San Clemente Sheep Co. v. Commissioner

*1263 This proceeding was brought to redetermine deficiencies in the income taxes of the petitioner for the fiscal years ending June 30, 1922, and June 30, 1923, in the amounts of $270.41 and $616.05, respectively.

The petitioner alleges that the respondent erred in that (1) he refused to determine a value of $102,508.50 for a certain leasehold and tenant improvements thereunder acquired from the San Clemente Wool Company, and (2) he refused to allow a deduction for amortization and depreciation of the said leasehold and improvements based upon the said value of $102,508.50.

FINDINGS OF FACT.

On April 7, 1909, the San Clemente Wool Company (a corporation, hereinafter called the Wool Company) entered into an agreement of lease with representatives of the United States whereby the said corporation leased all of the San Clemente Island in Los Angeles County, California, from January 1, 1910, to December 31, 1931, inclusive, for an annual rental of $1,500. The*1741 lessee further agreed to expend the sum of $25,000, in installments of not less than $1,000 per year, in improving the island by constructing storage reservoirs and dams, erecting tanks, windmills, houses, etc., building roads and fences, protecting the island from sand devastation, increasing pasturage areas, and otherwise adding to its value. All such improvements were to become the property of the United States upon termination of the lease.

San Clemente Island is situated about 60 miles from the mainland and contains approximately 61 1/2 square miles of surface. Its climate is mild, there being no frost. The rainfall is between 13 and 14 inches yearly. The stored rainwater is supplemented by spring and well water, in all ample for sheep raising. There are no predatory animals or poisonous plants or snakes on the island. It is exceptionally well adapted to the raising of sheep - from 12,000 to 18,000 can be taken care of comfortably. In 1916 over 3,000 acres of land were under cultivation.

*1264 On March 29, 1916, Lewis Penwell, acting initially for himself and later for himself and others, secured an option from the stockholders of the Wool Company to purchase*1742 its entire capital stock for $225,000, making a cash payment of $2,000 thereon. He, with others, made a number of trips to the Island and made a complete and thorough investigation of the enterprise and the conditions surrounding its operation. As a result of his detailed examination he and his associates concluded that the price asked was too high and decided that unless it should be reduced to $175,000 he would forfeit the $2,000 paid on the option. The vendors agreed to such reduction in price. Penwell, himself, is a practical sheep raiser, having organized 10 or 15 sheep companies in Montana and California and having been chief of the Wool Division, War Industries Board during the World War. He was 47 years of age in 1916. He associated with him in the San Clemente venture E. G. Blair, an old friend now about 60 years of age and also a successful sheep raiser of extensive experience. On July 1, Penwell and Blair organized the petitioner corporation and transferred to it the above mentioned option. Penwell was the vice president and director of the company. The petitioner exercised the option, paid $98,000 in cash and assumed a note for $75,000. On July 1, 1916, the leasehold, *1743 with the consent of the lessor, was transferred to the petitioner.

The personal property contained on the Island on July 1, 1916, was valued at $131,491.50. It consisted of 14,000 or 15,000 sheep, 30 or 40 head of horses, 13 head of cattle, farming implements, hay, groceries and other supplies, all in estimated quantities. The Wool Company had reported to the Department of Commerce expenditures for improvements aggregating over $45,000 made prior to July 1, 1916. Such improvements included building dams and reservoirs, renewing fences, constructing tanks, corrals, wells, etc., erecting buildings, improving roads, plowing land, cutting, baling and shipping hay, purchasing tools and paying for labor and materials.

Under the management of the Wool Company the character and condition of the stock were not good. The distribution of feed and water was not accomplished efficiently. The enterprise, as a whole, was being conducted in a slipshod manner.

On January 15, 1917, Penwell executed a capital-stock-tax return on behalf of the Wool Company, signing it as the vice president thereof. Attached to that return appears the following statement:

Shortly before June 30, 1916, the*1744 owners of the (San Clemente Wool Company) stock contracted to sell the entire capital stock for $175,000; on or about July 1, 1916, $100,000 in cash was paid on the contract price of said stock by the organizers of the San Clemente Sheep Company, a new corporation which was organized to take over all of said capital stock and finally to absorb the assets of said San Clemente Wool Company and on the 1st of November, 1916, *1265 the San Clemente Sheep Company gave its note * * *. We have estimated the value of said stock, therefore, as of June 30, 1916, at $175,000. So far as we know no stock has ever been sold and no price ever been quoted on the market and we know of no other way to fix its value except as stated.

The respondent determined the value of the leasehold and improvements thereon to be $43,508.50, the difference between the value of the personal property and the purchase price of the business. The petitioner alleges that the proper value was $102,508.50. This figure was arrived at by adding to the purchase price of $175,000 the sum of $59,000, representing the amount of the bonus stock of the petitioner issued to Penwell and his associates at the time of purchase*1745 and purporting to be the value of the leasehold in excess of the amount paid for it. The petitioner sold $100,000 of capital stock for cash.

OPINION.

VAN FOSSAN: The sole question at issue in this proceeding is the value on July 1, 1916, of the leasehold and improvements thereon covering San Clemente Island. The respondent has fixed the value at $43,508.50. The petitioner claims that it should be increased by $59,000.

On July 1, 1916, the petitioner purchased from the stockholders of the Wool Company its entire capital stock and on the same day the said leasehold was assigned to the petitioner. Simultaneously, the petitioner issued to Penwell and his associates its capital stock in the amount of $59,000, purporting to be in exchange for the value of the leasehold in excess of the amount designated as its value in the transaction with the Wool Company stockholders.

After an exhaustive survey and detailed scrutiny of the property subsequently purchased by the petitioner, Penwell and his associates decided that the purchase price of $225,000 originally named in the option was entirely too high and they refused to complete the transaction, preferring to forfeit the amount*1746 paid as a "binder." The Wool Company reduced its price to $175,000, and the sale was closed. The sum of $131,491.50 is established as the true value of the personal property. The Wool Company had expended about $45,000 in so-called improvements up to 1916, but we observe that some of this expenditure was applied on current items of maintenance and operation. We do not know by how much the value of the leasehold had been enhanced on account of increased capital assets. The thorough examination of the physical assets of the sheep ranch and the keen consideration of the potential value of the island, with its advantages and disadvantages of character, topography and accessibility, resulted in the decrease in the sale price of the leasehold, the value of the personal property being fixed. Necessarily, the unexpired *1266 term of the lease was an essential factor in arriving at such a conclusion.

At the time of the purchase sheep raising on San Clemente Island had not been a conspicuously successful venture. By independent and efficient management Penwell anticipated that he could develop it into a profitable business. He capitalized his hopes by issuing bonus stock of*1747 the par value of $59,000. The fact that the enterprise may or may not have proved successful at a later date does not establish the value of the property sold on July 1, 1916.

The sale of the essets of the Wool Company was an arm's-length transaction consummated after a reduction in price consequent upon a careful check and appraisal of the property purchased. It serves as a definite measure of value. Furthermore, on January 15, 1917, over six months after the purchase, Penwell filed a capital stock return on behalf of the Wool Company. He executed the return as its vice president. In it the fair value of the stock as of June 30, 1916, was placed at $175,000, representing the basis on which the respondent allowed a valuation of $43,508.50 for the leasehold and improvements thereon. We believe that the respondent's determination of value of the leasehold and improvements is consonant with the facts appearing in the record and we so hold.

Judgment will be entered for the respondent.