*1528 1. DEDUCTIONS FOR DEPRECIATION - BASIS - In 1934 a corporation was indebted to petitioner in the amount of $3,305.73. The corporation was also indebted to its president and principal stockholder in an amount in excess of $100,000. The tangible assets of the corporation had a value of approximately $20,000. The president of the corporation transferred, as a gift, to petitioner's account from his account on the books of the corporation, a credit in the amount of $16,694.27, and petitioner thereupon acquired all the corporation's assets in satisfaction of his then total claim against the corporation of $20,000. Held, the basis for depreciation of the assets so acquired by petitioner was $20,000 at the time of acquisition.
2. DEPLETION - BASIS. - Held, petitioner is not entitled to percentage depletion on the basis of income derived from the processing, under a royalty contract, of tailings of lead and zinc ores theretofore mined, milled, and deposited on the surface of the land. Atlas Milling Co. v. Jones, 115 Fed.(2d) 61, followed.
*254 This proceeding is for the redetermination of deficiencies in income tax for the years 1935 and 1936 in the amounts of $1,537.66 and $39.86, respectively. The issues submitted for decision involve the amounts petitioner is entitled to deduct from gross income for the taxable years on account of depreciation of certain buildings, machinery, and equipment, and whether or not petitioner is entitled to deductions for depletion on the basis of income from the milling of materials known as tailings or chats, which resulted in the production of marketable lead and zinc ores.
FINDINGS OF FACT.
Petitioner is an individual, residing at Miami, Oklahoma, and for some time prior to 1935 was a stockholder and superintendent of the Pioneer Lead & Zinc Co., a corporation, which had been engaged in *255 the business of mining and milling lead and zinc ores. From time to time petitioner had made advances to the corporation and paid certain of its bills, so that on or about September 11, 1934, it owed him an aggregate of $3,305.73. On the date last stated, the corporation was also indebted to D. L. Larsh, president of the corporation, for loans made by him to*1530 it in the total sum of $105,480.30.
About September 1934 the Pioneer Lead & Zinc Co. shut down its plant and ceased activities. Larsh then caused a credit of $16,694.27 of the sum due him to be transferred from his account with the corporation to the account of petitioner, as a gift, which amount, together with the sum of $3,305.73 which petitioner had previously advanced to the corporation, made an aggregate of $20,000 then owing to petitioner by the corporation. With this credit of $20,000, petitioner acquired on or about September 11, 1934, all of the physical assets of the corporation, consisting principally of a tailings mill, certain ground equipment, air compressor, shovel, truck, locomotive, cars, and livestock.
The assets so acquired by petitioner, other than the tailings mill, were not used by him in his business. The tailings mill was operated by petitioner as an individual during the years 1935 and 1936 under the name of Britt Milling Co. The assets acquired by petitioner from the Pioneer Co. were set up on the books of the Britt Milling Co. at a cost of $20,000.
For the year 1935 petitioner claimed a deduction for deprediation on buildings, machinery, and*1531 equipment in the amount of $4,932.50, based on a cost of $20,000. The Commissioner allowed a deduction for depreciation for 1935 of $1,125 and disallowed the amount of $3,807.50, on the theory that the assets had a depreciable basis to petitioner of not more than $5,000 at the time acquired and a remaining depreciable basis of $4,500 at January 1, 1935.
For the year 1936 petitioner claimed a deduction for depreciation on the same assets in the amount of $4,388.62, of which the Commissioner allowed $1,013.62 and disallowed $3,375, in line with the adjustment made for the prior year. After acquisition of the assets of the Pioneer Co. by petitioner in 1934 and cancellation of the indebtedness of $20,000 then owing to him, the corporation had no other unpaid obligations except an amount due Larsh, which amount was lost by Larsh. He got nothing from the corporation. The assets acquired by petitioner had at that time a salvage value of not less than $20,000. Larsh subordinated his claim against the company to that of petitioner, and consented that the company's assets should be applied entirely to the payment of the indebtedness due petitioner.
Petitioner did not mine or extract*1532 from the earth the materials which were processed in his tailings mill during the years 1935 and 1936, but used materials which are commonly called tailings or chats, *256 consisting of lead and zinc ores that had been partially treated in the prior milling operations and deposited on top of the ground for retreatment to effect further separation and concentration of the minerals therein.
Petitioner did not own the tailings or chats which were processed by him in his mill during the taxable years, but acquired by lease the right to enter upon certain property described in the lease contract and "take from the surface thereof all tailings, slimes and sludge there located, and cause the same to be removed to the tailing mill" of petitioner "to be crushed, cleaned, and the lead and/or zinc ores extracted therefrom and prepared for market." As a consideration for such lease petitioner was to pay 15 percent royalty to the lessor, and in addition a percentage of the profits realized from the operations.
From the processing of the tailings in question, petitioner obtained lead and zinc ores, from the sales of which he realized gross profit and paid royalties to the lessor. A*1533 deduction claimed by petitioner for the year 1935 as depletion in the amount of $8,489.99, with respect to the income derived by petitioner from his operations, was disallowed by respondent in its entirety. No depletion was claimed by petitioner for the year 1936 for the reason that his return for that year disclosed no net income from mining operations.
The operations carried on by petitioner are not known in Oklahoma as "mining", although he extracted the minerals the same as they do in "mining."
Petitioner operated under two leases during the year 1935, one of which was the Good Eagle lease. In his return he claimed depletion with respect to the income from his operations under both leases. During the year 1936 petitioner operated only under the Good Eagle lease. For the year 1935, petitioner now limits his claim to depletion of $4,197.93 on the basis of income derived from his operations under the Good Eagle lease.
Petitioner kept his accounts and returned his income for the taxable years on the basis of cash receipts and disbursements.
An item of $512.22 representing expenditures for labor, supplies, and materials, which was disallowed by the Commissioner as a deduction*1534 for the year 1936, was paid by petitioner in January 1937.
An item of $375.09 representing expenditures for labor, supplies, and materials, which was paid by petitioner in January 1936, was not deducted from income for that year.
On January 5, 1935, petitioner received proceeds from sales of ores which were in transit on December 31, 1934, in the amount of $5,201.89, which amount was included by him in his income reported for the year 1935.
Early in January 1936 petitioner received $4,538.91 representing proceeds from sales of ores in transit on December 31, 1935, which *257 amount was also included by petitioner in his income reported for the year 1935.
OPINION.
HILL: Some of the issues raised in the pleadings have been settled by agreement of parties. These issues relate to the year in which certain deductions should be taken and certain accounts included in gross income. Petitioner kept his books and returned his income on the cash receipts and disbursements basis, and it is now agreed that the deductions in question are properly allowable from gross income for the year in which actually paid, and the items of income are includable for the year in which actually*1535 received. The facts necessary to make the adjustments are set out hereinabove, and will be reflected in the recomputations under Rule 50. If such adjustments result in an increase of the deficiency for the year 1936, respondent has timely made claim therefor, and same will be allowed.
The remaining issues submitted for decision involve (a) the amounts of the deductions allowable on account of depreciation of petitioner's buildings, machinery, and equipment, and (b) whether or not petitioner is entitled to any depletion deductions on the basis of income derived from the milling of tailings or chats.
For the year 1935, petitioner claimed a deduction of $4,932.50 and for 1936 a deduction of $4,388.62 for depreciation on the theory that the buildings, machinery, and equipment had a depreciable basis of $20,000 when acquired. Respondent, using the same rate of depreciation, allowed the amounts of $1,125 and $1,013.62, respectively, on the theory that at the time of acquisition by petitioner the assets had a depreciable basis of $5,000 and at the beginning of the taxable year 1935 had a basis of $4,500.
In September 1934 petitioner acquired the assets in question from the Pioneer*1536 Co. in satisfaction of his claim against the company in the amount of $20,000. The corporation owed petitioner $3,305.73 for money advanced, and the balance of the consideration paid by petitioner for the assets represented a credit of $16,694.27 which D. L. Larsh, president and principal stockholder of the corporation, had caused to be transferred, as a gift, from his account to petitioner's account on the corporation's books. The assets then had a salvage value of not less than $20,000.
The basis for depreciation in respect of the property here involved is the basis for determining gain upon sale or other disposition, section 114(a), Revenue Acts of 1934 and 1936, and such basis is cost, except that, in the case of the property acquired by gift after December 31, 1920, the basis is the same as it would be in the hands of the donor, section 113(a)(2).
*258 So much is agreed to by the parties. But respondent argues that, since the corporation was indebted to Larsh in an amount in excess of $100,000, and its assets were worth only about $20,000, the credit of $16,694.27 transferred by Larsh to petitioner's account had a value in Larsh's hands of only approximately 20*1537 cents on the dollar, and petitioner's basis is the same; also the indebtedness of $3,305.73 owing by the corporation to petitioner for money advanced by him to it, which he exchanged in part for the assets, likewise had a value of not more than 20 cents on the dollar, since the basis is cost and cost is the value of the thing exchanged. Hence, respondent contends that petitioner's total basis at the time of acquisition of the assets was less than $5,000, the basis upon which respondent computed the depreciation deductions allowed by him.
We are unable to agree with respondent's contention on this point. The records show that, in substance and effect, Larsh agreed to subordinate to petitioner's claim so much of the indebtedness owing by the corporation to Larsh as was in excess of $16,694.27 and that petitioner should be permitted to purchase the corporation's assets, worth $20,000, in satisfaction of his aggregate credit of $20,000. Pursuant to such agreement, the credit was transferred by Larsh and the assets were acquired by petitioner. Therefore, at the time of the transfer the credit was worth face value in Larsh's hands, and at the time of the acquisition of the assets, *1538 petitioner's total credit also was worth face value.
Respondent argues further, in an apparent effort to justify his action in disallowing the deductions claimed by petitioner, that petitioner did not use in his business all of the assets acquired from the corporation. In reply, petitioner contends that he is entitled to deduct depreciation on all of the assets for the reason that they were all purchased for business purposes, and were held for such future use, although a portion temporarily was not used during the taxable year. We pass discussion of the point on its merits. Respondent did not determine the deficiency on the basis that only a part of the assets were used in petitioner's business, and no proof was offered in respect of the portion not used. The point was raised for the first time in respondent's brief. This Board will not consider issues of fact not raised by the pleadings. ; ; ; *1539 ; .
Respondent's action on the first issue is reversed.
The second issue presented for decision is whether or not petitioner is entitled to percentage depletion on the basis of income derived from the milling of lead and zinc ores, known as tailings or chats, which petitioner had not mined or extracted from the earth, but *259 processed, under a royalty contract, from ores theretofore milled and deposited on the surface of the land. Precisely the same question, under facts not distinguishable from those of the instant case, was decided adversely to petitioner's contention by the United States Circuit Court of Appeals for the Tenth Circuit in .
In its opinion the court pointed out that the statute authorizes, as a matter of grace, an allowance for depletion in the case of "mines" and that the word "mines" as so used is limited to natural deposits and does not include a tailings dump deposited on the surface of the land, consisting of a residue of ores that has been severed and milled. In an opinion*1540 rendered on rehearing of the same case on October 14, 1940, , the court adhered to the conclusion reached in its former opinion.
In our opinion the court in the cited case correctly decided the question we have here. Accordingly, we hold that petitioner is not entitled to any deduction for depletion in either of the taxable years.
Decision will be entered under Rule 50.