American Colortype Co. v. Commissioner

*1276 In this proceeding the petitioner seeks a redetermination of the income and profits-tax liability for the years 1919 and 1920 for which the Commissioner has determined deficiencies of $17,072.67 and $20,744.50, respectively. The petitioner alleges error on the part of the Commissioner in disallowing, as part of invested capital, (1) any value for*3918 good will for which $3,000,000 par value of common stock and $79,249.86 par of preferred stock was issued; (2) an amount of $3,600 paid in cash to the Maas Engraving Co. for plant and good will; (3) an amount of $13,940.35, paid in connection with the purchase of the business of the Thomas D. Murphy Co.; (4) an *1277 amount of $2,254.09 representing good will purchased from the Gibson Calendar Co.; (5) an amount of $8,841.78, representing the value of a building demolished on land acquired; and (6) an amount of $3,143.49, representing organization expenses.

FINDINGS OF FACT.

The petitioner is a corporation organized in 1902 under the laws of the State of New Jersey, with an authorized capitalization of $4,000,000 par value of capital stock, of which $300,000 was first preferred, $700,000 preferred, and $3,000,000 common stock.

Under date of February 21, 1902, the stockholders of the then newly organized American Colortype Co., the petitioner herein, passed a resolution authorizing the issue to three trustees of 5,999 shares of 8 per cent preferred stock ($100par), and of 30,000 shares of common stock (par $100), for the purpose of acquiring the plants, assets, properties, *3919 and good will of the National Colortype Co. of Chicago, the American Three-Color Co. of Chicago, and the Osborne Co. of Newark, and certain corporations affiliated with them.

The agreement of consolidation was in part as follows:

AGREEMENT entered into between The National Colortype Company, of Chicago, The American Three Color Co., of Chicago, and The Osborne Company of Newark, N.J.

For the purpose of consolidating the three companies into one corporation, to be organized under the laws of the State of New Jersey, and to be known as The American Colortype Company.

The following described basis is agreed upon for determining the value of the assets of every description of each company and for determining the proportion of the stock of The American Colortype Company to be given to each of the three parties hereto:

THE CAPITALIZATION of The American Colortype Company shall be Four Million Dollars, of which Three Hundred Thousand Dollars shall be first preferred, Seven Hundred Thousand preferred, and Three Million Dollars Common.

Two Million Four Hundred Thousand Dollars common stock shall be divided in three equal portions, of Eight Hundred Thousand each, to each of the*3920 three parties hereto.

Six Hundred Thousand of the preferred stock shall be divided among the three parties hereto, in proportion to their assets in the following manner, to-wit:

DIVISION OF STOCK: The Company having the highest assets shall be given an amount of preferred stock equal to the amount of the assets. Then each of the other companies shall be given an amount of preferred stock equal to its assets. Then if the company having the highest assets has less than Two Hundred Thousand Dollars, there shall be added to the preferred stock of each company an amount equal to the difference between Two Hundred Thousand Dollars and the highest assets. Then the amount of stock remaining shall be divided between the three companies, respectively, in proportion to their assets. TO ILLUSTRATE: If the assets of the largest Company are One Hundred and Eighty-five Thousand Dollars, the next One Hundred and Seventy-five Thousand Dollars, and the next One Hundred and Sixty Thousand Dollars, *1278 the largest Company shall be assigned One Hundred Eighty-five Thousand Dollars preferred stock, the second One Hundred and Seventy-five Thousand, the third, One Hundred and Sixty Thousand, *3921 and to each of these there shall be added Fifteen Thousand Dollars preferred stock, making a total of Five Hundred and Sixty-five Thousand and leaving a balance to be distributed among the Three Companies of Thirty-five Thousand. This balance shall be divided between the three Companies in proportion to their assets. The total assets amounting to Five Hundred and Twenty Thousand, the largest Company shall have 185-520's, the second 175-520's and the third 165-520's.

In case the assets of any company should exceed TWO Hundred Thousand, it shall be assigned preferred stock to the full amount of its assets, each of the other Companies to the full amount of its assets, and any portion of the Six Hundred Thousand preferred remaining shall be divided between the three companies, in the proportion of their assets.

The remaining Six Hundred Thousand Dollars of Common, and One Hundred Thousand Dollars Preferred Stock shall be used in the new Company for providing operating capital, or for any other purpose that the new board of directors may consider desirable.

TIME OF TRANSFER: The property of The Osborne Company shall be transferred to the American Colortype Company, immediately, *3922 on the basis of its condition Feb. 1, 1902, and the properties of the other two Companies shall be transferred as soon after this date as inventories of their assets can be obtained.

VALUATION OF PROPERTIES: Each concern shall transfer to The American Colortype Company all its assets of every kind and nature whatsoever, including real estate, good-will, patentsInterests in inventions patented or unpatented, copyrights, contracts for work finished or unfinished, stock in all or any other companies incorporated or not incorporated, and all these shall be value in the inventory in the manner described below.

From the sum total of the assets of each concern there shall be deducted its total liabilities.

* * *

Maas Engraving Co. account. The National Colortype Company and The American Three Color Company shall be credited in their assets with $1,250.00, each, for money paid to the Maas Engraving Company for its good-will and plant, and the four notes of $1,100.00 each, given jointly by The National Colortype Company and American Three Color Co., shall be assumed and paid by the American Colortype Co. As The American Three Color Co., and the National Colortype Co. will be credited*3923 all they have paid to the Mass Engraving Co., no allowance in inventory shall be made for any machinery, fixtures, or other assets received from the Maas Engraving Co.

* * *

The parties hereto do agree with each other that for the purpose of carrying out the consolidation aforesaid, and for the transfer and coveyance of the assets of the parties hereto to the said American Colortype Company on the basis herein agreed, the parties hereto will convey or transfer all their corporate assets and property of every kind and description, including the capital stock of subsidiary Companies owned or controlled by any of the parties hereto, or put the same under the control of Edmund B. Osborne, Julius Regenstein and John F. Behrens, who are hereby authorized and empowered by the parties hereto to transfer and convey the same to the American Colortype Company for $599,000 of the preferred stock, and $3,000,000 of the common stock of the said last mentioned Company, and the several parties hereto will on *1279 request of the said Edmund B. Osborne, Julius Regenstein and John H. Behrens transfer and convey all of their said assets and property, including the stocks aforesaid, either*3924 to the said Edmund B. Osborne, Julius Regenstein and John H. Behrens, or to the American Colortype Company directly, as may be deemed most convenient for completing the consolidation hereby contemplated:

And it is further agreed that as a further basis of such consolidation and as part consideration as between the parties hereto therefor, the parties heretowill procure and cause to be signed with the said American Colortype Company contracts by Edmund B. Osborne, George W. Reynolds, A. D. Sheridan, Julius Regenstein, Francis Lackner, John H. Behrens, Frederick S. Osgood and Theodore Regenstein, who are now officers, directors, or connected with the business of the parties hereto, agreeing that they will not as principals, agents or employees, or as officers or stockholders of any corporation or otherwise, directly or indirectly, in the United States of America or Canada, for a period of ten years following the organization of the said American Colortype Company, engage or be interested in the manufacture of 3 color plates or printing therefrom, or selling such plates, or products of the printing of such plates, or the manufacture or sale of advertising calendars, or in the manufacture*3925 or sale or die stamp or steel embossed stationery for business or other purposes.

The consolidation was completed and stock was issued to the trustees for distribution. A condensation of the opening entries on the books was as follows:

The petitioner allocated $520,750.14 of the preferred stock to tangible assets and $79,249.86 to good will, plates and copyrights. The entire $3,000,000 par value of common stock was assigned to good will, plates and copyrights.

The earnings of the three companies for periods prior to consolidation as shown by the books and adjusted by the accountants were:

*3926 *1280 A computation for a 12-month period shows:

The net earnings and average tangible assets of the petitioner for six subsequent years as calculated by the petitioner are as follows:

Following organization and prior to the end of petitioner's fiscal year ended January 31, 1903, petitioner issued additional preferred stock in the amount of $348,200 par and during the following year $15,500 more of such stock was issued. The capitalization of the company remained the same during the year ended January 31, 1905, but during the year ending January 31, 1906, an additional preferred stock authorized issue of $300,000 was made, of which $200,000 was issued in exchange for 5,224 shares of common stock. Other changes in stock issues were made during the following two years and on January 31, 1908, $39,700*3927 preferred stock and $1,098,100 of common stock had been returned to the company and held as treasury stock.

The object of the consolidation was to combine companies having knowledge of the secret processes of three-color printing, and to protect such knowledge by agreements as far as possible.

The three-color process was a new development in the printing of color work and was discovered about 1895 but was not commercially successful until several years thereafter. Previous to this time the general process of printing in colors was either lithography or the zinc etching process. The three-color process was a great improvement on these methods in that either paintings or merchandise could be reproduced in natural colors, the high lights and shadows being similar in all respects to a photograph in colors. The American Three-Color Co. and the National Colortype Co. had been using similar processes prior to consolidation. The consolidation resulted in combining the best features of both processes.

The value of the intangibles acquired for stock was $350,000.

Under date of April 3, 1902, the board of directors authorized the exercise of an option on the business of the Thomas*3928 D. Murphy Co., of Red Oak, Iowa, and authorized Albert D. Sheridan to enter into a contract for the purchase of the stock, property, good will *1281 and assets of that company, on behalf of the American Colortype Co. Pursuant to this resolution a contract was entered into on April 9, 1902, for the purchase of the capital stock of the Thomas D. Murphy Co. The contract provided in part:

The real estate free and clear of all liens and incumbrance for $15,000.00 or upon the basis of $15,000.00 you to take the same subject to all liens and incumbrances and pay us the difference in cash, or, if you do not desire to buy the real estate and do buy the aforesaid capital stock we will require you to pay us a bonus of $7500.00 for the reason that the real estate is the home of the plant of the Thos. D. Murphy Co., and if it was not used for the purpose it now is used for it would depreciate in value.

* * *

(16) If you accept this offer we will allow you one week after this date to indicate to us whether you will purchase the above real estate for $15,000.00 or will pay us the bonus of $7500.00 and if you do not indicate to us which you wish to do within that time we shall consider*3929 that you agree to buy the real estate at $15000.00 and further if you elect to pay us the bonus we shall allow you free use of said real-estate for the period of three months from this date and the further use of said real-estate up to February 1st 1903 at the monthly rental of $120.00 per month.

* * *

(10) We shall require you to pay us a commission of 25% on all the good business on the books of the T.D.M. Co., but undelivered at the time of first payment for the purchase of the capital stock as hereinafter set out.

We mean by good business on the books of the T.D.M. Co. orders taken at list prices from parties whose rating by banks or commercial agencies as would warrant credit to the amount of said order but an exception is made on a few sales at cut prices in which the cut does not exceed 10% from the list price and is to be charged back to salesmen as provided for in their contracts with the T.D.M. Co. The total cut price sales chargeable to salesmen do not exceed a few hundred dollars.

* * *

(14) The allowance of 25% commission as contemplated in item 10 of this offer shall be computed on good business, up to the date of the first payment upon the purchase price*3930 of the capital stock as hereinafter set out. We personally will pay operating expenses of plant up to said date of first payment.

Pursuant to paragraphs marked "10" and "14" of the contract, the petitioner paid the vendors of the stock $13,940.35, which amount was charged off on the consolidated income statement for the year 1903.

The petitioner exercised the option to include the real estate in the purchase at a price of $15,000. Subsequently the building on this land was torn down to make way for a more suitable building and the amount of $8,841.78 was written off as expense during the year ending January 31, 1906. This amount was entered as the estimated value of the building which was demolished.

The books of the petitioner show a charge to expense for the year ending January 31, 1906, of $2,254.09 designated "Good Will of *1282 Gibson Calendar Company," and of $5,026.57, designated "Investment, Gibson Calendar Company," at which time the Gibson Calendar Co. became inactive and had no assets.

At January 31, 1903, an amount of $3,143.49 was charged to expense. This amount was a part of a sum of $25,978.02 designated "Expenditures incident to organization of*3931 company" and was made up of the following items:

The amount of $3,143.49 constituted necessary organization expenditures.

In 1905 Clifford D. Beebe, then a stockholder, exchanged 5224 shares of common stock for $200,000 par value of a newly authorized issue of preferred stock and at the same time agreed to resell this preferred stock to the petitioner for $75 per share and accrued dividends.

OPINION.

TRUSSELL: Issues 1, 2 and 4. - It appears from the record that in making its income-tax returns for the years here under review the petitioner claimed invested capital on account of good will and other intangibles in the amount of $775,900, which is 25 per cent of the outstanding capital stock on March 3, 1917. The Commissioner has made no allowance for invested capital on account of intangibles. An examination of the business of the petitioner as disclosed by the record shows that the three predecessor companies earned a generous return during a year prior to the consolidation and that for the six years immediately following the consolidation*3932 large profits were produced as set forth in the findings of fact, and for the taxable year 1919 the Commissioner found, as shown by his deficiency letter, that the petitioner had accumulated a surplus of more than a million and a half dollars. All of this indicates that upon organization the petitioner acquired a business capable of producing large profits and that such business has enjoyed a continuous period of prosperity from the time of its organization to the years under review and leads to the conclusion that the petitioner's claim that it acquired a valuable intangible asset for which it issued its stock requires a thorough investigation as to what may have been the cash value of such intangibles. In other cases we have for the purpose of ascertaining the value of intangibles made comparisons between earnings and capital invested in tangible assets. ; *1283 ; . We have also given consideration to the selling values of the stock of corporations claiming to have acquired good will and other intangibles. *3933 .

In the instant case a comparison of earnings both before and following the consolidation and the application of generally accepted formulae for capitalizing such earnings in excess of a reasonable return upon the investment in intangible assets point to the conclusion that the intangibles in the instant case had a considerable earning value and therefore a resulting capital value. During the first four years of petitioner's life its average earnings for years of 12 months were approximately $186,000. During this time there was outstanding common stock in the amount of $3,000,000 and preferred 8 per cent stock of slightly less than $1,000,000. Therefore, if 8 per cent were paid upon the preferred stock outstanding, a little more than $100,000 of average earnings for the four-year period was applicable to earnings of the common stock, which would mean an earning of a little more than three dollars per share of the common stock.

In 1905 one of the stockholders exchanged 5,224 shares of common stock for $200,000 of the newly authorized issue of preferred stock and at the same time agreed to resell the preferred stock to the petitioner*3934 at $75 per share and accrued dividends. This indicates that in 1905 this stockholder placed a value of $75 per share upon petitioner's preferred stock and about $28.70 per share upon the common stock. Between the time when the common stock was issued and the date of this exchange petitioner had accumulated surplus applicable to dividends upon common stock equivalent to about $13.66 per share. Subtracting this from the $28.70 valuation then placed upon the common stock indicates a value of about $15 per share at the date of organization.

Taking into consideration the earnings of the predecessor companies and the average earnings of the petitioner for the first four years of its existence and comparing the same with the indicated stock values resulting from the exchange above referred to and all the circumstances and data contained in the record pertaining to the organization and business of the petitioner, we have arrived at the conclusion that upon organization the petitioner acquired intangible assets of a cash value of $350,000 and that the same should be included in invested capital for the years here under review, subject to statutory limitations.

Concerning the claim*3935 of the petitioner for further intangible values acquired in respect to the Maas Engraving Co., it appears that this account was acquired at date of organization. We have, however, found it necessary to value intangibles upon the basis of business *1284 conditions during the four years following organization and having used that method of valuing intangibles the value so found must include any intangible values resulting from the Maas Engraving transaction.

The books of the petitioner show a charge to expense for the year ending January 31, 1906, of $2,254.09 designated "Good Will of Gibson Calendar Company," and also a charge to expense of $5,026.57, called "Investment Gibson Calendar Company." The petitioner desires to restore the $2,254.09 to capital as representing good will purchased with cash. It appears from the record that prior to January 31, 1906, the Gibson Calendar Co. went completely out of business. The write-off on the books of this amount would indicate that whatever good will had existed was lost at that time. Since no showing has been made to the contrary we must hold that the write-off was justified.

The petitioner claims that the $13,940.35 which*3936 represented the 25 per cent commission on good business paid to the vendors of the stock of the Thomas D. Murphy Co. represented a part of the cost of such stock and should be included as a part of invested capital. We have examined the contract of sale and are of the opinion that the $13,940.35 was not a part of the purchase price of the stock but was an additional business expense chargeable against the good business standing on the books of the Murphy Company. This expense would enter into cost of manufacture as directly as other items of expense incident to the obtaining and filling of orders, and accordingly was a proper deduction when incurred and not a capital item.

The petitioner deducted $8,841.78 as expense in the year ending January 31, 1906, representing the value of the building demolished on the land owned by the Thomas D. Murphy Co., a subsidiary, and now desires to restore such amount to capital as representing the value of land, on the assumption that the entire payment of $15,000 was for the land. We are unable to find any legal basis for the petitioner's claim in this instance. Nothing has been introduced to show that the land and building in question changed*3937 hands. It was owned by the Thomas D. Murphy Co. both before and after the stock of that company was acquired by the petitioner. Consequently, the petitioner did not purchase the land and building. However, the Thomas D. Murphy Co. is entitled to restore to invested capital the $8,841.78 previously written off as a loss since no deductible loss was realized. By the removal of the building the company was enabled to put the land to better use and realize larger gains than it was able to do with the old building standing on the land. . Accordingly, the $8,841.78 should be added to the cost of the *1285 new building and recovered by depreciation over the life of the new building.

The record establishes that the items making up the $3,143.49 are clearly costs incident to organization and should be restored to invested capital.

The deficiencies should be recomputed in accordance with the foregoing findings of fact and opinion.

Reviewed by the Board.

Judgment will be entered on 15 days' notice, under Rule 50.

MURDOCK, dissenting: I dissent from that part of the opinion which leads to the conclusion*3938 that upon organization, the petitioner acquired intangible assets of a cash value of $350,000.