Court Opinion

ID: 4634724
Source: CourtListenerOpinion
Date Created: 2020-11-21 03:16:37.751916+00
Date Added: 2024-06-11T07:58:15.833977
License: Public Domain

J. C. BLAIR CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.J. C. Blair Co. v. CommissionerDocket No. 7147.United States Board of Tax Appeals11 B.T.A. 673; 1928 BTA LEXIS 3749; April 18, 1928, Promulgated *3749  1.  In computing the amount of dividends paid from surplus during the years 1918 and 1919, the respondent first deducted from current earnings the amount of a tentative tax accrued for each of said years.  Held, that the petitioner's invested capital for said years may not be reduced to the extent that the amount of the dividends paid from surplus is affected by the deduction of the tentative taxes.  L. S. Ayers & Co.,1 B.T.A. 1135">1 B.T.A. 1135. 2.  Held that the evidence is insufficient to enable us to determine that the respondent's determination of the cost of design plant or its March 1, 1913, value was erroneous.  W. W. Spalding, Esq., and H. A. Fellows, Esq., for the petitioner.  D. D. Shepard, Esq., for the respondent.  TRAMMELL *674  This is a proceeding for the redetermination of deficiencies in income and profits taxes for the calendar years 1918 and 1920 in the amounts of $7,848.57 and $22,163.04, respectively.  No deficiency has been asserted by the respondent for the year 1919, and hence that year is involved herein only insofar as it affects the tax liability for the year 1920.  The following issues are raised by*3750  the pleadings: (1) Whether the respondent erred in refusing to include in the computation of the petitioner's invested capital for each of the years 1918, 1919 and 1920 the amount of $156,511.91, alleged to represent that part of the cost of the petitioner's design plant erroneously charged to expense; (2) whether the respondent erred in reducing invested capital for the years 1918 and 1919 by the amount of certain dividends paid in those years in excess of current earnings, the respondent having deducted from the amounts of the available earnings an accrued or tentative tax liability for each of said years; and (3) whether the respondent erred in refusing to allow, for each of the years involved, depreciation based on the fair market value of the petitioner's design plant as of March 1, 1913, plus the cost or subsequent additions thereto.  The petitioner also alleged in its pleadings that the respondent erred in prorating from invested capital for each of the years involved the full amount of the tax liability for the preceding year, but this issued was abandoned at the hearing.  The petitioner further alleged in its original petition that its taxable income for 1919 was overstated*3751  by the amount of $4,963.92, and for 1920 by the amount of $9,910.27, due to a clerical error in computing depreciation.  Later, a stipulation was filed with the Board in which it was agreed that the taxable income for said years, as shown by the deficiency letter, should be decreased by said amounts, and by amended answer filed January 21, 1926, the respondent admitted that said income should be so reduced.  FINDINGS OF FACT.  The petitioner is a Pennsylvania corporation, with its principal office and place of business at Huntingdon, and for the years involved filed its tax return with the collector of internal revenue at Philadelphia.  *675  In 1867, J. C. Blair started a small stationery business in Huntingdon, and in 1877 purchased a small printing press operated by foot power.  He conceived the idea of making pads or tablets of writing paper, which at first were made without covers and were permanently fastened together with copper tacks.  Later, he made the tablets with covers.  He was a pioneer of the tablet industry.  The first cover was intended only to protect the sheets from soiling.  The design for first cover used was made by an artist connected with the normal*3752  school in Huntingdon.  Several years later, lithographs were used for covers on tablets used principally by school children, the lithograph being intended to attract the attention of the children.  The next step was the use of "illuminated" covers, the designs being prepared by artists.  From the designs, electrotypes were made from which the tablet covers were then produced.  Between $35,000 and $50,000 capital was employed in the business in 1881.  The petitioner corporation was organized May 22, 1891, with a capital stock of $200,000.  The increase of capital came from the accumulation of earnings.  A part of the petitioner's plant is known as the "design plant," which consists principally of original drawings, wood cuts, electrotypes, half-tones and steel dies.  The original drawings are made by the artist, from which the wood cuts are engraved; the electrotypes are then made from the wood cuts, also half-tones and steel dies.  The ideas usually originate with the president or employees in the office connected with that particular work.  The idea is given to the artist in the form of a rough pencil sketch, and the artist then prepares a colored drawing.  After the drawing submitted*3753  by the artist is approved by the officers of the petitioner, a wood cut is engraved from the design, and from the wood cut electrotypes are made, which are used in printing the covers for the tablets.  Some of the designs represent a number of different colors, each of which is printed from a separate electrotype.  The wood cuts from which the electrotypes are made last indefinitely.  They are kept permanently in the petitioner's design plant, being filed away for use in reproducing the electrotypes as needed.  The petitioner does not maintain a separate building for its design plant; this is a designation applied to a part of its printing establishment.  The wood cuts, electrotypes, steel dies, half-tones and zinc etchings are kept in two vaults, about 10 feet by 12 feet each.  The cuts are kept in these vaults, except when actually in use in the printing department.  The petitioner has a large number of these articles in its vaults, some of which have been there continuously since the inception of the business.  They are not scrapped except when worn out.  *676  A design is a reproduction of some idea that is used on a particular line of goods, similar to a pattern in dry*3754  goods.  Some of the petitioner's designs have been in use for a great number of years; others are used for only two or three years and then discontinued.  Some so discontinued are used again later.  The designs largely create the demand for the petitioner's tablets.  It is necessary to have designs on the tablets in order to sell them in large quantities.  The petitioner could not successfully carry on its business without the use of designs.  Some of the petitioner's designs have been in use for 40 years, some for 10 years, and others for five years and three years.  As of December 31, 1921, the petitioner's design plant included 2,607 artists' designs, 8,177 wood cuts, 1,953 etchings, 1,461 type forms, 76,921 electrotypes, 509 dies, 660 half-tones, 16 photographs, and 16 wax engravings; also about 10,000 titles.  There were as many as 32 electrotypes for a single title, but some titles had only one and some had none.  At March 1, 1913, the design plant contained approximately 2,331 artists' designs, 7,470 wood engravings, 1,209 etchings, 1,394 type forms, 65,520 electrotypes, 264 metal dies, 418 half-tones, 4 photographs, and 13 wax engravings.  And at January 1, 1918, there*3755  were approximately 2,446 artists' designs, 7,924 wood engravings, 1,331 etchings, 1,426 type forms, 71,150 electrotypes, 392 metal dies, 562 half-tones, 4 photographs, and 16 wax engravings.  During the years from 1891 to 1917, inclusive, the petitioner charged to the capital accounts on its books a total of $101,093.39 for items entering into its so-called design plant.  Said amount represents the total cost reflected by the petitioner's books or total of the individual items of cost recorded in the petitioner's books from 1891 to 1917, inclusive, on account of the design plant.  During the said years the petitioner's books did not include any account designated "design plant," nor did the books contain any separate account wherein the said amount of $101,093.31 or any part thereof was recorded.  The individual amounts making up said total were charged to the petitioner's plant account.  The depreciated balance of said total amount was included in the depreciated balance of the petitioner's plant account, and was included by the petitioner in its invested capital for the years in controversy.  In computing the petitioner's invested capital for said years, as shown by the deficiency*3756  notice, the respondent included said item, which has not been reduced by any amount on account of items discarded or items which have gone out of use.  The petitioner's system of accounting was to capitalize expenditures for outside purchases only.  All expenditures for salaries and general overhead items were charged to expense.  Electrotypes were *677  purchased from the outside market, and the amounts paid for the electrotypes and similar articles were capitalized.  The cost of the etchings, half-tones and some of the drawings were capitalized.  However, the electrotypes as purchased were not in a suitable form for immediate use, but were merely rough castings.  It was necessary for the petitioner to take the rough castings as received and underlay or line them up so that they would operate properly to produce the prints, that is, to print uniformly over their entire surface.  The cost of underlaying the electrotypes, half-tones, etc., was not capitalized or charged to the plant account.  It was also necessary that the electrotypes be recorded so that they could be used in such manner that the various colors would be printed in their proper places in relation to each other. *3757  This required the time of the printer, the printer's helper and the use of a press.  In view of the large number of designs and units of equipment in the design plant, it was necessary that an operating record be made so that at any time the required electrotypes or other articles might be placed in immediate use.  To that end, the printer prepared card schedules or records, showing how the various electrotypes should be set, and the colors and color mixtures that should be used, and these records were filed away for use when needed.  No expenditures on account of such elements of cost were included in the petitioner's plant account.  Also, copyright cost were not charged to the plant account, nor did this account include any element representing the salaries of the executives, either as overhead for the direct costs incident to the installation of the various units as a part of the design plant, or as part of the cost of their activities in developing and building up the design plant.  During a part of the time the petitioner employed its own artist as a designer, and his salary was not charged to the plant account.  With a view to determining the cost of its design plant, the*3758  petitioner employed the American Appraisal Co., of Milwaukee, Wis., to make a retrospective appraisal or ascertainment of cost.  During 1922 the appraisal was made through a representative of the appraisal company, who was sent to Huntingdon for that purpose, and under date of May 12, 1923, its report of the retrospective appraisal was submitted.  After a general inspection of the property, the appraiser prepared a form upon which the various items should be inventoried, and the information indicated was then compiled by an employee of the petitioner.  Upon completion of the inventory forms, the appraiser made spot checks to test the information recorded on the forms against the actual existence of the various property units, and these forms were thereafter accepted as comprising a complete inventory of the physical properties of the design plant for purposes of the appraisal.  *678  In preparing the retrospective appraisal report, the cost of the properties comprising the design plant were determined as follows: The appraiser took from the company's records the cost of outside purchases, which had been capitalized and which were largely for material.  These amounts included*3759  no element of cost for overhead.  From the books, a tabulation was then made of the salaries paid to the officers and employees of the petitioner, who were engaged for a part of their time upon work in connection with the design plant, for the years from 1891 to 1921, inclusive, and a portion of the salaries so determined was allocated to the cost of the design plant.  Next, there were added to the cost of the design plant such varying percentages of the salary allocations for the different years or periods as the officers of the petitioner considered proper to cover the overhead expenses attributable to the design plant.  The general overhead expenses thus allocated to the cost of the design plant consisted of executive traveling expenses, legal expenses, salesmen's annual conference, printer proving designs, printer underlying cuts, press helper, printer filing and numbering, interest on borrowed money, and copyright expenses.  The total cost of the design plant, so determined, included the cost of obsolete designs, as well as the cost of designs forming a part of the active plant.  From the petitioner's records, there was no basis upon which the total cost could be directly distributed*3760  to the various units of property in order to eliminate a proper proportion for the obsolete items.  Accordingly, there was determined, based upon the various assets, a relation both for the types of assets and for the character of the various units of the same types.  On that basis, there was developed a unit basis from which unit costs for each year could be determined, based upon the total units produced and the total costs as previously determined.  The units were then worked backward to get a distribution of the total costs, and the obsolete items eliminated as they occurred.  The cost thus determined were depreciated at the rate of 5 per cent per year, which included obsolescence.  In connection with the allocation of wages, salaries, legal expenses and other items of overhead, the portions allocated to the cost of the design plant were determined by the president of the petitioner, in consultation with other officers of the corporation, and the appraiser.  The appraisal report contained a schedule consisting of certain expenditures from 1891 to 1921, which the petitioner contends should be capitalized and added to the cost of the design plant.  The books of the corporation*3761  were closed only once from 1891 to 1896.  They were closed again in 1903, and annually thereafter.  Consequently, *679  the items are grouped in the appraisal report according to the periods for which the books were closed.  The items of expense, consisting of salaries of the president, vice president, design recorder, stenographers and factory artist, represent the actual payment of salaries and wages, as shown by the books, and the amount allocated to cost of the design plant included an addition of 40 per cent of such salaries and wages for general overhead.  The amounts allocated to cost of the design plant on account of "printer proving designs" and "printer underlaying cuts," represent wages of employees who are claimed to have spent part of their time developing color schemes, etc., and finishing up cuts, plus 75 per cent of such wages for overhead.  Also, 75 per cent for overhead was added to the amount of wages allocated to cost for "press helper" and "printer filing and numbering." The percentages of increase for overhead were not matters of record in the petitioner's books.  In computing the amount of dividends paid out of surplus in 1918, the respondent deducted*3762  from available earnings the amount of $26,483.50 representing a tentative tax accrued for that year.  Likewise, in computing the amount of dividends paid out of surplus in 1919, the respondent deducted from available earnings a tentative tax in the amount of $55,970.90.  For each of the years involved herein, the respondent allowed a deduction for depreciation, computed on the petitioner's plant, including the design plant, at the rate of 7 1/2 per cent, and on buildings at 2 per cent.  The rate of 7 1/2 per cent for depreciation on the plant also took into consideration an element of obsolescence.  OPINION.  TRAMMELL: The original petition filed in this case includes the calendar year 1919, and purports to seek a redetermination of the petitioner's tax liability because of errors alleged for that year, as well as the years 1918 and 1920.  The deficiency letter attached to the petition discloses that the respondent determined an overassessment for 1919, not arising from the denial of any claim for the abatement of a deficiency.  Hence, we have no jurisdiction to redetermine the tax liability for 1919, and the appeal as to that year is dismissed.  *3763 . However, in redetermining the deficiencies for 1918 and 1920, we will determine and consider such facts with relation to the tax liability for 1919 as may be necessary correctly to redetermine such deficiencies.  Sec. 274(g), Revenue Act of 1926.  We will consider first the contention of the petitioner that the respondent erred in reducing invested capital for 1918 and 1919 by *680  certain amounts representing dividends paid from surplus.  This contention is based on the fact that, in computing said amounts, the respondent first deducted from the current earnings available for the payment of dividends, the amount of a tentative tax accrued for each of said years.  The respondent concedes that his action in this respect comes within the principle of our decision in . Accordingly, on this point we must hold that the petitioner's invested capital for said years may not be reduced to the extent that the amount of the dividends paid from surplus is affected by the deduction of the tentative taxes.  See also *3764 . The next and principal issue presented involves the question whether the respondent erred in refusing to include in the computation of invested capital for the years 1918, 1919 and 1920, the amount of $156,511.91, alleged by the petitioner to represent that part of the cost of its design plant erroneously charged to expense during the years from 1891 to 1921.  From 1891 to 1917, inclusive, the petitioner capitalized, by charging to its general plant account, the total sum of $101,093.39 for items entering into its so-called design plant.  The depreciated balance of the plant account, which included the depreciated balance of the items comprising the book cost of the design plant, was included in the petitioner's invested capital and is not involved in the controversy here.  The petitioner's design plant was not a segregated unit, but this term was used to designate an integral part of its general plant or printing department.  Nor did the petitioner maintain a separate account on its books to show cost of the design plant.  The total sum above referred to represents the aggregate expenditures made by the petitioner during*3765  the years stated for outside purchases of electrotypes, and other material entering into the design plant, which were recorded in its plant account.  The electrotypes purchased by the petitioner were in the form of rough castings, and it was necessary to underlay and build them up so that they could be used in printing tablet covers.  It was also necessary to record and file the electrotypes and other cuts so they would be available for use when needed.  This work was performed by the employees of the petitioner.  Apparently, no employee devoted his whole time to this work, but only such part of his time as was required.  It further appears that the officers and certain employees of the petitioner were engaged for a part of their time in connection with other matters pertaining to the design plant.  The total sum capitalized as cost of the design plant, above mentioned, did not include any element of overhead expenses, or for *681  salary or wages.  All items of salary and wages, as well as general overheard, were concurrently charged to expense.  The petitioner now seeks to capitalize, and to include in the computation of its invested capital for the years in question, the*3766  additional aggreagate amount of $156,511.91, which, it contends, represents that part of its general overhead expense and expenditures for salaries and wages, properly allocable to cost of the design plant, and which it alleges was erroneously charged to expense.  The respondent refused to include said amount in the computation of invested capital on the ground, first, that the charging to expense of said items, was as a matter of good accounting, to a large extent optional, and that in charging said items to expense and deducting such expense from income, the petitioner exercised a binding option; and, second, on the ground that the retrospective appraisal offered to substantiate the amount claimed depended in a large measure upon estimates as to both basic and overhead figures.  For substantially the same reasons, the respondent here urges that the petitioner should not be permitted to include any part of said amount in its invested capital.  The fact that expenditures made in the develpment or creation of capital assets were concurrently charged to expense and deducted from income does not bar their restoration to capital, if the amounts of the expenditures and the fact that*3767  they were capital expenditures are established by satisfactory evidence.  And the fact that such expenditures were erroneously charged to expenses and deducted from income does not constitute the exercise of a binding option, which will prevent their restoration to capital.  . To the same effect, and for further discussion of the principles involved, see also , and . Therefore, to decide this issue as presented here, it remains only to determine whether the petitioner has fairly established the amount of the expenditures which it claims were erroneously charged to expense and should now be capitalized, and whether such amounts in fact represent capital expenditures.  The evidence offered by petitioner in support of its contention consists substantially, if not wholly, of the retrospective ascertainment of cost, which is referred to for convenience as the retrospective appraisal, together with testimony concerning the methods by which the appraisal report was prepared.  The details of those methods are set forth at some*3768  length in our findings of fact.  The appraisal was made during 1922, and the appraisal report was completed in May, 1923.  A statement was prepared from the books showing the total amounts of salaries and wages paid to the *682  officers of the petitioner and certain employees from 1891 to 1896, from 1896 to 1903, and for each year thereafter up to and including the year 1921.  The president of the petitioner in consultation with other officers and the appraiser then determined the amount of the total salaries and wages paid for each period or year, which, in their opinion, was properly allocable to the cost of the design plant.  To such portions of the salary expenditures amounts were then added varying from 40 per cent to 75 per cent thereof, as representing what was considered to be proper allocations of general overhead expenses.  It thus appears that the amount of the expenditures, which the petitioner now contends should be capitalized, was retrospectively determined in 1922, for a period extending more than 30 years into the past.  The percentages of overhead allocated to cost were not matters of record in the petitioner's books, and the evidence does not disclose*3769  that those who participated in making the allocations, both of salaries and overhead, had personal knowledge of the facts essential to the making of substantially accurate allocations.  The president was the only witness who had been with the company during the prior years.  This officer was an employee of the petitioner in 1891, and has continued his connection with the corporation down to the present time.  He became president in 1919, but during the early years subsequent to 1891, the evidence does not disclose that he exercised any supervision over the design plant or performed any functions pertaining thereto.  It is not shown that his personal knowledge was more than casual with respect to the amount of time devoted by the various officers and employees of the petitioner during those years in creating or building up the design plant, nor that he otherwise possessed accurate information as a basis for the allocations made.  In , we held that amounts expended in prior years for materials and labor in the manufacture of tools, dies, etc., charged to expense, should be restored to capital account for the purpose*3770  of computing invested capital, but the evidence in that case satisfactorily established the cost of material and labor used, and enabled us to find with reasonable accuracy the amounts of the respective expenditures.  However, no element of overhead expenses was included, and in considering that question, we said: In arriving at the cost of such replacements we have not included the charges for overhead which petitioner claims is properly to be attributed thereto.  * * * At best, the allocation of overhead expenses between various operations is unsatisfactory, and where it appears that the consistent practice has been to charge off such expenses as incurred we are not inclined to change the accounts in order to capitalize them.  *683  Again, in , we declined to include in invested capital an estimated portion of the salary paid to the corporation's president, previously charged to expense, which, it was contended, was properly allocable to the cost of capital assets.  Without considering generally the difficulties encountered in attempting to allocate overhead to the cost of capital assets, it is sufficient here to*3771  say that the evidence adduced by the petitioner in support of its contention is, in our opinion, too indefinite, uncertain, and speculative to form a basis for including in its invested capital any part of the additional amount claimed.  The determination of the respondent on this point is, therefore, approved.  With respect to the third issue, the petitioner contends that the fair market value of its design plant at March 1, 1913, was $300,000, and that the respondent erred in refusing to allow a deduction for depreciation based on this valuation, plus the cost of subsequent additions thereto.  The president of the petitioner testified that the conservative fair market value of the design plant at March 1, 1913, was about $300,000.  He further testified with respect to this matter as follows: Q.  Have you ever sold any so-called design plants?  A.  No.  Q.  Do you know of any sales of design plants?  A.  I do not know of any of design plants, but that is one part of the industry that is very valuable.  * * * Q.  So that is the reproductive cost that you are referring to as of March 1, 1913?  A.  That would be a fair price for the reproduction, yes.  Q.  You mean*3772  it would cost $300,000 to reproduce these assets in the so-called design plant?  A.  I think it would.  Q.  Is that less depletion?  A.  I cannot answer that question.  I am not in the bookkeeping end of it.  * * * Q.  Is your opinion based in any degree upon an appraisal?  A.  It is based on those figures that I have gone over at the time of the appraisal.  * * * Q.  Then you must admit that all your testimony as heretofore stated, that this so called value of $300,000 is a mere estimate of the cost of reproduction?  A.  I think it would be a very low estimate.  Q.  It is an estimate?  A.  It is an estimate.  Jackson, who prepared the retrospective appraisal report, testified that the depreciated reproductive value of the design plant as of March 1, 1913, was $206,492.42.  This amount was arrived at by *684  applying to the reproductive costs of each year to March 1, 1913, retrospectively determined, a theoretical depreciation rate of 5 per cent per year.  This witness further testified that he believed the fair market value at the basic date to be not less than the depreciated reproductive value.  McSheehy, the only remaining witness who testified*3773  as to the March 1, 1913, value, stated that in his opinion the petitioner's design plant had a fair market value at that date of not less than $350,000.  These three witnesses were closely associated in the work of preparing the retrospective appraisal or cost determination and their testimony does not, in our opinion, furnish a satisfactory basis for the determination of the fair market value of the property in question.  The market value of property at a given date is a fact, which often has no direct relation to depreciated cost.  The witnesses mentioned did not convince us of their knowledge of market values.  However, without further reference to the qualifications of these witnesses to express opinions on the fair market value of the petitioner's design plant, we can not escape the conclusion, upon consideration of all the evidence before us, that their opinions were largely if not solely based upon the so-called retrospective appraisal or determination of cost which they, each, had helped to make.  In many prior cases, we have refused to accept retrospective appraisals as a satisfactory basis for determining market value.  *3774 ; ; . While under some circumstances a retrospective determination of cost or appraisal may be considered some evidence of market value, the particular appraisal or cost determination here was based on such indefinite and uncertain facts, depending to such a large extent for its accuracy on the memory of a single witness as far back as 30 years in the past, and, it not being shown that the witness was in a position in the past years to ascertain or learn the facts with any degree of accuracy, in our opinion it is of little or no value as a basis for determining fair market value of assets.  We did not accept it as a determination of cost, and there is no more reason why it should be used as the basis of market value.  Upon consideration of all the evidence in the record, we are unable to say that it is sufficient to justify the substitution of any other or different basis for invested capital and depreciation purposes with respect to the assets in question than that used by the respondent.  Accordingly, the respondent's*3775  determination is approved.  Judgment will be entered on 15 days' notice, under Rule 50.