J. Duncan Co. v. Commissioner

*1216 The petitioner brings this proceeding for the redetermination of a deficiency in income and profits taxes for 1919 in the amount of $8,981.34. The petition alleges that the respondent committed the following errors:

(a) Metal patterns having a value at incorporation of $51,895.57 and paid in for capital stock of the corporation, are omitted from invested capital for 1919 to the extent of $38,921.68, the depreciated value.

(b) Depreciation of 4% annually, or $2,075.82, on the above-mentioned patterns, is omitted from deductible expenses.

(c) Invested capital is understated $5,000 by the omission of that amount of the earned surplus.

(d) The opening inventory is understated*4266 by $9,499.75.

(e) Deductible expenses entered on the books in 1920 but accrued in 1919 are omitted, to the extent of $810.70.

(f) Deductible expenses amounting to $5,438.55, charged on the books to capital assets, are omitted from the total deductions.

(g) Depreciation is understated to the amount of $2,646.81.

(h) Invested capital is understated, on account of excessive depreciation taken in prior years, by $740.98.

The parties stipulated with respect to errors (b), (e), (f), (g), and (h).

FINDINGS OF FACT.

The petitioner is a Massachusetts corporation, organized October 1, 1912, to take over the business and the assets of the J. Duncan & Co., a partnership. The business acquired was that of manufacturing and installing overhead tramways and conveyor systems, and had been in existence since 1888. All the capital stock of the petitioner, amounting to $50,000, was issued for the machinery and equipment, stocks and supplies on hand, patterns, and the good will of the partnership. In setting up the partnership assets on the books of the corporation the bookkeeper used such values as were found on the partnership's trial balances. The value at which the patterns*4267 *1217 were set up on the books of the corporation was a nominal one amounting to $1,500.

A considerable portion of the partnership's business consisted in perfecting patterns for switches, hangars, wheels and rollers, which were extensively used in its business. The partnership and the corporation employed a number of men who devoted all or a considerable portion of their time to the making of patterns. The evolution of a pattern is a complicated process requiring considerable time and the expenditure of a large amount of money. The first step in the development of a pattern is to draw a blue print, which is then used to make a pattern of wood. Before being finally made out of metal the pattern undergoes many changes and alterations until the desired state of perfection is reached. The principal cost in the development of patterns was the wooden or master pattern. The metal pattern could then be made for approximately $20 each. The life of a metal pattern is at least 25 years. The patterns taken over by the petitioner at October 1, 1912, continued in use through 1919. The average cost of the switch patterns ranges between $150 and $300 and most of them were developed*4268 by the partnership, J. Duncan & Co. On October 1, 1912, the partnership turned over to the corporation at least 233 patterns, which had cost the former on an average of $150 each, and 18 hangar patterns which had cost $50 each. The value of the patterns on October 1, 1912, was $35,850.

The parties agreed that, if the petitioner proved any value for the patterns, 4 per cent annual depreciation should be allowed upon the same.

During the year 1918 the stockholders of the petitioner orally agreed that they would not retain their dividend checks but would return them to the corporation for the purpose of meeting the payments on the new building which was being constructed. The quarterly dividends of 5 per cent were declared payable on April 1 and July 1, 1918. Checks amounting to $5,000, made out to the stockholders, were accordingly endorsed and returned to the corporation. When the dividends were declared the petitioner had cash available to pay the same, although the corporation at the time was borrowing money. The accounts of the stockholders were credited with the amount of the dividends, but these credits were subsequently wiped out.

The petitioner had no method of*4269 taking inventory prior to December 31, 1919. The bookkeeper valued the inventory by asking how much merchandise there was on hand and one of the officers, or partners, prior to 1912, would estimate the amount on hand. Generally, the inventory value was the same from year to year unless a large amount of merchandise had been purchased at the end of the year. In such cases the purchases were added to the book figure *1218 to arrive at the inventory value. The first physical inventory was made December 31, 1919. The closing inventory for 1918 as shown by the books and as accepted by the Commissioner was $9,925.30. This figure was obtained by taking the inventory on the books and adding to it certain purchases made late in 1918, such purchases being then on hand or in transit. Subsequently, the petitioner discovered additional inventory items, representing purchases made late in 1918, of $8,558.77. Of this amount, purchases amounting to $7,754.77 were on hand or in transit on December 31, 1918. The difference of $804 represented the cost of certain castings included in the purchases of $8,558.77 which were used in the manufacture of 800 switches at an additional cost of*4270 $396. These switches were shipped on December 31, 1918, but were not billed until January, 1919.

The Commissioner admitted that expenses in the amount of $810.70 should be deducted from 1919 income instead of 1920, as entered on the books.

The Commissioner admitted that $3,310.84 of the amount of $5,438.55 charged on the books to capital assets should be allowed as deductible expenses and petitioner abandoned its position as to the balance.

Parties agreed on $2,192.99 as the correct depreciation, exclusive of any depreciation on patterns.

The Commissioner admitted that invested capital should be increased in the amount of $740.98, due to excessive depreciation taken in prior years.

OPINION.

MORRIS: The first error assigned relates to the exclusion from invested capital of $38,921.68, the depreciated value of patterns paid in for stock. The issue is solely one of fact as to the value of such patterns on October 1, 1912. We have found as a fact that such patterns had a value on that date of $38,850. The depreciated value of such patterns should be included in invested capital for 1919.

In accordance with the stipulation of the parties, depreciation at the rate*4271 of 4 per cent should be allowed on the above value of the patterns.

The third error alleged was the understatement of invested capital by the omission of $5,000 earned surplus. The facts are that the stockholders endorsed and returned two quarterly dividend checks to the corporation for the purpose of meeting the payments on a new building. Their accounts were credited with the amounts of the dividend. We are of the opinion that such amounts constitute borrowed capital and can not, therefore, be included in invested capital. Cf. ; .

*1219 In addition to $9,925.30, the amount allowed by the respondent as the petitioner's opening inventory for 1919, purchases were made late in 1918 amounting to $8,558.77. Purchases representing $7,754.77 of this amount were on hand or in transit on December 31, 1918. The difference of $804 was the cost of certain castings used in the manufacture of 800 switches at an additional cost of $396, the total of which, or $1,200, the petitioner contends should also be included in the inventory. The record shows, however, *4272 that these switches were shipped on December 31, 1918. They, therefore, should not be included in the 1918 closing inventory. The closing inventory for 1918 should be increased by $7,754.77 over the amount allowed by the respondent.

The parties stipulated the remaining assignments of error as set out in the findings of fact. The tax should be recomputed in accordance with the foregoing decision and the stipulation.

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