*2959 1. Upon the evidence, held, that the closing inventory of petitioner is acceptable for income and profits-tax purposes.
2. Cash value of promissory notes paid in for capital stock of a Texas corporation allowed for invested capital purposes.
3. In view of the evidence, held that petitioner is not liable for the negligence penalty.
*1351 This proceeding results from the determination of a deficiency in income and profits taxes for the calendar year 1920, amounting as follows: additional taxes, $21,201.86; penalty for negligence, $581.80, or an aggregate of $21,783.66.
The petitioner alleges error with reference to the following issues: (1) The closing inventory was correctly reported in the return; therefore, the respondent should not have held that it was understated in the amount of $35,193.06; (2) the failure to allow in invested capital for a pro rata part of the taxable year of an amount of $125,000 paid in for capital stock in the form of interest-bearing promissory notes; (3) a*2960 penalty for negligence should not be asserted.
FINDINGS OF FACT.
The petitioner is a Texas corporation with its principal office at Dallas, Tex., and is engaged in the wholesale machinery and mill supply business.
*1352 For the taxable year the petitioner employed a firm of public accountants in an advisory capacity with reference to their accounts and tax returns, and also to make a detailed audit of the accounting records. The audit began in October of the taxable year and was completed shortly after the end of the year. In the latter part of November in the taxable year, inventory sheets were prepared from the perpetual inventory records of the petitioner, for use in the physical count of the stock on hand. The count began near the end of November of the taxable year, and continued through December, being completed at the end of the year with interim adjustments so that it represented an inventory of the stock actually on hand at the end of the taxable year. Upon the advice of the public accountants, circular letters were prepared and mailed to over 200 addresses, requesting quotations on the products of the addressees. In addition, price records were maintained*2961 by the petitioner showing the current quotations on the machinery, tools and supplies dealt in by the petitioner; these quotations were mainly at complex rates per centum of discount from standard list prices and were either subject to the allowance of the freight charges on the shipments or were effective at the point of shipment, without freight allowance, according to the trade custom attached to the particular item. The discount rates varied according to the rise or fall of the market but the list prices remained constant. Where quotations were made f.o.b. point of shipment it was customary for the petitioner to compute the cost of the freight upon statements of the weight of the item in the price lists, and at the established freight rates. The cost of freight charges which were or would have to be borne by the petitioner was always considered in computing either the cost or the current market prices of the items.
During the latter part of the taxable year, the market broke badly and prices declined for the machinery, equipment and supplies carried in stock by the petitioner, save that for the pumping equipment the decline was not large. The current prices quoted by the*2962 manufacturers at this time did not always reflect the lower market values for the reason that the supply exceeded the demand, and it was sometimes possible to buy below the quoted prices. Upon completion of the physical count, the inventory sheets were turned over to employees for valuation, with instructions to value each item upon a basis of the lower of cost or market. The valuation was in charge of and under the supervision of the vice president and treasurer of the petitioner; the same official was in general charge of the buying end of the business; he reviewed the valuation of the inventory and approved it. W. W. Williamson, the purchasing agent of the petitioner, valued the mill supplies and the miscellaneous or general *1353 stock; he had been with the petitioner since 1911; he kept in daily actual touch with market prices through quotations made to the petitioner by mail, and also through interviews with sales representatives of concerns from whom the petitioner purchased. W. Edward Hagan, a graduate engineer and formerly a professor of engineering in an university, who had been in the employ of the petitioner since May, 1918, valued the heavy machinery and equipment*2963 in the inventory; he was in charge of the engineering sales of the petitioner; was entrusted with the buying of the heavy machinery; he maintained current price schedules for use in estimating the current cost of machinery and equipment in connection with the customary bidding on power plant equipment; he kept in active touch with market conditions and current prices. W. D. Boyd, an employee of the petitioner, was an assistant to Hagan. During the taxable year he was immediately in charge of sales of pumps and compressed air equipment; he was in the Army during the World War and entered the employ of the petitioner thereafter; he had been employed in the business about one year prior to the taxable year; he assisted Hagan by entering the prices of most of the pumping equipment on the inventory; he kept in active touch with the quotations made to the petitioner.
All of these employees compared the actual costs derived from the purchase invoices, with the current market quotations, including the expense of the freight charges, and the inventory was priced on the basis of the lower of cost or market. The final inventory comprised over one thousand sheets and was priced in lead pencil. *2964 A number of items, but not comparatively many, were first priced at specified discounts and additional amounts of cost were entered for freight. Subsequently, but prior to the summation of the values, these freight allowances were erased. The mathematical accuracy of the inventory was verified by the public accountants employed by the petitioner. A few months thereafter a revenue agent examined the returns and determined that the inventories, both opening and closing, for the taxable year, were understated, and he increased the amounts of the inventories, computing the increases by the application of a rate per centum to the totals shown by the petitioner. The same rate per centum was used in adjusting both inventories. Thereupon the petitioner filed an amended return for the taxable year accepting the revised amount of the opening inventory but not accepting the revised amount of the closing inventory. The value of the inventory of the petitioner at the close of the taxable year amounted to $959,723.47.
During May of the taxable year, it was decided to amend the charter of the petitioner so as to authorize an increase in the authorized capital stock. The additional stock*2965 was subscribed for by a *1354 few individuals who were stockholders, officers, and/or employees of the petitioner. Originally it was the intention to accept payment of one-half of the amounts of the subscriptions in cash and one-half in promissory notes of the subscribers, but this arrangement was somewhat modified in that certain of the subscribers preferred to pay in amounts of cash in excess of one-half of their subscriptions. Interest-bearing promissory notes were paid in and were accepted for capital stock, and the notes were paid, as follows:
| Name | Date | Date of payment | Amount |
| J. E. Dale | May 31, 1920 | June 20, 1921 | $46,400.00 |
| J. T. Dale | do | Nov., 1920 | 4,653.33 |
| W. D. Trotter | do | Mar. 10, 1921 | 1,900.00 |
| A. S. Weaver | do | 5,000.00 | |
| J. C. Weaver | do | Jan. 31, 1921 | 12,500.00 |
| W. W. Williamson | do | 4,000.00 | |
| Total | 74,453.33 |
J. E. Dale, the maker of the note for $46,400 and J. T. Dale, the maker of the note for $4,653.33, were possessed of large means. They were the owners of ranch lands, oil lands, banking interests, various investments in bank stocks and large amounts of Liberty bonds. This note had a cash value at the time paid*2966 in equal to its face value.
W. D. Trotter, the maker of the note for $1,900, was possessed of moderate means, including 162 shares of corporate stock which was worth more than par value, $16,200, and a home probably worth $15,000, on which he was indebted about $4,000. He had credit at his bank having borrowed in the past, $5,000 without security.
A. S. Weaver, the maker of the note for $5,000, was a son of J. C. Weaver. He had no means. The stock which was issued for his note was not turned over to the maker of the note but was attached to the note and held as collateral. The understanding with the maker of the note was that the principal of the note could be paid off gradually out of dividends paid on the stock issued for the note. The note has not been paid except for credits attributable to such dividends.
J. C. Weaver, the maker of the note for $12,500 was president of the petitioner. He owned 1,751 shares, par value $175,100, of the capital stock of the petitioner; that stock had a book value of about $125 at that time. He was possessed of other valuable assets.
W. W. Williamson, the maker of the note for $4,000, was issued stock upon his note under an employees' *2967 contract providing that he would apply all dividends paid on his stock in liquidation of the principal and would make such further payments as he could; the stock was not turned over to Williamson but was attached to the note *1355 as collateral; a number of dividend payments were credited to the note, and, finally, when Williamson left the employ of the petitioner the stock was surrendered and the note was canceled.
The return filed by the petitioner for the taxable year was made up by a senior member of the firm of public accountants employed by the petitioner. Net income has been computed by the respondent in the deficiency letter as follows:
| Net income as originally reported | $163,910.27 | |
| Ending inventory understated | 35,193.27 | |
| Lobbying expense disallowed | 25.00 | |
| Improvement taxes disallowed | 200.00 | |
| Time clock disallowed as expense | 119.00 | |
| Capital expenditures disallowed | 9,119.25 | |
| 208,566.58 | ||
| Less: | ||
| Depreciation understated | $561.32 | |
| Less amount of expenditures allowed | 75.15 | |
| 1 486.15 | ||
| Beginning inventory understated | 26,431.19 | 26,917.34 |
| Net income as corrected | 181,649.24 |
*2968 The capital expenditures included the cost of renewing the flooring on a part of the ground floor of petitioner's building; moving the office from one side of the house to another; repairing the roof, a general rearrangement of the interior of the store to provide for the enlarged business. The expenditures were discussed by the officers of the petitioner and the auditor in the employ of the public accountants. The public accountants recommended to the petitioner that the expenditures should be charged off to profit and loss and deduction should be claimed in the return.
OPINION.
LOVE: The question for decision in the first issue is whether the respondent erred in increasing the value of the inventory of the petitioner at the close of the taxable year. A very few months after the inventory was completed and the original return was filed by the petitioner a revenue agent investigated the return. He increased the values of both the opening and the closing inventories. The petitioner accepted the revised opening inventory and immediately filed an amended return for the taxable year, but the value of the closing inventory is not accepted and is in dispute. The respondent*2969 admits that the amounts of the increases of the inventories were computed by applying a percentage rate, determined by the revenue agent, to the *1356 original aggregate values claimed by the petitioner. The percentage rate used was the same for both inventories. A subsequent second field investigation was made by the respondent. There is no evidence to show what were the bases for the increases in value. From the oral discussions at the hearing it would appear that the bone of contention is whether the petitioner did, in fact, include in the detailed valuations of all of the items of the inventories appropriate allowances for the cost of the freight charges on the shipments to the petitioner. There is no question of interrelation of the two inventories. The question is not one of method or consistency. The valuation of the opening inventory is not before us and we do not pass upon it. The closing inventory of the petitioner consisting of a loose leaf book of over a thousand pages is in evidence. The large stock in trade included a varied assortment of supplies, tools, machinery and equipment. Obviously the detailed valuation of such an inventory is an undertaking*2970 requiring experience and judgment. From an inspection of the inventory and from the testimony of the officers and employees well qualified for the task who valued the inventory, deriving the cost prices from the purchase invoices, and the market prices from current quotations and offerings, supplemented by their own experience and knowledge of the market and of values, we are well satisfied that the cost of incoming freight was carefully considered, and that the basis of the valuation was the lower of cost or market.
There is an entire absence of contraverting evidence. On its face the adjustment of the revenue agent appears arbitrary; merely a summary approximation of personal opinion. Summary adjustments either upward or downward are unacceptable where unsupported by facts. Orkins Bros.,2 B.T.A. 65">2 B.T.A. 65; Orents Department Store Co.,3 B.T.A. 52">3 B.T.A. 52. Valuation of the closing inventory claimed by the petitioner should be accepted. Cf. W. C. Miles Co.,5 B.T.A. 625">5 B.T.A. 625; Fred S. Stewart Co.,5 B.T.A. 436">5 B.T.A. 436; *2971 T. B. Floyd,11 B.T.A. 903">11 B.T.A. 903.
The second issue relates to the failure of the respondent to allow any value whatever for invested capital purposes attributable to the interest-bearing promissory notes of certain of the stockholders and employees paid in to the petitioner for stock. The respondent contends that the notes did not have the value claimed for them and that even though the notes are found to be valuable they are unallowable in invested capital since the constitution of the State of Texas prohibits the issuance of capital stock for notes. Taking up, first, the question of fact, we are well satisfied from the record that the notes of J. E. Dale, $46,000; J. T. Dale, $4,653.33; W. D. Trotter, $1,900; and J. C. Weaver, $12,500, were fully worth a cash value *1357 equal to the amounts of their face values; there was a ready market for the notes; the makers were financially able to pay; there is not the slightest doubt of the bona fides. The notes of A. S. Weaver and W. W. Williamson, we believe to be unallowable for invested capital purposes; we discern no amount of cash value allowable for them when paid in. The transactions were nothing more than prospective*2972 inducements held out to employees with the understanding that they would be permitted, but would not be required, to make capital contributions to the petitioner, and in the meanwhile the dividends on certain stock issued for their notes, but held by the petitioner as collateral, would be applied against the notes if and when paid. There remains the question of law. The Revised Civil Statutes of the State of Texas provide so far as material here, as follows:
ART. 1308. Capital Stock. Before the charter of a private corporation created for profit can be filed by the Secretary of State, the full amount of its authorized capital stock must be in good faith subscribed by its stockholders and fifty per cent thereof paid in cash, or its equivalent in other property or labor done, the product of which shall be worth to the company the actual value at which it was taken or at which the property was received. * * *
ART. 1330. Increase of capital.The board of directors, trustees or managers of a corporation may increase its authorized capital when empowered to do so by a two-thirds vote of all its stock, by complying with the provisions of Article 1348. Upon such increase*2973 of stock being made in accordance with such provisions and certified to the Secretary of State by the directors, and, if the Secretary of State is satisfied that the increase has been made in accordance with law and that the requirements of law have been complied with as to the subscription and payment of stock and in other respects, as on an original application for charter, he shall file such certificate of increase; and thereupon the same shall become a part of the capital stock of such corporation. Such certificate shall be filed and recorded in the same manner as the charter.
ART. 1331. Unpaid Increase. In case of failure by the stockholders to pay the unpaid portion of an increase of stock within two years from the date of the filing of the certificate of increase in the office of the Secretary of State, the charter of such company shall be forfeited, and the provisions of Articles 1339 to 1343 inclusive, shall govern the same as in case of the creation of a corporation.
ART. 1335. Payment of stock. The board of directors of any corporation may require the subscribers to the capital stock of the corporation to pay the amount by them respectively subscribed, in*2974 such manner, and in such installments, as may be required by the by-laws.
ART. 1353. Watering stock.No corporation shall issue any stock whatever, except for money paid, labor done which is reasonably worth at least the sum at which it was taken by the corporation, or property actually received reasonably worth at least the sum at which it was taken by the company. Any corporation which violates any provision of this article shall, on proof thereof in any court of competent jurisdiction, forfeit its charter, permit or license, as the case may be, and all rights and franchises which it holds under, from, or by virtue of the laws of this State.
*1358 In the face of these statutory provisions allowing subscriptions for stock payable 50 per cent in cash or property, with the payment of the balance deferred, the respondent contends that the acceptance of the notes is prohibited under section 6 of Article XII of the Constitution of Texas, providing as follows:
No corporation shall issue stock or bonds except for money paid, labor done or property actually received, and all fictitious increase of stock or indebtedness shall be void.
*2975 It has been held, however, that neither the note given nor the stock issued for the note is utterly void in Texas. Washer v. Smyer,211 S.W. 985">211 S.W. 985; Thompson v. First State Bank of Amarillo,211 S.W. 977">211 S.W. 977. We have had occasion previously to consider the same question with reference to similar situations in other States and have uniformly allowed the cash values for invested capital purposes. Our reasons for so holding are set out at length in the Appeal of Hewitt Rubber Co.,1 B.T.A. 424">1 B.T.A. 424, and need not be repeated here. See also Construction Co. of North America (Delaware),9 B.T.A. 963">9 B.T.A. 963; New Orleans Can Co. (Louisiana),7 B.T.A. 1175">7 B.T.A. 1175; Feeders Supply Co. (Missouri),8 B.T.A. 839">8 B.T.A. 839; Haskell & Barker Car Co. (New York),9 B.T.A. 1087">9 B.T.A. 1087; Williams Steamship Co. (New York),7 B.T.A. 451">7 B.T.A. 451; Pictorial Review Co. (New York),5 B.T.A. 416">5 B.T.A. 416; American Steel Co. (Pennsylvania),1 B.T.A. 839">1 B.T.A. 839; *2976 R. H. Cunningham & Sons Co. (Pennsylvania),10 B.T.A. 113">10 B.T.A. 113; Deerland Turpentine Co. (South Dakota),4 B.T.A. 1236">4 B.T.A. 1236; Coon Auto Co. (South Dakota),8 B.T.A. 763">8 B.T.A. 763; Cross Mountain Coal Co. (Tennessee),2 B.T.A. 587">2 B.T.A. 587; Bowers v. Kaufman, 18 Fed.(2d) 69.
In our opinion the respondent erred in failing to allow for invested capital purposes the effective average amounts of the face values of the notes of J. E. Dale, J. T. Dale, W. D. Trotter, and J. C. Weaver.
In the remaining issue the petitioner questions the propriety of the action of the respondent in adding a penalty of 5 per cent for negligence under the provisions of section 250(b) of the Revenue Act of 1918. If after giving effect to the revisions of income and invested capital authorized in this opinion there remains a deficiency, it will be attributable to the adjustment of capital expenditures disallowed, not at issue here, but shown by the testimony of the public accountant employed by the petitioner to have been largely a question of a controversial and economic nature in which the opinion of the public accountant was followed by the petitioner.
*2977 In view of the evidence we do not believe that the petitioner is liable for the negligence penalty.
Judgment will be rendered under Rule 50.
Footnotes
1. Discrepancy of 2 cents unaccounted for. ↩