*3634 1. Promissory notes given in 1921 by the vendees to the vendors, in consideration of which all claims and rights reserved under a contract of sale entered into in 1920 were mutually released and satisfied, constitute income for 1921, and not for 1920.
2. The respondent's action in eleminating the balance of an improvement account from invested capital approved.
3. Invested capital should not be increased by the cost of a dry kiln erected in 1917 and charged to improvement account.
4. Respondent's action in increasing the depreciation reserve approved, where petitioner fails to adduce affimative evidence substantiating the deductions shown on its books.
*1329 In this proceeding the petitioner seeks a redetermination of a deficiency of less than $10,000 income and excess profits taxes for 1920. The petition sets forth the following allegations of error:
(1) The inclusion in income for 1920 of the sum of $13,333.33, received by the petitioner in 1921 from Joe L. Long, Harold K. Munroe, and George I. Hill, pursuant*3635 to agreement made and entered into January 3, 1921.
(2) Elimination from invested capital of improvement account amounting to $14,066.82.
(3) Failure to include in invested capital the sum of $4,458.76, representing the cost of a new dry kiln built in 1917, not capitalized on company's books.
(4) Elimination from invested capital of the sum of $6,828.36, said to be additional income taxes due. This amount should be $361.99.
(5) Elimination from invested capital of depreciation for prior years, amounting to $14,980.53.
(6) Deduction of $10,024.04 from amount available for payment of dividends, in arriving at average deduction from invested capital on account of dividends paid during the taxable year.
FINDINGS OF FACT.
The petitioner is a Washington corporation, engaged in the manufacture of wood pipe and tanks, with its principal office in Seattle.
In 1920 the petitioner, by its president, acting in the capacity of trustee, entered into the following agreement.
THIS AGREEMENT, made and entered into this 18th day of September, 1920, between T. B. GARRISON, Trustee, and T. B. GARRISON, individually, parties of *1330 the first part, and JOE L. LONG and*3636 HAROLD K. MUNROE, parties of the second part, WITNESSETH:
1. Said Garrison agrees to sell to second parties thirteen hundred thirty-four (1334) shares of stock of Continental Pipe Manufacturing Company now standing in his name, as trustee, and six (6) shares of the same stock, standing in his name individually, and second parties agree to buy the same on the terms herein stated.
2. The purchase price hereby agreed upon of said stock is at the rate of One Hundred Ten Dollars ($110.00) per share, aggregating One Hundred Forty-seven Thousand Four Hundred Dollars ($147,400.00), and in addition thereto first parties are to receive the pro rata share of accrued profits of said corporation (that is to say, the proportion that 1340 bears to 4000, the total number of shares of said corporation) up to the close of the month of August, 1920, the method of ascertaining said accrued profits to be the same as that used in making up the statements prepared by the bookkeeper of said corporation showing the accrued profits for the first six months of the year 1920, so that said accrued profits shall be figured on the same basis as that used in former statements. A dividend to the stockholders*3637 of said corporation having been declared by the trustees thereof on this date payable September 30, 1920, in an amount intended to cover and equal the full accrued profits of said corporation up to August 31, 1920, it is hereby agreed that said dividends shall be paid to first parties on said thirteen hundred forty (1340) shares, in order that first parties may receive their pro rata share of said accrued profits as herein agreed. It being impossible at this time to ascertain the exact amount of the income tax and excess profits tax which said corporation will have to pay next year for the income and profits of this year, it has been arranged that in declaring said dividend said corporation will withhold approximately the sum of Seventy-eight Thousand Dollars ($78,000.00) to cover the said Federal taxes for income and profits up to said August 31, 1920. When the exact amount of said Federal income and excess profit taxes shall be ascertained after the close of the year 1920, eight twelfths of the same shall be deemed to represent the tax applicable for the period ending August 31, 1920. In case said eight twelfths differs one way or the other from the amount (approximately Seventy-eight*3638 Thousand Dollars) withheld for that purpose by said corporation in paying the dividend declared this day, the parties hereto will adjust said difference by paying the one to the other, whichever way the fact requires, the difference in cash so that first parties will in fact bear, out of said entire accrued profits, 1340/4000 of eight twelfths of said Federal taxes for the year 1920, and no more.
3. Said sum of One Hundred Forty-seven Thousand Four Hundred Dollars ($147,400.00) shall be paid by second parties, the purchasers, to first parties, as follows: on September 30, 1920, second parties shall pay to first parties in cash one-half of said amount, and for the balance second parties shall give to first parties two promissory notes of second parties, each for the sum of Thirty-six Thousand Eight Hundred Fifty Dollars ($36,850.00), one of said notes payable on or before one year from said date with interest at the rate of seven per cent (7%) per annum payable quarterly, and the other note payable on or before two years from said date with interest at the rate of seven per cent (7%) per annum payable quarterly, both said notes to be payable at the Dexter Horton National Bank in*3639 Seattle, Washington. The certificates representing said shares of stock shall be pledged by second parties to first parties as collateral security for the payment of said promissory notes and a *1331 collateral security agreement will be signed by second parties evidencing the pledging of said stock for payment of said notes.
4. It is understood and agreed that second parties expect to associate with them in said purchase Eleanor Long Hill, of Tacoma, and in event that said Eleanor Long Hill elects to associate herself with second parties as one of the purchasers under this agreement, the promissory notes aforesaid will be executed by said Eleanor Long Hill along with the second parties herein named.
5. The payment of said money and the delivery of said stock is to be made on September 30, 1920, at said Dexter Horton National Bank of Seattle.
IN WITNESS WHEREOF the parties have hereunto set their hands the day and year first above written, in consideration of the mutual promises herein made and of the sum of One Dollar to each party in hand paid by the other party, receipt whereof is hereby acknowledged by each party.
In duplicate.
T. B. GARRISON, Trustee.*3640
T. B. GARRISON.JOE L. LONG.
HAROLD K. MUNROE.
The $78,000 withheld under the contract to cover Federal taxes was computed under the direction of or by a certified public accountant, who first computed the earnings through August 31, 1920, in the manner specified in the contract, and then estimated the amount of tax based on such earnings.
Thereafter and on January 3, 1921, the parties entered into the agreement set out below:
The undersigned, PACIFIC COAST PIPE COMPANY, has this day received from Joe L. Long, Harold K. Munroe and George I. Hill three promissory notes of this date for principal sums aggregating Thirteen thousand four hundred Dollars ($13,400) secured by stock of Continental Pipe Manufacturing Company which the undersigned already holds in pledge as collateral security for other notes of said parties, said additional notes this day received maturing respectively on or before six, twelve, and eighteen months from date. Said additional notes dated this day are received by the undersigned in full settlement of balance of purchase price owing to the undersigned on shares of stock of Continental Pipe Manufacturing Company sold by the undersigned to said*3641 Long, Munroe and Hill as by written agreement dated September 18th, 1920, appears.
It is further agreed that the amount of said notes represents a full settlement of all claims which either party might make against the other under said agreement of September 18th, 1920, for the purchase price of said stock, including all claims or accountings with reference to any government tax on or against said Continental Pipe Manufacturing Company or its assets, all of which matters are hereby settled and mutually released by the parties.
WITNESS our hands in duplicate to this agreement the day first above written.
PACIFIC COAST PIPE COMPANY,
By T. B. GARRISON, Prest.
JOE L. LONG.
HAROLD K. MUNROE.
GEORGE I. HILL,
*1332 The amount of the additional notes received under the above agreement, applying to the stock of the petitioner, namely $13,333.33, was returned as income for 1921. The respondent added it to petitioner's income for 1920.
Petitioner kept its books of account and made its return on the accrual basis.
Under date of September 30, 1913, the petitioner received from the City of Seattle as principal and interest of an award for damages upon condemnation, *3642 the sum of $40,553.64, and in 1914 the further sum of $866.70, being contribution for its proportion of work done in connection with said condemnation, making a total received on account of such condemnation of $41,420.34, which was credited on its books to an account called "Improvement Account", and set up on the balance sheet as a liability. This condemnation did not constitute a physical taking of petitioner's property, but simply damages resulting from change of grade.
There was expended and charged against the said "Improvement Account" the following items:
| 1913 Legal expense | $2,156.16 |
| 1914 Roof repairs | 952.76 |
| 1914 Alterations necessitated by condemnation | 16,523.19 |
| 1915 Alterations necessitated by condemnation | 1,771.09 |
| 1916 Alterations necessitated by condemnation | 133.46 |
| 1916 Legal expense | 1,358.10 |
| 1917 Cost of new dry kiln | 4,458.76 |
The alterations and repairs were for the purpose of restoring petitioner's property to a condition similar to what it had been prior to the time the grade of the street was changed. Included in this work was a bulkhead on the outside and the installation of an electric hall or elevator to get to the track.
The*3643 balance of the improvement account of $14,066.82 was carried as a credit. The money received was placed in the bank and carried as an asset of the company, being used as and when needed.
In 1917 the petitioner erected a new dry kiln at a cost of $4,458.76. The new kiln was needed because of the increase in business, and the inability of the old kiln to provide sufficient lumber. In constructing the new addition petitioner utilized one side of the old kiln as a wall for the new, and erected the other three walls. The cost of the new kiln was charged on the books of the petitioner to the improvement account.
Prior to the year beginning January 1, 1920, the petitioner had charged on its books and deducted as depreciation on buildings the sum of $9,329.91, which amount was increased by the respondent by $5,650.62, through the process of restoring the said amount previously *1333 charged as depreciation on buildings and setting up a depreciation reserve for buildings of $14,980.53; in 1920 the actual paid-in capital of the petitioner was $100,000, and the respondent reduced petitioner's invested capital for said year by various deductions, including the item of additional*3644 depreciation above referred to, and including also inadmissibles amounting to $70,258.40, and determined it at $96,161.66, or $3,838.34 less than the actual paid-in capital.
In creating the depreciation reserve above referred to the respondent used a 2 per cent depreciation rate on petitioner's factory and a 4 per cent rate on its buildings, based on their cost. The petitioner took depreciation in a lump sum in 1909 of approximately $7,000, and another lump sum in 1917 of approximately $2,140.
In computing the deduction from invested capital on account of dividends paid during the taxable year 1920, the respondent estimated a tax of $10,024.04 upon the net income of the taxpayer for said taxable year, and deducted the same from the available earnings of the year, and held that the balance only, after making such deduction, was available for payment of dividends during such year.
OPINION.
MORRIS: Considering the issues in the order presented, our first question is whether the notes of $13,333.33 paid under the agreement of January 3, 1921, constituted income for 1920 or 1921. The respondent holds that this amount was income for 1920, since petitioner is on the accrual*3645 basis, and it represents the final payment on the purchase of stock sold by the agreement of September 18, 1920.
In our opinion the contract of September 18, 1920, unequivocally sold the stock in question for the sum of $110 per share. But the vendors, being at that time cognizant of a dividend declared on that date, but payable twelve days later, reserved their rights to such dividends, which had been declared out of earnings for the first eight months of 1920. At the same time the vendors agreed to bear their pro rata share of taxes due on such earnings.
The sum of $78,000 had been set aside out of earnings by the Continental Pipe Co. to meet such taxes, but the parties recognizing the impossibility of an exact estimate of the tax liability agreed that "when the exact amount of said * * * taxes shall be ascertained at the close of the year 1920, eight-twelfths of the same shall be deemed to represent the tax applicable for the period ending August 31, 1920." In the event that petitioner's pro rata share of the taxes differed one way or the other it was agreed that "the parties hereto will adjust said difference by paying the one to the other, whichever way the fact requires, *3646 the difference in cash so *1334 that first parties will in fact bear, out of said entire accrued profits, 1340/4000 of eight-twelfths of said federal taxes for the year 1920 and no more."
Thereafter, and on January 3, 1921, the parties, with the addition of a third vendee, mutually released each other as to all claims or accountings which might arise on account of adjustments for taxes under the agreement of September 18, 1920, by the vendees giving the vendor's notes for $13,400, of which the petitioner's share was $13,333.33. This payment is referred to as the balance on the purchase price of the stock in one paragraph, and as in settlement of all claims, accountings and rights of the parties in another paragraph. Reading the two agreements together, the conclusion is inescapable that by the agreement of January 3, 1921, the vendees intended to and did purchase the contractual rights which the vendors had reserved under the prior agreement. Prior to January 3, 1921, it was an open question whether there was a liability on the vendees or the vendors, and the best that either party could do was to conjecture with respect thereto. Under such circumstances, it is our opinion*3647 that there was nothing to accrue at the end of the taxable year, and that the final adjustment represented income for 1921. Cf. .
Petitioner's second contention is that the respondent has erred in excluding from invested capital for 1920 the credit balance in the improvement account. This account was created in 1913 and 1914 by credits thereto of the sums, aggregating $41,420.34, paid to the petitioner in those years by the City of Seattle for damages sustained by the petitioner under condemnation proceedings. Subsequently, and during 1913 to 1916, inclusive, petitioner charged against this account expenditures for restoration of its properties, totaling $22,894.76, leaving a credit balance in the account of $18,525.58. In 1917 petitioner made a further charge against this account of $4,458.76, representing the cost of erecting a new dry kiln to meet the needs of its increased business; so that at the beginning of the taxable year 1920 the improvement account contained a credit balance of $14,066.82. The petitioner included this credit balance in invested capital and it now asks us to overrule the respondent's determination that*3648 it should not have been so included. To hold with petitioner on this issue would necessitate a finding that the credit balance in the improvement account is, in fact, earned surplus, representing a gain arising out of the reimbursement made to petitioner by the City of Seattle, for damages to its properties under condemnation proceedings. This we can not do, for the record is void of any evidence upon which to predicate such a findings. It may be that the total sum expended by petitioner for restoration of its properties is a *1335 fair measure of the damages which it sustained, but there is no proof that such is the fact, and, until overcome by a preponderance of the evidence, we think the presumption is entitled to prevail that the damages sustained by the petitioner are fairly measured by the amount of the reimbursement made by the City of Seattle, in which event no gain could have been derived from the transaction. Furthermore, the record is silent as to whether petitioner reduced its property asset accounts by the amount of damages sustained, or has continued to carry them at the same value on its books. If not so reduced, and we allow this balance in improvement account*3649 to be included in invested capital, there would be a deplication in petitioner's invested capital. In the absence of evidence showing that duplication would result, we affirm the determination of the respondent.
Petitioner further alleges error in respondent's failure to include the cost of a new dry kiln, to wit, $4,458.76, erected in 1917 in invested capital. This is the expenditure referred to in the discussion of the preceding issue. The expenditure in question is undoubtedly of a capital nature, and should have been charged to a capital asset account, but instead the petitioner charged it against the improvement account. Before charging this item against the improvement account, there was a credit balance in that account of $18,525.58; after the charge was made the credit balance stood at $14,066.82. When, therefore, the respondent eliminated from invested capital only the credit balance of $14,066.82 in the improvement account, his action resulted, indirectly though none the less effectively, in the inclusion in invested capital of the contested item. For us to say now that invested capital should be increased by $4,458.76 would result in the inclusion of the same item*3650 in invested capital twice. We find no error in respondent's action.
The next issue was stipulated by the parties, the petitioner conceding the correctness of the respondent's action in reducing invested capital by $6,828.36 on account of taxes for prior years.
The next error alleged is the reduction of invested capital by increasing the amount of the depreciation reserve. Petitioner took a lump sum deduction for depreciation in 1909 and 1917, but the respondent, using the straight-line method, has increased the reserve by $5,650.62. We have repeatedly held that the burden of proof is on the petitioner where error is asserted as to the actions of the respondent, and that the latter's determination is prima facie correct, and can only be disturbed by proof of the error or errors committed. Book entries are evidentiary, but not conclusive, and where the respondent has held that the book entries do not correctly reflect the condition of depreciable assets, his determination must be overcome by evidence substantiating and corroborating the book entries.
*1336 In the cases cited by petitioner in support of its position as to this issue, namely, *3651 ; , and , affirmative evidence was adduced in support of the depreciation deductions which the petitioners were there claiming. The first two cases cited supra, and , were distinguished in , wherein we held that the taxpayer did not rebut the prima facie case by the mere production of its books. The respondent's action with respect to the depreciation reserve is, therefore, approved.
The last issue relates to respondent's reduction of earnings available for dividends by the amount of a tentative tax. We have previously held in , that such action by the respondent was erroneous, and on the authority of that decision we sustain the petitioner.
Judgment will be entered under Rule 50.