*1600 1. Corporation held liable as transferee of dissolved affiliated corporation, but only for that portion of total tax on consolidated income property allocable to such dissolved corporation.
2. Notes determined to be worthless and uncollectible, and written off during taxable period, allowed as deduction from income.
3. Special assessment allowed.
4. Organization expenses disallowed as deduction from income as business expense.
5. Granted that intercompany transactions should be eliminated from income, but held that evidence does not show such transactions to be so included in this case.
6. Burden of proving existence or nonexistence of agreement between affiliated corporations respecting allocation of consolidated tax liability held to be upon taxpayer, and petitioner having failed to meet this burden, respondent's allocation of tax upheld.
*776 Respondent has asserted against petitioner, as transferee, liability for a deficiency of $3,161.33 in income and profits taxes of the Morgan Crucible Company of America during*1601 the period from March 18 to November 30, 1920. Petitioner contends that the affiliation existing between itself and the transferor during said period defeats such liability, or at least in respect of the tax on that portion of consolidated net income assignable to it. Petitioner also seeks a redetermination of the deficiency on the ground that certain bad debts were disallowed as a deduction; that certain items representing paid-in surplus were excluded from invested capital; that invested capital and the specific exemption were erroneously prorated for the taxable period; that organization expenses in the amount of $3,591.20 were disallowed as a deduction; that the Commissioner undervalued assets exchanged for stock; and that income representing an intercompany transaction has not been eliminated. It also seeks relief under the provisions of sections 327 and 328, Revenue Act of 1918.
FINDINGS OF FACT.
Petitioner is a New York corporation with its principal office in Long Island City, New York. It was incorporated March 17, 1920, to act as an operating company for the Morgan Crucible Company of America (hereinafter called the Crucible Company), a Delaware corporation, organized*1602 at the same time. The two corporations were formed to take over the assets and business of the American branch *777 of the Morgan Crucible Company, Ltd., of London (hereinafter called the London company), a foreign corporation, and they continued to conduct business from the London company's former premises in New York.
The London company was and is engaged in the manufacture and sale of brushes designed to conduct a current to or from a rotating electric machine. The brushes are made from a finely ground mixture of carbon, distilled from various substances, largely produced by the company itself from its own mines and plants. In the course of manufacture this mixture is converted under great pressure into blocks and subjected in a kilning process to high temperatures for a week or ten days. This kilning process requires high technical skill in its supervision and entails considerable expense, as it is subject to wastage. The blocks so produced are then cut and ground with minute accuracy into brushes of various shapes and sizes to fit electrical machines of all kinds. Contact between the brush and the electric instrument is effected by a flexible copper cable, known*1603 as a pigtail, which is inserted in a single hole drilled in the corner of the brush and made fast by a caulking of powdered copper. This method of attachment was covered by a patent and effected a saving to the company on the process of 42 cents a hundred over the cost to competitive firms, which used the old method of drilling a hole in the brush, bolting solid copper to it by means of a tubular rivet, and soldering the whole assembly. This patented method also eliminated the necessity of plating the brushes with copper as was required by the old method. Since the expiration of the patent nearly all competitive firms have adopted this method.
There had been considerable development in the science of manufacturing electric brushes up to 1920, and to meet the changing demands of the industry the London company retained at great expense the services of numerous chemists and engineers who had made experimentally more than 4,000 carbon mixtures, subjecting the same to extensive tests both in laboratory and field. Of these mixtures about 25 had been found efficient and were being sold as standard in 1920. The London company also expended large sums in checking competitors' methods*1604 and in investigating improvements to manufacturing processes and products. It owned also various valuable patents, covering improvements to processes, one of which entirely eliminated the kilning operation, and thus effected a very substantial saving in manufacturing cost. The company sold its products under trade names and trade-marks which in 1920 had been favorably known to the trade through the world for 30 years, and were of value as an income-producing factor. Its capital was a half million pounds sterling.
*778 The company's largest foreign market was the United States, where its products had been sold since 1911 through a branch. It desired to form domestic corporations to take over its American business, and for this purpose the Morgan Crucible Company of America and petitioner were organized. In exchange for the Crucible Company's entire capital stock of $400,000, which was held by appointees, the London company transferred to the Crucible Company all the assets and liabilities of its American branch with the exception of $100,000 cash, which was transferred to petitioner in exchange for its entire capital stock of $100,000.
The terms of the exchange of*1605 the Crucible Company's stock for the London company's assets were set forth in an agreement executed December 9, 1920, but made effective as of January 1, 1920. It provided that all assets were to be taken as of January 1, 1920, and that the assignment comprised all which had been acquired in the United States since that time, including any profits which might have accrued. It provided, further, that if an appraisal should thereafter determine that the assets sold exceeded $400,000 in value, an additional share of stock for each $100 in value of such excess should be issued the London company. A license to use without charge in the United States the patents, trade-marks and trade names owned by the London company and an assignment of the lease on its premises in New York City were expressly recognized in the agreement.
The following balance sheet, showing the assets and liabilities transferred to the Crucible Company, contains figures accurately reflecting values and appearing on the London company's books as of January 1, 1920:
| Assets and liabilities of Dom. Corporation as of Jan. 1, 1920 | ||
| ASSETS | ||
| Mach., tools, equipment | $62,811.32 | |
| Automobiles | 8,772.51 | |
| Office Furn. & Fix | 5,749.76 | |
| Cash | 10,827.01 | |
| Accts. rec | 180,887.60 | |
| Notes rec (including Knott notes) | 22,651.75 | |
| Advance to Salesmen | 595.00 | |
| Inventories: | ||
| Raw materials | 224,363.88 | |
| Canadian consignment | 1,018.31 | |
| U. S. Lib bonds 4 1/4 | 1,000.00 | |
| Ins. Prem. prepaid | 2,030.54 | |
| Rent | 3,000.00 | |
| Total | 523,707.68 | |
| LIABILITIES | ||
| Accts. pay | $10,515.80 | |
| Duties pay | 41,078.58 | |
| Taxes pay | 2,532.06 | |
| Morgan Crucible Co. Ltd., London | ||
| Reserves: | ||
| Bad Debts | 11,563.83 | |
| Depreciation | 24,272.99 | |
| Net worth (400,000 stock 3/18/20) | 433,744.42 | |
| (Exchanged for) | ||
| March 18/1920 | ||
| Cap. stock (Dom. Corp.) | $400,000.00 | |
| Total | 523,707.68 |
*1606 On account of difficulties and delays petitioner and the Crucible Company were not in fact incorporated until March 17, 1920, the London company continuing to operate the business during the *779 period January 1 to March 17. Although the balance sheet showed assets of the value of $33,744.42 in excess of the capital stock, no additional shares were issued, as provided in the aforesaid agreement, but said excess was eventually placed in an account representing current transactions with the London company, and was carried as a liability. The respondent excluded this item from the Crucible Company's invested capital.
Under an agreement, executed June 23, 1920, but made effective as of January 1, 1920, the Crucible Company employed petitioner as agent for the manufacture and sale of electric brushes and other commodities, undertaking to furnish petitioner with raw or partly manufactured materials, to keep its equipment in proper condition, and to pay for its services 10 per cent of the gross sales. In consideration of the payment of the contractual rental and $2,000 per annum it reassigned the lease of the business premises to petitioner, and it further turned over all*1607 machines and equipment to it for an annual rental of $12,000. It also allowed petitioner to use without charge all patents, trade-marks and trade names, license to which it had received from the London company.
Under this agreement petitioner fabricated finished brushes from rough carbon block, all of which were imported from the London company's foreign plant, using the patented method of inserting the "pigtail," and sold the products under the London company's trademarks and trade names. While the London company sold finished brushes to the general trade, it furnished only the rough blocks to its American subsidiary and did considerable research and development work in order to furnish a product meeting the requirements of the American market. It charged for these blocks on the basis of cost and normal profit. The savings in manufacturing costs effected by the London company's patented process eliminating kilning of the blocks were thus passed on to the Crucible Company and petitioner. Substantial savings in manufacturing costs of this finished products were effected by use of the patented method of inserting the pigtail.
Among the assets transferred to the Crucible Company*1608 were three $3,000 notes of H. W. Knott, who from 1911 to 1919 was manager of the American branch of the London company. During 1919 an audit revealed that under his management the books had been carelessly kept for several years, and that some $30,000 could not be accounted for. Knott claimed that the shortage had been spent in the company's interest, but he admitted negligence in the records, resigned his position, and in September, 1919, turned over some cash, an automobile, Liberty bonds, and these three notes in order "to square himself with the Company." The notes matured May 1, 1920, December 31, 1920, and May 1, 1921, respectively. After his resignation *780 Knott became vice president of a bonding company in Cleveland at a salary reported to be larger than that he had been receiving. He had always lived well, was thought prosperous, and the notes were regarded as good by the officers of the London company until his failure to make payment of the first at maturity. The notes were then placed for collection with an attorney who reported in September, 1920, that judgment had been obtained, but could not be collected. It was then learned that Knott had lost his position*1609 with the bond company and had left for Shanghai, China. In November, 1920, the notes were charged off the books as worthless, but were left with the attorney, who succeeded in collecting $400 in installments in 1921 and 1923. Knott was never regarded as an embezzler and there was no intention of prosecuting him. The Commissioner disallowed $9,000, representing the face value of these notes, as a deduction from gross income for the period in issue and excluded it in computing for invested-capital purposes the value of assets turned over to the Crucible Company by the London company in exchange for stock.
The assigned lease on the American branch's premises covered a practically new brick, fireproof, mill construction building, five stories in height, at 519-23 West 38th Street, New York City. It provided for an annual rental of $12,000 for a period of ten years beginning April 1, 1917, and required the tenant to keep the building in repair, but not to pay taxes. It was never carried on the books of the petitioner or the Crucible Company as an asset. It had a value on March 17, 1920, of $14,000 in excess of the stipulated rent.
During the taxable period in issue a credit*1610 of $12,833.33, representing rents charged to petitioner in excess of what was paid by the Crucible Company, was transferred to the Crucible Company's profit and loss account.
In connection with their organization and incorporation the Crucible Company and petitioner expended a total of $3,591.20 in lawyers', accountants' and appraisers' fees, of which one-half or $1,795.60 was charged by each to profit and loss in 1920. The respondent disallowed those expenses as a deduction from gross income.
Petitioner and the Crucible Company were affiliated during that part of the year 1920 subsequent to their organization. On February 15, 1921, they filed a consolidated income and profits-tax return for the period March 18 to November 30, 1920, and an amended return for the same period on October 1, 1921. In computing their tax liability the respondent determined a consolidated net income of $303,780.55 for the period, of which he assigned $294,746.62 to the Crucible Company and $9,033.93 to petitioner. Of net income reported by them, he treated $87,967.01 and $2,696.17, respectively, *781 or a total of $90,663.18, as earnings of the London company between January 1 and March 17, 1920. *1611 However, these earnings were received by the Crucible Company as a part of the assets taken over from the London company under the contract of December 9, 1920.
In computing the invested capital of the Crucible Company respondent included $400,000, representing the book value of the specified assets transferred to it by the London company, and added a bad debt reserve of $2,563.83. For petitioner's invested capital respondent allowed $100,000, representing cash paid in. He then prorated the invested capitals so determined as follows:
| Crucible Company | Petitioner | |
| Capital, surplus, etc | $402,563.83 | $100,000.00 |
| For period Jan. 1, 1920, to Nov. 30, 1920, 335 days | 368,466.89 | 91,530.05 |
| Proportion for 258 days of 335 day period | 283,774.50 | 70,491.80 |
| Consolidated invested capital | $354,266.30 |
In computing the excess-profits credit, an exemption of $2,116.67 was allowed, representing a similar proration of the statutory exemption of $3,000 for the taxable year.
On February 11, 1927, the respondent asserted liability for a deficiency of $3,161.33 in income and profits taxes of the Crucible Company from March 18 to November 30, 1920, against petitioner*1612 as transferee of the assets of that company, which, meantime, had dissolved on June 7, 1922. Petitioner received assets of a net value in excess of the deficiency here asserted. In determining this deficiency, respondent computed the total tax due on the consolidated net income of both companies to be $121,361.93, of which $118,200.60 had been previously assessed against the Crucible Company, leaving $3,161.33 unassessed against either.
OPINION.
GOODRICH: Respondent seeks to hold petitioner liable as transferee for a deficiency alleged to be due from the Morgan Crucible Company of America, a corporation with which petitioner was affiliated during the period here in issue and which, upon subsequent dissolution, transferred all its assets to petitioner, of a net value in excess of the deficiency asserted. The petition, as amended, charges that this action is erroneous on the following grounds: That petitioner is liable only as an original taxpayer, not as a transferee within the meaning of section 280 of the Revenue Act of 1926; that the assessment and collection of the deficiency asserted against the Crucible Company can not now be made against petitioner as original taxpayer*1613 because *782 barred by the statute of limitations; that the Crucible Company should be charged with tax only on that part of the consolidated income properly allocable to it, rather than to assert against it the entire deficiency on the consolidated income, as has been done.
It appears that when respondent asserted the liability against petitioner for payment of the taxes of the Crucible Company, the statute had run upon any deficiency which might be due from petitioner as original taxpayer. It was admitted by counsel that the statute had not run against the liability, if any, of petitioner as transferee of the assets of the Crucible Company to pay the taxes of that company. Petitioner takes the position that, since it filed one consolidated return with the Crucible Company, any liability on its part must be as a taxpayer and not as a transferee. We believe this position to be unsound. The law provides for a consolidated return of income by two or more affiliated corporations and the computation of the total tax upon the basis of the consolidated income, but it also provides for the allocation of the tax among the consolidated corporations. *1614 Each is a taxpayer and liable for its part of the total tax. But there is no reason why, if one of these affiliated corporations takes over all the assets of another, leaving nothing from which to pay taxes, the transferee should not be liable for the tax of the transferor. That tax was not one for which the transferee was liable as a taxpayer, but represents a liability for which it became responsible by reason of the transfer. See ; ; ; ; and .
We are therefore of the opinion that the liability now asserted is not barred from collection because of the expiration of the statute upon taxes which might originally have been due from the petitioner as a taxpayer, and that petitioner is liable as a transferee under section 280 of the Revenue Act of 1926 for that portion of the total tax properly allocable to the Crucible Company.
But petitioner also complains that, even if liable as a transferee for taxes properly*1615 assessed against the Crucible Company, it is not so liable for that portion of the deficiency representing tax on that part of the cinsolidated net income properly assignable to it and as to which the statute has run. Section 240 of the Revenue Act of 1918 provides for the apportionment of the tax among affiliated companies upon the basis of their net incomes in the absence of any agreement with respect thereto. Here there is no evidence as to the existence or nonexistence of any such agreement between these corporations. The returns filed contain no specific notice of such an agreement but, on the other hand, they are filed in the name of the *783 parent company (the Crucible Company) and might be assumed to indicate that the entire liability disclosed thereby was undertaken by that company. Whether or not the specific notice of an agreement required by the Commissioner's regulations was filed, the record does not disclose. It is our opinion that the mere absence of proof of such an agreement can not be construed to mean that the agreement did not exist, and, consequently, that the tax liability of an affiliated group must be assessed against the members thereof on the*1616 basis of their respective net incomes, for we must treat as correct respondent's determination of petitioner's tax liability until petitioner, by positive evidence, has proved the same to be erroneous. The rule that the burden of proof is on petitioner is too well established to require citation or further discussion. The proof of the existence or nonexistence of an agreement between corporations as to the allocation of tax among them is, beyond doubt, a part of the taxpayer's burden. The facts concerning such an agreement lie in the taxpayer's hand and can be proved with ease. It may be that respondent, in allocating this tax liability upon a basis other than the net incomes of the affiliated corporations, had knowledge of some agreement between them. That we do not know, but we are bound to assume that his action was in accordance with the statute and that his determination of tax liability, and his allocation of the same, were correct, until the contrary is proved. We therefore sustain respondent in asserting the entire tax liability against the Crucible Company and hold petitioner liable therefor as the transferee of that company.
*1617 In its argument, petitioner strongly relies upon the decisions in , and . In the Phoenix case it was found as a fact that no agreement existed, and therefore the decision approved the allocation of tax liability as made by the Commissioner. The principle governing that decision is not in conflict with our conclusion here. We believe the decision in the Essex case is based strictly on the facts in that case and is not controlling of the case at bar. See . In passing, it should be noted that the records in ; ; ; ; , and other cases relied on by petitioner, disclose positively that there was no agreement between the various affiliated corporations as to the allocation of tax. See also *1618 ; ; ;
*784 With respect to petitioner's claim for a deduction from income in the amount of $9,000 on account of notes ascertained to be worthless and charged off within the taxable period, it appears from the record that respondent has two conflicting theories regarding these notes. First, he claims that the loss should be disallowed because the notes never had a value; next he claims the loss should be disallowed because the notes were not determined to be worthless within the taxable period. The evidence does not justify either position. The evidence is that when Knott gave the three notes, he was apparently prosperous and not considered dishonest, and petitioner's officers had faith that he would make payment on them. To oppose this testimony respondent's counsel sought to show that the amount of Knott's property was unknown to the officers and that they were in no position to conclude that he was*1619 capable of making payment. But even if he had insufficient assets with which to meet these obligations when made, that fact is not sufficient reason for holding that the notes were then worthless and that their worthlessness could not be subsequently ascertained. As said in :
A person may have credit to such an extent that he could borrow money upon his promissory note without having any other assets than his good name and character and yet circumstances may subsequently occur which would warrant the payee of the note in ascertaining that it was worthless and charging it off.
See also . The notes were treated as collectible when given, and nothing occurred to destroy faith in their value until Knott's failure to meet the first, maturing in the taxable period. Such an event, followed by the attorney's inability to collect the judgment, the loss of Knott's new position and his removal from the country, constituted good reason to regard them all as worthless.
We have consistently held that an ascertainment of worthlessness is to be reached by the exercise of sound business judgment*1620 in the light of surrounding facts and circumstances which would lead a reasonably prudent business man to conclude the debt worthless. A remote hope of ultimate salvage is insufficient to defeat deduction (; ), for no taxpayer is required to be an incorrigible optimist. . To the same effect see . Nor is the fact that two small collections were later made of controlling significance. ; affd., ; ; ; and . The deduction of $9,000 on account of bad debts should be allowed.
*785 Let us now consider petitioner's claim for relief under the provisions of sections 327 and 328 of the Revenue Act of 1918. The facts place this claim under subdivisions (a) and (c) of section 327, which read in*1621 part as follows:
(a) Where the Commissioner is unable to determine the invested capital as provided in section 326.
* * *
(c) Where a mixed aggregate of tangible property and intangible property has been paid in for stock * * * and the Commissioner is unable satisfactorily to determine the respective value of the several classes of property at the time of payment, * * *
It was the intent of the London company to transfer to the Crucible Company all the assets, tangible or intangible (except the $100,000), which had belonged to its American branch. The Crucible Company actually took possession of these assets and, with petitioner, continued the American business. In addition to the physical assets mentioned in the list later compiled, the bill of sale expressly permits the free use of the London company's valuable patents, trade-marks and trade names, and authorizes the transfer of the lease on its New York premises. The list compiled for the purpose of valuation was not a part of the bill of sale, and does not limit the assets exchanged for stock to those specifically mentioned thereon. The good will, license to use patents and trade-marks, and the lease were equally a*1622 part of the consideration for which the Crucible Company's stock was issued, and should be included in a computation of its invested capital, or if their value is undeterminable, then special assessment should be granted under subdivisions (a) or (c). But a taxpayer should be held to a reasonable diligence in determining his invested capital, and only after a showing of such diligence and a resulting inability to establish it do the relief provisions apply. ; ; (affd., ); ; .
Competent witnesses testified that, while they could not assign to the patents, good will, and trade-marks a specific monetary value, there was no doubt but that these assets had a very substantial value and their use contributed largely to the earnings. For instance, by use of the patent covering the insertion of the pigtail a saving of 42 cents a hundred on the manufacture of brushes was effected. From the evidence, the London company appears clearly to have been a leader in*1623 this specialized industry throughout the world, and to have spent considerable money in experiment and development, and in investigation of competitor's methods. It had developed superior combinations in the composition of its brushes and in the detail of cable contact with the machine. The adoption of this latter *786 method by competitors upon the expiration of the patent corroborates the witnesses' opinion that in 1920 the patent was very valuable. All these assets the Crucible Company, and through it the petitioner, acquired and used, and they were material factors in the production of its income.
The right given for the exclusive purchase in the country of the rough carbon blocks from the London company was also of substantial value, carrying as it did the benefits of the expensive technical experiments looking toward the improvement of the product, conducted by the London company both in laboratory and field, carrying also the benefits of reduced production costs resulting from use of the patent eliminating the kilning operation and the established superiority of the product, recognized by the electrical trade throughout the world. The London company's reputation*1624 for a superior brush was based upon the result of these experiments and activities, carried on over a long period. To duplicate this product a far greater working capital would have been required by the American companies than that with which they were equipped. There is good reason to agree with the witnesses that no specific value can be given the good will, trade-marks and patents. The business naturally resulting from the reputation of the London company for a superior product redounded to the benefit of the American companies and their sales in the United States. A mixed aggregate of this resulting good will, together with tangible assets of a value equal to the shares issued, was exchanged for the Crucible Company's capital stock. This situation is one contemplated by section 327 and, since the evidence establishes that these intangibles, the patents, good will and trade-marks did constitute material factors in the production of income, special assessment should be granted. & ; Rothschild Colortype Co.,; *1625 ; and .
Having granted special assessment, it is unnecessary to consider the other issues relating to petitioner's invested capital.
We sustain respondent in disallowing as a deduction from income the sum of $3,591.20, representing the expense of organizing these domestic corporations. The rule that organization expenses are not deductible as ordinary and necessary business expenses is so well settled as to merit no further discussion or citation herein.
At the hearing petitioner's counsel orally amended his petition, complaining further that the Commissioner erred in not excluding from income of the consolidated group (1) the sum of $9,033.93 income shown applicable to the Morganite Brush Company; (2) in not excluding $1,795.60, one-half of the organization expenses *787 charged off by the Morganite Brush Company; and (3), in not excluding from income the sum of $12,833.33, representing the rent paid by the Morganite Brush Company to the Morgan Crucible Company in excess of the amount paid by the Morgan Crucible Company to outsiders.
*1626 The first two errors have already been covered. Respecting the third, petitioner is correct in its insistence that the $12,833.33 is merely an intercompany transaction, and intercompany transactions should be eliminated in the computation of consolidated net income, ; ; certiorari denied, . But while there is testimony to the effect that an intercompany charge and credit of this amount was made on the books, as would normally be done, there is no evidence that it was not properly reported in the return, nor do the deficiency notice and letters on which the computation of the deficiency is based show that respondent has failed to exclude the amount from taxable income. The allegations supporting this belated assignment are covered by a blanket denial, and as the burden of showing error in the respondent's acts rests on petitioner, it must here fail for lack of proof in substantiation of its allegations.
Reviewed by the Board.
Judgment will be entered under Rule 62(c).