Toxaway Tanning Co. v. Commissioner

*377OPINION.

These appeals were consolidated for hearing and decision. The Commissioner in his answer objected to the jurisdiction of the Board with regard to the year 1917. On a statement of the facts involved the Commissioner’s objection to the Board’s *378jurisdiction was overruled by the division hearing this case. That ruling is approved. The Commissioner’s answer also set up a counter-claim for the year 1918, but such counter-claim was abandoned and no proof in support thereof was introduced.

The issues involved are as follows:

1. The disallowance for 1917 of all but $12,000 of $88,000 claimed for officers’ salaries.

2. The failure to restore to and include in the invested capital for 1917 and 1918 the cost, less depreciation, of tanning 322 vats constructed in 1904, 1907, 1912, and 1914.

3. Failure to include in invested capital for the years 1917 and 1918 the cost on December 31, 1916, and December 31, 1917, respectively, of tanning liquors in vats on those dates.

4. Failure to allow the full amount of loss from the destruction and damage by fire in 1918 to certain capital assets.

5. The reduction of invested capital for 1917, 1918, and 1919, by the amount of prior years’ income and profits taxes.

The first question is whether the petitioner is entitled to a deduction for 1917 for the full amount of the $88,000 officers’ salaries voted and accrued during 1917 for that year. The record discloses that it had been the consistent policy of the directors for many years prior to 1917 to agree upon the officers’ salaries for each year at a meeting held in ÍTew York during the summer of that year. At that meeting, which occurred immediately subsequent to the semiannual inventory, after the profits for the first six months’ operations had been determined, all of the officers and directors were present. Officers’ salaries in the amount of $128,000 for 1916 were agreed upon in the summer of 1916. The same was true for prior years. The salaries voted during the summer of 1917 for that year were entered on the books of the company and credited to the officers’ accounts before the close of that calendar year. This was also in accordance with the regular custom of the corporation. These salaries were corporate liabilities in 1917. Four of the five directors testified as to the action taken in regard to the salaries and the amounts agreed upon, and the record discloses that the salaries accrued for 1917 were decided upon and voted in July, 1917, although no minutes were made showing such action and no entries made on the books until the close of the year.

The question was raised as to whether the salaries of the officers for the year 1917 were reasonable. We believe from all of the evidence that this objection is not well taken. The sales for 1917 exceeded $1,000,000. In addition the petitioner tanned and sold raw hides on commission for Swift & Co. in an amount aggregating in excess of $790,000. During the same year it added to its surplus, after payment of officers’ salaries and other charges, $192,615.43, *379and paid its stockholders a cash dividend of 40 per cent. Each of the officers was actively engaged in the administration of the company’s affairs during 1917 and from its organization in 1902. In our opinion the salaries for 1917 were reasonable and should be allowed. The Parisian, 2 B. T. A. 415.

The next question is whether invested capital for 1917 and 1918 should be increased by the cost, less depreciation, of tanning its 322 tanning vats. The tanning of the wooden lining of each of the vats was as essential as the lining itself. Hides could not be tanned until the lining itself had first been tanned. When the lining was once saturated with tannin the vat was ready for use and there was nothing further to be done. The lining had a useful life equal to that of the vat. Each vat when tanned had a useful life of at least 50 years. The Commissioner did not contend that this cost .was not a capital expenditure. His objection was that the specific costs could not be definitely determined from the petitioner’s books, that the cost of tanning the vats was charged to expense and included with other such items and for that reason it would be impossible to make a separation on the books of the petitioner.

The cost of tanning a vat was standard. The 322 vats were 8 feet by 9 feet by 6 feet in depth. Each vat had a content of 432 cubic feet and absorbed one-fifth of its cubical contents in the process of tanning. A liquor of 46 degrees strength was used in the process. Each cubic foot of this liquor weighed 64½ pounds. Four and one-half per cent in weight of each pound of this liquor was tannin. The total tannin required for each vat was 1,500¾ pounds; one-half of this amount was actually absorbed by the wooden lining; one-half of the remainder was lost in the necessary process of filtration and purification of the residue. The tanning of each vat, therefore, consumed 1,125 pounds of tannin. The cost of tannin per pound in 1904,1907, 1912, and 1914 was disclosed by the petitioner’s books. The dimensions of the vats and the cost per pound of tanning being given, it is but a mathematical process to determine the cost of tanning a vat. The cost of farming the 322 tanning vats was $33,884.78. The useful life of each vat was 50 years. The proper deduction for depreciation was 2 per cent. The addition to petitioner’s invested capital for 1917 and 1918 was cost, less depreciation at 2 per cent from the date of construction. The deduction for exhaustion, wear and tear of the vats for 1917 and 1918 should be computed at the rate of 2 per cent.

The third issue is whether the petitioner is entitled to include in its invested capital for 1917 the cost of tanning liquor in its vats at December 31, 1916, and for 1918 the cost of such liquor at December 31, 1917. Upon the construction of the vats and before the process of tanning hides could be commenced, it was necessary *380to fill each vat with liquor to a depth of 4½ feet and constantly to maintain this liquor at an average strength of 46 degrees Barko-meter. The cost of the original liquor placed in the 322 vats is not shown. In the process of tanning the hides, a portion of the tannin, which is the essential element, is absorbed from day to day, and additional tannin must be added to maintain the liquor at the required strength. The cost of the tannin fluctuates from time to time. It is contended that “the taxpayer’s investment in tanning liquor is the cost of the original liquor plus all additions thereto to maintain the required strength, less the cost of the liquor actually absorbed by the hides,” and that “it is clear therefore that on a given date all the liquor in the vats constitutes the capital item in question.” The Board can not agree with this contention. It may be that the cost of the liquor with which the vats were originally filled was a capital expenditure, since the liquor was as essential as the vats or any other item of a major character, and since it was necessary to maintain the liquor throughout at a uniform strength, but the cost of tannin subsequently added from time to time during the year made necessary by the constant absorption thereof by the hides was an ordinary and necessary manufacturing expense within such year.

The method contended for by the petitioner would permit it to include in invested capital for the year the cost not only of the liquor originally placed in the vats, but also any increase in the cost of tannin used for replacement purposes, such increase in cost being deducted as an expense of manufacture.

We have no evidence as to the cost of the liquor with which the vats were originally filled, and it is not necessary therefore to consider whether any amount should be restored to invested capital on this account. It is our opinion that the Commissioner correctly denied the claim that the cost of the liquor in the vats on December 31, 1916, and December 31, 1917, should be included in invested capital for 1917 and 1918, respectively.

The fourth issue concerns the amount which the petitioner is entitled to deduct from income for 1918 as losses sustained by it from fire during that year. Its plant was destroyed by fire on October 11, 1918. The plant was partially covered by insurance and for every dollar of damage done, as determined by the insurance company, the petitioner received 58 cents. It was under-insured 42 per cent. At the time of the fire the petitioner was engaged in war production. The settlement with the insurance company was not satisfactory to the petitioner but was accepted in order that it might rebuild its plant and resume work. The entire amount of the insurance was received by the petitioner during the year 1918 and was included in taxable income for that year.

*381The tanning liquor in the vats on October 11, 1918, was completely destroyed by fire. The cost thereof, which had been charged to expense, was $74,451. The petitioner received in 1918 insurance of $19,706.54 for the destruction of this liquor and included the same in income for 1918 and claimed a loss of $72,451. The Commissioner declined to allow the deduction of any portion of the claimed loss.

For the reason stated in connection with the preceding issue relating to the capitalization of the cost of tanning liquor, it is the opinion of the Board that the Commissioner correctly denied the deduction of the cost of the liquor destroyed by fire as a loss sustained within the year. When the petitioner received $19,706.54 from the insurance company, it was in the same position as if it had incurred an expense for liquor of $54,744.46. The petitioner had already deducted from income, and we think properly, the cost of the liquor destroyed, and it may not again reduce its income by the same amount or in the amount of the difference between the insurance received and the cost of the liquor destroyed.

A pump ringer costing $1,056.25 was purchased by the petitioner in 1917, which cost was charged to expense during the year 1917. The deduction was disallowed by the Commissioner and the cost restored to capital. This article was totally destroyed by the fire. Some insurance was recovered but was included in income for 1918. The petitioner is entitled to a deduction from income for 1918 of the total cost of this article, amounting to $1,056.25, less one year’s depreciation at 6% per cent, since the useful life of the article was 15 years.

The petitioner had on hand at the date of the fire, in process of tanning, hides which had cost it $641,565.77. This amount did not. include manufacturing or selling cost. The hides were badly damaged by heat and discolored as a result of pieces of iron, nails and other debris falling into the vats. The exact amount of the damage done could not be determined at that time. It was necessary to complete the tanning process and then dispose of the hides, if possible, in order definitely to determine the extent of the damage. As soon as the settlement was made with the insurance company, the tanning of the hides was resumed and was completed, in 1919.

On December 31, 1918, petitioner reduced its inventory of hides in process by $140,505.09, leaving a net cost of hides in process of $501,151.68. This figure included the cost of the raw hides exclusive of the cost of manufacture. The total cost of tanning the hides damaged by the fire was $212,650.11, which was also carried in the inventory. The damaged hides were subsequently sold for $560,874.07. The Commissioner allowed $140,505.09 as a deduction from income for 1918 for damage to hides in process; From the evidence we are of opinion that the damage to hides in *382process was $293,341.81. The petitioner is therefore entitled to a deduction from income for the year 1918 of this loss. The petitioner received from the insurance company on account of the damage $84,185.23. This was included in 1918 taxable income and need not be considered in determining the loss.

The fifth issue involved in this appeal is whether invested capital for the years 1917, 1918, and 1919 should be determined without reduction thereof on account of prior year’s income and profits taxes. We approve the Commissioner’s computation of invested capital in this regard. Appeal of Russel Wheel & Foundry Co., 3 B. T. A. 1168.

Judgment mill he entered on 15 days' notice, wider Rule 50.