*2191 The petitioners charged the cost of certain road-construction equipment against the income derived from the jobs for which the equipment was first purchased. Held, that as to the equipment continued in use on subsequent jobs, the cost thereof should be capitalized and depreciated over its useful life.
*1423 These proceedings, consolidated for hearing and decision, are for the redetermination of deficiencies in income taxes of $31,504.81 and $1,845.62 for the years 1922 and 1924, respectively.
*1424 The errors complained of in the pleading of the two proceedings are:
1. Disallowance of a $93,486.27 deduction, representing the cost of equipment charged to "Moville job";
2. Refusal to allow a $32,480.35 deduction, representing a portion of the loss sustained in connection with a partnership agreement with one B. A. Inglis;
3. Disallowance of a $9,435.05 deduction, representing interest on borrowed money;
4. Rejection of petitioner's (C. F. Lytle Construction Co. *2192 ) method and practice of equipment accounting, and in restoring to its capital assets equipment charged off and then depreciating it upon the socalled straight-line method; and
5. Restoring to its capital assets charged off, equipment aggregating $56,100.01, depreciated down to $14,764.95 as allocated to the year 1924.
Issue numbered three was expressly abandoned by the petitioner at the hearing.
FINDINGS OF FACT.
For many years prior to 1922 C. F. Lytle (hereafter referred to as Lytle) was in the contracting business, being engaged during the taxable periods in question almost exclusively in the construction of public roads. The C. F. Lytle Construction Co. (hereafter referred to as the company), was organized under the laws of the State of Iowa in 1915 or 1916, but was inactive until 1923, when it took over the individual business of Lytle.
Prior to about 1921 concrete paving in Iowa had been confined to small contracts calling for the paving of one or two miles, but beginning in that year major paving contracts were entered into calling for the construction of several miles of concrete road per contract. During December, 1920, Lytle secured one of these major contracts*2193 (hereafter referred to as the "Moville job"), with Woodbury County, Iowa, which provided for the grading and paving of approximately seventeen miles of country road in said county. In January, February, and March, 1921, Lytle purchased the following new equipment together with steel forms, etc., for use in completing that contract, all of which was charged to the cost of said job when purchased.
| Cost | |
| 20 Kissel, 2 1/2-ton, trucks | $62,000.00 |
| 1 locomotive crane | 13,416.27 |
| 2 #21 concrete mixers | 13,320.00 |
| Road finishers | 4,750.00 |
| Total | 93,486.27 |
*1425 The trucks used on the Moville job had to be operated over a freshly graded dirt roadbed of light clay that wound through a hilly section with numerous heavy grades. Materials were hauled from Lawton on the C. & N.W.R.R. about eight or nine miles from one end and about six or seven miles from the other end of the job. The trucks were loaded with three batches of material for the concrete mixers, weighing about 10,000 pounds, whereas their rated capacity was 2 1/2 tons. To further speed up operations the speed regulators, which prevented operating the trucks in excess of 16 miles per hour, were opened*2194 up to secure greater speed; consequently, they were driven much faster than they should have been under such conditions. The truck drivers, generally speaking, were not skilled operators, and there were numerous accidents such as collisions, turning over, and ditching of trucks, besides trouble from improper lubrication. At the close of the 1921 working season the trucks were in bad shape despite the fact that a repair crew had been constantly on the job making minor repairs and replacing broken parts. However, no major repairs thereto were attempted during the winter season, the work being continued in the 1922 working season and completed in July or August of 1922 with the same equipment.
Upon completion of the Moville job the equipment had to be completely overhauled before it could be used again. Some six or eight of the trucks were so battered and worn that they were unable to operate under their own power. All of the trucks were rebuilt or reconditioned, entirely new motors being purchased for some. Transmission plates and other worn out parts had to be replaced and quite extensive repairs otherwise made before the trucks could be used again. The condition of the other*2195 equipment upon completion of the Moville job was much the same as that of the trucks. The road finishers had practically shaken themselves to pieces and had to be rebuilt. The locomotive crane was shipped to the factory and completely overhauled. The two concrete mixers were used on two or three small jobs for a few weeks, but never again on a highway job. One of the mixers was sold in 1924 or 1925 for $900, and the other was given to a junk dealer.
At or about the time the Moville job was completed Lytle, individually, secured two additional contracts with Woodbury County; one, for paving about seven miles of the Lakeport road, running south out of Sioux City, and the other, for paving six or seven miles of the Denison highway running southeast from Sioux City. Work was commenced on these contracts by Lytle in the summer of 1922 with reconditioned equipment from the Moville job, consisting of the 20 Kissel trucks, the road finishers, and forms used on the Moville job but not included in the items of new equipment listed above. In *1426 1923 Lytle, then being the owner of 95 per cent of the company's stock, transferred these jobs in their partially completed state to*2196 the company for completion, together with all the equipment, which had theretofore been charged off on his books to the cost of the job, under an arrangement whereby he should receive 90 per cent and the company 10 per cent of the ultimate profits derived therefrom. These two contracts were completed by the company in 1923 principally with left over equipment from the Moville job, although some new equipment was purchased. Upon completion of the Denison and Lakeport contracts the trucks were completely overhauled.
On January 26, 1922, Lytle and one Inglis entered into a contract of partnership for the purpose of entering into and performing a contract with the State of Florida to grade and pave 42.78 miles of country road in that State, and they purchased and charged to the cost of said contract the following equipment:
| Narrow gauge railroad track, ties and cars | $30,433.25 |
| 5 locomotives | 15,502.50 |
| Locomotive crane | 12,346.00 |
| Road finishers | 4,780.00 |
| 1-ton Kissel truck | 1,402.52 |
| 2 rollers and frt | 7,871.83 |
| 2 mixers | 13,500.00 |
| Total | 85,836.10 |
In addition to the new equipment the locomotive crane used on the Moville job, after being overhauled at the factory, *2197 was shipped to Florida in 1922 and used on that job as auxiliary equipment.
Work was commenced on the partnership contract in April, 1922, and carried on continuously until completion in July or August, 1923. The partnership accounts were kept on the accrual basis and at the end of the calendar year 1922 an accounting according to the revenue agent's report of examination, showed a loss from operations of $88,755.78, and a second accounting for the three-month period ended March 31, 1923, indicated a further loss of $37,730.16. The partnership was dissolved as of March 31, 1923, and Lytle, individually, completed the contract. The total loss on the contract according to petitioner's records was $116,004.29.
Upon completion of the partnership contract the industrial railroad equipment had to be completely overhauled and extensive repairs made before it could be used again. The rails and ties were straightened, new parts installed and major repairs made, particularly on the locomotives. The two original mixers purchased for use on this contract were worn out and discarded before completion, but the third one, which does not appear as a charge against this job, was used at*2198 intervals on other jobs in Florida.
*1427 Prior to completing the partnership contract Lytle successfully bid on two other paying projects in Florida, covering 12.34 miles, known as 27A and 27B. As in the case of the Lakeport and Denison contracts Lytle assigned the contracts and transferred the partially completed jobs to the company for completion, under an arrangement whereby he would receive 90 per cent and the company 10 per cent of the profit.
The nature of the soil and layout of the road on contracts 27A and B was such that both automotive and industrial railroad equipment had to be employed. A portion of the equipment which had been used on the aforementioned partnership contract was reconditioned and used on these contracts, together with the following new equipment which was purchased by the company:
| 6 Kissel trucks | $19,621.50 |
| 1 Kissel truck | 1,452.83 |
| Total | 21,074.33 |
Work on these contracts was started late in 1923 and completed in 1924. Those trucks were charged to the cost of those contracts by Lytle, and were not capitalized after they were transferred to the company with said contracts.
In respect to the above-mentioned Lakeport*2199 and Denison jobs in Iowa and 27A and 27B in Florida, the contracts were turned over to the company just as they stood on Lytle's books, the equipment purchased for each contract being shown as an expense of the particular job for which it was purchased. Whatever value existed in the equipment at the time the contracts were turned over went to the construction company, but no entry was ever made on its books showing that equipment was acquired as an asset.
In 1924 the company secured a second contract with Woodbury County, Iowa, for paving approximately 20 miles of road on the Lakeport road and the Denison Highway in said county. In addition to used equipment on hand the company purchased new equipment for this contract as follows:
| 1, 40-ton locomotive crane | $13,432.00 |
| 1, 2 1/2-ton Kissel truck, rebuilt | 2,678.00 |
| 1, 1-ton Kissel truck | 1,454.93 |
| 3, 2 1/2-ton Kissel trucks | 9,810.75 |
| Total | 27,375.68 |
The cost of the new equipment was charged as expense of the second Lakeport-Denison contract, and was still in use upon completion of the job in 1924. The Kissel trucks used on this contract, which included some of the trucks used on the Moville job, were shipped*2200 to Florida, where they were used only on paved roads. The *1428 trucks were not used continuously in Florida, their period of service being a part of 1924, a part of 1925, and into the spring months of 1926, when the last job was completed.
During 1924 the company purchased a Holt tractor for $5,100, and a Shawnee tractor and grader for $2,550, to be used on a 17-mile-paving contract in Woodbury County, known as the "Correctionville job." The hauling on this job was let out on contract so that none of the company's trucks were used, but a crane and the mixers used on the second Lakeport-Denison contract were used. Upon completion of the Correctionville road in December, 1924, said crane was shipped to Sioux City, where it was completely overhauled and was never used thereafter by the petitioner for paving work, but was sold in 1926 or 1927. The Shawnee tractor was abandoned after completion of the Correctionville contract, but the Holt tractor was sold early in 1925 for between $4,000 and $5,000, without further use thereof by the company. The sale price of said tractor was reported as income in the year of sale.
In 1924 the company was also engaged in two paving jobs*2201 in Florida, known as 36-B, near Fort Pierce, and the Beach Road in Duval County in which Lytle, individually, had a 90 per cent interest. Contract 36-B was completed in 1924 and the Beach Road contract in 1925. A portion of the equipment used on contracts 27A and 27B was used on the said Beach Road and 36-B contracts, together with a good deal of new equipment purchased for those jobs, such as mixers and some smaller items.
While work may be carried on continuously in Florida, without interruption because of seasons, the road construction season in Iowa usually extends from about May 1 to October 15, during which time the contractor operates at full capacity, working hours commonly being from about daylight to dark, Sundays included, where there is no statute to prohibit.
The type of construction work in which the petitioners were engaged during 1921 to 1924, inclusive, was very hard on their equipment. In addition to the rough treatment and hard usage given the equipment, the contractor was faced with the possibility of such equipment becoming obsolete. In 1921 the equipment manufacturers and the contractors were without detailed knowledge or experience as to the useful*2202 life or efficiency of the various classes of road-building equipment. The manufacturers were constantly introducing new improvements and betterments, some of which radically changed the then existing equipment, with the result that sometimes an efficient piece of equipment became obsolete within six months or a year.
*1429 The petitioners' books of account were kept on the cash receipts and disbursements basis, and when new equipment was purchased for a construction job its cost was charged to that job as an expense. Where used equipment was overhauled and reconditioned for use on another job, such cost was charged as an expense of the second job. When equipment was taken from one job to another, the cost of which had already been charged to the job for which purchased, no further charge was made to any succeeding job, nor was any depreciation charged in such succeeding job for that equipment. When equipment was sold after having been used on a construction job, the sale price was reported as income for the year in which received. The petitioners never kept an equipment account on their books, nor did they show equipment as an asset in making financial statements to*2203 banks or credit associations, or in bidding on construction jobs.
In reporting income for 1922 Lytle reduced his gross profits from the Moville job by $93,486.27, representing equipment charged to the job as an expense. The respondent disallowed the deduction, capitalized the equipment, and allowed Lytle a deduction of $63,907.52, representing depreciation at 33 1/3 per cent per year for the two years 1921 and 1922 on the several items of equipment, except road finishers which were depreciated at 50 per cent per annum. On the Florida job, carried on by the partnership, Lytle deducted his one-half of the $88,755.78 loss sustained according to the partnership records for operations during 1922. The respondent capitalized the equipment charged to this job and allowed depreciation at the rate of 33 1/3 per cent per annum on such equipment, eliminated an item of interest amounting to $9,435.05, determined the loss from the partnership operations to be $64,960.69, and allowed petitioner to deduct $32,480.35 as his one-half of said loss. Certain other adjustments not here in dispute were made by respondent, with the result that petitioner's net income as reported on his 1922 return*2204 was increased from $127,784.62 to $183,445.96, and a deficiency of $31,504.81 determined against him.
The company in reporting income for 1924 charged the cost of new equipment against each contract as an expense item. The respondent capitalized items of equipment used on the second Lakeport and Denison contract and the Correctionville contract in the amount of $35,025.68, and that used on contracts 27 A and B in Florida in the amount of $21,074.33, and allowed the petitioner depreciation as to most items of equipment at the rate of 33 1/3 per cent per annum. This adjustment resulted in the major portion of the deficiency determined for 1924.
The petitioners reported income for both taxable years on the completed-contract basis, except the Florida partnership contract. *1430 No adjustment as to the manner of reporting income was made by respondent.
OPINION.
MORRIS: The sole question presented by the several issues raised in these proceedings, aside from the third, which has been abandoned, is the proper treatment to be accorded certain expenditures for new equipment made during the taxable years in controversy. The petitioners contend that the expenditures in*2205 question constitute a part of the costs of completing the contract jobs on which the equipment was first employed and should be deducted from income in arriving at the gains and losses derived from such jobs. The respondent had held that such expenditures are of a capital nature, made in the acquisition of assets having a useful life extending beyond the completion of the jobs on which first employed, and in excess of one year, which should be added to capital accounts and written off against income, by way of deductions for depreciation, over the period of useful life.
Unquestionably, the accounting for these expenditures contended for by the petitioners would be quite proper and available for the purposes of the tax if the equipment for which the expenditures were made had been acquired solely for the completion of the jobs against which it has been charged and was not suitable, or could not be used, for any other purpose of petitioners' businesses and had to be discarded and abandoned when those jobs were completed. But the facts readily disclose that that is not the case. Except for the concrete mixers first used on the Moville job, the two mixers first used on the Florida*2206 job undertaken by the partnership, and the Shawnee tractor used first on the Correctionville job, all of the equipment was continued in use after the jobs on which it was first used had been completed, and in a very substantial way on later jobs. Under the circumstances, to permit the costs of this equipment to be charged against the income derived from the jobs on which the equipment was first used would result in an accounting not truly representative of the facts and, thus, net income would not be clearly reflected.
As to the concrete mixers used on the Moville job and on the Florida job completed by the partnership, and the Shawnee tractor used on the Correctionville job, these items of equipment were entirely used up on those jobs and were of no practical use thereafter. The costs of these items of equipment, less the salvage recovered, constitute proper charges against the jobs on which the equipment was used, in computing the gains and/or losses derived or sustained on those jobs.
The petitioners alternatively contend that, if the cost of equipment should be held to be capital expenditures and not deductible *1431 expenses, they are entitled to depreciate the*2207 said cost over the useful life thereof at the rate of 50 per cent per annum. This question is not properly before us, as an examination of the pleadings fails to disclose anywhere therein that the rate of depreciation was placed in controversy. But, if the question were properly presented, we are of the opinion that the petitioners have not overcome the prima facie correctness of the rate of 33 1/3 per cent, or the 3-year life, determined by the respondent. While the record is not as clear as it might be respecting individual pieces of machinery and equipment, that is, as to the time of acquirement and final abandonment due to wear and tear in use, the record does show very clearly that the majority of equipment was in use, although possibly after having been overhauled and repaired on several occasions, for a somewhat longer period than two years.
Decision will be entered under Rule 50.