*3085 1. The petitioner, on February 25, 1918, retired 2,000 shares of its preferred stock at $10 per share above par. Held, that the retirement having been made within the first 60 days of the taxable year, invested capital should be reduced by the full amount paid for the stock.
2. A liability for a breach of contract occuring in 1918, is not a proper deduction for that year where the taxpayer, although having knowledge of its liability to respond in damages for the breach, does not admit liability to the injured party, or accrue it on its books during the taxable year.
3. The petitioner is entitled to have its profits tax computed under the provisions of section 328 of the Revenue Act of 1918.
*1259 The petitioner seeks the redetermination of a deficiency of $1,016.72 in income and excess-profits taxes for the year 1918. The petitioner claims that error was committed in:
1. Adjusting invested capital by reducing net income by a tentative tax to determine the amount of current earnings available for the*3086 retirement of preferred stock.
2. Declining to reduce net income by $1,518.16, representing liquated damages collected by the Government in 1925 for the late delivery in 1918 of material under a war contract, and
3. Refusing to compute excess-profits tax under the provisions of section 328 of the Revenue Act of 1918.
*1260 The respondent, by his amended answer, alleges that he should have reduced invested capital by the full amount paid for certain shares of preferred stock retired by the petitioner on February 25, 1918, instead of reducing invested capital only by the difference between the amount paid and the amount of current earnings to the date of the stock retirement. An increased deficiency is claimed by reason of this allegation.
FINDINGS OF FACT.
The petitioner is a New Jersey corporation with principal offices at Ludlow, Pa., engaged in the business of tanning bag, strap and case leather. The business was started in 1872 by J. G. Curtis and was transferred by him to the J. G. Curtis Leather Co., a Pennsylvania corporation, in 1898. Upon the organization in 1901 of the petitioner corporation, it acquired all of the assets of the Pennsylvania corporation*3087 for $3,000 cash, $97,000 of its common stock, $50,000 of its preferred stock, $100,000 of its bonds, and promissory notes of a total amount sufficient to make up the difference between the sum of the cash and securities paid and the book value of the assets transferred. The consideration paid for the business was, in turn, distributed to the stockholders of the Pennsylvania corporation. The balance sheet of the two corporations on March 1, 1901, the date of the sale, was as follows:
| Pennsylvania corporation | New Jersey corporation | |
| Assets | ||
| Cash | $14,583.93 | $14,583.93 |
| Plant | 30,000.00 | 30,000.00 |
| Accounts receivable | 22,923.60 | 22,923.60 |
| Inventories | 219,680.10 | 219,680.10 |
| Prepaid expenses | 7,068.04 | 7,068.04 |
| Total assets | 294,255.67 | 294,255.67 |
| Liabilities | ||
| Accounts payable | $454.19 | $454.19 |
| Notes payable to stockholders | 43,801.48 | |
| Bonds | 100,000.00 | |
| Preferred stock | 50,000.00 | |
| Common stock | 100,000.00 | 100,000.00 |
| Surplus | 193,801.48 | |
| Total liabilities and capital | 294,255.67 | 294,255.67 |
At the time of acquisition by the petitioner of the business of the Pennsylvania corporation, the latter transferred to it a large number of processes and formulae*3088 for tanning leather and for leather finishes. Between 1901 and 1918 the petitioner, because of the almost complete change in the tanning industry during that period and to meet the demands of its customers, perfected a number of additional processes and formulae. No attempt was ever made to segregate the cost of the raw hides, chemicals, labor, and other expense, entering into the development of the process and formulae. The entire cost, amounting to from $8,000 to $15,000 per year, was charged to operating expenses and to the cost of goods sold. None of it was ever capitalized. *1261 The petitioner is now unable accurately to determine the amount of its expenditures between 1901 and 1918 in developing such formulae and processes. As a process or formula was perfected, it was reduced to writing and retained as a trade secret. Only two of the petitioner's employees had knowledge of the process and formulae. None of them were ever patented or copyrighted. In 1918 the petitioner had about 75 of such formulae or processes on hand for the production of various kinds and colors of leather it manufactured. Few, if any, of them were among those acquired from the Pennsylvania*3089 corporation in 1901. A great deal of the profits made by the petitioner in 1918 were directly attributable to processes and formulae previously perfected by it.
On February 6, 1906, there was issued to James A. Connelly, an employee of the petitioner since 1894 and a stockholder of the corporation from 1906 to and including 1918, United States Letters Patent No. 811904 for an invention on a locking device for frames used for stretching hides and skins. The petitioner had a large number of the locking devices manufactured under the patent at its own expense. Between 2,500 and 3,000 of the 4,000 to 4,300 stretching frames used by the petitioner in 1918 for stretching hides were equipped with locking devices covered by the patent. The use of this mechanism enabled the petitioner to increase the measurement of hides from 2 per cent to 5 per cent. All leather produced by it was sold on a square-foot basis.
Connelly never transferred or assigned the patent to the petitioner or granted it the exclusive use thereof. He also never received any consideration from the petitioner for the privilege granted of having devices manufactured under the patent, or for the use of the devices*3090 after their manufacture. The mechanism was used by the petitioner during the entire life of the patent with the permission of the patentee.
The flexible inner soles manufactured by the petitioner and its predecessors were sold under a trade-mark called "Curtis Flexible Inner Soles." The trade-mark has been in continuous use since 1887, but was not registered with the United States Patent Office until January 2, 1923. The trade-mark has been advertised by the petitioner and its immediate predecessor since 1900.
During the period from 1901 to 1918 the petitioner constructed a number of buildings as additions to its plant, at a cost of $155,776.35. The designs necessary for the buildings were prepared by officers and employees of the petitioner and the construction work was supervised by the petitioner's secretary. The salary paid to the petitioner's officers and employees during the time they devoted part or all of their time in connection with the construction of the *1262 buildings, was charged to operating expenses. The book value of the petitioner's buildings as of December 31, 1917, does not include any sum for engineering fees or contractor's profits in connection*3091 with the erection of the additional buildings.
For some time after 1901 the petitioner followed a conservative policy with respect to the capitalization of expenditures. Because of the manner in which the corporate books were kept, it is now impossible for the petitioner to designate or determine the amount of the items charged to operating expenses, which without such a policy would have been capitalized.
The sales, tangible net worth, and the net income, without any deduction for Federal taxes, of the petitioner for the years 1901 to 1919, inclusive, were as follows:
| Year | Total sales | Tangible net worth | Net income before Federal taxes |
| 1901 (10 months) | $100,000.00 | $24,901.32 | |
| 1902 | $705,837.26 | 124,901.32 | 49,970.49 |
| 1903 | 773,182.44 | 155,371.81 | 58,032.30 |
| 1904 | 967,163.85 | 205,404.11 | 67,834.61 |
| 1905 | 1,228,670.56 | 260,238.72 | 61,787.76 |
| 1906 | 1,506,265.32 | 303,026.48 | 97,689.30 |
| 1907 | 1,684,596.17 | 377,215.78 | 118,877.68 |
| 1908 | 1,739,532.31 | 460,093.46 | 303,462.17 |
| 1909 | 2,302,345.13 | 710,555.63 | 224,222.31 |
| 1910 | 2,582,977.05 | 879,577.94 | 127,147,99 |
| 1911 | 2,753,546.80 | 952,325.93 | 378,241.99 |
| 1912 | 3,086,033.88 | 1,163,212.01 | 357,193.85 |
| 1913 | 2,888,838.62 | 1,232,555.86 | 342,214.86 |
| 1914 | 2,789,577.54 | 1,267,131.53 | 445,904.79 |
| 1915 | 3,978,930.08 | 1,329,236.32 | 335,536.44 |
| 1916 | 3,884,700.13 | 1,082,023.25 | 384,681.18 |
| 1917 1 | 4,378,736.55 | 1,723,170.32 | 471,628.48 |
| 1918 1 | 4,819,506.90 | 1,978,002.07 | 799,239.82 |
| 1919 1 | 5,122,148.68 | 2,171,694.20 | 1,303,623.98 |
The balance sheet of the petitioner as of December 31, 1917, as adjusted by the respondent, with the exception of the asset account designated "Good Will, Processes, Inventories and other Intangibles," which he declined to allow, reflect the following:
| Assets | Liabilities | |||
| Cash | $109,386.42 | Accounts payable | $22,865.43 | |
| Buildings, plant and | ||||
| equipment | $447,487.28 | Bills payable | 60,000.00 | |
| Less: Reserve for | ||||
| depreciation | 186,146.81 | Reserve for | ||
| Federal taxes | 66,000.00 | |||
| Net depreciated value | ||||
| of plant, buildings and | ||||
| equipment | 261,340.47 | Capital stock | 1,200,000.00 | |
| Merchandise inventory | 1,500,643.34 | Surplus | 1,893,286.58 | |
| Accruals | 95,515.47 | |||
| Stocks | 18,000.00 | |||
| Bills receivable | 2,000.00 | |||
| Accounts receivable | 244,096.40 | |||
| Liberty bonds | 6,000.00 | |||
| Cash surrender value, | ||||
| life insurance | 4,620.50 | |||
| Organization expense | 549.41 | |||
| Goodwill, processes, | ||||
| inventions and other | ||||
| intangibles | 1,000,000.00 | |||
| Total assets | 3,242,152.01 | Total | ||
| liabilities, | ||||
| capital stock | ||||
| and surplus | 3 242,152.01 |
*1263 Under date of March 11, 1911, the*3093 petitioner's board of directors valued its good will, trade-marks, processes, formulae and inventions at $1,000,000, and directed that an account be opened on the corporate books entitled "Good Will and Processes" and charged with that amount.
During 1917 the petitioner entered into two contracts with the United States Government for the manufacture and delivery of a stipulated quantity of leather. Article five of each agreement provided for the assessment of liquidated damages against the petitioner in the event of late deliveries of material under the agreements. Deliveries made under the contracts were shipped by the petitioner and paid for in full by the Government in 1918. In 1918 the petitioner was aware that it had failed to make delivery of one shipment within the time agreed upon, but did not admit liability to the Government for the breach. No demand was made by the Government for the payment of liquidated damages on account of the breach, until December 18, 1925, when the petitioner received word that there had been deducted from a refund for 1919 taxes, the sum of $1,518.16 as liquidated damages on account of the delay in making shipment. The petitioner kept its*3094 books on the accrual basis and filed its return for the year 1918 on the basis of a calendar year.
On February 25, 1918, the petitioner retired 2,000 shares of its preferred stock, each of the par value of $100, at $110 per share. On account of this retirement of stock, the respondent reduced the petitioner's invested capital by $131,832.46, this figure having been determined by him in the following manner:
| Net income for year 1918 | $799,239.82 |
| Tentative tax | 369,348.67 |
| Available for retirement of preferred stock | 429,891.15 |
| Earnings available to Feb. 25, 1918 | 64,777.90 |
| Payment for stock retired as at Feb. 25, 1918 | 220,000.00 |
| Paid out of surplus | 155,222.10 |
| $155,222.10 prorated for 310 days, resulting in a reduction of invested capital by | 131,832.46 |
The petitioner's return for the year 1918 was filed on June 14, 1919. On February 21, 1924, the petitioner executed, and subsequently filed with the respondent, a consent agreement extending the statutory period of limitations for the assessment of taxes for the year 1918, to June 14, 1925. No other consent agreement was ever signed by the petitioner for the year 1918. The tax in controversy was assessed*3095 January 19, 1925. The letter rejecting the petitioner's claim in abatement was issued on February 8, 1926, and based thereon this proceeding was instituted.
*1264 OPINION.
ARUNDELL: The respondent, in support of the proposition raised by his amended answer that invested capital should be reduced by the full amount at which the stock was retired, relies upon our decision of a similar issue involved in the case of Clearfield Lumber Co.,3 B.T.A. 1282">3 B.T.A. 1282. The petitioner, on the other hand, has no fault to find with the respondent's adjustment except in so far as he reduced net income by a tentative tax to determine the amount of current earnings available for the redemption of the stock, and cites the case of Hutchins Lumber & Storage Co.,4 B.T.A. 705">4 B.T.A. 705, as being opposed to the contention now being made by the respondent.
We find no inconsistency between the two cases. In the Clearfield case, where all of the taxpayer's preferred stock and about one-half of its common stock was retired prior to and during the year 1918 at par, the respondent during the taxable year in controversy, related the retirements made to the earnings for the*3096 year. This we held to have been erroneous on the principle that a retirement of the stock at the price paid for it does not impair surplus, but simply amounts to a return to the stockholder of the amount of his capital contribution.
The facts in the Hutchins case presented a different situation. There, the petitioner not only returned to the stockholder the amount of its original investment, but its proportionate share of accumulated surplus. In that proceeding we said in approving the adjustment made by the respondent:
It was a capital transaction involving a return to this particular stockholder or its capital contribution plus its share in the accumulated surplus, and the paid-in capital and surplus, of which these funds were a part, were lessened by a withdrawal of the same. The purchase by a corporation of its own capital stock eliminates the stockholder without substituting another in its place, repays to the withdrawing member his share of the capital, and reduces the amount of the fund contributed to the common venture.
To the same effect, see *3097 Simmons & Hammond Manufacturing Co.,1 B.T.A. 803">1 B.T.A. 803.
The purchase by the petitioner of a part of its own capital stock was a capital transaction involving a return to the stockholders of the amount of their investment, plus a portion of the accumulated surplus. In the Hutchins case, however, the redemption of stock took place after the first 60 days of the taxpayer's taxable year and in that respect differs from the facts here, where the retirement was made on February 25, 1918, a date falling within the first 60 days of the petitioner's taxable year. Subdivision (e) of section 201 of the Revenue Act of 1918 provides that "Any distribution made during the first sixty days of any taxable year shall be deemed to have been *1265 made from earnings or profits accumulated during the preceding taxable years; * * *" The petitioner's surplus at the close of 1917 was approximately $1,900,000. The retirement having been made within the first 60 days of the petitioner's taxable year, it is apparent that no part of the fund used to redeem the stock should be regarded as having been derived from current earnings. Petitioner's invested capital should be recomputed*3098 by reducing the amount thereof, $220,000, prorated over the year.
Our decision on the issue just disposed of renders unnecessary a ruling upon the question raised by the petitioner as to the reduction of net income by a tentative tax to determine the amount available for the retirement of stock. The question is, however, governed by L. S. Ayers & Co.,1 B.T.A. 1135">1 B.T.A. 1135.
Under the second assignment of error, the petitioner claims that the amount of liquidated damages paid by it should be allowed as a deduction from gross sales for the year 1918 or as a loss sustained under the contract for that year. That the breach of contract occurred in 1918 is not disputed. The petitioner, of course, knew in 1918 that it had made a late delivery, but it did not admit its liability in that year or receive any notice from the Government in 1918 of an assessment of, or an intention to assess, liquidated damages on account of the late delivery of material under the contract. No claim was made by the Government for damages until during the year 1925, when the full amount was deducted from a tax refund for the year 1919. Until then, the claim existed only in contemplation and there*3099 was nothing for the petitioner to accrue on its books or pay. The respondent's action is sustained. M. C. Stockbridge, et al.,2 B.T.A. 327">2 B.T.A. 327; Bump Confectionery Co.,4 B.T.A. 50">4 B.T.A. 50; and Empire Printing & Box Co.,5 B.T.A. 203">5 B.T.A. 203.
The petitioner, prior to the taxable year, expended from $8,000 to $15,000 each year in the development of secret processes and formulae for finishing leather, and for leather finishes. The cost of chemicals, labor and raw material necessary for the perfection of the processes and formulae was charged to operating expense and the petitioner can not now accurately establish the amount expended for such purposes. The processes and formulae developed and used by the petitioner were necessary for the successful conduct of the business and contributed towards the earning of large profits, not only in the taxable year but during prior and subsequent years as well. That the processes and formulae were valuable intangible assets in the hands of the taxpayer can not be seriously disputed.
The corporate books likewise fail to show capital charges for certain expenditures made by the petitioner after 1901 in connection*3100 with plant additions and improvements referred to in our findings *1266 of fact. The revenue agent who examined the petitioner's books fully recognized the fact that many of these items should have been capitalized and made a few changes in the accounts to bring them in harmony with the facts. It was entirely impracticable, however, to rewrite the books to disclose the correct situation in this particular.
In the computation of invested capital the respondent allowed no value for the secret processes and formulae developed and owned by the petitioner, and did not include, in any amount, many capital items improperly charged to expense. In Deltox Grass Rug Co.,7 B.T.A. 811">7 B.T.A. 811, special assessment was allowed because of the inability of the taxpayer to determine from its books the amount of development cost improperly charged to expense. See also The Viscose Co.,3 B.T.A. 444">3 B.T.A. 444, and Northwestern Yeast Co.,5 B.T.A. 234">5 B.T.A. 234.
It is our conclusion, from all the evidence, that the petitioner is entitled to have its tax liability computed under the provisions of section 328 of the Revenue Act of 1918.
The petitioner is contending*3101 that the Board is without jurisdiction to increase the deficiency, on the ground that the period within which any further assessment might be made had expired prior to the date of the mailing of the notice of deficiency. Inasmuch as the computation of the tax under section 328 may reduce the unpaid tax to a sum not greater than the present outstanding and unpaid assessment, this question will not be determined until the further hearing under Rule 62(c) is had.
Recomputation of the deficiency should be made under Rule 62(c).
Footnotes
1. Net income and invested capital as computed by the Commissioner. ↩