*3714 Value of gravel pit for depletion purposes, which was acquired by a corporation in consideration of stock, determined.
*829 This proceeding is to redetermine a deficiency in income tax for the year 1919 in the amount of $1,194.24.
Petitioner assigns two errors, in substance, as follows:
(1) The Commissioner erred in disallowing a deduction from gross income for depletion of its gravel pit in the amount of $2,981.95.
(2) The Commissioner erred in failing to allow, for invested capital purposes, paid-in surplus in the amount of $268,814.22, the same being the fair market value of 200 acres of gravel deposits acquired by it at date of organization.
Assignment of error No. 2, was withdrawn at the hearing.
Counsel for the respondent conceded at the hearing that the petitioner is entitled to a deduction on account of depletion, of $198.38.
FINDINGS OF FACT.
The petitioner is a Texas corporation with its principal office in Beaumont, Tex. It was incorporated in November, 1915, with an authorized capital stock of $20,000 par value. On*3715 December 14, 1914, one G. D. Buchanan entered into a lease contract with Edgar Snell, whereby Buchanan obtained a lease on a part of the gravel pit land (acreage not given) on a royalty basis of one cent per cubic yard of gravel, with a stipulation for $50 per annum until operations began, said lease being for a period of 20 years.
On September 16, 1915, Buchanan obtained a lease from the R. McDonald estate for 173.3 acres of gravel pit land on a royalty basis of 2 cents per cubic yard for gravel, with a minimum payment after the first six months of $240 for each six-months period, said lease being for a term of 30 years.
Associated with Buchanan in those leases was one Wyatt who discovered the gravel. Wyatt sold his interest to E. A. Fletcher for $5,000.
Fletcher then purchased one-half of Buchanan's interest for $10,000 in cash. He owned then a three-fourths interest and Buchanan a one-fourth interest. The acreage of the pit was approximately 200 acres and the gravel in place was estimated at 6,000,000 cubic yards. This gravel pit was located about one and one-half miles from the G.C. & S.F. Railroad, about 62 miles north of Beaumont. The G.C. & S.F. Railroad Company*3716 was in the market for gravel.
On October 12, 1915, E. A. Fletcher entered into a contract with the G.C. & S.F. Railroad Co. by the terms of which said company agreed to construct a spur track of its road from Romayor station to said gravel pit, a distance of 8,500 feet, and to construct all necessary machinery on the ground for mining and loading the gravel. The company agreed to pay Fletcher 5 cents per cubic yard for all *830 gravel taken out by it. Fletcher agreed to produce for the company at his own expense right-of-way for the spur track from said station to the pit, give the company freedom of ingress and egress, and all rights necessary to its proper operation of said gravel pit, and agreed to hold the company harmless against all adverse claims to said gravel up to 5 cents per cubic yard. Fletcher did acquire for the use of the company said right of way, and adjusted some few adverse claims to said gravel, the cost of which is not disclosed.
The contract with the railroad company was to continue in force for 19 years from its date, subject to cancellation at any time by the company, after six months' notice, and in the event of such cancellation the company*3717 was authorized to remove its spur track.
The petitioner corporation was organized in November, 1915. On November 24, 1915, Buchanan and Fletcher executed a conveyance of said gravel pit and assets incident thereto, which document is as follows:
KNOW ALL MEN BY THERE PRESENTS: That we, G. D. Buchanan of Hardin County, Texas, and E. A. Fletcher of Jefferson County, Texas, for and in consideration of the sum of Twenty Thousand ($20,000) Dollars cash to us in hand paid by Romayor Gravel Company, the receipt of which is hereby acknowledged, have GRANTED, SOLD AND CONVEYED and by these presents do GRANT, SELL and CONVEY unto the said Romayor Gravel Company, a corporation created and existing under the laws of the State of Texas, with its principal office at Beaumont in Jefferson County, Texas, all and singular those certain gravel leases acquired by said G. D. Buchanan on lands situated in the J. F. de Romayor and Aaron Cherry Grants in Liberty County, Texas, including those certain gravel leases acquired by said G. D. Buchanan from Edgar Snell and wife, Edgar Snell as Guardian, Green Sewell, W. W. Watley, Charles Oliver, J. S. Warren, W. M. Cruse, T. B. Allen & Company and Marry E. *3718 McDonald as well as any other gravel leases by us or either of us in said vicinity, it being intended hereby (subject to the royalty hereinafter reserved in favor of E. A. Fletcher) to include in this transfer and conveyance all of our rights and privileges under each and all of said leases, and all and singular our interest in and to all rights-of-way to and from the lands covered by said gravel leases, so as to vest in said Romayor Gravel Company full and complete title to each and all of said gravel leases and all rights, privileges and easements thereunder, and all rights-of-way acquired by us or either of us from other persons leading into said gravel beds, subject only to the hereinafter mentioned royalties in favor of said E. A. Fletcher.
And we do further transfer, sell and convey unto the said Romayor Gravel Company all and singular all of our rights in and to that certain contract between E. A. Fletcher and the Gulf, Colorado and Santa Fe Railway Company dated October 12, 1915, relating to the construction, maintenance and operation of a track approximately 8,500 feet in length from the Santa Fe station of Romayor to serve said gravel beds, and relating to the sale of*3719 certain gravel to said G.C. & S.F. Railway Company.
To have and to hold all and singular said gravel leases, rights, privileges, easements and contracts unto the said Romayor Gravel Company, its successors and assigns forever, subject to the following stipulations:
*831 1. It is understood and stipulated that said Romayor Gravel Company, its successors and assigns shall assume and pay all royalties, which shall become due under the aforesaid gravel leases, and perform all other obligations imposed upon the lessee by each and all of said gravel leases, and further said Romayor Gravel Company, its successors and assigns shall assume and perform all obligations imposed upon the said E. A. Fletcher by the terms of said contract with the G.C. & S.F. Railway Company, and in accepting this conveyance said Romayor Gravel Company obligates itself, its successors and assigns to forever hold harmless said G. D. Buchanan and E. A. Fletcher from all and every liability to the makers of said gravel leases or any of them by reason of the provisions of said gravel leases or any of them, and from any and all liability to said G.C. & S.F. Railway Company, under said contract with the latter.
*3720 2. It is expressly understood and stipulated that said E. A. Fletcher shall have and there is hereby reserved to him, his heirs or assigns, a royalty interest amounting to three-eights (3/8) of one cent for each cubic yard of gravel removed from said property and premises above referred to covered by the lease from Mary E. McDonald which royalty the said Romayor Gravel Company by its acceptance of this conveyance binds and obligates itself, its successors and assigns to pay to the said E. A. Fletcher, his heirs or assigns on the 15th day of each calendar month at Beaumont, Texas, for all gravel removed from said premises covered by Mary E. McDonald lease during the next preceding calendar month; such royalty of three-eighths of one cent in favor of E. A. Fletcher, being in addition to all other royalties required to be paid by the terms of said gravel leases or any of them.
And we the said G. D. Buchanan and E. A. Fletcher do hereby bind ourselves, our heirs, executors and administrators to warrant and forever defend all and singular said premises herein conveyed unto the said Romayor Gravel Company, its successors and assigns against every person whomsoever lawfully claiming*3721 or to claim the same or any part thereof, by, through or under us.
The annual production for the years indicated was as follows:
| Cubic yards. | |
| 1916 | $72,311.00 |
| 1917 | 23,015.93 |
| 1918 | 19,448.93 |
| 1919 | 60,116.70 |
| 1920 | 37,149.24 |
| 1921 | 86,543.27 |
| 1922 | 94,370.68 |
| 1923 | 101,050.27 |
| 1924 (10 months) | 131,958.30 |
The Romayor gravel pit is located in a territory that demands for consumption large quantities of gravel or crushed stone, and has no sharp competition to contend with on account of its proximity to such territory. Petitioner had the right to mine gravel and sell some to the public and the market price of such gravel f.o.b. cars at the pit was $1.25 to $1.50 per cubic yard, and the cost of production was approximately $1 per yard.
The stock of the corporation was issued to Fletcher and Buchanan and none of it was sold or offered for sale.
OPINION.
LOVE: By reason of the fact that petitioner, at the hearing of this case, abandoned its second assignment of error, relative to amount of *832 invested capital, we have left only one issue, viz, the proper amount of depletion to be allowed petitioner for the year 1919. Petitioner claimed depletion*3722 in the amount of $2,981.95.
The Commissioner refused to allow any depletion at all. At the hearing, counsel for respondent conceded that depletion should be allowed in the amount of $198.38.
As between petitioner's claims and the amount conceded by the respondent, the difference arises by reason of the fact that petitioner claims a value of assets conveyed to it at date of incorporation of $300,000, while the respondent contends that $20,000, the par value of the capital stock issued for such assets, is the basis upon which depletion should be taken.
Depletion is recognized as one of the means by which "exhaustion, wear, and tear of property" is permitted to be allowed as a deduction under section 234(a)(7) of the Revenue Act of 1918. Depreciation or depletion is permitted for the purpose of enabling the taxpayer to recoup, during the useful life of the asset, its cost to the taxpayer.
Using such cost as a basis, and dividing it by the number of units by which its exhaustion, wear, or tear is measured, gives the rate. In the case of buildings, machinery and such like, a unit of time is used. In the case of coal mines the unit is tons, and in the case of gravel, it may*3723 be cubic yards, as in the instant case. In the instant case the owner of the asset, and the person entitled to the deduction for depletion, is the corporation, the Romayor Gravel Co. There is no dispute over the number of cubic yards of gravel in place in the pit. The only controversy is in regard to cost. It is evident that the cost of the assets to the corporation was the fair market value of its stock issued in payment therefor. The total amount of stock issued was $20,000 par value. If the fair market value of that stock was less than par, then the assets cost petitioner less than $20,000 regardless of the potential value of those assets. And if the fair market value of the stock was greater than par, then the cost of the assets to petitioner was in excess of $20,000.
As there were no sales, or offers of sale of stock, we are forced to look to and analyze the circumstances and conditions and determine, if we may, what amount of stock might have been issued with a reasonable business-like prospect of selling any substantial amount of same at par to one or more conservative, prudent business men who were put in possession of all the facts affecting the value of such stock.
*3724 It seems evident that petitioner purchased a valuable asset. It will be noted that in its first year's operation, 1916, its production was over 72,000 cubic yards. During the World War and the depressed period immediately following, production was very much lower. In *833 1921, and the three following years, production increased with each succeeding year.
The capacity of the pit permitted production to the extent of 300,000 yards per annum, for 20 years, provided a demand for that amount existed. The demand increased after 1920. With full knowledge of all the facts in his possession, and in view of prospects for demand for that gravel in the future, what value would a conservative business man have placed on those assets for capitalization purposes, to have justified such a business man paying par for the stock.
We believe that $50,000 was the maximum limit of such valuation. In order to produce profits sufficient to pay an 8 per cent dividend on that capitalization at a net royalty of 3 cents per yard (same being the net royalty received from the railroad company) an annual production of at least 134,000 yards was necessary, an amount in excess of production*3725 for any of the first 9 years of operation.
We have not lost sight of the fact that war conditions materially affected that as well as most other lines of business; neither are we unmindful of the fact that the railroad company was not its only available customer.
Under all the facts of this case we believe and so hold, that the fair market value of the stock exchanged for those assets was $50,000 and that petitioner is entitled to a rate of depletion on gravel mined of .0083 cents per cubic yard.
Judgment will be entered on 15 days' notice, under Rule 50.