Connors-Weyman Steel Co. v. Commissioner

*625 These proceedings, which were consolidated for hearing and decision, are for the redetermination of deficiencies in income and profits taxes for the period January 1, 1920, to June 30, 1920, of $8,590.18 in the case of Connors-Weyman Steel Company and $37.21 in the case of Connors Steel Company. In its reply brief the Connors-Weyman Steel Company withdrew an objection theretofore advanced against the Board's jurisdiction, leaving the following as the only matters in controversy: (1) The correctness of the respondent's action in denying the applications of the petitioners for a determination of their profits tax under the provisions of section 328 of the Revenue Act of 1918, and (2) whether the respondent erred in*1844 determining the amount to which the Connors Steel Company was entitled as a deduction for the exhaustion, wear and tear of property used in its business. With respect to (1) the hearing was limited to the question of whether the petitioners are entitled to have their profits tax determined as provided in section 328.

FINDINGS OF FACT.

During the taxable period here involved the petitioners were Alabama corporations with their principal offices at Birmingham and were engaged in the manufacture of cotton ties and steel hoops. *626 As of June 30, 1920, the assets of both corporations were acquired by the Connors Steel Company, a new corporation organized under the laws of Delaware.

About 1911 the Bullard Car Door Company built a rolling mill at Woodlawn near Birmingham at an approximate cost of between $200,000 and $250,000. The company's operations were not successful and it was taken over by a bank which acted as receiver. The bank also went into the hands of a receiver. The receiver for the bank tried for some time to sell the rolling mill plant hereinafter referred to as the Woodlawn plant, but was unable to do so until in January, 1916, when at the receiver's*1845 sale George W. Connors bought it for $10,000. Thereafter, during 1916 Connors made certain changes in the plant so as to render it suitable for the manufacture of hoops and cotton ties. These changes, together with certain repairs, were made at a total cost of $39,500.

After the conversion of the Woodlawn plant into a hoop and cotton tie mill it was operated for part of 1916 and all of 1917 by a partnership composed of Connors, his wife, and one Hoke. Connors' wife and Hoke each had a one-fourth interest which was given to them by Connors. From the operation of the plant for the calendar year 1917 the partnership earned a taxable net income of $258,300.04 after the allowance of $100,000 representing salaries of $50,000 each to Connors and Hoke.

About January 1, 1918, the Connors Steel Company, one of the petitioners herein, was incorporated under the laws of Alabama and all the assets of the partnership, including accounts receivable, cash on hand, and the Woodlawn plant and equipment, were transferred to the company at a total valuation of $300,000, for $300,000 par value of its common capital stock. Of the $300,000, $39,500 was entered on the corporation's books as of*1846 January 1, 1918, as being the portion allocable to the Woodlawn plant. The plant and equipment as transferred to the Connors Steel Company consisted of the following: a coal trestle 250 feet long and 12 feet high; a crane runway 52 by 400 feet and 22 feet high; rolling mill building 40 by 60 feet; a warehouse 50 by 300 feet; a rolling mill building 60 by 300 feet; a supply house 40 by 100 feet; a boiler house 30 by 60 feet; a blacksmith shop 20 by 40 feet; one 12-inch rolling mill with three stands of rolls; one 8-inch rolling mill with four stands of rolls; a railroad track 3,110 feet long, with 75-pound rails and grading for the track; a conveyor 200 feet long with six motors; a cast-iron cooling bed 20 by 200 feet; a machine shop with three roll lathes and supplementary equipment; five carloads of 8 and 12 inch rolls; six pairs of shears; two heating furnaces including the foundations therefor and spare or supply parts for the above machinery.

*627 The buildings were of mill construction, that is, heavy timber tramework sufficient to support the roof and the cranes, and were covered and sided with corrugated iron siding.

At January 1, 1918, building costs were high*1847 and building materials were difficult to obtain. Rolling mills of the character of the Woodlawn plant were in great demand at that time, and they were all so busy that none was available. The rolling mill business was from 100 per cent to 150 per cent better at January 1, 1918, than at January 1, 1916, and plants that had been idle for years were in full operation at January 1, 1918. The Woodlawn plant was properly laid out and at January 1, 1918, was a going plant in good physical condition. It had gone through the "breaking in" process necessary for the operation of a rolling mill, which usually costs from 5 per cent to 7 per cent of the purchase price. The plant was well located geographically. It was near the source of supply of raw materials for the making of hoops and cotton ties and was located in the South, where most of cotton ties are sold. It was also well located with respect to transportation facilities. The fair market value of the Woodlawn plant and equipment at January 1, 1918, was $225,000.

Throughout 1918, 1919, and the first half of 1920 the Connors Steel Company continued to operate the same kind of business as that carried on by the partnership prior*1848 to 1918. The corporation had a net taxable income of $246,552.59 for 1918 after the allowance of $50,133.35 for officers' salaries. Its net taxable income for 1919 was $69,582.87 and for the period from January 1, 1920, to June 30, 1920, was $95,653.67.

In determining the deficiency here involved for the Connors Steel Company the respondent determined that of the $39,500, the amount at which the Woodlawn plant and equipment were entered on the company's books as at January 1, 1918, $2,000 represented the cost of the land and $37,500 represented the cost of the depreciable property. He determined that the annual rate of depreciation was 8 per cent and accordingly allowed a deduction of $1,500 for the six-month period. A reasonable allowance for depreciation is at the rate of 12 per cent annually or for the six-month period - an amount of $13,500.

While it had been known that hard steel with a high carbon content could be softened and made less brittle and more pliable by annealing, this process so far as was known to Connors had never been applied in making steel hoops and cotton ties. About 1915 and after some experimenting, Connors found that the process could be used in*1849 the manufacture of these products from hard steel with a high carbon content. He did not, however, begin the use of the process *628 until in 1917, when on account of conditions incident to the World War soft steel could not be obtained at satisfactory prices. After experimenting further he was able to make hoops and cotton ties from steel-shell discards with a high carbon content. The hoops and ties made from such material had more tensile strength than those made from soft steel and while scarcely as pliable would bend enough to be salable at the same price as those made from soft steel. Although Connors knew of the advantage of having a patent, he did not make an application for one for the process immediately after perfecting it because of the time required to obtain a patent and also because he had for the time being bought all the available steel-shell discards. Connors did not make application for a patent on the process until recently and then only because he had "tied it in" with certain machinery and appliances.

The process was used by the partnership in 1917 and by both of the petitioners during 1918, 1919, and through the first six months of 1920, and thereafter*1850 by the new Delaware corporation through 1921 and until the steel-shell discards were no longer available. About three or four years ago the process was again brought into use in making hoops and cotton ties from discarded railroad rails. Connors did not sell the process to either of the petitioners, nor did either of them pay him any compensation for the use of it.

By the use of the process the petitioners were able to use steel-shell discards which on an average cost $20 per ton less than the price they would have had to pay for soft-steel billets. During 1917 the partnership used 12,500 tons of steel-shell discards at the Woodlawn plant and the Connors-Weyman Steel Company used 11,500 tons.

During 1920 cotton ties were manufactured by only three other steel companies. Of the total number of cotton ties manufactured in 1920, the United States Steel Corporation manufactured from 45 to 48 per cent, Atlantic Steel Company from 25 to 30 per cent, the Connors Steel Company 20 to 25 per cent, and the Pittsburgh Steel Company from 2 to 5 per cent. There were more companies engaged in making steel hoops than in making cotton ties.

On account of war conditions the business of*1851 steel companies began to increase about the latter part of 1916 and began to decrease after the signing of the armistice, dropping off decidedly in 1919. With some companies there was no noticeable decline until in 1920 when with some, business for the first half of the year was much better than in the last half. Due largely to postwar conditions, there was a considerable drop in the business of the new Delaware corporation during 1921 and 1922, it losses for the years ended June 30, 1921, and June 30, 1922, being $2,165.96 and $144,757.07, respectively. *629 During these years the corporation was breaking in a new plant at Woodlawn and this cost the company about $100,000.

The process for making hoops and cotton ties from steel-shell discards had a substantial value and its use by the partnership and Connors Steel Company had considerable effect in making the profits heretofore shown for the partnership and the company. A portion of the profits of the Connors Steel Company for 1918, 1919, and the first six months of 1920 was made by the purchase of soft-steel billets before, and their sale after, the rise in prices on account of the war.

In determining the deficiencies*1852 here involved the respondent denied the applications of the petitioners for a determination of their profits-tax liability under the provisions of section 328 of the Revenue Act of 1918.

The net income, invested capital, profits tax, income tax, and total tax liability of the petitioners as determined by the respondent for the period here involved were as follows:

OPINION.

TRAMMELL: With respect to the issue relating to the allowance of an additional amount to the Connors Steel Company for depreciation, it is contended and we have so found as a fact, that the Woodlawn plant and equipment had a fair market value of $225,000 at January 1, 1918, when transferred to the company for stock. In support of the contention the testimony of four well qualified witnesses, including Connors, was offered. All of the witnesses were familiar with the plant, two of them having been acquainted with it from the time it was originally constructed*1853 by the Bullard Car Door Company. These witnesses testified to values for the plant at January 1, 1918, ranging from $202,400 to $350,000. The opinions of these witnesses as to the values testified to were not contradicted nor in any wise discredited but, on the other hand, were supported by substantial reasons.

Since the fair market value of the Woodlawn plant and equipment at the time paid into the Connors Steel Company for stock was $225,000, that amount represents cost upon which depreciation *630 should be computed. ; .

Connors was the only witness who expressed an opinion concerning the depreciation of the plant, machinery, and equipment. We think from all the testimony considered together that a reasonable allowance on account of exhaustion, wear and tear of plant, equipment and machinery is at the composite rate of 12 per cent.

The petitioners contend that the use of Connors' process by which cotton ties and hoops were made from steel-shell discards instead of from soft steel resulted in an abnormal condition affecting their capital and their income, *1854 since the value of such process could not be reflected in invested capital, a substantial part of their income was attributable thereto and the income could not be reduced by deductions for exhaustion of the value thereof or on account of royalties paid.

This process, however, is not shown by the evidence to have been a secret process available only to the taxpayers. On the other hand, it was a process long known. What Connors did was to apply a well known process used in the softening of steel to the particular kind of steel used by these companies in the manufacture of their products, that is, cotton ties and hoops. Apparently other taxpayers were free to adopt the same process if they had seen fit to do so, and from the testimony we gather that others knew of this particular process for these particular kinds of articles. Undoubtedly these companies were enabled by use of this process to manufacture their products much cheaper than they could have if they had been forced to use soft steel, which would have cost about $20 per ton in excess of the price of the hard-shell discards which could be acquired practically as scrap, but it seems to us that this advantage was in the*1855 nature of a benefit to be derived from economy of operation or manufacture, of which, so far as the evidence discloses, any taxpayer wisely directed could have availed itself. We do not consider that a well known process applied by a taxpayer to his particular product, which worked a great economy of operation or manufacture, although he was the first to so apply it, is such an abnormality as is contemplated by the statute unless it be shown that the particular application to the specific articles manufactured was not known to or available to others similarly situated. Shrewd business management and unusually capable men may work many economies in the operation of business, but we do not consider that this factor constitutes an abnormality, either of capital or income. Connors was undoubtedly a very efficient and capable steel man and undoubtedly was able to make profits and conduct his business with greater economy and in a more efficient manner than others not so qualified, and we think that this process of annealing steel which *631 he applied to cotton ties and hoops manufactured by these companies was no more than an application of his good business judgment in working*1856 out and using economies in manufacture. Apparently any other taxpayer in the same business was free to use the same process, which consisted merely of applying a process generally used to the particular products. It is not necessary to discuss here what might have been the effect if the evidence had established that this was a secret process available to only the taxpayers and that other taxpayers in the same or a similar business did not know or were not able to use that method or some equally efficient method. For all we know, the only reason other taxpayers did not use this method is because they had what they considered to be equally efficient methods or were able to acquire soft steel at reasonable prices. No abnormality affecting capital is, in our opinion, shown by the facts relating to the process.

Decision will be entered under Rule 50.