1932 BTA LEXIS 1571">*1571 1. The basis to a corporation for exhaustion of a contract held to have been the same as that to the one who transferred the contract to the corporation for more than 80 per cent of the outstanding stock of the corporation.
2. A contract for the exclusive use in New Orleans of a paving mixture, on which application for a patent had been made, held to have had no fair market value at the time paid in for stock.
25 B.T.A. 146">*147 The Commissioner determined deficiencies in the petitioner's income-tax liability as follows:
| Docket No. | Year | Amount |
| 43438 | 1925 | $1,626.27 |
| 1926 | 2,088.97 | |
| 51694 | 1927 | 2,254.47 |
| 53310 | 1928 | 192.30 |
The errors assigned are that the Commissioner has disallowed the deduction of: (1) $2,941.18 for each year representing exhaustion of patent rights which cost $50,000; (2) $1,543.20 for each year representing exhaustion of the total amount $26,234.46) expended in developing a market for the patented product; and (3) $8,850 for each of the years 1925 and 1926 representing the cost of financing certain1932 BTA LEXIS 1571">*1572 construction jobs executed and completed in those years. The respondent made some affirmative allegations in regard to 1927 which need not be set forth in detail, since the parties disposed of these items by agreement. The cases were consolidated.
FINDINGS OF FACT.
The petitioner was incorporated in March, 1921, under the laws of Delaware. Its authorized capital stock of $100,000 was divided into 10,000 shares, each having a par value of $10. Its principal office is at New Orleans, Louisiana.
On October 7, 1921, Dennis A. Casey, chemist at the plant maintained by the city of New Orleans for the repair of its streets, filed in the United States Patent Office, Application No. 506092, for a patent on a bituminous paving mixture to be known as "Cascemco." Casey, by a writing dated December 1, 1921, granted to Edgar J. Kelly, in consideration of a royalty of fifteen cents per square yard, the exclusive right within the United States to lay and promote the pavement covered by Application No. 506092 for letters patent.
Only 31 shares of the capital stock of the petitioner were outstanding prior to December 19, 1921. On that date the petitioner, by a resolution of the stockholders1932 BTA LEXIS 1571">*1573 and the board of directors, agreed to issue 5,000 shares of its capital stock to Kelly, and Kelly agreed to transfer to the corporation his interest in the contract with Casey. The 5,000 shares were issued to Kelly on January 3, 1922. On March 31, 1922, Kelly, in pursuance of an oral understanding which he had with the following persons that out of the 5,000 shares he would assign certain shares, assigned 250 shares to H. M. Ansley, 500 shares to his brother, Robert E. Kelly, 500 shares to Sidney A. Souers, 100 shares to A. Dazet, 5 shares to A. Loustalot and 5 shares to F. N. Oertling, and reserved for himself 3,140 shares.
25 B.T.A. 146">*148 Ansley, an attorney, had secured the petitioner's charter and had drawn up the Casey-Kelly agreement and the various minutes of the meetings of the petitioner's stockholders and directors. R. E. Kelly, a promoter had made some investigation of types of pavements used in New Orleans and other cities, and had secured some statistics on these subjects. L. M. Dalgarn, an engineer, had made some investigation of the pavement for which Casey hoped to secure a patent and had attended some of the corporate meetings of the petitioner. Souers, the vice1932 BTA LEXIS 1571">*1574 president of a bank, had attended the petitioner's meetings. Dazet, a bank officer, made some investigation of the ability of E. J. Kelly as a paving contractor. He had known Kelly for many years. Loustalot and Oertling had looked up some points and had reported to the corporation some things they had heard. The only consideration for the shares of stock which were received by these individuals was the services or alleged services performed by them on behalf of the corporation, as described in this paragraph,
The Municipal Repair Plant of the city of New Orleans during 1920 and 1921 was using the material later known as "Cascemco" in repairing streets. The cost of laying this material was about 30 cents per square yard less than the cost of laying some standard paving materials then being used in New Orleans. In the latter part of 1921 there was considerable agitation for the improvement of streets in New Orleans and prospects were good for an increase in the paving program of the city. The paving specifications theretofore adopted by the city council permitted the use of at least two kinds of street paving material. Both were patented materials.
Soon after the petitioner1932 BTA LEXIS 1571">*1575 acquired the Casey-Kelly contract it made an unsuccessful attempt to have "Cascemco" included in the paving specifications of the city of New Orleans. Thereupon, the petitioner started a campaign to secure the backing of property owners in its efforts to have "Cascemco" included in the paving specifications of the city. It expended $3,197.20 in this camgaign.
On August 17, 1922, an ordinance was passed which permitted the use of "Cascemco" under certain circumstances as a street paving material. Thereafter, the petitioner, by bids and otherwise, attempted to secure a contract for paving one or more streets in the city with "Cascemco." It was awarded a contract for paving two streets where more than 33 per cent of the property owners had designated "Cascemco" as the material they desired to be used. But in connection with these contracts ordinances were passed on February 9, 1923, whereby the council declared that a necessity existed for requiring the use of bituminous concrete in lieu of "Cascemco" in order to meet the requirements of heavy traffic, and agreed that the city would bear the difference in cost between "Cascemco" and 25 B.T.A. 146">*149 bituminous concrete. At the same1932 BTA LEXIS 1571">*1576 time the petitioner secured the contract for paving another street where the property owners had not designated "Cascemco." By ordinance dated the same day, the commission council selected bituminous concrete as the material to be used in paving this street, and the petitioner had to assign all three of the contracts to another firm.
On September 4, 1923, letters patent were issued for "Cascemco." On October 10, 1923, the petitioner entered into a contract with William F. Kelly, whereby it gave him or his assignees the exclusive right to "Cascemco" in the Parish of Orleans, State of Louisiana, in consideration of the payment of a royalty of 10 cents per square yard "on a yardage amounting to approximately one-third of all 'soft-top' pavement contracted for or laid by said Kelly or his assignees under the yearly paving programs of the City of New Orleans beginning 1925 program and terminating with the completion of the program of 1929." Kelly agreed to make every effort to have any contractor who might underbid him use "Cascemco" and thus increase the royalty. On February 29, 1924, a contract was let for the paving of a street with "Cascemco." This contract was carried out.
1932 BTA LEXIS 1571">*1577 During the years 1922 and 1923 the petitioner sold some of its stock at par. Also a few shares were sold about the time of the organization in 1921. Most of this stock was sold for notes of the purchasers, which were paid in installments. The total amount received for this stock was $13,592. During the same period the petitioner expended over $2,900 in promoting the sales of this stock.
After December 19, 1921, Casey entered into various agreements whereby the royalty which he was to receive was reduced and the terms on which he was to receive it were changed from what they had been in his contract with Kelly. During the taxable years in controversy the petitioner never used "Cascemco" in laying pavements, but it collected royalties from paving laid by others who were permitted to use "Cascemco" and paid a part thereof to Casey, as shown in the following table:
| Year | Royalties received | Royalties paid to Casey |
| 1925 | $5,022.33 | $2,485.23 |
| 1926 | 4,569.57 | 903.26 |
| 1927 | 9,767.97 | 1,529.84 |
| 1928 | 9,126.65 | 2,423.25 |
On October 10, 1924, the petitioner's board of directors adopted a resolution authorizing the corporation to enter into a contract with L. M. 1932 BTA LEXIS 1571">*1578 Dalgarn, whereby Dalgarn agreed to finance such contracts 25 B.T.A. 146">*150 as the corporation might secure in consideration of the issuance to him of 1,570 shares of stock of the company. This contract was entered into and the stock was issued to Dalgarn. These services were to be performed thereafter. In 1925 and 1926 Dalgarn endorsed the petitioner's notes in the amount of $55,000 and quaranteed indemnity companies on the petitioner's bonds for street contracts. The amount of the paving contracts was $260,000. This same resolution recited that Kelly had been president and general manager of the company since March 7, 1921, and had only drawn $30 per week as compensation. It was then agreed that his compensation should be figured at the rate of $600 per month for the period of three years and six months, or a total of $25,200, against which should be debited the sum of $5,900 drawn by him during this time, and, as the company had no funds to pay the balance of $19,300, it was agreed that stock of the company of the par value of $19,300 should be issued to him in complete settlement of his salary and expenses up to and including the month of October, 1924. This stock was issued to1932 BTA LEXIS 1571">*1579 Kelly. Neither Kelly nor Dalgarn included any amount in their income-tax return representing the value of the stock of the petitioner which they received in 1921 or 1924.
The petitioner did some work for private individuals or firms in 1922 or 1923.
OPINION.
MURDOCK: The petitioner claims that its interest in the Casey-Kelly contract cost it $50,000 and, therefore, it is entitled to deduct one-seventeenth of this amount in each year under that provision of the revenue acts which permits the deduction of "a reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence." This allowance for the years in controversy must be based upon either the cost of the property to Kelly, or the cost of the property to the petitioner. The respondent contends that the property was acquired after December 31, 1920, by the corporation by the issuance of its stock or securities in connection with a transaction described in paragraph 4 of subdivision (b) of section 203 of the Revenue Act of 1926, and therefore the basis for depletion or depreciation would be the cost to the transferor, Kelly, which cost was1932 BTA LEXIS 1571">*1580 nothing. Section 204(a)(8) and section 204(c). Section 203(b)(4) provides for a situation where property is transferred to a corporation by one or more persons solely in exchange for stock of the corporation, and immediately after the exchange such person or persons are in control of the corporation. Control means the ownership of at least 80 per centum of the stock. We think that the provisions of the sections 25 B.T.A. 146">*151 above mentioned apply to the facts in this case, and the basis to the petitioner for depletion or depreciation is nothing.
The petitioner's original allegations in these proceedings were that 5,000 shares of its capital stock, which had a par value and an actual value of $50,000, were issued to Kelly in consideration for his rights under the contract with Casey. Kelly swore to these allegations. According to the corporate minutes of the petitioner, stock of the par value of $50,000 was issued to Kelly in consideration for his interest in his contract with Casey. At the hearing, after it was called to the attention of the petitioner's counsel that his allegations did not set forth a cause of action on this point, he amended his pleadings to allege that Kelly1932 BTA LEXIS 1571">*1581 received only 3,140 shares for himself for his interest in the contract, and the other shares issued were to go as prearranged to other individuals in consideration of certain services which these individuals had performed for the corporation. There is no suggestion in the corporate minutes that these shares were to go to these individuals under the circumstances mentioned in the amended petition. On December 19, 1921, Kelly assigned his interest in the contract to the corporation and received 5,000 shares of stock. None of these shares were distributed to any others until March 31, 1922. We are now asked to find that during this time Kelly did not own the stock, since he had previously entered into oral agreements requiring him to transfer to various individuals certain of the 5,000 shares which he received. Ansley had done a little legal work. But the proof offered to show what the other individuals had done for the corporation is not convincing. Most of them had done nothing, so far as we can see, which would be consideration for Kelly's promise or justify the issuance to them of any valuable stock. The mere promise to make a gift transfers no title in property. So far1932 BTA LEXIS 1571">*1582 as we can see, Kelly was the owner of the shares until he actually gave them away on March 31, 1922. The petitioner would be no better off, however, if these individuals acquired an interest in the contract prior to the time that Kelly turned it in to the corporation, for in that case section 203(b)(4) would still apply, since there was an exchange by two or more persons each of whom received stock substantially in proportion to his interest in the property prior to the exchange.
If our reasoning above is wrong and these sections do not apply, then the amount of the deduction to which the petitioner is entitled depends upon the fair market value of the property acquired. This is so because when the petitioner acquired the property in question it had no other property, so far as we know, and the fair market value of the stock which it paid for this property was no greater than the value of the property. Thus, it was incumbent upon the petitioner 25 B.T.A. 146">*152 to prove the value of the property which it acquired from Kelly on December 19, 1921. Cf. 1932 BTA LEXIS 1571">*1583 ; affd., . The petitioner realized this and offered a great deal of evidence which was intended to support the alleged value of $50,000. Opinions were given by a number of witnesses. But no qualified witness gave an estimate which appears to be reliable or justified by the facts. Each failed to consider one or more of the essential facts or uncertainties which a prospective purchaser would undoubtedly have taken into consideration. They disregarded the fact that Casey was to be paid a royalty of 15 cents. None made any allowance for the fact that there was on December 19, 1921, only an application for a patent. The value of the contract to the owner on that date depended a great deal upon the prospects and probabilities of the ultimate issuance of letters patent. No witness was shown to be qualified to estimate these probabilities and to gauge their effect upon value. Casey and Kelly were witnesses for the petitioner on the question of the value of Kelly's rights. Kelly acquired these rights from Casey on December 1, 1921, at no cost. Yet both say that they were worth over $50,000 eighteen1932 BTA LEXIS 1571">*1584 days later. Shortly thereafter Kelly gave away over 37 per cent of the stock which he acquired in exchange for these rights. There is no reason to believe that the rights fluctuated in value during this period.
The petitioner intended to operate only in New Orleans. The council of that city had adopted specifications for the construction of its streets which did not permit the use of "Cascemco." The petitioner experienced great difficulty in having "Cascemco" included in the specifications. Not until February 29, 1924, did the council finally permit the paving of one street with this material. It appears from the evidence that any reasonable person would have anticipated some such difficulties as the petitioner later actually experienced.
The sales of stock do not show that the assets had any value on December 19, 1921, when we consider the time of the sales and the circumstances under which they were made. Cf. ; . Frequent contradictions weaken the effect of the petitioner's evidence. The future for "Cascemco" was extremely doubtful on December 19, 1921, and the evidence1932 BTA LEXIS 1571">*1585 does not indicate that the rights acquired by the petitioner had any fair market value on that date. Thus, whether the basis for the deduction is cost to Kelly or cost to the petitioner, the result is the same. The Commissioner must be sustained on this point.
The petitioner contends that it expended $26,431.25 in a successful campaign to have "Cascemco" included in the paving specifications 25 B.T.A. 146">*153 of the city of New Orleans, and, therefore, it should be permitted to deduct a portion of this amount in each of the years before us. The petitioner conducted the campaign and no doubt expended some money in that connection, but the first question is, How much did it expended which should be capitalized? The respondent made no objection to the offer in evidence of a very badly kept book of accounts. It was admitted with the understanding that any material entries would be called to our attention and properly explained. The petitioner failed to do as directed and we might well disregard the evidence contained in this book. But, since the respondent seems to be satisfied with what the book shows, we have found from it that the petitioner expended $3,197.20 in promoting "Cascemco. 1932 BTA LEXIS 1571">*1586 " A portion of this amount may be deducted in each year as contended by the petitioner. In its brief the petitioner contends that Kelly's salary, as president and general manager, amounting to $19,300, other salaries, and organization expenses should be capitalized and exhausted over the life of the patent. The petitioner did some business during the years 1922 or 1923. How much we do not know. The corporate minutes refer to Kelly's salary, but we do not know of any other salaries or organization expenses. The record does not justify capitalizing all or any particular part of Kelly's salary during these years.
The remaining issue relates to the right of the petitioner to deduct $8,850 in each of the years 1925 and 1926. The petitioner has failed to tell us under what section of the revenue act it claims this right. Each amount is supposed to represent one-half of the cost of financing certain construction work performed in those years. In 1924, 1,570 shares of the petitioner's stock were issued to Dalgarn in consideration of the latter's promise to finance the corporation in such contracts as it might secure. This contract was not offered in evidence but, according to Dalgarn1932 BTA LEXIS 1571">*1587 and the corporate minutes, it covered an indefinite period, the probable extent of which we are totally unable to estimate. The benefits were not restricted to the two years. The payment was not made in these years. It was never made as cost of any contract. The method of bookkeeping and income reporting has not been shown. Under such circumstances the petitioner is not entitled to the deductions claimed.
Judgment will be entered under rule 50.