Elmore Milling Co. v. Commissioner

ELMORE MILLING COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Elmore Milling Co. v. Commissioner Docket Nos. 46768, 52972. United States Board of Tax Appeals 27 B.T.A. 84; 1932 BTA LEXIS 1129; November 16, 1932, Promulgated *1129 1. DEPRECIATION ALLOWANCE - BURDEN OF PROOF. - Where the taxpayer has claimed certain deductions for depreciation on its income tax returns for the respective taxable years and the Commissioner has allowed these deductions in part and disallowed them in part, and the taxpayer appeals and assigns this action of the Commissioner as error, the burden of proof is on petitioner to show that the action of the Commissioner was wrong and, if so, what the correct base, rates and amounts should be. Reinecke v. Spalding,280 U.S. 227. 2. DEPRECIATION - BASIS - PROPERTY ACQUIRED FROM PETITIONER'S TRANSFEROR. - Where petitioner is claiming depreciation deductions on certain depreciable assets used in its business during the taxable years, such deductions to be based on the March 1, 1913, value of such property while in the hands of its transferor, and where petitioner is claiming bad debt deductions on debts acquired from its predecessor, based on cost to such predecessor, the burden of proof is on petitioner to show that it acquired these assets in a transaction in which neither gain nor loss is recognized, because coming within the exception enumerated in section 203(b)(4), *1130 of the Revenue Act of 1926. 3. BAD DEBTS. - Evidence examined and claims for deduction of bad debts allowed in part. The part of the bad debts deduction claimed, which represents advances made by petitioner's predecessor is not allowed, because petitioner has not shown itself entitled to take the same basis of cost as its transferor and has not shown what its own costs were. The correct basis for loss in such cases is not the amount of the accounts at the time they were transferred to petitioner, but the amount of their cost to petitioner. O. N. Townsend,13 B.T.A. 386, followed. William Cogger, Esq., for the petitioner. L. W. Creason, Esq., for the respondent. BLACK *85 Respondent determined deficiencies in income tax of $2,374.08 for 1927 against petitioner and $9,363.72 for 1928. Petitioner appealed and assigned certain errors which will be stated in detail in the opinion which follows. FINDINGS OF FACT. Petitioner is a corporation organized under the laws of New York in 1925, and began business January 1, 1926. It was and is engaged in the milling and sale of flour, feed, cement and fertilizer. Its principal*1131 office is at Oneonta, New York. The business is mainly wholesale, but it conducts several branch retail stores in the State of New York. From 1910 to January 1, 1926, the business was conducted as a partnership, which was composed of E. W. Elmore, his wife Florence G. Elmore, and their son, Earl P. Elmore. In December, 1925, the partnership, Elmore Milling Company, made an offer to the Elmore Milling Company, Inc., to sell and transfer to it all the assets of the partnership in consideration for all the stock of the corporation to be issued in accordance with the offer and in further consideration of the corporation assuming all the outstanding liabilities of the partnership. This offer was as follows: We, the undersigned being all the members of the firm of Elmore Milling Company, a copartnership owning and conducting a feed, grain and milling business in Oneonta, Morris and Davenport, N.Y., do hereby submit the following offer for your consideration and acceptance: We do hereby offer to sell and transfer to your corporation on January 2nd, 1926, by a good and sufficient bill of sale, the above mentioned business, including all our right, title and interest in and to the*1132 same, the goodwill thereof, the leases, stocks on hand, in transit and in process of manufacture, tools, machines, fixtures, appurtenances, vehicles, trademarks, trade-names, brands, *86 formulae, books, bills and accounts receivable, contracts, orders, cash in bank and on hand and personal property of every kind used in the conduct of said business and owned by said firm at that time; and all real estate then owned by said firm; the said Edwin W. Elmore also offers to sell and transfer unto your corporation all the real estate used by said corpartnership in Otsego and Delaware counties and the premises known as the Bowdish property adjoining the mill of said copartnership and located at the corner of Main Street and Neahwa Place in Oneonta, a good and sufficient warranty deed of said premises to be given on or before July 1926, and possession of said premises to be had by said corporation from January first, 1926, to accept in full payment for said properties Five Thousand (5,000) shares of the capital stock of your company and also the assumption by your company of our outstanding indebtedness. If this offer is accepted, 4,495 shares of said stock are to be issued to Edwin*1133 W. Elmore, his nominees or assigns, 500 shares to Earl P. Elmore and 5 shares to Harry M. Goldsmith. [Signed] EDWIN W. ELMORE FLORENCE C. ELMORE EARL P. ELMORE Dated, December 1925. This offer was accepted by the corporation and the following bill of sale was executed on January 2, 1926, by the three partners, Edwin W. Elmore, Florence C. Elmore and Earl P. Elmore: Know all men by these presents, that we, the undersigned, composing the firm of ELMORE MILLING COMPANY, a copartnership doing business at Oneonta, N.Y., and elsewhere, for and in consideration of the delivery to us, or our nominees of 5,000 shares of the capital stock of the Elmore Milling Company, Inc., and the assuming of said firm's indebtedness and obligations by said corporation, do hereby sell and transfer unto said corporation, its successors and assigns, the business of said copartnership, including all our right, title and interest in and to the same, the good-will thereof, the leases, stock on hand, in transit, and in process of manufacture, tools, machines, fixtures, appurtenances, vehicles, trademarks, trade-names, brands, formulae, books, bill and accounts receivable, contracts, orders, cash*1134 in bank and on hand and every kind of personal property used in the conduct of said business and owned by said firm. In opening the petitioner's books on January 2, 1926, the following accounts were included as assets transferred from the preceding partnership: G. H. Elmore, personal $23,925.99 E. W. Rucker, special 11,696.43 E. W. Rucker, personal 5,525.48 Investment, Oneonta Storage Battery Company 23,209.55 Between January 2, 1926, and December 24, 1928, when these accounts were charged off, additional charges were added to the accounts, G. H. Elmore, personal; E. W. Rucker, special; and Investment, Oneonta Storage Battery Company, resulting in the following totals: G. H. Elmore, personal $25,485.99 E. W. Rucker, special 15,957.61 Investment, Oneonta Storage Battery Company 24,050.00 *87 Petitioner deducted these accounts from its income in its 1928 tax return as debts ascertained to be worthless in the taxable year and charged off at the close of such year. These deductions were disallowed by the respondent. G. H. Elmore account. G. H. Elmore was a brother of E. W. Elmore, and the uncle of Earl P. Elmore. He was*1135 a consulting engineer and inventor of machines for removing scale from steam boilers, washing coal, and other appliances used on machinery in the mining industry. In need of money to manufacture and market his inventions, advances by way of loans to him were made by the Elmore partnership, and by the petitioner after it succeeded the partnership. G. H. Elmore was active in the prosecution of his profession and the manufacture and sale of his machines, which were sold to and used by a number of factories and mines, up to and through part of the year 1928, but the business was not a financial success. His health broke down in 1928, resulting in his death during the next year. On December 24, 1928, petitioner's officers determined that the account was uncollectible and charged it off to profit and loss. Petitioner has never collected anything on said account. The account was worthless when charged off in 1928. E. W. Rucker accounts. E. W. Rucker was the son-in-law of E. W. Elmore, and brother-in-law of Earl P. Elmore. He was in the stock and bond brokerage business in St. Louis, Missouri, at the time he married the daughter of E. W. Elmore. Desiring to have his daughter*1136 reside near him and wishing his son-in-law to enter and learn the milling and feed business, E. W. Elmore induced Rucker to come to Oneonta and enter the business as an employee on a salary basis. This was prior to October 31, 1923, during the existence of the partnership. Two accounts with E. W. Rucker appear on the books of both the partnership and the petitioner, one marked "Special" and the other "Personal." There is evidence to the effect that the "Special" account represents amounts overdrawn by Rucker over the amount of his salary, and that after he severed his connection with the partnership in 1924, the "Personal" account was opened and represented loans or advancements made to him. The accounts themselves contradict this in some particulars. The "Personal" account shows that it was opened prior to October 31, 1923, and that on that date there was a debit of $2,941.14. It continued to June 25, 1924, consisting of cash items advanced to Rucker and his wife and a number of bills for household expenses paid by the partnership and charged to Rucker, amounting in all to $5,525.48. The "Special" account appears to have been opened June 27, 1924, on the partnership books and*1137 continues until April 9, 1927, amounting to $15,957.61, and consists of the same character of items as the "Personal" account, viz., cash and payment of household and personal *88 expenses. There is no evidence as to the amount of Rucker's salary while he was an employee of petitioner. About 1924 he left the employment of the partnership and joined G. H. Elmore in the promotion and sale of his inventions, and continued in this employment up until the breakdown of G. H. Elmore's health in 1928. After the death of E. W. Elmore, his father-in-law, officers of the petitioner approached Rucker for a settlement, which Rucker declined and denied the debt, claiming that when he moved from St. Louis to Oneonta, New York, his father-in-law agreed and promised to take care of him and his family financially. No steps have been taken to force collection. Both the E. W. Rucker special account and the E. W. Rucker personal account were charged off as worthless December 24, 1928. Rucker had no means other than his earnings, and the evidence is to the effect that these earnings were small and were terminated altogether, at least temporarily, by the breakdown of the health of G. H. Elmore*1138 in 1928. These debts were ascertained to be worthless by petitioner in 1928, the year in which they were charged off. Oneonta Storage Battery Company account. The Oneonta Storage Battery Company was a corporation organized in 1922 for the purpose of making and selling storage batteries. Its plant adjoined that of petitioner. E. W. Elmore, at the time of his death, owned 1,010 shares of its capital stock and the petitioner owned 247 shares. Petitioner has been allowed its loss on the stock in 1928. The losses on the stock are not included in any way in the $24,050 investment account now claimed as a deduction. The account comprises charges for cash advanced, for heat and power furnished, and various other items, and was labeled "Investment Account." It was started some time previous to October 31, 1923, and continued to December 31, 1927, when it was transferred to the estate of E. W. Elmore on advice of counsel. It was returned to petitioner's accounts July 31, 1928. The account was the property of petitioner. The name of the Oneonta Storage Battery Company was changed to Kalo Storage Battery Corporation at some time prior to 1928 and the business continued under the*1139 latter name, and on August 18, 1928, it was adjudged a bankrupt by the United States District Court for the Northern District of New York, and it was clear in 1928 that the creditors and stockholders would receive nothing. They have received nothing. The account was charged off as worthless by petitioner December 24, 1928, and was worthless at the time charged off. Depreciation. Petitioner, in keeping its accounts, failed to set up on its books certain fixed assets comprising its water power system and machinery, much of which was acquired and installed by the previous partnership prior to March 1, 1913. Petitioner did not claim depreciation deductions on these assets in its income tax returns *89 for 1927 and 1928, but now claims depreciation deductions on those items. The following assets were owned by petitioner's predecessor, the partnership, on March 1, 1913, were still in use in petitioner's business during the taxable years, and had a value on March 1, 1913, and a remaining useful life as follows: Item Value Mar. 1, 1913 Useful life remaining after Mar. 1, 1913 Years Baxter Dam $16,206.07 [50] Retaining wall north of Baxter Dam 470.64 [25] City reservoir, spillway over canal and head gates 2,507.39 33 1/3 Trash rack and raceway to penstock 1,140.22 33 1/3 Tailrace bulkheads 2,196.62 [50] Flush rack and flume 267.00 [50] Penstock and flume 5,079.79 [25] 4 water wheels and governor 3,316.96 [25] Mechanical transmission 696.60 [25] *1140 OPINION. BLACK: At the hearing of these proceedings, the parties entered into a stipulation by which it was agreed that the net income of petitioner for 1927, as shown by the deficiency notice, should be reduced $4,793.94 on account of certain repair expenses incurred by petitioner in that year, and that the net income of petitioner for 1928, as shown by the deficiency notice, should be increased by the sum of $1,049.84, being an adjustment made necessary by the allowance of $4,793.94 deduction from 1927 income. Effect should be given to this stipulation in a redetermination of the deficiencies. The remaining issues for our determination are: 1. Did the Commissioner err in disallowing as deductions for the years 1927 and 1928 alleged depreciation in the amounts of $17,585.76, and $13,341.13, respectively, or any part thereof? 2. Did the Commissioner err in not allowing additional depreciation on machinery and construction used in petitioner's power plant for both 1927 and 1928? 3. Did the Commissioner err in not allowing alleged losses in the aggregate amount of $71,019.08 for the year 1928? We will discuss these issues in their order. 1. On its income tax return*1141 for the year 1927 petitioner claimed depreciation of $30,710.15. Of this amount respondent allowed $13,124.39 and disallowed $17,585.76. On its income tax return for the year 1928, petitioner claimed depreciation of $28,024.71. Of this amount respondent allowed $14,683.58 and disallowed $13,341.13. Petitioner in his petition assigned as error this action of the Commissioner, but at the hearing offered no evidence showing or tending to show that the base or rates used, or the amounts of depreciation determined and allowed by the Commissioner for either of the years 1927 or 1928 on the property claimed by petitioner, were wrong *90 and, if so, what the correct base, rates and amounts should be. Therefore, the amounts determined and allowed by the Commissioner are presumed to be correct and should stand. ; . 2. and 3. But petitioner claims that it is entitled to additional depreciation other than that claimed in its returns filed for 1927 and 1928 on property which was used in its business during the tax years, but which was not carried as assets*1142 on its books, but was acquired by it from its predecessor, the partnership of Elmore Milling Company, and which was owned by said partnership on March 1, 1913, and had the value and remaining useful life on March 1, 1913, which we have found in our findings of fact. Before we discuss this contention of petitioner we must determine a very important factor in this case. Petitioner is only entitled to use the basis of cost (in this instance March 1, 1913, value) of its predecessor partnership, Elmore Milling Company, upon a showing that the transfer of assets from the partnership to the corporation, which took place January 2, 1926, was a nontaxable transaction under the Revenue Act of 1926. The same situation exists as to the losses claimed on bad debts transferred by the partnership to the corporation on that date. Petitioner has not shown the cost of the property in question to it at the time the partnership transferred it to the corporation, but has confined itself to showing the March 1, 1913, value of certain physical assets owned by the partnership on March 1, 1913, and the amounts of money advanced by the partnership on the several accounts on which losses are claimed. This*1143 is all well enough in the event petitioner is entitled to take the same basis of cost or March 1, 1913, value that its predecessor partnership would be entitled to take, were it before us. In such a case we have sufficient evidence before us to determine the depreciation deduction to which petitioner is entitled on the additional assets now being discussed and to determine the losses incurred by petitioner by reason of the bad debts charged off in 1928. But if petitioner is not entitled to take the same basis of cost or March 1, 1913, value that the predecessor partnership was entitled to take, then we must disallow petitioner any depreciation on the particular assets in question, because it has failed to offer any evidence as to the cost of such depreciable assets to petitioner, and we must also disallow the loss claimed on the bad debts in question to the extent of the amounts due at the time the debts were transferred to the corporation by the partnership, because petitioner has not offered any evidence of cost to the corporation of these debts at the time they were transferred to it by the partnership. It is the general rule under the Revenue Act of 1926 that the basis of*1144 depreciation *91 on assets acquired by a taxpayer after March 1, 1913, is cost. Likewise, the basis for loss on accounts and notes receivable and investments acquired after March 1, 1913, sold or otherwise disposed of, is cost. There are certain exceptions to this general rule. These exceptions are contained in sections 203 and 204 of the Revenue Act of 1926. If the facts in the instant case present an exception to the general rule above stated, it is because the transfer from the partnership to the corporation, which took place January 2, 1926, falls within the provisions of section 203(b)(4) of the Revenue Act of 1926, which reads: No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation and immediately after the exchange such person or persons are in control of the corporation; but in the case of an exchange by two or more persons this paragraph shall apply only if the amount of the stock and securities received by each is substantially in proportion to his interest in the property prior to the exchange. [Italics supplied.] If the foregoing section*1145 of the 1926 Act, as applied to the facts of the instant case, gives an exception from the ordinary rule governing the recognition of gain or loss, then petitioner is entitled to use the transferor's basis of cost or March 1, 1913, value in 1927 and 1928 in determining depreciation and losses, because section 204(a)(8) of the Revenue Act of 1926 reads: If the property (other than stock or securities in a corporation a party to a reorganization) was acquired after December 31, 1920, by a corporation by the issuance of its stock or securities in connection with a transaction described in paragraph (4) of subdivision (b) of section 203 * * *, then the basis shall be the same as it would be in the hands of the transferor * * *. To the same effect is section 113(a)(8) of the Revenue Act of 1928, which, of course, governs the taxable year 1928. It will be noted that there is a provision in section 203(a)(4) which says that the paragraph shall apply only in the event that the amount of the stock and securities received by each of the transferors is substantially in proportion to his interest in the property prior to the exchange. The transferors of the property in the instant case*1146 were the three partners of the Elmore Milling Company, viz., Edwin W. Elmore, Florence C. Elmore and Earl P. Elmore. Each of these transferors did not receive an amount of stock in the newly organized corporation, Elmore Milling Company, Inc., substantially in proportion to his interest in the property prior to the exchange. The evidence shows that 4,495 shares of stock were issued to Edwin W. Elmore, 500 shares to Earl P. Elmore, and 5 shares to Harry M. Goldsmith (not a partner). No shares of stock were issued to Florence P. Elmore, one of the partners making the transfer. Hence, we hold that petitioner has failed to prove that the *92 transfer of assets from the partnership to the corporation on January 2, 1926, was a nontaxable transaction under the quoted provision of the Revenue Act of 1926. This being true, it follows that petitioner is not entitled to take transferor's basis of cost for purposes of determining depreciation and the calculation of losses for the years 1927 and 1928 under the provisions of sections 204(a)(8) of the Revenue Act of 1926 and 113(a)(8) of the Revenue Act of 1928. If petitioner is not entitled to take depreciation and to calculate losses*1147 on the basis of cost to its transferor, the partnership, then the only basis on which these can be allowed is that of cost to petitioner. We have no evidence on that point. When debts are acquired by one person from another and subsequently have to be charged off as worthless, the basis is not the amount of the debts, but their cost to the taxpayer, and, there being no proof of such cost, no deduction, either as a loss or a bad debt, can be allowed. ; ; . We, therefore, hold that petitioner has failed to show itself entitled to take the additional depreciation claimed by it on certain depreciable assets owned by its predecessor at March 1, 1913, and to show itself entitled to take as losses or bad debt deductions the accounts hereinbefore referred to, to the extent of the amounts that existed at the time they were transferred to petitioner on January 2, 1926. To the extent that said accounts were increased by additional advancements made by petitioner, after it acquired them, the situation is different. The cost of these advancements*1148 would be the additional amount of money which petitioner expended, and we have evidence as to these amounts. Petitioner advanced on the G. H. Elmore personal account, after the transfer, $1,560; on the E. W. Rucker special account, $4,261.18; and on the Oneonta Storage Battery Co. investment account, $840.45. We will now take up these accounts and rule on them separately. The account carried as G. H. Elmore, personal, represented advancements made to G. H. Elmore with reasonable expectation that he would be able to repay same. A letter received from him in 1928 by petitioner was introduced in evidence, which shows that he recognized and admitted the validity of the debt and was making bona fide efforts to pay it. Petitioner's officers were in constant touch with the situation and had hopes of the ultimate success of G. H. Elmore's inventions, and did not lose such hopes until his breakdown in health in 1928, and his cessation from business activities, when they determined that the account was worthless and charged it off. To the extent of $1,560, this bad debt deduction should be allowed. *1149 . *93 What we have said above concerning the G. H. Elmore personal account largely applies to the E. W. Rucker special account. When Rucker quit the employment of Elmore Milling Company in 1924, he went with G. H. Elmore in the marketing of his various inventions and continued with him through the taxable years. As long as G. H. Elmore was in good health and active, there seemed to be some prospect that E. W. Rucker would be able to pay. True, E. W. Rucker was the son-in-law of E. W. Elmore, president of petitioner, and the brother-in-law of Earl P. Elmore, vice president of petitioner, and family transactions of this kind should be carefully scrutinized. That has been done in this case and we think the evidence is sufficient to show that these advances made to Rucker were not gifts, but loans, and that up until 1928, there was an expectation on the part of petitioner that it would be repaid these loans. We hold that the evidence is sufficient to show that petitioner ascertained that its E. W. Rucker special account was worthless in 1928, and that it charged the account off its books in that year. To the extent*1150 that the E. W. Rucker special account represented advances made to Rucker since petitioner began business in 1926, the deduction should be allowed. This deduction we find to be $4,261.18. . The Oneonta Storage Battery Company account represented loans for business purposes and did not represent gifts. E. W. Elmore was largely interested in it as a stockholder, as was petitioner, and the account represents an effort on their part to make the company and their stock investment a financial scuccess, and their hopes in that regard were not abandoned until the company went into bankruptcy in 1928, in which year the account was charged off. In , it was held that were during the taxable year there has been an identifiable event, such as bankruptcy, fixing the loss, the taxpayer is entitled to take the loss in that year. We hold that petitioner is entitled to a loss on the Oneonta Storage Battery Company investment account to the extent of $840.45 in 1928. Reviewed by the Board. Decision will be entered under Rule 50.