*1764 The value of patents acquired in exchange for stock determined for the purpose of exhaustion.
*941 These proceedings, consolidated for hearing and decision, are for the redetermination of deficiencies in income taxes of $2,482.40 for 1923, $1,802.91 for 1924, and $897.83 for the period January 1 to September 30, 1925.
*942 The errors alleged to have been committed by the respondent are:
(1) Failure to allow petitioner any depreciation on patents for the year 1923; and
(2) Failure to allow petitioner as a credit against income for 1923, the total statutory net loss sustained by the petitioner for 1921 and not absorbed by the correct income for 1922; and
(3) Erroneous disallowance by the respondent of the entire $14,708.16 claimed by the petitioner as depreciation of patents for the calendar year 1924; and
(4) Erroneous disallowance by the respondent of the entire $11,031.12 claimed by the petitioner as depreciation of patents for the nine-month period ended September 30, 1925.
FINDINGS OF FACT.
On March 13, 1908, Irving Fisher, professor*1765 of economics at Yale University, filed an application with the Patent Office for letters patent on "new and useful Improvements in Indexes or Files." The application related to an invention whereby overlapping cards or members were arranged so as to disclose at all times a portion thereof upon which appeared any desired records, memoranda or indicia. On January 26, 1919, and on July 29, 1911, Fisher filed applications for other letters patent for inventions relating to the same subject matter. On December 24, 1912, Letters , , and were issued to Fisher on the above applications.
While the applications were pending Fisher and his brother attempted to determine whether the patents would be valuable by selling the device to the public. Beginning in 1909 or 1910 they spent several years in selling the device, and as a result of their experiences and upon the advice of efficiency engineers they decided that the patents were very valuable. This conclusion was based on two facts: first, that from the start the business showed a very high repeat ratio, indicating that it would become a relatively lucrative business from repeat orders alone; and, *1766 second, that patent protection was necessary in order to secure the receipt of this repeat business to Fisher or his assignees.
Accordingly, in June, 1913, the Index Visible, Inc., hereinafter referred to as the 1913 company, was organized under the laws of the State of New York, to take over these patents and function as a business concern. The authorized capital stock of the company was 2,000 shares of 6 per cent cumulative preferred stock, par value $100 per share, and 2,000 shares of common stock, par value $100 per share. In exchange for his patents and an agreement to turn over any further inventions of the same nature, Fisher received 1,995 shares of the common stock of the company.
*943 The visible indexing field which the 1913 company entered was highly competitive, and the company encountered strong opposition from concerns that were much better organized and established. However, by virtue of its patents, the 1913 company had a remarkable advantage over its competitors in that competing devices required something additional to the holder and the card, while the Fisher patented card carried its own holder, cut into the paper itself, which made the card more*1767 easily insertable or removable. The Fisher indexing system and equipment required less space and sold during the period 1913 to 1920 for less than competing systems.
The 1913 company encountered all its sales resistance in making its initial sales, as the repeat orders were secured without difficulty and they finally became the major part of the business. The repeat business from an initial sale is illustrated by using as an example the New York Central Telephone Co., which used the Fisher visible index in handling telephone changes. These change lists were carried in triplicate and, since the changes amounted to about 1,000 a day, the telephone company used 3,000 cards per day. Installations of the Fisher system and equipment were made for telephone companies, public utilities, and department stores, principally in the larger northern cities, as the sales organization of the 1913 company was small and the territory covered was limited. The ratio of repeat business to new business was 4.6 for the period January 1, 1916, to May 1, 1917, 5.7 for the period May 1, 1917, to February 1, 1919, and 2.5 since the World War.
Despite the advantages enjoyed by the 1913 company over*1768 its competitors, the company was unable to operate profitably, due principally to two factors: first, the reluctance of Fisher to raise the selling prices during the war as costs were raised, and, secondly, bad management. Sales and profits and losses of the 1913 company, as contained in capital-stock and income-tax returns filed, were as follows:
| Period | Sales | Losses |
| 1913 and 1914 | $76,100.36 | |
| 1915 | $43,944.69 | 32,406.75 |
| 1916 | 103,857.62 | 7,198.53 |
| 1917 | 140,577.64 | 28,551.06 |
| 1918 | 322,881.65 | 1 50,627.10 |
| 1919 | 260,759.10 | 45,108.06 |
| January-June, 1920 | 166,140.23 | 11,425.82 |
In order to remedy the existing conditions and to secure additional capital the stockholders reorganized the company in 1920. A new company, the petitioner, was incorporated on June 16, 1920, having an authorized capital stock of 2,000 shares of 8 per cent cumulative *944 preferred stock, par value $100, and 2,000 shares of no par value common stock. The petitioner, according to its charter, was organized "In particular, but not exclusively, to take over all the property, both real and personal, the good will, and all other assets of, and to succeed to and*1769 carry on the business now conducted by Index Visible, Inc., a New York corporation."
At the initial meeting of the board of directors of the petitioner the following resolutions were adopted:
WHEREAS, this Company has been incorporated for the purpose of taking over the property and assets of INDEX VISIBLE, INC., a New York corporation, and of continuing the business heretofore carried on by said Company; and
WHEREAS, in the judgment and discretion of this Board, the good will of said Index Visible, Inc., is of the full and fair value to this Company of $50,000, and the patents, numbers U.S. 1048056, 1048057, and 1048058, all issued December 24, 1912, and Great Britain No. 12984 of 1909, issued to Prof. Fisher, of New Haven, Connecticut, and by him transferred to said Index Visible, Inc., in exchange for $199,500 par value of the common stock of the Company, are fully and fairly worth the sum of $110,000 to this Company; and
WHEREAS, in the judgment and discretion of this Board, the remaining assets of said Index Visible, Inc., are fully and fairly worth a sufficient sum in connection with the said good will, and the said patents taken at the respective values of $50,000 and*1770 $110,000 to make the total net assets of said Index Visible, Inc., over and above all the liabilities of said Company, worth at least $240,000;
Now, THEREFORE, BE IT RESOLVED, that the President of this Company be, and he hereby is, authorized to make, and sign in the name of this Company, and to deliver to said Index Visible, Inc., an offer to purchase all the property and assets of said Index Visible, Inc., including its good will, patents, and the right to use the said corporate name, and to pay therefor a consideration consisting of 1873 shares of the preferred capital stock of this Company, and 2,000 shares of the common capital stock of this Company, together with the agreement of this Company to pay and satisfy all the liabilities of said Index Visible, Inc., as the same shall mature and become due and payable; and be it further
* * *
The stockholders of the 1913 company accepted the offer of the petitioner to purchase its business and assets, and the following agreement of July 1, 1920, in so far as pertinent, was spread on the petitioner's minute book, the 1913 company being the party of the first part and the petitioner being the party of the second part.
* * *
*1771 Now, THEREFORE, in consideration of the premises; of the sum of one dollar, by each of the parties hereto to the other of them in hand paid at or before the ensealing and delivery of these presents, the receipt whereof by each of the parties hereto from the other of them is hereby interchangeably acknowledged; and of the mutual covenants and agreements herein contained; the parties hereto have mutually and severally agreed, and by these presents do mutually and severally agree, as follows:
FIRST. The party of the first part has bargained and sold, and by these presents does grant, sell and convey, unto the said party of the second part, its successors and assigns, the business of manufacturers of visible indexes and *945 associated articles heretofore conducted by the party of the first part at No. 30 Church Street, Borough of Manhattan, City, County and State of New York; 441 Chapel Street, New Haven, Connecticut; and elsewhere; including the good will thereof, stock on hand and in process of manufacture, raw materials, tools, machines, fixtures and appurtenances, trade marks, trade names, brands, formulae, books, bills and accounts receivable, contracts, chattels, real*1772 and personal property of every name and description so used in the conduct of said business, and owned, by the party of the first part; together with the right to use the corporate name of the party of the first part as the corporate title of the party of the second part.
TO HAVE AND TO HOLD the same unto the said party of the second part, * * *
SECOND, Said party of the first part covenants and agrees with the said party of the second part, its successors and assigns, that the total indebtedness of said party of the first part on the date hereof does not exceed the sum of One hundred and Sixty-five Thousand Dollars ($165,000).
THIRD. In consideration of the foregoing sale and agreements, the party of the second part will deliver to the party of the first part eighteen hundred and seventy-three (1873) shares of the preferred capital stock of the party of the second part, and the entire authorized issue of two thousand (2,000) shares of the common capital stock of the party of the first part; and also hereby assumes and agrees to pay all the liabilities and obligations of the party of the first part validly existing and outstanding against the said party of the first part on*1773 the date hereof. The said preferred and common capital stock of the party of the second part shall be delivered to the party of the first part forthwith after the execution and delivery of these presents; and the aforesaid debts and obligations of the party of the first part shall be paid and discharged by the party of the second part as and when the same shall mature and become due and payable. The party of the second part, however, shall have the right, at its own cost and expense, to dispute and to resist payment of any such debt or obligation which it shall in good faith consider excessive, invalid, or for any other reason not an existing claim or charge against the party of the first part on the date hereof.
* * *
The patents were entered on the petitioner's books at $148,617.67.
At the stockholders' meeting of the 1913 company called to consider the proposal of the petitioner, all the stockholders, except Hayes, who was manager, voted in favor of the transfer. A few days after the meeting Hayes served notice on the 1913 company, in accordance with the New York statutes, that he refused to consent to the sale and transfer, and demanded that appraisers be appointed to*1774 fix the value of his 30 shares of preferred stock and 60 shares of common. Thereafter, and in accordance with the procedure provided for in the statute, the Supreme Court of New York at a special term appointed three appraisers to value Hayes' stock. The appointees, all prominent New York lawyers, held five meetings and took 700 pages of testimony in considering the value of Hayes' stock. Both Hayes and the 1913 company were represented by counsel, the efforts of the 1913 company being directed toward keeping the valuation as low as possible. After the hearings each side submitted briefs and reply briefs.
*946 The action of the appraisers is shown by the following report submitted to the Supreme Court of New York:
SUPREME COURT - NEW YORK COUNTY.
In the Matter of the Application of ROBERT D. HAYES, A Stockholder in the Index Visible Inc., for the appraisal of his Stock in said corporation.
Report of the Appraisers of the Value of the Capital Stock of Robert D. Hayes.
Your appraisers herein respectfully report as follows:
That on the 5th day of August, 1920, pursuant to provisions of the Stock Corporation Law, section 17 thereof, an order was entered herein*1775 by Mr. Justice Glennon appointing your appraisers to estimate and certify the value of the capital stock of Robert D. Hayes in said Index Visible Corporation as of July 14th, 1920.
That thereafter and on the 21st day of September, 1920, in pursuance to the terms of said order, your appraisers, namely, Harry M. Durning, John A. McEveety, and Julius C. Feder, did meet at the principal office of said company at # 30 Church Street, Borough of Manhattan, New York City, and were duly sworn and did qualify herein.
That a number of meetings were thereafter held, between September 21st, 1920 and December 1st, 1920, at which a number of witnesses were examined and many exhibits submitted, which testimony of the witnesses and exhibits are herewith submitted.
That thereafter and on or about January 7th, 1921, counsel for the petitioner and for the Index Invisible, [Visible] Inc., respectively, submitted memoranda and replying memoranda herein.
That the testimony showed that the Index Invisible, [Visible] Inc., was a New York corporation, organized in the State of New York in the year 1913, with an authorized capital stock of $200,000 common (being 2,000 shares of the par value*1776 of $100.00 each) and $200,000 preferred (2,000) shares of the par value of $100.00 each). That all of the common stock ($200,000) was issued, and that $187,300 of the preferred stock was issued.
That the company started in active business in the year 1913, and has been actively engaged in business ever since, up to about June, 1920, when said company sold all of its property and assets, including its name and good will, to a new corporation, called the Index Visible, Inc., also a New York corporation.
That to this sale of its entire property and assets the petitioner, Robert D. Hayes, duly objected, and at the time of his objection said Hayes was the owner and holder of sixty shares of the common stock and thirty shares of the preferred stock of the old company.
The object of this appraisal is to determine the value of said stock as of July 14, 1920, the date of his objection to the transfer.
A number of accountant's reports as to the financial condition of the company were introduced in evidence, the one nearest preceding the date for fixing the value of the stock, i.e. July 14th, 1920, being Exhibit #12, the accountant's report of June 30, 1920. This report contains*1777 a balance sheet showing the tangible assets and liabilities of the corporation, and it was stipulated by the parties that for the purpose of fixing the value of the stock the assets and liabilities of the corporation should be taken by the appraisers at the book value, as set forth in said accountant's report Exhibit #12, with the exception of the two items of assets therein, namely, patents and goodwill; *947 the value of these last two items should be fixed by the appraisers. Accordingly, we have the following conceded assets and liabilities:
| ASSETS | |
| Fixed assets, including land, building, | |
| machinery, fixtures, etc | $92,038.02 |
| Materials, goods and processes, etc | 82,190.87 |
| Accounts Receivable | 43,744.49 |
| Notes Receivable | 60.89 |
| Liberty Bonds and interest | 2,460.31 |
| Cash | 3,364.29 |
| Deferred charges | 2,326.98 |
| $226,190.85 | |
| LIABILITIES (Exclusive of capital stock) | |
| Accounts payable | 24,204.27 |
| Notes Payable | 114,500.00 |
| Mortgages Payable | 32,750.00 |
| $171,454.27 |
This leaves a balance of $54,736.58 for the assets of the company over and above its liabilities, exclusive of its patents and good-will.
Considerable testimony was produced as to the*1778 value of the patents owned or controlled by the company. Mr. Campbell, the President of the company, testified that in his opinion the value of the patents was not in excess of $100,000. The patents of the company are carried on its books at of June 30, 1920, at $148,617.67. Robert D. Hayes, the petitioner, testified that in his opinion the patents were actually worth $500,000. From all the testimony taken with respect to the patents we believe the value of the patents as shown on the books of the company actually represent their true value, namely, $148,617.67.
The company has had no net earnings applicable to dividends since its organization and in only one year did it operate at a profit. Consequently, the value of the good-will cannot be arrived at on a basis of net earnings, but from all the evidence introduced at the hearings with respect to the good-will we believe that the company had a good-will as a going concern, and that the value of such good-will on July 1st, 1920 was $25,000.
That in view of the foregoing values placed upon the assets of the company, the only value the common stock would have is a speculative one and in our opinion the value of such stock*1779 on July 1, 1920 was $5.00 per share.
Accordingly, we respectfully report to the Court that in our opinion the fair value of the preferred stock owned by Robert D. Hayes on July 1, 1920, taking into consideration the cumulative dividends, was $121.92 per share, amounting to the sum of $3,657.60, and that the value of the common stock was $5.00 per share, amounting to the sum of $300.00, amounting in all to the sum of $3,957.60, which this petitioner, Robert D. Hayes, is entitled to receive from the Index Visible Corporation for his thirty (30) shares of preferred stock and sixty (60) shares of common stock.
March 7th, 1921.
In accordance with this award the petitioner paid Hayes the value of his preferred and common stocks in March and April, 1921, and on or about April 27, 1921, the stock certificates formerly held by Hayes were canceled.
*948 In order to continue its predecessor's business it was necessary for the petitioner to raise additional capital. The condition of its balance sheets and its earnings record left open but two courses for securing such funds, the sale of additional stock and borrowing from its stockholders. Both plans were used to raise the*1780 required capital; loans were obtained from stockholders and the capital investment of almost every stockholder was increased so that the total capital of the petitioner exceeded that of the 1913 company by approximately 25 per cent. Some new subscribers were acquired, but these were principally employees who purchased small amounts of stock. Both preferred and common stock were sold at $100 per share.
The petitioner issued preferred stock at par for cash during the period June 30, 1920, to December 31, 1920, in the amount of $12,375 and during that period it received for capital stock, together with subscriptions, cash in the amount of $58,882.29. During the period July 1, 1920, to December 31, 1921, it received cash for capital stock in the amount of $71,509.50. It received installment subscriptions for capital stock on which cash was paid in the following amounts:
| Period June 30 | Period Jan. 1 | |
| to Dec. 31, 1920 | to Dec. 31, 31, 1921 | |
| Preferred stock | $27,176.79 | $2,552.21 |
| Common stock | 19,330.50 | 10,075.00 |
At the date of incorporation the petitioner issued $187,300 and $40,000 of preferred and common stocks, respectively, and it issued during the*1781 period January 1, 1921, to December 31, 1921, $29,900 and $4,160 of preferred and common stocks, respectively.
In addition to the basic patents (Nos. 1,048,056, 1,048,057, and 1,048,058, hereinbefore referred to) secured by petitioner from the 1913 company, it acquired the following patents which had been issued to the 1913 company on the dates specified, pursuant to assignments of Robert D. Hayes and said Fisher:
| Patent issued | Patent No. |
| July 6, 1915 | 1,145,411 |
| April 17, 1917 | 1,223,168 |
| July 1, 1919 | 1,308,586 |
| May 1, 1917 | 1,224,636 |
On October 7, 1924, was issued to petitioner, upon the assignment of said Hayes, on an application filed on October 16, 1915.
*949 About the time of the purchase of the 1913 company by petitioner James H. Rand, Sr., of the Rand Co. approached Fisher with a proposition to purchase the business and patents of the petitioner for $150,000. This offer, which contained a separate valuation for the patents of $100,000, was rejected because Fisher believed the patents to be worth more. From time to time other parties approached Fisher with propositions looking forward to the purchase of the patents, but*1782 these efforts were discouraged to such an extent that no definite offer was submitted.
The change in corporate ownership of the business and patents was followed by a complete reorganization of the business. The new president, Charles S. Campbell, installed a modern set of books of account, including an up-to-date system of cost accounting, reorganized the sales force, began advertising on a small scale, and increased the prices of the company's products about 25 per cent. He introduced numerous economies in operation and production, increased the number of salesmen, created a better feeling among the employees, and otherwise improved the business and management of the company.
The net earnings and net losses of the petitioner for the period July 1, 1920, to September 30, 1925, before deductions for exhaustion on patents, were as follows:
| Period | Earnings |
| July 1, 1920 to December 31, 1920 (Loss) | $7,373.78 |
| Calendar year 1921 (Loss) | 23,209.98 |
| Calendar year 1922 | 18,669.43 |
| Calendar year 1923 | 58,149.04 |
| Calendar year 1924 | 71,162.25 |
| January 1 to September 30, 1925 | 24,921.03 |
The petitioner charged off on its books of account and claimed as a deduction*1783 for exhaustion of its patents in its income-tax returns the amounts for the periods hereinafter listed.
| For 6 months in 1920 | $7,354.08 |
| For year 1921 | 14,708.16 |
| For year 1922 | 14,708.16 |
| For year 1923 | 14,708.16 |
| For year 1924 | 14, 708.16 |
| For 9 months in 1925 | 11,031.12 |
In February, 1921, the stockholders voted to increase petitioner's capital stock, as recommended by the board of directors in September, 1920, to 2,500 shares of preferred and 2,500 shares of common. In February, 1923, the capital stock was increased to 4,000 shares of preferred and 4,000 shares of common. No dividends were ever paid on the 1913 company's stock, and no cash dividends were paid by petitioner on its stock although there were some stock dividends.
*950 At some time prior to June 30, 1925, two of the petitioner's principal competitors, the American Kardex Co. and the Rand Co., operated by James H. Rand, Jr., and James H. Rand, Sr., respectively, were consolidated under the name of the Rand-Kardex Co. Later the Library Bureau was absorbed by the Rand-Kardex Co., forming the Rand Kardex Bureau, Inc. Rather than compete with this growing combination of the Rands, the petitioner*1784 accepted an offer to merge with these companies upon the basis of an exchange of stock for stock. The merger took place on or about June 30, 1925, and the stockholders of the petitioner received 11 1/4 shares of stock of the purchasing company for each share held. The stock received in exchange for petitioner's stock was supposed to have had a value of about $20 per share, so that the acquisition of the petitioner's business and assets, the most important part of which was the patents, cost something over $1,000,000. By this transaction the Rand Kardex Bureau, Inc., acquired from the petitioner 17 patents and 30 applications for patents, together with all the rights, title, and interest of the petitioner in and to said patents and applications.
Throughout the periods of existence of the 1913 company and the petitioner, the original patents granted to Fisher on December 24, 1912, were the basic patents of the companies.
The value of the patents for the purpose of exhaustion on June 30, 1920, was not less than $148,617.67.
The respondent allowed the petitioner a net loss for 1921 of $23,209.98, which did not include any allowance for exhaustion of patents, and applied it*1785 against 1922 income in accordance with section 204 of the Revenue Act of 1921.
OPINION.
MORRIS: While the pleaded issues set forth in allegations of error numbered one, three and four contest the respondent's determination respecting the exhaustion of patents, the basic question is the value of those patents for exhaustion purposes.
As stated in our findings of fact, we have determined the value of the patents to be not less than $148,617.67. One of the principal factors influencing this determination is the award of the appraisers appointed by the Supreme Court of New York. Their valuation was made as a result of a controversy between a stockholder and the corporation. In that controversy it was to the interest of the corporation to keep the valuation as low as possible. The record shows that the appraisers made an exhaustive investigation, extending over a period of several months, and were assisted in arriving at their valuation by briefs and reply briefs of the parties. Their award was the basis for the purchase of Hayes' stock by the corporation, *951 and since the valuation was made as of July 14, 1920, we believe it is entitled to considerable weight in*1786 valuing the patents for purposes of exhaustion.
In addition to the above evidence the petitioner offered the opinions of two reputed experts in the visible indexing field, Professor Fisher and Leroi Hutchings. Fisher's qualifications were unquestioned, and he valued the patents in 1920 at $1,000,000. The qualifications of Hutchings were questioned, but his testimony was by no means entirely discredited. He valued the patents as of 1920 at $1,000,000.
Other facts offered by petitioner in support of its valuation of $148,617.67 were its ability to sell its preferred and common stock during the period of reorganization, and the offer of James H. Rand, Sr., to purchase the business and assets in or about 1920 for $150,000.
The basis for the respondent's refusal to allow any value for the patents appears to be the unsatisfactory record of the 1913 company as to earnings. In our opinion the petitioner has adduced proof which satisfactorily explains the causes and reasons for the 1913 company operating at a loss. Considering all the facts in this case, we believe the evidence justifies the value claimed by the petitioner for exhaustion purposes.
In computing petitioner's*1787 taxable income for 1923 due credit should be given for its corrected net loss sustained in 1921 and unabsorbed by its 1922 income as provided in section 204(b) of the Revenue Act of 1921.
Decision will be entered under Rule 50.
Footnotes
1. Profit. ↩