Inecto, Inc. v. Commissioner ( 1930 )

INECTO, INCORPORATED, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Inecto, Inc. v. Commissioner

Docket No. 40375.

United States Board of Tax Appeals

20 B.T.A. 566; 1930 BTA LEXIS 2087;

August 14, 1930, Promulgated

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The Commissioner's disallowance of a deduction under section 234(a)(7) approved where the cost of a secret formula on which the allowance is claimed does not appear.

John Wallace Young, Esq., for the petitioner.

Elden McFarland, Esq., for the respondent.

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MURDOCK

The Commissioner determined a deficiency for the year 1924 of $5,984.83 and an overassessment for the year 1925 in the amount of $1,371.88 in the petitioner's income taxes. The petitioner alleges that the Commissioner erred in disallowing in each of these years a deduction of $15,000 as depreciation on a formula. Upon motion of the respondent the appeal for the year 1925 was dismissed for lack of jurisdiction. Most of the facts were stipulated.

FINDINGS OF FACT.

The petitioner, a Delaware corporation, with its principal office in New York City, is engaged in the manufacture and sale of hair dyes. It began operations on August 1, 1923.

In or about the month of May, 1923, Ralph L. Evans, without cost or expense, invented a certain secret formula or process applicable to hair dyes. He then sought to acquire the hair dye business being conducted by Inecto, Incorporated, a New York corporation, all of the capital stock of which was owned or controlled by Phillip W. Ducker.

As the result of negotiations between Evans and Ducker relative to the purchase by Evans and the sale by Ducker of the hair dye business, Ducker caused a corporation to be organized under the laws of the State of Delaware bearing the name of Inecto, Incorporated (the petitioner herein).

On or about July 28, 1923, and in furtherance of the purchase and sale arrangement above mentioned, Inecto, Incorporated, of New York, transferred and conveyed all its assets to the petitioner and in consideration thereof the entire authorized capital stock of the petitioner, to wit, 1,000 shares, were issued and delivered to Inecto, Incorporated, of New York.

At a meeting held August 28, 1923, at which all of the parties interested in the transaction were present, the following took place:

Evans, his attorney Gordon, and Phillips, who was Gordon's assistant, were elected officers of the petitioner corporation. Evans offered to transfer and deliver to the petitioner corporation his secret process or formula applicable to hair dyes. The petitioner corporation, by resolution of its board of directors, Evans not voting, accepted the offer and authorized the pledging of its accounts receivable in the amount of $100,000 odd to secure a loan from the Manufacturers' Finance Co. of Baltimore, Md., in the amount of $75,000. The Manufacturers' Finance Co. delivered to the petitioner, as a loan, its certified check for $75,000 and took as security the pledging of the accounts receivable of the petitioner in the amount of $100,000 odd, and in addition the personal guarantee of Evans as an individual. The check was then endorsed as follows:

Pay to the order of

Ralph L. Evans

Inecto Inc. a

Delaware Corp.

By Neal R. Andrews

Mgr.

Gordon Gordon,

V. Pres.

Pay to the order of

Inecto Inc. a

N.Y. Corporation

Ralph L. Evans.

The check was handed to Evans by Gordon, who had already prepared thereon the endorsement to the New York corporation. Evans thereupon endorsed the check and returned it to Gordon, who then delivered it to Bell, the attorney for the New York corporation. Bell, acting for the New York corporation, handed over to Gordon, as attorney for Evans, a certificate duly endorsed in blank for the entire capital stock of the petitioner corporation. The check was subsequently deposited to the credit of the New York corporation, and in the due course the amount of the check was paid out and distributed by that corporation in liquidation to Phillip W. Ducker, the sole stockholder. The stock certificate received from the New York corporation was thereafter canceled and a new certificate for the entire capital stock of the petitioner corporation issued to Evans under date of August 28, 1923.

It was not the intention of the parties that Evans was to have any control over the check. He was to transfer his formula to the petitioner corporation, and although the check was first endorsed to him, it was not intended that he was to receive anything except all the stock of the petitioner corporation. Ducker was unwilling to part with control of the corporation unless simultaneously he received $75,000 by means of this indirect method. It had been suggested that the check be endorsed directly to the New York corporation, but Ducker's attorney said that the only way he would part with the stock was to part with it for a check made payable to Evans personally and endorsed by him to the New York corporation.

Beginning in May, 1924, the petitioner manufactured hair dye under the secret formula acquired from Evans. Evans and others connected with the petitioner were constantly experimenting and trying to improve the hair dye and the formula under which it was manufactured. Changes were made in the formula from time to time, and by 1928 it had been virtually replaced by a new formula.

Some time in 1924, probably in December, the formula was entered upon the books of the petitioner at $70,000, and depreciation of $15,000 was charged off for that year and claimed as a deduction from gross income. The Commissioner disallowed the deduction with the following explanation:

Your contention relative to the cost of formula for depreciation purposes has been denied since the formula was acquired for capital stock and the cost to the transferor was nothing in accordance with Sections 203(4) and 206(6) of the Revenue Act of 1926.

OPINION.

MURDOCK: If the petitioner is entitled to any deduction under section 234(a)(7) of the Revenue Act of 1924, the allowance must be based on the cost of the property to the petitioner. It contends that it paid Evans $75,000 for the formula on July 28, 1923, at which time the probable useful life of the formula was not more than five years. The facts, however, contradict this contention. Ducker owned the New York corporation and wanted $75,000 in cash for his interests. The petitioner, with the understanding that all of its capital stock theretofore issued to the New York corporation would be transferred to Evans, borrowed $75,000 and endorsed the check for this amount to Evans, who in turn endorsed it to the New York corporation. Evans received all of the stock of the petitioner, and at the same time the petitioner received the formula. It therefore contends that the formula cost it $75,000.

Inasmuch as Evans one moment owned the formula and the next owned all of the stock of a corporation which owned the formula, the fact that the corporation paid out $75,000 and got nothing but the formula loses much of its significance. Moreover, it nowhere appears that the petitioner either paid or agreed to pay $75,000 or any part thereof, solely for the formula. But it affirmatively appears that the $75,000 was paid for an entirely different purpose, namely, to enable Evans to buy out Ducker.

This same transaction was before this Board in the case of , where we held that under section 202(c)(3) of the Revenue Act of 1921, Evans realized no taxable income upon the transfer of this formula to the petitioner. In that case Evans alleged that he never had any personal right to or claim upon the check for $75,000, but it was understood and agreed between all the parties concerned, that the method used in handling the check and the value of $75,000 assigned to the formula were merely means to an end, "to wit, for the purpose of meeting the terms of the agreement between the taxpayer [Evans] and the owner of said shares of said Inecto, Inc. of Delaware, and of utilizing the taxpayer's ownership and control of said hair dye formula for the purpose of acquiring said Inecto hair dye business." In the opinion, the Board stated:

The petitioner at no time had any proprietary right in the check for $75,000. He had no right to use and employ it as his own. * * * It was not intended that Evans was to have any control over the check. He was to transfer his formula to the Delaware corporation and although the check was first endorsed to him, it was not intended that he was to receive anything except all of the capital stock of the Delaware corporation.

In the present case, Evans testified that, in arriving at the amount of $75,000, no consideration was given to the value of the formula, but that he was merely seeking to provide a means to pay Ducker. Where a deduction under section 234(a)(7) is based on cost, the value of the property purchased usually makes no difference. But if value has any materiality, at any rate, there is no proof or suggestion of the value of the formula. Throughout the transaction the value of the formula was ignored and, furthermore, there was not, so far as concerns the acquisition of the formula, an arm's-length transaction between persons having opposite interests. Under such circumstances, how can it be said that the petitioner paid $75,000 for the formula? In our opinion it is impossible from this record to determine the cost, if any, of the formula to the corporation. Cf. ; affd., . Further discussion is unnecessary, as the petitioner must lose in any event.

Judgment will be entered for the respondent.