*1310 1. Invested capital can not be determined, therefore the profits taxes must be determined as provided in section 210 of the Revenue Act of 1917 and section 328 of the Revenue Act of 1918.
2. Disallowance of an additional deduction for officers' salaries approved where the amounts paid represented a distribution of profits in the guise of salaries.
*771 The Commissioner determined deficiencies in income and profits taxes of $752.83, $127,210.24 and $25,079.52 for the years 1917, 1918, and 1920, respectively.
The respondent concedes that he committed certain of the errors assigned by the petitioner. He also concedes that, after the correct tax liability for the earlier years involved herein is determined, the liability thus determined should be used in computing invested capital for the later years involved herein. The issues raised by the pleadings on which the parties still disagree are: (1) Whether the petitioner's profits taxes should be computed in accordance with section*1311 210 of the Revenue Act of 1917 and section 328 of the Revenue Act of 1918; (2) how much the petitioner is entitled to deduct in 1920 as officers' salaries; and, in the event (1) is decided favorably to the petitioner; (3) whether certain amounts allowed as deductions for expenses should have been capitalized and not allowed as deductions. The third issue is raised by the respondent.
FINDINGS OF FACT.
The petitioner is a corporation organized in 1903 under the laws of the Commonwealth of Pennsylvania. Its principal office is in Pittsburgh, Pennsylvania.
*772 Prior to 1903 Herbert DuPuy, J. H. Hillman, John F. Brennan, and John C. Neff had been buying and selling coal lands and options on coal lands in Fayette County, Pennsylvania, as partners. They had acquired there, among other properties, several contiguous tracts containing in all about 550 acres of land underlaid with the Pittsburgh vein of coal. They conveyed this property to the petitioner in 1903 for all of its capital stock, having a total par value of $500,000, and its noninterest-bearing non-negotiable note for $325,000. The stock was issued and the note was payable to the individuals as follows:
| Per cent | |
| Herbert DuPuy | 55 |
| J. H. Hillman | 15 |
| John P. Brennan | 15 |
| John C. Neff | 15 |
| Total | 100 |
*1312 The note was paid in full. Payments were made as follows:
| 1904 | $20,000 |
| 1905 | 65,000 |
| 1906 | 15,000 |
| 1910 | 72,000 |
| 1912 | 153,000 |
The petitioner at once began to mine the coal from its property. Practically all of the coal produced has been manufactured into coke and sold as such by the petitioner. It has sold some coal to employees and others at its mines but the amount sold has been negligible.
It first constructed its Low Phos mine. This mine was almost exhausted at the beginning of the year 1917 and is not here in controversy. In 1906 it began a second mine known as the Herbert mine. The shaft was completed in 1907. This shaft was located so that its base would be at the lowest point in the coal. Two hundred and ten rectangular coke ovens were constructed at the Herbert plant in 1906, 1907 and 1908. The mine was intended to supply coal for these ovens.
The Herbert mine was designed and operated upon what is known as a "retreat" system as opposed to an "advance" system. In the latter system most of the coal is extracted as the mining operations proceed outward or away from the base of the shaft. In the retreat system entries are driven in the*1313 coal from the base of the shaft to the extreme limits of the property with a minimum of delay and most of the coal is mined as the operations retreat from these limits towards the shaft. In 1913 the most advanced entries or headings had reached the extreme limits of the property and by 1915 this part of the plan had been completed.
*773 After 1915 all coal was mined on the retreat. In 1908 all coal produced was mined from entries. In 1910 and 1911 about one half of the coal produced was obtained from entries. The remainder, and in later years most, of the coal was obtained from rooms and pillars.
Ventilation of the mine was accomplished in a large part through the headings driven to the limits as above described. Ditches were dug and pumps installed in them. Drainage of the mine was obtained through these headings. Main permanent haulage ways were built in some of them after any necessary grading and timbering. The cost of mining coal from entries was, at all times material hereto, greater than the cost of mining the same amount of coal from rooms. The system thus constructed prior to 1915 was a useful and valuable asset of the petitioner throughout the life of*1314 the mine. The part of the system which remained had a substantial value during the years 1917, 1918, and 1920. No part of the large amount expended in constructing this system was ever capitalized on the petitioner's books. All amounts expended for labor and materials were charged to expense. Because of the method of keeping the books and records and the fact that some of the original records were destroyed in a fire in 1917, it is now impossible to determine how much was actually spent in this connection. No part of these expenditures has been included in the petitioner's invested capital for the years 1917, 1918, or 1920.
During the years 1917, 1918 and 1920, the taxpayer did not have any gains, profits, commissions, or other income derived on a cost plus basis from a Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive.
Originally Neff's annual salary as general manager was $2,000. In 1906 it was increased to $5,000, and in 1917 it was increased to $6,000. He also received a 10 per cent bonus in 1916 and 1917. DuPuy received no salary as president prior to 1920. In that year, in addition to the amount hereinafter*1315 mentioned, he was paid a salary of $3,000 as president. The petitioner's books of account show that directors' salaries were paid as follows:
| 1906 | 1907 | 1909 | 1911 | Total | |
| John C. Neff | $7,500 | $24,750 | $11,250 | $24,750 | $68,250 |
| Herbert DuPuy | 27,500 | 90,750 | 41,250 | 90,750 | 250,250 |
| J. H. Hillman | 7,500 | 24,750 | 11,250 | 43,500 | |
| J. H. Hillman Estate | 24,750 | 24,750 | |||
| J. P. Brennan | 7,500 | 24,750 | 11,250 | 24,750 | 68,250 |
| Total | 50,000 | 165,000 | 75,000 | 165,000 | 455,000 |
*774 Hillman died in 1911. Neff and Brennan died in 1920.
At a meeting of the petitioner's directors held on November 28, 1920, the following resolution was adopted:
WHEREAS, this company began the work of its development in the year 1903, securing coking-coal properties assembled in Fayette County, Pa., through the foresight and efforts of the late J. H. Hillman, the late J. P. Brennan, John C. Neff and Herbert DuPuy. During the period of its organization and development and for several years thereafter the affairs of the company were conducted without remuneration to Messrs. Hillman, Brennan and DuPuy, and with but a small salary to Mr. Neff, the profit accruing*1316 from its operation being retained to a large extent for improvements and betterments to the property; therefore,
IT IS RESOLVED, that in appreciation of the work which was done by the late J. H. Hillman, the late J. P. Brennan, John C. Neff and Herbert DuPuy, that a bonus, free from all taxes, be given them in consideration of said services, and the treasurer is directed to draw checks to them or to their estates as follows:
Estate of J. H. Hillman, $9,000; Estate of J. P. Brennan, $9,000; John C. Neff, $6,000; Herbert DuPuy, $33,000.
As a result of the foregoing resolution the petitioner made payments to the four individuals or their estates, as follows:
| Paid to | Date | Amount |
| Herbert DuPuy | Dec. 2, 1920 | $33,000.00 |
| Estate of J. H. Hillman | Dec. 4, 1920 | 9,000.00 |
| Estate of J. P. Brennan | Dec. 4, 1920 | 9,000.00 |
| John C. Neff | Dec. 4, 1920 | 6,000.00 |
| Total for 1920 | 57,000.00 | |
| Herbert DuPuy | June 6, 1921 | 4,708.29 |
| Estate of J. H. Hillman | July 11, 1921 | 1,284.08 |
| Estate of J. P. Brennan | July 11, 1921 | 1,284.08 |
| Estate of John C. Neff | July 11, 1921 | 1,284.08 |
| Total amount paid | 65,560.53 |
All of the petitioner's capital stock was owned in 1920 by the*1317 four individuals above named, or their immediate families; and the payments authorized by the foregoing resolution were approximately in proportion to those stockholdings, but not in proportion to the value of services rendered by the four individuals. These payments were distributions of profits.
In computing net income in the original return for 1920, the petitioner deducted from gross income the sum of $18,963.26, as compensation of officers. In an amended return, the petitioner deducted from gross income the sum of $84,523.79 as compensation of officers. In computing the deficiency the Commissioner used the net income reported by the petitioner in the original return as a starting point, and made no adjustment thereof on account of compensation of officers. In determining the deficiency for 1920 the Commissioner computed *775 the net income, without deduction of additional salaries of $65,560.53, to be $787,373.80, and the invested capital to be $765,723.39.
DuPuy was president and a director of the petitioner from 1903 until after the years here involved. Brennan was a director from 1903 until his death in 1920. Hillman was a director from 1903 until his death*1318 in 1911. Neff was secretary-treasurer, a director, and general manager from 1903 until his death in 1920.
Neff devoted most of his time to the petitioner's affairs at the petitioner's office in Pittsburgh. He made regular visits to the mine. DuPuy devoted only a small part of his time to the petitioner's affairs. His other interests were many and took most of his time. His office adjoined that of the petitioner and almost every day he visited the petitioner's office and discussed its affairs. Brennan devoted most of his time to matters unrelated to the petitioner's business. He visited the petitioner's offices two or three times a week and frequently visited its plant, at which times he discussed the petitioner's affairs with the other directors. Hillman was principally engaged in the coal brokerage business. He was very much interested in the construction of the rectangular ovens and during the experimental and construction period relating to these ovens he devoted a substantial part of his time to the petitioner's affairs. All four of these men were experienced in the coal and coke business.
There was a ready market for coke during 1918 and 1920 and the petitioner*1319 maintained no sales organization, but sold its products through the efforts of its stockholders. In 1918 almost all of its coke was sold to the Crucible Steel Company of America, of which DuPuy was president. In 1920 practically all of its coke was sold to the J. H. Hillman Company, a coke brokerage firm owned by the same persons who owned 15 per cent of the petitioner's capital stock. The prices for which the petitioner sold its products to these two companies were the fair market prices existing at the dates of sale. No commissions were paid on sales made in these two years.
The total amount of dividends paid by the petitioner up to December 31, 1918, was $2,376,650. In 1920 it paid a dividend of $102,500. The following table shows the net profit or loss of the Herbert plant for various periods:
| Period | Profit | Loss |
| To January 1, 1908 | $17,397.53 | |
| Jan. 1 to Oct. 31, 1908 | $16,655.01 | |
| Years ended Oct. 31 - | ||
| 1909 | 6,394.56 | |
| 1910 | 107,020.60 | |
| 1911 | 52,151.37 | |
| 1912 | 47,399.54 | |
| 1913 | 141,323.00 | |
| Years ended Oct. 31 - Con. | ||
| 1914 | $51,613.41 | |
| 1915 | 43,718.79 | |
| 1916 | 107,643.14 | |
| Calendar years - | ||
| 1917 | 1 1,548,303.00 | |
| 1918 | 1 888,325.05 | |
| 1920 | 1 774,766.38 |
*776 OPINION.
MURDOCK: The first question is to determine how the profits taxes due for the years 1917, 1918 and 1920 should be computed. Section 210 of the Revenue Act of 1917 provides that if the Secretary of the Treasury is unable in any case to determine satisfactorily the invested capital, a deduction shall be computed by a certain comparison with other representative taxpayers engaged in a like or similar trade or business. Section 327(a) of the Revenue Act of 1918 provides that the tax shall be determined as provided in section 328 where the Commissioner is unable to determine the invested capital as provided in section 326. These particular provisions of the two acts need not be discussed separately. Cf. . The Commissioner has determined an amount to represent the petitioner's invested capital for each year. The petitioner claims, however, that its invested capital can not be determined satisfactorily. If this contention is correct we need not consider whether there are any abnormal conditions within the meaning of section 327(d).
*1321 It is fair to assume, from the record before us, that the petitioner has some earned surplus. If the amount of that surplus can be satisfactorily determined, it must be included in invested capital. The theory of the petitioner's case must be that it has capital assets not shown on its books as such; the cost of these can not be determined at this time; and, as a consequence, its invested capital can not be determined since a part of the cost of these assets should be reflected in a correspondingly larger surplus than its books now show. The alleged assets are entries or tunnels in the Herbert mine which were intended and equipped for further use in extracting other coal. Coal was produced in driving these entries, but another important purpose in driving them was to provide the mine with a system for the future. They were constructed and equipped in the early years of the mine, yet the system, once developed, had an effect on all of the remaining coal in the mine. Certain of these entries existed at the beginning of the fiscal year 1917 and were actually used during the three years 1917, 1918 and 1920 in earning the income now being taxed. The petitioner claims that the*1322 cost of the part of this system which remained in use was substantial. No amount of diligence would disclose the actual cost. Cf. . It attempted to show the approximate cost. The respondent strenuously attacks the testimony of a witness on this subject, but the case does not stand or fall on his testimony. There is other evidence of the approximate cost and we are satisfied from the whole record that the cost was substantial.
*777 The respondent concedes that the driving and equipping of these entries was development work. In most cases he requires, in accordance with good accounting practices, that the cost of assets having a useful life beyond the year in which acquired be capitalized so that income may be clearly reflected. Yet he has refused to permit the capitalization of any part of the cost of these entries and the equipment in them. As a reason in the case of mines for an exception to a general rule, he points to the fact that the entries were dug through solid coal and contends that the coal thus produced more than compensated the petitioner for the cost of digging it. He would apply a portion of article*1323 222(a) of Regulations 45, as amended on January 28, 1921, to the effect that, while a mine is in the development stage, there shall be charged to capital account only those expenditures for development in excess of receipts from minerals sold. The article in its original form and as amended is set forth in the margin. 1 Regulations 45 relate to the Revenue Act of 1918. The year 1917, here involved, is not affected by the Revenue Act of 1918. But the amended regulation probably relates back to the years 1918 and 1920, even though it was not promulgated until afterward.
*1324 The respondent contends that the Herbert mine was in the "development stage" until 1915 and that a profit was made during this period by the petitioner from the sale of minerals. On his theory there were no expenditures for development in excess of receipts from minerals sold in the case of the Herbert mine, and, consequently, nothing to be charged to capital account recoverable through depletion. The regulation introduces the phrase "receipts from minerals sold". The petitioner sold only a negligible amount of coal, and if the regulation were to be construed strictly, practically all of *778 the development costs would be capitalized. Even under a liberal construction and assuming the validity of the regulation since the petitioner manufactured its coal into coke the cost and receipts allocable to the manufacturing process should be eliminated in order to determine how much should be charged to capital account.
The entries in question, when once they had been developed and equipped, added value to the mineral deposit beyond the current year. The regulation itself provides, where such development takes place after the "development stage" is over, that the cost shall*1325 be carried as a "deferred charge" and deducted over later years. The quoted words do not occur in the statute. We do not know what significance the respondent attaches to the words "deferred charges". Perhaps he would allow such expenditures to be capitalized. Cf. Regulations 65, article 224(a). He recognizes that the "development stage" need not continue until all development work is done. For various definitions of "development stage" see the corresponding articles of later regulations and also ; . The latter case was reversed in . It is obvious from the testimony in this case that the Herbert mine did not continue in the "development stage", as we would interpret the words, until 1915. The petitioner maintains that it passed out of the "development stage" on or about November 1, 1909, and that the net result of the entire operation of the Herbert plant up to that date was a loss. We need determine no exact date in this connection. The mine was designed*1326 to supply the ovens with coke. It was fulfilling this purpose long before 1915, and at an early date it had sufficient entries developed for this purpose.
However, the question at once arises as to whether or not the portion of article 222 relied upon by the Commissioner is a reasonable regulation or a proper one to apply in this case. The respondent has neither cited authority nor advanced any sound argument in support of this provision of his regulations. None occurs to us. Although there may be a practical difficulty in dividing the cost of producing coal from the cost of development, yet this difficulty need not deter us, since other portions of the regulation require such a division. The Circuit Court of Appeals for the Fifth Circuit has held, in , that the cost of development in a coal mine should be capitalized regardless of whether or not a profit is made during the development period. In that case the development in question was the driving of a main entry into the coal from an outcrop. The case is not distinguishable *779 from the present case. It sets at naught the very provision of the regulation which the*1327 Commissioner now relies upon.
The Revenue Act of 1913 permits as a deduction from income "a reasonable allowance for the exhaustion, wear and tear of property arising out of its use or employment in the business, not to exceed, in the case of mines, 5 per centum of the gross value at the mine of the output for the year for which the computation is made * * * provided, that no deduction shall be allowed for any amount paid out for new buildings, permanent improvements or betterments made to increase the value of any property or estate." The Revenue Acts of 1916 and 1918 contain similar provisions but omit the 5 per centum limitation. The latter act contains also section 234(a)(9), which allows as a deduction:
In the case of mines * * * a reasonable allowance for depletion and for depreciation of improvements, according to the peculiar conditions in each case, based upon cost including cost of development not otherwise deducted.
Through the expenditures incurred in driving and equipping these entries, the petitioner acquired facilities, including haulage ways, ventilation and drainage, which were necessary for and were actually used in the mining of the remaining coal. They*1328 not only decreased the cost of producing the remaining coal in the mine, but the evidence also indicates that they actually added value to the mine after due allowance is made for the coal extracted. The driving of an entry is a more expensive proposition than the mining of an equivalent quantity of coal from portions of the mine which are not to be used as entries. The petitioner actually found this to be true. Therefore, it seems only proper that not all of the cost of driving and equipping these entries should be charged as an ordinary and necessary expense in producing only that coal recovered from these entries. So that the remaining coal may bear its proper share of this cost, some part of the cost should be capitalized. Here we need not determine what part, for we are convinced that a substantial amount should be capitalized and that a substantial part of this cost remained during the taxable years in question after proper allowances for exhaustion. The statutes require that the cost of development be recovered upon a reasonable basis so that income may be clearly reflected. Good accounting requires that part of the cost be capitalized if income is to be clearly reflected. *1329 Under the statutes the petitioner was entitled to have a substantially larger amount of invested capital than the respondent has allowed or it is able to establish. Its invested capital can not be determined.
We have held that the petitioner should have capitalized certain amounts which it deducted as expenses. Anticipating the possibility of such a holding, the respondent contends that under that *780 view of the case he erred in allowing deductions of $1,250 and $16,125 in computing the petitioner's net income for 1917 and 1920, respectively. These amounts he contends represent the cost of entries constructed in those years. However, the record does not show in regard to these years what deductions the Commissioner has allowed representing cost of driving entries, the amount expended by the petitioner in driving entries, nor the nature or character of the entries actually driven. Consequently, we hold for the petitioner on this point.
The remaining issue is raised by the petitioner's assignment of error to the effect that the Commissioner failed to allow a deduction of $65,560.53 which amount was authorized during the year 1920 "and either paid or credited during*1330 the year 1920 as compensation to officers for services rendered in prior years". Section 234(a)(1) of the Revenue Act of 1918 allows as a deduction "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for services actually rendered". Additional compensation authorized to be paid for services rendered in prior years may be deducted under this provision in the year in which paid or incurred, provided that it is a reasonable allowance for the services rendered. ; affd., . Distributions of profits made to stockholders in the guise of salaries are not deductible. ; ; affd., ; ; affd., ; ; affd., *1331 ; ; affd., ; ; affd., .
In its original return for 1920 the petitioner claimed a deduction of $18,963.26 as compensation of officers. The respondent has allowed this deduction. The petitioner has not shown what items go to make up this total nor who received the compensation. Fifty-seven thousand dollars was shown on the original return as an unallowable deduction representing special bonuses to officers. But on the amended return $84,523.79 was claimed as a deduction representing compensation of officers. Thus the petitioner increased its claim by $65,560.53. The Commissioner has allowed no part of this increase. The $65,560.53 represents $57,000 paid in the early part of December 1920, and $8,560.53 paid a little more than six months *781 later. Apparently the additional amounts were paid in 1921 because the resolution of November 28, 1920, provided that the bonus be "free from all taxes". We are unable to say, however, that the $8,560.53 was either paid or incurred*1332 in 1920 and for this reason, if for no other, this amount should not be allowed as a deduction for 1920.
The petitioner claims the right to deduct the additional amount in controversy as compensation of officers, yet the record does not show that either Brennan or Hillman ever held any office in the corporation. They were directors but, so far as we know, they were not officers. However, the four individuals in some capacity or another rendered some valuable services to the corporation. But prior to 1920 each one of these individuals had been amply compensated for all services which he had rendered the corporation up to that time. They had received a total of $455,000 in prior years as directors' salaries. Neff had received, in addition, his regular salary. The directors' salaries were in direct proportion to stockholdings. Counsel for the petitioner did not learn until after the hearing that these directors' salaries had been paid. They now contend in a reply brief that these amounts were really a distribution of profits and not compensation for personal services rendered. But the extra compensation authorized in 1920 was also in direct proportion to stockholdings rather*1333 than in proportion to the value of services rendered by the four and it came nine years after Hillman's death. There is more reason to hold that the four individuals were compensated in full for their services by the amounts paid them in the earlier years than there is to hold that the authorization in 1920 was a belated recognition of services rendered in years long past. The petitioner was well able to pay any amount which it owed to its officers and directors prior to 1920 and the amounts paid over that period to these individuals amply compensated them for all services rendered up to 1920. In our opinion the amount authorized in 1920 was not a reasonable allowance for salaries or other compensation for services actually rendered. Rather, it was a distribution of profits in the guise of compensation.
DuPuy was paid a salary of $3,000 in 1920, but the record is not clear as to the total compensation received by Neff for that year. We have no reason to believe that the Commissioner has not already allowed as a deduction the $3,000 paid to DuPuy, and whatever amount was paid to Neff. Both Brennan and Neff died in 1920. Hillman had been dead for nine years. There is some*1334 evidence to indicate that Neff had been ill and unable to perform any services *782 for the petitioner for a year or more prior to his death. We are unable to say that the amount allowed by the Commissioner was any less than a reasonable allowance for all salaries and other compensation for services rendered. Certain returns of other companies which were offered in evidence indicate that the allowance made by the Commissioner was adequate.
Decision will be entered under Rule 62(c).
Footnotes
1. Includes profit or loss, if any, of Low Phos plant. ↩
1. [Article 222, Regulations 45, as originally promulgated.] In the case of mining operations all expenditures for plant equipment, development, rent, and royalty prior to production, and thereafter all major items of plant and equipment, shall be charged to capital account for purposes of depletion and depreciation. After a mine has been developed and equipped to its normal and regular output capacity, however, the cost of additional minor items of equipment and plant, including mules, motors, mine cars, trackage, cables, trolley wire, fans, small tools, etc., necessary to maintain the normal output because of increased length of haul or depth of working consequent on the extraction of mineral, and the cost of replacements of these and similar minor items of worn-out and discarded plant and equipment, may be charged to current expense of operations.
[Article 222, Regulations 45, as amended January 28, 1921.] (a) All expenditures for development, rent, and royalty in excess of receipts from minerals sold, shall be charged to capital account recoverable through depletion, while the mine is in the development stage. Thereafter any development which adds value to the mineral deposit beyond the current year shall be carried as a deferred charge and apportioned and deducted as operating expense in the years to which it is applicable.
(b) All expenditures for plant and equipment shall be charged to capital account recoverable through depreciation, while the mine is in the development stage. Thereafter the cost of major items of plant and equipment shall be capitalized but the cost of minor items of equipment and plant, necessary to maintain the normal output, and the cost of replacement may be charged to current expense of operation. ↩