*2602 1. Where tax liability has been determined under the provisions of section 328 of the Revenue Act of 1918, and the taxpayer asks for a redetermination of the deficiency so determined, the burden of proof is on the petitioner to show (1) that its tax liability correctly computed under section 301 is less than the deficiency asserted, and (2) that the deficiency asserted has been erroneously computed.
2. Held, that the petitioner may not include certain alleged values of good will and of a purported contract in its paid-in surplus for invested capital or depreciation purposes.
3. Contract with underwriters for the sale of preferred stock issued or to be issued by the petitioner held to be a stock subscription and not a note paid in for stock.
4. Respondent's adjustments of invested capital on account of unpaid Federal taxes for prior years and of such taxes for the preceding year paid in the taxable year approved.
*325 The respondent has refused to abate an asserted deficiency in income and profits tax for the fiscal year ended May 31, 1920, in*2603 the amount of $3,949.22, and has asserted a deficiency in income and profits tax for the fiscal year ended May 31, 1921, in the amount of $4,895.83. For its causes of action the petitioner asserts:
(1) That the Commissioner has assessed an excessive tax for the fiscal year ended May 31, 1920, under the provisions of section 328 of the Revenue Act of 1918;
(2) That in the determination of its tax liability for each of the fiscal years involved, it is entitled to have included in its invested capital certain amounts representing the value of good will and a contract for which it issued its stock at date of incorporation;
(3) That it is entitled to include in the computation of its invested capital for each of the taxable years the total par value, properly prorated, of an issue of preferred stock which it contracted with underwriters to sell and not that part of such stock for which it received payment in the respective taxable years; and
(4) That its invested capital for each of the taxable years should not be reduced by proration of respective preceding year's taxes or by the amount of additional taxes found due with respect of prior years.
The two proceedings have been*2604 consolidated for hearing and decision.
FINDINGS OF FACT.
The petitioner is an Ohio corporation, organized in 1916, with its principal office at Cincinnati, where it is engaged in the manufacture *326 and sale of shoes. It was formed by a merger of two predecessor corporations, the Holters Shoe Co. and the Miller Shoe Manufacturing Co., hereinafter designated as Holters and Miller, respectively, each of which had been engaged in the manufacture and sale of shoes for several years prior thereto.
At a special meeting of the stockholders of the petitioner, held on September 27, 1916, the following merger proposition was read and by a unanimous vote the directors were authorized to accomplish the same by proper corporate action:
It is proposed to consolidate The Holters Shoe Company and The Miller Shoe Manufacturing Company, corporations of Cincinnati, Ohio. A tentative agreement or arrangement by which this is to be accomplished is as follows:
1. All assets of each Company other than cash, on hand, accounts and bills receivable, fire and life insurance, patterns and lasts, as well as work in process and finished goods, are to be appraised by The American Appraisal*2605 Company on the same basis for each Company. The real estate of the Miller Shoe Manufacturing Co. is also to be excluded from the appraisement.
2. The lasts and patterns belonging to each Company are to be appraised by Messrs. Holters and Miller on the same basis as to costs to each Company and at cost prices. These patterns and lasts are to be added to the assets of the Company at one-half of the cost price arrived at by the appraisement, but patterns and lasts which have been received or made for use in the factory within 90 days past are to be taken at their actual cost or invoice price. An appraisal also is to be made of leather, floor goods, and other items not included in the above by Messrs. Holters and Miller, and the new Company is to take the same over at the appraisal, paying therefor in money. Samples and low shoes are to be taken at $1.00 per pair. Each concern is to run through as rapidly as possible leather already cut and to dispose of the manufactured product. The new Company, however, will on request dispose of any manufactured production on a 5% basis.
3. A new corporation, The Holters Company, is to be organized under the laws of Ohio, with an authorized*2606 capital stock of $300,000 Common and $300,000 7% non-voting, cumulative Preferred, redeemable after five years at $105.
4. The Miller Shoe Mfg. Co. and The Holters Shoe Co. will each sell and transfer to the new corporation the above mentioned assets at the appraised value thereof each taking for its assets:
1st, Common Stock in the new corporation in the amount of $100,000 par.
2nd, Preferred Stock in the new corporation for the balance of the value of the assets transferred.
3rd, Common Stock of the new corporation in the amount of $100,000 par for good will, one-half to each Company. This $100,000 of Common Stock is to be returned to the new corporation as fully paid stock to be held by it as Treasury Stock.
5. The Miller Shoe Mfg. Co. will cause to be executed to the new corporation a ten year lease upon the real estate owned by it on Spring Grove Avenue at a rental of 6% on $80,000. Lessee is to pay all taxes, assessments, insurance, any improvements necessary to maintain the buildings in their present condition, ordinary wear and tear excepted, and any changes and improvements required by public authorities.
*327 6. Each corporation will at once proceed*2607 to liquidate its assets, the new corporation attending to the matter of collections without charge for its services and assisting through its salesman in making adjustments, etc. No allowance will be made to customers without the consent of the officers of the old Companies, owners of the claim. When the debts are all paid and the assets all collected, each of the old Companies will reduce its authorized capital stock to a nominal amount, and control of the stock will be transferred to appointees of The Holters Company, so as to preserve corporate existence for the benefit of the new Company.
7. In the new organization it is understood that Mr. John G. Holters is to be President and General Manager at a salary of $6000.00 per year; that the consolidation is to be consummated as soon as possible; that all good will is to be turned over to the new Company by the old Companies; that the new corporation will move to the Spring Grove Avenue plant, and on October 1, 1916, will assume all obligations of the present Holters lease; that the salaries of the administrative officers, including John G. Holters and Charles Miller, will commence at the same time, the date to be fixed by the*2608 Board of Directors; that the new company will assume all taxes on real and personal property payable in December by each of the old Companies. Attached hereto is a list of salesmens' contracts and other contracts for purchases, etc., which are to be assumed by the new company. Proper assignments of all copyrights, patents, sales contracts, etc., to be executed to the new company at once.
The directors of the petitioner effected the merger authorized as above and in due course common capital stock of the par value of $50,000 was issued to each of the prior corporations as consideration for good will transferred to the petitioner. A few days thereafter such stock was transferred to the petitioner without consideration and taken into its accounts as treasury stock.
The business of Holters was established something like 20 years before the incorporation of the petitioner. Beginning about 1912, its activities increased so rapidly that within five years it was twice forced to move into larger quarters and in 1916 it was again crowded for room. It produced only women's shoes, and about 75 per cent of its output was sold under trade brands which it owned known as "Holters Shoe" and*2609 "Oh-So-Easy Shoe." Such brands were well advertised and had a good standing in the shoe trade.
At date of the incorporation of the petitioner Miller was a well-established concern with an old fashioned and conservative business policy. It owned the trade-marks "Miller Shoe" and "Soft Shoe" and marketed the greater part of its production under such trade names. At the time of the merger the Potter Shoe Co., the largest retail shoe house in Ohio, was a regular customer, purchasing at profitable prices a very large part of the Miller output. The president of the Potter Shoe Co. was one of the largest stockholders of Miller.
At the date of the merger Miller occupied a series of connected buildings facing on three streets, which were well adapted to its purposes and to the needs of the petitioner. The tenure and terms *328 upon which these premies were held and used prior to the merger are not disclosed by the record. The aggregate floor space of these buildings was 80,783 square feet. It owned the machinery and other personal property used in its operations in such building. At date of the merger the real estate was owned by one Frederick A. Geier, who had purchased*2610 it on November 4 for a consideration, and the same day had leased it to James P. Orr for a term of 99 years, renewable forever, with rentals reserved at the rate of $2,750 per annum and with an option to the lessee to purchase the property at any time within the first five years of the leasehold term for a consideration of $50,000. In addition to the reserved rentals, the lessee was to pay all taxes, rate charges and assessments levied against the premises for any purpose, to maintain the buildings in good repair, and to make at his own expense any changes, additions or improvements required by public authorities. On November 6, 1916, the petitioner leased such premises for a term of ten years, at a rental, payable on the first day of each month in advance, of $400, and as further consideration agreed to pay all taxes and assessments imposed during the term of the lease, to maintain the buildings in good repair, pay for any changes or improvements incident to its use of the buildings, and to bear the cost of any changes, additions or improvements lawfully required by public authorities. No bonus value of this lease was ever included in the asset accounts of the petitioner.
At*2611 the date of the petitioner's lease of the premises as above set forth a little more than one-fifth of the floor space thereof was under sublease at a rental of $175 per month. On July 1, 1917, the petitioner renewed such sublease for a term of two years at a rental of $200 per month. The subleased portion comprised 17,933 square feet of interior space and was less desirable for manufacturing purposes than that part of the buildings used by Miller and the petitioner.
On March 1, 1920, the petitioner entered into an agreement with certain underwriters for the sale of its preferred stock of the par value of $500,000. The terms and conditions of such agreements, so far as they are material to this proceeding, are as follows:
THIS AGREEMENT entered into this 1st day of March, 1920, between THE HOLTERS COMPANY, a corporation under the laws of Ohio, herein called the "Company" and the partnership firms of BEAZELL and CHATFIELD and CHANNER AND SAWYER, herein called the "Underwriters,"
WITNESSETH:
WHEREAS, the Company desires to sell $500,000 par value of a proposed issue of 7% First Preferred Stock and the Underwriters desire to purchase said stock for re-sale at public offering,
*2612 THEREFORE, the Underwriters agree to underwrite or purchase $500,000 or 5000 shares of the par value of $100 each of the proposed new issue of First *329 Preferred Stock of the Company and to pay therefor the total sum of $465,000 or $93 per share, subject to the following terms and conditions, to-wit:
(1) The Company at the present time has an authorized capital stock of $600,000 divided into $300,000 of common stock and $300,000 of preferred stock, of which all of said common stock and $263,300 par value of said preferred stock are outstanding.
The Company hereby agrees to procure the retirement of all of the said outstanding preferred stock and its exchange share for share for 8% Second Preferred Stock herein provided for.
The Company further agrees to take such legal steps which shall be approved by the firm of Waite, Schindel & Bayless, Attorneys for the Underwriters, as may be necessary in order to recapitalize the Company so that its authorized capital stock will be $2,000,000 divided into $700,000 par value of common stock; $1,000,000 par value or 10,000 shares of the par value of $100 each of 7% First Preferred Stock, bearing the terms, conditions and restrictions*2613 contained in copy of stock certiflcate hereto attached and made part hereof as Exhibit "A," and $300,000 par value, or 3000 shares of the par value of $100 each of 8% Second Preferred stock.
(2) The Company guarantees to the Underwriters that it will thereupon immediately sell $100,000 par value of the additional authorized common stock for cash to present common stockholders, so that there will be $400,000 par value of common stock outstanding at the beginning of the 90 day period hereinafter provided.
(3) The Company further agrees to appoint and maintain the Union Savings Bank and Trust Company of Cincinnati as Registrar and The First National Bank of Cincinnati as transfer agent of said First Preferred Stock.
(4) The Company further agrees to have an audit of its books prepared by J. D. Cloud & Company, Accountants, and further agrees to have an appraisement of its plant and equipment by the American Appraisal Company and an appraisement of its real estate by the Frederick Schmidt Company, said audit and appraisements to be made at the expense of the Company. The Company also guarantees that after said audit and appraisements have been completed, the net worth of the*2614 Company shall not be less than the amount shown on the balance sheet, a copy of which is hereto attached and made a part hereof as Exhibit "B."
(5) The Company agrees to furnish such statements and other information as may be requested from time to time by the Underwriters and to lend assistance through its officers and agents to the Underwriters to help them obtain a re-sale of said issue to the public.
(6) The Company further agrees to have audits of its books made annually and to furnish copies of said audits to the Underwriters as long as the First Preferred Stock issue remains outstanding.
(7) The Underwriters on their part agree to pay said sum of $465,000 or $93 per share for 5000 shares of said 7% First Preferred Stock, said payment to be made in full within 90 days from the date when said audit and appraisements have been completed and said preferred stock issue has been legally authorized and is ready for issuance and stock certificate books have been deposited by the Company with the designated transfer agents.
(8) It is mutually agreed that from the time when the foregoing steps have been completed until said 90 day period has elapsed, the Underwriters may obtain*2615 deliveries from time to time of certificates issued in accordance with their instructions upon payment of $93 for each share so purchased, with the understanding that said payments shall apply on account of the total purchase price aforesaid.
*330 (9) The Underwriters further agree to have said First Preferred Stock listed on the Cincinnati Stock Exchange. The expense of listing shall be borne by the Company.
The agreement for the sale of preferred stock, supra, was accomplished only in part and was canceled on May 31, 1921. In its income and profits-tax return for the fiscal years ended May 31, 1920, and 1921, respectively, the petitioner included the full amount of the $500,000 par value of preferred stock covered by the above contract with underwriters in the computation of its invested capital for periods of 91 and 365 days, respectively. The Commissioner adjusted invested capital for each of such years by including in the computation thereof only that portion of the preferred stock turned over to the underwriters for which the petitioner received cash payments, which he prorated from date of receipt.
The petitioner timely filed its income and profits-tax*2616 return for the fiscal year ended May 31, 1920, showing tax liability in the amount of $145,721.97. Upon audit of such return the Commissioner determined a total tax liability in the amount of $156,683.60 and a deficiency of $10,961.63. The additional tax asserted resulted from an addition to income of $179.97, which is not now disputed, and from an adjustment of invested capital by the exclusion therefrom of the following items: Good will paid in for stock $100,000; agreement to procure lease $100,000; pro rata portion of prior year's taxes $37,061.73; $6,141.73 taxes for 1916, 1917, and 1918 not claimed or paid in such taxable year; all in the total amount of $243,202.74. Petitioner duly protested such exclusion, and it requested that, if it were finally determined that its invested capital should be so reduced, its tax liability should be determined under the provisions of section 328 of the Revenue Act of 1918. The Commissioner excluded the items in controversy and granted the petitioner's request for special assessment, which resulted in tax liability in the amount of $149,671.19 and an additional tax of $3,949.22 instead of $10,961.63 which had been determined by the computation*2617 of tax liability under the provisions of section 301 of the Revenue Act of 1918. Petitioner now alleges that if the excluded items are included in its invested capital for the taxable year its true tax liability will be found to be $144,426.18 and that it will be entitled to a refund for such year in the amount of $1,295.79.
The petitioner timely filed its income and profits-tax return for the fiscal year ended May 31, 1921, showing tax liability in the amount of $10,927.93, which was duly paid. Upon audit of such return the Commissioner determined a deficiency in the amount of $4,895.83. This additional tax liability resulted from the exclusion from invested capital of the following items: Good will paid in for *331 stock $100,000; agreement to procure lease $100,000; proration of $62,535.99 out of invested capital on account of previous year's income and profits tax paid in the taxable year in the amount of $149,670.29; $3,048.88 representing unpaid taxes claimed for years prior to May 31, 1920; and only a prorated part of an alleged sale of capital stock in the amount of $465,000.
OPINION.
LANSDON: The only allegation of error relating to the deficiency asserted*2618 for the fiscal year ended May 31, 1920, is as follows:
That the Commissioner has assessed a higher excess-profits tax under the provisions of section 328 of the Revenue Act of 1918 than the correct tax assessable under the provisions of section 301 of said Act.
The record fails to support this contention. Computing the petitioner's tax liability for the fiscal year ended May 31, 1920, under the provisions of section 301(b), the Commissioner determined a tax in the amount of $156,683.60 and asserted a deficiency in the amount of $10,961.63. Subsequently, the Commissioner denied the petitioner's contention that certain items which he had excluded from invested capital should be restored thereto, and granted a request for the computation of its tax liability under the provisions of section 328, found thereby that the tax for the year in question was $149,671.19, and asserted a deficiency in the amount of $3,949.22, which is the deficiency we are asked to redetermine. As decided hereinafter, the evidence adduced by the petitioner fails to show that the Commissioner's adjustments of invested capital were erroneous. It follows, therefore, that the tax liability determined under*2619 section 301(a) of the Revenue Act of 1918 is "the correct tax assessable" thereunder. The determination of the petitioner's tax liability under section 328 resulted in relief to the extent of $7,012.41. The petitioner's allegation that the tax liability has been increased by the application of the relief section is not proved, and the deficiency so determined is approved.
The petitioner contends that on the facts set forth above it is entitled to include the amount of $100,000, representing good will acquired from its predecessors, in the computation of its invested capital for each of the taxable years. The record discloses that shortly after incorporation stock of such par value was issued for good will and that a few days later it was donated back to the petitioner and taken into the accounts thereof as treasury stock. Common and preferred stock was issued for all tangible assets at the agreed inventory values thereof. The books of the petitioner show no entries representing paid-in surplus. The petitioner concedes that in the years immediately preceding the merger neither Miller *332 nor Holters earned operating profits in excess of a fair return on the value of*2620 the tangible capital employed. It argues, however, that each of its predecessors paid in trade-marks, trade-names, business prestige, established clientele and valuable contracts for the sale of output and the purchase of raw materials that should receive favorable consideration as components of good will value. It includes in this list of valuable intangibles the profitable trade relation of Miller with the Potter Shoe Co. The contracts for the purchase of raw materials which the petitioner acquired from Holters are not in evidence and we know nothing of the alleged advantageous terms thereof or of the volume or value of the transactions thereunder. Without more we can not hold that the trade arrangement between Miller and the Potter Shoe Co. and the Holters raw materials contracts had any value which can be translated into dollars and cents as an element of good will. ; . The petitioner also relies on the fact that since it was formed it has earned profits much in excess of a fair return on its investment in physical assets as evidence that it received more than bare manufacturing*2621 facilities and equipment from its predecessors. We have several times held that large profits earned subsequent to incorporation is not convincing evidence that good will was acquired from predecessor concerns. . The evidence fails to overcome the presumption that the Commissioner properly excluded the alleged value of good will from his computation of the petitioner's invested capital in the taxable years. ; ; ; ; .
The petitioner also contends that paragraph 5 of the merger proposition, whereby Miller undertook to secure for the petitioner a 10-year lease on the business premises then in use by it on certain stated terms and conditions, should be regarded as a tangible property paid in for stock which should be included in paid-in surplus as an element of invested capital and that the alleged value thereof, in the amount of $80,000, is a capital investment in a wasting*2622 asset which it is entitled to recover free from Federal income tax by ratable annual deductions from its gross income during the term of the lease afterwards secured in conformity with such agreement. The evidence in support of this contention consists largely of an attempt to prove that when acquired by the petitioner the lease had a bonus value of the amount claimed. The president of Holters, who later held the same position with the petitioner, testified that at the time of the transaction in question desirable floor space for manufacturing *333 purposes commanded an annual rental price of 20 cents per square foot. If the premises were worth that much to the petitioner, the terms of its lease indicate a bonus value in the amount claimed. Against this testimony, however, is the proved fact that only two days before the agreement in question was accepted by the directors of the petitioner the identical property had been leased for a term of 99 years, renewable forever, at a rental only a little more than half as much as that specified in the lease, with a further provision that the lessee might purchase the fee at any time within five years for $50,000. There is no evidence*2623 that the leasing of the property by Geier to Orr was not a transaction at arm's length. Obviously the terms of this lease measured the rental value of the premises only a day or two before Miller entered into its obligation and the execution of the petitioner's sublease from Orr. We conclude, therefore, even if the Miller undertaking included in the merger proposition was a contract to be measured by the bonus value of the lease afterwards acquired, that not only was there no bonus value in the amount alleged, but apparently the lease was a liability to the petitioner during the term thereof. It is also worthy of notice that neither the alleged contract nor the leasehold acquired in conformity therewith was ever included in the asset accounts of the petitioner at any value and it is not even contended that any stock was issued therefor. In these circumstances we are unable to find tht either the alleged contract or the lease acquired in conformity therewith had any value that can be included in the petitioner's paid-in surplus at date of incorporation for invested capital or exhaustion purposes.
The petitioner contends further that its contract with certain underwriters, for*2624 the sale of its preferred stock of the par value of $500,000, evidences an executed sale of stock and that such contract is in effect a promissory note for $465,000, which it is entitled to take into its invested capital. In support of this claim it relies on our decision in , and a long series of decisions in proceedings involving similar facts based thereon. We are not impressed with petitioner's argument on this issue. In our opinion the underwriters' agreement is no more than a subscription for stock to be executed in conformity with the terms and conditions therein set forth. In ; ; and , we held that stock subscriptions may not be included in invested capital until the actual time when payment is made on account thereof. The Commissioner has observed this rule in the instant proceeding and has prorated all actual payments received from the underwriters into the petitioner's invested capital.
*2625 *334 Even if it be conceded that the petitioner's contention that the underwriters' contract is in effect a promissory note paid in for stock, it by no means follows that the amount thereof should be included in invested capital as herein claimed. In every decision involving this claim, beginning with , and ending with , we have held that the value of the notes at the date paid in, the solvency of the makers, the good faith of the transaction, and the collectibility of the notes under the laws of the local jurisdiction must be established. No evidence was introduced as to any of these things, all of which are vital to the petitioner's contention on this issue. The determination of the respondent is approved.
The remaining issue challenges the respondent's action in deducting the amount of income and profits taxes due and unpaid from invested capital and in prorating out of its invested capital income and profits taxes of the preceding years which were paid in the taxable years. Each of these questions has been decided adversely to the petitioner. *2626 ; .
Decision will be entered for the respondent.