*75 Decision will be entered for the respondent.
T Corp. purchased the operating assets of a predecessor company, and continued the business of the predecessor. As part of the purchase agreement T was required to procure a release of the predecessor's liability under a union contract for severance pay to employees upon permanent closing of the plant. T obtained such release by entering into a new agreement with the union which imposed liability upon T for severance pay only where T failed to give specified notice to its employees prior to closing. Held, T may not increase its cost basis of the assets purchased by reason of its contingent liability for severance pay.
*831 Respondent determined a deficiency in income tax of petitioner in the amount of $ 16,959.40 for the year 1955.
The sole question is whether petitioner overstated its cost basis in computing depreciation and gain on sale with respect to certain assets which it purchased in 1955.
FINDINGS OF FACT
Some of the facts have been stipulated, and, as stipulated, they are incorporated herein by reference.
Albany Car Wheel Company, Inc., the petitioner, was incorporated under the laws of New York on June 2, 1955, and at all times material its principal business was the manufacture and sale of chilled iron wheels for railway freight cars. Its plant, consisting of a pattern shop, *832 foundry, and machine shop, and its offices were located at 185 Broadway, Menands (Albany), N.Y.
The taxable period involved is petitioner's first fiscal period from June 2, 1955, to December 31, 1955, for which it timely filed its corporate income tax return with the district director of internal revenue at Albany, N.Y.
Petitioner kept its books and records and reported its income*77 for Federal income tax purposes on an accrual method of accounting.
During the taxable period ending December 31, 1955, petitioner's president and majority stockholder was Robert A. Cooley. Prior to 1955 Cooley had had 30 years' experience in the car wheel industry. He was president of the Albany Car Wheel Co, petitioner's predecessor, from 1952 until petitioner acquired its assets in 1955.
Albany Car Wheel Co. (hereinafter referred to as the Old Co.) was a Delaware corporation, indirectly owned by L. B. Smith, who was not related to any of petitioner's stockholders or officers. Prior to the sale of its assets to petitioner on June 9, 1955, as hereinafter noted, the Old Co. was engaged in the manufacture and sale of chilled iron wheels for railway freight cars.
Up to the 1920's most of the wheels used on American freight cars were made of chilled iron. However, in order to meet the more rigorous demands made by increased speeds of freight trains, the steel wheel began to replace the iron wheel during the 1920's. The decline in the chilled iron car wheel industry was manifested by a decrease in the number of manufacturers. In the 1920's there were about 25 companies operating*78 about 50 plants. In 1955 there were about 8 companies operating from 20 to 25 plants. In December 1962 only one chilled iron car wheel plant was in operation and it was in the process of closing down.
The demise of the chilled iron car wheel industry was accelerated by the Association of American Railroads beginning in 1953 when it promulgated the first of a series of new rules prohibiting the use of chilled iron wheels on certain kinds of freight cars. Thereafter successive rules were enacted prohibiting the use of such wheels under all new and rebuilt freight cars, and, finally, in 1961 there came the expected death knell in the form of an absolute ban placed on the casting of any more iron wheels after December 31, 1963, or their use by American railroads after December 31, 1967. The useful life of such wheels is about 7 years.
For a period of approximately 15 years prior to 1955 the Old Co. had been operating under successive labor agreements which provided for severance pay to workers. The labor agreement operative in early 1955 was an agreement between the Old Co. and the United Steelworkers of America, dated December 30, 1952, as amended by *833 the parties on August*79 26, 1953. Section 15 of that agreement provided as follows:
SEVERANCE PAY
Each employee with one year of continuous service shall be allowed four (4) week's severance pay; each employee with five or more years service shall be allowed eight (8) week's severance pay.
The above provisions shall apply when any portion, facility or the plant should be closed down permanently or by improvement brought about through technicological improvements.
Severance allowance will not be allowed to any employee refusing to accept employment with the Company in accordance with Section -- 7; Seniority.
An employee who receives severance allowance under the provisions of this Section and is rehired by the company within six (6) months of the termination of his employment, his continuous service record shall be maintained in accordance with Section 7 of the Agreement covering Seniority, except that for the purpose of this Section, his continuous service record shall be deemed to have commenced as of the date of rehiring.
The determination of continuous employment and the computation of the amount of pay (with respect to the amount of hours per week and the rate of pay) applicable for each employee shall*80 be made on the basis of Section 14; and Section 7 of this Agreement covering Vacation and Seniority.
The plant of the Old Co. did not permanently close or cease operations due to technological improvements during the period December 30, 1952, to June 9, 1955.
Early in 1955 Cooley estimated that a chilled iron car wheel plant had a remaining economic life of from 2 to 5 years. He then informed Smith that he desired to leave his job with the Old Co. but that he would stay long enough for Smith to get a replacement. Smith at that time was anxious to dispose of the business and suggested that Cooley purchase it. On or about June 2, 1955, Cooley, on behalf of a corporation to be formed, the petitioner, made a written offer to purchase certain assets of the Old Co. The offer was accepted on June 7, 1955. The offer proposed that the new corporation acquire the Old Co.'s assets other than cash and receivables, assume certain liabilities, and pay $ 15,000 on a promissory note secured by a chattel mortgage. The offer provided, in part, as follows:
2. Subject to the terms of this offer, the NEW CORPORATION shall accept and purchase the specified assets at the time of closing and in full*81 consideration therefor agrees to pay the sum of Fifteen Thousand Dollars ($ 15,000.00) in the manner hereinafter set forth and as additional consideration will assume and agree to pay certain liabilities and obligations of the COMPANY as set forth and described in Schedule B 1 attached hereto and made a part hereof, being certain liabilities and obligations of the COMPANY as reflected on its books as of March 31, 1955, to be adjusted as of the close of business on the day preceding the closing hereof, which liabilities and obligations shall include any liabilities and obligations which are either classified or customarily classified in the named category *834 according to the usual practice of the COMPANY, and the NEW CORPORATION further agrees to assume and pay all liabilities and obligations whether or not reflected or disclosed on the books of the COMPANY which may arise or have arisen from the operations of the COMPANY's facilities at Albany, New York, up to the date of closing, excepting, however, therefrom any liability for Federal or State income taxes, which are specifically not assumed by the NEW CORPORATION; * * *
* * * *
4. * * * At the closing, the NEW CORPORATION*82 shall deliver to the COMPANY its undertaking wherein it shall assume and agree to pay or discharge the liabilities and obligations to be assumed hereunder as set forth in Paragraph 2 hereof and in Schedule B; * * * and the NEW CORPORATION shall deliver to the COMPANY a document executed by the Union evidencing a full and complete release of any and all obligations to the Union or the members thereof, including any obligation with respect to vacation, holiday, and severance pay and pensions, whether accrued or not. * * *
On June 9, 1955, the Old Company executed a "Bill of Sale," pertinent parts of which read as follows:
KNOW ALL MEN BY THESE PRESENTS, that ALBANY CAR WHEEL COMPANY, a Delaware corporation, hereinafter referred to as "SELLER", in consideration of One Dollar ($ 1.00) and other *83 valuable consideration, receipt whereof is hereby acknowledged, does hereby sell, assign, transfer and set over, and deliver unto ALBANY CAR WHEEL COMPANY, INC., a New York corporation, hereinafter referred to as "PURCHASER", its successors and assigns, forever, all right, title and interest in and to the personal property set forth and contained in Schedule A attached hereto and made a part thereof.
SELLER hereby warrants that the said property is free and clear of all liens and encumbrances whatsoever.
Schedule A referred to in the foregoing bill of sale reads as follows:
| ALBANY CAR WHEEL COMPANY | |
| Assets To Be Sold | |
| As of June 7, 1955 | |
| Notes receivable | $ 7,050.00 |
| Inventories (Subschedule A-1) | 72,267.29 |
| Plant and equipment (Subschedule A-2) | 50,120.60 |
| Deferred accounts (Subschedule A-3) | 8,106.06 |
| 137,543.95 |
Lease with Delaware & Hudson Railroad Corp.
The above amounts are the balances of the accounts as they appeared on the books of the Old Co. as of June 7, 1955, and were carried on petitioner's opening statement at substantially the same basis. Petitioner used such basis for the purpose of determining gain on sale of its products as well as depreciation *84 on plant and equipment.
The actual values of "Plant and Equipment" and of some of the items included in "Inventories" were in excess of the amounts on the Old Co.'s books.
*835 On June 9, 1955, petitioner executed a document entitled "Warranty and Guaranty" which reads in part as follows:
FOR VALUE RECEIVED, the undersigned, ALBANY CAR WHEEL COMPANY, INC., a New York corporation, on behalf of itself, its successors and assigns, does hereby by these presents warrant and guarantee unto ALBANY CAR WHEEL COMPANY, a Delaware corporation, its successors and assigns, that it does hereby assume and will pay and discharge the liabilities and obligations set forth and contained in Schedule A attached hereto and made a part hereof, which liabilities and obligations are taken from the books and records of said ALBANY CAR WHEEL COMPANY as of the close of business June 7, 1955; and the undersigned, on behalf of itself, its successors and assigns, further warrants and guarantees that it does hereby assume and will pay and discharge all liabilities and obligations which may arise or have arisen from the operation by said ALBANY CAR WHEEL COMPANY of its facilities at Albany, New York, as of the*85 date hereof, which are not disclosed or recorded on its books and records, excepting therefrom Federal and State income taxes that may be due or owing by said ALBANY CAR WHEEL COMPANY.
Schedule A referred to in the foregoing Warranty and Guaranty reads as follows:
| ALBANY CAR WHEEL COMPANY | |
| Obligations To Be Assumed | |
| As of June 7, 1955 | |
| Trade accounts payable (Subschedule A-1) | $ 16,430.59 |
| Exchange wheel accounts | 14,987.79 |
| Accrued accounts payable (Subschedule A-2) | n2 45,036.52 |
| 76,454.90 |
Obligations under Union Contract
Subschedule A-2 reads as follows:
| ACCRUED ACCOUNTS PAYABLE | |
| As of June 7, 1955 | |
| Accrued payroll | $ 7,056.28 |
| Accrued vacation and holiday pay | 8,059.57 |
| Accrued taxes | 101.18 |
| Accrued payroll taxes | 1,403.29 |
| Accrued water | 3,054.62 |
| Reserve for pensions | 25,361.58 |
| 2 45,036.52 |
Severance pay.
*86 *836 While "severance pay" (in no fixed amount) was listed under liabilities of the Old Co. assumed, there had been no accrual of any severance pay liability on the books of the Old Co. since it never closed its plant and never became obligated under the severance pay provisions of its contract with the union to make any payments. Petitioner did not in fact assume any liability of the Old Co. in respect of "severance pay"; its only obligation in that connection arose under a new contract, hereinafter described, which was negotiated on its behalf with the union.
While negotiating with Smith for the purchase of the assets of the Old Co., Cooley entered into discussions with the union to obtain a release of the Old Co. from its obligations to the union under the collective bargaining agreements then in existence, and to have the union eliminate provisions as to severance pay from the collective bargaining agreement to be entered into with petitioner if it acquired the assets of the Old Co. The union agreed to release the Old Co. from its obligations on condition only that provisions as to severance pay be incorporated in the new agreement; however, it agreed to accept provisions*87 in its contract with petitioner different from those contained in prior agreements with the Old Co. A crucial difference between the provisions in the new contract and those contained in the agreements with the Old Co. was that petitioner could discharge its obligation to its employees simply by giving them notice for specified periods (6 or 12 weeks depending upon length of prior service) before closing the plant; if all eligible employees worked during such periods, petitioner would owe them no more than their wages during such periods. The collective bargaining agreement entered into between petitioner and the union was dated June 1, 1955, and, in this connection, contained the following provisions:
SECTION XIV
SeveranceEach employee with one year or more, but less than five years, of continuous service shall be given six (6) weeks written notice, or pay at his regular straight time rate in lieu thereof, and each employee with five or more years of continuous service shall be given twelve (12) weeks written notice, or pay at his regular straight time rate in lieu thereof, in the event of severance as defined in this Section.
Severance shall mean the termination of employment*88 because of the permanent closing of the plant, or of any portion or facility thereof, or because of technological improvements.
Severance notice or pay will not be allowed to any employees refusing to accept employment with the Company in accordance with Section VII -- SENIORITY.
*837 If an employee receives severance notice or pay under the provisions of this Section and is rehired by the Company within six months of the termination of his employment, his continuous service record shall be maintained in accordance with Section VII of this Agreement covering Seniority, except that for the purpose of this Section, his continuous service record shall be deemed to have commenced as of the date of closing.
* * * *
SECTION XXII
Cancellation of Prior AgreementThe Union recognizes that the Company is the successor in the operation of its business to Albany Car Wheel Company. The Union has had successive collective bargaining agreements with said predecessor Company. The Union recognizes that by entering into this Agreement the present Company has in effect assumed substantially the same obligations to the Union and to the employees as those which had been undertaken by the predecessor*89 Company. In consideration of the execution of this Agreement by the new Company therefore the Union hereby releases the predecessor, Albany Car Wheel Company, from all obligations to the Union or its members imposed upon said AlbanyCar Wheel Company by the terms of the collective bargaining agreements heretofore in existence between it and the Union including specifically all liability for vacation or holiday pay or benefits and severance pay, and all liability with respect to a pension plan or fund, whether arising from such collective bargaining agreements or special agreements relating to a pension plan.
At that time, June 1955, the union contracts of three other corporations, which accounted for more than 92 percent of sales in the chilled iron wheel industry, contained no comparable provisions for severance or notice pay to employees.
Petitioner took out five separate fire insurance policies in the face amount of $ 15,000 each, or a total of $ 75,000, to cover its liability under the severance pay clause of the 1955 union agreement in the event that fire destroyed enough of the premises to cause a shutdown. All of these policies contain the following provision:
The insured*90 agrees to exercise due diligence and dispatch in giving to its employees the notice required above, and if possible, to use their services in gainful work during the notice period required. By so doing, any reduction in the Labor Agreement Severance Liability will be applied to reduce the loss under this policy.
The cost to petitioner of these five policies was $ 3,844.45 for a 5-year term and they were canceled just prior to the expiration date when petitioner closed down its car wheel division and received a small refund of premium. In December of 1956 the face amount of each policy was reduced $ 3,000, thereby reducing the total insurance to $ 60,000.
The difference between the $ 137,543.95 book value of the assets acquired by petitioner and the $ 76,454.90 book value of liabilities assumed by petitioner was reflected in petitioner's opening balance sheet of June 7, 1955, as $ 15,000 of notes payable to the Old Company *838 and $ 46,089.05 of Reserve for Contingencies, the latter being intended to reflect a contingent liability in respect of the severance or notice pay requirement under the new union contract.
On June 9, 1955, petitioner issued a promissory note to the*91 Old Co. in the amount of $ 15,000, $ 500 of which was payable on December 9, 1955, and $ 500 on the 9th day of each month thereafter until the entire amount was paid, with interest at 4 percent per annum. The note was secured by a chattel mortgage dated June 10, 1955.
During petitioner's operation of its car wheel facility it had four major railroad customers, the largest of which was the New York Central Railroad which accounted for over 60 percent of petitioner's business. In February 1960, after petitioner had experienced several months' losses and after it had already been advised that the New York Central would probably discontinue ordering wheels from it, petitioner decided to close its car wheel facility. A letter was sent to all employees on March 4, 1960, notifying them of the permanent closing of its plant and of the closing of its business on May 31, 1960. The union required petitioner to rehire or give severance pay to all employees with seniority who had been laid off within 2 years of the notice date. After March 4, 1960, petitioner rehired 14 employees who had been laid off within the previous 2 years.
The actual wages paid by petitioner for the period after March*92 4, 1960, until the date of closing on May 31, 1960, were $ 74,901.90 to 75 regular employees and $ 6,304.65 to the 14 recalled employees, a total of $ 81,206.55 paid to 89 employees. Since petitioner gave the notice required by its contract with the union and since it rehired the 14 employees who had been laid off, the wages thus paid to all 89 employees for services actually performed relieved petitioner of any further obligation to its employees in relation to closing its plant.
When petitioner began operations in June of 1955, it had 111 employees. Of the 89 employees at the time of closing in 1960, 31 had been hired after petitioner commenced operations; thus, only 58 of petitioner's employees at the time of closing were among the 111 originally employed in June 1955.
The foregoing wages totaling $ 81,206.55 for work performed between March 4 and May 31, 1960, were included in cost of goods sold and deducted in petitioner's tax return for 1960.
OPINION
On June 9, 1955, petitioner acquired by purchase the operating assets of a corporation engaged in the business of manufacturing and selling chilled iron wheels. The Commissioner's adjustments here in issue relate to his reduction*93 in the basis of the assets thus acquired, which in turn resulted in a disallowance of part of the *839 cost of goods sold as well as in a reduction of the depreciation allowance. The total reduction in basis presently in dispute is $ 46,089.05. 3
The starting point in this case is section 1012 of the 1954 Code which provides that "The basis of property shall be the cost of such property * * * [except in certain situations not applicable here]." Accordingly, the decisive question before us is: What did petitioner pay for the assets that it acquired from the Old Co.?
According *94 to the stipulation of facts and the evidence before us, petitioner paid $ 15,000 in cash on a note to the Old Co., and assumed certain specified liabilities of the Old Co. in the net amount of $ 74,360.35. The Commissioner insists that the sum of these two figures, namely, $ 89,360.35, represents the "cost" of the assets purchased. Petitioner, on the other hand, claimed a cost of $ 137,543.95, 4 which was the book value of the assets in the hands of the Old Co. Petitioner undertook to support its higher cost basis by contending that, in addition to the foregoing $ 89,360.35 which it paid for the assets in the manner described, it also assumed an obligation of the Old Co. for severance pay to its employees under a union contract, that such obligation was equal to at least the difference between the $ 89,360.35 and the book value of the assets in the hands of the Old Co., and that it therefore represented an additional item of cost for the assets which it thus acquired. We disagree. We hold that although petitioner did in fact procure the cancellation of the Old Co.'s contingent liability in respect of severance pay by executing a new and different type of contract with the union, *95 petitioner's obligation under the new contract was of such contingent character that it could not be considered part of the cost of the assets which it acquired, and that any such obligation which might actually result in a fixed liability in a later year may properly be taken into account in petitioner's behalf as a deduction in such later year.
The Old Co.'s contract with the union provided that, upon permanent closing of the plant, employees with from 1 to 5 years of service were to be allowed 4 weeks' severance pay and employees with 5 or more years of service were to be allowed 8 weeks' severance pay. It had 111 employees in 1955, and when Cooley was negotiating for the purchase of the assets, he was naturally concerned about any liability that might result in respect of severance pay, particularly since the chilled iron wheel industry was moribund. Indeed the evidence shows that he *96 had calculations made showing that if the plant *840 were to close at that time, the liability for severance pay would be approximately $ 48,000 in respect of the employees then working for the Old Co. Had the petitioner assumed fixed obligations in any such amount we would agree that such assumption would constitute a part of its cost of the assets acquired. But that is not what occurred.
In the first place, and perhaps of lesser importance, the Old Co.'s contract in respect of severance pay spelled out a liability to employees as of the time of closing. There was no liability for severance pay in respect of those employees who had died or who had voluntarily terminated their employment. 5 In the second place, and of greater significance here, petitioner did not assume the Old Co.'s liabilities in respect of severance pay. While it is true that section XXII of petitioner's new agreement with the union recites that "The Union recognizes that by entering into this Agreement the present Company has in effect assumed substantially the same obligations to the Union and to the employees as those which had been undertaken by the predecessor Company," the fact is that petitioner*97 did not assume the Old Co.'s obligations and that its own obligations under the new contract were radically different from those of the Old Co.
Petitioner's obligations, set forth in section XIV of the new contract, revolved primarily around notice. Under these provisions petitioner's liability to its employees at the time of permanent closing of the plant could be met by giving 6 weeks' written notice to employees with from 1 to 5 years of service and 12 weeks' written notice to employees with 5 or more years of service. 6 Petitioner was liable*98 for severance pay under the new contract only where it failed to give the specified notice. And the record shows that when petitioner in fact determined to close its plant in 1960 it gave the required notice to its employees. As a consequence, it paid their wages for work performed during the 6- or 12-week periods prior to closing, but they received no severance pay whatever. Those wages were deducted in petitioner's 1960 income tax return, in determining cost of goods sold in that year. Petitioner recognizes that it cannot have it both ways -- i.e., it concedes that if it is entitled to have severance pay included as part of the cost of assets acquired in 1955, the deduction for *841 wages paid in 1960 must be reduced by a like amount. However, we think that petitioner's method of reporting for 1960 was correct, that the wages paid in that year during the notice period prior to closing were properly deductible in 1960, and that they were not in any part a component of the "cost" of the assets acquired in 1955.
*99 Of course, there was always the possibility that petitioner might become liable for severance pay, if, for example, the plant should burn down and the employees were thrown out of work without having received the required notice. But petitioner protected itself against this contingency by insurance, and the premiums paid therefor were plainly deductible as a business expense. We think that petitioner's liability for severance pay, in view of the notice provisions, was so speculative that its obligations under the union contract cannot fairly be regarded as part of the "cost" of the assets acquired from the Old Co. To the extent that any liability might accrue in a later year as a result of that contract, payments thereunder may properly be taken into account at such later time; they may not be used to increase the cost of goods sold in an earlier year or to increase the amount of the depreciation allowance for such earlier year.
Both parties have cited a number of cases, which we have examined and considered. However, we find that none of them is sufficiently close to the present case to warrant discussion.
Decision will be entered for the respondent.
Footnotes
1. The items listed in schedule B as liabilities and obligations to be assumed by petitioner are the same as those contained in schedules hereinafter set forth showing liabilities and obligations actually assumed by petitioner.↩
2. The parties have stipulated that the liability of the Old Co. for accrued accounts payable assumed by petitioner was $ 42,941.97, and not $ 45,036.52. Thus, the foregoing total of $ 76,454.90 of liabilities assumed was in error to the extent of $ 2,094.55; petitioner in fact assumed fixed liabilities in the amount of $ 74,360.35.↩
3. The Commissioner disallowed $ 48,183.60; however, as a result of a concession by the taxpayer (see footnote 2, supra↩), $ 2,094.55 thereof is no longer in controversy. As to the remaining $ 46,089.05, there is no controversy between the parties in respect of its allocation to inventory and depreciable assets if it be held that the Commissioner was correct in disallowing the total amount as part of cost of all the assets acquired.
4. It now concedes that this amount may be reduced by $ 2,094.55, the amount of the error referred to in footnote 2, supra↩.
5. Thus, of the 111 employees in 1955, only 58 remained in 1960 when the plant was actually closed, and if petitioner had in fact assumed the Old Co.'s obligations under the contract in force in 1955, its contingent liability in respect of the 111 employees would have become fixed only as to 58 of them. And of course, any liability to employees hired after petitioner began business could not properly be regarded as part of the cost of the assets acquired from the Old Co.↩
6. The union construed the contract under the seniority provisions as applying also to employees who had been laid off within 2 years, and, under this interpretation, petitioner was compelled to rehire 14 employees for periods of 6 weeks each at the time of closing in 1960. However, the evidence discloses that every one of these 14 employees was originally hired by petitioner several years after it commenced business in 1955, and petitioner had incurred no obligation as to them, contingent or otherwise, when it acquired the assets of the Old Co.↩