*4318 1. Under a resolution of the board of directors adopted November 7, 1904, and ratified by the stockholders on May 17, 1915, petitioner agreed to pay its officers and certain employees additional compensation out of profits for the fiscal years 1915 and 1916. Prior to the close of the fiscal year 1915, objection to this arrangement was made by a minority stockholder, who, shortly thereafter, instituted an equity action to determine the legal liability of petitioner to pay such additional compensation. To prevent the issuance of a restraining injunction, petitioner and its officers entered into a stipulation by which it was agreed that the additional compensation for said years should not be paid until petitioner's liability had been finally determined upon termination of the litigation. Petitioner kept its books of account by the accrual method, and during the fiscal years 1915 and 1916, credited the accounts of the officers and employees with part of the additional compensation and credited the balance to a so-called contingent fund, the entire amount being charged against surplus. The litigation was terminated by a decision of the appellate court on April 16, 1917, under which*4319 a part of the additional compensation in controversy became due and payable. On the facts, held that petitioner's liability to pay the additional compensation was incurred prior to the beginning of its fiscal year 1917, and being on the accrual basis, it is not entitled to deduct any part of the accrued liability from income for the years 1917 and 1918, as claimed by it. Held, further, that no part of the aggregate amount in controversy may be included in invested capital for the years 1917 and 1918, the amount of $19,752.20 restored to surplus, having been allowed by respondent.
2. Certain amounts expended for plans, drawings, tracings and patterns held on the facts to constitute capital expenditures and the depreciated cost thereof should be included in the petitioner's invested capital.
*1242 These proceedings are for the redetermination of deficiencies in income and profits taxes as follows: For the fiscal year ended September 30, 1917, in the amount of $9,543.97; for the fiscal year ended September 30, 1918, in*4320 the amount of $35,108.29; for the period begun October 1, 1918, and ended December 31, 1918, in the amount of $5,983.92, and for the calendar year 1920, in the amount of $10,580.21. It is stated in the petition that the total amount of $85,637.05 is in controversy. Docket No. 16097 involves the fiscal years ended September 30, 1917 and 1918, and the three-month period ended December 31, 1918. Docket No. 8603 involves the *1243 calendar year 1920. The proceedings were consolidated for hearing and decision.
The principal issues raised under the pleadings are: (1) Whether the petitioner is entitled to a deduction for the Fiscal year ended in 1917, of the sum of $54,845.99, paid to its officers and employees during the said year as salaries or additional compensation for the fiscal years ended in 1915 and 1916; (2) whether the petitioner is entitled to a deduction for the fiscal year ended in 1918, of the sum of $51,326.18, paid to its officers and employees during said year as salaries or additional compensation for the fiscal year ended in 1916; (3) whether petitioner is entitled to have included in the computation of its invested capital for the fiscal year ended in 1917, *4321 the sum of $106,172.17, alleged to represent a reserve fund set up, prior to the beginning of the said fiscal year, to protect its contingent liability for salaries or additional compensation for the fiscal years 1915 and 1916; (4) whether petitioner is entitled to have included in the computation of its invested capital for the fiscal year ended in 1918, the sum of $51,326.18, alleged to represent the balance of a reserve fund set up prior to the beginning of said fiscal year, to protect its contingent liability for salaries or additional compensation for the fiscal year 1916; (5) whether petitioner is entitled to have included in its invested capital for the fiscal years ended in 1917 and 1918, and for the three-month period ended December 31, 1918, the sum of $42,000, representing the depreciated cost of plans and drawings alleged to have been owned and used by it in carrying on its business during said years and period; and (6) whether petitioner is entitled to have included in its invested capital for the fiscal years ended in 1917 and 1918, and the three-month period ended December 31, 1918, the sum of $12,434, representing the depreciated cost of patterns alleged to have been*4322 owned and used by it in carrying on its business during said years and period.
The only issue raised with respect to the deficiency for the calendar year 1920 involves the profits tax for that year to the extent that it is affected by the reduction of invested capital on account of deficiencies determined for the prior years.
FINDINGS OF FACT.
Petitioner is a Pennsylvania corporation, with its principal offices at Coatesville. It was organized in 1890, and is engaged in the business of constructing electric light plants, city waste-disposal plants and steam plants in general. It sometimes also furnishes engines and pumps, but its principal business is the construction of boilers, steel plates, smoke stacks, stand-pipes and tanks.
*1244 From about 1904 to 1913, the petitioner corporation was managed by an executive committee of three, composed of Charles Edgerton, president and chief engineer, Nelson H. Genung, vice president and assistant engineer in charge of sales in the City of New York, and Edwin T. Moore, secretary and treasurer. Edwin T. Moore died during the year 1913, and his place was taken by his brother, F. E. Moore.
On November 7, 1904, the board*4323 of directors of the petitioner adopted the following motion:
That in addition to their present salaries the managers of the company comprising Chas. Edgerton, Nelson H. Genung and Edwin T. Moore Participate from year to year in the net earnings as shown by the books at the close of each business year. The proportion so distributed to be fifty (50%) percentum of the net gain after the regular 8% dividend to the stockholders has been set aside, and is to be equally divided between them, the remaining 50% of profit to be proportioned to wear and tear of plant and machinery and to a surplus or undivided profit account as may be determined by the Board of Managers.
The directors of petitioner, who composed the board of managers above mentioned, devoted their entire time to the business, and in addition to the 50 per cent of the profits, after deduction of the 8 per cent dividend, were paid fixed annual salaries of $4,800 each. The terms of the motion or resolution of November 7, 1904, were carried out for a period of approximately 10 years, and the compensation provided for therein was paid to the managers for the years 1905 to 1913, both inclusive. No additional compensation was*4324 paid to the managers out of profits for the fiscal year ended in 1914, for the reason that no profits were available for the purpose in that year.
In 1914, a minority stockholder objected to the arrangement had by petitioner with its managers in respect to the compensation paid them and his objections were brought before the stockholders. A stockholders' meeting was held on May 17, 1915, at which a resolution was adopted ratifying and approving the action of the board of directors in paying to Edgerton, Genung, and Edwin T. Moore, as managers of the company, a share of the profits equal to 50 per cent of the net profits of the business at the end of each year from 1904 to 1914, in accordance with the resolution of the board of directors adopted at the meeting of November 7, 1904. This resolution further approved the method of arriving at the amount of the net profits by the board at the end of each year.
At the meeting of May 17, 1915, the stockholders also adopted another resolution reading as follows:
RESOLVED, that the Board of Directors of this Company be and are hereby authorized and directed for and on behalf of the company to enter into an agreement with Charles Edgerton, *4325 Nelson H. Genung, and such other employees of the Company as they may deem proper, for the payment, (in *1245 addition to their present salary) from year to year of fifty per cent, of the net earnings, as shown by the books at the close of each business year, after the regular eight per cent (8% dividend to stockholders has been set aside; this fifty per cent to be divided between them as follows: one-third thereof to be paid to Charles Edgerton, one-third thereof to Nelson H. Genung and the remaining one-third to such of the employees of the Company, as the Board of Directors may from time to time determine upon, the remaining fifty per cent per annum to be apportioned to wear and tear of plant and machinery, and to a surplus or undivided profit account, as may be determined by the Board, and in the same manner as heretofore practiced and carried out under the Resolution adopted November 7th, 1904.
Thereafter the following letter was sent by the dissenting minority stockholder to the board of directors of the petitioner:
Philadephia, July 9, 1915.
To the Board of Directors of the Coatesville Boiler Works.
Gentlemen: I am a stockholder in the Coatesville Boiler Works, *4326 a corporation under the laws of Pennsylvania, and hold 100 shares of stock in said corporation, and have held said shares of stock since the organization of the company.
Under a motion or resolution adopted by the Board of Directors of the Coatesville Boiler Works on November 7th, 1904, certain managers, officers and directors of said corporation have participated at the close of each business year, since that date, in the net earnings of said company to the extent of fifty per cent of the net gain of said company, after the regular eight per cent dividend to the stockholders had been first deducted.
I am advised by counsel that the amount so paid to said managers, officers and directors was unlawful, and was in fraud of the rights of stockholders, and should be recovered back by said corporation. You are fully acquainted with the facts in the matter.
The managers, officers and directors of said company to whom said payments were made from 1904 to date are: Charles Edgerton, Nelson H. Genung, Edwin T. Moore, and whomever else appear upon the Minutes of your Board or the Minutes of your corporation as having received said payments.
You are hereby requested to immediately*4327 demand back the amount of net earnings of said company so paid to said managers, officers and directors of said company, and to authorize suit to be brought in the name of said corporation against said managers, officers and directors for said purpose, or to authorize me to bring suit in the name of said corporation against said managers, officers and directors, for said purpose.
I am advised the Directors will hold a meeting on the second Tuesday of July, 1915. Please present this communication at said meeting.
Please advise me promptly, by the Secretary of your Board, after that meeting, what action was taken by your Board upon this communication.
I will wait until July 19, 1915, for a reply to this letter, addressed to me or to my counsel, J. Barton Rettew, Esq., Stephen Girard Building, Philadelphia. If I receive no reply by that date, I will understand that you decline to make said demand and to direct and authorize suit by said corporation against said managers, officers and directors, to whom said payments were made, or to authorize me to bring suit as herein stated.
Very truly yours,
(Signed) Frederick Sotter,
Address: Coatesville, Pa.
*1246 On or*4328 about October 16, 1915, the said Frederick Sotter, on behalf of himself and such other stockholders of the Coatesville Boiler Works, who might desire to intervene and become parties plaintiff therein, filed a bill in equity against the Coatesville Boiler Works, Charles Edgerton, Nelson G. Genung and H. Blanche D. Moore, W. Park Moore and Fred E. Moore, executors of the Estate of Edwin T. Moore, deceased, in the Court of Common Pleas of Chester County, Pennsylvania, in which he alleged, among other things, that the resolution of the board of directors of November 7, 1904, was ultra vires; that the payments made thereunder to Edgerton, Genung and Edwin T. Moore were unlawful and in fraud of the rights of the stockholders of said corporation; that the receipt of said payments by said persons was fraudulent and unlawful; that the sums of money so paid were illegally paid out of the net earnings of the corporation, and should be distributed to the stockholders as dividends on the stock held by them.
Sotter, in his said bill, prayed for relief, inter alia, as follows: (1) That the court declare null and void the resolution of November 7, 1904, and any other motions or resolutions*4329 subsequently passed by the board of directors of the said corporation, which relate thereto, whether supplemental, enabling or ratifying in character; (2) that pending the bill, the said corporation, its officers, directors, agents and servants, by injunction, preliminary until hearing and perpetually thereafter, be restrained from taking any further action, by resolution, motion, agreement or otherwise, relating to said resolution of November 7, 1904, for the purpose of supplementing, attempting to ratify or validate said resolution or from further complying with or carrying into effect the terms of said resolution of November 7, 1904; (3) that pending the bill, the said corporation, its officers, directors, agents and servants, by injunction, preliminary until hearing and perpetually thereafter, be restrained from making any payment or payments under the terms of the resolution of November 7, 1904, or under or by virtue of any supplemental, enabling or ratifying resolution or motion by the said corporation or its board of directors; and (4) that pending the bill, the said corporation, its officers, directors, agents and servants, by an injunction, preliminary until the hearing and*4330 perpetually thereafter, be restrained; (a) from entering into any agreement or agreements with said Charles Edgerton, Nelson H. Genung or any other officer or officers, employee or employees of said company, relating to the payment of amount or amounts, annually or otherwise, from the net earnings of said company, in the nature of a premium or bonus, and in excess of the salary or salaries, lawfully paid, in accordance with the lawful action of said corporation or its board of directors; (b) from making any *1247 payments under any such agreement or agreements, alleged to have been theretofore entered into or executed by the said corporation.
On November 8, 1915, a hearing was held on the said bill in equity in the said Court of Common Pleas on a motion for a preliminary injunction, at which hearing the Court being about to grant an injunction restraining the Coatesville Boiler Works from making any payments during the pendency of the said bill, counsel for the respective parties executed a stipulation, which was filed with the court, and which provided that the fund in the hands of the treasurer of said corporation, representing the portion of the net earnings of the corporation*4331 for the fiscal year ended in 1915, which the managers and employees claimed was payable to them, would not be distributed under the resolution of the board of directors adopted November 7, 1904, or under the resolution adopted at the meeting of the stockholders in 1915, until the then pending proceeding was finally determined.
Following the hearing on the motion for a preliminary injunction a hearing on the bill was had in said Court of Common Pleas, which, on December 29, 1915, filed its opinion and preliminary decree. Thereafter, exceptions were filed by the parties, and on April 3, 1916, said court filed its opinion dismissing all exceptions, and entered its final decree as follows:
The Coatesville Boiler Works, one of the defendants, and all of its agencies, are restrained from making any payment under its directors' resolution of November 7, 1904, subsequently ratified by its stockholders, of any part of its net profit of $102,456.60 for the fiscal year ending in 1915 to Fred E. Moore; and this fund will not be depleted by virtue of the recited resolution and its ratification, beyond the payment of one-third of 50 per cent of it to Charles Edgerton and one-third of 50 per*4332 cent of it to Nelson H. Genung. Annually hereafter out of the so-called net profits the Coatesville Boiler Works is restrained from paying to Edgerton and Genung greater sums than with their fixed salaries will give to each $12,000. It is further directed that the Coatesville Boiler Works shall pay the costs of this suit.
An appeal was prosecuted to the Supreme Court of Pennsylvania, which handed down its opinion on April 16, 1917. The appellate court in its opinion held in substance that all salaries and bonuses voted to the officers and employees of the corporation for the fiscal years ended 1915 and 1916, should be paid, with the exception of $19,752.20 of the amounts voted to Edgerton and Genung for the fiscal year ended in 1915, this amount being withheld because of the fact that the lower court had found that $12,000 for each was reasonable compensation, and this particular finding had not been assigned as error. ; . During the war period, the business of the petitioner was largely increased, approximating double the amount done theretofore. Prior to the war, petitioner's business*4333 amounted to about $1,000,000 per year, and during the war period it amounted to about $2,000,000 *1248 per year. Likewise, the duties of the executives of the corporation were increased; they were required to do more work and worked harder during the war period than theretofore.
The amount of the net profits of the petitioner corporation for the fiscal year ended in 1915, payable to its officers and employees under the directors' resolution of November 7, 1904, and the stockholders' resolution adopted May 17, 1915, was $51,228.32. This amount was charged against profit and loss and credited to the accounts of the respective officers and employees on petitioner's books in the closing entries as of September 14, 1915, as follows:
| Debit | Credit | |
| 339 Profit and loss | $51,228.32 | |
| 7 Charles Edgerton | $17,076.10 | |
| 25 Nelson H. Genung | 17,076.10 | |
| 386 Fred E. Moore | 7,076.12 | |
| 228 Penrose N. Davis | 5,000.00 | |
| 264 Harry R. Walton | 3,000.00 | |
| 387 John F. Jackson | 2,000.00 | |
| $51,228.32 | $51,228.32 |
The net profits of petitioner for the fiscal year ended in 1916, which, under the resolutions of November 7, 1904, and May 17, 1915, were to be apportioned*4334 50 per cent to the officers and employees and 50 per cent to undivided profits, amounted to $149,392.10, as shown by the petitioner's books. In the closing entries for the fiscal year 1916, under date of September 14, 1916, the amount of $74,696.05 or one-half of the said net profits, was transferred from the profit and loss account to undivided profits as follows:
| Debit | Credit | |
| 680 Profit and Loss | $74,696.05 | |
| 690 Undivided Profit | $74,696.05 |
The balance of the net profits for the fiscal year 1916, or the like amount of $74,696.05 was transferred from the profit and loss account to the credit of the officers and employees in part and to the credit of a contingent fund in part, as follows:
| Debit | Credit | |
| 680 Profit and Loss | $21,600.00 | |
| Management: | ||
| 96 Charles Edgerton | $7,200.00 | |
| 96 Nelson H. Genung | 7,200.00 | |
| 306 Fred E. Moore | 2,880.00 | |
| 227 Penrose N. Davis | 2,160.00 | |
| 227 Henry R. Walton | 1,440.00 | |
| 306 John F. Jackson | 720.00 | |
| 680 Profit and Loss | 53,096.05 | |
| 154 Contingent Fund | 53,096.05 | |
| $74,696.05 | $74,696.05 |
*1249 An explanation of the contingent fund was set forth on petitioner's books as follows:
| Statement Losses & Gains. |
| Sept. 14, 1916. |
*4335 * * *
| Profit & Loss | ||
| Contingent fund | ||
| Charles Edgerton | $17,698.68 | |
| Nelson H. Genung | 17,698.68 | |
| Fred E. Moore | 7,079.47 | |
| Penrose M. Davis | 5,309.61 | |
| Henry R. Walton | 3,539.74 | |
| John F. Jackson | 1,769.87 | |
| $53,096.05 |
The amount of $51,228.32 credited to the officers and employees of the petitioner at the close of the fiscal year 1915, plus the amount of $21,600 credited to the officers and employees, and the amount of $53,096.05, credited to the contingent fund, at the close of the fiscal year 1916, makes the total sum of $125,924.37.
Under the opinion of the Supreme Court of Pennsylvania, rendered on April 16, 1917, the total compensation payable to Edgerton and Genung, for the fiscal year ended in 1915, was the sum of $12,000 each. They had each been credited on the books of the petitioner with the amount of $17,076.10, representing their respective shares of the net profits at the close of the fiscal year 1915. Each had also received a fixed salary of $4,800 for that year, and was entitled under the court's decision to receive only the additional amount of $7,200 out of the profits. Accordingly, under date of August 20, 1917, the accounts of Edgerton*4336 and Genung on the petitioner's books were each charged with the amount of $9,876.10, and the surplus account credited with the aggregate amount of $19,752.20.
The total amount credited to the accounts of the officers and employees as compensation for the fiscal years 1915 and 1916, plus the amount credited to the contingent fund at the close of the fiscal year 1916, less the amount charged back against the accounts of Edgerton and Genung and credited to surplus, makes the net amount of $106,172.17, which, under the court decisions, was payable out of the net profits credited to the officers and employees and the contingent fund in the total amount of $125,924.37 as additional compensation for the fiscal years 1915 and 1916. Of this amount, the sum of $54,845.99 was paid to the officers and employees of the petitioner during the *1250 fiscal year ended in 1917 and the sum of $51,326.18 was so paid during the fiscal year ended in 1918, as follows:
| May 1, 1917 Fred E. Moore | $7,076.12 | |
| H. R. Walton | 3,000.00 | |
| P. M. Davis | 5,000.00 | |
| John F. Jackson | 2,000.00 | |
| May 29, 1917 Charles Edgerton | 7,200.00 | |
| N. H. Genung | 7,200.00 | |
| $31,476.12 |
The above amounts*4337 were paid and charged against the credits to the respective accounts made under date of September 14, 1915, as compensation for the fiscal year 1915, the total amount of the credits so entered being $51,228.32. The difference between the total amount paid and the total credits, or the amount of $19,752.20, was charged equally to the accounts of Edgerton and Genung, and credited to surplus, on August 20, 1917.
On May 29, 1917, the petitioner also paid to its officers and employees the amount of $21,600 representing the credits entered under date of September 14, 1916, as additional compensation for the fiscal year ended in 1916. On August 22, 1917, the amount of $1,769.87 was paid to John F. Jackson as additional compensation for the fiscal year ended in 1916, being the amount credited in his name to the contingent fund under date of September 14, 1916.
There were thus paid by the petitioner to its officers and employees, during the fiscal year ended in 1917, the amount of $31,476.12, as additional compensation for personal services for the fiscal year 1915, and the amounts of $21,600 and $1,769.87 as additional compensation for personal services for the fiscal year 1916, or*4338 the total amount of $54,845.99, so paid for personal services during the fiscal year ended in 1917.
On November 9, 1917, during the fiscal year ended in 1918, the petitioner paid to its officers and employees the sum of $51,326.18, as additional compensation for personal services for the fiscal year 1916, this being the amount of the contingent fund of $53,096.05 set up under date of September 14, 1916, less the amount of $1,769.87 credited therein to John F. Jackson and theretofore paid on August 22, 1917.
From the beginning of its operations, petitioner prepared plans, drawings and tracings of each article manufactured by it, and carefully preserved in fire-proof vaults the plans, drawings and tracings so prepared, which now number approximately 8,000. About 20 per cent of the petitioner's current business consists of duplicate orders for parts or articles theretofore manufactured by it, which duplicate orders are executed from the old plans, drawings and tracings *1251 Such old drawings and tracings are also consulted from time to time in the preparation of new plans, drawings and tracings, for articles to be manufactured of a design or character similar to those previously*4339 manufactured, although not exact duplicates. Petitioner charged to current expense all expenditures for plans, drawings, and tracings, no part of such expenditures being set up on the books as a capital investment. The said plans, drawings, and tracings have an average useful life of 20 years, and during the years 1906 to 1917, both inclusive, petitioner expended on such account the total sum of $98,196.64. While the old plans, drawings and tracings were made in the first instance primarily for use in connection with the manufacture of specific articles for which orders had been received, they also possessed a material value to the petitioner, in the nature of a capital asset, and were actually used by it in carrying on its business through the subsequent years. The petitioner expended in each year for plans, drawings and tracings the following amounts:
| Plans, drawings, and tracings | |
| 1906 | $1,912.50 |
| 1907 | 5,812.50 |
| 1908 | 6,365,16 |
| 1909 | 6,347.50 |
| 1910 | 5,815.00 |
| 1911 | 7,668.45 |
| 1912 | 9,710.00 |
| 1913 | $10,545.50 |
| 1914 | 9,803.33 |
| 1915 | 10,357.78 |
| 1916 | 11,894.96 |
| 1917 | 11,963.96 |
| Total | 98,196.64 |
The foregoing amounts represent the salaries paid by the petitioner*4340 in each year to its draftsmen and other employees engaged exclusively in the preparation of the plans, drawings, and tracings, and do not include the cost of materials used, nor any portion of overhead expense.
All plans, drawings, and tracings used by the petitioner were made in its own plant, and after the plans, drawings, and tracings for the manufacture of a certain article had been so prepared, a pattern was then made for each casting to be used in the manufacture of that article. Petitioner did not operate a pattern shop, but purchased its patterns from other concerns by whom they were made from the petitioner's plans, drawings and tracings.
While the patterns were manufactured primarily for use in connection with specific orders, they also possessed a value to the petitioner in the nature of a capital asset, as they were preserved and used thereafter in filling duplicate orders. The patterns also have an average useful life of 20 years. The amounts paid out by petitioner for patterns were charged to a pattern account up to and including the fiscal year 1916. At the close of that year, the balance of the pattern account was charged to profit and loss, and the *1252 *4341 amounts expended for patterns during the years 1917 and 1918 were charged directly to profit and loss, no part of such expenditure being set up on the books as capital. At the beginning of the year 1898, the petitioner's pattern account showed a depreciated balance of $1,811.02. The amounts expended thereafter for patterns, including the 1898 depreciated balance, are as follows:
| Patterns - Amount expended | |
| 1898 | 1 $1,811.02 |
| 1898 | 717.24 |
| 1899 | 937.63 |
| 1900 | 1,630.15 |
| 1901 | 898.11 |
| 1902 | 2,141.70 |
| 1903 | 1,426.28 |
| 1904 | 1,537.46 |
| 1905 | 1,545.23 |
| 1906 | 1,521.11 |
| 1907 | 1,637.86 |
| 1908 | 782.16 |
| 1909 | $2,105.98 |
| 1910 | 2,186.39 |
| 1911 | 3,284.47 |
| 1912 | 3,842.83 |
| 1913 | 3,424.89 |
| 1914 | 2,038.46 |
| 1915 | 2,918.73 |
| 1916 | 3,004.69 |
| 1917 | 2,837.29 |
| 1918 | 1,626.95 |
| Total | 43,856.63 |
During the taxable years and period involved herein, petitioner kept its books of account substantially on the accrual basis, and computed its net income and made its tax returns on the same basis. The deficiencies involved were computed by the respondent on the accrual basis. The petitioner's returns were filed with the collector of internal*4342 revenue at Philadelphia, Pa.
OPINION.
TRAMMELL: The principal issues involved herein may be divided into three groups of two each. The first group comprises the questions (1) whether the petitioner is entitled, in computing its taxable income for the fiscal year ended in 1917, to deduct as a business expense the amount of $54,845.99, paid to its officers and employees during that year as additional compensation for the fiscal years ended in 1915 and 1916, and (2) whether petitioner is entitled, in computing its taxable income for the fiscal year ended in 1918, to deduct as a business expense the amount of $51,326.18, paid to its officers and employees during that year as additional compensation for the fiscal year ended in 1916.
The second group comprises the questions (1) whether petitioner is entitled to have included in its invested capital for the fiscal year 1917, the amount of $106,172.17, part of which was credited to its officers as additional of compensation and part of which was set up as a contingent fund, both amounts being charged against surplus prior to *1253 the beginning of that year, and (2) whether petitioner is entitled to include in invested capital*4343 for the fiscal year 1918, the amount of $51,326.18, being the amount remaining in the contingent fund at the beginning of that year.
The third group comprises the questions (1) whether petitioner is entitled to include in its invested capital for the fiscal years and period in question the depreciated cost of plans, drawings, and tracings used in its business, and (2) whether it is entitled to include in invested capital for said fiscal years and period the depreciated cost of its pattern account. In connection with these principal issues, several minor or preliminary issues arise.
The only issue involving the calendar year 1920 relates to the profits tax insofar as it is affected by the reduction of invested capital on account of the deficiencies determined for the prior years. At the hearing, the parties stipulated that proper adjustments to invested capital for all years would be made on the basis of the deficiencies finally determined for the prior years. It is unnecessary, therefore, to give further consideration here to the deficiency for the calendar year 1920.
The issues raised with respect to the fiscal years ended in 1917 and 1918, and the three-month period ended*4344 December 31, 1918, will be considered in the order hereinbefore indicated.
During the fiscal year ended September 30, 1917, the petitioner paid to its officers and employees, on the dates and under the circumstances detailed in our findings of fact, supra, the total sum of $54,845.99 as additional compensation for the fiscal years 1915 and 1916. During the fiscal year ended September 30, 1918, petitioner paid to its officers and employees the total sum of $51,326.18 as additional compensation for the fiscal year 1916. Thus, during the fiscal years 1917 and 1918 petitioner so paid the aggregate amount of $106,172.17.
Petitioner contends that it kept its books of account on the basis of cash receipts and disbursements, and that, in computing its net income for each of said fiscal years, it is entitled to deduct as a business expense the amount so expended in each year, respectively. The respondent refused to allow the deductions claimed, or any part thereof, for the fiscal years 1917 and 1918, on the theory that the petitioner kept its books on the accrual basis, should have accrued said amounts in the fiscal years 1915 and 1916, and should have taken the deductions for*4345 those years.
The first question presented in this connection, therefore, concerns the basis upon which the petitioner kept its accounts, that is to say, whether petitioner kept its accounts upon the basis of cash receipts and disbursements, or "upon any basis other than that of actual *1254 receipts and disbursements." The record contains no suggestion that the method actually used by the petitioner in keeping its accounts does not clearly reflect its income, and hence under the statute its tax must be computed upon its net income ascertained in accordance with such method.
The petitioner contends that, during the years here involved it kept its books of account and computed its net income on the basis of cash receipts and disbursements, while the respondent contends that the petitioner kept its books, computed its net income and made its tax returns on the accrual basis.
We have found, as set out in our findings of fact hereinabove, that the petitioner kept its books of account substantially on the accrual basis during the taxable years and period involved, although minor items of deferred charges and credits may not have been accrued. This conclusion is reached on*4346 the evidence in the record before us, which shows that in determining the cost of goods sold, the petitioner took into consideration opening and closing merchandise inventories; that goods were sold on credit, the amount being credited to sales and debited or charged to accounts receivable; that when payments were made on accounts receivable, such accounts were credited accordingly and the amounts debited or charged to cash; that when an account receivable was found to be uncollectible, the amount was charged as a loss and a deduction therefor taken in the petitioner's tax return. The books also included accounts payable, and notes receivable and payable, and such items were given consideration in computing net income.
In considering a similar situation in , we said:
The first question - that of whether the taxpayer kept its books of account on an accrual basis - is not difficult of solution. We found as a fact, above, that the taxpayer carried inventories and notes and accounts receivable and payable on its books, and in determining its income these items were given consideration. In view of these facts we can not hold otherwise*4347 than that the taxpayer operated on an accrual basis. The mere fact that some deferred charges and credits to income may not have been included in the accounts carried can not destroy the principle upon which the system of accrual bookkeeping is based.
See also .
At the hearing, after the introduction of considerable evidence tending to show that the petitioner kept its books on the accrual basis, counsel for the petitioner sought to show that its books were in fact kept on a sort of hybrid basis, or partly on the basis of cash receipts and disbursements and partly on the accrual basis, because of the fact that certain minor items consisting of interest, taxes, *1255 insurance and work in process were not accrued. However, we are not convinced by this evidence that the method of accounting regularly employed by the petitioner in keeping its books was not fundamentally the accrual method. The evidence as a whole shows that the petitioner kept its books and computed its income on the accrual basis. The fact that some deferred items were not accrued may indicate defective bookkeeping, but can not change the fundamental basis upon*4348 which the books were kept.
The evidence also shows that the respondent, in determining the deficiencies involved herein, computed the petitioner's net income by the accrual method. Since that method appears in any event to approach more closely the predominating method employed by the petitioner, the action of the respondent in so computing the net income must be approved. .
Having determined that the petitioner kept its books of account and computed its net income by the accrual method, it follows that the amounts in controversy constitute lawful deductions from income only for the year or years in which the liability therefor was incurred. In order that an item may be accrued, the liability must actually be incurred in the taxable year. .
A deduction can not be taken for a year in which the liability was not incurred. .
When was the liability here incurred? A careful consideration of all the facts and circumstances set out in our findings of fact, supra, leads us to the conclusion that petitioner incurred the liability*4349 in 1915 and 1916 to pay the respective amounts authorized for those years.
The facts show that the additional compensation in question was authorized by the directors' resolution of 1904, which was ratified and confirmed by the resolution of the stockholders of May, 1915. The services were rendered and the obligation to pay in accordance with the resolution became final. Just prior to the close of the fiscal year 1915, the amounts authorized for that year were formally accrued on the petitioner's books, and at that time there was no legal obstacle to the payment of the money.
With respect to 1915, therefore, it is our opinion that the petitioner incurred liability to pay the aggregate amount authorized for that year on September 14, 1915, when the amount was ascertained and entered upon the books.
On September 14, 1916, the amounts authorized for the fiscal year 1916 were accrued on the petitioner's books, although litigation was pending at that time and payment could not be made because of the stipulation entered into to prevent the issuance of an injunction. *1256 However, in determining the year for which a deduction may be taken by a taxpayer on the accrual basis, *4350 the date of the actual payment is immaterial.
And with respect to 1916, it is our opinion that the petitioner incurred liability to pay the aggregate amount authorized for that year on September 14, 1916, when the amount was ascertained and entries were made on the books, notwithstanding litigation was then pending, which, at some time in the future, might or might not have the effect of defeating that liability in whole or in part. The corporation did not deny the liability, but contended at all times that it was legally responsible for the compensation. The litigation was instituted by a minority stockholder to prevent the corporation from paying the compensation agreed to be paid. The court of last resort in 1917 upheld the corporation and held that the compensation should be paid for that year in accordance with the resolution. The decision of the court, however, did not create the liability to pay. That liability existed by virtue of the fact that the corporation had agreed to pay and the fact that the services were rendered. The corporation itself had never denied its liability which existed in 1916. The court merely affirmed the action of the corporation. See *4351 .
For the foregoing reasons we are impelled to conclude that the petitioner did not incur any liability with respect to the amounts in controversy during either of its fiscal years ended in 1917 or 1918, and is not entitled to a deduction of any amount from the income for those years on that account. Accordingly, the action of the respondent in denying the deductions claimed by the petitioner for 1917 and 1918 is approved.
The issues of the second group relate to the inclusion in invested capital of the amounts credited to the accounts of the officers and employees, and the amount credited to the contingent fund, on the books of the petitioner during the fiscal years 1915 and 1916. Of the total credits in the amount of $125,924.37, the amount of $19,752.20 was held by the courts not to be payable, and on August 20, 1917, this amount was charged against the officers' accounts and credited back to surplus. The respondent included in the computation of the petitioner's invested capital the amount of $19,752.20 so returned to surplus, but refused to include the other amounts, or any part thereof, credited to the accounts of the officers*4352 and employees, and the contingent fund. The petitioner contends that the aggregate net amount of $106,172.17 excluded by the respondent should be included in its invested capital for 1917. During the fiscal year 1917, the petitioner paid against said credits the amount of $54,845.99, thus *1257 leaving to the credit of the contingent fund at the beginning of its fiscal year 1918 a balance of $51,326.18, which amount petitioner contends should be included in its invested capital for the latter year.
Having reached the conclusion above set forth, that the petitioner incurred the liability on September 14, 1915, to pay the amounts authorized and accrued for its fiscal year 1915, and incurred the liability, on September 14, 1916, to pay the amounts authorized and accrued for its fiscal year 1916, petitioner is not entitled to include in its statutory invested capital for 1917 and 1918, any part of said amount of $106,172.17. Since the petitioner had incurred the liability to pay and had accrued on its books the aggregate net amount of $106,172.17 prior to the beginning of its fiscal year 1917, the amount on that date had ceased to be a part of the petitioner's invested capital. *4353 It then became an obligation or liability. It was owing to the officers and in effect was borrowed capital, which may not be included in the computation of its invested capital. A corporation is not entitled to include in invested capital items of salary credited to stockholders but not drawn by them. . Such items represent borrowed capital, . Accordingly, the action of the respondent, in respect of the issues of the second group, is approved.
The third group of issues relates to the inclusion in invested capital of amounts expended by the petitioner for (1) plans, drawings, and tracings, and (2) patterns, which were used by it in its business. The petitioner contends that it is entitled to include the depreciated cost of those items in its invested capital, while the respondent contends "that the petitioner has neither established the cost or the March 1, 1913, value of the plans and drawings in use and therefore is not entitled to include in invested capital the amount of $42,000 as contended for by the petitioner." And with respect to patterns, the respondent contends*4354 that "there is no competent evidence of record to warrant the conclusion that the petitioner is entitled to include in invested capital any amount on account of the purchase of patterns."
The evidence in the record before us discloses that it was necessary for the petitioner to prepare detailed plans, drawings, and tracings of each boiler or other article before its manufacture could be commenced. It was also necessary to make a pattern for each casting before it could be manufactured. These plans, drawings, and tracings, as well as the patterns, were thereafter carefully preserved and the former were kept in fire-proof vaults. In fact, so valuable did the petitioner regard the former that duplicates were kept in separate vaults, so that if one set should be destroyed, the other *1258 would be available. After the manufacture of a particular article, the plans, drawings, and tracings were preserved for use in connection with the manufacture of duplicate orders in the future. The plans, drawings, and tracings were in many instances also valuable in preparing the engineering data for the manufacture of similar, although not exactly duplicate, articles. During the years*4355 involved, approximately 20 per cent of the petitioner's gross business consisted of duplicate orders, executed from the old plans, drawings, tracings and patterns. These assets were actually used by the petitioner in carrying on its business from year to year, and had a useful life extending over an average period of 20 years. We think that these facts clearly establish that the expenditures in question were capital rather than expense. Such expenditures resulted in the acquisition by the petitioner of additional assets having a useful life of 20 years, and which were actively and continuously used by it in carrying on its business. In fact, the evidence justifies the conclusion that the petitioner could not successfully have operated its business without these assets.
In , the Supreme Court said at page 420:
Theoretically, the expenses chargeable to earnings include the general expenses of keeping up the organization of the company, and all expenses incurred in operating the works and keeping them in good condition and repair; while expenses chargeable to capital include those which are incurred in the*4356 original construction of the works, and in the subsequent enlargement and improvement thereof.
In considering what constitutes a business expense and what constitutes a capital investment, we said, in :
Generally speaking, items to be deductible [as business expenses] must be those ordinary and usual expenditures incurred in the conduct of a going business. * * * On the other hand, amounts expended for assets that are to continue in use in the business over several years are usually to be classified as capital items. * * *
It is shown that the assets here in question had a useful life of 20 years, and were actually used in the petitioner's business over that period. To constitute invested capital, it remains then only to determine their cost. The amount of salaries or wages paid to regular employees, while engaged exclusively in the creation of a capital asset, may be included in invested capital. .
Here, however, the petitioner seeks to include in invested capital not only the cost of the patterns and the amount of the salary paid to its employes who were*4357 engaged exclusively in the preparation of *1259 the plans, drawings, and tracings, but also the amount of $2,400 for each year, or one-half of the fixed salary paid to its president and chief engineer, as representing a proper allocation to the cost of the assets of the compensation paid him, on account of his supervision of the drafting room. It does not appear from the evidence that the duties of the president and chief engineer were generally different from those of a chief corporate executive officer, except that in addition to such duties he also supervised the engineering work or preparation of the plans, drawings, and tracings. No additional compensation was paid to him on account of such supervision.
In , we held that certain amounts, in addition to stated salaries, paid to the general manager and plant superintendent of the petitioner corporation for services in supervising the construction of plant buildings, were capital expenditures. In that connection we said:
To secure the services of these men for the purposes here indicated, the petitioner paid each of them the amount of $50,000, which was in addition*4358 to remuneration for services connected with the operation of the enterprise. We are of the opinion that these payments were capital expenditures and should be included in the computation of the petitioner's invested capital for profits-tax purposes in each of the taxable years.
Cf. .
In each decision above cited, a definite amount, paid to the corporate officers exclusively for their services in that connection, entered directly into the cost of the capital assets. The evidence in the instant case is vague and uncertain with respect to the amount of time devoted by the president and chief engineer of the petitioner to the supervision of the work of preparing the plans, drawings and tracings. No additional compensation was paid to him for such services, and we are unable to say that any part of the compensation paid to its president and chief engineer may properly be included in the cost to the petitioner of said assets. The petitioner's contention on this point must, therefore, be denied.
In our findings of fact above, we have set out the amount which the evidence shows was actually expended by the petitioner*4359 in each year for patterns, and for the services of employees engaged exclusively in the preparation of the plans, drawings and tracings, which, in our opinion, constitute capital expenditures. The fact that those expenditures were improperly charged to expense, and so reported in the petitioner's tax returns, does not preclude the correction of the error here. The nature of the expenditure must be determined from the facts. ; .
*1260 In computing the petitioner's invested capital for the fiscal years ended in 1917 and 1918, and the three-month period ended December 31, 1918, there should be included the depreciated cost of (1) plans, drawings and tracings, and (2) patterns, based on the amounts of the yearly expenditures set out in our findings of fact above, the depreciation to be computed upon the basis of a useful life of 20 years.
Reviewed by the BOARD.
Judgment will be entered on 20 days' notice, under Rule 50.
Footnotes
1. Depreciated balance at beginning of year. ↩