*3501 1. Patents are exhaustible assets and the mere fact that during the life of the patents a good will value comes into existence does not prevent the elimination of the patents from the asset account upon the expiration of their life.
2. Restoration to invested capital of the cost of patents the life of which had expired, denied.
3. Petitioner has followed the consistent policy over a long period of years of charging the cost of drawings to expense. This cost represents a constantly recurring charge which has been fairly uniform for many years. No evidence was furnished as to the life of these drawings. Reversal of this long established practice and permission to set these costs up as capital assets denied.
*621 The Commissioner determined a deficiency in income and profits tax for 1919 in the amount of $1,276.39. Petitioner claims that the Commissioner erred in refusing to include in invested capital the cost to petitioner's predecessor of certain patents and also the cost to petitioner of certain drawings*3502 which were charged to expense, but which the petitioner now claims should have been capitalized.
FINDINGS OF FACT.
The petitioner is a New York corporation with its principal office and place of business at Newark, N.J.
Smith & Sayre Manufacturing Co. was incorporated under the laws of New York in 1865, its purpose being "to manufacture MacKenzie blowers, cupola furnaces, pumps, gas exhausters and other machinery." The par value of its stock was $150,000, which was *622 later increased to $160,000. Charles W. Isbell and George G. Porter were active in the operation of this corporation and closely identified with its development. Between 1865 and 1890, these two men gradually acquired practically the entire capital stock of the corporation.
January 22, 1890, petitioner was incorporated with an authorized capitalization of $400,000, represented by 4,000 shares of the par value of $100 each, the purpose of incorporation being to identify the names of Isbell and Porter, the principal stockholders in Smith & Sayre Manufacturing Co., with the business. The charter disclosed that its object was to manufacture and sell "machinery and apparatus for gas works, iron foundries, *3503 refrigerating and ice making plants, and other like machinery, apparatus and appliances."
After the organization of petitioner, the stockholders of Smith & Sayre Manufacturing Co. adopted the following resolution Authorizing the sale of the corporation's assets to petitioner:
Object of meeting was then stated as follows: To authorize the sale and transfer of Real Estate, patterns, machinery and tools, drawings, patents, office furniture and stock of the company to their successors the Isbell Porter Company, as per inventory of Feb. 1st, 1890.
Mr. A. H. Isbell moved that the officers of the Company be authorized to sell and transfer to the Isbell Porter Co. its real estate in Newark, N.J., for the sum of Sixty-five thousand ($65,000.) Dollars. The existing mortgages on same amounting to Twenty two thousand ($22,000) Dollars, to be assumed by the Isbell Porter Co; also to sell and transfer the tools and machinery, stock supplies, patterns, drawings, office furniture and patents of the Co. to the Isbell Porter Co. as per inventory of Feb. 1st, 1890, for the sum of Two hundred and two thousand (202,000) Dollars, and accept in payment for the same the stock of the Isbell Porter*3504 Co. at par, to the amount of Two hundred and sixty-seven thousand ($267,000.) Dollars.
On the same day, the trustees of petitioner authorized the purchase of the assets of the Smith & Sayre Manufacturing Co. in a resolution in part as follows:
Objection of the meeting stated: To authorize the officers of the Company to purchase the real estate of Smith & Sayre Mfg. Company, located at Newark, N.J., for the sum of $65,000, and to assume the existing mortgages on same, amounting to $22,000. Also to purchase the tools and machinery, stock and supplies, patterns and drawings, office furniture and patents of the said Smith & Sayre Mfg. Company as per their inventory of February 1st, 1890, for the sum of $202,000, and to issue in payment therefor, including real estate, the stock of the Isbell Porter Company at par for the sum of $267,000.
The transaction was reflected on petitioner's books by the entry therein of asset accounts as follows:
| Works and machinery | $100,390.86 |
| Real estate | 87,000.00 |
| Patterns | 42,523.31 |
| Merchandise | 54,355.74 |
| Drawings | 4,730.09 |
*623 The offsetting entries to the foregoing asset total of $289,000 were capital stock, $267,000, *3505 and mortgage, $22,000. The patents acquired were not entered upon the books of the petitioner. The bookkeeping methods employed by the petitioner in the earlier years were crude, and it was not until many years subsequent to 1890 that patents were entered upon its books as assets. The patents finally entered in the books were acquired after 1890.
Prior to the transfer of the assets, George G. Porter and Charles W. Isbell each owned 800 shares of the stock of Smith & Sayre Manufacturing Co. While the entire capital stock of the petitioner of 2,670 shares was issued to the Smith & Sayre Manufacturing Co. in exchange for the latter corporation's assets, shortly after the issuance of the stock it was distributed as follows: Charles W. Isbell, 1,270 shares; George G. Porter, 1,270 shares; Samuel F. Hay, 50 shares; A. F. Wehner, 50 shares; and Arthur H. Isbell, 30 shares. The three last-named persons were employees of the petitioner.
Smith & Sayre Manufacturing Co. was dissolved in 1890, and the petitioner has continued to carry on the business along the same lines and at the same place as theretofore carried on by the predecessor corporation. Certain articles manufactured were*3506 gradually eliminated in the development of its business to the end that gas works apparatus is now practically the entire output. In addition, petitioner does a substantial amount of engineering business in connection with the installation of its apparatus and equipment.
While petitioner is still operating under the charter obtained in 1890, certain changes were made in 1903 with respect to the outstanding stock, as the result of a reorganization plan arising from a receivership, which was caused by the failure of a corporation on the notes of which petitioner was collaterally obligated to certain banks. At this time petitioner's assets exceeded its liabilities, but since its assets were not liquid it concurred in a bill requesting the appointment of a receiver. The receivership continued from the early part of 1903 to January 1, 1904, at which time the liabilities of the petitioner were fully discharged by an issue of mortgage bonds to some creditors and the issue of preferred stock to others. The authorized capital stock of petitioner of $400,000 common stock was reduced to $200,000, classified as follows: common stock, $100,000; first preferred stock, $75,000; and second*3507 preferred, $25,000. The common stockholders surrendered common stock as originally issued and received in exchange new common stock.
During the existence of Smith & Sayre Manufacturing Co. this corporation acquired patents as follows:
In 1865, certain patents for blowing blasts of air, for improvements in cupola furnaces, for gas compensators and for other types of apparatus, for which it issued $75,000 par value of stock and paid $35,000 in cash.
*624 In 1865, similar patents for which it issued capital stock of a par value of $40,000.
In 1865, patents in connection with a steam engine for which stock of a par value of $10,000 was issued.
These patents were originally issued at various dates from 1855 to 1865.
In 1885, fifteen patents on sundry types of apparatus for which the corporation paid $60,000 in cash to its principal stockholders, Isbell and Porter. These patents were originally issued at various dates from 1876 to 1885.
In 1888, other similar patents from the same parties for $50,000 in cash. These patents were originally issued from 1885 to 1887.
The resolution authorizing the sale of assets by Smith & Sayre Manufacturing Co. to petitioner*3508 and the corresponding resolution of purchase by petitioner recited that patents owned by the Smith & Sayre Manufacturing Co. were transferred to petitioner.
The patents enumerated above were, in part, for the manufacture of articles similar to those manufactured by petitioner during 1919 and in many instances were basic patents which furnished the foundation for improvement or modernization of apparatus. Much of the apparatus manufactured by petitioner at the present time represents improvements or developments of similar types of apparatus covered by the patents acquired by Smith & Sayre Manufacturing Co. prior to 1890.
During the years when Smith & Sayre Manufacturing Co. and petitioner were protected from competition by the patents here in controversy, good will of a substantial value was built up with the result that after the life of the patents had expired, orders continued to be received for the same articles or other similar articles. Many sales of apparatus at the present time are attributable to improvements on and good will arising from the foregoing patents.
Petitioner has over 20,000 drawings of apparatus and designs of plants for producing and purifying gas*3509 which are useful and necessary in the conduct of its business. Some of these drawings were made by Smith & Sayre Manufacturing Co.
These drawings fall into three classes: (1) Drawings for work in process, attributable to a particular job; (2) standard model drawings, the object of which is to bring apparatus up to date to meet conditions from year to year and month to month; (3) design drawings, which assemble the various types and classes of apparatus into a complete gas plant.
Drawings of class one are designed for current business and are charged to the current business as part of the cost of the job.
The standard model drawings are not designed for any work for which there are orders or probable orders on hand, but are made because the magnitude of the various pieces of apparatus makes it impracticable to use models. These drawings are used as stock in *625 trade and are displayed to customers as being the drawings of a piece of apparatus that will accomplish a particular result. They are also used to find an apparatus suitable for meeting the particular requirements of a customer, and as the basis of various units entering into a complete gas plant, and in the*3510 making of bids on prospective work and installation.
The third class of drawings known as design drawings, represents various units of apparatus assembled into a complete installation, and requires considerable engineering work in determining the capacities, stresses and various other items entering into an engineering unit. Drawings of this type are also essential to petitioner's business, and are used constantly by it.
The drawings are made on tracing cloth or paper, and if damaged, may be retraced. The gas industry, in which petitioner is now engaged, has developed gradually in such a manner that apparatus used at the present time represents an outgrowth of earlier methods and designs and as a result, drawings made by petitioner many years prior to the year involved are still useful and are used in petitioner's business. None of these drawings include drawings of buildings, but represent the arrangement and design of apparatus for gas production. The drawings are further used for locating trouble and need for development in the apparatus as the art progresses.
The cost of standard model drawings and design drawings which petitioner claims should be restored to invested*3511 capital was not recovered from customers in the cost of a particular job, but was included in the general expenses of the petitioner for the year in which the drawings were made. The books do not reflect an asset account for drawings, except a small account which has remained practically stationary for many years and which arose at the time of the transfer of assets from Smith & Sayre Manufacturing Co. A few changes have been made in this account, but the additions were insufficient to reflect the costs which it is now desired to have added.
The drawings in question were made by engineers, draftsmen and other employees who were employed by the petitioner in the operation of its business. No definite item in petitioner's books shows the cost of individual drawings, though the drawings themselves show by date or serial number when they were made and from the initials of the employees by whom made. The drawings also show whether they were charged to particular jobs and thus the cost recovered from the customers. The books also show the salaries being paid to employees who were engaged in work of this character when the drawings in question were made.
The cost of producing the*3512 standard model drawings in question was not less than as shown by the following schedule:
| Year | Drafting and tracing | Engineering |
| 1904 | $2,130 | $1,810 |
| 1905 | 2,790 | 2,230 |
| 1906 | 1,365 | 1,175 |
| 1907 | 795 | 653 |
| 1908 | 3,555 | 2,693 |
| 1909 | 1,358 | 1,181 |
| 1910 | 2,688 | 2,297 |
| 1911 | 633 | 629 |
| 1912 | 378 | 427 |
| 1913 | 984 | 695 |
| 1914 | 3,579 | 3,944 |
| 1915 | $1,548 | $1,505 |
| 1916 | 894 | 922 |
| 1917 | 636 | 475 |
| 23,333 | 20,636 | |
| Drafting and tracing | 23,333 | |
| Total cost for drafting, | ||
| tracing, and engineering | 43,969 |
The cost of producing the design drawings was not less than as shown by the following schedule:
| Year | Drafting and tracing | Engineering |
| 1904 | 603 | $1,013 |
| 1905 | 996 | 1,432 |
| 1906 | 810 | 1,105 |
| 1907 | 726 | 924 |
| 1908 | 300 | 418 |
| 1909 | 432 | 926 |
| 1910 | 1,156 | 1,433 |
| 1911 | 1,335 | 1,930 |
| 1912 | 2,220 | 3,838 |
| 1913 | 2,820 | 5,242 |
| 1914 | 2,526 | 4,002 |
| 1915 | 1,242 | $2,326 |
| 1916 | 897 | 2,276 |
| 1917 | 582 | 1,394 |
| 16,645 | 28,259 | |
| Drafting and tracing | 16,645 | |
| Total cost of drafting, | ||
| tracing, and engineering | 44,904 |
*626 The cost of the individual drawings making up the foregoing totals varied in amount from $3 to approximately $300, the greater number showing*3513 a cost of less than $100, and only a very small number showing a cost in excess of $200.
The foregoing total costs of standard model drawings and design drawings do not include any allowance for overhead expenses, bonuses paid to employees, and certain increases in salaries during the period 1904 to 1917, which would amount to not less than 50 per cent of total costs for engineering, drafting and tracing as represented in these schedules.
The drawings represented by the costs as shown in the above schedules were being used in petitioner's business during the taxable year.
Petitioner contends that it should be allowed to include in invested capital for the year 1919, $133,309.50, representing the alleged prime cost for standard model drawings of $43,969, and for design drawings of $44,904, plus 50 per cent for overhead expenses, bonuses, etc. No allowance was made on this account for invested capital purposes by the Commissioner.
OPINION.
LITTLETON: Petitioner first contends that it is a corporate continuation of Smith & Sayre Manufacturing Co. and that there should be *627 restored to its invested capital an amount of $270,000, representing cash and stock paid*3514 by Smith & Sayre Manufacturing Co. for certain patents. That is, that in determining its invested capital we should allow to it the same invested capital that would have been allowable to the Smith & Sayre Manufacturing Co., and that in so doing, there should be added to invested capital the cost of certain patents acquired by that company but which were not entered on petitioner's books in 1890 when the assets then owned by Smith & Sayre Manufacturing Co. were transferred to petitioner. The respondent denies that the petitioner is a corporate continuity of Smith & Sayre Manufacturing Co., and that the cost of assets to that company is a basis for determining the invested capital of the petitioner. The respondent also offered evidence with respect to a reorganization in connection with a receivership of petitioner in 1903 and 1904 for the purpose of showing that the petitioner's invested capital should be computed on the basis of a corporation beginning at that time. No proof was offered by petitioner with respect to the value of assets in 1903 and 1904, and little proof with respect to the value in 1890.
In view of the nature of the assets on account of which the restoration*3515 is asked, we find it unnecessary to pass on the questions raised with respect to corporate changes in 1890 and in 1903 and 1904. Petitioner asks to have included in its invested capital the cost of patents issued from 1855 to 1887. We held in , that "patents are by nature exhaustible," and that while "it may be true that the exercise of a monopoly, under a patent, may tend to build up a good will increasing in value as rapidly or more rapidly than the patent is exhausted, exhaustion of a patent can not be offset by appreciation in a different asset, good will." We further said in the same opinion that "the benefits derived under a patent may in effect be prolonged by the issuance of new patents, just as the benefits of a lease may be prolonged by new leases - but after the expiration of the original patent, as after the expiration of the original lease, the benefits and values are not attributable to it but to the new ones." See also .
While it may be true that the cash amount equal to the value of assets once paid in may not be reduced for invested capital*3516 purposes, it can not be understood from this that any asset once paid in, whether for cash or stock, will always remain on the taxpayer's books, without taking into consideration, in the case of depreciable or exhaustible assets, the depreciation or exhaustion occurring over the life of the assets. Ordinarily, the depreciation or exhaustion taking place is accounted for on the taxpayer's books by a charge against earnings of the depreciation or exhaustion sustained in a given year *628 and a credit to a depreciation or exhaustion reserve of the same amount, so that at the end of the life of the asset the reserve would equal the cost of the asset. Where the asset account is carried at cost, the reserve would not be a proper item to be included in invested capital, but the invested capital would be represented by the capital stock and surplus exclusive of the depreciation reserve. In the ordinary business enterprise, during the exhaustion of an asset, amounts are being earned which are represented by other assets which serve to take the place of the asset being exhausted. In this manner an amount at least equal to that originally paid in will be represented in the taxpayer's*3517 invested capital though, obviously, the asset originally paid in may have been completely exhausted and properly removed from his books. Often the imprudent business man will not provide for the exhaustion of his assets and will not make a charge against earnings for such exhaustion. In this manner the true earnings for a given year are overstated. Consequently, when dividends are paid out of these earnings which are in excess of the earnings after allowance for exhaustion, an impairment of capital originally paid in takes place and under the statute, invested capital must be reduced on account of this impairment.
In this case, the patents in question, exhaustible assets, were not entered upon petitioner's books, and if we grant petitioner's contention and allow their restoration, we must likewise make provision for their exhaustion, which, since the life of each patent had completely expired prior to 1919, would serve to offset the asset value restored. We have no evidence as to the earnings of the petitioner or its predecessor over the years when the patents were expiring other than that the letter from the respondent notifying the petitioner of the deficiency in question*3518 shows a surplus of $372,498.11 as at January 1, 1919, without making the restoration sought. We are likewise without information as to the extent to which dividends were paid over these years other than that a letter from the respondent to the petitioner which was introduced in evidence shows small dividend payments during 1917 and 1918 and that the early record of Smith & Sayre Manufacturing Co. shows a dividend declared in the first year of its existence.
In view of the foregoing, the Board is of the opinion that even if it should be held that the petitioner is a corporate continuation of Smith & Sayre Manufacturing Co. which was not affected by the transactions occurring in 1890 and 1903, a restoration to invested capital of patents the life of which had expired long prior to the year 1919 can not be permitted.
The second issue is whether petitioner is entitled to have restored and included in invested capital the cost of certain drawings previously *629 charged to expense. Petitioner is engaged in the manufacture, sale and installation of gas apparatus, and as a part of such business makes drawings of the apparatus which it manufactures for sale and drawings showing*3519 the arrangement of this apparatus in plants where it is to be installed. It has on hand over 20,000 drawings, some of which were made during the existence of Smith & Sayre Manufacturing Co. With the exception of a small account, entered in the books at the time of the transfer of assets from Smith & Sayre Manufacturing Co. to petitioner and minor changes therein since that time, petitioner has followed the conservative accounting practice of charging the cost of producing these drawings to expense. At least from 1904 to 1917 the amount expended each year has been fairly uniform, and apparently throughout the life of the petitioner and its predecessor, expenditures of this nature have been made and charged to expense. No evidence was introduced with respect to the period during which these drawings would be useful to petitioner.
While the evidence establishes that in the aggregate, substantial amounts were expended in the production of these drawings and that they had a useful life extending beyond the year when produced, we are not convinced that the long consistent practice of the petitioner of charging these items to expense was erroneous. As we said in *3520 , the fact that an item was erroneously charged to expense in the first instance does not preclude a correction of this mistake at a later time, but it is often difficult to differentiate between capital and expense items in certain classes of expenditures. In the , the Board said:
In the ordinary conduct of a manufacturing business the differentiation of capital expenditures and operating expense disbursements is largely a matter of sound discretion and experienced business judgment. The dividing line between the two classes can not be defined by statute and, so far as has come to our attention, no court has ever yet attempted to make a definition that can apply to any case except the one under review.
In that proceeding, expenditures for drawings, patterns, etc., which were made during a transition period of three years when the taxpayer was changing the character of its output, were allowed as capital charges. This, however, is not comparable to this case. Here we are dealing with a situation where the expenditures were not made within a short period, but represent a constantly*3521 recurring charge made each year in order to keep pace with the development of the industry in which petitioner is engaged. Changes are constantly being made, and while engineering work done in the designing of a piece of a particular apparatus may be useful in an improved item of the same type made many years later, the value of the first drawing *630 can hardly be said to be what it was before the improved type was made. As evidence that through the development of petitioner's business many changes have taken place the evidence shows that, whereas the petitioner or its predecessor were originally engaged in various lines of manufacture, many have been gradually abandoned so that it is now engaged almost exclusively in the gas industry. It is difficult to believe that this development of its business did not involve a corresponding abandonment in drawings made for a particular line.
Petitioner asks us to accept the proposition that the drawings made from 1904 to 1917 should be capitalized without furnishing any basis for their exhaustion, depreciation or obsolescence, and that their full cost should be restored to invested capital and there kept until such time as we know*3522 not when. Even if it were correct to reverse the long established practice of charging these items to expense, some basis should exist for eliminating items from the capital account when their useful life expires and as new or improved types are constructed to take their place. Certainly, if the capitalization theory contended for is sound, a concern with a business history of more than 50 years should be able to furnish a basis for exhaustion of these drawings which would prevent the building up of an account which neither good accounting practice would sanction, nor sound business policy approve. A similar situation was before the Board in the , wherein the following statements were made:
* * * No evidence was introduced as to the actual life of a pattern, a mold, a flask, or a fallow board. The taxpayer contents itself with the mere argument that these articles are the subject of constant replacement and repair, and are at all times kept in an efficient condition. Such an argument would apply equally to any other tangible property, no matter how ephemeral its life in the business. It would apply to the pencils of the*3523 stenographer as well as to her typewriter, although one is a well-recognized expense, and the other a capital asset. If the taxpayer had an actual capital asset with an appreciable life as it claims, and had records extending back to 1909 of the actual construction of such assets and their cost, it was in a position to set up records showing construction from year to year, to estimate the life of the molds, flasks, and fallow boards constructed, to depreciate them over that life, and to set up the replacement if any from time to time. The taxpayer has done none of these things, but asks the Board to accept a mere conclusion that these assets had a substantial life based on a mere argumentative claim that they are constantly replaced and kept in an efficient working condition. We consider that the evidence is insufficient to establish that the assets so claimed were of such a substantial character as to require capitalization in view of the consistent policy followed by the taxpayer both before and after 1917. * * *
In , the Board dealt with a situation fairly analogous to this case as follows:
*631 The taxpayer contends*3524 that prior to 1917 it had expended $18,032.76 for the manufacture or purchase of molds and patterns, and that no part of this amount was included by the Commissioner in invested capital for the years 1917, 1918, and 1919. The evidence shows that some of these molds and patterns last from a day or two to five years; that the corporation has always charged to expense the cost of the manufacture or purchase of them; and that no capital account has ever been maintained in respect of them.
We are of the opinion that it was entirely proper for the taxpayer to charge these items as expenses when the molds and patterns were acquired. Conservative accounting would warrant such action. The Commissioner has never raised any question as to the correctness of such treatment. We are therefore of the opinion that the taxpayer is not entitled to include in invested capital any amount representing the estimated cost of the molds and patterns acquired in past years, and that it is not entitled to any deduction from gross income for the years 1917, 1918 and 1919, in respect of depreciation upon the estimated cost of them.
Montgomery, in his work on "Income Tax Procedure," 1927 Edition, p. 999, *3525 makes the following observations with respect to items such as we are here concerned with:
The difficulty which the accountant encounters in the proper valuation of such patterns as are successful is to persuade proprietors to accept valuations which are reasonably conservative. Where patterns are used for stock or regular output, their value depends upon their life and upon the probability of renewed use. Where they are acquired or made for special jobs, their residual value is small, and their life should be considered coextensive with the life of the jobs themselves. In every case items such as these should be looked upon with suspicion, and convincing proof must be adduced before placing any material sum on their account as an asset. An auditor often meets with strong opposition in his efforts to reduce these items to reasonable amounts, for they represent the skill and often the affections of the proprietors, who dislike to see their value depreciated on the books. But the public demand is fickle, and patterns must be made to suit the changing taste. Even what appear to be standard patterns for staple businesses often change rapidly. Engineers made almost as many alterations*3526 in their "styles" as do milliners. When the demand ceases most of the old patterns should be scrapped. This rule applies to hardware designs as well as to patterns for women's dresses.
While the , on which petitioner places much reliance, contains language which tends to support its position, the fact that the restoration there sought was denied prevents its being complete authority for the principle contended for.
In view of the foregoing, the Board is unwilling to say that constantly recurring charges of the fairly uniform amounts here in question, which have been consistently charged to expense over a long period of years, should now be capitalized, particularly when we are without evidence as to a proper basis for the reduction of this account as the useful life of the drawings expires.
In view of our decision on the two preceding issues, it becomes unnecessary to pass on the third issue advanced with respect to the *632 effect on invested capital in 1919 of the erroneous taxes computed for 1917 and 1918 without the benefit of the restorations to invested capital hereinbefore considered.
In the petition the*3527 claim was made for a determination of profits tax under section 328 of the Revenue Act of 1918, as provided in section 327 of the same Act. All allegations with respect to this claim were denied by the respondent and no evidence was presented on account thereof. Likewise, no argument was advanced in petitioner's brief on this point. The petitioner's contention as to this issue is accordingly denied.
Reviewed by the Board.
Judgment will be entered for the respondent.