*1583 1. Value of lease acquired May 18, 1921, may not be included in invested capital under section 331 of the Revenue Act of 1921, where prior owner acquired same without cost and received and retained all but three of the shares of capital stock of petitioner in payment thereof.
2. Value of lease determined for purpose of exhaustion thereof for years 1921 and 1923.
3. No deduction for exhaustion of lease allowable for the year 1926 under Revenue Act of 1926 where cost of lease to transferor was nothing.
*877 These are procedings duly consolidated for hearing and opinion for the redetermination of deficiencies in income and profits taxes as follows:
| Docket No. | Kind of tax | Year | Deficiency |
| 16627 | Income and profits | 1921 | $19,684.69 |
| 29264 | Income | 1923 | 1,058.08 |
| 45537 | do | 1926 | 1,142.72 |
In Docket No. 16627, it is alleged that the respondent erred in:
(1) Failing to hold that the petitioner by inadvertence and mistake erroneously reported its net income for the year 1921 as $85,170.97*1584 instead of $80,897.32, and in holding the net income to be $87,361.96;
(2) Refusing to allow petitioner, for the year 1921, a deduction in the amount of $6,464.64 on account of the exhaustion of a lease;
(3) Eliminating from petitioner's claimed invested capital for the year 1921 the sum of $483,945.20 on account of stock issued to C. J. Milliron in payment of a certain agreement for a lease dated November 1, 1920, entered into by and between Gladys Bilicke and A. B. C. Dohrmann as first parties and W. A. Faris and R. M. Walker as second parties, which agreement had previously been transferred on November 2, 1920, without consideration, by said W. A. Faris and R. M. Walker to C. J. Milliron, and holding that petitioner's invested capital was $8,904.66 instead of $492,849.86;
(4) Holding that section 331 of the Revenue Act of 1921 has any application to petitioner's case; and
(5) Failing to determine that there has been an overassessment and overpayment of $1,212.59 of income and excess-profits taxes of petitioner for the year 1921.
In each of Docket Nos. 29264 and 45537, relating to the years 1923 and 1926, respectively, it is alleged that the respondent erred in refusing*1585 to allow the petitioner a deduction in the amount of $6,464.65 on account of obsolescence, depreciation, or exhaustion of a leasehold.
*878 These proceedings were submitted on the pleadings, stipulation of facts, and testimony, from which we make our findings of fact as follows:
FINDINGS OF FACT.
On November 1, 1920, an agreement was entered into between Gladys Bilicke and A. B. C. Dohrmann, first parties, and W. A. Faries and R. M. Walker, second parties, in which the first parties, as executors of the estate of A. C. Bilicke, deceased, agreed to cause to be executed a lease of certain real property in Los Angeles, Calif., the same being a portion of Lots 4 and 5 in Block 14 of the Ord Survey, as follows:
AGREEMENT, made as of this 1st day of November, 1920, by and between GLADYS BILICKE and A. B. C. DOHRMANN, as first parties, and W. A. FARIS and R. M. WALKER, as second parties.
The first parties represent that they are the Executors of the Last Will and Testament of A. C. Bilicke, deceased, and the said estate owns real property in the City of Los Angeles, State of California, substantially described as follows: [Description omitted.]
1. The first parties*1586 agree that they will forthwith cause a corporation to be organized under the laws of the State of California, having some suitable name, and that they will immediately institute and take such proceedings as may be permitted by law to cause the real property to be distributed pursuant to the said Will and to be acquired by said corporation, or by said corporation and said Gladys Bilicke, to the end that Gladys Bilicke, one of the said first parties, individually, and as the guardian of her three minor children, shall own all of the issued stock of said corporation, and that said corporation, or said corporation and said Gladys Bilicke, may make a valid lease of said real property for the term of ninety-nine years. Said first parties agree that they will use every endeavor to promptly accomplish the above and foregoing results.
2. The second parties agree that they will cause a corporation to be organized under the laws of the State of California having some suitable name, for the purpose of leasing the said real property for a term of ninety-nine (99) years commencing January 1, 1921. And the first parties agree that when the said real property shall be acquired by the corporation*1587 to be organized by them in accordance with the provisions of this agreement, they will cause said corporation or said corporation and said Gladys Bilicke, to execute, as Lessor, an indenture of lease substantially in the form of the document attached hereto and market "A". The second parties agree that they will thereupon cause the said corporation to be organized by them, as aforesaid, to execute, as lessee, the said indenture of lease, and that they, as individuals, will at the same time execute in favor of the lessor a guaranty substantially in the form of the document attached hereto and marked "B". It is agreed between the parties that at the time of the execution of the indenture of lease marked "A", there shall also be executed by the parties thereto a supplemental agreement substantially in the form of the document attached hereto marked "C".
* * *
The proposed lease provided, among other things, that the lessee should pay a yearly rental of $50,000 throughout the term of the *879 lease, should pay all taxes, etc., should erect at its own cost a modern steel frame or reinforced concrete fireproof store and loft building, having a basement and at least eight stories, *1588 such building to cover at least the area covered by the old buildings then on the premises. It also provided that the lessee should have the right to encumber, hypothecate or assign the leasehold interest, subject to the rights of the lessor. It further provided that in the event of default by the lessee for a period of 90 days of any of its obligations under the lease the lessor should have the right to terminate the lease.
Below and following the signatures of Gladys Bilicke and A. B. C. Dohrmann, W. A. Faris and R. M. Walker, on the agreement for lease, the following appears:
NOVEMBER 1, 1920.
It is further agreed that in consideration of the cancellation as of December 31, 1920, of the present lease held by the second parties on the above described property, the second parties will pay to the first parties Thirty Thousand Dollars (30,000) on December 31, 1920, and in the event of a failure to execute the proposed lease annexed hereto and marked "A", the said Thirty Thousand Dollars ($30,000) shall be returned to the second parties with interest at the rate of six per centum (6%) per annum, in which said event said present lease shall remain in full force and effect.
*1589 GLADYS BILICKE.
A. B. C. DOHRMANN. W. A. FARIS. R. M. WALKER.Prior to November 1, 1920, three leases, all dated December 27, 1911, together covering the same property described in the contract for lease of November 1, 1920, had been executed by A. C. Bilicke and Muse, Faris & Walker Company, a corporation. These leases provided for an aggregate rental of $96,000 and the term of each lease expired October 31, 1922. On December 22, 1916, these leases were assigned by Muse, Faris & Walker Company to R. M. Walker and W. A. Faris, doing business under the firm name of Faris-Walker, The 5th Street Store.
On November 2, 1920, the following letter was signed by Faris and Walker and delivered to C. J. Milliron:
In consideration of your assuming all of the duties and obligations imposed upon us by reason of our contract to execute a lease dated November 1st, 1920, between Gladys Billicke and A. B. C. Dohrman and ourselves as second parties, a copy of which agreement is attached, we hereby give and assign to you all our right, title and interest in said agreement, it being understood that you are to assume all of our obligations either directly or indirectly imposed as*1590 a result of this agreement.
On the same date the following letter was signed by C. J. Milliron and delivered to W. A. Faris and R. M. Walker:
*880 Your gift to me today of your contract of November 1st to execute a lease on the premises generally known as the "Billicks" properties, is hereby accepted and I agree to assume all your obligations thereunder and to hold you free and clear of any liabilities as a result thereof.
I will cause to be prepared an assignment of this contract executed in due form for the purpose of record.
(Only the bodies of the foregoing letters are set forth.)
On November 1, 1920, Faris and Walker paid $30,000 to the estate of A. C. Bilicke, deceased, and received a receipt therefor as follows:
Received from Faris-Walker, a partnership composed of W. A. Faris and R. M. Walker, the sum of thirty thousand dollars ($30,000) as a bonus for the cancellation of three certain leases dated December 27, 1911, between A. C. Billicke, lessor, and Meuse, Faris Walker Company, a corporation, as lessee, under which said leases Faris-Walker now occupy the premises described therein facing on Broadway and Fifth Street, in the city of Los Angeles, California, *1591 which said payment is received on account of cancellation of said lease, in accordance with the agreement entered into November 1, 1920, between Gladys Billicke and A. B. C. Dohrman, as executors of the will of Albert C. Billicke, deceased, and W. A. Faris and R. M. Walker.
[Dated] Los Angeles, California, this 31st day of December, 1920.
[Signed] Estate of Albert C. Billicke, deceased, by Arthur C. Hurt, Attorney for the Executors.
On January 2, 1921, Clark J. Milliron, as first party, and W. A. Faris and R. M. Walker, copartners, doing business under the firm name and style of Fifth Street Store, as second parties, executed a lease wherein and whereby the premises described in the agreement for lease of November 1, 1920, were leased to Faris and Walker from January 1, 1921, to December 31, 1921, and for such longer time thereafter as the parties shall agree at a rental of $150,000 payable in twelve equal installments of $12,500. It further provided that Faris and Walker were to pay in addition to the rental, all taxes and keep the premises fully insured.
January 15, 1921, a corporation was organized under the laws of the State of California, with a corporate name*1592 of Fifth and Broadway Investment Company, and the stock thereof was acquired and owned by Gladys Bilicke, individually, and as guardian of her three minor children.
On March 30, 1921, C. J. Milliron caused to be organized, under the laws of the State of California, a corporation known as Fifth Street Building, with an authorized capital stock of $1,500,000, divided into 15,000 shares of the par value of $100 each. This corporation is the petitioner in this proceeding.
*881 Minutes of a special meeting of stockholders of petitioner held May 18, 1921, contain the following resolution (preamble setting forth the history of the transaction up to that time omitted):
RESOLVED: That the Board of Directors of Fifth Street Building, is hereby authorized and directed to purchase from said Clark J. Milliron all his right, title and interest in and to said contract for lease between Gladys Billicke and A. B. C. Dohrman as lessors and W. A. Faris and R. M. Walker as lessees, for and in consideration of the sum of $640,000, to be paid to said Clark J. Milliron in capital stock of this corporation at its par value, and as lessee to execute and enter into the aforesaid lease with Fifth*1593 & Broadway Investment Co., a corporation, as lessor.
A further resolution was adopted authorizing the board of directors to execute the lease pursuant to agreement for lease. At the time of this meeting three shares of the capital stock of petitioner had been subscribed for by Clark J. Milliron, J. D. McLeod and W. M. Pargellis, respectively.
On May 18, 1921, C. J. Milliron and wife by agreement in writing sold, transferred and set over to Fifth Street Building, the petitioner, all the right, title and interest of every kind and nature in and to the agreement for lease of November 1, 1920, and the lease to be entered into between Fifth and Broadway Investment Company, as lessor, and Fifth Street Building, as lessee, pursuant to the agreement of lease of November 1, 1920.
On May 20, 1921, an agreement of guaranty, with copy of the lease attached, was entered into between Fifth and Broadway Investment Company, as lessor, and W. A. Faris and R. M. Walker, as guarantors, providing that:
WHEREAS, it is to the benefit and advantage of the Guarantors, that said Lease should be entered into by said Lessor; and
WHEREAS, said Lessor would not enter into said Lease save for the*1594 guarantees and obligations hereinafter set forth and assumed by said Guarantors with respect to said lease.
Faris and Walker guaranteed the full and faithful performance by the lessor of each and all the terms and provisions relating to the construction of the new buildings upon the demised premises and the faithful performance by the lessor of each and every term, condition, provision and obligation contained in the lease and to be performed by the lessor, provided, however, that all obligation of Faris and Walker, as guarantors, should cease upon the full completion of and payment for the new buildings.
On May 20, 1921, following the execution of guaranty agreement, a lease in the form attached to the agreement for lease of November 1, 1921, was entered into between Fifth and Broadway Investment Company and the petitioner, Fifth Street Building, for an annual rental of $50,000, payable in four equal installments, the *882 lessee to pay all taxes. This lease is in full force and effect and petitioner has been at all times since its execution the owner thereof.
The lease, on January 1, 1921, and May 20, 1921, had a value of $640,000.
On March 1, 1922, a lease was*1595 entered into covering the same premises between Fifth Street Building and Faris-Walker, a Californai corporation, for a term of 30 years beginning on March 1, 1922, and ending February 28, 1952, unless sooner ended in accordance with the provisions of the lease, for a net monthly rental of $12,500 for March, April and May in 1922, and a net monthly rental of $13,333 for each month of the remainder of the term. In addition, the lessee was required to pay the taxes paid by the lessor pursuant to terms of the ground lease and also all settlements paid by lessor to complete the building and improvements then upon the premises or thereafter to be constructed and to insure them against loss by fire as required by the terms of the ground lease, the ground lease being the lease of May 20, 1921, between the Fifth and Broadway Investment Company and Fifth Street Building.
Clark J. Milliron, counsel for petitioner, and C. J. Milliron, to whom the letter of Faris and Walker, dated November 2, 1920, is addressed, are one and the same person. He represented Faris and Walker as counsel prior to and at the time of the execution of the agreement for lease of November 2, 1920, and until about 1924*1596 or 1925.
Muse, Faris and Walker, later Faris and Walker, have occupied all or part of the premises described in the contract for lease since about 1906, and continued doing so even during the construction of the new building as provided for in the lease, vacating the old building and moving into parts of the new building as completed from time to time.
Ever since February 10, 1922, the total of issued and outstanding shares of capital stock of petitioner has been and is 6,713 shares.
In the deficiency letter dated April 19, 1926, relating to the asserted deficiency in income and profits taxes for 1921, the Commissioner stated as follows:
* * *
The adjustment made by the examining officer allowing amortization of ground rent in the amount of $2,000.00 has been eliminated for the reason that no value has been established on the agreement for a lease, which was paid in for stock, since such agreement had no value and was not enforcible in the hands of anyone but the original parties thereto.
* * *
The elimination from invested capital of $483,945.20 shown in Schedule H of your return as the prorated amount of stock issued for lease is in accordance with Section 331 of*1597 the Revenue Act of 1921 which provides that for *883 invested capital, purposes such an asset may be included only at its cost to prior owner, which in this case was nothing.
The petitioner filed its income returns for the years 1921, 1923 and 1926 within the time provided by law and paid taxes thereon in the amounts of $16,361.81, $2,212.98 and $3,051.01, respectively.
OPINION.
MCMAHON: As to the first error assigned in the proceeding in Docket No. 16627, the respondent in his answer, as amended at the hearing, admitted that the petitioner erroneously reported its net income for the year 1921 as $85,170.97 instead of $80,897.32, and that the net income on which the respondent determined a deficiency for the year 1921 was $87,361.96, having disallowed a deduction of $6,464.64 on account of depreciation of an alleged leasehold. We, therefore, approve this correction of error.
The first question presented for consideration is whether the value, if any, of a certain agreement for lease should be included in invested capital.
The petitioner contends that the contract for lease was, in fact, a ground lease and that from and after March 30, 1921, such leasehold interest*1598 was a part of its invested capital, and having issued 6,400 shares of its stock of the par value of $100, the invested capital should be the sum of $640,000 prorated over the remaining 276 days of 1921, or the sum of $483,945.20. It is to be noted that March 30, 1921, is the date of the incorporation of the petitioner and that it was not until May 18, 1921, that the stockholders of the petitioner authorized the purchase of the agreement from Clark J. Milliron and Milliron transferred all his right and interest in and to the agreement for lease to the petitioner.
Respondent eliminated the sum of $483,945.20 from invested capital under section 331 of the Revenue Act of 1921, which provides:
That in the case of the reorganization, consolidation, or change of ownership of a trade or business, or change of ownership of property, after March 3, 1917, if an interest or control in such trade or business or property of 50 per centum or more remains in the same persons, or any of them, then no asset transferred or received from the previous owner shall, for the purpose of determining invested capital, be allowed a greater value than would have been allowed under this title in computing*1599 the invested capital of such previous owner if such asset had not been so transferred or received: Provided, That if such previous owner was not a corporation, then the value of any asset so transferred or received shall be taken at its cost of acquisition (at the date when acquired by such previous owner) with proper allowance for depreciation, impairment, betterment or development, but no addition to the original cost shall be made for any charge or expenditure deducted as expense or otherwise on or after March 1, 1913, in computing the net income of such previous owner for purposes of taxation.
*884 Clearly, since the previous owner, Clark J. Milliron, paid no consideration for the assignment to him of the agreement for lease, the cost of acquisition to him was nothing; and as Milliron received 6,400 shares of the 6,403 shares of the stock of the petitioner outstanding in payment for the assignment of the agreement, in interest or a control of more than 50 per centum of the property remained in him. In fact, he was practically the sole owner at that time, there being only 2 shares held by two other stockholders. *1600 He was also the president of the petitioner and was its counsel. There is no ambiguity in the provisions: "That, if such previous owner was not a corporation, then the value of any asset so transferred or received shall be taken at its cost of acquisition (at the date when acquired by such previous owner)." The statute applies not only to reorganizations and consolidations, but also to a change of ownership of a trade, business or property under conditions set forth therein. ; ; ; ; and .
The action of the respondent in this respect is, therefore, approved.
The petitioner further contends that it is entitled to deduct in each of the years 1921, 1923 and 1926, on account of depreciation or exhaustion of the leasehold interest acquired by petitioner May 18, 1921, one ninety-ninth of the value of the leasehold, to wit, one ninety-ninth of $640,000. We agree with petitioner that, although no value could be included*1601 in invested capital by reason of the limitation of section 331 of the Revenue Acts of 1918 and 1921, the cost as determined from the fair market value of the property acquired for its stock may be used as a basis for computing deductions for exhaustion over the term thereof for the years 1921 and 1923. .
As to the allowance of exhaustion for the year 1926, we must be governed by the provisions in that respect contained in the Revenue Act of 1926, which are as follows:
SEC. 204. (c) The basis upon which depletion, exhaustion, wear and tear, and obsolescence are to be allowed in respect of any property shall be the same as is provided in subdivision (a) or (b) for the purpose of determining the gain or loss upon the sale or other disposition of such property, except that * * * [Exceptions not material herein.]
SEC. 204. (a) The basis for determining the gain or loss from the sale or other disposition of property acquired after February 28, 1913, shall be the cost of such property; * * *
(8) If the property (other than stock or securities in a corporation a party to a reorganization) was acquired after December 31, 1920, by*1602 a corporation by the issuance of its stock or securities in connection with a transaction described in paragraph (4) of subdivision (b) of section 203 (including, also, cases *885 where part of the consideration for the transfer of such property to the corporation was property or money in addition to such stock or securities,) then the basis shall be the same as it would be in the hands of the transferor, increased in the amount of gain or decreased in the amount of loss recognized to the transferor upon such transfer under the law applicable to the year in which the transfer was made;
* * *
SEC. 203. (i) As used in this section the term "control" means the ownership of at least 50 per centum of the voting stock and at least 80 per centum of the total number of shares of all other classes of stock of the corporation.
The petitioner acquired the contract for lease on May 18, 1921. The provisions with respect to recognizable gain or loss in a transaction of the kind here involved are the same in the 1921 Act as in the 1926 Act, though stated differently.
Since the facts in this proceeding bring it squarely within the above quoted provisions of the 1926 and 1921 Acts, *1603 it follows that for the year 1926, no deduction for exhaustion of the lease is properly allowable.
As a deduction for exhaustion is allowable in 1921 and 1923 it remains for us to determine the fair market value of the property acquired by petitioner.
It appears that petitioner was incorporated March 30, 1921, pursuant to the contract for lease, for the purpose of acquiring this lease. The contract for lease was assigned to C. J. Milliron upon condition that he carry out the provisions of such contract, one of which was to cause the petitioner to execute the lease therein provided for. The lessor corporation had been incorporated, pursuant to the contract for lease, January 15, 1921. Practically, petitioner, although it did not actually execute the lease until May 20, 1921, acquired it May 18, 1921, the date of the transfer to it of the contract for lease by C. J. Milliron and wife. To hold otherwise would be to regard the form rather than the substance of the transaction. See ; *1604 ; and . The term of the lease is 99 years commencing January 1, 1921.
As we have found the value of the leasehold to be $640,000, in our opinion, the value may be ratably exhausted over the term of the lease for the years 1921 and 1923. However, under the provisions of the Revenue Act of 1926, no deduction can be allowed on account of the exhaustion of the lease for the year 1926.
Judgment will be entered under Rule 50.