*230 Decisions will be entered under Rule 50.
Excess Profits Tax -- Relief Under Section 721. -- A corporation prospected for iron ore throughout 1938 and for several months in 1939 when it located a large body of ore from the sales of which it realized income in 1940 in excess of 125 per cent of average income for the years 1938 and 1939. Held, that the corporation realized income of the class defined by section 721 (a) (2) (C) and is entitled to relief. Amount of net abnormal income attributable to prior years determined.
*926 The respondent has determined that each of the petitioners is liable as a transferee for a deficiency in excess profits tax of Wade and Richey, Incorporated, for the calendar year 1940 in the amount of $ 6,832.12. The deficiency results from the respondent's disallowance of the claim of Wade and Richey, Incorporated, that it was entitled to relief under section 721 of the Internal Revenue Code by reason of part of its income being net abnormal income which is attributable to prior years. More specifically, the claim is made *927 under section 721 (a) (2) (C) as having realized income resulting from exploration, prospecting, and developing of iron ore property.
Stipulated figures established transferee liability. Oral and documentary evidence at the hearing was directed to the question of relief under section 721.
FINDINGS OF FACT.
The petitioners were the sole stockholders of Wade and Richey, Incorporated, which was an Alabama corporation. Wade and Richey, Incorporated, herein called the corporation, commenced business as a corporation on January 1, 1938, although articles of incorporation*232 were filed on January 14, 1938. It made its income tax returns on a calendar year basis. Its returns for the year 1940 were filed with the collector of internal revenue for the district of Alabama.
The corporation was dissolved on or about December 31, 1940. Immediately prior to dissolution each stockholder held 5 shares of its outstanding 20 shares of capital stock. Upon dissolution, the assets of the corporation were distributed equally among its shareholders. The value of the assets so distributed to each shareholder, over and above the liabilities assumed, was in excess of the amount of the deficiency determined by the respondent in excess profits tax of the corporation for the year 1940.
During the existence of the corporation, it was engaged in the business of mining brown ore and quarrying dolomite. It succeeded a partnership composed of R. A. Wade and Simpson Richey. The brown ore operations of both the partnership and the corporation took place on a tract of some 500 or 600 acres of land in Alabama which was originally leased by Richey from Republic Steel Corporation. The lease was transferred to the corporation at the time of its organization. Operations of the *233 corporation in its brown ore activities and the quarrying of dolomite were entirely separate, being located about 30 miles apart.
Brown ore, also known as limonite, is an iron ore. Brown ore deposits occur in pockets, as distinguished from seams in which red ore is found. The pockets are not continuous. They may be close together or they may be separated by considerable distances. The size of a deposit in a pocket may range from a few truck loads of ore to several acres. The pockets are sometimes deep in the ground and sometimes so near the surface that there are surface indications of their existence. Mud, sand, and other foreign substances infiltrate the ore pockets, and the ore must be washed before it is salable.
During the entire year 1938 the corporation was engaged in prospecting the leased lands by the open pit test method. That method consisted of the digging of open pits or wells by professional diggers. *928 The pits were dug by hand, about 30 to 36 inches in diameter, and to a depth usually of 20 to 30 feet. Digging to any greater depth is dangerous to the men in the pits because of the possibility of cave-ins and the accumulation of foul air. A number of*234 test holes were dug in 1938. After the middle of 1938, a number of test holes were sunk in a portion of the tract that was covered by a hill of strip mine overburden that had been deposited by Republic Steel Corporation when it had operated on the property a number of years previously. The test holes in the vicinity of the hill indicated the presence of ore, but the test holes could not be carried to a sufficient depth to go through the overburden.
In order to continue the prospecting in the vicinity of the hill, the corporation on January 15, 1939, purchased and put into operation a Keystone drilling machine which was capable of drilling 6-inch holes to a great depth. At that time, prospecting by means of open pits was discontinued. The Keystone driller was used to sink test holes in various parts of the tract covered by the hill of overburden. The overburden ran as high as from 100 to 125 feet. Under that a body of brown ore was encountered ranging from 50 to 95 feet in thickness and some 10 or 12 acres in extent. The pocket so discovered was unusually large for that part of the country. It became known as the Big Pit.
Tests with the Keystone driller were carried on for *235 some 4 or 5 months. By that time the ore body had been outlined and the corporation purchased additional equipment including shovels, trucks, and a wagon drill. The corporation at or about that time commenced the removal of the overburden at the Big Pit and began to mine the ore. In the mining operations, the Keystone driller was used to drill holes in the ore body in which explosives were placed and large blocks were blasted off. The wagon drill was then used to drill 2-inch holes in such blocks which were blasted into pieces small enough to be picked up by shovels and loaded into trucks. A number of accessories were acquired with both the Keystone driller and the wagon drill. Depreciable assets owned by the corporation, depreciation reserves and remaining costs at the close of 1938, 1939, and 1940 were as follows:
| Cost | ||||
| Depreciation | Remaining | |||
| Dec. 31 | reserve | cost | ||
| Autos and | ||||
| Equipment | trucks | |||
| 1938 | $ 51,093.16 | $ 1,427.98 | $ 20,393.12 | $ 32,128.02 |
| 1939 | 91,494.76 | 5,521.50 | 26,467.25 | 70,549.01 |
| 1940 | 115,680.35 | 2,816.49 | 37,971.25 | 80,524.99 |
*929 Among the items of equipment, autos and trucks included in the depreciable assets at the*236 close of 1939 and 1940 were the following items of heavy equipment which were acquired on the dates and at the costs shown:
| Date acquired | Description | Amount |
| Jan. 2, 1939 | Keystone driller | $ 2,495.74 |
| May 18, 1939 | Wagon drill and compressor | 2,738.00 |
| July 10, 1939 | Power line | 2,500.00 |
| Aug. 1, 1939 | Drag line | 1,905.00 |
| Aug. 11, 1939 | Tractor and bulldozer | 2,250.00 |
| Aug. 30, 1939 | 4 International trucks | 4,443.52 |
| Dec. 5, 1939 | Diesel shovel | 19,900.00 |
| Dec. 31, 1939 | Thomas plant | 13,021.56 |
| Jan. 1, 1940 | 2 International trucks | 2,816.49 |
| June 17, 1940 | Bulldozer and tractor | 3,578.75 |
| July 31, 1940 | Washing plant | 7,928.76 |
| July 31, 1940 | Water line | 4,207.50 |
| Aug. 1, 1940 | Well drill | 4,850.29 |
| Nov. 29, 1940 | Pump and motor | 1,360.00 |
| Nov. 30, 1940 | Washing plant | 13,341.55 |
| Dec. 5, 1940 | Pump and motor | 1,734.72 |
During the year 1940 the corporation retired from service assets that had cost it $ 23,555.06.
Some of the equipment listed in the foregoing schedule was used to mine and haul ore from the Big Pit and some was used to build and maintain roads on the tract leased by the corporation. The ore was hauled to a washing plant owned by the corporation where, after being cleaned, it was carried*237 by a belt to railroad cars. When mining operations were commenced at the Big Pit, the corporation had in use for the cleaning of that ore a 2-log washing plant. In 1940 when the corporation completed mining operations at another site some distance away, it brought over from that site another 2-log washer which was thereafter used to clean ore from the Big Pit. The four logs were operated from a single power unit. The addition of the two logs in 1940 increased the washing capacity of the plant. The Big Pit washing plant was destroyed by fire in October 1940, and the washing plant listed above, as acquired on November 30, 1940, was acquired to replace it.
Under the provisions of the lease of the land on which the corporation operated, Republic Steel Corporation purchased the entire output of the corporation during its existence. During the years 1938, 1939, and 1940, the market at Birmingham, Alabama, was good for the grade of brown ore that was mined by the corporation. Republic Steel Corporation would have purchased more ore from the corporation than it did if more had been produced. The iron content of the ore mined by the corporation was considerably above the average grade*238 of ore that was then being purchased by Republic Steel Corporation.
*930 Only one change in the brown ore price schedule between Republic Steel Corporation and the corporation occurred in the years 1938-1940, which change was effective on November 1, 1939. The prices in those years were as follows:
| PRICE PER UNIT OF IRON AND MANGANESE | ||
| Assay | Prior to November 1, 1939 | On and after November |
| 1, 1939 | ||
| 40% to 44.99% | $ .04 per unit | $ .04 per unit. |
| 45% to 46.99% | .06 per unit | .06 per unit. |
| 47% and up | .06 per unit | .06 1/4 per unit. |
The production, assay, unit and ton prices, and net sales of brown ore produced by the corporation in the years 1938, 1939, and 1940 were as follows:
| Average sales price | |||||
| Brown ore | Average assay | per: | Net sales | ||
| Year ended Dec. 31 | production | of iron and | after freight | ||
| in tons | manganese | and royalty | |||
| Unit | Ton | ||||
| 1938 | 49,217T | 48.90% | $ 0.05932 | $ 2.91 | $ 99,956.68 |
| 1939 | 92,486T | 53.82% | .06039 | 3.22 | 221,399.62 |
| 1940 | 168,543T | 52.47% | .06259 | 3.28 | 410,250.64 |
The corporation's gross income from sales of brown ore, direct costs and expenses, and net income from such sales were as follows: *239
| 1938 | 1939 | 1940 | |
| Gross income representing receipts from | |||
| Republic Steel Corp. after deducting | |||
| freight and royalty | $ 99,956.68 | $ 221,399.62 | $ 410,250.64 |
| Direct costs and expenses | 98,555.45 | 174,929.87 | 334,184.56 |
| Net income from sales of brown ore | $ 1,401.23 | $ 46,469.75 | $ 76,066.08 |
The corporation had more employees engaged in brown ore mining operations in 1940 than it had in either of the two preceding years. Mining at the Big Pit was carried on from about the middle of 1939 to the early part of 1943.
In its excess profits tax return for the year 1940, the corporation claimed that the amount of $ 22,780.27 was net abnormal income attributable to the two preceding years in which it was in existence.
In the year 1940 the corporation, Wade and Richey, Incorporated, derived income from sales of brown ore includible in its gross income in excess of 125 per cent of the average of gross income of that class for the two preceding years that the corporation was in existence.
The income of the corporation in 1940 from sales of brown ore resulted from exploration, discovery, prospecting, and development of tangible property extending over a period of more than 12 months.
*240 *931 The net abnormal income of the corporation for the year 1940 was in part the result of high prices. It was not due to low operating costs or increased physical volume of sales due to increased demand for or decreased competition in the type of ore mined and sold by it.
A part of the income of the corporation for the year 1940 was net abnormal income which is attributable to the years 1938 and 1939.
OPINION.
There was originally an issue in each of these proceedings as to whether the petitioners were liable as transferees of Wade and Richey, Incorporated, for any deficiency in the taxes of that corporation. The parties have stipulated figures which disclose that, as stockholders of the corporation, each of the petitioners upon dissolution of the corporation received from it net assets of a value in excess of the amount of the deficiency determined by the respondent. The petitioners are therefore liable as transferees for any deficiency that may result from our decision on the excess profits tax issue.
In its excess profits tax return for the year 1940, Wade and Richey, Incorporated, reported a net profit from sales of brown ore in the amount of $ 53,261.41 of which it *241 deducted $ 22,780.27 as being net abnormal income which was attributable to prior years. The respondent disallowed the deduction and the petitioners allege that he erred in that disallowance. On amended petitions it is now claimed that the amount of net abnormal income was either $ 38,825.13 or $ 45,670.05, dependent on the method of computation.
The corporation of Wade and Richey, Incorporated, was engaged in the mining of brown iron ore and the quarrying of dolomite. The parties are agreed that the two operations were separate. The claim in these proceedings rests entirely on the brown ore mining operations. The evidence establishes that the corporation, as the result of its prospecting on the land leased from the Republic Steel Corporation, discovered the extensive iron ore deposit that became known as the Big Pit. As the result of that discovery, the corporation's production of ore and its income were considerably higher in 1940 than in the two preceding years in which it was in existence.
The respondent's objection to any allowance for abnormal income is based on two grounds. First, that there was no abnormal income within the meaning of section 721 (a) (2) (C) of the Internal*242 Revenue Code. Second, that if there was abnormal income, the petitioners have not shown that it was attributable to 1938 and 1939.
Section 721 (c) of the Code provides for the exclusion from income of the current year of the net abnormal income that is attributable to other taxable years. Section 721 (a) (2) (C) recognizes as a separate *932 class of income the income resulting from exploration and/or prospecting extending over a period of more than 12 months. Even though a taxpayer is engaged in mining, the income that results from prospecting is a separate class of income under section 721. Morrisdale Coal Mining Co., 13 T. C. 448. The net abnormal income is excludible if the abnormal income exceeds 125 per cent of the average amount of gross income of the same class for the four previous years, or if the taxpayer was not in existence for that number of years, then for the years in which it was in existence. Code section 721 (a) (1).
We think that the corporation has met the tests prescribed by the statute.
The respondent's arguments to the contrary are not convincing. He contends that the petitioners have confused gross income from brown*243 ore with income resulting from exploration, discovery, etc., of tangible property, citing Eitel-McCullough, Inc., 9 T.C. 1132">9 T. C. 1132. In that case, we pointed out that the taxpayer's income was due to a number of factors, and the evidence did not establish separately the part that was due to research and development and the part that was the result of other factors. We said in that case, in part:
The statute by its terms requires identification of a "class" of income, either of any class described in subsections (a) (2)(A) to (F), inclusive, or of some other class under the regulations prescribed by the Commissioner with the approval of the Secretary.
The corporation in this case has elected to come under the class described in subsection (C) of section 721 (a) (2). It kept separate from its other operations the operations which it claims bring it under that subsection. The exploration and prospecting operations, and the resultant income, are thus identifiable, and in this respect the present case is distinguishable from that of Eitel-McCullough, Inc., supra.
The respondent's argument places stress on the two methods used*244 by the corporation in prospecting for ore. In 1938 and in the early months of 1939, the corporation prospected by the open pit method. It found some ore pockets by that method. The indications were that there was a more extensive deposit, but it could not be reached by the digging of open pits. The corporation then, in 1939, purchased and began the use of a Keystone drill which was capable of sinking holes to a much greater depth than the open pits which were dug by hand. Within a few months -- less than 12 -- the corporation blocked out the Big Pit and thereafter mined and sold ore from it.
The statute does not prescribe that exploration or prospecting shall be confined to any particular method. Here, although the corporation changed its method of prospecting from hand digging to machine drilling, the prospecting was continuous throughout the year 1938 and well into 1939 before it discovered the deposit which resulted in *933 increased income in 1940. Prospecting has been defined as the "searching for new deposits * * *." 1 We know of no definition that restricts prospecting to a particular method.
*245 The respondent also argues that at least some part of the income realized in 1940 was due to an increased price for ore and that such part is not to be attributed to prior years, citing Regulations 109, section 30.721-8, and Southwestern Oil & Gas Co., 6 T. C. 1124, 1132. The respondent's basic position is sound. But the fact that some part of the increased income is due to an increased price does not preclude allocation of the remainder of the abnormal income to prior years. Southwestern Oil & Gas Co., supra. The stipulation is that in November 1939, the price paid by Republic Steel Corporation was increased from 6 cents per unit 2 to 6 1/4 cents. The parties have also stipulated figures which show that the average sales price of ore per unit and per ton was higher in 1940 than in the two preceding years. From these figures it is possible to work out fairly the amount of 1940 income that was due to the higher price for ore in that year. This matter will be discussed further in the latter part of this opinion.
*246 Another argument advanced by the respondent is that there was no mining income in 1940 which was the result of over a year's unproductive exploration or prospecting. The statute does not require that the exploratory years be wholly unproductive. We think that this is a sufficient answer to this part of the respondent's argument.
The respondent also contends that the increase in income was not due solely to exploration and prospecting, as required by section 721, but resulted from a combination of factors. He cites cases wherein we referred to income being due to factors other than those mentioned in the statute, such as management and salesmanship, good will, the use of physical assets, and the use of new machinery and equipment. Ramsey Accessories Manufacturing Corporation, 10 T. C. 482, Keystone Brass Works, 12 T.C. 618">12 T. C. 618. Such factors were not responsible for the increased income of Wade and Richey, Incorporated, in the year 1940. There was no element of good will in its sales as all of its ore was sold to one customer who was willing to take all that it could produce. It did acquire some additional machinery, but*247 that was solely for the purpose of realizing income as quickly as possible from the discovery of the large iron ore deposit. The use of additional equipment was incidental to the increased income and not the direct cause of it as, for instance, in the case of the expansion of manufacturing facilities.
As we have indicated, we think that the petitioners have demonstrated that the corporation met the basic requirements for relief as *934 to its 1940 income in that the income from brown ore operations was in excess of 125 per cent of the average amount of income of that class for the years 1938 and 1939, and that such excess income resulted from exploration and prospecting of leased tangible property extending over a period of more than 12 months.
Section 721 (a) (3) defines the term "net abnormal income" as follows:
The term "net abnormal income" means the amount of the abnormal income less, under regulations prescribed by the Commissioner with the approval of the Secretary, (A) 125 per centum of the average amount of the gross income of the same class determined under paragraph (1), and (B) an amount which bears the same ratio to the amount of any direct costs or expenses, *248 deductible in determining the normal-tax net income of the taxable year, through the expenditure of which such abnormal income was in whole or in part derived as the excess of the amount of such abnormal income over 125 per centum of such average amount bears to the amount of such abnormal income.
Section 721 (b) provides that the amount of net abnormal income that is to be attributed to other years shall be determined under the respondent's regulations. Regulations 109, section 30.721-1, et seq., as amended by T. D. 5045, 1941-1 C. B. 69, use as the basis for the computation of the amount attributable to prior years the gross income of the particular class. Such gross income is reduced by the statutory 125 per cent of the average for prior years, and then by an allocated portion of direct costs deductible in determining the normal tax net income for the taxable year. The petitioners have submitted a computation of the amount of net abnormal income that is attributable to prior years which is based on stipulated figures and appears to us to follow the provisions of the statute and the regulations. That computation is as follows:
| Brown ore gross income for 1938 and 1939 | $ 321,356.30 |
| Average | 160,678.15 |
| 125 per cent of average | 200,847.69 |
| (1) 1940 gross income from brown ore | 410,250.64 |
| (2) Less 125 per cent of average of 1938 and 1939 excess of (1) | |
| over (2) | 200,847.69 |
| 209,402.95 | |
| Direct costs for 1940 | 334,184.56 |
| Ratable portion of direct costs | 170,577.82 |
| Excess of 1940 abnormal income over average of 1938 and 1939 | |
| income | 209,402.95 |
| Less allocable portion of 1940 direct costs | 170,577.82 |
| Net abnormal income attributable to prior years | $ 38,825.13 |
*249 *935 The respondent has not submitted any proposed computation of the amount of the net abnormal income that is to be attributed to prior years, presumably because of his position that the petitioners have failed to establish that the operations of Wade and Richey, Incorporated, qualified that corporation for relief under Code section 721.
The petitioners' computation follows the pattern of examples given in the regulations. The starting point of the computation is the gross income for 1940 in the amount of $ 410,250.64. That amount, we think, should be reduced so as to eliminate the result of the increased price for ore that went into effect on November 1, 1939. Applying to the 1940 tonnage sold the average price that was in effect prior to November 1, 1939, and reducing the resultant figure by 125 per cent of the average of 1938 and 1939 income and by an allocated portion of 1940 direct costs leaves $ 17,220. That amount we hold is the net abnormal income for 1940 that is attributable to the years 1938 and 1939.
Reviewed by the Special Division.
Decisions will be entered under Rule 50.