*1842 1. Reasonable deductions for officers' salaries determined.
2. Respondent's determination of income derived by petitioner as lessor on account of the erection of improvements upon a leased property approved.
*654 This proceeding results from the respondent's rejection of claims in abatement for the years 1924 and 1925 in the amounts of $2,095.40 and $2,532.01, respectively, being in each instance the full amount of the abatement claim. The petitioner also purports to seek a redetermination for the year 1923, as to which year the respondent, so far as the record before us reveals, has not determined a deficiency. We, therefore, do not have jurisdiction to consider petitioner's tax liability for that year. The proceeding, so far as it relates to the year 1923, is dismissed.
The petition asserts error for the years 1924 and 1925 in the disallowance in part of deductions claimed as expenses for officers' salaries and the inclusion in income of a pro rata portion of the cost of a certain building erected by a lessee on land owned by a subsidiary of*1843 the petitioner. For the year 1925 the petitioner alleges a further error in the disallowance of the $2,000 specific credit provided by section 236 of the Revenue Act of 1924.
FINDINGS OF FACT.
The petitioner is a New York corporation with its principal place of business at Niagara Falls, N.Y.
The petitioner was organized in 1886 for the purpose of engaging in the manufacture of ice and the cold storage business. It also engages in the coal business. During the taxable years involved the officers of the petitioner were John T. Williamson, president and treasurer, and William H. Williamson, vice president and secretary. The two officers mentioned have each been engaged in the ice, cold storage and coal business for approximately forty years.
In December, 1922, the petitioner acquired by purchase the entire capital stock of the Niagara Falls Ice Manufacturing & Storage Company, hereinafter termed the Niagara Company, also located at Niagara Falls. The business of this company was continued under its own name during the taxable years involved. The Williamsons *655 each devoted approximately fourteen hours per day to their duties with the petitioner and the Niagara*1844 Company. They alternated in periods of supervising the early morning activities of the businesses which commenced about 4 a.m., and consisted of having the delivery trucks loaded, routed, etc. During the day one of them directed the business of the petitioner while the other directed that of the Niagara Company, and they interchanged these duties at times. At each plant it was necessary for them to superintend the mechanical operations, soliciting, deliveries, and purchases of coal and ice. In connection with the cold storage business, especially that of the Niagara Company, the companies involved commonly financed the products stored, particularly, apples. Their financing consisted of advances to the parties placing the apples in storage, the amount of such advances running as high as $1.50 per box and totaling approximately $200,000 per year. Storage fees on apples are about 15 cents per box. The funds for financing storage products were mostly borrowed from banks, the negotiation of such loans being among the duties of the Williamson brothers.
The Niagara Company rented certain cold storage space to Swift & Company, meat packers, and also to the Peerless Ice Cream Company, *1845 hereinafter termed the Peerless Company, and it was necessary for the petitioner's officers to see that such rented space was adequately refrigerated.
The petitioner and the Niagara Company filed consolidated returns for the taxable years involved. The consolidated return for the year 1924 reported the following:
| GROSS INCOME | ||
| "Sales of Storage space" | $26,364.96 | |
| Sales of ice | 174,775.73 | |
| Freight rebate | 4.58 | Interest |
| 45.18 | ||
| "Rents from storage space" | 6,856.46 | |
| $208,046.91 | ||
| DEDUCTIONS | ||
| Compensation of officers | 24,000.00 | |
| Repairs | 876.53 | |
| Interest | 5,940.00 | |
| Taxes | 6,843.62 | |
| Depreciation | 24,766.63 | |
| Salaries and wages | 61,492.32 | |
| Materials used | 45,290.44 | |
| Other expenses | 37,548.74 | |
| 206,758.28 | ||
| Net Income | 1,288.63 |
*656 The consolidated return for the year 1925 reported the following:
| GROSS INCOME | ||
| "Storage Rentals" | $23,153.48 | |
| Sales of ice | 180,182.90 | |
| Sales of scrap | 6.60 | |
| Interest | 303.06 | |
| "Rents from Storage" | 6,843.96 | |
| Royalties - interest earned | 1,596.57 | |
| $212,086.57 | ||
| DEDUCTIONS | ||
| Compensation of officers | 24,000.00 | |
| Repairs | 1,267.16 | |
| Interest | 5,880.00 | |
| Taxes | 6,195.46 | |
| Losses by fire, storm, etc | 545.00 | |
| Depreciation | 24,766.63 | |
| Salaries and wages | 60,230.04 | |
| Operating account | 64,805.41 | |
| Office. $2,560, Ins. $3,400.38 | 5.960.38 | |
| Feed | 4,605.81 | |
| Sundries | 1,647.29 | |
| 199,903.18 | ||
| Net Income | 12,183.39 |
*1846 The respondent accepted these consolidated returns and computed the tax liability of the two companies upon a consolidated basis.
Balance sheets included in the return for the year 1924 indicate that consolidated assets were, at January 1, 1924, $658,165.31, and at December 31, 1924, $676,988.79, these sums not including a depreciation reserve in the amount of $125,606.54 at January 1, and in the amount of $158,156.48 at December 31.
Balance sheets included in the 1925 return indicate that consolidated assets at January 1, 1925, were $658,165.31, not including a depreciation reserve in the amount of $158,156.48. Total assets, including the depreciation reserve at January 1, 1925, therefore amounted to $835,145.27, this being in agreement with the statement of the National Credit Company. The balance sheet also indicates that consolidated assets at December 31, 1925, were $626,983.33, not including a depreciation reserve in the amount of $182,923.11. Total assets at the date last mentioned, including the depreciation reserve, are therefore indicated as $809,906.44.
Capital stock of the petitioner outstanding during the taxable years involved amounted to $165,000. Surplus*1847 and/or undivided profits at the beginning and end of each of the taxable years is shown as follows:
| Surplus and/or undivided profits | ||
| Year | January 1 | December 31 |
| 1924$264,632.15 | $258,438.16 | |
| 1925 | 258,438.16 | 251,272.77 |
*657 The deductions in the amount of $24,000 taken as officers' salaries in the consolidated returns for each of the years involved were claimed as deductions for the salaries of John T. and William H. Williamson; each in the amount of $12,000 per year. Upon recommendation of a revenue agent the respondent has disallowed these deductions to the extent of $16,000 in each of the years involved, his theory being that they represent a distribution of dividends rather than an ordinary and necessary expense.
The two Williamson brothers came into the control of the petitioner upon the death of their father in 1909. The petitioner had a minute book, but while the brothers have conducted the business corporate action has always been informal and no entries respecting such action have been made in the minute book for several years. The petitioner has never declared a dividend while the Williamson brothers have controlled it except that*1848 upon the death of their father a dividend was declared to straighten out accounts.
It is customary for the two Williamsons, who it appears are the only stockholders and directors of the petitioner, to discuss corporate policies informally and decide corporate action among themselves. During, and apparently for some years prior to 1922, the Williamsons had each drawn salaries of $4,000 per year from the petitioner. In an informal discussion occurring sometime toward the close of the year 1922, the Williamsons came to the conclusion that their salaries of $4,000 per year were too small because of the fact that their personal expenses were larger than this amount and because they believed that, in comparison with the services and salaries of other persons in the same line of business in Niagara Falls, they were entitled to a Greater salary. The Williamsons therefore agreed that for the year 1923 they would each draw salaries of $6,000 per year from the petitioner. During the years 1924 and 1925, and until the present time, the Williamsons have each been credited with salaries of $6,000 per year by the petitioner.
It was not customary for the Williamsons to draw the full amount*1849 of the salaries credited to them, but each drew such amount as he needed from time to time.
After the petitioner acquired ownership of the Niagara Company in 1922 its corporate affairs were conducted by the Williamsons in the same informal manner in which they conducted the petitioner's *658 affairs. Toward the close of the year 1923 the Williamsons concluded that in view of the enlarged responsibility and increased efforts entailed by their conduct of the affairs of the Niagara Company they were entitled to draw salaries from that company as well as from the petitioner. They therefore agreed that each of them should draw a salary of $6,000 per year from the Niagara Company for the year 1923. For the years 1924 and 1925 each of the Williamsons was credited with a salary of $6,000 per year by the Niagara Company.
The Niagara Company has a greater potential capacity for the production of ice than the petitioner.
The widespread introduction of electric refrigeration has severely affected the business of the petitioner and the Niagara Company since 1920. Since 1922 or 1923 ice manufacturers in Niagara Falls have had to meet the competition of firms at Buffalo and Tonawanda*1850 which have expanded their markets by the use of motor truck and railroad transportation and which seek to dispose of their surplus production in cities such as Niagara Falls. Competition of outside manufacturers was unknown when transportation depended upon horse-drawn vehicles. Prior to 1920 the volume of the petitioner's ice business was greater than it has been since that year and it was also greater than the combined volume of business of the petitioner and the Niagara Company during the taxable years. The competitive factors mentioned above have made the conduct of the business of the petitioner and the Niagara Company's affairs more exacting upon the managing officers of these concerns.
Prior to the petitioner's purchase of the capital stock of the Niagara Company, the Peerless Company had leased certain ground owned by the Niagara Company and erected thereon a building for the manufacture of ice cream. Three walls of this building were constructed of stucco and board, upon brick foundation pillars. The building abutted upon the building of the Niagara Company, one wall of which served as the fourth wall of the ice cream plant. The building was two stories high in part, *1851 the upper story being used as an office and the lower story as an ice cream manufacturing plant. The lease of the Peerless Company was a five-year lease terminating of April 30, 1926, and was renewable at the option of the lessee for another five-year period. This lease provided that the Peerless Company should erect the building in question and that it should revert to the Niagara Company at the end of the five-year lease.
In the spring of 1925 a concern known as the General Ice Cream Company, whose operations extend from Montauk Point to the Niagara River, had commenced the erection of a large ice cream manufacturing plant at Niagara Falls. Some time early in 1925 *659 the manager of the Peerless Company intimated to the officers of the Niagara Company that the Peerless Company had passed or would pass into the control of the General Ice Cream Company. The officers of the Niagara Company understood this to mean that the Peerless Company would move into the new plant of the General Ice Cream Company and that the lease expiring in April, 1926, would not be renewed.
In 1926, about one month prior to the expiration of the lease above mentioned, the Niagara Company was*1852 formally advised that the Peerless Company did not intend to exercise its option of renewing the lease. Although the lease expired in April, 1926, the Peerless Company was permitted to retain possession of the property until early in June, 1926, because the new plant into which the company was moving was not prepared for operation when the lease expired and because of the time required to dismantle and remove the machinery. The Peerless Company removed practically everything movable, leaving only the machinery foundations and some insulation without the coils. In the condition in which it was left when vacated by the Peerless Company the building was not suitable for any useful purposes except the manufacture of ice cream, and installation of apparatus for that purpose was feasible only if the apparatus conformed to the machinery foundations used by the Peerless Company. The Niagara Company has never been able to secure a tenant for the building since the original lessee vacated.
The respondent has determined that the petitioner received income in the amount of $8,000 due to the erection of the building by the Peerless Company, and has added to consolidated income for each of*1853 the years in controversy an amount of $1,600, i.e., the respondent has prorated the amount of $8,000 over the five-year term provided in the original lease.
OPINION.
MCMAHON: The petition purports to cover the year 1923, but we have no jurisdiction as to that year because the respondent has not determined a deficiency respecting it. .
The alleged errors of the respondent relating to his determination for the years 1924 and 1925 are, first, the disallowance in part of a claimed deduction for officers' salaries, and, second, the inclusion in income of a pro rata portion of the cost of a building erected by a lessee on land owned by the Niagara Company. In respect of the year 1925 the petitioner also complains of the respondent's denial of the specific credit in the amount of $2,000, which, under the provision of section 236(b) of the Revenue Act of 1924, is allowed domestic corporations having a net income of $25,000 or less.
*660 The petitioner's contention respecting the claimed deduction for officers' salaries is predicated upon section 234(a)(1) of the Revenue Act of 1924 which provides:
SEC. 234. (a) In computing*1854 the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions:
(1) All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered * * *.
The petitioner and the Niagara Company became affiliated in 1922 when the petitioner purchased the entire capital stock of the latter. The affiliated status was maintained during the taxable years involved in this proceeding. The books of the affiliates were kept upon the accrual basis. For each of the taxable years involved there was credited upon the books of the petitioner and the Niagara Company, as salaries to each of their two principal officers, the amount of $6,000 per year. The record indicates that the officers were the only stockholders of the petitioner. Upon the consolidated returns for each of such years the petitioner claimed deductions as officers' salaries of the amount of $24,000, representing the total of the $6,000 salaries credited by each corporation to each of the said officers. Upon audit a revenue agent*1855 disallowed these deductions to the extent of $16,000 for each of the years involved, and the respondent has approved this action, his deficiency letter stating "it is held that a portion of such officers' salaries is excessive and in effect a dividend."
Although the deficiency letter did not challenge the corporate authorizations of salaries in the amounts claimed as deductions upon the returns, the record is largely devoted to establishing the fact that the salaries claimed as deductions were properly authorized by the corporate directors. The Board has frequently recognized that the affairs of closely held corporations are often conducted informally and that informal determinations of the directors of corporations so conducted are effective for purposes of fixing the amounts of officers' salaries. ; .
In this proceeding it appears that the two Williamsons, as the only stockholders and directors, had long conducted the petitioner's affairs in an informal manner and that after the petitioner's acquisition of the Niagara Company, they, as the directors of that concern, conducted its*1856 affairs in the same manner. It further appears that sometime in 1922 the Williamsons agreed that for the year 1923 their salaries from the petitioner should be $6,000 per year and that by agreement between them salaries at the rate of $6,000 per year *661 were credited to each of them by the petitioner for the years 1924 and 1925. Toward the close of the year 1923 the Williamsons, as directors of the Niagara Company, agreed that they would each draw a salary of $6,000 per year from that company. For the years 1924 and 1925 the Niagara Company credited each of the Williamsons with $6,000 per year as salary.
We are satisfied that the amounts claimed as deductions for officers' salaries for the years 1924 and 1925 were authorized by corporate action. The determination of whether or not such salaries are deductible in the computation of the net corporate income subject to Federal income tax depends, however, upon the applicable statute, i.e., section 234(a)(1) of the Revenue Act of 1924, supra.
The evidence discloses that the Williamsons were men with approximately 40 years experience in this type of business and that they devoted from 12 to 14 hours per day to the*1857 business. The acquisition of the Niagara Company with its large storage facilities, together with the increased strength of competition, entailed more intensive effort on their part than had theretofore been necessary.
Considering the whole record we are not persuaded that the petitioner has sustained its burden of proving that the deduction of $12,000 per year as salary for each of the two principal officers of the consolidated companies constituted the "reasonable allowance" prescribed by statute. Neither are we inclined to hold with the respondent that salaries of $4,000 per year from both companies to each of these officers were reasonable compensation to them. It is our opinion that each of the affiliated companies is entitled, in each of the years 1924 and 1925, to deduct the amount of $4,000 as the salary of each of the two officers. Adjustment will be made accordingly under Rule 50.
The petitioner also alleges as error the respondent's inclusion in income for each of the years involved of the amount of $1,600. The respondent determined that petitioner realized income in the amount of $8,000 due to the erection of a building by the Peerless Company on land leased*1858 from the Niagara Company, and prorated this amount over the five year term of the lease. The petitioner is not questioning the action of the respondent in prorating whatever income petitioner derived from the erection of the building, but contends that it sustained no income at all thereby. It is petitioner's contention that the building was valueless at the conclusion of the term of the lease, this being in effect a contention that even if the improvements constituted income, such income was offset by obsolescence. Obsolescence, being a question of fact, must be determined upon the facts peculiar to each case. .
*662 In , the Board said:
Obsolescence, we have said, is the state or process of becoming obsolete, and the state of obsolescence is reached when the property which can not be used for any other purpose is no longer useful for the purpose for which it was acquired. ; *1859 . The right to an obsolescence deduction must be based upon substantial reasons for believing that assets would become obsolete prior to the end of their ordinary useful life; and it must have been known, or believed to have been known to a reasonable degree of certainty, under all the facts and circumstances, when that event would likely occur. ;.
It does not appear that during 1924 or 1925 petitioner was aware of any facts or that facts existed upon which it could be concluded that the useful value of the improvements erected by the Peerless Company was to be limited to the original term of the lease. Indeed, during those years the petitioner did not know as a fact that the building would be vacated in 1926. We believe that the petitioner is mistakenly ascribing to the years 1924 and 1925, a knowledge of events of which it was not aware until 1926. Furthermore, an allowance for obsolescence would require a showing of the prospective salvage value of the obsolete property or that no such value*1860 did remain, and on this point the record is silent. .
The respondent having determined that the petitioner derived income in the amount of $8,000 due to the erection of the building by the Peerless Company, such determination is presumed to be correct and the burden is upon the petitioner to establish that it was erroneous. This the petitioner has failed to do. Upon the authority of ; ; and , we approve the respondent's inclusion in consolidated income for each of the years in controversy of a pro rata portion of the amount of $8,000.
The petitioner's contention respecting the respondent's denial for the year 1925 of the specific credit in the amount of $2,000 which is granted, under provision of section 236(b) of the Revenue Act of 1924, to all domestic corporations having a net income of $25,000 or less will be sustained if the recomputation in accordance with our opinion discloses that the net income of the consolidated companies for the year 1925 is less*1861 than $25,000. Otherwise, petitioner's contention will be denied.
Reviewed by the Board.
Judgment will be entered under Rule 50.
MURDOCK, dissenting: The salary allowances are not shown to have been reasonable in amount. The value of the building was all income when it was erected.