*724 1. During the period of development of petitioner's mine, one of its officers embezzled or misappropriated funds belonging to petitioner. Held, the amount so embezzled or misappropriated may not, for tax purposes, be capitalized as development costs, recoverable through deductions for depletion.
2. During the development period, prior to the taxable years, petitioner exchanged valid shares of its stock for unauthorized shares fraudulently issued by one of its officers, and thereby sustained a loss. Held, the amount of such loss is not allowable as a statutory net loss, nor may such loss be capitalized as development cost, recoverable through deductions for depletion.
3. The amount allowable on account of depreciation sustained on petitioner's equipment for the period prior to the beginning of active production, not being attributable to the operation of a trade or business regularly carried on, is not a statutory net loss, but such amount may properly be capitalized as development cost to be recovered through deductions for depletion.
*377 *725 This proceeding is for the redetermination of deficiencies of $5,025.65 and $4,337.88 in income taxes for the years 1928 and 1929, respectively. The issues presented by the pleadings and the facts are:
(1) Should the sum of $122,239.19 representing money embezzled or misappropriated from the petitioner by one of its officers during the development period of petitioner's mine be charged to capital account as capitalized development costs, recoverable through depletion?
(2) If the above amount is not an item of capitalized development costs recoverable through depletion, should the loss sustained or expenditures made by petitioner during the years 1926 and 1927 through the exchange of valid shares of its stock for unauthorized shares fraudulently issued by one of its officers be allowed as statutory net losses in the sum of $22,316.55 for 1926 and $31,510.21 for 1927, or, in the alternative, should such amounts be charged to capital account as development costs, recoverable through depletion?
(3) Is the amount of $3,736.23 representing allowable depreciation on petitioner's equipment for the period January 1, 1926, to February 29, 1928, deductible either by way of creating a*726 statutory net loss to be carried forward or charging it to capitalized development costs to be recovered through depletion?
All the facts were stipulated and from such stipulation we make the following finding of fact.
FINDINGS OF FACT.
The petitioner, New Quincy Mining Co., was incorporated in 1915 under the laws of Utah, with an authorized capital stock of 1,250,000 shares of a par value of 10 cents per share. It was authorized under its charter "to purchase, acquire, own, hold, operate and develop mining *378 claims, * * * mineral lands, claims and mining rights in the State of Utah; * * * and to carry on the business of mining in all of its branches."
The entire capital stock was fully paid for by the transfer and conveyance made by the Thompson-Quincy Consolidated Mining Co. of its property to petitioner. Money for development purposes was obtained through assessments levied and collected from the time of incorporation ot the year 1928.
Petitioner was in the development stage until it struck its main ore body in the latter part of February 1928, at which time active production began. Between 1915 and February 28, 1928, while petitioner was in the development*727 stage, several small bodies of ore were developed from which income aggregating $21,272.14 was received. In none of those years, however, was there an excess of income over operating expenses. Up to March 1, 1928, all expenditures were added to capitalized development costs, except expenditures made for tangible depreciable assets.
Late in December 1925 certain irregularities were discovered in the matter of the issuance of capital stock of petitioner by its secretary. Sometime between 1915 and December 1925, the secretary of petitioner, without the knowledge or approval of other members of the board of directors or other officers of petitioner, and without authority, sold 446,331 shares of capital stock of petitioner at the rate of 5 cents per share, totaling in amount $22,316.55, to investors to whom the petitioner issued certificates represented to be petitioner's capital stock of the par value of 10 cents a share. All of the stock so sold was in excess of the authorized capital stock of petitioner. The proceeds from such sales were deposited by the secretary in a bank account in the name of petitioner. When and as petitioner levied assessments on its capital stock the*728 secretary of petitioner, unknown to, and without authority from, petitioner, collected assessments on the unauthorized stock in the amount of $89,441.78. The secretary also deposited this money in the same bank account in the name of petitioner. Both of these funds were deposited in a bank other than the regular depositary bank of petitioner without the knowledge or consent of petitioner's other officers, and such deposits were neither disclosed to the other officers or directors of petitioner nor used in connection with its mining operations. The entire amount thereof was used by the secretary for his own personal and private use.
In addition to the above there was also found among the irregularities on the part of the secretary a cash shortage of $10,480.86 of other funds of petitioner. This amount was also appropriated by *379 the secretary to his own personal use and was not used by petitioner in its mining operations. All of these misappropriations, totaling $122,239.19, occurred prior to the year 1926. Following the discovery of these irregularities, an audit investigation was made early in 1926 to determine the character and status of the company's outstanding*729 capital stock. Thereafter, in 1926, an assessment was levied on petitioner's stock and, when certain individuals presented their certificates of unauthorized stock and tendered assessment money thereon, petitioner declined to recognize their status as shareholders on the ground that the shares were spurious. These parties in many instances threatened the company with recourse to legal action for accountings, receivership, and for adjudication as to the validity of such shares. Owing in part to technical and legal difficulties in segregating and allocating the several classes of spurious shares where a sequence of transfers of valid and spurious shares had been made and intermingling of spurious and valid shares had occurred, it was deemed advisable by petitioner to effect an exchange of valid shares for such unauthorized shares to eliminate whatever liability it may have had to the holders thereof through the unauthorized acts of its secretary. A settlement with the holders of such shares was accordingly effected.
The petitioner had in its treasury only 263,198 shares of its original authorized stock. It purchased on the open market 10,000 shares of its stock for $500, and*730 on June 12, 1926, borrowed from its principal stockholders 173,133 shares, making a total of 446,331 shares necessary for exchange for the outstanding unauthorized shares of an equal amount.
On June 12, 1926, the stock of petitioner had a market value of 5 cents per share.
Petitioner borrowed stock from its stockholders by authority of its board of directors and under a written agreement to return the stock so borrowed "or stock of like kind and denomination", on or before March 1, 1927, and executed a mortgage agreement to secure performance of the loan agreement.
On February 4, 1927, petitioner's authorized capital stock was increased by 250,000 shares to 1,500,000 shares of a par value of 10 cents per share, and on March 3, 1927, pursuant to a resolution of its board of directors, petitioner issued to its stockholders who had loaned certain of their shares to it in 1926, 173,133 shares of its capital stock in discharge of its obligation to such stockholders under the stock loan agreement.
On March 3, 1927, the market value of the stock of petitioner was 23.2 cents per share.
*380 There was set up on petitioner's books in 1928 the following charge against its*731 secretary:
| Date | Amount | |
| 6-30-26 | Cash shortage | $10,480.86 |
| 3-31-28 | Assessments collected | 89,441.78 |
| 3-31-28 | 446,331 shares of spurious stock at par value of 10?? per share | 44,633.10 |
| Total | 144,555.74 |
Petitioner, on December 31, 1928, charged off the above amount of $144,555.74 and claimed the same as a bad debt deduction in filing its income tax return for 1928. Upon investigation by a Federal revenue agent, the deduction was disallowed as a bad debt deduction, but the agent allowed of said amount a part, to wit, $122,239.19, to be capitalized as development costs for purposes of depletion. The Commissioner, upon review of the agent's recommendations, refused, in determining the deficiencies, to allow the $122,239.19 either as a bad debt or as a part of development cost for depletion purposes.
In the years 1926 and 1927 and for the period January 1, 1928, to February 29, 1928, the petitioner sustained allowable depreciation on mining machinery and equipment and office furniture and fixtures in the respective amounts of $1,667.50, $1,759.99, and $308.74, or a total of $3,736.23. During the periods named petitioner had no gross income or any income*732 from dividends or from nontaxable interest and sustained no allowable depletion. The respondent has refused to allow the amount of $3,736.23, or any part thereof, to be included as a part of the petitioner's capitalized development costs for depletion purposes.
OPINION.
HILL: The first question for determination is whether petitioner is entitled to include as part of its capitalized development costs recoverable through depletion an amount of $122,239.19, representing money embezzled or misappropriated by one of its officers in years prior to 1926. This amount is made up of the following items: $22,316.55 proceeds of sales of unauthorized stock; $89,441.78 collected as assessments on such stock; and $10,480.86 of other funds of petitioner, being the amount shown in the findings of fact which were embezzled or misappropriated by petitioner's secretary.
Petitioner's mine was in the development stage prior to March 1928, and petitioner contends that the items enumerated should be included in its capitalized development costs in order that they may be recovered through deductions for depletion. Respondent contends to the contrary.
*381 Section 23(l) of the Revenue*733 Act of 1928 is, so far as pertinent here, as follows:
(1) Depletion. - In the case of mines, oil and gas wells, other natural deposits, and timber, a reasonable allowance for depletion and for depreciation of improvements, according to the peculiar conditions in each case; such reasonable allowance in all cases to be made under rules and regulations to be prescribed by the Commissioner, with the approval of the Secretary. * * *
Article 242 of Regulations 74, promulgated by the Commissioner under the Revenue Act of 1928, is applicable to this question and is as follows:
ART. 242. Allowable capital additions in case of mines. - (a) All expenditures in excess of net receipts from minerals sold shall be charged to capital account recoverable through depletion while the mine is in the development stage. The mine will be considered to have passed from a development to a producing status when the major portion of the mineral production is obtained from workings other than those opened for the purpose of development, or when the principal activity of the mine becomes the production of developed ore rather than the development of additional ores for mining.
(b) Expenditures*734 for plant and equipment, not including expenditures for maintenance and for ordinary and necessary repairs, shall be charged to capital account recoverable through depreciation.
We think it a fair construction of the meaning of such regulation that expenditures which may be included in the capitalized development costs of a mine must be expenditures made for the purpose of such development. The items involved here had no relationship to the development of petitioner's mine. The stock sold by the secretary and issued in excess of the authorized capital stock was not a part of the authorized capital structure of petitioner. However, petitioner was legally obligated either to adjust its capital structure to validate the stock in question or to reimburse or satisfy the holders thereof for the moneys received by it for such stock and assessments collected thereon. The moneys so received by petitioner were lost to it through misappropriation or embezzlement by its secretary in the years prior to 1926. Thus petitioner sustained a loss in such prior years in the amount of the moneys so embezzled, but the loss was sustained through the unauthorized and illegal acts of its secretary, *735 entirely separate and apart from the operations in the development of its mines or mineral lands. The proceeds of the sale of the unauthorized stock were not chargeable to capital account in petitioner's mining operations because they were never invested either in the purchase of the mining properties or in the development of such properties.
For the same reasons the moneys collected as assessments on the unauthorized stock were not chargeable to capital account either as capitalized development costs or otherwise.
*382 The item of $10,480.86 claimed by petitioner to be part of the capitalized development costs of its mining operations was money which petitioner's secretary abstracted and embezzled from petitioner's operating funds and was thus prevented from being used as such. The embezzlement was a thing apart from the development operations of the mines. This money, not having been used or lost in such development, can not be capitalized as development costs.
We hold, therefore, that none of the items comprising the amount of $122,239.19 can be charged to capital account, recoverable through depletion.
The second question presented for determination is (1) *736 whether the losses sustained or expenditures made by petitioner through the exchange of valid shares of its stock for unauthorized shares fraudulently issued by one of its officers should be allowed as statutory net losses in the sum of $22,316.55 for 1926 and $31,510.21 for 1927, deductible in subsequent taxable years; or, in the alternative, (2) whether such amounts should be included as part of the capitalized development costs, recoverable through depletion. The amount of $22,316.55 represents the value of 446,331 shares of petitioner's stock which it exchanged for an equal number of shares of outstanding spurious stock in 1926. The market value of petitioner's stock at the time of such exchange was 5 cents per share. The amount of $31,510.21 represents the excess of the market value of 173,133 shares of petitioner's stock on March 3, 1927, the date that amount of borrowed stock was returned to its principal stockholders, over the market value of the same number of shares of its stock on June 12, 1926, the date the stock was borrowed. The value of the stock on June 12, 1926, was 5 cents per share, and the value of such stock on March 3, 1927, was 23.2 cents per share.
Petitioner*737 contends that these amounts represent losses incurred in the operation of a trade or business regularly carried on by it and therefore constitute statutory net losses in 1926 and 1927, respectively, which may be carried forward into the two succeeding years as deductions from gross income in such years. The respondent contends that the losses in question were not so incurred and hence do not constitute statutory net losses, deductible subsequent to the taxable year in which incurred. Assuming without deciding that the items in question represented losses deductible in the taxable years in which incurred, it is necessary to the solution of the question presented to determine whether such losses were incurred in a trade or business regularly carried on by petitioner.
*383 The applicable provisions of the statute are section 117(a)(1), (b), and (e) of the Revenue Act of 1928. 1
*738 Petitioner's mine was in the development stage up to March 1, 1928, and up to that date all expenditures were added to capitalized development costs, except expenditures for tangible depreciable assets, as required by article 242 of Regulations 74 hereinabove set out. Petitioner contends that in the development of the mine it was carrying on a business within the meaning of section 117, supra, and that the losses in question were incurred in such business and were net losses for the years 1926 and 1927. Assuming, for argument only, the correctness of this contention, the items are not deductible as net losses but recoverable only through depletion deductions as capitalized development costs. Article 242, supra; ; cf. . The principle upon which article 242 rests is that the development of a mine is the development of a capital asset entailing expenditures for original construction and equipment.
However, it is obvious from the facts in this case that petitioner was not engaged in the development of its mining properties as a trade or business regularly carried*739 on, but that such development was merely preliminary to the carrying on of the trade or business of mining after such development had been accomplished. The losses here sought to be deducted as net losses were sustained within the period of the development stage of the mine and not after it had reached a producing status. The losses, not having been incurred in a trade or business regularly carried on by petitioner, are not statutory *384 net losses and not deductible as such. .
The case of , cited and relied on by petitioner, is not in point on the question of whether such losses constitute net losses deductible in subsequent taxable years, since this question was not involved in that case.
Petitioner contends, in the alternative, that if the items in question totaling the amount of $53,826.76, are not statutory net losses, deductible in subsequent taxable years, they should be charged to capital account as part of development costs, recoverable through depletion.
These items had no connection with the development operations of petitioner's mines. *740 They had to do solely with the adjustment of claims affecting petitioner's capital stock structure and involved no expenditure in connection with petitioner's mining or mine development operations. Therefore, they can not be capitalized as development costs recoverable through depletion allowances.
The third question presented for determination is whether the items of allowable depreciation on petitioner's equipment in the amounts of $1,667.50, $1,759.99, and $308.74 for the years 1926, 1927 and the period January 1 to February 29, 1928, respectively, are deductible in the taxable years here involved as net losses in the taxable years above mentioned, or, in the alternative, chargeable to capital account as development costs recoverable through depletion.
Respondent, in his brief, confesses error in disallowing the items in question as capitalized development costs and admits that they constitute a part of development costs recoverable through depletion, but contends that there is a failure of proof to show the amount of net loss, if any, that was sustained in either of the periods above named. In our view of the case it is unnecessary to consider whether there was a failure*741 of proof of the amount of the claimed net loss based upon the items of allowable depreciation. Since this depreciation was sustained during the development stage of the mine it does not constitute the basis for net loss because such loss was not incurred in a trade or business regularly carried on by petitioner and such depreciation is, therefore, not deductible as net loss. Respondent admits that the items of depreciation constitute a part of development costs recoverable through depletion. We so hold.
Judgment will be entered under Rule 50.
Footnotes
1. SEC. 117. NET LOSSES.
(a) Definition of "net loss". - As used in this section the term "net loss" means the excess of the deductions allowed by this title over the gross income, with the following exceptions and limitations:
(1) NON-BUSINESS DEDUCTIONS. - Deductions otherwise allowed by law not attributable to the operation of a trade or business regularly carried on by the taxpayer shall be allowed only to the extent of the amount of the gross income not derived from such trade or business;
* * *
(b) Net loss as a deduction. - If, for any taxable year, it appears upon the production of evidence satisfactory to the Commissioner that any taxpayer has sustained a net loss, the amount thereof shall be allowed as a deduction in computing the net income of the taxpayer for the succeeding taxable year (hereinafter in this section called "second year"), and if such net loss is in excess of such net income (computed without such deduction), the amount of such excess shall be allowed as a deduction in computing the net income for the next succeeding taxable year (hereinafter in this section called "third year"); the deduction in all cases to be made under regulations prescribed by the Commissioner with the approval of the Secretary.
* * *
(e) Net loss for 1926 or 1927.↩ - If for the taxable year 1926 or 1927 a taxpayer sustained a net loss within the provisions of the Revenue Act of 1926, the amount of such net loss shall be allowed as a deduction in computing net income for the two succeeding taxable years to the same extent and in the same manner as a net loss sustained for one taxable year is, under this Act, allowed as a deduction for the two succeeding taxable years.