American Envelope Co. v. Commissioner

The American Envelope Company, Petitioner, v. Commissioner of Internal Revenue, Respondent American Envelope Co. v. Commissioner Docket No. 60951 United States Tax Court 29 T.C. 307; 1957 U.S. Tax Ct. LEXIS 37; November 20, 1957, Filed *37 Decision will be entered for the respondent. In 1951 petitioner expended the sum of $ 98,586.76 in compromise and settlement of a lawsuit arising out of a dispute with its contractor for the construction of a paper machine. It also spent the sum of $ 4,558.74 for legal fees and expenses in connection with the litigation. Held, the aggregate expenditure constituted additional cost of acquiring a capital asset having a useful life of more than 1 year and was not deductible either as an ordinary and necessary business expense or as a loss. Charles T. Akre, Esq., and Irvin G. Bieser, Esq., for the petitioner. Stanley E. Jennings, Esq., for the respondent. LeMire, Judge. LEMIRE *308 This proceeding involves a deficiency in income tax of the petitioner for the year 1951 in the amount of $ 86,323.36. The*38 questions are: (1) Whether the amount of $ 90,000 paid in the settlement of the controversy as to the amount to be paid for a paper machine constructed by Sandy Hill Iron & Brass Works for the petitioner is a capital expenditure; (2) whether the amount of $ 6,802.98 for parts and labor to reconstruct the rope carrier originally installed by Sandy Hill Iron & Brass Works is a capital expenditure; (3) whether the amount of $ 1,765.78 charged by petitioner against Sandy Hill Iron & Brass Works as the difference between normal freight rates and the rates paid by petitioner is a capital expenditure; and (4) whether the amount of $ 4,558.74 expended by petitioner for legal services in connection with the settlement of the suit by Sandy Hill Iron & Brass Works against petitioner is a capital expenditure. FINDINGS OF FACT. The stipulated facts are found as stipulated and incorporated herein by reference. Petitioner is an Ohio corporation engaged in the manufacture of paper and paper envelopes with its principal office and plant located in West Carrollton, Ohio. It filed its income tax return for the year 1951 with the collector of internal revenue for the first district of Ohio. Sandy Hill*39 Iron & Brass Works, hereinafter referred to as Sandy Hill, is a New York corporation having a place of business at Hudson Falls, New York, for the manufacture, construction, assembly, and rebuilding of paper machines. On or about October 14, 1946, a written contract dated September 20, 1946, was entered into between petitioner and Sandy Hill under which the latter agreed to manufacture, construct, and rebuild, in accordance with specifications, a 120-inch Fourdrinier paper machine. The price of the equipment was set at $ 311,798, f. o. b. Hudson Falls, New York, or other shipping point, and any increase or decrease in certain items was to be affected up or down as is reflected by the cost to the contractor. A letter dated January 11, 1946, from petitioner to Sandy Hill was incorporated in the contract and made a part thereof. By an amendment of August 27, 1947, to the contract, it was agreed that certain spiral bevel gears originally to become the property of Sandy Hill were to remain the property of the petitioner and in consideration thereof the original contract price was to be increased $ 9,000. *309 Petitioner agreed to pay 25 per cent of the purchase price of the machine*40 when the contract was signed, 25 per cent when parts were offered for shipment, 25 per cent when the parts were delivered, and the final 25 per cent when the machinery was installed and operating. The machine was installed and operating by the first week in May 1948. By May 21, 1948, petitioner had paid Sandy Hill $ 353,485.89. By March 15, 1950, as the result of conferences with Sandy Hill's representatives, petitioner paid an additional amount of $ 59,307.97 for extras, bringing the total amount paid to $ 412,793.86. On September 11, 1950, petitioner received from Sandy Hill a new invoice dated January 28, 1948, containing the following information: Increased costs due to excessive changes, delays, and special requests $ 176,558.66 Invoice Nos. 23204, 23205, 23207, superseded by this invoice. The three invoices above referred to totaled $ 39,288.97. During the construction and rebuilding of the paper machine, a number of extras were ordered and major and minor changes were made in the specifications which were not covered by the original contract. Some of the changes were made at the instance of the petitioner through its engineer and others. Delays were incurred*41 by Sandy Hill because of the changes. Negotiations were conducted between the petitioner and Sandy Hill to determine the amounts the petitioner ought to pay for the extras added and the changes made in the specifications. The petitioner paid additional amounts for some of the extras and changes, but negotiations on additional claims by Sandy Hill broke down. The petitioner refused to pay any more and Sandy Hill refused to give up its claim for additional amounts. After a review of the negotiations between the parties, the construction of the machine, and the agreements, legal counsel for Sandy Hill concluded it had a meritorious claim and suit was filed on December 12, 1950, in the United States District Court for the Southern District of Ohio by Sandy Hill against the petitioner, alleging as a first count that $ 231,089.46 was due from petitioner by reason of its breach of contract, and in the alternative, a second count for damages in the amount of $ 176,558.66 caused by acts of petitioner. Irvin Bieser, counsel for petitioner, after investigation of the claims made by Sandy Hill, advised Carlton Smith, petitioner's president, that in his opinion petitioner had no further liability*42 under the contract, that a lawsuit would be long and costly because of the condition of the calendar, the health of the judge, the type of the suit, and the nature of the testimony required, and that it might be the part of wisdom to make some kind of settlement if it wished to avoid the harassment of litigation. *310 On or about May 30, 1951, at a meeting to take the deposition of Frank J. Juckett, president of Sandy Hill, Smith and Juckett had a conference together and as a result, the parties executed an agreement dated May 30, 1951. The agreement provides in part as follows: Whereas, the parties hereto entered into a certain contract for the fabrication and for the furnishing of certain machinery and services by Sandy Hill to American, and containing certain other provisions, dated the 20th day of September, 1946; and Whereas, Sandy Hill has claimed damages from American by reason of alleged breaches of contract; and Whereas, American has made certain claims against Sandy Hill by reason of alleged breaches of contract; and Whereas, the parties hereto desire to settle and compromise all claims and counterclaims of every character whatsoever which may exist now or may have*43 existed in the past, or may exist or be claimed to exist in the future, arising out of any acts and/or omissions of either of the parties prior to the signing hereof; and Whereas, the parties desire to release each other and their respective successors and assigns from any and all such claims and counterclaims; Now Therefore, in consideration of the sum of Ninety Thousand Dollars ($ 90,000.00), to be paid by American to Sandy Hill, as follows: Thirty Thousand Dollars ($ 30,000.00) in cash forthwith; Thirty Thousand Dollars ($ 30,000.00) within thirty (30) days from the date of this instrument, and Thirty Thousand Dollars ($ 30,000.00) within sixty (60) days from the date of this instrument, the deferred payments to be represented by promissory notes payable to the order of Sandy Hill, by American, bearing three (3) per cent interest, with the privilege on the part of American to prepay the notes at any time without penalty; and in further consideration of the release by American hereunder, Sandy Hill, on behalf of itself and its successors and assigns, hereby forever releases, acquits and discharges American and its successors and assigns, from any and all claims, causes of action, *44 actions, legal or equitable or both, of every character whatever, arising out of the aforesaid contract or from any other cause or ground whatsoever heretofore existing, now existing, or hereafter arising or being claimed to arise out of any acts and/or omissions of either of the parties prior to the signing hereof; And in consideration of the said release by Sandy Hill, American shall make the payments aforesaid, and for itself and its successors and assigns, hereby forever releases, acquits and discharges Sandy Hill, its successors and assigns, of and from any and all claims, causes of action, actions, legal or equitable or both, of every character whatever, arising out of the aforesaid contract or from any other cause or ground whatsoever heretofore existing, now existing, or hereafter arising or being claimed to arise out of any acts and/or omissions of either of the parties prior to the signing hereof. Further, the parties hereto agree that a certain action now pending in the District Court of the United States, Southern District of Ohio, Western Division, captioned "THE SANDY HILL IRON & BRASS WORKS vs. THE AMERICAN ENVELOPE COMPANY" and being Case No. 1387 of the Civil Docket*45 of said Court, shall be dismissed, with prejudice, each party to pay its own costs. On June 4, 1951, two separate orders were entered in the United States District Court for the Southern District of Ohio disposing of the two causes of action set forth in the complaint in civil action No. 1387. *311 In its return for 1951 under Schedule A, petitioner deducted the amount of $ 98,568.76 which is the total of the $ 90,000 paid to Sandy Hill under the agreement of May 30, 1951; the amount of $ 6,802.98, representing parts and labor to reconstruct a rope carrier originally installed by Sandy Hill; and the amount of $ 1,767.78, representing the difference between normal freight rates and rates paid by petitioner, the latter two items which had been placed on petitioner's books as accounts receivable from Sandy Hill. Petitioner also deducted as an ordinary and necessary business expense the amount of $ 4,558.74 paid in 1951 to its counsel for legal services performed and expenses incurred in connection with the Sandy Hill controversy and settlement. In the deficiency notice, the respondent increased the gross income of petitioner by the amount of $ 98,568.76, representing settlement *46 of the Sandy Hill suit and the amount of $ 4,558.74, representing legal expenditures, with the explanation that such amounts were capital expenditures and not deductible under section 24 (a) (2) of the 1939 Code. The payment by petitioner of $ 90,000 for settlement of the controversy with Sandy Hill is a capital expenditure attributable to the cost of the paper machine. The sum of $ 6,802.98 for reconstruction of the rope carrier originally installed by Sandy Hill is a capital expenditure attributable to the cost of the paper machine. The sum of $ 1,765.78, representing the difference between normal freight rates and the rates paid by petitioner and charged against Sandy Hill is a capital expenditure attributable to the cost of the paper machine. The payment by petitioner of $ 4,558.74 for legal services and expenses incurred in connection with the Sandy Hill controversy and settlement thereof is a capital expenditure attributable to the cost of the paper machine. OPINION. The question presented is whether the uncontested amounts involved herein are expenditures of a capital nature and therefore nondeductible under section 24 (a) (2) of the Internal Revenue Code of 1939, or are ordinary*47 and necessary business expenses of carrying on petitioner's trade or business and deductible under section 23 (a) (1) (A), or are a loss and deductible under section 23 (f). The respondent contends that the payments in question were made in connection with the acquisition of a paper machine having a useful life of more than 1 year and are capital expenditures. *312 Petitioner takes the position that the payments were made to put an end to litigation, to stop injury to petitioner's reputation and credit, and to permit normal business operations, and that the expenditures were ordinary and necessary business expenses of carrying on petitioner's trade or business. International Shoe Co., 38 B. T. A. 81; Camloc Fastener Co., 10 T. C. 1024; Pressed Steel Car Co., 20 T. C. 198; Welch v. Helvering, 290 U.S. 111; Federation Bank & Trust Co. 27 T. C. 960, on appeal (C. A. 2). It is well settled that, even though an expenditure is ordinary and necessary and is related to a business, it is not deductible if it is an expense of acquiring*48 a capital asset which will not be exhausted during the taxable year. Petitioner accepts the rule that the decisive test is the character of the transaction which gives rise to the payment. Colony Coal & Coke Corporation, 20 B. T. A. 326, affd. 52 F. 2d 923; Hales-Mullaly, Inc. v. Commissioner, 131 F. 2d 509, 512; Mt. Morris Drive-In Theatre Co., 25 T. C. 272, affirmed per curiam 238 F. 2d 85. The record establishes that petitioner and Sandy Hill entered into a contract whereby the latter was to rebuild and reconstruct a paper machine. The original contract was modified from time to time by oral agreement. A controversy arose as to the amount Sandy Hill was entitled to be paid by reason of its additional costs incurred as a consequence of extras furnished and changes requested by petitioner. Various negotiations between the parties resulted in an adjustment of certain items, but no agreement could be reached as to other disputed items, and Sandy Hill sought redress through legal action. Subsequently, the presidents of the corporations*49 involved arrived at the compromise embodied in the agreement of May 30, 1951. That agreement clearly indicates that the parties were settling their respective claims arising in connection with the fabrication of a paper machine. Petitioner makes no contention that the payments it made to Sandy Hill prior to the institution of the suit were other than capital expenditures. Petitioner takes the position that the expenditure was not of a capital nature, since it was advised by its counsel that its liability to Sandy Hill had been fully paid and the compromise payment was made to end the litigation because petitioner felt that to defend the suit would be expensive and interfere with the normal operation of its business and because petitioner felt that the fact that it was being sued for so large an amount would injure its reputation and standing. We do not agree. We think the additional payment made subsequent to the suit was of the same character as the payments agreed upon and made prior to the institution of the action. The fact that petitioner was motivated in making the payment in a compromise settlement of the litigation for the reason testified *313 to by its president *50 does not change the character of the transaction which was the acquisition and improvement of a capital asset having a useful life of more than 1 year. Cf. Colony Coal & Coke Corporation, supra. The cases relied upon by petitioner in support of its contention that the amounts here in controversy are deductible, either as ordinary and necessary business expenses or as a loss, do not involve capital expenditures and are otherwise factually distinguishable. Therefore, a discussion of them is not deemed necessary. We hold that the amount of $ 90,000 which petitioner paid to Sandy Hill pursuant to the settlement agreement was a capital expenditure. Petitioner makes no argument that the amount of $ 6,802.98 to reconstruct the rope carrier, the amount of $ 1,765.78 expended on excessive freight rate charges, and the amount of $ 4,558.74 expended for legal services and expenses, are deductible as ordinary and necessary business expenses, in the event it is held that the $ 90,000 paid under the settlement agreement is a capital expenditure. We have found as a fact that such payments were made in connection with the acquisition of the paper machine. Therefore, the respondent's determination*51 that such payments were in the nature of capital expenditures is sustained. Since we have held that all the amounts in controversy are capital expenditures within the purview of section 24 (a) (2) of the 1939 Code, they are not deductible as a loss under section 23 (f). Colony Coal & Coke Corporation v. Commissioner, 52 F. 2d 923; Levitt & Sons, Inc. v. Commissioner, 160 F. 2d 209, affirming 5 T. C. 913. Decision will be entered for the respondent.