Bay Counties Title Guaranty Co. v. Commissioner

Bay Counties Title Guaranty Company, Petitioner, v. Commissioner of Internal Revenue, Respondent Bay Counties Title Guaranty Co. v. Commissioner Docket No. 63623 United States Tax Court 34 T.C. 29; 1960 U.S. Tax Ct. LEXIS 177; April 12, 1960, Filed *177 Decision will be entered for the respondent. Petitioner is an underwritten title and controlled escrow company engaged in the business of making abstracts of titles. It had an established title plant prior to 1952 which was its chief capital asset. Since petitioner started business it has followed the practice of acquiring for a consideration from others each year a substantial number of previously prepared title reports showing the status of titles to pieces of property up to some date prior to petitioner's purchase. Most of such title reports were filed in petitioner's records for use in subsequent years depending on when the petitioner might receive business requiring its preparation of up-to-date abstracts on the same pieces of property in connection with new transactions. Prior to 1952 petitioner charged the cost of such reports to the capital account for its title plant, but in 1952 it charged the same expense to current operating expenses and deducted it as ordinary and necessary business expense. The same practice was followed in 1953 and 1954. Held, the purchased title reports represented additions to and betterments of petitioner's title plant; their useful*178 life extended beyond the year of purchase; and the expenditure was a nondeductible capital expense. Kenneth S. Carey, Esq., and Joseph S. Rogers, Esq., for the petitioner. Edward H. Boyle, Esq., and Joseph D. Holmes, Jr., Esq., for the respondent. Harron, Judge. HARRON *30 The Commissioner determined deficiencies in income tax for the taxable years 1952, 1953, and 1954 in the amounts of $ 2,068.80, $ 2,574.30, and $ 1,924.71, respectively. The issue is whether expenditures in each year which allegedly were made for copies of preliminary reports on pieces of real estate constitute ordinary and necessary expenses of carrying on petitioner's business under section 23(a) (1)(A), 1939 Code, and section 162, 1954 Code, or are nondeductible capital expenditures. FINDINGS OF FACT. The petitioner is a California corporation which was *179 incorporated on July 3, 1946, and entered into business operations in September 1946. Its office is in San Francisco, California. It filed its returns with the collector of internal revenue for the first district of California. Petitioner keeps its books and reports income on an accrual basis. However, the expenditures in question were cash disbursements. The petitioner is an underwritten title company, as defined in section 12402 of the California Insurance Code, and escrow company. Petitioner is an agent of the Pacific Coast Title Insurance Company of Los Angeles, hereinafter called PacificTitle, which began business in 1944 and has nine other agents. PacificTitle is engaged in the title insurance business. It is an underwriting company which issues policies of title insurance insuring titles to real property. Its coinsurer is the Louisville Title Insurance Company of Louisville, Kentucky. The president of the petitioner, J. M. Rolls, is an assistant secretary of PacificTitle. The petitioner conducts examinations and searches of titles and then requests PacificTitle to issue policies of title insurance based *31 upon its title examination. The petitioner sells title*180 insurance policies of PacificTitle. The petitioner, as agent of PacificTitle, has an exclusive agency in San Francisco County which includes the city of San Francisco. The records for title examination and search are in the offices of the petitioner. The petitioner is also an escrow company. The closings of transactions involving transfers of real estate are held in its offices. Petitioner receives escrow fees for its services which are paid by the purchasers of real estate. A great deal of petitioner's business is referred by real estate brokers. Petitioner also handles accommodation and other escrows and it receives income from such general services in addition to fees for the closing of real estate transactions. As of December 31, 1951, petitioner had an established and a typical title plant. The term "plant" is used by title companies to describe collectively the complex of the records which it owns and uses in making searches of titles and preparing abstracts of titles to all of the real estate within the area of a company's operations. Petitioner's title plant included books of maps of all of the real estate, by parcels and lots, in San Francisco County; the lot books*181 covering every lot in the county; books of abstracts of recorded instruments; a set of general indices; the tax assessor's ownership records back to 1938; a complete set of Edwards Abstracts going back to 1908, which contains daily reports of all recordings affecting titles to and interests in real estate such as transfers, bankruptcies, probate records, and litigation; and an accumulation of petitioner's records of searches, abstracts, documents, opinions, and miscellaneous data. Petitioner's title plant was acquired and accumulated during the 5 years 1947-1951. A typical title plant is augmented in the course of time. In carrying on its business, petitioner uses its own basic records and, in addition, the city and county recorder's office records, and other customary sources of relevant records. In its own plant, information is segregated as to pieces of property in connection with which a code system is used. For all practical purposes, as of the end of 1951, petitioner's title plant contained records of every piece of property in San Francisco County for which records existed. Also, its records in its plant showed every recorded transaction affecting real property in the county*182 for a period in excess of 5 years. The set of Edwards Abstracts provides information back to 1908. Because of the destruction of records in 1906 during the San Francisco fire, property records for the city and county of San Francisco were reestablished after 1906. Petitioner's capital consists of $ 25,000 represented by common *32 stock. Its authorized stock is 2,500 shares having a total par value of $ 25,000. At the end of 1951, the book value of petitioner's title plant was $ 25,000. Prior to 1952, the petitioner charged to capital, i.e., capitalized, all of its expenditures for real estate records of every kind including those for its basic title records plant. By the end of 1951, the total cost of petitioner's plant amounted to $ 25,000. When petitioner began its business in 1946, it had 4 employees. In 1952, it had 34 employees including 13 searchers and 2 examiners, and 3 in the general indices section. The work of a searcher is to search and assemble material relating to titles; the examiner writes an abstract report and opinion about titles. In general, in order to collect the information required before a policy of title insurance will be issued, it is necessary*183 to make a complete search of the records of ownership of a piece of property (the chain of title) over a period of years, to search for interests in and encumbrances on a title, and to examine all records affecting title so as to determine whether a buyer will obtain a clear title, and so as to guarantee a title or the correctness of information with respect thereto. A factual determination of title must be made and of the conditions and limitations attaching to the title to property. There are no statutory requirements relating to the method or means by which those engaged in making title searches, examinations, and abstracts of title for use by title insurers shall secure information. Although it is customary for title companies to cause to be made independent searches, it is also common for their examiners to make use of previously prepared, or old, title reports and preliminary title reports as a starter, and to search the period after the end date of such reports to bring the search up to the date required. The practice of using existing preliminary reports on titles and existing title insurance policies is generally followed. Such practice eliminates the procedure of abstracting*184 the title to a piece of property back to the first record. If there is a starter report of title to a particular piece of property, it is generally considered unnecessary to make a complete search back to the earliest records. But if a starter report is not available, a complete search must be made. Frequently a starter report, or a previously prepared policy of title insurance, provides a title record up to within a few years of the date of the examination which is to be made. In the title company business a preliminary report and a starter report mean the same thing. A title examiner seldom retraces the search covered by a starter report or a previously prepared title policy; he does not go behind the starter report. Time and expense *33 are saved where starter reports on a piece of property are used in examining the title to a piece of property. In San Francisco there are four old and well-established title companies which issue policies of title insurance, the California Pacific Title Company, Western Title Insurance and Guaranty Company, Northern Counties Title Insurance Company, and City Title Insurance Company. Among them, there is an understanding and arrangement*185 for the reciprocal exchange of information about real estate titles which each has in its files. Thus, one concern making a search of title to a piece of real estate with respect to which another previously has made an examination may make use of the existing report made by the other concern, as a starter. The petitioner is not admitted to participation in the reciprocal exchange arrangements of the four above-named title companies. The petitioner and PacificTitle compete with the above companies. Some title companies purchase copies of preliminary, starter reports and of old title policies from various sources, such as real estate brokers, escrow companies, and lending institutions, and in California this is a common practice. There is no statutory reason why a title insurance company or an abstract company may not purchase a copy of an old title insurance policy or preliminary report on a specific property and issue a new policy of title insurance relying in whole or in part upon information contained in the former policy. Petitioner has followed the practice since it began business of obtaining copies of preliminary, starter reports and of old title policies from real estate*186 concerns, real estate brokers, lending institutions, and others. It followed that practice before and during the taxable years. It has made payments for them or sometimes it has obtained them free of charge. It is routine for a real estate broker who is handling a proposed transaction for the sale of a piece of real estate to obtain an up-to-date preliminary report on the particular property involved. Such preliminary report shows the owner of record, the tax status of the property, liens and encumbrances, if any, existing restrictions, and obligations of the record owner. Such preliminary title report is obtained from the title company from which it is anticipated the completed title insurance policy will be purchased when the sale is closed. No charge is made for the preliminary report by the title company since the full charge will be made for the title policy. The title policy will be the complete and current coverage. In connection with a proposed sale of a piece of property, the real estate broker often is asked by the title company with which he is dealing in respect to the contemplated sale if he can furnish a previous title policy, or a copy. If the real estate broker*187 can furnish a previous *34 policy, he may obtain the requested preliminary report of the title company sooner. Before and after 1951, several real estate brokers in the San Francisco area have frequently furnished the petitioner with copies, from their files, of preliminary reports and of title policies on various pieces of real estate involved in transactions which they have handled in the past and in which transactions the petitioner did not participate, for which they have received cash payments from the petitioner. Often copies of such reports or old title policies on a particular piece of property have been furnished upon requests of petitioner, and at times petitioner has made use of them in its current search on a particular property. At other times, petitioner has put copies of preliminary reports or of old title policies in its files to serve as a starter in a future search. In most instances, real estate brokers do not charge any stated fee or exact amount for furnishing a copy of a preliminary report or old title policy to the petitioner, and petitioner has followed the practice of making payments periodically to real estate brokers of some amounts which it determined. *188 Such payments, at times, have been made monthly and they have been in varying amounts ranging from $ 25, $ 60, $ 90, $ 100, or more. In 1952, as an example, petitioner had an arrangement with one real estate firm in San Francisco whereby it could look through its files and locate copies of preliminary reports or old title policies which it wanted to use and obtain them at no cost. In another instance, a real estate broker having his own business regularly provided petitioner with copies of preliminary reports or old title policies from his files and he periodically received lump-sum payments from petitioner for such general accommodation but not for individual copies of report or policies. Such payments always were made in cash. During the taxable years, petitioner made cash payments to real estate brokers in the total amounts set forth below: Year Amount [1952] $ 6,896 [1953] 8,581 [1954] 7,534 The following schedule shows the amounts of such cash payments by months: Month [1954] January $ 386 $ 736 [0] February [521] $ 556 March [467] April [812] May [470] June [480] July [645] August [674] September [589] October [693] November [700] December [716] 1,116 1,448 Total 6,896 8,581 7,534 *189 *35 The names of the real estate brokers and the payments received by them in 1952, 1953, and 1954 were not reflected in the books and records of petitioner, but were in a personal record belonging to petitioner's president, Rolls. The payments to the real estate brokers were made by Rolls personally in cash. Checks of the petitioner were made payable to cash and cash was made available in this way to make payments to real estate brokers. The accounting records showed the cash withdrawals, and the amounts of the payments to real estate brokers were charged on the books to an expense account such as advertising expense. In petitioner's returns for the taxable years 1952-1954, inclusive, the total amounts paid to brokers, stated above, were included in the entire amount deducted in each year for advertising expense, or some other operating expense. There have been many instances where real estate brokers have placed business with the petitioner and the petitioner has not purchased any title reports or copies of old title policies from them. Rolls kept a personal record, apart from the accounting record of the petitioner, of the payments made to brokers which he describes as *190 his personal, broker account record. He maintained those records. They show the volume of business received from various real estate brokers. In these records Rolls made note of the amounts of payments which he made to real estate brokers, and he also entered the amounts involved in transactions handled by the petitioner which were closed by the individual brokers. However, this particular record does not show what preliminary reports and copies of title policies on particular pieces of real estate might have been received by the petitioner from any individual real estate broker. Neither the petitioner nor its president, Rolls, maintained any record at any time, including the taxable years, showing the specific preliminary title reports or copies of old title policies on particular pieces of real estate which the petitioner had purchased during a year from any real estate broker or any other source. Of course, reference to such individual preliminary title reports and copies of old title policies might indicate to whom or for whom the reports were made and, therefore, an inference might be drawn with respect to the concerns or persons from whom the petitioner acquired such reports*191 and title policies. Petitioner did not keep a record of how many preliminary reports or old title policies on various pieces of real estate it had purchased in each of the taxable years. The petitioner's system for filing the copies of preliminary title reports and old title policies on various pieces of property is as follows: Petitioner's office records are maintained on the basis of the assessor's lot and block system. The number of a lot and its location *36 in a block is entered in the upper right-hand corner of a copy of a preliminary title report or old title policy. Such numbers serve to relate such documents to the petitioner's index of properties in its title plant. On the individual cards in petitioner's card system, which serves as an index to records on individual pieces of property in the county of San Francisco, a red letter "S" is placed to show that petitioner has a preliminary title report or a copy of an old title policy relating to a piece of property. Through such index system, the petitioner is able to determine whether or not it has a preliminary title report on a piece of property which can be used as a starter when and if it makes a title search *192 and abstract on the property. During the years 1952-1954, petitioner acquired many preliminary title reports or copies of old title policies; it paid for some of these documents; and it filed them in its plant records. The bulk of the preliminary title reports and title policies which petitioner purchased during the taxable years did not relate to any searches and examinations of titles which it made in the taxable years for the issuance of title insurance policies. Therefore, such documents were filed for such future use, if any, as might develop. Prior to 1952, petitioner capitalized in its accounting records all payments for preliminary title reports and all old title policies. Petitioner, for the first time, in 1952, 1953, and 1954 charged all payments for such preliminary title reports and old title policies to current operating expenses and took deductions therefor in its income tax returns. The respondent disallowed the entire amounts of the deductions, $ 6,896 in 1952, $ 8,581 in 1953, and $ 7,534 in 1954. The preliminary title reports and old title policies purchased by the petitioner in each taxable year had a useful life beyond the year of purchase which extended until*193 such years as petitioner might make use of them in its own up-to-date title abstracts relating to the same pieces of property in connection with future transactions dealing with them. The future time of use in petitioner's business was problematic and indefinite depending upon when, as, and if the petitioner might be called upon to make abstracts of title to the same pieces of property. The old preliminary title reports and old title policies constituted additions and betterments to petitioner's title plant, and the expenditure for them was a nondeductible capital expense. The expenditures were not current maintenance expenses within the category of ordinary and necessary business expenses. OPINION. The issue relates to the matter of the proper treatment for tax purposes of an expense which petitioner incurs and pays in cash each year to real estate brokers, chiefly, for *37 preliminary title reports and copies of noncurrent title insurance policies which have been prepared and used previously by others in the same business. For convenience such material is described hereinafter, collectively, as starter reports. It is understood that for the most part each of the starter*194 reports acquired deals with the status of the title to an individual and different piece of real estate up to a date which is prior to the time of petitioner's purchase, although petitioner concedes that there are instances of purchasing more than one report which relates to the same piece of property, in which event there is some duplication of starter reports which are purchased. It is understood, further, that the petitioner makes no effort to ascribe a purchase price to each individual starter report which it acquires; that sellers of such reports do not fix a price for each report sold to petitioner; that petitioner pays a lump sum periodically (usually monthly) for several reports; and that during a year an undisclosed number of starter reports are purchased. Thus, for example, the record does not show how many reports petitioner purchased in 1952 for $ 6,896, or in 1953 for $ 8,581, or in 1954 for $ 7,534. It is understood, also, that the petitioner concedes that "the bulk" or most of the reports which it purchases in a year are not, during the same year as the expense is incurred and paid, made use of in the searches, examinations, and writing of abstracts of title on individual*195 pieces of real estate, but, rather, are filed away in petitioner's files of records for future use, if, as, and when petitioner should write abstracts of the title to any of the properties covered by such starter reports. It is noted at the outset, in addition, that the record does not show anything about the fees, or rates of charges, which petitioner receives for a title abstract, or what elements enter into its costs of making the search, the examination, and finally writing a title abstract. For example, the petitioner does not contend, where it makes use of one of the purchased starter reports on the title to a piece of property in its search and writing of a title abstract which is brought up to the date of the closing of a real estate transaction, that it includes in its charge for its completed abstract any amount as its cost of the purchased starter report. The facts have been set forth fully in the Findings of Fact and with the foregoing summary of certain relevant factors, the circumstances within which the issue to be decided arises is, we think, clear. The primary question is whether the total amount of expense paid in each taxable year is a nondeductible capital expense*196 under section 24(a)(2), or ordinary and necessary business expense deductible *38 under section 23(a)(1)(A). For convenience, reference is made to the applicable sections of the 1939 Code. The corresponding provisions of the 1954 Code are substantially the same. In substance, it is the petitioner's view that the expense of purchasing starter reports which, for the most part, are held in expectation of future use, is comparable to the expense of maintaining its title plant, a capital asset, in good and efficient working condition. Having such starter reports on hand, argues the petitioner, later saves time and expense in writing a particular title abstract. Such alleged maintenance expense is claimed by the petitioner to be of the same nature as ordinary maintenance expenditures which do not benefit future periods and are, therefore, properly charged to operations in the year the expenses are incurred and paid, and are deductible as ordinary and necessary expenses of petitioner's business. The petitioner does not cite any case specifically dealing with the issue to be decided. However, petitioner relies largely upon the respondent's O.D. 1018 (1921), 5 C.B. 119,*197 set forth in the margin. 1 Whether a given expense is an ordinary and necessary business expense deductible from gross income in the year of payment under*198 section 23(a)(1)(A), or whether it constitutes an amount paid for an asset, or an addition to assets, or a betterment which increases the value of assets so as to be not deductible under section 24(a)(2) is a question of fact. Russell Box Co. v. Commissioner, 208 F. 2d 452, 454. It is often a difficult matter to draw the line between a capital outlay and one for current maintenance. Hotel Kingkade v. Commissioner, 180 F. 2d 310, 312. It is helpful to bear in mind, nevertheless, the basic distinction between an ordinary and necessary business expense and a capital expenditure. In this connection, the following statement of the fundamental distinction, stated in Kester, Principles of Accounting, p. 130, is helpful: Asset and Expense Expenditures. -- At the time of organization of a business, the capital contributed by the owner is expended to acquire the necessary assets with which to carry on the business. A fundamental distinction must be made between expenditures for the purchase and installation of the assets themselves and expenditures for expenses in connection with their repair, maintenance, and upkeep. *199 *39 An asset account is chargeable with all costs incurred up to the point of putting the asset in shape for use in the business. It may be charged also with subsequent expenditures resulting in an increase in its value. Such increase is frequently termed a betterment. Expenditures, however, which are for the purpose of repairs or of keeping the property from too rapid depreciation without adding anything to its original value, must be charged to a properly labeled expense account. These expenditures for expenses, such as repairs, maintenance, upkeep, together with depreciation, are subtractions from profit and proprietorship, while asset expenditures usually constitute an exchange of the asset cash for some other asset, which exchange has no effect on proprietorship. These expenditures are frequently distinguished as capital and revenue expenditures. After fully considering the complete record and petitioner's contentions and arguments, it is concluded that total expense of purchasing starter reports in each of the taxable years, incurred and paid in each year, is a nondeductible capital expense which properly is to be charged to petitioner's asset account for its title*200 plant as an expenditure which increases the title plant's value and is for betterment thereof, in general. Upon all of the facts and under all of the circumstances, it cannot be found and held that the respondent erred in disallowing the claimed deduction in each year. Petitioner contends, and it may be conceded, that as of the end of 1951 it had an established title plant, the cost of which had been capitalized. Petitioner agrees that the records which constitute a title plant are capital assets, as is now well established. See The Record Abstract Co., 2 B.T.A. 628, 631-632; Cuyahoga Abstract Title & Trust Co., 7 B.T.A. 95, 98-99, affd. 29 F. 2d 448, certiorari denied 279 U.S. 848; Crooks v. Kansas City Title & Trust Co., 46 F. 2d 928. Petitioner, however, is in error in its contention that since it had a title plant, the expense of purchasing previously prepared starter reports for title abstracts necessarily is a maintenance and, therefore, current operating expense. It is admitted that the value of the starter reports extends*201 beyond the year of purchase and continues until such time in some indeterminate future year as petitioner shall have the occasion to write an abstract on a title covered up to a point by a starter report. The time of future use may be many years later. We think it is clear beyond any doubt that the starter reports have an economic life extending beyond the year of purchase and that they represented additions and supplements to the plant which increased its value. It is a generally accepted rule that an amount expended for an asset having a useful life which is not consumed in the year of the expenditure is usually to be classified as a capital item. First National Bank of St. Louis, 3 B.T.A. 807; W. B. Harbeson Lumber Co., 24 B.T.A. 542. *40 Petitioner's reliance upon respondent's O.D. 1018 is misplaced. First, it must be observed that an Office Decision of the Commissioner lacks the status of a regulation and ordinarily must be regarded as having limited weight circumscribed by its particular facts. O.D. 1018 refers to the expense of obtaining "records that are being made daily in various courts and in the Recorder's*202 office" which title abstract companies continuously incur. Petitioner incurs the kind of expense described in the cited ruling by its continuous subscription to Edwards Abstracts which furnishes such daily records of the courts and the Recorder's office in San Francisco County. The expense under consideration here of purchasing starter reports is not the same and is distinguishable from the kind of expense described in the ruling. A starter report covers a search and examination of title and while it does not have the coverage of a completed abstract, it is within the same general category. O.D. 1018 does not refer to reports on title. The petitioner advances another argument which deals with the limitation contained in section 12372 of the California Insurance Code on a title insurer's valuation on its plant as an asset. Petitioner contends that since one of the provisions of that statutory provision limits the valuation of its title plant to actual cost, not to exceed 50 per cent of the total par value of its outstanding capital stock, it could not, after 1951, add to the then cost of its plant the amount expended in each year for starter reports. This contention has no relevance*203 here and is without merit. Section 12372 of the Insurance Code deals inter alia with an insurer's financial statement. It provides, also, in subsections (b) and (c) that an insurer may, in its statement, treat its plant as an asset having a lesser value than 50 per cent of the par value of outstanding stock, as allowed in (a); or it may omit entirely from the statement such asset. In any event, the cited provision of the California Insurance Code does not in any respect bear upon, relate to, or control the question here which arises under the Federal Internal Revenue Codes. Cases cited by the petitioner have been considered but they are distinguishable. Consolidated Apparel Co., 17 T.C. 1570, affirmed and reversed in part on other grounds 207 F. 2d 580, is distinguishable from this case in that the expense there, advertising expense, was clearly an item which properly can be expensed. In view of the conclusion reached under the main issue it is unnecessary to consider an alternative contention of the respondent that the petitioner, by deducting the expense in question in 1952, which it previously had capitalized, changed*204 its method of accounting without first obtaining the respondent's consent. The determinations of the respondent are sustained. Decision will be entered for the respondent. Footnotes 1. O.D. 1018 is as follows: Title abstract companies incur relatively large and continuous expenditures in keeping their plants up to date, such as the expense of adding and incorporating in the plant records that are being made daily in the various courts and in the Recorder's office. These records which are added to and incorporated in the plant for the purpose of keeping it in up to date running order and preventing depreciation are in the nature of ordinary and necessary repairs. The expenses, therefore, incurred in making such records are current expenses, and as such are deductible for the years in which incurred and paid or accrued. Since a title plant is not an asset of a nature which gradually approaches a point where its usefulness is exhausted, but is an asset of a more or less permanent character, it is not a proper subject of a depreciation allowance.↩