*4283 1. Depreciation upon building determined.
2. In 1918 the petitioner became liable to pay additional compensation to one of its employees. It disputed the amount of the liability. In 1919 suit was brought and settled and payment made for the services rendered. The petitioner kept its books on the accrual basis. Held, such payment is not deductible in computing net income of 1919.
3. Petitioner erected a building upon leased premises. It ceased to use such building in its business three years prior to the expiration of the lease, and thereupon leased such building to another. It claims the difference between the depreciated cost of the building and the net rental to be received over the term of the lease as a deduction for obsolescence. Held, not allowable.
4. Petitioner's claim of an overstatement of its inventory disallowed for lack of evidence thereof.
*1137 This proceeding arises from the determination by the Commissioner of a deficiency of $4,683.22 in income and profits taxes for the calendar year 1919. It is alleged that*4284 the respondent committed error (a) in failing to allow an adequate depreciation on buildings in the year in question; (b) in disallowing a deduction of $25,000, representing salary paid to P. F. Sheeran during the year in question; (c) in computing the loss of the J. J. McCabe Punch & Shear Co., an affiliated company, in that no deduction was allowed for obsolescence of buildings or for shrinkage in inventory value. Certain other errors alleged in the petition were waived by the petitioner at the hearing.
FINDINGS OF FACT.
The petitioner is a New York corporation with its principal office at 149 Broadway, New York City.
On January 1, 1919, petitioner owned and occupied a building located at Tenth and Brunswick Streets, Jersey City, N.J., which it had acquired January 1, 1918, at a cost of $13,801.68. During 1918 additions were made at a cost of $2,969.30. Such building had a reasonably anticipated useful life of fifteen years from January 1, 1918.
Prior to 1918 the business now conducted by petitioner had been owned by J. J. McCabe individually. When the petitioner took over the business of J. J. McCabe in 1918, P. F. Sheeran, who had been employed for several years*4285 as general manager, continued to hold *1138 that position. McCabe had paid Sheeran $30 per week and extra compensation at the end of the year of $2,065 in 1912, $2,065 in 1913, $2,065 in 1914, $9,000 in 1915, $10,000 in 1916, and $15,000 in 1917. The profits for 1912 were $44,279.86; 1913, $32,333.14; 1914, $4,945.49; 1915, $165,717.22; 1916, $155,331.14; 1917, $183,336.43; and 1918, $207,453.96. Petitioner had agreed to pay Sheeran extra compensation for 1918 and 1919. The amount due under such agreement was not less than $15,000 for 1918 and $5,000 for the first four months of 1919.
Early in 1919 a dispute arose between petitioner and Sheeran over the extra compensation to be paid Sheeran for the year 1918. At that time J. J. McCabe was dead or insane. As a result of this dispute and the failure of petitioner to make satisfactory settlement, Sheeran resigned from his position in April, 1919, and went into business in competition with petitioner under the name of the Sheeran Machinery Co., with his office next door to the office of the petitioner. He also instituted suit against petitioner for compensation in the amount of $23,000 for 1918 and $6,000 for the period*4286 from January 1 to April 19, 1919. Service was made on the petitioner, but the suit was subsequently settled by an agreement executed May 12, 1919, which provided as follows:
MEMORANDUM OF AGREEMENT between MARCELLA A. MCCABE, widow of the late James J. McCabe, (hereinafter referred to as "Mrs. McCabe") party of the first part, JAMES J. MCCABE, JR., and RAYMOND J. MCCABE, parties of the second part, J. J. MCCABE LATHE & MACHINERY CORPORATION, Party of the third part and PATRICK F. SHEERAN, (Hereinafter referred to as "Mr. Sheeran"), party of the fourth part.
The parties in consideration of the mutual promises hereinafter contained and other good and valuable considerations, do agree as follows:
1. Mr. Sheeran agrees to accept in full settlement and liquidation of all claims against the late James J. McCabe and the J. J. McCabe Lathe & Machinery Co. arising either out of his association with the late James J. McCabe and the said J. J. McCabe Lathe & Machinery Co., whether by way of salary or compensation or in consideration of the discontinuance of the Sheeran Machinery Company, or otherwise, the sum of Fifth Thousand Dollars ($50,000.00) payable as hereinafter provided, and*4287 agrees to release the said James J. McCabe Lathe & Machinery Co., the J. J. McCabe Punch & Shear Co., James J. McCabe, Jr. and Malcolm Sumner, as committee of James J. McCabe, incompetent, and the Estate of James J. McCabe, and all persons interested therein, from any and all liabilities, claims and demands of any kind or character arising either out of contract or out of any alleged will or codicil of the said James J. McCabe.
2. Mr. Sheeran agrees for the period beginning May 15, 1919, and ending December 31, 1921, to work for the J. J. McCabe Lathe & Machinery Co. and to continue to perform the duties heretofore performed by him for said company, and agrees faithfully and diligently to perform said duties and to promote the business interests of the said corporation as fully as may be. During said time he will give his entire attention and energies to the upbuilding of the said company, and will discontinue and terminate immediately the business now carried on by him under the trade name of the Sheeran Machinery Company. *1139 He agrees not to engage in any other business of any kind or character than that of the J. J. McCabe Lathe & Machinery Co. as an employee aforesaid, *4288 during the term of this agreement. Mr. Sheeran will receive as compensation a salary at the rate of Seventy-five hundred dollars ($7,500.00) per annum, payable monthly, and in addition thereto a sum equal to 15% of the net profits of the company after deducting all proper taxes and charges and allowing for an eight per cent (8%) dividend to stockholders, said latter sum to be paid at the end of each calendar year; but it is understood that for the period of May 15th, 1919, to December 31st, 1919, the profits shall be calculated on the basis of the new business undertaken during said period and shall not apply to any profits prior thereto.
3. The parties agree that all proper steps will be taken by the Estate of James J. McCabe and by the J. J. McCabe Lathe & Machinery Co. to effectuate the foregoing agreement.
4. Mr. Sheeran will consent to the discontinuance of the suit instituted by him against the J. J. McCabe Lathe & Machinery Co. and will execute proper releases to that corporation.
5. Payment of the Fifty-Thousand dollars ($50,000) mentioned in Paragraph 1, shall be made as follows:
Payment of Twenty-five Thousand dollars ($25,000.00) shall be made simultaneously*4289 with the execution of this agreement. The balance shall be paid within one year from the date of the probate of the will of the said James J. McCabe, deceased, or the granting of letters of administration upon the estate of the said deceased.
IN WITNESS WHEREOF, we have hereunto set our hands and seals this 12th day of May, 1919.
In the presence of:
ANNE B. DERINGER
MARCELLA A. MCCABE (L.S.)
J. J. MCCABE, JR. (L.S.) R. J. MCCABE (L.S.) J. J. MCCABE LATHE & MACHINERY CORP.By J. J. MCCABE, Jr., PRES.
PATRICK F. SHEERAN (L.S.)
Under a purported will of J. J. McCabe, dated March 28, 1918, Sheeran was made beneficiary to the amount of $25,000. J. J. McCabe had been adjudged mentally unsound in the fall of 1918 and a committee appointed for him. This purported will was not probated and no attempt was made by Sheeran to have it probated. Other parties, however, did make such an attempt but failed. It was declared void in June, 1922.
Fifty thousand dollars was paid Sheeran in 1919 under the above agreement. On its books the petitioner treated $25,000 of such payment as salary to Sheeran for 1918 and $25,000 as salary for 1919. The Commissioner refused to allow*4290 petitioner to deduct any part of such payment in computing its income for 1919.
The J. J. McCabe Punch & Shear Co., an affiliated concern, leased a plot of ground in Chattanooga, Tenn., in 1918, for a term of five years at a rental of $600 a year, and constructed a building thereon. *1140 Under the terms of the lease the building reverted to the lessor at the expiration of the term. The building was used for the manufacture of large punch and shear machines particularly adapted for the requirements of ship-building yards for punching and shearing plates. The demand for this company's product ceased with the termination of the war. The business was discontinued and the plant shut down early in 1919. The Punch & Shear Co. thereupon ceased to use the building for the purpose for which it was erected and leased it for the remainder of the five-year term (about three years) at a rental of $1,500 per year, or a total net return to the petitioner for the remainder of the term of $2,700 in excess of the rental it was required to pay.
The Commissioner allowed depreciation on said building for the year 1919 of $5,384.27, leaving a depreciated cost as of January 1, 1920, of*4291 $16,152.80. The petitioner contended that this depreciated cost, less the net return of $2,700 from the rental of the buildings, should be allowed as obsolescence in 1919 when he abandoned the building for the purpose for which it was built. The Commissioner refused to allow such deduction.
The J. J. McCabe Punch & Shear Co. had on hand on December 31, 1919, two large punch and shear machines weighing approximately 30,000 pounds each, which it had manufactured for sale. One of these machines had been shipped to a customer in West Virginia, but on use it proved to be defective in design and broke. It was rejected by the customer and was never paid for. It was left in West Virginia, the Punch & Shear Co. having determined that it was not worth the return freight charges. Efforts were made to sell the other machine, but without success. Attempts to interest scrap dealers in these machines were unsuccessful on account of their weight and the cost of moving them. The inventory of the J. J. McCabe Punch & Shear Co. as of December 31, 1919, was $42,839.04. Prior to this date the Punch & Shear Co. had ceased manufacturing and closed down the plant. These machines were defective*4292 and had only a scrap value of $420 in 1919.
OPINION.
PHILLIPS: Petitioner claims a deduction of $25,000 as compensation paid to P. F. Sheeran during 1919 for services rendered. The Commissioner disallowed this deduction on the ground that it was paid for other consideration than salary and treated it as dividends to the estate of J. J. McCabe.
Sheeran had been employed by J. J. McCabe, petitioner's predecessor, as general sales manager for many years. He had received a salary of $30 a week and, after the end of the year when the profits *1141 had been determined, additional compensation varying from $2,065 in 1913 to $9,000 in 1915; $10,000 for 1916, and $15,000 for 1917. When petitioner was incorporated as of January 1, 1918, it took over the business of J. J. McCabe, including his assets and liabilities, in exchange for its stock. It continued the services of Sheeran as secretary and general sales manager on the same basis as he had worked for McCabe, paying him $30 a week as a drawing account during 1918, and for approximately the first four months of 1919. Sheeran devoted all his time to petitioner's business. There was an agreement between himself and McCabe*4293 under which he was entitled to receive additional compensation for 1918. He claimed the amount to be $23,000. McCabe had become a mental incompetent in 1918 and the petitioner corporation disputed its liability to pay this amount. In April, 1919, upon failure to come to any agreement concerning additional compensation to be paid for 1918, Sheeran resigned and instituted suit against petitioner for $23,000 for additional compensation for 1918 and $6,000 for additional compensation for the time he had worked during 1919. At the same time he set up a competing business. The suit was compromised and under the terms of the compromise agreement Sheeran was paid $50,000 in settlement of his claim for compensation, and for other considerations, including giving up of the competing business and the release of all claims against the estate of J. J. McCabe arising out of contract or a will or codicil of J. J. McCabe.
The evidence establishes the existence of an agreement to pay Sheeran additional compensation based on profits, which compensation, judged by the amount paid in prior years, would have amounted to at least $15,000 for 1918 and $5,000 for the first four months of 1919. It*4294 is proper to treat the payment made in 1919 as having been made to that extent in discharge of an obligation for services rendered in 1918 and 1919. The question then arises whether the $15,000 paid in 1919 for services rendered in 1918 may be deducted in the year of payment, the petitioner having admitted no liability in 1918, but having disputed such liability and having accrued no amount upon its books in that year.
In computing net income the statute provides for the deduction of "all ordinary and necessary expenses paid or incurred in the taxable year in carrying on any trade or business, including a reasonable allowance for salaries and other compensation for personal services actually rendered." In , the Board had before it a similar situation arising under the provisions of the statute allowing a deduction of taxes paid or accrued within the taxable year. There certain state inspection fees were payable at the time of inspection. Payment thereof was withheld *1142 until litigation instituted to test the validity of the statute had been completed and it was sought to deduct these fees in the year when*4295 paid. We there held that these fees accrued at the time of inspection and might not be deducted in the subsequent year. In the same manner compensation for services is to be deducted in the year in which the liability arose and the date of accrual may not be postponed by the debtor by disputing either the liability or the amount thereof.
The J. J. McCabe Punch & Shear Co., affiliated with petitioner, had leased a certain tract of land in 1918 for a term of five years and had erected thereon a building, said building to revert to the lessor at the end of the term. This building was to be used for the manufacture of punch and shear machines which were particularly adapted for the requirements of ship-building yards, for punching holes in and shearing the large plates used in the construction of ships.
Upon the signing of the armistice and the termination of the war, the demand for this company's production ceased. The business was discontinued and the plant shut down early in 1919. The punch and shear company thereupon ceased to use the building for the manufacture of punch and shear machines and leased it for the remainder of the five-year term at a rental of $1,500 per year.
*4296 The Commissioner allowed as a deduction for the year 1919 depreciation at the rate of 20 per cent, being predicated on the five-year term of the lease. The petitioner contends that, having abandoned the building in 1919 for the purpose for which it was erected and having sublet it for the balance of the term at a definite amount of rental, it is entitled to a deduction, as obsolescence, of the difference between the net income from its lease and the depreciated cost of the building as of January 1, 1919.
A deduction for obsolescence clearly contemplates that in addition to actual wear and tear, a further amount should be deducted because, due to some known reason, the asset will have to be discarded prior to the expiration of its normal life. In this case the building was not abandoned nor discarded when it ceased to be used for the manufacture of punch and shear machines. On the contrary the building was sublet by petitioner's affiliated company at a rental which yielded $900 a year for the remainder of its term in excess of the rental which it was required to pay. It did not assign and sell to its lessee its interest in the property, it gave only the possession and use*4297 of the property for the remainder of the term. During all the remainder of the term of its lease petitioner's affiliated company received an income from the use of the building. It is not material that this income was less than it might have been had the Punch & Shear Co. continued the use of the building for the purpose for which it was erected, nor is it material that it was used for a different *1143 purpose. The mere fact that a building is used for a purpose different than that originally intended does not determine the building to be obsolete. The loss which will be sustained over the remainder of the lease, after allowing for exhaustion of the cost of the building, is deductible yearly and can not be anticpated upon the theory that obsolesence has taken place when, in fact, the building continues to be suitable for the purpose of its erection and all that has taken place is a reduction in its income-producing capacity. The determination of the Commissioner as to this issue is, therefore, sustained.
The petitioner claims that the Commissioner overstated the inventory of its affiliated company as of December 31, 1919, by including therein two punch and shear machines*4298 at a value of $8,000. It appears that the Commissioner has used the same value for inventory that was used by the affiliated company in making its tax return. While it is demonstrated that these two machines were useless and worth only their scrap value, there is nothing in the record from which we may learn whether or not these machines were included in the inventory in question and, if so, at what value. The inventory was in the records of the company but was not produced at the hearing. The witness thought it probable that these machines were included. Something more than such indefinite testimony is required before we may attempt to find that the inventory used by the company in its tax return and adopted by the Commissioner is erroneous.
Reviewed by the BOARD.
Decision will be entered accordingly upon 15 days' notice, under Rule 50.