*2803 1. INVESTED CAPITAL - LIMITATION - ASSETS ACQUIRED FOR STOCK. - Assets consisting of an option to purchase property and certain contracts for production of motion pictures, acquired by an individual without cost and transferred to a corporation in return for capital stock issued in 1918 and thereafter set up on the books of the corporation at a capital value equal to the par value of the stock issued, held, under section 331 of the Revenue Act of 1918, not to be subject to inclusion in invested capital even though an actual value be proved for such assets equal to the book value assigned.
2. DEPRECIATION. - On the facts, held, that the proved values of depreciable assets acquired for stock, even though such values could not be included in invested capital by reason of the limitation of section 331 of the Revenue Act of 1918, is the basis for computing depreciation, that section not being a limitation upon the allowances granted by section 234(a)(7) of that Act, and, the values of such assets determined.
*728 This appeal is from the determination*2804 by respondent of deficiencies in income and profits taxes of $5,044.18 for 1918, $22,136.37 for 1919, and $7,486.94 for 1920.
Errors are assigned upon respondent's exclusion from invested capital of certain amounts representing values claimed for an option, three motion picture production contracts, and the services and good will of an individual alleged to have been acquired for capital stock issued, and upon his disallowance of certain deductions taken in the taxable years in question as representing exhaustion of these assets.
FINDINGS OF FACT.
Prior to the year 1918 a corporation, known as the Paralta Studios, Inc., was engaged in motion picture production, having a studio with the necessary equipment at Los Angeles, Calif. This business was directed by one Robert Brunton, a motion picture director of long experience and considerable prominence in his profession. In the year mentioned this corporation became financially involved and was forced to suspend operations, its unpaid obligations for physical properties purchased and general expenses of operation being approximately $175,000. Following the suspension of operations by this corporation, Robert Brunton, through*2805 an arrangement with it, continued the business as a personal venture, operating under the name of the "Robert Brunton Company." In July of 1918, Brunton, through one Howard C. Hickman, procured from Paralta Studios, Inc., a lease with option to purchase its assets. These assets consisted of a lease of the land upon which the studio was located, embodying an option to purchase, and its studio facilities, properties, and equipment. The price provided to be paid by Hickman under the option was $125,000 and by the terms of this contract the purchase money might be paid directly to Paralta Studios, Inc., or to its creditors in satisfaction of the $175,000 of indebtedness referred to. Brunton also procured from the Paralta Studios, Inc., $50,000 to apply in reduction of this outstanding indebtedness and this was paid thereon, the creditors agreeing to withhold enforcement of their claims for *729 eight months. Following this Brunton exercised the option to purchase and paid on the purchase price of the property the sum of $41,062.70, and thereafter, on August 28, 1918, incorporated under the laws of the State of Arizona the "Robert Brunton Studios, Inc.," one of the petitioners*2806 herein, with an authorized capital stock of 250,000 shares of a par value of $250,000. On the same day seven shares of stock of this corporation were issued for cash at par, and Brunton made an offer in writing, entered on the minutes of the corporation, to convey or cause to be conveyed to the latter certain assets in return for the issue of 149,993 shares of its capital stock, these assets being described in the written offer as:
1st. That certain lease and option to purchase, dated the 10th day of August, 1918, made and entered into between Paralta Studios, Inc., a California corporation, party of the first part, and Howard C. Hickman, of Los Angeles, California, party of the second part, the same being an option to purchase the motion picture studio premises and property known as the Paralta Studio property, situated on Melrose Avenue, in the City of Los Angeles, County of Los Angeles, State of California, together with certain equipment and paraphernalia now situated upon said premises.
2nd. All of the equity and interest of said Howard C. Hickman in and to said studio premises, property and paraphernalia under said lease and option to purchase, arising by reason of payments*2807 made on account of the purchase price thereof or by reason of any other matter or thing whatsoever, the amount of such payments on account of said purchase price being the sum of $41,062.70.
3rd. A certain agreement dated the 12th day of July, 1918, made and entered into by and between Robert Brunton, doing business under the fictitious name of Robert Brunton Company, and Pathe Exchange, Inc., a New York Corporation for the manufacture and production by said Robert Brunton for said Pathe Exchange, Inc., of two certain motion picture photo-plays, together with all of the rights of said Robert Brunton therein and thereunder, said assignment to take effect as of the 1st day of August, 1918.
4th. A certain contract dated the 8th day of July, 1918, made and entered into by and between Robert Brunton, doing business under the fictitious name of Robert Brunton Company, and Haworth Pictures Corporation, an Arizona corporation, for the manufacture and production by said Robert Brunton for said Haworth Pictures Corporation of one motion picture, together with all of the rights of said Robert Brunton therein and thereunder, said assignment to take effect as of the 1st day of August, 1918.
*2808 5th. A certain contract dated the 27th day of July, 1918, made and entered into by and between Robert Brunton, doing business under the fictitious name of Robert Brunton Company, and Helen Keller Film Corporation, a New York Corporation, for the manufacture and production by said Robert Brunton for said Helen Keller Film Corporation, of certain motion pictures, together with all of the rights of said Robert Brunton therein and thereunder, said assignment to take effect as of the 1st day of August, 1918.
6th. Generally the Good Will of Business of the business of said Robert Brunton heretofore conducted under the name and style of Robert Brunton Company in the manufacture and production of said motion pictures.
The offer was accepted by the corporation, the assets transferred, and the stock issued as called for. Following this, it being necessary *730 to procure a working capital for the corporation, Brunton and two of his associates, Levee and Hickman, interested two men of large means, Hutton and Danzinger, and negotiated a contract to which the first named three individuals, the corporation, and the last named two individuals were parties. By this contract it*2809 was provided among other things that Hutton and Danzinger would subscribe to 50,000 of the 100,000 shares of treasury stock of the corporation at par; that Brunton and associates would convey to them, as a bonus, 50,000 of the 149,993 shares theretofore issued and also subscribe personally for 20,000 shares of the treasury stock at par, the latter to be paid for by surrender and cancellation of $21,000 in promissory notes of the corporation held by them and representing money advanced the corporation by them; that Brunton would individually purchase 7,500 shares of the treasury stock at 65 cents per share; that Brunton would not sell any of the stock held or to be purchased by him for a period of two years, would devote his entire time to managing and directing the corporation during that time with option given the corporation of two additional years' service; and that the aggregate of the compensation paid officers of the corporation for the succeeding five years should not exceed $60,000 per year.
Capital stock was subscribed for, paid for, and issued in accordance with the foregoing agreement.
Robert Brunton started as a scenic artist on the legitimate stage, and later he*2810 was one of the pioneers of art directing in the motion picture business. He had a very broad knowledge of the motion picture business and was experienced as a general supervisor and producer of pictures. Prior to August, 1918, much publicity had been given to his name with reference to his ability as an art director, and he was very highly regarded. He received at least one offer for his services of $1,000 per week in 1918. Robert Brunton is dead, his connection with petitioner having ceased in December, 1921.
On February 24, 1920, a reorganization was effected whereby a new corporation by the same name, "Robert Brunton Studios, Inc.," was chartered under the laws of the State of Delaware and took over all assets and liabilities of the Arizona corporation and the latter thereupon suspended. In 1922 the name of petitioner was changed to "United Studios, Incorporated." M. C. Levee was an officer of both the Arizona and Delaware corporations during the periods in controversy and executed for both, returns for those years.
The assets, business, and income here involved were from August 18, 1918, to February 24, 1920, the property of the Arizona corporation and during the balance*2811 of the calendar year 1920 were the property of the Delaware corporation.
In setting up its books upon organization in 1918, the Robert Brunton Studios, Inc., balanced the stock issue of 149,993 shares by *731 allocating portions of same at par to the various assets acquired as follows:
| Equity paid for under option | $41,062.70 |
| Good will | 50,000.00 |
| Original value of lease and option | 35,000.00 |
| Original value of contracts | 23,930.30 |
| Total | 149,993.00 |
In determining the deficiencies here appealed from respondent allowed, for invested capital purposes only, the item of $41,062.70 as representing the stock issue of 149,993 shares.
The Arizona corporation made a return for only the calendar years 1918 and 1919, and the Delaware corporation made a return for the full period from January 1 to December 31, 1920. In making such returns these two corporations included in their asset accounts, subject to depreciation, as an item of cost of the studio facilities and equipment, the $35,000 set up as the value of an option to purchase acquired for a similar amount of stock at par, and on this item deducted depreciation as follows:
| 1918 | $2,860.49 |
| 1919 | 6,964.99 |
| 1920 | 6,964.99 |
*2812 Upon account of the items of $50,000 and $23,930.30, allocated to "good will" and "contracts," the Arizona corporation for the years 1918 and 1919, and the Delaware corporation for the year 1920, made deductions for exhaustion as follows:
| 1918 | 1919 | 1920 | |
| Good will | $16,666.66 | $16,666.67 | |
| Contracts | $9,870.95 | 14,358.18 |
All of these deductions were disallowed by respondent.
The assets covered by the option to purchase acquired by Brunton from the Paralto Studios, Inc., had on August 18, 1918, a cash value of $35,000 in excess of the $125,000 required to be paid thereunder, or a total value of $160,000, and the payment of this sum of $125,000 by Brunton and the Robert Brunton Studios, Inc., cleared these assets of all prior liens and liabilities.
OPINION.
TRUSSELL: The deficiency notice dated July 27, 1925, and which is made a part of the petition filed, asserts deficiencies for the three calendar years 1918, 1919, and 1920, against the "Robert Brunton Studios, Inc., 5341 Melrose Ave., Los Angeles, Calif."
*732 There are two issues presented for decision in this appeal - (a) what amounts, if any, may be included in petitioner's invested*2813 capital for the taxable years involved as representing assets stated to consist of an option to purchase certain tangible assets, together with an equity in such assets represented by payments made under the option, the good will of an individual business and three contracts, all of this property having been acquired for stock, and (b) whether or not a deduction from gross income is allowable on account of exhaustion of such assets.
A decision on the first issue requires little discussion. Much testimony has been introduced with respect to the value of the assets in question but value in this instance is not the basis for computation of invested capital, as the acquisition of these assets was from an individual for stock issued in an amount in excess of 50 per cent of the total authorized capital stock of the corporation, and section 331 of the Revenue Act of 1918 applies, limiting the amount to be included in invested capital on account of the assets to their cost to the previous owner from whom acquired.
The record shows no cost to Robert Brunton of the assets in question, other than payments totaling $41,062.70 made by him on the purchase price of the property covered by*2814 the option to purchase. No question is raised as to the action taken by respondent in respect to the equity in this property represented by the sum of these payments, its full cost having been allowed by him. This asset is the only one of the several acquired for the stock in question which shows a cost to the previous owner and respondent's determination of invested capital is approved.
The second issue presents a different question, as the values of assets, allowable for purpose of computation of deductions from income on account of exhaustion, under section 234(a)(7) of the Revenue Act of 1918, are not subject to the limitations imposed by section 331 of that Act. ; .
Let us consider the assets separately. A total of 149,993 shares of stock of a par value of $149,993 was issued for four assets, one of these being an equity in property of $41,062.70, representing cash payments already made on account of the purchase price. To this asset the corporation allotted a book value of $41,062.70. To the remaining three assets the corporation allotted the balance of the stock*2815 issue at par in the sum of $108,930.30, divided as follows:
| Good will | $50,000.00 |
| Contracts | 23,930.30 |
| Option to purchase | 35,000.00 |
| 108,930.30 |
*733 If these values are provable as of the date of acquisition and the assets are depreciable in character, petitioner is entitled to deduction of a reasonable allowance for exhaustion. ;; .
Petitioner's insistence is that the asset described as good will and which was acquired for 50,000 shares of stock issued was not the good will of the old business of Robert Brunton Co. but was a contract made by Robert Brunton to give his entire service to the corporation for a period of two years, with option given the latter for two years additional, and that the limitation of $60,000 per year placed on the aggregated salaries of all officers of the corporation by that agreement gave the corporation his services at a figure greatly below what he might expect to receive from other companies. It is insisted that although this item is designated as good will it really represents*2816 a contract for service to be rendered which had a great value above the salary to be paid and that the period of that service was in fact three years and this gave a basis upon which its value may be depreciated.
We are satisfied from the record that Brunton was a man of great ability and experience in his profession, with a fine reputation, personal influence and good will. There is no doubt that his services were of great value to the corporation, probably in excess of the salary he drew. However, all other questions aside, the record shows clearly that this contract for services, which petitioner insists constituted the value of the item of good will and was the basis of its estimate of $50,000 ascribed to that value, was not acquired for the issue of stock in question. Brunton was in no way obligated to render service to the corporation as a consideration of the stock received. The contract for his services was executed on October 4, 1918, more than a month after the sale and transfer to the corporation of the assets in question for 149,993 shares of stock, and is shown to have been entered into as one of the considerations for the purchase of 50,000 shares of treasury stock*2817 at par by two wealthy investors, Hutton and Danzinger. Brunton was the holder of three-fifths of the corporate stock and it was essential to obtain cash capital and desirable to interest wealthy investors who would give financial strength to the corporation. Hutton and Danzinger were of this character, but, as a condition of their investment, they required of Brunton a contract to serve the corporation for a definite term and a share of his stockholdings as a bonus. Petitioner only claims a value for the item of good will as a result of the contract for service, and this we find was not acquired for the stock issued, but was an asset acquired later without cost to the corporation, and *734 any value which it might have is accordingly not the basis for a deduction for exhaustion. ; ;
Aside from this question, however, the record shows that the asset actually acquired for this issue of 50,000 shares of stock was not Brunton's contract of service but the good will of the old business known as "Robert Brunton Company. *2818 " The contract detailing the transaction describes it in clear and unmistakable terms as:
6th. Generally the Good Will of Business of the business of said Robert Brunton heretofore conducted under the name and style of Robert Brunton Company in the manufacture and production of said motion pictures.
The proof also gives a picture of the motion picture industry, and this business in particular, which shows that good will existed and had a very definite value. In fact we have no doubt that its value was equal to the par value of the 50,000 shares of stock issued therefor, but such conclusion does not make a loss in value of that asset due to the death of Robert Brunton the subject of a deduction under section 234(a)(7) of the Revenue Act of 1918 in arriving at net income.
The three contracts for production of motion pictures which Brunton assigned the corporation as one of the considerations for the issue of 149,993 shares of stock and to which the latter allocated $23,930.30 par value of the stock issued, and which value it now seeks to prove and to be allowed to depreciate, are shown to our satisfaction to have had an intrinsic value. Moreover, the action of the officers*2819 of the corporation in the exercise of their best judgment in placing a value of $23,930.30 on these contracts when acquired, although not sufficient in itself, in this instance, to carry the burden of proof of such value, is evidence of actual value. .
These contracts provided in the case of the Pathe Company for two pictures at $15,000 each, with a conditional bonus in each case of $3,000. The other contracts provided for rental of the studio to the producing companies for $500 per week and properties at a percentage of their cost and for reimbursement of the corporation at cost plus 10 per cent profit for any additional labor and material expended by it. The use of the properties of the corporation under these latter contracts was not exclusive, the corporation reserving the right to contract with other companies for their use concurrently and to use them itself during this time in the production of motion pictures. Under these latter contracts there was no possibility of loss to the corporation. They meant an absolutely certain income, the amount of which was dependent upon the time to produce the *735 pictures and*2820 the additional amount of scenery, sets, etc., which the corporation would be required to construct at the expense of the producer, and these conditions appear to us to be ones which could be calculated in advance with reasonable accuracy by the officers of the corporation. In other words, it appears to us that at the time when these officers placed a value of $23,930.30 on these contracts the facts were in their possession upon which men of the character and experience that the record shows them to be could have made a correct valuation. Certain of these officers testified at the hearing as to their valuation of the contracts and as to the reasonableness of that valuation in their opinion, both in the light of the facts then existing and now known after performance of the contracts.
The net profit from these contracts is not shown, but it does appear in evidence that from the Pathe Company and Helen Keller Co. contracts, gross income of $24,095.52 and $57,000 was received during the balance of the calendar year 1918, and it is very apparent from the record that the operations of the corporation were profitable from its inception.
We are of the opinion that petitioner has sustained*2821 sufficiently the burden of proof that the contracts in question had a reasonable value of $23,930.30. It appears that these contracts were performed in the calendar years 1918 and 1919, and the value assigned them is the basis for the deductions for exhaustion over those years, as made by petitioner.
The remaining question pertains to the asset consisting of an option to purchase the properties of the Paralta Studios, Inc., acquired by the Arizona corporation from Brunton, and to which it ascribes a value of $35,000 on its books, balancing thereby a similar amount at par of the total stock issued to Brunton and associates.
In respect to this item there is no proof as to a value for the property represented by the option to purchase held by the Paralta Studios, Inc., on the real property which it leased, which option was included in the assets covered by the option to purchase given Brunton by that company, but there is ample proof that the studio facilities and equipment had a value in excess of the $35,000 plus the option price of $125,000. This property is shown to have cost the Paralta Studios, Inc., a sum very largely in excess of $125,000 and the payment of that price*2822 under the option secured it clear of indebtedness. Its value was placed by witnesses in the neighborhood of $200,000.
We conclude that the option to purchase had a reasonable cash value of $35,000 when acquired by Brunton from the Paralta Studios, Inc., under the proof showing that the property covered by it was worth that sum in excess of the option price of $125,000 or $160,000. *736 Robert Brunton, however, exercised the option and paid $41,062.70 on the purchase price and what the Robert Brunton Studios, Inc., acquired for the issuance of stock in the amounts of $35,000 and $41,062.70 to Brunton was the $160,000 property itself subject to an indebtedness thereon of $84,937.30 which the corporation thereafter paid off. This total of $160,000 represents the cost of these studio facilities and equipment in cash and stock to the corporation and this total is subject to depreciation for the taxable years in question. There appears to be no issue as to rate of depreciation upon the property.
The deficiencies will be redetermined in accordance with the foregoing findings of fact and opinion.
Reviewed by the Board.
Judgment will be entered pursuant to Rule 50.
*2823 STERNHAGEN concurs in the result.
SIEFKIN, dissenting: The findings of fact in these proceedings show that Robert Brunton Studios, Inc., the Delaware corporation, did not exist until 1920 and that it acquired the assets and liabilities of the Arizona corporation of the same name, "and the latter thereupon suspended."
It seems to me that we lack jurisdiction to pass upon the deficiencies asserted against the Arizona corporation, which must be for the years 1918 and 1919 (and possibly part of the year 1920). Neither the statute nor the rules of the Board permit a joint petition or a petition by other than the taxpayer. Whichever corporation filed the petition in this proceeding may require us to pass upon its tax liability, but we can not go further and pass upon the liability of someone other than the petitioner. The petition in Docket No. 7477 is verified by the president of United Studios, Inc., the same corporation as Robert Brunton Studios, Inc., the Delaware corporation, except for the change of name.
The verification reads:
M. C. LEVEE, being duly sworn, says that he is the President of the petitioner above named (name changed since 1920 from*2824 Robert Brunton Studios, Inc. to United Studios, Inc.); that as such officer and because of his connection and activities in the business and affairs of the Robert Brunton Studios, Inc., an Arizona company, and the Robert Brunton Studios, Inc., a Delaware company, he is thoroughly familiar with the situation brought about by the proposed action of the Commissioner of Internal Revenue resulting from audit of the corporation's books and records for the years 1918, 1919 and 1920; * * *
I think it is obvious that the Delaware corporation is attempting to obtain a redetermination of the deficiency asserted against the *737 Arizona corporation. I believe the proceeding in Docket No. 7447 should be dismissed for lack of jurisdiction.
MARQUETTE, TRAMMELL, ARUNDELL, VAN FOSSAN and MURDOCK agree with this dissent.