*2481 1. INVESTED CAPITAL. - The value of good will acquired for stock at the time of the organization of the petitioner corporation determined for the purposes of invested capital. Good will purchased in 1914 for cash, representing a part of the petitioner's earned surplus, should be included in invested capital for the years 1919 and 1920.
2. OBSOLESCENCE OF BREWERY BUILDINGS. - The petitioner's buildings designed and constructed especially for uses of a beer brewery business held subject to obsolescence and the amount of such obsolescence determined and allowed as deductions from gross income for the years 1919 and 1920.
3. BAD DEBTS. - Certain debts ascertained to be uncollectible by petitioner and charged off in the years 1919 and 1920 and disallowed as deductions by the Commissioner, examined in the light of the evidence respecting each of such debts and deductions allowed in the respective years in accord with the proof.
*945 By letter of October 14, 1925, the Commissioner served notice of deficiencies upon the J. Chr. G. Hupfel Brewing*2482 Co. of New York City, in the amounts of $112,419.13 for 1919 and $1,416.71 for 1920. The deficiency stated for 1920 was, on motion of the respondent at the hearing, increased to $2,771.63, to correct an error in computation in the statement attached to and made a part of the letter. The deficiency alleged for the year 1919 is based upon the disallowance by the respondent of deductions by petitioner from gross income for that year of alleged bad debts and obsolescence of tangible assets, and by readjustment of the invested capital reported. The deficiency for the year 1920 is based upon a disallowance by the respondent of certain debts deducted as uncollectible by the petitioner from gross income for that year.
There are four issues presented:
1. May the value of good will acquired for stock on original organization in 1887 and for cash in 1914 be included in invested capital in 1919 and 1920?
2. Is the value of such good will subject to deduction for obsolescence under the provisions of section 234(a)(7) of the Revenue Act of 1918?
3. On buildings constructed for and used as a brewing plant, is petitioner entitled to a reasonable allowance for obsolescence in 1919*2483 as a result of the forced discontinuance of brewery business?
4. Are certain debts in the amount of $162,484.91 for the year 1919 and $40,271.93 for the year 1920, charged off by petitioner as uncollectible and deducted from gross income in those respective years, proper deductions under section 234(a)(5) of the Revenue Act of 1918?
FINDINGS OF FACT.
Petitioner was incorporated under the laws of New York in September, 1887, as J. Chr. G. Hupfel Brewing Co. The total capital stock of $500,000 was issued on October 19, 1887, to J. Chr. G. Hupfel in exchange for the total assets, including good will, of a brewing business which the latter owned and had successfully operated for some years prior to that date. The tangible assets of this business had a gross value at the time acquired of $625,290.86, and liabilities of the business in the sum of $225,290.86 were assumed by petitioner. The net value of the tangible assets thus acquired was $400,000. The good will acquired in this transaction was set up on petitioner's books at $100,000. The net profits of the business for the period of 11 months preceding the date of acquisition, amounted to $42,415.45, for the year following*2484 that acquisition the sum of *946 $36,859, and for the next year $51,025.16. On August 7, 1914, petitioner acquired by purchase for $247,500 in cash, the trade and good will of the Eppig Brewing Co. of New York City, together with certain tangible assets of that company consisting of chattel mortgages, horses, automobile trucks, wagons, etc. Of this amount $161,255.68 represented the amount paid for the tangibles and $86,244.32 the amount paid for the intangible assets.
The petitioner as a corporation held directors' meetings only as some legal necessity arose in the transaction of the business for recorded action by the board of directors. Matters which normally would be passed upon by the directors of a corporation were usually informally determined between J. Chr. G. Hupfel and his sons, the stock of the corporation being at all times held by Hupfel and members of his immediate family. Prior to ratification of the Eighteenth Amendment by the last necessary State on January 15, 1919, J. Chr. G. Hupfel, as president, and two of his sons as secretary and treasurer of the corporation, respectively, held informal meetings and discussed the situation and decided to liquidate*2485 the brewing business and to begin such liquidation immediately if the amendment submitted to the States was ratified. In accordance with this decision, petitioner, on January 15, 1919, ceased the buying of any additional supplies for manufacture of beer, near beer or cereal beverage, and its activities were occupied in using up the supplies on hand, and those received on the contracts made prior to that date, in the manufacture of nonalcoholic beer, the alcohol being eliminated by a crude process of boiling as the petitioner had no dealcoholizing plant. All brewing by petitioner ceased in December, 1920, the supplies on hand being used up on that date with the exception of a small amount. From December, 1920, to March, 1921, petitioner made sales and deliveries to its customers of near beer already manufactured by it and on hand, and for a year following that date, delivered to its customers near beer purchased from the F. and M. Schaeffer Brewing Co.
Petitioner owned as part of its brewing plant certain buildings known as Buildings A, B, C, D, and E. These buildings were originally erected many years before as brewery units and designed especially for such use and contained*2486 many features which precluded their adaptation to other commercial uses without considerable demolition and reconstruction. In some of these buildings the brewing apparatus extended through three floors and the removal of this left only portions of the steel structures. The ceiling heights were excessive for ordinary commercial purposes and the cellars were arched vaults for beer storage, constructed before the days of artificial refrigeration.
*947 In the years 1919, 1920, and 1921 there was no market for a brewing plant as such. The petitioner remodeled the buildings in question for commercial purposes. Building E was adapted with comparatively little remodeling to use as an ice plant. Buildings A, B, C, and D were remodeled for general commercial use. All of these buildings had been owned for some years by petitioner and their cost had been regularly depreciated during that time. The original cost of these buildings, less depreciation regularly charged off prior to the fiscal year 1919 was $115,191.54 for Buildings A, B, C, and D and $142,225.81 for Building E, these amounts representing the unextinguished or depreciated cost of these buildings at the beginning*2487 of the year 1919. The remodeling of these buildings by demolition of a portion thereof was necessary to realize on the value of the portion remaining. In this remodeling 46.9 per cent of the depreciated cost of Buildings A, B, C, and D and 4.8 per cent of the depreciated cost of Building E were represented by the portions demolished. There was no salvage resulting from the work of demolition and reconstruction. This work was begun in March, 1921, and finished the following year.
In its business petitioner had certain brewery equipment such as machinery, fixtures, vats, etc. For the year 1919 it charged off for exhaustion, wear, and tear, including obsolescence, a total of $226,954.14 on the equipment and on the buildings mentioned. Of this amount respondent disallowed the sum of $117,286.95 representing obsolescence on buildings but allowed in full the obsolescence claimed by petitioner on machinery, fixtures, vats, etc.
Petitioner changed its name in November, 1921, to the J. Chr. G. Hupfel Co., Inc., and has continued from that time in the business of manufacturing ice, using the reconstructed Building E for that purpose. Buildings A, B, C, and D are rented to tenants*2488 to tenants for commercial purposes.
Petitioner had for many years prior to 1919, in accordance with the general custom among brewers in New York City, financed for various saloonist customers the equipping and operating of their bar rooms in return for an agreement on their part to sell its product to patrons. This was done by advancement of money from time to time in the purchase of leases, bar-room fixtures, equipment, licenses, etc. These loans were made due and payable one day after date and in the larger amounts were secured by chattel mortgages on the bar fixtures but in some cases were evidenced by unsecured notes and in others by merely a charge on the books of petitioner to the general account maintained of the customers' indebtedness. Petitioner also furnished for use to some customers equipment such as signs, chairs, and tables to which it retained title. As to these latter the only obligation of customer was to return them to petitioner in *948 case he ceased using them. The cost to petitioner of these fixtures was charged against the customer on petitioner's books. Collections were made by petitioner weekly for beer delivered to the customer and from the*2489 gross price certain discounts were allowed, the amount represented thereby being credited to the customer on his indebtedness secured by chattel mortgage. With respect to that part of the indebtedness represented by unsecured notes or running account the usual arrangement for payment was by an agreed amount payable weekly or monthly.
When petitioner began in January, 1919, to liquidate its brewing business it ceased its custom of financing saloonist customers and its former method of sales. No discounts were allowed on the price of the near beer delivered. Sales were for cash with little credit extended. This custom was followed during 1919 and 1920 while petitioner was manufacturing its supplies on hand into near beer and during 1921 and 1922 when the petitioner was purchasing from the F. M. Schaeffer Brewing Co. the near beer with which to supply its trade.
Petitioner in making its return for the fiscal year ending September 30, 1919, deducted from gross earnings certain debts as uncollectible and charged off on that date. From these the respondent disallowed the total amount of $162,484.91. The petitioner in making its return for the fiscal year ending September 30, 1920, deducted*2490 from gross earnings certain debts as uncollectible and charged off on that date. Of these the Commissioner disallowed the total amount of $40,271.93. These disallowances were on the ground that the debts in question had not been sufficiently determined as uncollectible in the respective years in which charged off, as they represented chattel mortgages by parties still doing business in those years. The total amount of $162,484.91 disallowed by the respondent for 1919 represented debts due from various saloonist customers of petitioner made up of charges on its books for advances made them, some secured by chattel mortgages and others unsecured and of charges for fixtures loaned to customers by petitioner. Of this total amount of $162,484.91 the sum of $110,704.97 represented the debts of customers, who on September 30, 1919, were determined by petitioner to be without assets and financially irresponsible according to all information obtainable. All of these debtors had been customers of petitioner for years and its officers had become possessed of considerable knowledge as to their personal worth and solvency. In the case of all of these debtors, an effort was made to collect*2491 and payment was refused, and an inability to pay pleaded by the debtor and an unsuccessful effort made by petitioner to find assets from which to satisfy a judgment in whole or in part. In the case of such of these debts as were secured by chattel mortgages on bar fixtures, this security was practically worthless owing to the advent of prohibition *949 and would have brought on sale under foreclosure not more than the cost of such foreclosure and sale. The debts making up this amount of $110,704.97 were determined by the taxpayer on September 30, 1919, to be wholly uncollectible. Of the balance of the amount of $162,484.91, the sum of $49,640.45 represented portions of the debts of various saloonist customers determined as of September 30, 1919, by petitioner to be partially uncollectible. A portion of each of the debts contributing to this total was maintained on petitioner's books. The remaining balance of the amount of $162,484.91, or $2,139.49, represented the cost to the taxpayer of certain fixtures loaned customers and charged in that amount in their accounts on its books.
The debts charged off by the petitioner in the amount of $40,271.93 for the fiscal year 1920, *2492 and disallowed by the respondent, were identical in character to those involved herein for the fiscal year 1919 and the determination of the petitioner as to their collectibility was arrived at in the same manner and with the same method of investigation. Of the total amount of $40,271.93, so disallowed, the sum of $33,760.17, represented debts determined by the petitioner in the fiscal year to be wholly uncollectible; the sum of $3,498.28 represents portions of debts determined in that year to be partially uncollectible; the sum of $2,513.32 represents the cost of fixtures loaned customers and the sum of $500.16 represents an alleged indebtedness of one Patrick Chat, in respect of which petitioner is unable to furnish any evidence. Of the total amount of $162,484.91 disallowed by the respondent for the fiscal year 1919, six debts totaling $19,417.65 were allowed by him in the fiscal year 1920 as proper deductions for that year. Three of these debts, amounting to a total of $5,883.55, are debts determined by petitioner in the fiscal year 1919 to be wholly uncollectible. The remaining three debts, amounting to a total of $13,534.10, are portions of debts which were determined by*2493 petitioner in the fiscal year 1919 to be partially uncollectible. Of the total of $49,640.45 of debts determined by petitioner in 1919 to be partially uncollectible, the sum of $44,378.88 represents portions of debts which were in the fiscal year 1920 determined by petitioner to be wholly uncollectible, the balance of these debts being charged off in that year. Most of the customers whose debts were charged off in 1919 and 1920 as uncollectible were doing business with petitioner during those years and up to the time when petitioner finally ceased selling near beer. Of the total amount of the debts charged off during 1919 and 1920 by petitioner and disallowed by the respondent, a sum less than $2,000 was realized from collections during the succeeding six years and this amount was taken up by petitioner as income for the years in which collected.
*950 OPINION.
TRUSSELL: As to the first issue the proof shows that J. Chr. G. Hupfel and for some years prior to 1887 owned and successfully operated, at a profit, a brewery business under his name in New York City, and had built up an established trade with many customers using his product. This condition had consequently*2494 created an intangible asset in the business in the nature of good will which was acquired by petitioner, together with all tangible assets, in that year in exchange for its total capital stock of $500,000. The value of the tangible assets acquired in this purchase was $625,290.86, and the indebtedness assumed was $225,290.86, the net value of tangible assets was $400,000. The average yearly earnings over a period of 11 months prior to the acquisition of the business by petitioner and two years following that acquisition were $44,674.20. The excess of net earnings over 10 per cent on net assets, capitalized at 15 per cent gives $31,161.40, which the Board finds is the value of the good will acquired for stock on that date.
On August 7, 1914, petitioner acquired by purchase the trade and good will, together with tangible assets of the Eppig Brewing Co. The consideration paid was $247,500, of which $86,244.32 was set up on the books of petitioner as representing good will purchased and then charged off as the corporation did not then carry a good will account. This amount of $86,244.32 represents good will acquired for cash.
The Revenue Act of 1918, under which the issue here*2495 presented is to be determined, permits the inclusion in invested capital of intangible assets acquired for stock in an aggregate amount not to exceed 25 per cent of the par value of the total stock of the corporation outstanding at the beginning of the taxable year. The value of the good will acquired by petitioner for stock on organization in 1887, which the Board finds to be the sum of $31,161.40, being less than 25 per cent of the capital stock outstanding at the beginning of the taxable years 1919 and 1920, should be included in invested capital for those years.
The purchase by petitioner of the trade and good will of the Eppig Brewing Co. for the sum of $86,244.32 represents a capital expenditure and it is accordingly included in invested capital for 1919 and 1920. American Seating Co.,4 B.T.A. 649">4 B.T.A. 649; Goodell-Pratt Co.,3 B.T.A. 30">3 B.T.A. 30; Market Supply Co.,3 B.T.A. 841">3 B.T.A. 841; Rockford Brick & Tile Co.,4 B.T.A. 313">4 B.T.A. 313.
In respect to the second issue, the Board has followed the rule laid down by the United States Circuit Court of Appeals in the case of *2496 Red Wing Malting Co. v. Willcuts, 15 Fed.(2d) 626, that obsolescence *951 of good will of a business is not the subject of a claim for deduction under section 234(a)(7) of the Revenue Act of 1918. Manhattan Brewing Co.,6 B.T.A. 952">6 B.T.A. 952; Olt Brothers Brewing Co.,6 B.T.A. 974">6 B.T.A. 974; Secor Hotel Co.,7 B.T.A. 158">7 B.T.A. 158.
On the third issue presented the proof shows beyond question the obsolescence of the brewing plant of petitioner as a result of national prohibition legislation. Petitioner alleges that prior to January 15, 1919, the date of the ratification of the Eighteenth Amendment by the last of the necessary number of States, it had decided to liquidate its business beginning with the date of such ratification, without awaiting the expiration of the 12-month period which would elapse before national prohibition would become effective. Federal regulations prior to 1919 already forbade the manufacture or sale of beer from cereals after July 1, 1919, except for export, and petitioner's business was the manufacture of beer in bulk for sale in New York City and surrounding territory through various saloons. The evidence*2497 supports petitioner's claim of a final determination in January, 1919, to liquidate its brewing business beginning at once. No further contracts were made for supplies, its system of advancing credits to saloonist customers and financing their operations ceased, and it began, on the other hand, to collect and close up such accounts as could be collected. This action is consistent only with a determination to cease operation, as the marketing of its product was dependent on the maintaining of its fixed trade and this could only be done through the continuance of the credit system by which it controlled the business of its customers. The only thing left for petitioner to do in January, 1919, so far as its brewery plant was concerned, was to either liquidate or to continue as a manufacturer of nonalcoholic cereal beverages and this would require the construction of a boottling plant, which petitioner did not have, at cost of approximately $500,000, with profitable operation most doubtful, as a new market, through other mediums than the saloon, would have to be sucured.
Faced with these conditions, petitioner began liquidation on January 15, 1919, of its business by the manufacturing*2498 of supplies on hand or under contract into near beer and disposed of this through such of its customers as remainer in business. It had no dealcoholizing plant and used a crude process of boiling out the alcohol. After ceasing manufacture in 1920 it continued to dispose of its product on hand, and during 1921 and part of 1922, purchased near beer from another brewer for sale to its old customers and in this way received some return on the trade and custom it had built up in past years. While doing this it began, in 1921, the remodeling of its brewing *952 plant for general commercial use. Under the proof as to conditions respecting petitioner's business, the lack of a bottling plant, a trade wholly with the old time saloon and with legislation in effect in January, 1919, which called for national prohibition in 12 months and with the business in process of liquidation, we must conclude that the resulting losses of value of petitioner's plant as a brewery due to these definite and known conditions were completely established. Up to January, 1919, although faced with legislation which would shortly put an end to its business, it continued in operation and made no deduction*2499 for obsolescence in its plant for the year 1918. For the year 1919 it appears to have made a deduction of $117,286.95 for obsolescence of buildings designed and constructed for brewery purposes, this being its determination of the total reduction in value of these assets by obsolescence.
On its brewing equipment and fixtures it made a similar deduction for obsolescence for 1919. The Commissioner allowed in full the obsolescence claimed on equipment for the year 1919 and disallowed the claim for obsolescence of the assets consisting of brewery buildings. We are of the opinion that the evidence proves that the obsolesence of Buildings A, B, C, D, and E began on January 16, 1919, and was completed on January 16, 1920. The fact that these buildings were used for a period subsequent to January 16, 1920, does not alter that fact. Such use has been shown to have been incident to the final liquidation of the business decided and entered upon in January, 1919. In the remodeling and reconstruction of the buildings involved 46.9 per cent of the depreciated cost of Buildings A, B, C, and D and 4.8 per cent of the depreciated cost of Building E represented the portions demolished and no*2500 salvage was secured from this operation. The cost of these buildings unextinguished by depreciation taken in past years was $115,191.54 for Buildings A, B, C, and D and $142,225.81 for Building E. Applying the percentages demolished we have $54,024.83 for Buildings A, B, C, and D, and $6,826.84 for Building E, or a total of $60,851.67, allowable as obsolescence for the years 1919 and 1920. Petitioner made its return for the fiscal year from October 1 to September 30, and the total amount of $60,851.67, determined as obsolescence is allowable in the amount of $43,103.27 for the fiscal year 1919 and $17,748.40 for the fiscal year 1920. Manhattan Brewing Co., supra.
The fourth issue is upon the disallowance by the respondent of certain debts charged off by petitioner and deducted from gross income in 1919 and 1920. Prior to the advent of prohibition the value to a brewer of a saloonist as a customer, was measured by his ability to sell beer rather than his personal solvency, and advances were made him by the brewer with no other security than a chattel *953 mortgage on the bar fixtures purchased with the money advanced, and in many cases without even this*2501 security. There was before prohibition, a market for bar fixtures or the lease of an established saloon. In case of foreclosure of such a chattel mortgage a substantial amount could be realized from the sale of the security. The indebtedness secured by such chattel mortgage was being automatically paid off from week to week by the debtor through credits on the beer purchased by him from the brewer. In time, if the business continued, the entire indebtedness would be thus paid. When petitioner in January, 1919, began the liquidation of its brewing business, it ceased making further loans to its customers and began to attempt to realize on the debts of such customers on its books. Many of these saloonists had no property. Many had been financially irresponsible at the time the accounts were first opened. With such debtors the only source from which to satisfy a judgment was the bar fixtures covered by the mortgage, and in 1919 these could not be sold for lack of purchasers. No one was then going into the saloon business. Many were going out. Some bar fixtures foreclosed on by petitioner could not be sold at any price and were finally used as fuel.
At the close of the fiscal*2502 year ending September 30, 1919, petitioner charged off as bad debts from these saloonists' accounts the sum of $162,484.91, and deducted these from gross income in making its return for that year. Some of these debts represented the total indebtedness of the particular customer where petitioner could not secure payment of any amount and the debtors were known to him to be insolvent. Some of the amounts charged off in this total represented a portion of the indebtedness of customers, part being held on the books because the debt was not considered entirely uncollectible. In making its return for the fiscal year 1920, petitioner charged off similar items of indebtedness in the total amount of $40,271.93. This latter sum represented in some cases the balance of debts, a portion of off represented portions of individual debts determined in 1920 to be off represented portions of individual debts determined in partially uncollectible, and others represented debts determined in that year to be wholly uncollectible. The total amounts charged off in both 1919 and 1920 included some items representing the cost of fixtures loaned to customers by the petitioner.
*2503 The proof shows very clearly that the evidence of insolvency and financial irresponsibility of the individual debtors and the practically worthless character of the chattels covered by the various mortgages, on which the petitioner based his determination of the uncollectibility of these various debts, amply justified such a conclusion and its corrections is further indicated by the fact that in the six years following the charging off of these debts, less than $2,000 out of the *954 total of more than $200,000 has been collected. In Egan & Hausman Co.,1 B.T.A. 556">1 B.T.A. 556, the Board said:
In adjusting their accounts and debts business men are called upon to use sound business judgment and prudence and are justified in eliminating from their assets such accounts and debts as are past due and which they are satisfied that they can not realize upon within some reasonably determinable period.
The fact that during the year in which these debts were charged off and following that year the petitioner continued to do business with these debtors does not negative the correctness of his determination as to the uncollectibility of the debts. *2504 Midland Coal Co.,1 B.T.A. 311">1 B.T.A. 311. In the present case, however, the proof shows that the business relations of petitioner with these creditors subsequent to the charging off of these debts were not of a character indicating to any degree a belief in their solvency. Sales to them were for cash without discount, credit being extended in some cases for one week in a small amount, and there were no advances of money to them as formerly. The Revenue Act of 1918, section 234(a)(5) permits deduction of "debts ascertained to be worthless and charged off within the taxable year." That portion of the total of $162,484.91, charged off in the year 1919, representing debts ascertained in that year to be wholly worthless and charged off in their entirety, is a proper deduction for 1919. This amount is found to be $110,704.97. Applying this same rule to those debts deducted in 1920 and disallowed by the respondent, we find $33,760.17 as properly allowable in that year of the total sum of $40,271.93 then charged off and deducted by the petitioner. This latter amount should be increased by $44,378.88, representing that portion of the total indebtedness charged off in 1919 and not*2505 allowable as a deduction in that year because composed of portions of debts not finally determined to be wholly uncollectible until 1920, but for this reason proper for allowance in the latter year. Joseph E. Reed, Estate,2 B.T.A. 1198">2 B.T.A. 1198; Mason Machine Works,3 B.T.A. 745">3 B.T.A. 745; Patrick J. Shouvlin,3 B.T.A. 499">3 B.T.A. 499. The totals allowable for 1919 and 1920 of the entire amounts of debts charged off by the petitioner for these two years and disallowed by the respondent are thus determined to be $110,704.97 for 1919 and $78,139.05 for 1920. The balance of the entire amount involved for the years 1919 and 1920, or the sum of $13,912.82, is composed of (a) the amounts of $2,139.49 of the sum for 1919, and $2,513.32 of the sum for 1920, or a total of $4,652.81, representing the value of certain fixtures loaned to various customers by petitioner; (b) the sum of $500.13 in respect of which petitioner admits inability to furnish any information; and (c) the sum of $8,759.88, which represents parts of various debts charged off where there is no evidence to show whether the balance was later *955 charged off or is still maintained on petitioner's*2506 books. With respect to the first of these three items it is evident that these charges do not represent debts and accordingly can not be included. Item (b) can not be included as petitioner does not know what it represents, and item (c) is not allowable as it can not be determined when the debts, a portion of which it represents, were finally determined to be uncollectible or whether they were ever so determined.
The deficiencies should be redetermined in accordance with the foregoing findings of fact and opinion.
Reviewed by the Board.
Judgment will be entered upon 15 days' notice, pursuant to Rule 50.