*2909 1. INVESTED CAPITAL. - Petitioner acquired the assets and liabilities of a profitable business for stock and cash after agreement upon the values of the various items transferred. The actual cash values of the assets for purposes of invested capital and also for the computation of depreciation, are determined to be the values agreed upon for the sale rather than an appreciation of petitioner's book values based upon an appraisal.
2. INCOME. - Petitioner acquired accounts receivable at an agreed cost which was set up on its books, together with a reserve for losses. Upon collection or charging off such accounts the reserve showed a balance. Held, that such balance is income as gain derived in excess of the cost of such accounts receivable.
3. EXPENSES. - The amount of the cost of deductible repairs determined.
*175 The Commissioner has determined deficiencies in the amounts of $30,574.55 and $16,168.83 for the fiscal years ended March 31, 1920, and 1921, respectively, in the matter*2910 of petitioner's income and profits-tax liability for those years.
Petitioner alleges that the Commissioner erred as follows:
1. That, for both years, he excluded from invested capital certain asset values alleged to be paid-in surplus and disallowed deductions for depreciation based on said asset values.
2. That, for 1920, he disallowed a deduction of $7,819.19, as an expense in connection with the publication of Crocker-Langley Directory and also reduced invested capital by the said amount.
*176 3. That, for 1920, he added to net income $10,949.89, representing the balance of a "Reserve for Contingent Charges," set up at date of acquisition of assets and liabilities, and reduced invested capital by said amount.
4. That, for 1920, he disallowed a deduction of $17,330.92, representing cost of alleged repairs charged to expense and added said amount to invested capital for the fiscal year 1921.
5. That, for 1921, he added $4,179.70 to income as an adjustment arising out of a question of the cost of certain assets sold in that year.
FINDINGS OF FACT.
Petitioner, a California corporation, with its principal place of business at San Francisco, was incorporated*2911 on March 31, 1919, for the sole purpose of succeeding to the business of the H. S. Crocker Co., which had been engaged for many years in the business of stationers, printers, lithographers, bookbinders, copper plate engravers, publishers, etc.
The stockholders of the H. S. Crocker Co. (hereinafter referred to as the predecessor) desired to retire from active business and their negotiations with S. S. Kauffman resulted in the execution of an agreement under date of March 19, 1919, whereby Kauffman, on behalf of a corporation to be organized, acquired an option to purchase and take over the going business, assets, and good will, and to assume certain liabilities of the predecessor in the following manner: A California corporation (the petitioner herein) was to be organized with an authorized capital stock of $2,000,000, consisting of 10,000 shares of common stock of the par value of $100 each, and 10,000 shares of preferred stock of the par value of $100 each, the latter toprovide for 7 per cent cumulative dividends and for preference in distribution of assets upon dissolution of the corporation. The preferred and common stock was to have equal voting rights. The whole or any part*2912 of the preferred stock was to be subject to retirement at par on any dividend-paying date. Kauffman was to subscribe for at least 5,000 shares of common stock at par. In consideration of the transfer of the business, assets and liabilities of the predecessor the latter was to be issued 5,000 shares of petitioner's preferred stock, valued at par, and the remainder of the purchase price, the amount of which was to be determined, was to be paid in cash in installments, specifically set out. In determining the purchase price, saleable merchandise was to be inventoried at cost or at current market price on March 31, 1919, whichever was lower; dead stock was to be taken at its actual value on March 31, 1919; all tools, machinery and fixtures were to be taken at their value as carried on the books of the predecessor as of March 31, 1919; outstanding *177 accounts and notes receivable were to be taken at their face value including interest due, it being understood, however, that the predecessor would guarantee payment thereof at maturity; accounts standing as uncollectible on the books of the predecessor were not to be assigned to petitioner; the directory business known as "Crocker-Langley*2913 Directory" was to be taken at the value of $25,000; that certain shares of stock of the predecessor's subsidiary were to be taken at a value based upon a valuation to be made of the subsidiary's assets; certain real property to be taken at a value to be agreed upon during September, 1920, and cash and unexpired insurance were to be considered in determining the purchase price. In the event any disputes arose as to valuations, such disputes were to be settled by arbitration. The sale of the business and assets were to be made as of March 31, 1919. It was further provided that Kauffman, individually, should purchase from the predecessor 5,000 shares of petitioner's preferred stock at par, in certain amounts annually from 1922 to 1926, inclusive. It was agreed that the firm of Klink-Bean & Co., certified public accountants, should taken inventory and make a complete audit of the affairs of the predecessor and its subsidiary.
The option was exercised, petitioner was duly incorporated on March 31, 1919, and the business, assets and liabilities of the predecessor were transferred to petitioner as of March 31, 1919, in accordance with the terms of the agreement, and petitioner issued*2914 $500,000 par value of its preferred stock and paid $300,000 cash to the predecessor as part of the purchase price. Immediately thereafter the parties undertook to determine certain valuations in the manner agreed upon.
For the purpose of settling disputes as to various valuations and in order definitely to fix the amount to be paid by petitioner to the predecessor, the parties entered into a supplemental agreement on July 17, 1919, wherein it was agreed that the balance of the purchase price amounted to $281,117.69. The said agreement went into great detail in settling the disputed values of various items but not including tools, machinery and fixtures. It was further agreed that Kauffman, individually, should purchase from the predecessor 2,500 shares of petitioner's preferred stock instead of 5,000 shares as set out in the agreement of March 19, 1919, but the preferred stock remained subject to retirement at par by petitioner.
On the books of account of petitioner the assets received and the liabilities assumed were entered in amounts equalling the values agreed upon. The 5,000 shares of petitioner's preferred capital stock with a par value of $100 each, were issued to*2915 the predecessor and cash in the final total amount of $582.654.35 was paid for the assets transferred. Approximately 5,250 shares of petitioner's common stock, with a par value of $100 each, were sold to Kauffman and his *178 friends for cash. New interests owned and controlled in excess of 50 per cent of the total outstanding capital stock of petitioner.
In September, 1919, petitioner employed the American Appraisal Co. to appraise the value of a portion of the machinery, equipment and fixtures acquired from the predecessor at an agreed value of $160,642.22. The appraised value was based on reproduction cost as of September 20, 1919, less estimated accrued depreciation. The values of the appraised assets were thereupon entered upon petitioner's books, the total increase amounting to $155,228.36, which amount was carried as a paid-in surplus. Beginning in 1918 and extending into 1920, there was a scarcity of the type of machinery and equipment included in the appraisal and prices thereon increased almost from day to day until the prices on some items had increased 150 per cent. At the time of the transfer involved in this proceeding Kauffman was of the opinion that*2916 the predecessor's book values of the fixed assets were too low, due to an excessive depreciation reserve.
Kauffman became president of petitioner and the president and secretary of the predecessor became directors of petitioner.
The predecessor retained certain real estate and other assets and reduced its authorized capital stock.
In its tax returns for the years ended March 31, 1920, and 1921, petitioner included in its invested capital as paid-in surplus the appreciated book values of its assets and took deductions from income for depreciation based upon such appreciated values. The respondent reduced invested capital by the net amount of $173,945.66 for 1920 and $128,436.61 for 1921, which amounts included the said appreciated values together with other adjustments. The respondent further disallowed deductions from income in the amounts of $16,242.16 for 1920 and $21,744.19 for 1921, claimed by petitioner as depreciation based upon the appreciated book values of $155,228.36 in excess of the net amount of which certain fixed assets were carried on the books of the predecessor.
Among the assets acquired by petitioner from the predecessor was the Crocker-Langley directory, *2917 which was transferred at an agreed value of $25,000. Prior to the transfer the predecessor had expended $7,819.09 in connection with the forthcoming issue of the directory. Petitioner entered upon its books the agreed value of $25,000 for the directory business and also set up on its books on March 31, 1919, the said sum of $7,819.09 as a deferred expense, which was charged off to expense in the fiscal year 1921 when the directory was published. For the fiscal year ended March 31, 1920, the respondent excluded the sum of $7,819.09 from petitioner's invested capital as a paid-in surplus and disallowed the deduction of the said amount as an expense.
*179 When the values of the accounts receivable and other assets subject to possible shrinkage were set up on the books of petitioner, there was also set up a reserve in the amount of $47,289.23 for possible losses. After accounts receivable were collected or written off and other assets subject to shrinkage were realized upon, it was determined in 1920 that the balance remaining in that reserve for possible losses amounted to $10,949.89. Petitioner entered the said balance on its accounts as a paid-in surplus and included*2918 it in invested capital. The respondent excluded the said amount from invested capital and added it to income for 1920 as an increase realized in that year in the net value of the accounts receivable transferred to petitioner.
In the latter part of 1919 petitioner entered into a lease with Lillian M. Carlton for the use of a building in Los Angeles for a period of 10 years beginning January 1, 1920. The building consisted of 4 floors and a basement, the walls were of brick and the floors and partitions of wood. The building was in very poor condition and had not been occupied by a permanent tenant for some time. In addition to certain improvements and betterments deemed desirable, the cost of which petitioner capitalized on its books of account, petitioner expended an amount of $17,330.95 in putting the building in condition for occupancy and use, which amount it charged to expense as repairs. The flooring on the first floor was worn through; all the plaster on the walls and ceilings had to be replaced; all the windows had to be replaced; a new roof was essential, the electric wiring was broken, missing or contrary to city regulations; the elevators required new cables and an*2919 overhauling; repainting inside and outside was required, including tinting the walls and ceilings; and the glass areaway lights in the sidewalk required repairing. The work cost as follows:
| Elevators | $ 2,151.00 | |
| Electric wiring | 2,377.95 | |
| New roof | 350.00 | |
| Work done under contract with McGuire Cabinet Company: | ||
| Flooring, 1st floor | $ 1,500.00 | |
| Plastering & tinting walls and ceiling | 4,000.00 | |
| Painting outside front | 300.00 | |
| Repairing sidewalk lights | 200.00 | |
| Replaced window frames | 2,000.00 | |
| Miscellaneous | 2,452.00 | |
| Remodeling mezzanine floor, admitted to be capital item | 2,000.00 | |
| 12,452.00 | ||
| Total | 17,330.95 |
The terms of the lease required petitioner to make all repairs at its own expense. The respondent disallowed petitioner the deduction taken in the amount of $17,330.95 as an expense in the fiscal year *180 ended March 31, 1920, and added the said amount to invested capital for the year ended March, 1921.
During the fiscal year 1921, petitioner sold certain assets, using as the cost thereof the increased book value which was included in the total increase of $155,228.36 hereinbefore set out. The respondent reduced the cost to the net*2920 amount for which said assets were carried on the books of the predecessor, resulting in the disallowance of the amount of $4,179.70 in computing the cost and the profit derived from the assets sold.
OPINION.
TRUSSELL: The first issue involves primarily the question of fact as to the value of certain assets for the purpose of invested capital. As of March 31, 1919, petitioner acquired the going business of a predecessor corporation in consideration of cash and its capital stock at par, totaling $1,082.645.35. The predecessor corporation had been in business for a good many years and had built up a large and profitable business, but in 1919 its stockholders desired to retire from active business. On March 19, 1919, the parties in interest entered into a contract for the sale of the predecessor's business upon a certain basis and upon certain agreed valuations or values to be determined in an agreed manner, and on July 7, 1919, the parties entered into a supplemental agreement for the purpose of settling disputes and definitely fixing the purchase price. It was agreed that the purchase price should be $582.645.35 in cash and 5,000 shares of petitioner's preferred capital stock*2921 with a par value of $100 each, which stock was redeemable at par by petitioner at any dividend-paying date. The agreements further provided that Kauffman, president of petitioner, should purchase at par from the predecessor, 2,500 shares of petitioner's preferred stock.
Immediately upon incorporation approximately 5,250 shares of petitioner's common capital stock were sold for cash at par value of $100 each of Kauffman and his friends. In September, 1919, petitioner employed the American Appraisal Co. to appraise a portion of the machinery, equipment and fixtures and after such appraisal was made upon the basis of reproduction cost less the estimated actual depreciation, the petitioner entered upon its books the appreciated values, the total increase amounting to $155,228.36, which was included in invested capital as paid-in surplus. Petitioner computed depreciation on its fixed assets upon the basis of the appreciated book values. To substantiate its claim for the paid-in surplus petitioner has introduced in evidence the appraisal made in 1919 and expert testimony as to the sound values of the assets in question in September, 1919, and as to the depreciation thereon. We are*2922 of the opinion that the sale of the business and *181 assets by a willing vendor and the purchase by the petitioner, a willing vendee, establishes the total actual cash value of all the assets transferred within the meaning of section 326 of the Revenue Acts of 1918 and 1921, especially in view of the fact that the parties went into such great detail in their contracts in setting forth the agreed values of all the various assets. The total cost to petitioner for all the assets transferred to it amounted to approximately $1,082,000, and without showing the actual cash values of the various items of property included therein, other than the agreed values, petitioner has singled out the item of machinery and equipment which was transferred at an agreed value of $160,624.22, and seeks to have the latter figure increased by $155,228.36. The machinery and equipment constitutes a relatively small item out of the total purchase price, and without proof that each of the other items had actual cash values equal to the agreed values, there is no basis for segregating the one item and allowing a paid-in surplus with respect thereto, even though its cash value may be in excess of $160,624.22, *2923 as indicated by the testimony. It may well be that the actual cash values of other items, if segregated, are less than the agreed values.
The respondent is sustained in his exclusion from petitioner's invested capital of the values ascribed to fixed assets in excess of the net book values of the said assets as recorded on the books of the predecessor and agreed upon by the parties as the values of those assets. Cf.
With reference to the directory business, petitioner claims a paid-in surplus in the amount of $7,819.09, representing prepaid expenses on the edition of the directory partly ready for publication at the time of its acquisition. The parties to the transfer agreed upon a value of $25,000 for the directory business. In*2924 setting up its accounts on March 31, 1919, petitioner included in its capital account the amount of $25,000, which was the agreed value of the directory business. At the same time the prepaid expense in the amount of $7,819.09 was set up as a deferred expense which was reflected in its surplus, but during that first fiscal year ended March 31, 1920, the directory was published and the said amount charged to expense. In computing petitioner's invested capital for the fiscal year ended March 31, 1920, respondent has included therein $25,000 as the cost of the directory business, an asset, but he has excluded therefrom the claimed paid-in surplus of $7,819.09, and, also, he disallowed a deduction *182 in that amount as an expense. We are of the opinion that respondent correctly excluded from invested capital the amount of $7,819.09 as a paid-in surplus for that item was not a capital item, but was a part of the cost of the publication of the directory and as such a business expense, deductible from gross income for the fiscal year ended March 31, 1920. Cf. *2925
The third issue is relative to the reserve for possible loss on accounts receivable and other like assets acquired from the predecessor. The parties to the transfer agreed that there be included in the purchase price the net value of certain accounts receivable and at the time of acquisition of such accounts petitioner set up on its books a reserve for losses in the amount of $47,289.23. The purpose of the reserve was to provide for contingencies in connection with the realization of the values at which the accounts receivable and other like assets were set up on the books. After the accounts receivable or other like assets subject to shrinkage were collected or charged off, the reserve was reduced to a balance of $10,949.89, which amount petitioner claims to be paid-in surplus and a part of its invested capital. In accordance with the view taken as to the first issue, the value agreed upon by the parties to the transfer should govern the value at which the accounts receivable should be included in invested capital. The respondent is sustained in the exclusion of $10,949.89 from petitioner's invested capital as paid-in*2926 surplus. The assets which petitioner purchased were realized upon at an amount of $10,949.89 in excess of the cost of those particular assets to petitioner and in our opinion such amount constitutes income within the meaning of section 213(a) of the Revenue Act of 1918. Cf.
The fourth issue involves the question of the character of certain expenditures totaling $17,330.95, which amount petitioner took as a deduction as an expense and which respondent disallowed. The question is one of fact as to whether the expenditures were for replacements, alterations, improvements, or additions which appreciably prolonged the life of the property and increased its value, or whether the expenditures were for the purpose of keeping the property in an ordinarily efficient operating, useful or serviceable condition over its probable useful life. If found to be the former, the expenditure must be capitalized, and if the latter, it is deductible as an ordinary and necessary business expense. See *2927
| Painting | $ 300 |
| Repairing sidewalk lights | 200 |
| Miscellaneous repairs | 2,452 |
| Total | 2,952 |
With the allowance of $2,952 as a deduction from income for the fiscal year ended March 31, 1920, any deductions allowed by way of depreciation on said assets should be eliminated. Invested capital allowed by respondent for the year 1921 should be reduced by the amount of*2928 $2,952 for repairs.
The last issue is decided by our holding relative to the first issue. The values agreed upon at the time of the transfer were the actual cash values in March, 1919, and also the cost to petitioner of the assets sold in 1921. The respondent is sustained.
Judgment will be entered pursuant to Rule 50.