*2884 Cash value of tangible and intangible properties paid in to the petitioner for its capital stock determined and segregated between the different classes of properties paid in for purposes of depreciation and invested capital.
*297 In this proceeding the petitioner seeks a redetermination of its income and profits-tax liability for the fiscal years ended June 30, 1918, 1919, and 1920, for which years the respondent has determined deficiencies of $75,475.63, $45,024.08, and $8,869.42, respectively.
The issues in this proceeding are:
(1) Whether the respondent has erred in allowing an insufficient amount as a deduction for depreciation of patents and certain tangible property, and
(2) Whether the respondent has erred in allowing an insufficient amount for invested capital purposes in connection with the property originally paid in for its capital stock.
Both of these issues narrow down to the question of the actual cash value of the tangible and intangible properties paid in to the petitioner for its capital stock, segregated*2885 as between the different classes of properties paid in.
Another error was alleged in the petition with respect to invested capital being improperly reduced on account of prior-year taxes, but since no evidence was offered in connection with this issue, it has been considered as abandoned.
FINDINGS OF FACT.
The Williams Foundry & Machine Co., hereinafter called the old company, was incorporated under the laws of the State of Ohio on July 18, 1908, with its principal place of business at Akron. Its authorized capital stock fully paid and outstanding on August 9, 1917, was $75,000. Its principal business was the manufacturing of machinery and appliances for making rubber tires and other articles of rubber.
On September 11, 1917, one Leary, being desirous of acquiring all of the assets of the old company for himself or a new corporation by the same name as the old, entered into a contract with Williams, the then president of the old company, acting for himself and all of the stockholders of the old company, whereby it was agreed that Leary would organize a new corporation of the same name as the old with *298 an authorized and paid-in capital stock of $2,000; that*2886 thereafter the said Leary would cause the capital stock of said corporation to be increased to $500,000 preferred and $2,000,000 of common stock; and that the new corporation would exchange all of said preferred stock and all of said common stock for all of the assets of the old company, with the proviso that if preferred stock in the amount of $1,000 and common stock in the amount of $1,000, being the original issue, could not be delivered, cash in the amount of $2,000 might be substituted therefor. It was further provided that the said preferred and common stock so acquired in exchange should be distributed to the stockholders of the old company and that the said stockholders would sell all of said common stock to Leary for the sum of $450,000, to be paid to said stockholders, $200,000 in cash and $250,000 in installment payments, which latter would be represented by notes, it being understood that the cash payments and the notes were to be payable to the individual stockholders in proportion to their stockholdings in the old company. The contract contained other provisions not here material.
Thereafter Leary organized the new corporation with the authorized capital stock of*2887 the amount agreed upon and said new corporation entered into an agreement with the old corporation to exchange all of its stock, or all of its stock except shares of the par value of $2,000 and $2,000 in cash, for all of the assets of the old company, provided an inventory and appraisal made by an appraisal company and an audit made by a firm of accountants disclosed net tangible assets of not less than $1,036,177.74, exclusive of good will, franchises, letters patent, licenses, trade-marks, copyrights, trade names and processes, and over and above all liabilities, which latter it was agreed would not exceed $40,000.
In said contract it was set out that the net earnings and net sales of the company from January 1, 1912, to May 31, 1917, were as follows:
| Year | Net earnings | Net sales |
| 1912 | $89,324.15 | $368,029.73 |
| 1913 | 72,303.17 | 309,709.08 |
| 1914 | 98,502.84 | 343,717.87 |
| 1915 | 250,988.34 | 709,115.64 |
| 1916 and first 5 months of 1917 | 445,454.60 | 1,358,552.23 |
It having been found that the tangible assets were of the values agreed upon, the exchange of stocks for assets between the two corporations was effected and the stock thus acquired by the old corporation*2888 distributed to its stockholders and the common stock thus acquired by them sold to Leary in accordance with the stockholders' agreement.
The old company was engaged in the manufacture of a diversified line of machinery, a substantial part of which was manufactured *299 under patents controlled by it. Among the more valuable patents were those relating to collapsible cores used extensively throughout the United States and in some foreign countries in the manufacture of automobile tires, certain patents and rights relating to automobile tire machinery and clay-working machinery. In addition to these patents, the petitioner had valuable contracts under which it was authorized to make or sell a product known as "Akron-Williams Simplex Boltless Quick Opening Door" and "Akron-Williams Tire Vulcanizer Pressers." There was a very large demand for the patented articles manufactured or sold by the old company, their business including substantial orders from practically all of the leading tire-manufacturing concerns in the United States.
In some instances the old company at the time of the transfer of its assets did not own an entire interest in the patents conveyed. The following*2889 is a schedule of the patents, together with the date of issue, the old company's interest, and the interest of other owners:
| Patent | Country | Date issued | Interest | Other owners of interest |
| owned by | who transferred to new | |||
| old company | company | |||
| 717480 | United States | Dec. 30, 1902 | Entire | None. |
| 776979 | do | Dec. 6, 1904 | One-half | J. K. Williams - one-half. |
| 776819 | do | do | Entire | None. |
| 885556 | do | Apr. 21, 1908 | One-half | J. K. Williams - one-half. |
| 886600 | do | May 5, 1908 | Entire | None. |
| 911861 | do | Feb. 9, 1909 | One-half | J. K. Williams - one-half. |
| 914905 | do | Mar. 9, 1909 | do | Do. |
| 119934 | Canada | Aug. 10, 1909 | do | Do. |
| 120937 | do | Sept. 28, 1909 | do | Do. |
| 933868 | United States | Sept. 14, 1909 | do | Do. |
| 948489 | do | Feb. 8, 1910 | do | Do. |
| 976969 | do | Nov. 29, 1910 | do | Do. |
| 1014192 | do | Jan. 9, 1912 | do | Do. |
| 1100934 | do | June 23, 1914 | Entire | None. |
| 1105737 | do | Aug. 4, 1914 | One-half | J. C. Lauritzen - one-half. |
| 1195480 | do | Aug. 22, 1916 | do | J. K. Williams - one-half. |
| 1197702 | do | Sept. 12, 1916 | Entire | None. |
| 174549 | Canada | Jan. 16, 1917 | do | Do. |
| 13837 | Great Britain | June 12, 1909 | None | J. K. Williams - entire. |
| 105890 | Italy | Nov. 14, 1909 | do | Do. |
| 404595 | France | June 30, 1909 | do | Do. |
| Application | United States | Mar. 11, 1919 | One-third | J. C. Lauritzen - two-thirds. |
| 752464, filed Mar. 6, 1913, Patent No. 1297226 granted.1 |
The contract also provided that until the notes were paid three out of the seven members of the board of directors of the new company would be chosen from the stockholders of the old company.
September 1, 1917, is the date from which the operation of the business was to be deemed conducted for the benefit and at the expense of the petitioner.
September 27, 1917, is the date of the execution and delivery of the bill of sale by the old company to the petitioner and the approximate date of the delivery of possession and control of the business, plant and assets to the petitioner. On Cotober 29, 1917, the old company *300 delivered a deed for its real estate to the petitioner and also on that date the petitioner issued 5,000 shares of its preferred stock and 19,990 shares of its common stock and paid $2,000 in cash to the old company for all of its assets then and previously transferred to the petitioner.
On November 7, 1917, 7,488*2891 shares of the common stock were reissued to J. K. Williams, 9,792 shares to William Leary, and $2,710 shares to the various nominees of the said Leary, and on this same day Williams, Leary and the Cleveland Trust Co. of Cleveland, Ohio, executed and delivered a declaration of trust. Under the terms of this trust agreement, the above-mentioned stock was to be held in escrow until notes aggregating $250,000, payable to various stockholders of the old company, were paid. Blocks of said stock were to be released upon the payment of $40 per share. These notes were also endorsed and guaranteed by Bertron Griscom & Co.
At the time of the transfer of the stock to Leary and his nominees, $200,000 in cash was paid to Williams and the above-mentioned notes for $250,000 payable in various amounts, representing the pro rata share of the old stockholders in the proceeds, were executed and delivered.
It has been stipulated by the parties that the 5,000 shares of preferred stock of the petitioner issued to the old company had a fair market value at the time of issue of $500,000.
The following is a copy of the revised balance sheet of the old company at December 31, 1916, and September 30, 1917, as*2892 prepared and shown by accountants under date of July 30, 1920, and is stipulated by the parties hereto to be a revised statement of the books of the old company as of the date indicated:
| Dec. 31, 1916 | Sept. 30, 1917 | |
| ASSETS | ||
| Current assets: | ||
| Cash | $39,094.69 | $76,081.18 |
| Accounts receivable | 237,230.36 | 182,152.57 |
| Notes receivable | 10,114.57 | 62,150.71 |
| Liberty Loan Bonds | 7,000.00 | |
| Inventory | 121,765.40 | 199,656.48 |
| Prepaid Insurance | 5,486.90 | |
| Total Current Assets | 408,205.02 | 532,527.84 |
| Fixed Assets: | ||
| Land | 35,814.45 | 35,814.45 |
| Buildings | 71,003.87 | 71,176.87 |
| Machinery & Equipment | 190,314.39 | 197,493.17 |
| Transmission | 5,054.00 | 5,054.00 |
| Tools | 13,588.26 | 13,588.26 |
| Auto Trucks | 447.20 | |
| Patterns | 40,048.51 | 40,048.51 |
| Drawings | 3,500.00 | 3,500.00 |
| Furniture & Fixtures | 3,925.68 | 2,925.68 |
| Patents | 2,332.50 | 2,332.50 |
| Cuts & Electrotypes | 645.00 | 645.00 |
| 366,226.66 | 374,025.64 | |
| Less: Depreciation reserve | 90,664.51 | 109,623.37 |
| Total Depreciation Reserve | 275,562.15 | 264,402.27 |
| 683,767.17 | 796,930.11 | |
| LIABILITIES | ||
| Current Liabilities: | ||
| Accounts Payable | $56,792.17 | $46,292.37 |
| Accruals | 316.66 | 7,164.62 |
| Total Current Liabilities | 57,108.83 | 53,456.99 |
| RESERVE FOR FEDERAL TAXES | 57,925.90 | |
| Capital Stock | 75,000.00 | 75,000.00 |
| Surplus | 551,658.34 | 610,547.22 |
| 683,767.17 | 796,930.11 |
*2893 *301 The following is a copy of the opening entries in petitioner's general journal showing the taking over by the petitioner of all of the assets and liabilities of the old company:
| OCTOBER 1, 1917 | ||||
| The following opening Journal Entries taking over all of the Assets, Liabilities and Patents etc. are in accordance with the Minutes of the New Company - "The Williams Foundry & Machine Company." | ||||
| Dr. | Cr. | |||
| 2,000.00 | 1 | Cash | ||
| 103 | To unissued stock | 2,000.00 | ||
| Wm. Leary 10 shrs. Preferred | ||||
| Wm. Leary 1 shrs. Common | ||||
| D. W. Maxon 1 shrs. Common | ||||
| L. I. Moore 1 shrs. Common | ||||
| R. I. Moore 1 shrs. Common | ||||
| C. G. Wise 1 shrs. Common | ||||
| 20 shrs. at $100.00 ea. | ||||
| 2,500,000.00 | 103 | Unissued Stock | ||
| 145 | To Authorized Capital Stock | 2,500,000.00 | ||
| 5000 shrs. 8% Cum Preferred | ||||
| 2000 shrs. Common | ||||
| All at a par value of $100.00 each, Issued and Outstanding to Stockholders of record as per the books of the Registrar | ||||
| 2,623,209.40 | 101 | Vendor a/c | ||
| To Sundry Liabilities | ||||
| 107 | Accounts Payable | 45,163.88 | ||
| 113 | Due to employees - Subscription to Liberty Loan Bonds | 1,010.00 | ||
| 117 | Unpaid Wages - accrued | 3,935.52 | ||
| 135 | Reserve for Excess Profits Tax and Income Tax | 46,100.00 | ||
| Unissued Stock | ||||
| 499 shrs. 8% Cum. Preferred | ||||
| 103 | 19990 shrs. Common | 2,498,000.00 | ||
| 1 | Cash | 2,000.00 | ||
| 139 | Reserve for Uncollectible Accounts | 27,000.00 | ||
| Sundry Assets | ||||
| 101 | To Vendor a/c | 2,623,209.40 | ||
| 76,081.18 | 1 | Cash | ||
| 205,188.55 | 7 | Accounts Receivable | ||
| 62,150.71 | 13 | Notes Receivable | ||
| 338,453.18 | 19 | Inventory (Estimated) | ||
| 301.02 | 23 | Accrued Interest on Notes Receivable | ||
| 7,000.00 | 25 | Liberty Loan Bonds | ||
| 102,900.00 | 27 | Real Estate | ||
| 86,062.12 | 31 | Buildings | ||
| 234,863.53 | 35 | Machinery & Equipment | ||
| 21,319.90 | 41 | Tools & Miscellaneous | ||
| 447.20 | 47 | Ford Chassis | ||
| 23,782.50 | 49 | Patterns & Drawings | ||
| 3,168.00 | 53 | Office Furniture & Fixtures | ||
| 2,670.00 | 57 | Patents | ||
| 5,486.90 | 73 | Prepaid Insurance | ||
| 1,453,334.61 | 85 | Patents etc | 2,500,000.00 | |
| Less: | ||||
| Capital Stock | 75,000.00 | |||
| Surplus from Re-appraisal of Fixed Assets | 229,405.75 | |||
| Undistributed Profits at May 31, 1917 | 688,341.99 | |||
| Net Profits for 4 months ended Sept. 30, 1917 | 53,917.65 | |||
| 1,046,665.38 | ||||
| Patents, Licenses Contracts | 1,453,334.61 | |||
| 2,670.00 | 85 | Patents, Licenses, Contracts, etc. | ||
| 57 | To Patents | 2,670.00 |
*2894 *302 An appraisal company found the sound value of the fixed assets of the old company as of May 31, 1917, to be:
| Land | $ 102,900.00 |
| Buildings | 85,889.12 |
| Machinery and equipment | 253,301.72 |
| Patterns and drawings | 23,782.50 |
| Total | 465,873.34 |
An audit was made by a reputable firm of accountants. They accepted the appraisal of the fixed assets as correct and ascertained the quick or current assets to be as follows:
| Cash | $56,220.61 |
| Accounts and notes receivable | 229,770.00 |
| Inventory | 259,949.73 |
The report disclosed a total indebtedness of $38,974.19.
Leary, in connection with the purchase of the assets of the old company, reported to the petitioner, of which he was then president, that the assets were worth at least $2,500,000.
The Commissioner of Securities for the State of Ohio issued a dealer's license and certificate for the sale of the stock in the new company after he had been satisfied that the value behind the securities which were to be issued represented the par value of these securities, or $2,500,000.
The rates of depreciation for the tangible assets have been stipulated to be as follows:
| Percentage for fiscal years | |||
| Character of assets | 1918 | 1919 | 1920 |
| Buildings on owned land (Old) | 2.42 | 2.42 | 2.42 |
| Buildings on owned land (New) | 2 | 2 | 2 |
| Buildings on leased land (Old) | 6 2/3 | 6 2/3 | 6 2/3 |
| Buildings on leased land (New) | 6.696 | 6.696 | 6.696 |
| Machinery and equipment (Old) | 14 | 14 | 14 |
| Machinery and equipment (New) | 10 | 10 | 10 |
| Patterns and drawings (Old) | 33 1/3 | 33 1/3 | 33 1/3 |
| Patterns and drawings (New) | 25 | 25 | 25 |
| Furniture and fixtures (Old) | 11.01 | 11.01 | 11.01 |
| Furniture and fixtures (New) | 10 | 10 | 10 |
| Auto equipment | 25 | 25 | 25 |
*2895 Practically all of the books and records of the old company have been lost and such information and data as to the accounts as has been offered in evidence has come from certain balance sheets taken from the books of the old company before their lease and certain information regarding sales compiled from the original shipping order. Among the assets scheduled in the balance sheet appears an item "Patents $2,332.50," and the evidence discloses that this item was carried at this amount on the books of the old company. It further discloses that this amount represents a part of the cost of obtaining the patents and that other costs, including development *303 cost, had been charged to expense. These patents had a substantial value.
The old company had built up a good will of a very considerable value and its sales were in no small part due to this good will.
During the period commencing January 1, 1912, and ending May 31, 1917, the total sales of the old company amounted to $3,089,125, divided as follows: patented articles, $1,845,193, and unpatented articles, $1,243,932. During this period the average annual profit on sales was 30.96 per cent. The sales per year averaged*2896 $570,300, of which amount $340,651 was attributable to sales of patented articles and $229,649 attributable to the sales of unpatented articles. The average profit per year from the total sales was $176,598. The profits derived from the sales of patented articles equaled and ordinarily exceeded the profits derived from the sales of unpatented articles.
Between September 20 and November 1, 1917, Leary secured subscriptions for the petitioner's stock at a price ranging from $45 to $50 per share. Approximately $165,000 was realized from these sales. Between November 1 and December 31, 1917, Leary sold some 2,500 shares for $50 a share. Subsequently, in the following year, the remainder of the stock was sold for a price not disclosed by the record.
All of the assets transferred to the petitioner had a value of $1,500,000; the tangible assets had a value of $950,000, and the remainder of the value should be divided between patents in the amount of $300,000 and good will in the amount of $250,000.
The old company exchanged its assets for all the petitioner's stock, which had a par value of $2,500,000. In determining petitioner's invested capital for each of the taxable years*2897 involved, respondent disallowed the amount of $231,481.38 thereof, on the ground that the value of all the tangible property paid for petitioner's stock was not in excess of $691,128.56 and disallowed $366,128.56 thereof for 1918, $359,678.56 thereof for 1919, and $355,053.56 thereof for 1920, on the alleged ground that the value of the intangible property paid in for petitioner's stock was not in excess of $258,871.44, consisting of patents of the alleged value of $2,332.50 and of good will of the alleged value of $256,538.94.
In each of the returns for the taxable years involved, petitioner took as deduction for the exhaustion of the patents acquired by it a ratable part of the alleged cost thereof to it, i.e., $525,000. Respondent disallowed the deductions claimed in the amount of $46,375.67 for each of the taxable years 1918 and 1919, and $45,709.17 for the taxable year 1920. Respondent added the amounts of these deductions to the taxable income of the petitioner for the respective taxable years involved.
*304 Petitioner claimed as deductions for depreciation of its depreciable tangible assets for the taxable years involved amounts of $41,682.90 for 1918, $47,658.12*2898 for 1919, and $52,428.30 for 1920. Respondent allowed as deductions for depreciation for the respective years the amount of $36,157.38 for 1918, $42,077.65 for 1919, and $46,796.83 for 1920, which resulted in the inclusion in petitioner's taxable income of amounts of $5,525.52 for 1918, $5,581.47 for 1919, and $5,631.47 for 1920. In his answer in this proceeding respondent admits that petitioner "is entitled to take depreciation on its property for the taxable years 1918, 1919, and 1920 in sums not less than $41,682.90 for 1918, $47,659.12 for 1919, and $52,428.30 for 1920."
Respondent determined petitioner's income and profits tax for the years 1918 and 1919 to be $88,791.40 and $62,014.64, respectively. Subsequent to the taxable year 1919, he assessed additional income and profits taxes for the taxable year 1918 in the amount of $75,475.63. Respondent reduced petitioner's invested capital for the taxable years involved by the amount of $32,962.03 for the taxable year 1919, representing a portion of its $88,791.40 income and profits tax for the taxable year 1918 as determined by the respondent and by the amount of $101,608.69 for 1920, $75,475.63 thereof representing the said*2899 additional taxes for the taxable year 1918 accrued and assessed subsequent to the taxable year 1919, and $36,133.06 thereof representing a portion of its $62,014.64 income and profits tax for the taxable year 1919 as determined by the respondent.
OPINION.
GREEN: In the deficiency letter proposing to assess the taxes here involved, appears the following statement:
This office is not in agreement with the Revenue Agent in regard to the computation of your invested capital under section 331 of the Revenue Act of 1918, as it is held that control passed and an actual reorganization took place at the time the old company was bought by William Leary.
The respondent in his brief contends that this section is applicable and that the petitioner's invested capital should be computed in accordance therewith. No such issue is raised by the pleadings and accordingly we have entirely disregarded the contention made by the respondent in his brief. A consideration of this question at this time would impose a hardship on the petitioner in that it has had no opportunity to offer evidence with respect to the question. If the respondent felt that the section was applicable, he having previously*2900 held it inapplicable, it was incumbent upon him to raise the issue by appropriate affirmative allegations in his answer, which allegations must then be supported by proper proof.
The principal question in this case has to do with the petitioner's statutory invested capital and the value of the assets acquired by *305 the petitioner in exchange for its stock. The facts may be summarized as follows: Leary, being desirous of acquiring the name and all of the assets of the old company, entered into an agreement with Williams as the representative of all of the stockholders of the old company, by the terms of which Leary agreed to organize a corporation with an authorized capital stock of $2,500,000, to be divided in $500,000 preferred and $2,000,000 common stock, each share to have a par value of $100, and Williams agreed that the old company would accept all of the stock in the new company in exchange for all of the assets of the old, which stock was to be forthwith distributed to the old stockholders and that, of the stock so distributed, said old stockholders would sell all the common to Leary for $450,000. Thereafter the new corporation was organized and a contract entered*2901 into between it and the old for the exchange of the assets of the old for the stock of the new. This contract was carried out and the stock thus received distributed to the old stockholders and they, pursuant to the agreement made for them by Williams, sold the common stock to Leary for $450,000, $200,000 of which was paid to the stockholders in cash in proportion to their stockholdings and $250,000 by notes payable to the various stockholders in the same proportion.
Section 326 of the Revenue Act of 1918 provides, among other things, that there shall be included in invested capital the actual cash value of tangible property actually paid in for stock and, subject to the limitations therein provided, the cash value of intangible property so paid in. The petitioner acquired all of the assets of the old company in exchange for all of its stock and is, therefore, entitled to have its invested capital determined in accordance with the above summarized provisions of section 326. That is to say, there should be included in invested capital an amount equal to the sum of the cash value of the tangibles and the value of the intangibles subject to the limitations.
From the deficiency*2902 letter we gather that the respondent proceeded upon the theory that the sale to Leary determined the market value of the stock and that such market value determined the value of the assets acquired in exchange therefor. We think that the provision of the statute requires the inclusion in invested capital of the cash value of the assets subject to the limitations. This value and not the market value of the stock is the test. In the absence of better proof, recourse may be had to value of stock as a measure of the value of assets acquired therefor, but the statute prescribes cash value of assets and in the determination of such cash value all facts and circumstances tending to establish such value should be considered and if it appears that the value of the assets exceeds the market value of the stock, the true value of the assets should be used.
Even if the sale of the common stock to Leary did establish its market value, we believe that the cash value of the assets acquired *306 in exchange for both the common and preferred stock exceeded $950,000, which is the sum of the par of the preferred and the market value of the common stock, and have accordingly found the total*2903 value of assets to be $1,500,000, which we have in our findings of fact allocated to tangibles and the two classes of intangibles. The petitioner's invested capital and depreciation should be computed accordingly.
Judgment will be entered under Rule 5o.
Footnotes
1. The application for this patent was contested and litigated, thus delaying the issue of letters patent. However, the device was manufactured by both the old and new companies pending settlement of the contest and issuance of letters patent. ↩