*1577 1. DEDUCTION - EXPENSE. Held, that the petitioner may not deduct as an expense any amount in excess of cost to it of materials and supplies used by it during 1920. The amount of such excess is determined upon the facts of record.
2. Id. The expense incurred by petitioner in negotiating a settlement with the Director General in 1921 held to be deductible from gross income for that year.
*109 The respondent has asserted deficiencies in the income taxes of this petitioner in the amounts of $3,560.55 and $1,647.77 for the calendar years 1920 and 1921, respectively.
The petitioner has assigned several errors in respondent's determination of said deficiencies, but has withdrawn all but the following: (1) respondent's erroneous inclusion in income for 1920 of *110 the amount of $47,086.62 as profit or income derived from the adjustment made with the Director General of Railroads on account of materials and supplies; (2) respondent's erroneous disallowance of a deduction of $160.01 from gross income for*1578 1920, alleged to represent payment made to the Association of Railway Executives; (3) respondent's erroneous disallowance of a deduction of $20,998.14 from gross income for 1921, alleged to represent expenses incurred in that year in securing a final settlement of its claims against the Director General due to Federal control and which amount petitioner failed to charge to operating expense. Petitioner also claims an overpayment of $257.01 for the year 1921. By his amended answer, the respondent alleges, in the alternative, that if the Board find from the evidence that a profit was realized through the settlement with the Director General of Railroads during 1921 for materials and supplies converted by him during Federal control, such profit should be included in petitioner's gross income for 1921 and the amount of $47,086.62 disallowed as a deduction by respondent for 1920 on account of materials and supplies charged to expense in excess of cost to petitioner should be reduced accordingly, provided, however, that the adjustment of $2,187.78 allowed by respondent for materials and supplies charged to additions and betterments should be adjusted to 4.44 per cent of the amount in excess*1579 of cost to petitioner of materials and supplies returned in kind by the Director General of Railroads and which were used and charged to petitioner's accounts during 1920.
FINDINGS OF FACT.
The petitioner is a New York corporation, with its principal office at Kingston.
During the period of Federal control of railroads, the railroad properties and transportation system of the petitioner were taken over and operated by the Director General of Railroads from January 1, 1918, to March 1, 1920. Included in the property turned over to the Director General were the materials and supplies which petitioner had on hand on December 31, 1917, inventoried at cost aggregating $189,725.48. Such amount was charged to the Director General on the petitioner's books.
The petitioner's inventory was taken into the Director General's accounts as the cost to him of such materials and supplies and during the Federal control period all purchases of materials and supplies were taken into his accounts at the cost thereof to him. The materials and supplies used by the Director General were charged to operating expense at cost.
*111 At the termination of Federal control on March 1, 1920, the*1580 Director General returned to the petitioner its transportation system and railroad properties, including the materials and supplies which he had on hand and which were inventoried as of that date at cost aggregating $173,548.36, exclusive of fuel. That inventory was taken from the Director General's stock books and included materials and supplies purchased by the Director General during Federal control, some unused materials and supplies purchased by the petitioner prior to Federal control, and also overages, i.e., a quantity of similar units in excess of those taken over on January 1, 1918, and a quantity of units unlike any of the units taken over from the petitioner.
As of March 1, 1920, the Director General's inventory, aggregating $173,548.36, was taken into the petitioner's accounts and entered in its stock books. Subsequent to March 1, 1920, all materials and supplies purchased by the petitioner were entered in its stock books at the cost price thereof and all materials and supplies used were charged to operating expense at such cost. The materials and supplies, exclusive of fuel, issued by petitioner and charged to expense during the period March 1, 1920, to December 31, 1920, aggregated*1581 not less than $128,804.72.
The petitioner did not enter into a contract with the Director General for his use of its properties and transportation system during the Federal control period and subsequent thereto a controversy arose regarding the petitioner's claim for compensation. That controversy was submitted to a board of referees, which made an award to petitioner for compensation for the use of the railroad on the basis of the standard form of contract provided for by the Federal Control Act. Such award was not accepted by the Director General and the petitioner brought an action in the United States Court of Claims to recover the compensation claimed and also certain other amounts claimed to be due it on account of depreciation, undermaintenance, timber, material and supply shortages, and interest on deferred payments of compensation.
After the petitioner had submitted its evidence to the said court and at the request of the Director General, the parties entered into negotiations for a settlement on the basis of the standard form of contract, and during the final negotations held in Mary, 1921, the Director General agreed to the petitioner's claims, aggregating $320,993.12, *1582 for lease of the road, depreciation of equipment, undermaintenance, and depletion of petitioner's timber tract. The parties also agreed that the amount of $20,033.66 was due from the petitioner to the Director General on open accounts, leaving an agreed net amount of $300,959.46 due the petitioner. The Director General refused to pay any amount as interest on deferred payments of compensation or *112 the amount of expenses incurred by petitioner in negotiating a settlement. The only remaining item in dispute on May 4, 1921, was petitioner's claim of $119,951.90 as the net amount due it for shortages in materials and supplies returned in kind by the Director General. A comparison of the petitioner's inventory of December 31, 1917, and the Director General's inventory of March 1, 1920, showed that the actual shortages by units at March 1, 1920, prices aggregated $160,207.72, and that the overages by units at March 1, 1920, prices aggregated $40,255.82, leaving a net balance of $119,951.90 due the petitioner for shortages on the basis of a settlement pursuant to the terms of the standard form of contract. The actual shortages in units at the December 31, 1917, inventory prices*1583 aggregated $99,426.09.
On May 5, 1921, the Director General and the petitioner agreed to a lump-sum settlement of $390,000. They had agreed that the net sum of $300,959.46 was due petitioner on certain of its claims and the balance of $89,040.54 was paid by the Director General in settlement of petitioner's net claim for shortages in materials and supplies returned in kind. The petitioner paid for the overages at March 1, 1920, prices by being given a credit for $40,255.82 by the Director General when he paid petitioner $89,040.54 in cash in settlement of petitioner's net claim of $119,951.90 for shortages.
The petitioner was not advised that the Director General distributed the said lump sum on his accounts in amounts other than those agreed upon and that he entered the amount of $98,000 as the sum paid in settlement of the materials-and-supplies account. The respondent has used that figure in his computation of the deficiency in question.
The petitioner's books carried suspense accounts for the several claims made against the Director General and the lump-sum settlement of $390,000 was credited to those accounts in the amounts agreed upon, except as to the materials and*1584 supplies suspense account. Instead of crediting $89,040.54 to the last named account, the petitioner credited $68,040.40 thereto and credited $20,998.14 to the suspense account, "government settlement expense," which petitioner now admits to be erroneous. The sum of $20,998.14 constituted petitioner's expense incurred in negotiating the final settlement, but it was not charged to operating expenses by the petitioner or deducted from gross income in its return for the year 1921.
The check made of the actual units of materials and supplies which the Director General had on hand on March 1, 1920, disclosed that units aggregating $4,121.21 included in that inventory were missing and that items aggregating $28,427.27 included in that inventory constituted signal, bridge and other materials left along a right of *113 way by the petitioner prior to Federal control but not included in the petitioner's inventory of December 31, 1917. The respondent has made allowance for those items by reducing the March 1, 1920, inventory value from $173,548.36 to $140,999.88.
In determining petitioner's taxable income for the year 1920 the respondent has disallowed $47,086.62 of the amount*1585 claimed as a deduction for materials and supplies used during that year, as representing the amount charged to expense in excess of the cost of such materials to the petitioner. The said amount so disallowed was computed as follows:
| Inventory value March 1, 1920 | $140,999.88 | |
| Allowance by Director General for shortages | 98,000.00 | |
| 238,999.88 | ||
| Inventory value December 31, 1917 | 189,725.48 | |
| Increase in value | 49,274.40 | |
| Deduct: | ||
| Materials and supplies issued March 1, to Dec. 31, 1920 | $128,804.72 | |
| Amount issued for A and B | 5,706.23 | |
| Per cent issued for A and B | 4.44 | |
| Proportion of materials and supplies estimated to be charged to A and B $49,274.40 X 4.44% | 2,187.78 | |
| Balance issued for maintenance (disallowed) | 47,086.62 | |
| Amount disallowed in Bureau letter dated Sept. 7, 1926 (30-day letter) in which inventory value on March 1, 1920, was placed at $173,548.36 | 81,822.88 | |
| Decrease as above | 34,736.26 |
For the year 1921, the respondent made the following determination:
| Net income | $21,047.78 |
| Less: Exemption | 2,000.00 |
| Balance taxable at 10% | 19,047.78 |
| Income tax | 1,904.78 |
| Previously assessed - on original return | 257.01 |
| Additional to be assessed | 1,647.77 |
*1586 The amount of $20,998.14 expended in negotiating the final settlement with the Director General has not been allowed as a deduction for 1921.
OPINION.
TRAMMELL: The principal issue involved in this case is whether or not the respondent erred in including in the petitioner's income for 1920 the amount of $47,086.62 as profit or income derived from the *114 adjustment made with the Director General of Railroads on account of materials and supplies. The amount stated represents the excess over cost to the petitioner of materials and supplies returned by the Director General, which the petitioner charged to expense and deducted from income, as determined by the respondent. Said amount so determined by the respondent as representing excess over cost was included in the petitioner's income in computing the deficiency for the taxable year 1920.
On January 1, 1918, the petitioner turned over to the Director General of Railroads its various railroad properties, including the materials and supplies then on hand, which were inventoried as of December 31, 1917, at a total cost to the petitioner of $189,725.48. The parties are in agreement as to this amount.
On March 1, 1920, at*1587 the termination of Federal control, the Director General returned to petitioner its properties, including the materials and supplies on hand inventoried as of that date at a cost to the Director General of $173,548.36, not including fuel. The parties are also in agreement as to this amount. Said inventory was taken into the petitioner's accounts and charged to expense as the materials and supplies were used.
The Director General and the petitioner had not entered into any contract during the period of Federal control, but in May, 1921, they negotiated a settlement of the petitioner's claims arising out of Federal control on the basis of the standard form of contract, which provided in section 9(b) as follows:
At the end of Federal control the Director General shall return to the Company all uncollected accounts received by him from the Company and also materials and supplies equal in quantity, quality and relative usefulness to that of the materials and supplies which he received and to the extent that the Director General does not return such materials and supplies he shall account for the same at prices prevailing at the end of Federal control. To the extent that the Company*1588 receives materials and supplies in excess of those delivered by it to the Director General it shall account for the same at the prices prevailing at the end of Federal control, and the balance shall be adjusted in cash.
On May 4, 1921, as a result of the negotiations theretofore carried on, the Director General and the petitioner had agreed on the settlement of all claims except that of the petitioner for the amount claimed to be due it for materials and supplies. On May 5, 1921, the parties agreed to a lump-sum settlement of $390,000, to be paid to the petitioner by the Director General, which included the petitioner's claim for shortages of materials and supplies.
Here arises the first disagreement between the respondent and the petitioner respecting the facts. The respondent contends, and on that basis computed the deficiency for 1920, that as a result of the lump-sum settlement the Director General paid to the petitioner *115 the sum of $98,000 for shortages of materials and supplies. The allocation by the respondent of that amount of the lump-sum settlement to materials and supplies is admitted to rest upon the similar allocation made by the Director General upon*1589 his books, and in support of his determination the respondent in his brief sets up a comparison of the difference in the various accounts as they appeared upon the books of the petitioner and of the Director General. Careful consideration of those accounts discloses, in our opinion, that neither party attempted to allocate the lump-sum settlement of $390,000 in its accounts so as to reflect the actual facts of the final agreement, but the allocation made by each was a mere matter of bookkeeping convenience.
However, the record establishes, and we have so found, that on or prior to May 4, 1921, the Director General and the petitioner had agreed upon the amount to be paid in settlement of each of the petitioners' claims, except that for shortages of materials and supplies. The aggregate of the amounts so agreed upon, subtracted from the amount of the lump-sum settlement made on May 5, 1921, leaves only the amount of $89,040.54 to be allocated to the settlement of the petitioner's claim for shortages of materials and supplies. This is the amount which the petitioner now contends is a proper allocation, and we agree with its contention on this point.
The petitioner claimed as*1590 due to it from the Director General on account of shortages in materials and supplies the net amount of $119,951.90, computed as follows: The shortages by units at prices prevailing on March 1, 1920, amounted to $160,207.72, and the overages by units at prices of the same date amounted to $40,255.82, leaving the net balance of $119,951.90 which the petitioner claimed to be due it for shortages. It is apparent that in the process of this settlement the petitioner in effect paid the Director General for the overages, by means of a credit, as effectively as if the Director General had first paid the petitioner the full amount due for shortages and the petitioner had thereupon paid to the Director General the full amount due to him for the overages. Nor is such result changed by the fact that the Director General settled the petitioner's net claim for shortages by the payment of an amount less than that claimed.
The petitioner having in effect purchased the overages from the Director General, for which it paid at March 1, 1920, prices, this item should be eliminated from the Director General's inventory in determining the cost to the petitioner of the materials and supplies returned*1591 to it in kind by the Director General. Since the respondent did not take this item into consideration in computing the deficiency, his determination must be modified accordingly.
*116 The parties are agreed that the Director General's inventory of materials and supplies returned in kind as of March 1, 1920, should be reduced from $173,548.36 to $140,999.98. This results from the respondent's action in deducting from the inventory value (1) items included in the inventory but missing, in the amount of $4,121.21, and (2) items on hand at December 31, 1917, which were not included in the petitioner's inventory but which were included in the Director General's inventory of March 1, 1920, in the amount of $28,427.27, making the total deduction for these two items of $32,548.48, recognized by the respondent.
Giving effect to the adjustments hereinabove indicated, the amount charged to expense in excess of the cost to the petitioner of the materials and supplies returned by the Director General should be recomputed as follows:
| Director General's inventory of March 1, 1920, and taken into petitioner's accounts | $173,548.36 | |
| Reduced by: | ||
| Items included but missing | $4,121.21 | |
| Items on hand on Dec. 31, 1917, but not included in petitioner's inventory and included in Mar 1, 1920, inventory | 28,427.27 | |
| Items of overages included in March 1, 1920, inventory but paid for by petitioner | 40,255.82 | |
| 72,804.30 | ||
| March 1, 1920, inventory value of similar units returned in kind by Director General | 100,744.06 | |
| Cash paid by Director General for shortages | 89,040.54 | |
| 189,784.60 | ||
| Value of petitioner's inventory Dec. 31, 1917 | 189,725.48 | |
| Excess over cost | 59.12 | |
| Deduct: Proportion of materials and supplies estimated to be charged to additions and betterments $59.12 X 4.44% | 2.63 | |
| Issued for maintenance and charged to expense in excess of cost | 56.49 |
*1592 The respondent erred in disallowing $47,086.62 of the amount claimed by petitioner as a deduction for materials and supplies used during the year 1920. The amount which should be disallowed as representing the sum charged to expense in excess of cost of such materials to petitioner is $56.49. See , and .
With regard to the second issue the respondent must be sustained, for, while we have held in , that an amount paid in the taxable year to the Association of Railway Executives is a deductible expense, the petitioner *117 has failed to prove that during 1920 it paid the sum of $160.01 to the association as alleged.
We have found as a fact that during the year 1921 the petitioner incurred expenses totaling $20,998.14 in negotiating a settlement of its claims against the Director General of Railroads, and that such expense has not been heretofore allowed as a deduction from gross income for the year 1921. This expenditure constituted an ordinary*1593 and necessary business expense and should be allowed as a deduction for 1921, pursuant to section 234(a)(1) of the Revenue Act of 1921.
The deficiencies will be redetermined in accordance with the foregoing opinion.
Judgment will be entered under Rule 50.