiece, which did not appear upon the books. The representative of the appraisal company testified that he and his associates made a complete search of the books and that wherever they found cost they used it; that often the cost found was only a partial cost and that time*3418 and time again they could not find any cost whatever for machines in actual existence and active use when the appraisal was made. Respondent's counsel subjected this witness to a most searching cross-examination and brought out that the cost of machine after machine could not be found in the books. The reason for this became apparent when it was developed that approximately two-thirds of the assets appraised were acquired prior to 1902 and that there was but little change between 1897 and 1902. The record discloses that the books of the company upon which respondent relied furnished an wholly inadequate basis for his determinations.
The only evidence we have before us on the question of cost is the report of the appraisal company and the testimony of its employees who made the appraisal. The first and most important fact that was developed was that every building, every machine and every piece of equipment that were appraised as of the year 1920 were in actual existence and in operation in that year. The appraisers had the benefit of the appraisal made in 1902. They deducted as abandoned assets at the Ninth Street Plant items, the total cost of which was $27,730, and at the*3419 Twelfth Street Plant items costing in all $2,958.94. The total cost of all items deducted which were acquired subsequent to 1902 was $415. All the remainder were acquired prior to that year. When we consider that the appraisers had the benefit of the 1902 appraisal, the fact that the assets appraised for the year 1920 were then in actual existence and operation, the checking of one appraisal against the other, and the care used by the appraisers to determine the date of acquisition of each item, we are convinced that the assets appraised as being in existence on March 1, 1913, and at the beginning of each year involved in this proceeding were in existence on those dates. Against these facts we have only respondent's determination which is based on the books of the corporation, which in turn were unreliable on this point. We accept the facts as to the existence of the assets appraised on the various dates as against the respondent's determination based on mutilated and unreliable books.
*1177 We next take up the question of the cost of these assets. Again it appears that the books can not be relied upon. We know that about two-thirds of these properties were acquired*3420 at times when the bookkeeping was quire defective and before the flood destroyed a part of petitioner's records. We know that machines of large value which were in actual operation in 1920 did not appear on the books. We must assume that machines of large value represent something in cost. As to what this cost was we have before us only the evidence and must be guided thereby. Here again we have only the evidence introduced by petitioner. That evidence consists of the appraisal and the testimony of those who compiled it. These witnesses testified that whenever cost was found on the books it was used. Where it could not be found the price of similar items on the date of acquisition was used. When a machine or piece of equipment was manufactured by petitioner, its cost was determined by the cost of the material, the cost of the labor and by adding an applicable proportion of the overhead expense. This overhead did not include interest, taxes, and similar carrying charges. If proper amounts were used in making such computation, the result arrived at would be the true cost. What constituted all the carrying charges which were attributed to each machine does not appear except*3421 as above stated. What these overhead charges consisted of could have been developed upon cross-examination, but they were not. It may also be true that the appraisers did not possess complete information as to the time necessary to complete a certain machine or the exact cost of the labor employed therein. If so, this also could have been but was not brought out upon cross-examination.
We have before us no evidence impeaching the cost set out in the appraisal and supported by the testimony of petitioner's witnesses. The whole appraisal, consisting of eight volumes, was introduced in evidence. Therein is recorded each item, its date of acquisition and its cost. Such an appraisal so meticulously and carefully made by expert and competent appraisers should not be discarded by raising a doubt here or a doubt there, especially since respondent has not attempted to supply the cost of items actually in existence, the cost of which does not appear on the books. Cf. Donaldson Iron Co., supra.We have set forth in our findings of fact the method used by the appraisers in determining the depreciated cost of petitioner's fixed assets as of March 1, 1913, and this method*3422 meets all proper requirements. Cf. Paducah Water Co.,5 B.T.A. 1067">5 B.T.A. 1067. After careful consideration of all the evidence, we are of opinion that costs of petitioner's fixed assets are the amounts set forth in the findings of fact and that the basis for computing its surplus is the depreciated cost of such assets. These costs should be adjusted for the years *1178 involved by a proper depreciation and by all additions and deductions, also properly depreciated.
The remaining question is, What was the fair market value of petitioner's assets at Erie on March 1, 1913, for the purpose of depreciation? The only evidence we have on this issue is the testimony of petitioner's president to the effect that in his opinion all petitioner's fixed assets at Erie, including real estate, on said date, had a fair market value of about $1,500,000, and the testimony of a representative of the appraisal company that the same assets had a fair market value of $1,170,610.53. Petitioner's president did not refer to nor does he appear to have had information relative to actual sales of similar plants. He testified solely from his knowledge of his own plant and of the industry in*3423 general. It is true he has had large experience in his business and has a general knowledge of the method in which similar concerns conduct their affairs. We regard his testimony more in the nature of a guess or rather an estimate of what amount petitioner was then willing to take for the plant. There is no testimony as to what a willing buyer might have offered. The testimony of an official of the appraisal company is based solely on the estimate made by his company of the depreciated reproduction cost of the assets as of March 1, 1913. He was not at the plant when the appraisal was made and there is nothing in the record to show that he was there either after or before that time.
Petitioner insists that depreciated reproduction cost represents true market value and in support of this contention refers to McCardle v. Indianapolis Water Co.,272 U.S. 400">272 U.S. 400. The water company involved in that case was a public service corporation, which had no competitors and which was not restricted in its charges by governmental regulation. Every such corporation, unless restricted by a valid contract, is entitled to a reasonable return upon its investment, a right guaranteed*3424 by the Fourteenth Amendment. Without discussing the question whether such a method of determining the value of properties of such public service corporations is or is not a proper or exclusive method, we point out that petitioner does not have the exclusive rights of such a corporation but is subject to competition. It is dependent upon the good will and needs of the purchasing public and the quality of and demand for its products. The real question presented in this proceeding is what would a willing buyer have given and what would a willing seller have accepted for these assets as a part of a going concern on March 1, 1913.
In the absence of other proof, true market value depends largely upon earning capacity. As concerns the earning capacity of petitioner, the only evidence is that introduced by respondent and that was the introduction of petitioner's returns for the years 1910, 1911, 1912, 1913, and 1917. In its returns for 1910, 1911, and 1912, petitioner *1179 reported as net income for those years respectively, $344,598.95, $290,721.21, and $383,167.58. For the year 1913 petitioner made an original and an amended return. In the original return it reported as*3425 net income the amount of $189,242 and in the amended return it reported $262,783. Respondent also read in the evidence the statement of the revenue agent made in his report that petitioner's capital, surplus and undivided profits at the end of the year 1909 amounted to $4,507,492.04 and that part of its return for 1917 where petitioner reported its capital, surplus and undivided profits as of the end of the years 1910, 1911, and 1912 in the respective amounts of $4,600,232.77, $4,640,953.98, and $4,824,121.56. On the basis of the report and the returns, the percentages of net income to capital were as follows:
| Per cent | |
| 1910 | 8.08 |
| 1911 | 6.3 |
| 1912 | 8.4 |
| 1913 | 5.42 |
The average percentage for the four years 1910 to 1913, inclusive, was 6.66 per cent. If we eliminate 1913, during which year it was testified there was a strike, and also for the reason that five-sixths of the year elapsed after March 1, 1913, the average for the years 1910 to 1912, inclusive, was 7.2 per cent. These returns were made on a cash receipts and disbursements basis, while it appears that petitioner was on an accrual basis and for this reason possibly may not truly reflect net income. Besides, *3426 we do not know what adjustments the Commissioner may have made. Under these circumstances, we can not say that we know what was the precise amount of net income, nor of capital, surplus and undivided profits for any of these years, Petitioner asks us to accept as fair market value the cost of its property determined upon the basis of reproduction as of March 1, 1913, properly depreciated. Whatever may be the merit of this method in determining value of properties of public service monopolies, we are of opinion that on the facts presented in this proceeding, such value would be in excess of fair market value as above defined. The only other evidence before us [respondent has found no March 1, 1913, value] is the cost of the various properties. These costs depreciated as of March 1, 1913, more nearly approach what we believe to be fair market value than reproduction cost. On the evidence before us we are of opinion that the actual cost of the assets, depreciated as found, represents their fair market value as of March 1, 1913, for depreciation purposes. Of course, the cost of the land should be eliminated since that is not a depreciable asset.
Judgment will be entered under*3427 Rule 50.