Forrester Box Co. v. Commissioner , 43 B.T.A. 657 ( 1941 )

FORRESTER BOX COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Forrester Box Co. v. Commissioner

Docket No. 93748.

United States Board of Tax Appeals

43 B.T.A. 657; 1941 BTA LEXIS 1473;

February 18, 1941, Promulgated

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1. In 1922 petitioner exchanged capital stock for certain depreciable assets. The transaction was held to be a taxable exchange in Forrester Box Co.,25 B.T.A. 128">25 B.T.A. 128, and is now res judicata. These assets were leased upon acquisition and thereafter some were sold on installments in 1929. One installment was received in 1935. The lease provided for the return of the assets in as good condition as when received, "reasonable wear and tear, * * * excepted." Held, petitioner's basis for determining gain on the sale is cost, which must be adjusted by depreciation sustained between date of acquisition and sale.

2. In the absence of evidence establishing the amount of depreciation by which petitioner's cost basis should be adjusted, respondent's determination of the amount of gain realized in 1935 on the 1929 installment sale of machinery and equipment is approved.

3. The amount of depreciation sustained on petitioner's buildings in 1935, determined.

John H. McEvers, Esq., Reece A. Gardner, Esq., and H. J. Plagens, Esq., for the petitioner.

Gene W. Reardon, Esq., for the respondent.

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ARNOLD

This proceeding involves income and excess profits tax deficiencies for 1935 in the amounts of $2,640.93 and $622.37, respectively. Two issues are presented, namely, (1) whether petitioner derived a capital gain of $12,000 from monthly installment payments on a 1929 sale of machinery and equipment; and (2) whether petitioner is entitled to a deduction of $4,729.71 representing depreciation of buildings used in its business.

The evidence of record consists of a voluminous stipulation of facts supplemented by exhibits and oral testimony. We adopt the stipulated facts as our findings of fact and hereinafter set forth a summary thereof, together with the other facts found.

FINDINGS OF FACT.

The petitioner is a Missouri corporation, with its principal office in Kansas City, Missouri. It was organized on December 5, 1922, for the purpose of acquiring a portion of the net assets of the Forrester-Nace Box Co. as of March 1, 1922, as hereinafter set forth.

The Forrester-Nace Box Co., hereinafter referred to as the Nace Co., was a Missouri corporation, organized on January 7, 1901. From 1901 to and including 1935 it was engaged in manufacturing and selling wooden boxes. Its principal place of business was located in Kansas City, Missouri. Prior to December 8, 1922, its 1,000 shares of common capital stock, par value $100 per share, were owned 50 percent by Bruce E. Nace, 25 percent by William S. Forrester, and 25 percent by D. Bruce Forrester, son of William S. Forrester.

Under date of December 15, 1921, a plan for the consolidation of various box companies, including the Nace Co., was perfected by certain individuals. The plan of consolidation provided for the creation of a new company, with Bruce Forrester as a member of its first permanent board of directors, which was to carry on the businesses conducted by the "Constituent Companies", nine in number, or such parts of said businesses as the new company should acquire as therein agreed and provided. The Nace Co. and two other companies were collectively referred to in the plan as "Lessor Companies", and it was agreed that:

* * * they shall respectively convey to the New Company all of their property and assets except their respective real estate (other than timber lands), buildings, and fixed machinery, and shall lease such real estate, buildings, and fixed machinery to the New Company under a lease containing substantially the following provisions:

(1) The basis upon which rent shall be paid and computed, hereinafter called the "rent base," shall be in the case of * * * [no amount specified for any of the three companies] * * * plus in either case an amount equal to any special assessment for improvements made subsequent to February 1, 1922, such increase to date from the time such special assessments are paid by the Lessor Company. The rental to be paid shall be an amount equal to seven per centum per annum upon the current rent base; and the obligation to pay the same shall be so phrased that it shall, so far as practicable, be of the same character as that of the New Company to pay dividends upon its preferred stock and enforcible paripassu therewith, and such obligation shall particularly be subject to all obligations of the New Company to any existing or future creditors; provided, however, that upon final termination of the lease or upon the exercise by the New Company of its right to purchase the leased property for cash there shall be immediately payable an amount equal to all rentals which would be payable if at such time the New Company should apply the whole of its undistributed net earnings to the payment of rentals upon such leases and of dividends upon its preferred stock. [Italics supplied.]

Under the plan the lessor companies had the right during the 10-year period of the lease to convey the leased property to the new company for class A preferred stock equal at par to the current rent base. The new company was given the right during the lease period to purchase the leased property for cash at a price equal to the current rent base plus accrued rent. The new company was to pay taxes, keep the leased property insured, in repair, and in good order. Upon termination of the lease the leased property was to be returned to the lessor companies in as good order as when received, reasonable wear and tear excepted. The lessee could change the machinery, install new machinery, and construct additional buildings, the fair value of the buildings to be paid by lessor upon termination of the lease. The lease period was 10 years from February 1, 1922, with the right to renew for a further period of 15 years upon the same terms.

In pursuance of the foregoing plan of consolidation the General Box Corporation was incorporated on March 15, 1922, under the laws of Delaware. On April 25, 1922, the General Box Co. was incorporated for the purpose of carrying out the plan of consolidation referred to above. The stock of the General Box Co. was acquired by the General Box Corporation.

On December 4, 1922, at a special meeting of the stockholders and directors of the Nace Co., resolutions were unanimously adopted providing for the reorganization of the company by separating its assets and creating a new corporation which was to own a part of the assets of the Nace Co. The directors were authorized and directed to incorporate a new company to be known as Forrester Box Co., petitioner herein, with a capital stock of $60,000, which stock was to be held 50 percent by Bruce E. Nace, 25 percent by William S. Forrester, and 25 percent by D. Bruce Forrester. The assets of the Forrester Box Co. were to consist of the real estate, described in the resolutions, with the buildings thereon, and also the open accounts of indebtedness owed by the three stockholders to the Nace Co., the indebtedness of other persons, and certain personal property thereafter to be determined. The Forrester Box Co. was to assume certain liabilities. The directors were authorized to make the transfers and conveyances and execute any instruments required to carry out the resolutions. After the creation of the Forrester Box Co. the capital stock of the Nace Co. was to be reduced from $100,000 to $40,000, the stockholders after the reduction to hold stock in the same proportion as prior thereto.

The petitioner was incorporated pursuant to the foregoing resolutions on December 5, 1922, as hereinabove set forth, and on December 7, 1922, it issued all of its capital stock, 600 shares, to Bruce E. Nace, William S. Forrester, and D. Bruce Forrester in the respective percentages of 50 percent, 25 percent, and 25 percent.

On December 7, 1922, the Nace Co. by warranty deed transferred to the petitioner certain parcels of land therein described, together with the building thereon and the equipment and fixed machinery therein contained. The property conveyed to the extent described in the deed is the same property described in the minutes of the Nace Co. of December 4, 1922.

On December 8, 1922, the Nace Co. and petitioner executed an agreement whereby in pursuance of the resolutions of December 4, 1922, the former transferred "all of its personal property, including book accounts and indebtedness of whatsoever kind or character, together with that certain fixtures, machinery and equipment * * *" to petitioner except certain specified items as of February 28, 1922, totaling $105,858.63. In "consideration of said conveyance and for the purpose of reorganization" the petitioner assumed and agreed to pay all obligations of the Nace Co. as disclosed by its books at the close of business February 28, 1922, except certain accounts payable amounting to $929.27 and reservation for state and Federal income taxes amounting to $9,916.44, all as referred to in an agreement dated December 8, 1922, between Bruce E. Nace, William S. Forrester, D. Bruce Forrester, the petitioner, and the General Box Corporation.

In the agreement last mentioned, which was entered into pursuant to the plan of consolidation, the three individuals, as owners of the remaining 400 shares of stock of the Nace Co., sold, assigned, and transferred their shares of stock to the General Box Co., the nominee and wholly owned subsidiary of the General Box Corporation, one of the parties to the agreement. In addition to their stock the individuals delivered the resignations of all directors and officers of the Nace Co. The consideration moving to the individuals was $21,000 par value of class A preferred stock, $95,000 par value of class B preferred stock, and 5,106 shares of the common stock of the General Box Corporation. The individuals agreed to cause petitioner, which also agreed for itself, to execute and deliver to the Nace Co. a lease of its box plant, machinery, and equipment. The General Box Corporation agreed to cause the Nace Co. to execute the lease and to make provision for the options granted therein to the lessor and lessee. The individuals guaranteed $27,320.72 of the assets of Nace Co. taken over by the wholly owned subsidiary of the General Box Corporation, and obligated themselves not to engage in the manufacturing or selling of shipping boxes or containers, with exceptions not here material.

On December 8, 1922, and presumably prior to the foregoing agreement, the three stockholders of the Nace Co. surrendered 600 shares of stock to that company for cancellation and redemption, which left the 400 shares outstanding that were transferred by the agreement last above referred to.

Pursuant to the agreement last mentioned, the petitioner, by a lease indenture dated December 8, 1922, leased its box plant, machinery, and equipment to the Nace Co. for 10 years from March 1, 1922. The rental fixed was $240,000, payable $2,000 per month. The Nace Co., as lessee, agreed to pay all current state, local, and other governmental charges, except special assessments, to carry insurance in favor of lessor, to keep the leased property in good repair, and to return it in as good order as when received, reasonable wear and tear excepted. The lessee was granted an option to renew the lease for a further period of 15 years upon the same terms.

In a supplemental agreement executed simultaneously with the lease indenture, the parties to the latter instrument agreed more specifically as to the manner and terms upon which the property was leased. The supplemental agreement, which superseded the lease indenture in case of conflict, specifically provided that the rental to be paid should be "an amount equal to the percentages hereinafter mentioned on the rent base as hereinafter provided", the obligation to pay the rental to be as far as practicable of the same character as that of the General Box Corporation's obligation to pay dividends on its preferred stock and enforceable pari passu therewith. The percentages and rent bases were fixed as 6 percent on $250,000 and 7 percent on $128,571.36, plus any additions as provide for in the supplemental agreement. At any time prior to the termination of the lease petitioner could convey "all, but not less than all", of the leased property to the lessee in exchange for class A preferred stock of the General Box Corporation. At any time during the lease period the Nace Co. could purchase "all, but not less than all", of the leased property for cash at a price equal to the then existing rent base plus unpaid accrued rentals.

In order to reflect the acquisition of the assets from the Nace Co., the assumption of liabilities of the latter, and the issuance of its capital stock, the petitioner made the following journal entries upon its books as of March 1, 1922:

Mar. 1, 1922:
Unissued stock		$60,000.00
Authorized capital stock			$60,000.00
To record the capital stock authorized by theArticles of Incorporation under date of December 5, 1922:
		Dr.	Cr.
Real Estate, Plant and Equipment		$417,666.79
Real Estate	$193,363.20
Buildings	113,543.88
Steam Power Plant	10,233.75
Electric power plant	11,544.75
Power Feed Wiring	1,802.30
Motors	7,594.88
Machinery	67,421.99
Extra Machinery	2,529.05
Machine Foundation	2,410.17
Dust Collector System	3,938.82
Pipe	2,047.66
Transmission	1,236.34
	417,666.79
		Dr.	Cr.
Suspended Accounts (see detail Ledger)		$3,338.05
K. C. Missouri River Navigation Co		1.00
Empire Development Company		55.30
Due from officers and stockholders		109,778.96
D. Bruce Forrester	$9,186.39
Wm. S. Forrester	13,164.89
Bruce E. Nace	45,611.25
Empire Acct	81,233.16
A. S. Malocsey	2,750.00
Bert Wood	200.00
Notes Receivable	19,000.00
Lassen Logging Co	2,694.44
Lassen Account	30,472.17
Overgaard Account	5,182.17
Christ Overgaard	28,406.83
	109,778.96
Sundry Advances		100.00
Cash surrender value, life insurance policy		2,209.27
To
Reserve for Suspended Accounts			$3,338.05
Forrester Nace Box Co			863.88
Notes Payable			13,000.00
Accrued Interest on Notes Payable			75.83
Paid in Surplus			108,769.00
Capital surplus			347,102.61
Forrester-Nace Box Co. Purchase a/c			60,000.00
To record Assets acquired and liabilities assumed from the Forrester Nace Box Company:
Forrester-Nace Box Co. purchase a/c	60,000
To
Unissued Capital Stock			60,000
To record the issue of 600 shares of a par value of $100 per share of capital stock of the company as authorized by the Board of Directors under date of December 4th, 1922, duly recorded in the Company's minute book.

Neither the Nace Co. nor any of its stockholders reported any gain or claimed any loss for Federal income tax purposes from the foregoing transactions consummated in 1922.

Pursuant to the lease indenture and supplemental agreement the Nace Co. immediately took possession of and used all the physical properties, particularly the land and buildings and all of the machinery and equipment leased to it by petitioner. D. Bruce Forrester was made president of the Nace Co. and general manager in charge of Kansas City operations, although he owned no stock in the Nace Co. As a stockholder of the petitioner he was interested in seeing that the machinery and equipment leased to the Nace Co. were kept in good repair. At his direction the Nace Co. made replacements and repairs to machinery and equipment of between $15,000 and $20,000 per year between 1922 and 1929. Said disbursements were considered business expenses by the Nace Co. and were never capitalized by petitioner.

Prior to July 1, 1929, the "cost to the Nace Company of the depreciable assets which were acquired by" petitioner in 1922 had been returned either to the Nace Co. or the petitioner through depreciation allowances.

On July 1, 1929, petitioner sold the machinery and equipment acquired from the Nace Co. in 1922 to the General Box Co. for $128,571.36, payable $25,285.91 in cash and credits and $103,285.45 in monthly installments of $1,000 each, commencing July 1, 1929, with interest on the unpaid balance. The 1922 lease and supplemental agreement were canceled and a new lease of the land and buildings, terminating in February 1947, was executed on July 1, 1929, by petitioner to the General Box Co. for a rental of $1,325 a month plus 6 percent per annum on any special assessments on the property. The General Box Co., as lessee, was granted the right to purchase "all but not less than all", of the leased premises for $265,000, plus any special assessments paid by petitioner. The General Box Co. took possession under said lease and remained in possession of the land and buildings throughout the calendar year 1935.

In its income tax return for 1929 the petitioner reported a net income of $38,139.40, which included a profit from the sale of machinery and equipment of $31,285.91, consisting of six monthly payments of $1,000 each plus the initial payment of $25,285.91. In schedule B of this return petitioner explained the profit reported on the sale as follows:

The company acquired the said machinery and equipment under a reorganization plan in December, 1922, from the Forrester-Nace Box Company and the value of the machinery and equipment was set up on the books of the company at $107,159.04, however since the machinery and equipment had been depreciated on the books of the predecessor corporation, the total sale price is considered as a profit. Under the installment sales provisions only that part of the sale price received in 1929 is reported as a profit.

In its income tax return for 1930 the petitioner reported the entire amount received in 1930 as taxable income.

In auditing petitioner's return for 1929 respondent determined that $14,979.69 of the $31,285.91 reported represented taxable gain. He allowed depreciation on the machinery and equipment in the sum of $3,322.79, and determined a net income of $17,110.92. Petitioner claimed no deduction for depreciation on the machinery and equipment in its 1929 return. The net income of the petitioner for 1929, exclusive of the gain, if any, on the sale of machinery and equipment, and without any deduction for depreciation on said machinery and equipment, was $5,454.02.

The assets sold by petitioner to the General Box Co. on July 1, 1929, and the lands and buildings leased by petitioner to the Nace Co. in 1922 were appraised by a nationally known and reputable appraisal engineering firm, on September 8, 1921. Their appraisal showed the "Replacement New Value" less "Accrued Depreciation", which gave a "Net Sound Value" for the various items of machinery and equipment in a total amount of $110,759.71. The "Net Sound Value" of land and buildings was fixed by the appraisal as $193,363.20 and $113,543.88, respectively. The "Net Sound Value" of machinery and equipment, land, and buildings totaled $417,666.79, and is more specifically set forth in the journal entries made on petitioner's books as of March 1, 1922, which are hereinabove set forth. On September 6, 1929, the same firm appraised the same machinery and equipment with replacements and repairs as having a "Net Sound Value" of $124,190.48.

The petitioner claimed, and was allowed, deductions for depreciation on the machinery and equipment leased to the Nace Co. for the taxable period March 1 to December 31, 1922, and the calendar years 1923 to 1928, inclusive, as follows:

1922	$441.51
1923	418.29
1924	418.29
1925	418.29
1926	197.51
1927	$0.00
1928	0.00
Total	1,893.89

On March 1, 1922, the buildings acquired by petitioner had an estimated useful life of 24 years, and would probably have no salvage value at the end of that time. On January 1, 1935 said buildings had an estimated useful life of 11 years, with no probable useful life at the end of that time.

The depreciation deductions claimed in petitioner's returns and allowed by respondent on the buildings from March 1, 1922, through 1934, except for 1932, were as follows:

Year	Amount claimed in return	Amount allowed by commissioner
1922	$2,414.10	$2,414.10
1923	2,896.94	2,896.94
1924	2,896.94	2,896.94
1925	2,896.94	2,896.94
1926	2,723.16	2,723.16
1927	0.00	0.00
1928	0.00	0.00
1929	$0.00	$4,631.97
1930	0.00	4,631.97
1931	5,677.19	5,677.19
1933	6,812.63	4,631.97
1934	6,812.63	4,631.97
Total	33,130.53	38,033.15

In 1932 petitioner reported a net loss of $6,179.86. In determining the net loss petitioner did not include in gross income any amount received by reason of the sale of its machinery and equipment, and it claimed a deduction for depreciation of its buildings of $6,812.63. The respondent made no investigation and accepted the return as filed.

During 1935 petitioner received twelve installment payments from the sale of its machinery and equipment, no part of which was included in its taxable income. In its return it reported a net income of $751.58 and claimed a deduction of $6,812.63 for depreciation of its buildings. For the taxable year petitioner had a net income, as that term is defined by the Revenue Act of 1934, exclusive of the gain, if any, realized upon the sale of machinery and equipment, and without any deduction for depreciation on its buildings, of $7,957.62.

The adjusted declared value of petitioner's capital stock for excess profits tax purposes was $60,081.81.

During all the times herein material petitioner kept its books and made its returns on the calendar year basis.

In determining the deficiencies the respondent disallowed the entire amount claimed as depreciation on buildings and increased income by $12,000 representing profit realized on the sale of machinery and equipment. Respondent refused to allow the depreciation deduction "for the reason that the value has been returned to you in depreciation allowances taken and allowed prior to 1935." Respondent fixed the depreciated value of buildings, land, machinery, and equipment on March 1, 1922, as $44,021.37, the value of other assets transferred at $140,551.36, and the amount of liabilities assumed as $42,346.54, which left net assets of $142,226.19, which respondent asserts were received by the three stockholders in redemption of $60,000 worth of stock, and resulted in a liquidating dividend of $82,226.19. Respondent's explanation of his disallowance of the depreciation deduction is in part as follows:

An inspection of the returns filed by the Forrester-Nace Box Company before its consolidation with the General Box Corporation on March 1, 1922, discloses that the land, buildings, machinery and equipment, the value of which you seek to establish, were paid over to the three stockholders prior to March 1, 1922, to redeem capital stock of $60,000.00. The Forrester Box Company was organized as a corporation on December 5, 1922, ten months after the assets had been transferred from Forrester-Nace Box Company. At the time of transfer the Forrester Box Company was not in existence as an entity. The stockholders of Forrester-Nace Box Company turned in to that company $60,000.00 worth of stock and agreed to assume certain liabilities. Ten months later the same individuals incorporated Forrester Box Company, turned in to the new corporation assets received from Forrester-Nace Box Company and received stock from the new corporation in the same proportions as they had held stock in the Forrester-Nace Box Company.

Respondent's explanation for adding the monthly installment payments to taxable income is in part as follows:

Insofar as the information before the Bureau shows, the three stockholders did not report profit on the liquidating dividends received in excess of the amount paid for stock nor did the Forrester-Nace Box Company report a profit on a sale to Forrester Box Company. The values shown on the balance sheet are the book values. It seems that instead of your being entitled to a stepped-up value the assets including notes and receivables, real estate, equipment, etc. should be reduced to $60,000.00, the amount paid for the stock surrendered by the stockholders. If the lessee had during the years 1922 to 1929 made such extensive replacements as to create a value of $128,571.36 on machinery which at the end of February, 1922, was included in a book value of $44,021.37 for land, buildings, equipment, etc., and which assets together with receivables and investments were turned over to the stockholders for $60,000.00, it would seem that the entire profit is taxable, Consequently, the entire amount received in 1935 has been included in taxable income, since the entire cost had been returned to you in depreciation allowances taken and allowed prior to 1935 and the basis to you at the time of the sale was zero.

In 1923 petitioner sold the account receivable designated "B. E. Nace and D. Bruce Forrester-Empire Development Company" which it received from the Nace Co. in 1922. In its 1923 income tax return petitioner claimed a deduction for loss of $102,449.47 upon the sale of said account. This deduction was disallowed by respondent. Petitioner appealed to the Board, which affirmed respondent's determination, Forrester Box Co,25 B.T.A. 128">25 B.T.A. 128. No appeal was ever taken from the decision of the Board entered January 12, 1932, and the decision became final.

OPINION.

ARNOLD: The petitioner contends that it realized a gain in 1935 of not more than $176.76, which represents a proportionate part of the total depreciation of $1,893.89 on machinery and equipment allowed petitioner prior to the sale thereof. Petitioner further contends that it is entitled to a deduction for depreciation on its buildings during 1935 of $3,853.76, which is less than the amount claimed in its petition.

Petitioner's contentions are grounded upon the premise that its basis for computing gain on the sale and its basis for computing depreciation on its buildings are the fair market values of these assets when acquired. Petitioner fixes the fair market value of the machinery and equipment when acquired at $128,571.36; it contends that this value or basis should be adjusted by the depreciation allowed petitioner prior to the sale totaling $1,893.89, which gives an adjusted basis for gain or loss of $126,677.47. The sale price on July 1, 1929, being the same as the alleged fair market value of the assets when acquired in 1922, the gain admitted by petitioner equals the total amount of depreciation previously allowed.

The basis for depreciation of the buildings is fixed by petitioner at $92,490.43, with a stipulated life of 24 years. Petitioner arrived at the basic value by allocating the agreed value of land and buildings, $250,000, in accordance with the appraised values of the land and buildings fixed by appraisal engineers on September 8, 1921. ^{*1495 and relies upon our decisions in Briggs-Darby Construction Co.,41 B.T.A. 136">41 B.T.A. 136, where we denied petitioners a stepped-up basis for depreciation of machinery and equipment, and Paradox Land & Transport Co.,23 B.T.A. 1229">23 B.T.A. 1229, where we held that the basis for depreciation was the transferor's cost.}

The opposing contentions squarely present the question of whether the 1922 transaction was a taxable exchange. With respect to this question petitioner urges that the character of the 1922 exchange is res judicata under the Board's decision in Forrester Box Co., supra. In that case we held, in determining the basis for gain or loss on the sale in 1923 of one of the assets acquired in the 1922 exchange, that the assets were purchased from the Nace Co., payment being made therefor with petitioner's capital stock. We denied petitioner any loss on the sale because there was "no evidence in the record to show the value of the stock paid for the" asset.

Petitioner has specifically pleaded that our decision in the foregoing proceeding has become final and that said decision is res judicata of the following determinations: (1) That petitioner acquired the assets in exchange for its capital stock; (2) that said exchange constituted a purchase; (3) that the property was not acquired by petitioner pursuant to a reorganization within the meaning of section 202, Revenue Act of 1921; and (4) that the cost of the property to petitioner was the fair market value of the stock issued in exchange therefor.

In our opinion petitioner's plea that respondent is estopped by the decision in the former proceeding to reexamine the character of the 1922 exchange is well founded, Bennett v. Commissioner, 113 Fed(2d) 837. In its opinion in the latter case the Fifth Circuit, speaking with regard to the plea of res judicata, said:

For, the rule of res judicata does not go on whether the judgment relied on was a right or a wrong decision. It rests on the finality of judgments in the interest of the end of litigation and it requires that the fact or issue adjudicated remain adjudicated. It, in short, is that one, who has permitted a final judgment to go against him, is estopped, by that judgment, from contending elsewhere, against the parties to it and their privies that the fact or issue is otherwise than as there adjudged.

See also Tait v. Western Maryland Railway Co.,289 U.S. 620">289 U.S. 620; Leininger v. Commissioner, 86 Fed.(2d) 791; and Pryor & Lockhart Development Co.,34 B.T.A. 687">34 B.T.A. 687.

Since respondent is estopped from again litigating the character of the 1922 exchange, the evidence adduced to establish the fair market value of the assets exchanged for stock must be considered. Accepting the recognized rule that the fair market value of property is the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, the petitioner argues that both parties to the 1922 exchange had full knowledge of the value of the assets. Petitioner asserts that it and the Nace Co. agreed in 1922 that the fair market value of the lands and buildings was $250,000 and that the fair market value of the machinery and equipment was $128,571.36. It is pointed out that these values were agreed upon for the purpose of fixing the rent base and also to fix the purchase price under the options granted in the lease indenture and the supplemental agreement thereto. In addition to the documentary evidence the petitioner offered the testimony of D. Bruce Forrester, who testified that the foregoing amounts were the agreed fair market values between the contracting parties, petitioner and the Nace Co.

The values agreed to for rental purposes and the price fixed at which the assets could be purchased for cash by the lessee or conveyed for preferred stock by the lessor are somewhat less, in the aggregate, than the appraised values fixed by the appraisal engineers on September 8, 1921. But the inferences to be drawn therefrom are more favorable than opposed to petitioner's contentions, since petitioner does not assert that cost of replacement new, less accrued depreciation, is the equivalent of fair market value. Petitioner's position is that the exchange was an arm's length transaction, and, that being so, the values fixed by the contracting parties are the best proof of fair market value. The decided cases support the latter proposition, Kitrell v. United States, 79 Fed.(2d) 259, 260; Andrews v. Commissioner, 38 Fed.(2d) 55, 56; John J. Flynn,35 B.T.A. 1064">35 B.T.A. 1064, 1067; and, since the facts herein establish that the Nace Co. and the petitioner were separate and distinct corporate entities, with separate and distinct stockholding groups, it is a fair inference that each corporation negotiated for its own best advantage.

Respondent has offered no evidence in opposition to petitioner's proof that the fair market value of the assets was the agreed value proof that the fair market value of the assets was the agrred value between the parties. His cross-examination of petitioner's witness did not weaken the valuation placed by the witness on the depreciable assets. Even granting respondent's assertion that the witness was interested in the pending proceeding, something more than interest is required to destroy the effect of testimony given under oath. The testimony of value here given, it must be remembered, is supported by the purchase price agreed upon by the contracting parties with respect to the possible future sale or purchase of the leased assets. It is our opinion, therefore, that petitioner has established that the cost of the property to it was the value of the stock issued therefor, and that the value of the stock is to be measured by the value of the assets behind it.

With respect to the machinery and equipment the fair market value is $128,571.36, but the fair market value of the land and buildings, $250,000, must be allocated between the land and the buildings. Petitioner proposes that the allocation be made in accordance with the appraised values for land and buildings fixed by appraisal engineers on September 8, 1921. The witness testified that this appraisal was made to establish the value of the properties for the purpose of leasing or renting the same, and to fix the sale price under the options granted the lessor and lessee in the supplemental agreement. True, the agreed rental base and the agreed optional purchase price as to land and buildings were less than their total appraised values, but we agree with petitioner that such values may be used to allocate the fair market value. Such an allocation gives a fair market value for the buildings in 1922 of $92,490.43 which, with a useful life of 24 years, gives an annual depreciation deduction on the buildings of $3,853.76. Since both the aggregate amount of depreciation on buildings claimed by petitioner and allowed by respondent is less than the aggregate amount allowable for the period March 1, 1922, to December 31, 1934, petitioner is entitled to an annual depreciation deduction on its buildings for 1935 and each year thereafter of $3,853.76.

Having determined that the basis to petitioner of its machinery and equipment is cost, the next question is the amount of gain realized from the sale thereof on July 1, 1929. Petitioner claimed it was allowed depreciation of $1,893.89 from 1922 to 1929, and it insists that its adjusted cost base is $126,677.47 ($128,571.36-$1,893.89). Petitioner contends that, contrary to general experience, its leased machinery and equipment did not depreciate in value during the time it owned the assets and that, therefore, its only gain from the sale is the amount of depreciation claimed and allowed.

In answer, no doubt, to the requirements of section 111(b)(2) of the Revenue Act of 1928, ^{allowable since the acquisition of the property, the petitioner introduced evidence to show that no depreciation of machinery and equipment in excess of $1,893.89 was claimed or resulted while it owned the property for the reason that the Nace Co. expended $15,000 to $20,000 a year in replacement and repairs. It is asserted that these expenditures not only arrested exhaustion, wear, and tear of the property, but actually increased the value thereof, so that said machinery and equipment were more valuable in 1929 than when acquired in 1922.}

Petitioner further asserts that it is well settled that to be entitled to depreciation one must not only own an interest in property, but must also establish a present actual loss. *1503 because at any time during the lease period it had the right to require the lessee to purchase the property for $128,571.36 of class A preferred stock of General Box Corporation, which fact, it is asserted, pegged the salvage value of the machinery and equipment at $128,571.36. Furthermore, since the difference between cost and salvage value at the end of the useful life of the property is the only amount that may be depreciated under the Treasury Department's regulations (Regulations 101, art. 23(1)-1), petitioner contends that it sustained no actual loss during any year.

Petitioner also points out that its evidence shows conclusively that there was no loss sustained by depreciation since the General Box Co. paid $128,571.36 for the property in 1929. Petitioner urges that this is not unusual because the Board and the courts have held in numerous instances that "where a lessee agrees to and does maintain, repair, and replace the leased property to the extent that no actual loss falls upon the lessor, no deduction for depreciation is allowable", and in support thereof petitioner cites numerous authorities. *671 The other evidence which petitioner says conclusively shows that no loss was sustained by reason of depreciation in value consists of the appraisals in 1921 and 1929, and the testimony of D. Bruce Forrester.

Petitioner's argument that its cost basis should be adjusted only by the depreciation allowed, and not by the depreciation allowable, is untenable. The rule is established by United States v. Ludey,274 U.S. 295">274 U.S. 295, and many other cases, that the base must be reduced by the aggregate amount of depreciation sustained in order to determine the gain or loss resulting from the disposition of a depreciable asset. Machinery and equipment used in production become exhausted and worn regardless of replacements, repairs and improvements. As parts are replaced or improvements are added, the depreciation shifts from the old to the new. In the final analysis petitioner's argument is that appreciation, together with repairs, replacements and improvements, have offset and prevented any actual loss through depreciation.

We can not agree. In our opinion each annual rental payment from the Nace Co. represented a partial recovery of petitioner's investment in the leased machinery and equipment. The expenditures of the Nace Co. had for their purpose the maintenance of the operating efficiency of the box factory. Whether such expenditures resulted in an appreciation in value of petitioner's property is immaterial, because the nature of the assets involved was such that they gradually became exhausted from use. No amount of appreciation in value, which grows out of extrinsic causes, will prevent the exhaustion, wear, and tear which result from the continuous use of machinery and equipment. Petitioner's argument that depreciation in this instance has been offset by appreciation is not therefore convincing. Even Realty Co,1 B.T.A.355.

Neither are we persuaded that petitioner's situation is similar to those in Atlantic Coast Line Railroad and the Cincinnati Gas & Electric Co., or the other cases hereinabove referred to. The lease indenture executed by this petitioner only required the lessee to "keep all of the leased property in good order and repair," and to return it upon termination of the lease "in as good order as when received, reasonable wear and tear, * * * excepted." This lease indenture contemplated that exhaustion, wear, and tear of the machinery and equipment would be borne by petitioner. No obligation to make good the depreciation was imposed on the lessee by the indenture. In the cases cited there was a specific obligation placed on each lessee to maintain, repair, and replace the depreciable assets so that they would be returned in as good condition as when received and, accordingly, the decided cases denied the owner-lessors any depreciation deductions.

The probative effect of the appraisals and the oral testimony is to corroborate the appreciation in value resulting from the repairs, replacements, and improvements made between 1922 and the date of sale. The appraisal values represent the fost of reproduction new, less accrued depreciation, which would give effect to extrinsic forces. The oral testimony likewise corroborates the appreciated value of the machinery and equipment when sold. It must be remembered, however, that the sale on July 1, 1929, established this fact by fixing the amount of appreciation that petitioner would realize. prior thereto any appreciation in value might have been wiped out by competition, by progress in the art, by fear of invasion, by a business depression, or by some other extrinsic cause. Even Realty Co., supra.

The petitioner converted the appreciated value of its machinery and equipment into a money obligation against the General Box Co. for $128,571.36 on July 1, 1929. A portion of this obligation was paid on July 1, 1929, and the balance was due in monthly installments of $1,000 each. The problem is what part of the $12,000 received in 1935 represented a return of investment and what part represented realized appreciation. Respondent determined that the entire $12,000 was income and no part thereof a return of investment. The burden of proof rests upon the petitioner to show what part, if any, was a return of capital, and what part was income. If it fails to sustain this burden respondent's determination must be approved.

In our opinion the petitioner has failed to sustain its burden of proof. We are satisfied that exhaustion, wear, and tear of the leased equipment resulted from the use thereof by the lessee, but the amount of such exhaustion, wear, and tear is not disclosed by the record. Petitioner attempted to limit the amount of depreciation sustained to $1,893.89, the amount allowed, but this gives no consideration to the amount allowable. When it is recognized that this small amount covers depreciation on $128,571.36 of machinery and equipment over a period of seven and one-half years, the weakness of petitioner's position is at once apparent. Failure to establish some reasonable allowance for depreciation leaves us no alternative but to approve respondent's determination.

The stipulated taxable income of $7,957.62 for 1935 should be adjusted by the gain realized on the sale and the depreciation sustained on its buildings, and the deficiency recomputed accordingly.

Decision will be entered under Rule 50.

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Footnotes

• 1. Appraisal values, land $193,363.20, plus buildings, $113,543.88, equals $306,907.08; $113,543.88/$306,907.08 equals 36.99617 percent; 36,99617 percent of $250,000 equals $92,490.43. ↩

• 2. (b) ADJUSTMENT OF BASIS. - In computing the amount of gain or loss under subsection (a) -

  * * *

  (2) The basis shall be diminished by the amount of the deductions for exhaustion, wear and tear, obsolescence, amortization, and depletion which have since the acquisition of the property been allowable in respect of such property under this Act or prior income tax laws: * * * ↩

• 3. Weiss v. Wiener,279 U.S. 333">279 U.S. 333; Commissioner v. Terre Haute Electric Co., Inc. (C.C.A., 7th Cir.), 67 Fed.(2d) 697; certiorari denied, 292 U.S. 624">292 U.S. 624; Georgia Railway & Electric Co. v. Commissioner (C.C.A., 5th Cir.), 77 Fed.(2d) 897; certiorari denied, 296 U.S. 601">296 U.S. 601; Terre Haute Electric Co.,33 B.T.A. 975">33 B.T.A. 975; affirmed on this point, 96 Fed.(2d) 383↩.

• 4. Atlantic Coast Line Railroad Co. v. Commissioner (C.C.A., 4th Cir.), 81 Fed.(2d) 309; Cincinnati Gas & Electric Co. v. Commissioner,36 B.T.A. 1122">36 B.T.A. 1122; appeal dismissed (C.C.A., 4th Cir.), 105 Fed.(2d) 1016; Mississippi River & Bonne Terre Railway,39 B.T.A. 995">39 B.T.A. 995; Commissioner v. Terre Haute Electric Co. (C.C.A., 7th Cir.), 67 Fed.(2d) 697, affirming on this point, 24 B.T.A. 197">24 B.T.A. 197; Nashville, C. & St. L. Ry. Co. v. United States (C.C.A., 6th Cir.), 269 Fed. 351; A. Wilhelm Co.,6 B.T.A. 1">6 B.T.A. 1↩.