*331 This is a proceeding for a redetermination of deficiencies in income and profits taxes for the years 1917, 1918 and 1919, in the amounts of $100,361.10, $41,249.68 and $32,092.07, respectively, making a total amount of $173,702.85.
There were a number of assignments of error in the petition, all of which have been waived or stipulated, except one, which is that the respondent erred in refusing to grant special assessment for the years in question. Upon motion, the hearing in the first instance was limited to the issues defined in subdivisions (a) and (b) of Rule 62 of the Board's rules of practice. The parties have entered into a stipulation and from this and the evidence adduced at the hearing we make the following findings of fact.
FINDINGS OF FACT.
The petitioner is a corporation, organized in 1899 under the laws of the State of Georgia, with office and principal place of business at Canton, Georgia. R. T. Jones was the principal organizer of the petitioner. The petitioner in the early years of its existence*1322 manufactured sheetings and other cotton products; after 1904 it specialized in the making of denims, a material used for overalls and other work garments.
The petitioner's plant was originally built in 1900 and had 300 looms and 10,000 spindles. In 1909 its capacity was increased to 600 looms and 20,000 spindles. During the period from 1910 to 1916, 17 additional looms were added.
The manufacture of denim is more difficult than that of other cotton goods. So-called white-back denim, the kind manufactured by the petitioner, is composed of a colored warp yarn and a white filling yarn. The dyeing of the colored yarn requires a high degree of skill. In weaving a piece of denim, two-thirds of the warp yarns *332 are turned to the face and only one-third to the back. This leaves the face of the goods well covered with color. Broken threads or waste in the cotton will show in the finished product, so that it will have to be sold as "seconds." The petitioner used a very fine grade of cotton in its denim. This cotton was raised in the northern part of Georgia, in a section close to the petitioner's plant, and was heavier bodied and cleaner than that raised in southern Georgia, *1323 Alabama, and the Carolinas. It was a better grade of cotton and cost the petitioner from 2 to 3 1/2 cents a pound more than the cotton which is ordinarily used in making denim. The petitioner specialized in a 2.20 denim, which means that 2.20 yards weigh a pound.
The petitioner did not do any advertising in newspapers or trade journals, but represented to its customers that it used a better grade of cotton than other denim manufacturers and its denim was stronger and wore better than that made of a cheaper grade. In the early years of petitioner's business New England denim was superior to any made in the South. However, as a result of using a better grade of cotton and of superior manufacturing the petitioner produced an excellent product. Due to these facts the petitioner acquired a reputation among manufacturers of overalls for making an excellent quality of denim and was able, from about 1912 on, to compete with companies making denims in New England. In about 1907 or 1908 the Amoskeag Gold Medal Denim was considered the best on the market. This was made in New England. The company that made this denim later discontinued its manufacture and the petitioner's product is*1324 now considered one of the best made. The petitioner's denim is known as "Canton Denim."
The petitioner did not usually sell its product at any higher price than other denims. As a result of its using better cotton and making a better product its gross sales have increased from year to year. The following table shows the number of bales of cotton used by petitioner in each of the years 1905 to 1919 and the number of pounds used in the years 1910 to 1919:
| Year | Bales | Pounds |
| 1905 | 4,037 | |
| 1906 | 4,378 | |
| 1907 | 5,273 | |
| 1908 | 4,393 | |
| 1909 | 5,438 | |
| 1910 | 7,830 | 3,428,173 |
| 1911 | 8,802 | 3,865,467 |
| 1912 | 8,732 | 3,865,191 |
| 1913 | 9,905 | 4,350,375 |
| 1914 | 10,633 | 4,761,721 |
| 1915 | 11,466 | 5,286,883 |
| 1916 | 12,316 | 5,441,696 |
| 1917 | 12,551 | 5,606,108 |
| 1918 | 11,302 | 5,117,970 |
| 1919 | 12,185 | 5,434,543 |
The average weight of a bale of cotton in the Northern Georgia section is approximately 450 pounds.
During the years 1917, 1918 and 1919, hereinafter referred to as the taxable years, the petitioner had 3,000 shares of stock outstanding. *333 R. T. Jones, its organizer and president, owned 1,000 shares, the Jones Mercantile Company, 568 shares, and relatives of Jones, 600*1325 shares, making a total of 2,168. The remaining, except for 60 shares, were owned by residents or former residents of Canton, most of them close friends and associates of R. T. Jones.
The Jones Mercantile Company is a corporation, organized about 1879, engaged in the general merchandising business. During the taxable years it had 3,000 shares of stock outstanding, 2,860 of which were owned by R. T. Jones and members of his family. Only one of these stockholders owned no stock in the petitioner. P. W. Jones, a son of R. T. Jones, was manager of the Jones Mercantile Company.
At no time during the period from January 1, 1917, to December, 31, 1919, was the petitioner affiliated with the Jones Mercantile Company within the meaning of the revenue acts. Separate returns were filed by these companies for the years involved, and no contention was ever made by the respondent that consolidated returns should be filed.
During the taxable years the Jones Mercantile Company purchased for the petitioner, free of charge, the number of bales of cotton shown in the following table:
| Bales | |
| 1917 | 9,527 |
| 1918 | 12,652 |
| 1919 | 23,314 |
A cotton broker's charge for this service*1326 would have been from $3 to $4 per bale, which, at an average of $3.50 a bale, would have amounted to $33,344.50 for 1917, $43,182 for 1918, and $81,599 for 1919.
During the years involved herein, the only two salaried officers of the petitioner were R. T. Jones, president and treasurer, and his son, Louis L. Jones, secretary and superintendent. The total salaries paid to each of these individuals during these years were as follows:
| Year | R. T. Jones | Louis L. Jones |
| 1917 | $6,000.00 | $4,000.00 |
| 1918 | 12,000.00 | 4,600.00 |
| 1919 | 12,000.00 | 5,000.00 |
On January 8, 1919, a resolution was passed on the motion of one of the stockholders increasing the salary of R. T. Jones to $24,000 for the year 1919. On April 4, 1919, at the insistence of R. T. Jones, the board of directors adopted a resolution reducing his salary to $12,000 a year.
Louis L. Jones came into the plant in 1909 as an ordinary workman. He was a college graduate and had specialized in chemistry. *334 He worked in all the departments until 1912, when he became bookkeeper and in 1916 when the superintendent left he took over his duties in addition to those of bookkeeper. As superintendent*1327 he had general oversight of the mill, of the machinery and of the dye plant. His duties kept him at the mill all day and sometimes at night. The duties of the superintendent of a denim mill are more onerous and require more skill than those of the superintendent of an ordinary textile mill.
R. T. Jones, the president and organizer of the petitioner, devoted all his working time to his duties at the mill. He was a well known man in the community and regarded as a very capable one. He regarded the mill as a family affair and did not want to receive a large salary.
The salaries paid during the taxable years to R. T. and L. L. Jones were inadequate compensation for the services rendered. A salary of $40,000 per year for R. T. Jones and $15,000 for L. L. Jones would not have been unreasonable compensation for the services rendered.
The following table shows the net income and invested capital of the petitioner for the years 1904 to 1919, inclusive:
| Year | Net income | Invested capital |
| 1904 | $43,803.32 | $141,525.45 |
| 1905 | 58,098.19 | 191,560.94 |
| 1906 | 62,529.52 | 212,320.58 |
| 1907 | 84,611.06 | 279,776.73 |
| 1908 (Loss) | -2,037.62 | 239,945.40 |
| 1909 | 43,530.63 | 243,945.40 |
| 1910 | 63,896.39 | 273,476.03 |
| 1911 (Loss) | -13,083.74 | 1 438,372.42 |
| 1912 | $65,140.88 | $424,607.74 |
| 1913 | 111,997.99 | 465,747.82 |
| 1914 | 141,450.95 | 577,144.41 |
| 1915 | 258,142.18 | 781,286.59 |
| 1916 | 504,749.84 | 786,552.27 |
| 1917 | 576,628.34 | 1,241,947.46 |
| 1918 | 632,504.12 | 1,471,315.93 |
| 1919 | 958,340.42 | 1,701,806.92 |
The amounts of invested capital for the taxable years, as shown in the above table, were the amounts allowed by the respondent in the notice of deficiency. Such amounts represent "capital stock and surplus" for the respective years and do not include any amounts for good will or trade brands. The books of the petitioner did not show any amounts as representing good will or trade brands.
Of the net profit for 1917 of $576,628.34, $292,978.96 represents profit on cotton contracts. In 1918 the petitioner had a loss from cotton contracts of $40,294.79, which was deducted from its gross profit in arriving at the net profit of $632,504.13. Of the net profit of $958,340.42 for 1919, $50,274.96 represents profit on cotton contracts and $123,827.36 profit on sale of spot cotton.
In computing the petitioner's net income and its allowance for depreciation for the years involved, the respondent determined a fair market value of the depreciable assets as of March 1, 1913, *335 of $561,921, which value was arrived at on the basis of an appraisal as follows:
| Gross reproduction cost March 1, 1913 | $639,992.11 |
| Less: Depreciation accrued, approximately 12.2% | 78,071.11 |
| Net reproduction cost and March 1, 1913, value | 561,921.00 |
*1329 In determining petitioner's invested capital, the respondent used the cost of assets acquired prior to March 1, 1913, as shown by the books, or $532,445.25, and set up a depreciation reserve as of March 1, 1913, based on a composite rate of 12.2 per cent, in the total amount of $64,915.26, or a net cost value of $467,486.99 as to said assets so acquired prior to March 1, 1913.
All of the above assets so acquired prior to March 1, 1913, were still in use in the petitioner's business in the years involved herein, except that assets were discarded as follows: 1914, $1,089.47; 1916, $2,350.
Due to a price war between textile machinery manufacturers, the March 1, 1913, price of taxtile machinery and equipment was from 25 to 30 per cent lower than the prices in 1902-1904.
The land on which the petitioner's manufacturing and other business was conducted stood on the petitioner's books as of December 31, 1916, at a total cost of $6,717.92; during 1917 an addition was made to said account in the amount of $1,555 and in 1918 another addition was made in the amount of $2,600 on account of purchases.
Prior to 1917 it was the practice of the petitioner to charge the cost of small*1330 items of machinery, installation of machinery, and excavation to the general pay roll or other expense accounts. It would be impossible, from the books, to determine the exact amounts so charged.
In determining the amount by which invested capital was to be reduced for the year 1917 on account of the payment of dividends, the respondent computed a tentative tax in the sum of $203,489.98 and reduced the earnings available for the payment of dividends by a proportionate part of said amount. The respondent admits that he erred in this respect and the parties have agreed that this adjustment on account of the accrual of a tentative tax will be taken care of in the computation to be made under Rule 50.
The petitioner did not, during the years 1917, 1918 and 1919, have any Government contracts on the cost-plus basis.
The total tax assessable as determined by the respondent was $219,160.41 for 1917, $404,565.51 for 1918, and $353,978.15 for 1919.
OPINION.
MATTHEWS: The only question to be decided is whether the petitioner is entitled to have its tax liability determined under the provisions *336 of section 210 of the Revenue Act of 1917 and sections 327 and 328 of*1331 the Revenue Act of 1918, the pertinent provisions of which are set forth by the footnote. 1
*1332 The petitioner is claiming special assessment upon the grounds (1) that invested capital can not be determined; (2) that capital is abnormal, due to the very valuable trade brand "Canton Denim" and the good will attached to the same, no part of which has been or can be included in invested capital; and (3) that income is abnormal, due to the payment of inadequate salaries and the fact that the Jones Mercantile Company rendered services free of charge.
The record in this case presents a very interesting situation. The petitioner is a denim-manufacturing corporation with its principal place of business and plant in Georgia. The officers of petitioner were men who stood high in the community and who had a reputation for honesty and veracity. As a result of using only the best grade of cotton and of superior workmanship they built up a business with a reputation like their own. The denim which was produced in the petitioner's plant was of an excellent qualify. Instead of expending money in advertising the officers expended it in purchasing the best quality of cotton. They used this fact as selling talk and because the product was of the quality that they represented it to be*1333 they were able to sell it and to increase their sales from year to year. The denim produced by the petitioner is now considered as good as any in the country. Several witnesses testified that manufacturers of overalls wanted "Canton Denim" and that they had very few complaints on overalls made of this material.
*337 The petitioner did not set up on its books any amount representing trade brand or good will and is not seeking to have any amount included in ivvested capital for these intangibles. Counsel for petitioner argue that the petitioner expended amounts to build up its trade brand and good will which can not be determined, and also that other items of a capital nature had been charged to expense and can not now be determined.
With regard to items of a capital nature being charged to expense, a former revenue agent who had examined the petitioner's books and made a report thereon to the respondent, and Louis L. Jones, secretary of the petitioner, testified in a general way that the costs of certain small items of machinery, of installing machinery, and of excavation work had been charged to expense, and that it was impossible to determine the amounts of such charges. *1334 However, the evidence does not show that the charges were substantial in amount or that the costs for labor were erroneously charged to expense. See ; and . Counsel for the petitioner in their brief contend that there were other items of a capital nature which did not appear in the invested capital, basing their contention upon the fact that the respondent in determining the basis for depreciation found that the gross reproduction costs as of March 1, 1913, were $639,992.11 and the gross actual cost, less depreciation at that date which was used for invested capital purposes, was $532,445.25. An engineer testified that machinery costs were 25 per cent to 30 per cent lower on March 1, 1913, whan at the time the petitioner equipped its mill, and in 1909, when it doubled its capacity. From this counsel argue that the machinery should have stood on the books at approximately 33 1/3 per cent more than its March 1, 1913, reproduction costs and then states:
* * * So it is plain that invested capital actually going into physical assets can not be satisfactorily*1335 determined within the meaning of section 210 of the Revenue Act of 1917 and section 327(a) of the Revenue Act of 1918. While it is impossible to determine the exact amount by which invested capital was thus understated, it is clear that it must have been understated to the extent of at least 33 1/3 to 50 per cent of the cost of the mechinery.
This is all the evidence we have on this point. We do not know exactly what the books show or exactly how the respondent arrived at the figures used by him. The evidence is insufficient to show that the machinery account does not represent the full amount of capital invested in it, or that invested capital can not be determined.
As to the good will and trade brand counsel for petitioner argue that since the petitioner did not expend any money for advertising but expended large sums in buying a superior grade of cotton, and *338 that since we have allowed special assessment in cases such as that of , we should allow special assessment in this case. They seek to draw an analogy between the situation herein presented and the one where a taxpayer has expended large amounts for advertising, *1336 a part of which contributed to the building up of a capital asset and the amount attributable to capital can not be determined. They contend that the excess, or at least a part thereof, of the cost of petitioner's cotton over that of cotton used by other manufacturers, contributed to building up the petitioner's trade brand and good will and that, since the exact amount so attributable can not be determined, special assessment should be allowed. We can see no merit in this contention. In the Northwestern Yeast Co. case, and similar cases, a portion of the amounts expended for advertising in early years was held to be investments in a capital asset. Here the petitioner expended no amounts for advertising, and all of the amounts paid for the highgrade cotton used in the manufacture of the denim sold were a part of the cost of the goods sold. We know of no theory of accounting which would permit the capitalization of any portion of the cost of materials going into goods sold. Since the amounts which the petitioner claims can not be determined were not of a capital nature, it is clear that this is not a situation where section 327(a) is applicable.
The petitioner's next contention*1337 is closely connected with the one just discussed. It contends that invested capital is abnormal in that the profits are largely due to the very valuable trade brand "Canton Denim" and the good will attached to the same, no part of which can be included in invested capital, using the same argument that a part of the cost of the cotton was the cost of building up its good will. Several witnesses computed the value of the good will at substantially $1,000,000 by using a formula which has been approved by the respondent and by this Board. We are convinced that the petitioner had built up a valuable good will and trade brand, which had been accomplished by using a superior grade of cotton and skillful workmanship. The reward for this was in the increase of gross sales, which showed that it paid to produce an excellent product, all the cost of which was reflected in the material and workmanship. However, neither this nor the fact that the petitioner had a large income in relation to invested capital results in an abnormal condition such as is contemplated by the statute. Good will in most cases results from the acquisition of a reputation for a good product acquired over a period of*1338 years and does not long retain its value if the quality of the product to which it attaches is not maintained. We have held repeatedly that the building up of a good will, the value of which can not be included in invested *339 capital, does not amount to an abnormality and we can not agree with counsel that the fact that the good will may have been of great value can make any difference. ; and . In the cases where we have allowed special assessment where good will or intangibles were not included in invested capital it has been where they have been acquired for stock and the value could not be determined, or where on account of statutory restrictions they could not be included in invested capital.
The situation is not the same as the one in the case of , wherein we said:
* * * It was these intangible assets which were the principal cause of the large income which petitioner enjoyed during the taxable years and on which the deficiencies in question are based. *1339 Because of its manner of organization these assets may not be included in the computation of its invested capital. We have held that a taxpayer does not fall within the provisions of sections 327 and 328 merely because assets are used in the business which may not be included in invested capital. . The exclusion must be such as to create an abnormal condition. Where, as here, the asset excluded is the most substantial part of its capital and is the principal contributing factor in the production of taxable income of the petitioner, it is our opinion that such an abnormality exists. ; ; ; ; ; .
The principle in the above case is not applicable in case where the taxpayer has by ordinary good business methods built up a valuable intangible, which is not in any case a part of its statutory invested*1340 capital. See ; and . We are therefore of the opinion that the petitioner's invested capital is not abnormal due to the fact that the petitioner over a period of nearly twenty years had built up a valuable good will and trade brand.
The petitioner next contends that net income is abnormal in that it received valuable services at one-third of their value and that it received the benefit of the services of the Jones Mercantile Company free. The evidence shows that the salaries paid to its two officers, R. T. Jones and Louis L. Jones, were inadequate, but we are of the opinion that this did not result in an abnormality. See . Neither does the rendering of the services by the Jones Mercantile Company constitute an abnormality. D. D. Summey, engaged in the cotton mercantile business, testified that these services were worth from $3 to $4 per bale. There is no testimony that it is the usual practice of a cotton manufacturing company to obtain its cotton through a broker. We would not consider *340 *1341 it unusual for a cotton mill to purchase its own cotton direct from the growers where, like the petitioner in this case, it is situated in a cotton growing district. A somewhat similar situation was presented in the case of the . In that case we said:
While the services rendered to petitioner without charge or at nominal charges, set forth as contentions (1), (3), (5) and (7), may have affected petitioner's income, we are of the opinion that no such abnormality has been established as contemplated by the statute. There can be no doubt that because of such advantageous arrangements and fortunate conditions petitioner's income was greatly increased, but we do not understand that Congress intended to favor corporations merely because they were able to earn a large income, even though it resulted partly from their favorable connections with another corporation. * * *
The petitioner contends that, even if none of the factors above discussed constitutes an abnormality standing alone, the combination is such as to entitle it to relief. However, we have held, in *1342 , that the aggregate of a number of conditions, each inadequate in itself to establish an abnormality, does not necessarily constitute a basis for special assessment. To the same effect in .
We are, therefore, of the opinion that upon a consideration of all the evidence the petitioner has failed to establish that it is entitled to special assessment and the determination of the respondent in this respect is therefore sustained.
Reviewed by the Board.
Judgment will be entered under Rule 50.
GOODRICH, dissenting: In my opinion, petitioner has proved abnormalities in its income sufficient to entitle it to special assessment.
TRAMMELL and BLACK agree with this dissent.
Footnotes
1. Additional capital paid in January 30, 1910, in the amount of $100,000.00. ↩
1. [Act 1917.] SEC. 210. That if the Secretary of the Treasury is unable in any case satisfactorily to determine the invested capital, the amount of the deduction shall be the sum of (1) an amount equal to the same proportion of the net income of the trade or business received during the taxable year as the proportion which the average deduction (determined in the same manner as provided in section two hundred and three, without including the $3,000 or $6,000 therein referred to) for the same calendar year of representative corporations, partnerships, and individuals, engaged in a like or similar trade or business, bears to the total net income of the trade or business received by such corporations, partnerships, and individuals, plus (2) in the case of a domestic corporation $3,000, and in the case of a domestic partnership or a citizen or resident of the United States $6,000.
* * *
[Act 1918.] SEC. 327. That in the following cases the tax shall be determined as provided in section 328:
(a) Where the Commissioner is unable to determine the invested capital as provided in section 326;
* * *
(d) Where upon application by the corporation the Commissioner finds and so declares of record that the tax if determined without benefit of this section would, owing to abnormal conditions affecting the capital or income of the corporation, work upon the corporation an exceptional hardship evidenced by gross disproportion between the tax computed without benefit of this section and the tax computed by reference to the representative corporations specified in section 328. This subdivision shall not apply to any case (1) in which the tax (computed without benefit of this section) is high merely because the corporation earned within the taxable year a high rate of profit upon a normal invested capital, * * * ↩