Western Wheeled Scraper Co. v. Commissioner

WESTERN WHEELED SCRAPER CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Western Wheeled Scraper Co. v. Commissioner Docket No. 12001. United States Board of Tax Appeals 14 B.T.A. 496; 1928 BTA LEXIS 2971; November 28, 1928, Promulgated *2971 1. The March 1, 1913, value of patents determined from expert testimony supported by evidence of advancement in the arts, the secure position attained in the class of machinery covered by the patents, growth and financial history of the business to the basic date, and the future prospects at that time. 2. Annual depreciation deduction determined by prorating March 1, 1913, value over the average remaining life of the patents on the basic date. 3. Invested capital can not be reduced on account of the excess of depreciation deductions based on the March 1, 1913, value over cost. 4. As overpayments in such prior years due to inadequate deductions may be recovered and restored to invested capital at any time under section 284(c), Act of 1926, invested capital should be adjusted in accordance with the correct tax liability for prior years. 5. Assets which are by definition classified as "inadmissibles" are not converted into "admissibles" by reason of their having been acquired in exchange for goods sold or in liquidation of a liability for such goods. 6. The Board is unable to determine that a group of alleged expenses were erroneously included in the overhead rate*2972 used in computing inventory, in the absence of evidence showing all the items of the group had no place in inventory. 7. Items found duplicated in inventory and adjustments made. 8. Where the pleadings, as amended, question the correctness of the closing inventory only, there is no question as to opening inventory before the Board. 9. A share of the 1920 earnings of a firm, held income for 1920 by a taxpayer on the accrual basis, though the amount was not known until the succeeding year, when received; and a corresponding share of 1919 earnings excluded from 1920 income. 10. Items of expense segregated from nondeductible items so far as the evidence permits. 11. An architect's fee for plans for new buildings contemplated early in 1920, which project was definitely abandoned within the year, found, duplicated in income, and held deductible. John E. Hughes, Esq., and William Cogger, Esq., for the petitioner. Shelby S. Faulkner, Esq., A. S. Lisenby, Esq., and C. R. Marshall, Esq., for the respondent. SIEFKIN *497 This proceeding results from respondent's determination of a deficiency of $5,437.61 in income and*2973 profits taxes for the calendar year 1920, all of which deficiency is contested. It is contended that respondent erred - (1) In failing to allow exhaustion deduction for patents based on the March 1, 1913, value thereof (in answer to which respondent alleges that, if such additional patent value is established invested capital should be reduced by additional depreciation computed on such value basis for prior years): (2) In reducing invested capital (a) on account of taxes for prior years by amounts in excess of the correct tax liability for such years, and (b) because of assets erroneously determined to be inadmissibles; (3) In failing to reduce closing inventory (a) on account of erroneous inclusion therein of expenses not ascribable to production, and (b) by reason of a duplication in expense items, properly a part thereof; (4) In not allowing a deduction for a wage liability accrued within the year; (5) In not excluding from income profits accrued in the previous year; (6) In failing to deduct accrued expenses; and *498 (7) In adding to income cost incurred within the year for new office building plans, which project was definitely abandoned before the close*2974 of the year, rather than allowing such cost as a deduction. The finding of fact and opinion are grouped and numbered in accordance with the above classification of subject matter. FINDINGS OF FACT. Petitioner is an Illinois corporation with principal offices at Aurora. It was organized in 1891 and has developed into the largest manufacturer of earth and rock handling machinery. Its patents give it a virtual monopoly on that class of machinery. By 1913 its products were in use throughout the United States and foreign countries for large scale dumping. Petitioner's books were kept on the accrual basis. 1. On March 1, 1913, and in 1920, petitioner owned and used in its business a number of patents, all of which had been developed in its engineering department. These patents, together with date of issuance, their nature (basic or improvement), and the device covered, may be tabulated as follows: Patent No. Date issued Basic or improvement Device covered 809552 Jan. 9, 1906 Basic Dump car or turntable permitting dumping from either side or end. 846501 Mar. 12, 1907 Basic Dumping car operated by air control. 873772 Dec. 17, 1907 Improvement On dump car body construction. 888188 May 19, 1908 Improvement Connection between car body and trucks. 888187 May 19, 1908 Improvement Connection between car body and trucks. 88526 May 26, 1908 Basic Car floor extension - dumping further from rails. 894280 July 28, 1908 Basic Air valve controlling dumping operation from locomotive cab. 905222 Dec. 1, 1908 Improvement On slide or door. 918911 1 Apr. 20, 1909 Improvement Hinge between body and draft sill. 920616 Apr. 4, 1909 Improvement On air dumping arrangement. 932564 Aug. 31, 1909 Improvement On car hinge. 940893 1 Nov. 23, 1909 Improvement 950554 Mar. 1, 1910 Improvement On journal box on axle. 961772 1 June 21, 1910 Improvement 773093 Oct. 25, 1904 Basic Dump wagon. 821730 May 29, 1906 Basic Brake for dump wagon. 981781 Jan. 17, 1911 Basic Grading machine; leveling railroad right of way outside of tracks. 727671 May 12, 1903 Improvement Elevating grader. 844387 Feb. 19, 1907 Improvement Belt tightener for elevating grader. 773092 Oct. 25, 1904 Improvement Wheeled scraper. 821729 May 29, 1906 Basic Axle on grading machine. 805258 1 Nov. 21, 1905 Improvement Wheeled scraper. 803186 Oct. 31, 1905 Basic Earth and ballast spreader. 825608 July 10, 1906 Basic Conveyer for rock crushing machinery. 932598 Aug. 31, 1909 Basic Portable bins for handling crushed stone. 1048013 Dec. 24, 1912 Improvement Folding elevator for rock crushing machine. *2975 The first fourteen patents listed in the above table related to railroad dump cars. Prior to the invention of dump cars the unloading of flat or gondola cars which were used to haul refuse, earth, rock, etc. was done by the slow, expensive means of shoveling by hand or by means of a plow pulled the full length of the train by a cable *499 attached to a winch. The first dump car was soon displaced by the invention of the dump car operated by air control, which enabled the engineer to dump the entire train to the right or left by the operation of levers. This car was adopted by the United States for use in building the Panama Canal, 900 cars being ordered and used for that purpose. Filling of this order was begun in 1905 at a net profit of about 20 per cent of the total price of $2,000 per car. Subsequently it has come into widespread general use on large projects. All patents were assigned to the petitioner at or about the time they were issued. No assignment of any of the patents or for their use was ever made by petitioner. Devices under patents which were in use on March 1, 1913, were*2976 placed in production promptly upon issuance of the patent. In some instances such delay in production amounted to but 30 days. In keeping with the policy of the company, improvements on the various patents were developed from time to time between March, 1913, and 1920, but no basic patents were developed during such period. The products in 1920 were basically the same as those produced at March 1, 1913. The only relation between the several types or devices patented was in their use, the same customers usually having occasion to use the several kinds of machinery produced. From 1905 to March 1, 1913, production tripled. On the latter date petitioner was manufacturing dump cars, grading machines, wheeled scrapers, rock crushers, earth and ballast spreaders, dump wagons and plowes. Aside from the plows all products were protected by patents. This protection amounted to a monopoly, their being no competition in such products between the years 1909 to 1913. The plows, which were a competitive product, were designed for grading work only, and represented approximately 3 per cent of petitioner's production and net earnings between the years 1909 and 1913, and about 1 per cent*2977 between 1913 and 1920. A composite balance sheet showing petitioner's assets and earnings for the 5-year period 1909 to 1913, inclusive, is as follows: Dec. 31, 1909 Dec. 31, 1910 Dec. 31, 1911 Dec. 31, 1912 Dec. 31, 1913 ASSETS $64,675.39 $110,951.32 $226,477.73 $68,009.08 $233,829.02 Accounts receivable 868,269.22 863,596.96 1,133,735.22 1,494,621.82 937,439.38 Accounts receivable (personal) 200.00 2.50 Bills receivable 505,738.26 699,854.88 730,787.75 933,220.15 987,651.45 Bills receivable (township) 9,335.74 6,323.83 12,368.55 7,298.75 4,176.38 C. H. Smith (trustee) 4,391.98 Bonds 13,214.00 23,722.00 23,492.00 58,475.00 23,245.00 Inventory 1,193,064.23 1,157,074.50 935,635.56 959,209.26 1,549,818.29 Tools and machinery 207,033.63 212,707.04 277,741.16 341,856.22 Patterns 24,930.40 28,937.79 32,442.55 33,530.85 Real estate 210,039.98 214,569.74 216,253.78 280,027.58 310,146.66 Office furniture 3,528.35 3,606.50 4,632.15 4,882.65 6,651.85 Patents 69,057.39 69,194.09 69,969.24 70,357.59 70,696.34 Total assets 2,941,514.54 3,380,857.85 3,594,996.81 4,186,288.09 4,499,041.44 LIABILITIES AND CAPITAL Accounts payable $75,663.96 $74,359.60 $69,777.39 $96,200.31 $65,163.39 Bills payable 1,593.00 1,593.00 1,593.00 1,593.00 Capital stock 400,000.00 400,000.00 400,000.00 400,000.00 400,000.00 Surplus 2,465,850.58 2,904,905.25 3,123,626.42 3,688,494.78 4,032,285.05 Total liabilities and capital 2,941,514.54 3,380,857.85 3,594,996.81 4,186,288.09 4,499,041.44 Surplus balance 203,816.54 439,054.67 218,721.17 564,868.36 343,790.27 Dividends paid 200,000.00 200,000.00 200,000.00 220,000.00 210,000.00 Earnings before dividends 403,816.54 639,054.67 418,721.17 784,868.36 553,790.27 *2978 *500 No trade-marks or trade names were owned by petitioner from 1909 to 1913. The petitioner did little advertising during such period as it had no competition and its customers were large contractors to whom advertisements did not appeal. In many cases the machinery produced did not bear the name of the petitioner, the customer's name being painted thereon, instead. The fair market value of the patents tabulated above as of March 1, 1913, was at least $1,500,000. The petitioner owned some other patents on March 1, 1913. Of these only two, (Patent No. 668,927, February 26, 1901, and Patent No. 699,266, May 6, 1902), were in use and of value on the basic date. They were then worth $60,000 and expired prior to the year 1920. The remaining other patents were not satisfactory and were never placed in production or were abandoned within three years of the patent date, such abandonment having taken place prior to March 1, 1913. Depreciation or exhaustion deductions, claimed on account of patents, and finally allowed by respondent for years prior to and including the year 1920, were based upon the value shown by the books, there having been, apparently, no prior attempt*2979 to establish a greater market value as of March 1, 1913. 2. The deficiency letter shows that petitioner's invested capital for 1920 was reduced (a) in the amount of $85,373.25, representing petitioner's tax liability for 1919 prorated for the year 1920. Additional taxes for years prior to 1919 served to further reduce such invested capital by $28,178.28. (b) Invested capital for 1920 was also reduced in the amount of $393,887.29 by an adjustment for inadmissibles. The inadmissible assets (aside from stock having a fair market value of $21,000) consisted of state and county warrants received in payment for goods sold. The income from such sales was reported and the tax paid thereon. 3-a. In computing closing inventory for 1920, an overhead rate of 225 per cent was used. Expenses of administration (consisting of officers' salaries, depreciation and insurance of office building and office furniture and fixtures, office supplies, and repairs and maintenance *501 of office), office and drafting were included in such overhead rate, and accounted for 28.2 per cent of the total rate of 225 per cent. Freight on materials purchased was added to the cost of such materials. *2980 Also, such freight charges were included in overhead, and accounted for an additional 28.2 per cent of the total rate used. Had these items not been included in overhead the rate used would have been 168.6 per cent rather than 225 per cent. The difference or 56.4 per cent represents $50,103.36 in terms of dollars and cents. 3-b. Production supplies costing $40,671.41 were included in closing inventory for 1920 as specific items. Such costs were likewise included in the overhead rate (either 225 per cent of 168.6 per cent as set out above). 4. It was stipulated at the hearing that the closing inventory for 1920 was overstated in the amount of $43,892.23, and the closing inventory for 1919 was overstated in the amount of $31,499.12, resulting in a net overstatement of $12,393.11 in 1920 inventory, on account of erroneous treatment of wages earned in the respective years but not paid until the succeeding year. 5. Petitioner had an agreement with a firm known as Beck & Babb, by the terms of which petitioner furnished some of the capital needed by that firm in return for a share of its profits. Petitioner's share of such profits amounted to $4,700 and $6,861.40 for the*2981 years 1919 and 1920, respectively. The amount of such share for each such year was not known or received until the respective following year, and was returned as income in the year of its receipt. The deficiency letter treats the $6,861.40 earned in 1920 as an accrued item in 1920 and adds it to income for that year. There is no corresponding adjustment reducing income for 1920 by the like share earned in 1919, but reported in 1920 income. 6. A number of items paid or accrued in 1920 were carried as accounts receivable as of the close of the year and were not deducted though they did not represent amounts due petitioner. Their being carried as accounts receivable was due to failure to enter offsetting credits. A list of such items is as follows: Expense items carried as assets December 31, 1920. Item Amount 1. Hilyard Lumber Co $0.16 2. Cleveland Hardware Co .17 3. Dougherty & Shelburer 685.66 4. R. G. Dun 175.00 5. R. & O. Overall Co 19.89 6. Illinois District Traffic League 5.00 7. Interior Coffee Co 40.40 8. W. D. Kerner 5.28 9. Manufacturers Publicity Bureau 2,129.61 10. J. A. Morrell .10 11. McLeod Lumber Co .26 12. National Carbon Co .80 13. National Life Building Co $1,120.00 14. C. F. Pease Co 3.00 15. C. A. Seagrove Co 568.60 16. Eugene Smith Co 4,681.89 17. Southern Construction News 3.00 18. R. E. Bressler 1,200.00 19. Upson Walton Co 1.04 20. Vengrd Film Corporation 90.60 21. Wells Shipping Co 1,004.64 $11,735.10 *2982 *502 Items Nos. 1 and 3 represented lumber purchased by petitioner in 1920. No. 2 was for carriage or wagon hardware purchased. No. 4 represents cost of commercial reports published by that company. No. 6 was the membership fee charged by said traffic league, which kept its members informed on traffic laws and freight rates. No. 9 represented cost of advertising paid in 1920. No. 13 was an item of rent paid on space occupied by a branch warehouse. No. 16 shows the amount of a liability for printing and office supplies. No. 18 represented salary paid an employee. 7. Early in 1920 an architect prepared plans for a new office building then contemplated by petitioner. The fee, which was paid in 1920, amounted to $3,000 and was capitalized by a charge to real estate. Later in 1920 the plans were definitely abandoned, due to the business outlook, and the plans were never used. No deduction was claimed nor allowed therefor in 1920, and no reversing entry in the real estate account was made until the following year. The deficiency letter shows this amount was again added to income for 1920. OPINION. SIEFKIN: The principal point in controversy is the March 1, 1913, value*2983 of patents owned and in use on such date and in 1920. Two experts, whose qualifications lend weight to their opinion, testified that they were worth at least $1,500,000. Their testimony is based upon and supported by the nature of the patents, the extent of advancement in the arts by the inventions covered, the secure position attained by petitioner in the manufacture of such machinery due to the protection afforded by the patents, the growth and financial history of petitioner's development to the basic date as well as the future prospects at that time. Their analysis and conclusion, as well as the facts from which they drew, were unshaken by cross-examination and are without contradiction in the record. Our finding has been made accordingly. Petitioner claims and is entitled to exhaustion upon that value for the year in question. The 1920 annual deduction will be recomputed by dividing such basic value by the average remaining life of the patents on March 1, 1913, in accordance with the method prescribed in ; *2984 . The contention by respondent that invested capital for 1920 should be reduced on account of inadequate depreciation deductions for prior years on patents, such deductions being based on the March 1, 1913, value rather than cost, is erroneous and has been rejected by this Board. See ; North Iowa*503 ; . 2-a. Invested capital for 1920 has been reduced by the proration of 1919 taxes, and additional taxes for the years 1914 to 1918, inclusive. Petitioner contends that such reduction is erroneous to the extent that the taxes for prior years were excessive. In view of the inadequate depreciation deductions in prior years, we are persuaded that such taxes were excessive. We have jurisdiction to determine the taxes for prior years for the purpose of determining the correct invested capital for the year in question. Section 272(g), Act of 1928; *2985 . It follows that we are in a position to correct the error unless the statute of limitations has run against the petitioner barring recovery of excess payments and their consequent restoration to invested capital. Section 284 of the Revenue Act of 1926 provides: * * * (c) If the invested capital of a taxpayer is decreased by the Commissioner, and such decrease is due to the fact that the taxpayer failed to take adequate deductions in previous years, with the result that there has been an overpayment of income, war-profits, or excess-profits taxes in any previous year or years, then the amount of such overpayment shall be credited or refunded, without the filing of a claim therefor, notwithstanding the period of limitation provided for in subdivision (b) or (g) has expired. * * * Manifestly, under this section petitioner is entitled to recover the excess taxes paid in prior years due to its failure to take adequate depreciation deductions. . The amounts of the overpayments constitute valid existing claims against the Government, and, like any other error in tax computation*2986 which remains subject to adjustment, should be corrected for invested capital purposes. 2-b. Petitioner claims that state and county warrants were erroneously excluded from invested capital as inadmissibles. That such warrants are of the kind of assets generally falling within the category of inadmissibles is admitted. The fact that such warrants were acquired not by the investment of funds but in payment for goods sold, the income from which sales were reported and taxed, is the basis urged for taking them out of their general class. The contention is not persuasive. Invested capital is a statutory concept. The definitions enacted by Congress must be strictly construed. Assets are classified by definition without regard to the manner of their acquisition. Manifestly, the primary purpose of Congress concerning inadmissibles was to exclude capital invested in assets not productive of taxable income from invested capital. Bearing in mind this purpose, we are unable to perceive any reason for *504 lifting the assets in question out of their defined classification. The fact that they were acquired in exchange for goods or in liquidation of a liability does not prevent*2987 them from being considered as property representing an investment. Nor does the fact that taxable income was realized on the exchange change the essential nature of the assets received. Furthermore, we have no assurance that the warrants were not held as an investment, as we are without evidence showing the length of the time they were held. In support of its contention petitioner quotes from article 847 of Regulations 45 as follows: Real or personal property taken by a corporation in payment or satisfaction of a debt, or property received in exchange for other property, will be an admissible asset at its fair market value upon receipt. We confess inability to see the pertinency of the excerpt to the subject matter under discussion. As a general proposition such regulation seems sound. It contains no hint that it was intended to convert inadmissible assets into admissibles merely by reason of their being received in an exchange. Respondent is sustained upon this point. 3-a. Petitioner claims that the closing inventory should be reduced because 28.2 per cent of the 225 per cent overhead rate used in the computation represented costs termed "administration and office*2988 drafting," which it is urged have no place in inventory. The record contains insufficient evidence for us to determine that all of the items should be excluded from inventory as claimed. For instance, the item "officers' salaries" is not shown to have been paid to officers engaged only in nonproduction. Nor is there any evidence showing that a portion of the item "drafting" should not be allocated to the cost of production of goods sold. Accordingly, we are unable to say that none of the said 28.2 per cent did not belong in inventory, and, since there was no attempt to establish amounts or percentages due to the several classes of expenses, taken separately, we must deny the grouped claim. The 28.2 per cent of the total overhead rate due to allowance in such rate for freight on goods received is a duplication in the inventory, and deduction amounting to one-half of $50,103.36 should be made accordingly. 3-b. In like manner the record clearly established that $40,671.41, the cost of production supplies, was twice included, as a specific item and in the overhead rate. Closing inventory should be reduced by that amount. At the hearing counsel for the respondent raised a*2989 question as to the opening inventory, and developed the fact that such inventory had been taken on a different basis than the one used in the closing *505 inventory. Counsel for the petitioner suggested in explanation that taxpayers were permitted, during 1920, to change the basis of inventorying. No further testimony was adduced upon the point. We think, in view of the pleading, no question concerning opening inventory is in issue. The petition, so far as germane, alleges: (f) Respondent erred in failing to allow petitioner to deduct from its 1920 closing inventory the sum of $50,103.36. (Accompanied by a statement of supporting facts.) (g) The respondent erred in failing to allow petitioner to deduct from its 1920 closing inventory the further sum of $40,671.41. (Likewise supported by a statement of facts.) These allegations were separately denied generally in the following form: (h) Denies the allegations contained in subparagraph 5 of the second amended petition. No motion was made to amend the answer to place the question raised in issue. It is, of course, true that the effect of inventory on taxable income depends upon two factors, i.e., opening and*2990 closing inventory. It does not follow, however, that one of such factors alone may not be placed at issue. In the pleading petitioner questions but one - the closing inventory. So far as his answer indicates, respondent was content to confine the contest to the same single factor. An analogous case would be presented where a taxpayer alleged error in the rate of depreciation allowed on a building, and respondent countered with a general denial. In such case, we would consider only the useful life, which is determinative of the rate, as being at issue. The parties, having raised no question as to the cost or other basis, the other factor essential to computing the correct depreciation deduction, we would have no reason to question agreement by the parties upon that score. The same is true of the factor of closing inventory in the case at bar. It is elementary that the function of pleading is to confine the issues, and that the only way to enlarge upon the issues is to amend the pleading. (4) This question is settled by stipulation, which will be given due consideration in the recomputation. (5) The accrual of $6,861.40, representing petitioner's share of the 1920 earnings*2991 of the firm of Beck & Babb, as an item of income in 1920, is not questioned by petitioner. . By the same token petitioner's share of 1919 earnings of that firm, or $4,700, accrued in 1919 income and should have been excluded from 1920 income. (6) We have found as a fact that no deductions were claimed on account of any of the items contained in the list set out in our findings *506 of fact, and now alleged to be deductible as expense. We can not assume that items numbered 1 and 2, therein, though trivial, were expense items. Likewise, we have no assurance that item No. 3 should not have been and/or was not included in inventory. The exact nature of the commercial reports received from R. G. Dun is not disclosed and we can not be expected to know, as a matter of common knowledge, that all commercial reports published by that firm have no value beyond the current year. The membership fee in the traffic league, the items of advertising and rent, and salary paid are deductible, as is the liability for printing and office supplies. The remaining items we must deny for lack of evidence. Another list representing*2992 commissions paid or purchases made was introduced in evidence. Such list gives only the dates of the several accounts, the name of the creditor, the amount of the liability, the number and page of the journal from which they were taken. No explanatory evidence was adduced concerning any of the items. Accepting the testimony as to what the accounts represented, we can not say that none of the purchases made were for capital items. The opinion of a witness that all the items were expense items is a conclusion of law, so far as purchases made are concerned, which we can not accept. Since we can not segregate the items, the claim is denied in toto. (7) The $3,000 architect's fees for plans for a new office building contemplated early in 1920, which project was definitely abandoned within the year, is an allowable deduction for 1920. ; . This amount was included in 1920 by being capitalized in the real estate account. Respondent has again added it to income. Adjustment will be made in income to correct such duplication, in addition to allowance of deduction. *2993 Judgment will be entered under Rule 50. Footnotes 1. Patented for protective purposes only. Device never manufactured. ↩