Oregon Brass Works v. Commissioner

*257 Proceeding for the redetermination of a deficiency of $3,660.08 in income and profits taxes for 1919. The issue is whether the petitioner is entitled to special assessment.

FINDINGS OF FACT.

The petitioner, an Oregon corporation engaged in the business of molding brass and bronze castings, was organized in 1906 by W. F. Prier and his brother, who were the sole members of a partnership then engaged in a like business under the name of Prier Brothers. The partners transferred the assets of the partnership to the corporation in exchange for all of its capital stock. The value of the assets so paid in for stock can not be determined.

*258 During the spring of 1913 all of the books of account of the petitioner were burned. Thereafter a new set of books was opened as of December 31, 1912, from such data as were available. After the books had been opened it was ascertained that they were out of balance to the extent that the liability accounts, including capital stock and surplus, exceeded the asset accounts*1888 by $19,175.08. There is no explanation in the books as to the basis for arriving at the figures entered in the new books. The stockholder of petitioner who had charge of opening the books died in 1916 and the whereabouts of the bookkeeper who made the entries is unknown. The books were in balance at the close of 1913.

The income-tax returns of the petitioner disclose that it earned profits of $17,273.56 in 1910, $11,911.82 in 1911, and $8,052 in 1912. Petitioner's books show that the business was operated at a loss in 1913, when the volume of sales exceeded any of the three preceding years, wages were favorable and the cost of metal was about one cent less per pound than in 1912. In 1919 petitioner's sales amounted to $518,346.43, and net income, $119,921.

Since its organization the petitioner has expended a substantial sum in the development of an undisclosed number of formulae for the production of metal for castings manufactured by it. The work connected with the development of such formulae consisted of determining the material, including metal, that should be used in the test, making a casting, and then subjecting the casting to a friction test. If the formula used*1889 did not produce the result desired, the process was repeated with a change in the formula until the proper result was reached. It was generally necessary tomake four or five tests in order to accomplish a certain result. The cost of perfecting the formulae was charged to expense. None of it has ever been capitalized. The formulae developed by the petitioner were a material factor in the production of income in 1919. It is impossible to determine the amount spent prior to 1913 in the development of the formulae.

During 1913 petitioner did extensive development work in perfecting the line of urns it produced. The cost of developing the urns was charged to expense and none of it has ever been capitalized. The urns developed in 1913 were income-producing assets in 1919. They were not, however, a major factor in the production of income in that year.

In 1913 and 1914 sums amounting to $7,595.46 paid out as rent on buildings and for printing were charged to "Building a/c," a capital account. None of the items has ever been transferred to an expense account.

W. F. Prier, the petitioner's president and general manager, supervised petitioner's finances, endorsed its papers, *1890 sold its products, *259 directed the manufacture of its products, made its purchases, negotiated all of its contracts, and wrote all of the formulae for the metal used in the castings produced. He devoted from fourteen to sixteen hours per day to the performance of his duties. In 1919 he was paid as compensation for his services, the sum of $7,000. This sum is in excess of the amount of salary he received in 1918 from the petitioner.

None of petitioner's income in 1919 consisted of gains, profits, commissions or other income, derived on a cost-plus basis from a Government contract or contracts.

The parties entered into the following stipulation:

It is hereby stipulated between counsel for petitioner and respondent that for the purpose of the determination of petitioner's tax under the provisions of sections 327 and 328 the invested capital for the taxable year 1919 is $128,759.42, the net taxable income $125,148.26.

OPINION.

ARUNDELL: We assume that the stipulation of the parties quoted at the conclusion of our findings of fact means that the parties are in agreement that the invested capital determinable from available data is $128,759.42, and, if the tax be*1891 computed under section 301 of the statute, that sum would be the amount to be used. The petitioner contends, however, and we agree with it, that the invested capital can not be determined in the manner provided by section 326 of the 1918 Act and that sections 327 and 328 must be invoked to reach petitioner's correct tax liability as provided by law.

At the time of the organization of petitioner all of its capital stock was issued to the members of the partnership of Prier Brothers in exchange for the assets of the partnership. Petitioner's books of account and other records were destroyed by fire in 1913, and as there are no records showing the assets paid in for stock, it is impossible to determine the value of such property for invested capital purposes. The new books, opened as of December 31, 1912, do not disclose the basis for the opening entries, and the evidence is that they are not accurate and no information is available from which petitioner's invested capital may be determined. Petitioner's high profits were very largely due to the use of formulae which enabled it to turn out a product more accurate and perfect than its competitors. The formulae were developed prior*1892 to and after 1913 by the expenditure of substantial sums, all of which were charged to expense, and, due to the destruction of records, such amounts may not now be segregated and capitalized. Petitioner is entitled to have its profits taxes determined under the provisions of section 328.

Further proceedings will be had under Rule 62(c).