Algernon Blair, Inc. v. Commissioner , 29 T.C. 1205 ( 1958 )

Algernon Blair, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent

Algernon Blair, Inc. v. Commissioner

Docket No. 62096

United States Tax Court

29 T.C. 1205; 1958 U.S. Tax Ct. LEXIS 220;

March 31, 1958, Filed

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Decision will be entered under Rule 50.

1. Petitioner, a general contractor, filed a consolidated return for 1953 with two wholly owned subsidiaries, Forest Hills and Loxley Annex. Petitioner reported its income on the completed contract method. Under that method it accumulated its revenues and costs (which it considered attributable to a contract) and reported the difference as gross profit or loss in the year of completion of the contract. It deducted the general expenses, which it did not consider attributable to any specific contract, currently, in the year in which incurred. During 1953, it completed nine contracts, including one each for Forest Hills and Loxley Annex. The subsidiaries held the housing projects completed under the contracts for rental purposes. In computing its net income for consolidation purposes the petitioner eliminated as "unrealized profit" the gross profit realized on the contracts with the subsidiaries. Respondent determined that only the net profit should be eliminated and computed the net profit by allocating the petitioner's general expenses for 1953 to all of the contracts on a gross profit basis and deducted the amount so allocated from the gross profit on each contract. Held, that the respondent's determination is erroneous and that the amount to be eliminated as unrealized profit is the gross profit less any other expenses reasonably related or incidental to the performance of the contracts.

2. Forest Hills and Loxley Annex treated the entire cost of their housing projects, except the basic cost of the land, as depreciable costs. The respondent determined (1) that the cost of clearing, grading, and landscaping should be added to the cost of the land and treated as nondepreciable; (2) that the cost of streets, curbs, sidewalks, sewers, and water mains, which were turned over to the local government units for maintenance purposes and dedicated to the public use, is not depreciable since the petitioner did not have a depreciable interest therein; and (3) that a portion of the indirect construction costs should be allocated to the basic land cost and treated as nondepreciable. Held, that except for certain concessions made by respondent and certain adjustments made herein the respondent's determination is sustained.

H. Cecil Kilpatrick, Esq., for the petitioner.

Lester R. Uretz, Esq., for the respondent.

Black, Judge.

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BLACK

The respondent has determined deficiencies in income and excess profits tax in the amounts of $ 7,518.58 for the year 1952 and $ 162,444.99 for the year 1953.

Petitioner filed a consolidated return with Forest Hills, Inc., a wholly owned subsidiary, for the year 1952 and with Forest Hills, Inc., and Loxley Gardens Annex, Inc., another wholly owned subsidiary, for the year 1953.

The deficiency for 1953 is due to two adjustments explained in the notice of deficiency as follows:

(a) It is determined that you are entitled to a depreciation deduction on the depreciable assets of Forest Hills, Inc. and Loxley Gardens Annex, Inc. in the amount of $ 110,158.68, as shown on Exhibits A and B attached. Inasmuch as the amount of $ 133,195.07 was claimed on the return filed by you for the year 1953 the difference of $ 23,036.39 is added to your income.

(b) It is determined that the profit realized on contracts completed during the year 1953 which were performed for Forest Hills, Inc. and Loxley Gardens Annex, Inc. amounts to $ 192,598.92. Therefore, the amount of $ 192,598.92 should be eliminated as intercompany profits on the consolidated return filed by you with Forest Hills, Inc. and Loxley Gardens Annex, Inc. Inasmuch as you eliminated $ 447,463.17 as intercompany profits, the difference of $ 254,864.25 has been added to the income reported in your return for the year 1953.

The deficiency for 1952 is due to the respondent's determination that petitioner is not entitled to an excess profits credit carryback. The 1952 adjustment is wholly dependent upon the results reached on the issues involved for 1953. Any adjustments necessary can be made under Rule 50.

By virtue of the pleadings the entire deficiencies are in issue.

FINDINGS OF FACT.

A stipulation of facts has been filed and is incorporated herein by this reference.

Algernon Blair, Inc., hereinafter referred to as petitioner, is a corporation organized under the laws of the State of Alabama on July 3, 1951. Forest Hills, Inc., hereinafter sometimes referred to as Forest Hills, a wholly owned subsidiary of petitioner, was incorporated under the laws of the State of Florida on December 24, 1951. Loxley Gardens Annex, Inc., hereinafter sometimes referred to as Loxley Annex, a wholly owned subsidiary of petitioner, was incorporated under the laws of the State of Virginia on March 27, 1953. Petitioner filed a consolidated income tax return with Forest Hills for the calendar year 1952 and a consolidated income tax return with Forest Hills and Loxley Annex for the calendar year 1953 with the director of internal revenue for the district of Alabama.

Issue 1. Intercompany Eliminations.

Petitioner is a general contractor engaged in the building construction business. It was organized by Algernon Blair, hereinafter sometimes referred to as Blair, who died in 1952 and who had for many years, as sole proprietor, engaged in the same business with many of the same employees.

Blair had for many years reported his income from the business on the completed contract basis. The petitioner reported its income for its first taxable period ending December 31, 1951, and for the years 1952 and 1953 on the completed contract basis. Respondent does not question petitioner's right to so report.

Under this method of accounting, the petitioner reported its gross profit from each contract in the year in which the contract was completed. Its gross profit on each contract was computed by deducting from the contract price (all receipts derived from the contract regardless of the period in which received) the total costs (during the life of the contract) which the petitioner considered directly related to the contract. The petitioner treated preliminary costs of securing a contract, on-the-job labor costs, cost of material used on the job, cost of subcontract work, and cost of on-the-job overhead, as direct costs relating to the contract.

From the gross profit on contracts completed during the year, the petitioner deducted all general expenses incurred during the year. It did not allocate these expenses to the separate contracts. Its general expenses consisted of expenses which it did not consider to be directly related to the performance of any specific contract and which it did not consider to be properly attributable to any specific contract. These expenses included, inter alia, the following:

1. Salaries of home office employees in Montgomery. Home office employees included engineers, clerks, bookkeepers, accountants, secretaries, and stenographers.

2. Salaries of officers.

3. Salaries of project managers. The petitioner had four project managers who performed their work at the home office in Montgomery. Each one was usually in charge of a number of projects at the same time and during each year. They performed such work as bidding for contracts, purchasing materials, hiring personnel, and supervising the project superintendent.

4. Bonus. In 1928, Blair, by agreement with his employees, established a bonus plan which was followed by him at all times thereafter and was carried on by the petitioner. Under this plan, each year 40 per cent of the net profits before taxes was distributed among all persons employed for a year or more, regardless of the type of work in which they were engaged. The amount allocated to each individual was fixed by Blair or his general manager during the existence of the sole proprietorship, and by the petitioner's president during the taxable years. The amount was based upon a consideration of the employee's loyalty, length of service (which, for 1952 and 1953, included service for the proprietorship as well as the corporation), his ability to get along with others, and his leadership. The amount paid an employee did not depend upon whether he was working or had worked on profitable or unprofitable contracts.

5. Expenses of unsuccessful estimating and bidding for contracts.

6. State income taxes.

7. Other general expenses of the home office, including legal and accounting fees, telephone, travel, donations, interest, insurance, postage, dues, subscriptions, and depreciation on office equipment.

During the year 1952, petitioner completed two construction contracts. Petitioner's net income as reported on its 1952 income tax return was as follows:

Gross profit
Fred Neymeyer Warehouse	$ 10,989.89
Mansion Homes	285,569.27
		$ 296,559.16
Expenses
Salaries and bonuses	130,646.16
General expense	27,575.50
Interest paid	924.93
Contributions	542.00
Building expense	124.33
Taxes	3,438.77	163,251.69
Net income (before net operating loss deduction)		133,307.47

Forest Hills did not earn any income during the calendar year 1952. Four contracts with accumulated costs amounting to $ 7,311,289.34 were incomplete at December 31, 1952. Included therein was the Forest Hills contract which had costs incurred of $ 2,958,252.64.

During the year 1953, petitioner completed nine construction contracts which included two completed for wholly owned subsidiaries. Petitioner's net profit as reported on the 1953 consolidated return was as follows:

	Job estimate	Job cost	Job profit
Gross profit:
Loxley Gardens Annex, Inc	$ 1,099,132.06	$ 961,308.54	$ 137,823.52
Forest Hills, Inc	4,091,117.20	3,781,477.55	309,639.65
Other contracts 9,038,272.86	8,336,171.91	702,100.95
Recoveries from prior year jobs	2,266.58		2,266.58
Total	14,230,788.70	13,078,958.00	1,151,830.70
Other income			36,930.21
Total gross income			1,188,760.91
General office expenses:
Salaries		211,842.08
Bonuses		355,828.00
Preliminary expense -- contracts
not received		15,464.06
Travel expense		14,010.06
Office rent and alteration		11,690.46
Legal and accounting fees		9,071.65
Taxes and licenses		7,201.13
Telephone and telegraph		5,070.04
Office supplies and expense		5,386.14
Sundry expense		2,824.40
Interest on equipment notes		4,000.00
Bad debts		838.02
Contributions		236.92
Insurance		6,274.41
Postage		3,123.81
Depreciation on office equipment		2,043.39
State income taxes		22,025.70	676,930.27
Net profit			511,830.64

Four contracts with accumulated costs amounting to $ 922,335.14 were incomplete at December 31, 1953.

Forest Hills and Loxley Annex reported their income for 1953 as follows:

	Forest Hills	Loxley Annex	Total
Rental income	$ 307,162.01	$ 10,809.65	$ 317,971.66
Service income	693.27		693.27
Gross income	307,855.28	10,809.65	318,664.93
Rental expense	339,069.40	20,205.11	359,274.51
Net loss	(31,214.12)	(9,395.46)	(40,609.58)

The combined separate net income for 1953 (not taking into account any eliminations for unrealized profit or loss on intercompany transactions) was as follows:

Algernon Blair, Inc. (income)	$ 511,830.64
Forest Hills and Loxley Annex (loss)	(40,609.58)
Total of separate income and loss	471,221.06

Two of the contracts completed by petitioner during 1953 were for its subsidiaries, Forest Hills and Loxley Annex. (See schedule of petitioner's income above.) Under the terms of its contracts with its subsidiaries petitioner constructed a housing project for Forest Hills consisting of 500 family units, and a housing project for Loxley Annex consisting of 135 family units. The subsidiary corporations held the property for rental purposes after construction. The Forest Hills construction project was begun in August 1952 and had an average completion date of March 3, 1953. The Loxley Annex project was begun in June 1953 and the average completion date was November 10, 1953.

As shown on the petitioner's schedule of gross profit, supra, it realized gross profit in 1953 on the contracts for its subsidiaries as follows:

Forest Hills	$ 309,639.65
Loxley Annex	137,823.52
Total gross profit	447,463.17

In computing its consolidated net income for the year 1953, the petitioner eliminated the gross profit of $ 447,463.17 as intercompany profit realized on the construction of the housing projects for its two subsidiary corporations and also made certain other eliminations. The net income reported on the 1953 consolidated income tax return was, therefore, computed as follows:

Total of separate income and loss		$ 471,221.06
Adjustments and eliminations:
Gross profit realized by petitioner on
contracts with subsidiaries	$ 447,463.17
Depreciation on unrealized gross profit	11,076.92	436,386.25
Consolidated net income		34,834.81

The respondent disallowed (adjustment B of the deficiency notice) the elimination of intercompany profit in the amount of $ 447,463.17 to the extent that it exceeded $ 192,598.92. The disallowance was based upon his determination that "net profit" should be eliminated rather than gross profit. He computed the net profit by allocating the petitioner's general expenses for 1953 to the contracts completed during 1953 in the same proportion that the gross profit on each contract completed in 1953 bore to the total gross income for 1953 (from both contracts completed and unrelated sources). Respondent's computation is as follows:

Gross income from contract jobs:		Job profit	Per cent of total
Forest Hills, Inc		$ 309,639.65	26.05
Loxley Gardens Annex, Inc		137,823.52	11.60
All other contracts and services		741,297.74	62.35
Total gross profit		1,188,760.91	100.00
Total expense incurred to produce the above
gross profit 1953		676,930.27
New income from construction reported by
Algernon Blair, Inc., for 1953			511,830.64
Expense allocated to intercompany job profits
on the basis of the respective jobs to total
gross profit:
			Loxley Gardens
		Forest Hills	Annex, Inc.
Gross job profit to Algernon Blair, Inc		$ 309,639.65	$ 137,823.52
Portion of Algernon Blair, Inc. expense
applicable to producing intercompany
gross income
Forest Hills., Inc., 26.05% X 676,930.27		176,340.34
Loxley Gardens Annex, Inc. 11.60% X
676,930.27			78,523.91
Net intercompany income applied to reduce
cost of subsidiary assets for depreciation
allowance		133,299.31	59,299.61
Amount eliminated on return		309,639.65	137,823.52
Excess elimination on return		176,340.34	78,523.91
Forest Hills, Inc	$ 176,340.34
Loxley Gardens Annex, Inc	78,523.91
Adjustment to income reported	254,864.25

The bonus of $ 355,828 for 1953 was distributed as follows:

19 home office employees whose duties pertained to
general corporate business	$ 147,733
8 home office employees whose duties pertained
entirely to specific contracts	58,825
Field office employees working on jobs	149,226
Other	44
Total bonus, 1953	355,828

Of the eight home office employees whose duties pertained to specific contracts, five worked on the Forest Hills and Loxley Annex projects. Those five received salaries in the amount of $ 27,360 and bonuses in the amount of $ 36,980. An allocation of those salaries and bonuses to the specific jobs on the basis of time spent on the specific job is as follows:

	Salary	Bonus
Loxley Annex	$ 1,230.60	$ 1,473.60
Forest Hills	5,773.20	6,337.20
Other jobs	20,356.20	29,169.20
Total	27,360.00	36,980.00

As stated previously, the salaries of the field employees were allocated to the specific jobs on which they worked. An allocation of the bonuses paid to those employees on the same basis that their respective salaries were allocated is as follows:

Loxley Annex	$ 13,801.60
Forest Hills	44,850.24
Other jobs	90,574.16
Total	149,226.00

The amounts of salary and bonus allocated to Forest Hills and Loxley Annex in the two schedules in the previous paragraph were reasonably related to the Forest Hills and Loxley Annex contracts, respectively. In addition, $ 30,000 of the other general expenses was reasonably related to the Forest Hills contract and $ 8,000 of the other general expenses was reasonably related to the Loxley Annex contract.

Issue 2. Depreciation.

The following schedule shows the depreciation computed by Forest Hills and Loxley Annex for 1953, the amount eliminated due to a reduction in basis because of the elimination of intercompany profit (see Issue 1, supra), and the amount deducted on the consolidated return for 1953:

	Forest Hills	Loxley Annex	Total
Depreciation computed on cost to
subsidiaries	$ 137,992.81	$ 6,279.18	$ 144,271.99
Amount eliminated due to
intercompany profit on
depreciable assets	10,682.57	394.35	11,076.92
Amount deducted on consolidated
return	127,310.24	5,884.83	133,195.07

Of the $ 133,195.07 claimed on the return the respondent disallowed $ 23,036.39, computed as follows:

Excessive depreciation based on cost to subsidiary:
Forest Hills		$ 29,334.63
Loxley Annex		988.25
Total		30,322.88
Less excessive amount eliminated due to intercompany
profit (respondent determined intercompany profit
was less than petitioner computed -- see Issue 1):
Forest Hills	$ 7,150.66
Loxley Annex	135.83	7,286.49
Depreciation disallowed per consolidated return		23,036.39

The difference between the depreciation claimed and the depreciation allowed is due to the respondent's adjustments to the basis of the depreciable property. ^{*235 in the same proportion that each category of direct cost bore to the total direct cost, except land. The petitioner then treated the entire cost in each category, except land, as depreciable and computed its depreciation thereon.}

The respondent made certain adjustments. First, he divided the direct costs in the category general improvements into depreciable and nondepreciable. (Petitioner had treated all direct costs in that category as depreciable.) In the nondepreciable category he included the direct cost of (1) items which he designated as additional land cost and (2) items which were maintained by the local governments and dedicated to the public use. *236 all of the categories of direct costs in the same proportion that each category bore to the total direct costs.

The following schedule shows the cost allocation of the Forest Hills project by Forest Hills and by the respondent:

Forest Hills Project
	Cost allocation	Cost allocation
	by Forest Hills	by respondent
Land -- book cost	$ 137,323.35	$ 137,323.25
Allocated from indirect costs		30,997.08
	137,323.35	168,320.33
General improvements:
Depreciable	903,733.61	153,367.88
Nondepreciable		742,803.57
	903,733.61	896,171.45
Building:
Depreciable	2,804,268.48	2,651,947.98
Nondepreciable		131,057.10
	2,804,268.48	2,783,005.08
Building equipment fixed:
Depreciable	171,388.65	161,964.30
Nondepreciable		8,001.77
	171,388.65	169,966.07
Building equipment portable:
Depreciable	85,765.29	81,080.97
Nondepreciable		4,010.46
	85,765.29	85,091.43
Furniture -- depreciable	280.29	280.29
Furnishings:
Depreciable	9,444.67	8,928.23
Nondepreciable		441.46
	9,444.67	9,369.69
Total cost	4,112,204.34	4,112,204.34
Total depreciable	3,974,880.99	3,057,569.65
Total nondepreciable	137,323.35	1,054,634.69
Total cost	4,112,204.34	4,112,204.34

A breakdown of the nondepreciable costs as determined by the respondent is as follows:

Forest Hills -- Nondepreciable Costs
Direct costs:
Land			$ 137,323.35
General improvements:
Maintained by city
	Site work, grading, utilities, and
	miscellaneous-	$ 440,954.64
	Street paving, curbs, and drives	111,971.81
	Sidewalks	43,542.20
	Curbs and gutters	12,908.52
Additional land cost
	Landscaping	60,747.00	670,124.17
Indirect costs		205,764.91
Supplemental charges:
4.75 acres of land transferred to city for public
park $ 9,262.50
Additional land cost 6,642.79
Sewers and water service facilities maintained by
city 3		25,517.37	41,422.66
	Total		1,054,635.09

The following schedule shows the cost allocation of the Loxley Annex project by Loxley Annex and the respondent:

	Cost	Cost
	allocation by	allocation by
	Loxley Annex	respondent
Land -- book cost	$ 40,500.00	$ 40,500.00
Allocated from indirect costs		13,031.36
	40,500.00	53,531.36
General improvements:
Depreciable	212,203.76	81,977.63
Nondepreciable		128,279.44
	212,203.76	210,257.07
Building:
Depreciable	783,129.61	736,890.81
Nondepreciable		35,981.94
	783,129.61	772,872.75
Building equipment fixed:
Depreciable	22,418.40	21,062.39
Nondepreciable		1,022.21
	22,418.40	22,084.60
Building equipment portable:
Depreciable	39,608.35	37,289.68
Nondepreciable		1,824.66
	39,608.35	39,114.34
Total cost	1,097,860.12	1,097,860.12
Total depreciable	1,057,360.12	877,220.51
Total nondepreciable	40,500.00	220,639.61
Total cost	1,097,860.12	1,097,860.12

A breakdown of the nondepreciable costs as determined by the respondent is as follows:

Loxley Annex -- Nondepreciable Costs.
Direct costs:
Land			$ 40,500.00
General improvements:
Maintained by city
	Streets and sidewalks	$ 74,911.11
	Sewers and water and gas mains	19,594.29
Additional land cost
	Site work	13,338.40	107,843.80
Supplemental costs		10,647.94
Indirect costs		61,647.87
	Total		220,639.61

OPINION.

The issues will be discussed in the same order as the findings of fact relating thereto.

Issue 1. Intercompany Eliminations .

Petitioner, a general contractor, filed a consolidated return for the year 1953 with two wholly owned subsidiaries, Forest Hills and Loxley Annex. The first issue requires a determination of the amount of unrealized profit arising from intercompany transactions which should be eliminated in the computation of consolidated net income on that return.

During the year in question, petitioner, which reports on the completed contract basis, completed nine contracts, including one for Forest Hills and one for Loxley Annex, both of which were wholly owned subsidiaries. Under the contracts with the subsidiaries housing projects were constructed. The subsidiaries held the projects for rental purposes.

Regulations 129, to which the petitioner consented by filing a consolidated return (see sec. 141 (a), I. R. C., 1939), *242 and losses in transactions between members of the affiliated group" (Regs. 129, sec. 24.31 (b) (1)).

Since the subsidiaries held the housing projects at the end of 1953, any profits realized on those contracts by the petitioner would be unrealized profits for consolidation purposes. Both parties agree to this. The dispute arises in the computation of the unrealized profits.

Petitioner computed its income on the completed contract basis. Under this method it accumulated the total revenues derived from the contract and the total costs which it considered were incurred in the performance of the contract. It characterized these costs as direct costs. The difference between the two it reported as gross profit or loss in the year in which the contract was completed. The costs which it did not consider attributable to any specific contract were deducted currently, in the year in which incurred. These latter costs which it characterized as general expenses included such items as officers' salaries, salaries of home office employees, other home office expenses, State income taxes, and bonuses (petitioner distributed among all employees 40 per cent of its net income before taxes as a bonus). This method of accounting is sanctioned by the regulations *244 from the revenue on each contract the total direct costs and the proportionate share of the general expenses. It may be pointed out that work was commenced in 1952 on some of the contracts completed in 1953 and that at the end of 1953 there were four uncompleted contracts on which costs had been incurred.

The regulations do not indicate whether the unrealized profit to be eliminated is gross profit or net profit. And although this is essentially an accounting problem there is disagreement among accountants as to the preferred practice. *245 In Union Pacific Railroad Co., 32 B. T. A. 383, 384-388 (1935), affirmed on other points (C. A. 2, 1936) 86 F.2d 637">86 F. 2d 637, a somewhat similar issue was involved. The affiliated corporations transported for one another material used in additions and betterments. The cost of these materials was capitalized by the receiving affiliate. The transporting affiliate charged the receiving affiliate the published tariff rate. In computing the consolidated net income these charges were eliminated from the revenue account of the transporting affiliate and from the expense account of the receiving affiliate. Thus, on the transporting affiliate's books was left the cost incurred by it in transporting the goods. Both the taxpayer and the Commissioner agreed that this cost should not be deducted currently but must be capitalized as part of the additions and betterments. The dispute related to the computation of that cost. The actual cost could not be computed. The Commissioner contended that the cost should be a proportionate share of all the costs including general expenses. The taxpayer contended that the latter expenses would have been incurred regardless of whether there was any intercompany transportation and that the cost should be only a proportionate share of the direct transportation costs. We rejected the contentions of both parties and held that the "cost" of transporting intercompany goods was a proportionate share of all costs reasonably related to transporting goods and, in the absence of such cost in the record, we used an Interstate Commerce Commission estimated figure.

The pertinent parts of the regulations in effect for the years involved in Union Pacific Railroad Co., supra, are for all practical purposes the same as involved here.

Also, by analogy, the problem here is the same as if the petitioner had built the projects for its own use. Instead of the question of intercompany profits there would be a question of cost to itself which, of course, requires the same determination. Cost to itself would depend on which costs are to be capitalized and which are to be deducted currently as ordinary and necessary business expenses. In Acer Realty Co., 45 B. T. A. 333, 336-338 (1941), affd. (C. A. 8, 1942) 132 F.2d 512">132 F. 2d 512, we held that costs incidental to the construction or improvement of buildings, or in connection with the acquisition of capital assets, is a capital expenditure and not ordinary and necessary expense of carrying on a business.

The rule emerging from these cases, stated in terms of cost, is that the cost of an asset includes all costs reasonably related or incidental to its construction or acquisition; in terms of profit for consolidation purposes it would be the gross profit less any other costs reasonably related or incidental to the construction or acquisition of the asset. This comports with an accepted accounting view *248 appears to be one based on practical necessities and reason. We follow it here.

Under the above rule we must determine which, if any, of the expenses characterized by the petitioner as general expenses are reasonably related or incidental to the two contracts completed for its subsidiaries. The petitioner has offered evidence showing an allocation of some of the general expenses. The respondent has offered no evidence supporting his determination and it is clear that his determination that all of the general expenses are allocable to the nine completed contracts on a gross profit basis cannot stand. Many of the general expenses are in no way related to any of the specific contracts. And even assuming that all of the general expenses were reasonably related to the specific contracts, the allocation is erroneous because there is no rational relation between the gross profit on a contract and the general expense incurred. For example, the contract with a gross loss would receive an allocation of a minus amount of general expenses. "In these circumstances the general rule of the burden of proof falls short of a solution, Helvering v. Taylor, 293 U.S. 507">293 U.S. 507." Union Pacific Railroad Co., supra at p. 387.

It is clear, it seems to us, that a portion of the salaries and bonuses of the project managers and the bonuses paid to those who worked on the contracts for the subsidiaries are reasonably related to the contracts performed for the subsidiaries. Petitioner has prepared an allocation of these costs, which seems reasonable, and we have adopted it as part of our findings of fact. The amounts so allocated should be added to the cost of the contracts performed for Forest Hills and Loxley Annex. No attempt has been made to allocate any of the other general expenses. We are convinced that some portion of the other general expenses is reasonably related to the performance of the contracts for the subsidiaries. In the absence of any specific evidence or proof, we have exercised our best judgment and found that an additional $ 30,000 of general expense incurred was reasonably related to the performance of the Forest Hills contract and an additional $ 8,000 of general expense incurred was reasonably related to the Loxley Annex contract. Cf. Cohan v. Commissioner, (C. A. 2, 1930) 39 F. 2d 540, 543-544; Union Pacific Railroad Co., supra.

These adjustments can be made under Rule 50.

Issue 2. Depreciation.

The respondent partially disallowed the depreciation claimed by Forest Hills and Loxley Annex. The dispute here relates only to the basis for depreciation.

In the construction of the multiple-housing projects, Forest Hills and Loxley Annex segregated their costs into groups, viz, land, general improvements, building, building equipment, and furnishings. In addition to the direct costs which could be clearly segregated into the above-mentioned groups there were a number of indirect costs which related to the projects as a whole such as engineering and architect fees, interest on construction loans, legal fees, various types of insurance, depreciation on equipment, etc. The petitioner allocated these indirect costs to the categories of direct cost, except land, in the same proportion that each category of direct cost bore to the total direct cost, except land. The petitioner then treated the entire cost in each category, except land, as depreciable and computed its depreciation thereon.

The respondent made certain adjustments. First, he divided the direct costs in the category general improvements into depreciable and nondepreciable. (Petitioner had treated all direct costs in that category as depreciable.) In the nondepreciable category he included the direct cost of (1) items which he designated as additional land cost and (2) items which were maintained by the local governments and dedicated to the public use. The former included the cost of site work, grading, landscaping, and planting grass and shrubs. The latter included the cost of street paving, curbs, sidewalks, and utilities such as water and gas mains, storm and sanitary sewers, and drainage facilities. The respondent then divided the indirect costs into depreciable and nondepreciable, the division being in the same ratio that the depreciable and nondepreciable direct costs bore to the total direct costs. The indirect costs, thus divided, were allocated to all of the categories of direct costs in the same proportion that each category bore to the total direct costs.

The respondent, on brief, has made certain concessions of error relating to the adjustments underlying his disallowance of a portion of the claimed depreciation. These concessions should be given effect under Rule 50. Although it is not clear from certain remarks at the hearing and from the brief which of the adjustments are still being contested, we will hereafter discuss the three basic adjustments of respondent which result in the disallowance, all of which (disallowance) was put in issue by the pleadings.

(a) Additional land cost. -- The petitioner included the direct cost of such items as clearing, grading, and landscaping, including planting of grass and shrubs, in the category of general improvements and claimed depreciation thereon. The respondent has determined that the cost of these items, less a portion which he attributed to depreciable assets, such as buildings, should be added to the cost of the land and treated as nondepreciable.

The petitioner offered no evidence on this point. It would seem that a portion of the clearing cost would be attributable to the buildings and respondent has allocated a portion thereto. The other items, from their description, appear to be "inextricably associated" with the land rather than the buildings. Furthermore, there are no patent inconsistencies in the adjustments made by respondent relating to these items as there are in some of the other adjustments.

In this state of the record we must uphold the respondent on these adjustments subject, of course, to any concessions made by him in his brief on this point.

(b) Facilities maintained by local governments and dedicated to public use. -- Forest Hills and Loxley Annex, concurrently with the construction of the housing units, constructed sidewalks, curbs, paved streets, sewers, and water mains. Upon completion of the projects the local government units took over all of the functions of maintenance of these facilities and they became part of the street systems for public use and convenience.

The costs of these facilities were capitalized and depreciation was claimed on the capitalized costs. Respondent disallowed the depreciation claimed thereon and contends that Forest Hills and Loxley Annex had no depreciable interest in these facilities. Petitioner, on the other hand, contends the facilities were constructed for the benefit of the housing units which they held for rental purposes, had no value other than in connection with the housing units, and that they are entitled to recover their cost through depreciation allowances.

It is clear that the facilities in question depreciate, i. e., they are subject to wear, tear, and exhaustion. It is also clear that if these facilities were constructed by the two subsidiary corporations on property owned by them and which they continued to own and possess, they would be entitled to recover their cost by depreciation allowances. Clinton Cotton Mills v. Commissioner, (C. A. 4, 1935) 78 F. 2d 292, 296, reversing 28 B. T. A. 1312 (1933). But the question here is whether the depreciation allowance is still available where the facilities are maintained by others and dedicated to the public use.

In F. M. Hubbell Son & Co. v. Burnet, (C. A. 8, 1931) 51 F.2d 644">51 F. 2d 644, affirming 19 B. T. A. 612 (1930), the taxpayer, an owner of rental property, was required by special assessments to make expenditures on account of paving, curbing, and sidewalk improvements in connection with property owned by it. It capitalized these costs and claimed an allowance for depreciation thereon. The court held that although the improvements increased the rental value of, and benefited, the taxpayer's property that they were not used exclusively in the taxpayer's trade or business but were used primarily in the business and for the service of the public. Also, the property being public property, the taxpayer would not have that special pecuniary interest in the property concerning which a depreciation deduction is allowable.

In the instant case, the facilities were built by the petitioner and turned over to the local governments rather than built by local governments and paid for through special assessments as in the Hubbell case, supra. But any real distinction in what occurred or in principle is at most tenuous. The fact that Forest Hills and Loxley Annex owned all of the adjoining properties is without controlling significance in view of the fact that the facilities are used primarily in the public business. Obviously, if the local governments had built the facilities and then assessed the adjoining landowner, the landowner could not recover the assessment by way of depreciation allowances. We think the instant facts require the same result. See Wilshire-LaCienega Gardens Co. v. Riddell, (S. D. Calif., 1956) 148 F. Supp. 938">148 F. Supp. 938, 940-941, where the same result was reached on facts similar to those here involved.

The petitioner's reliance on Clinton Cotton Mills v. Commissioner, supra, is misplaced. We stated (28 B. T. A. 1312, 1315-1316) that:

If these improvements were on the streets of Clinton dedicated to public use, the cost of paving is not amortizable; F. M. Hubbell Son & Co., 19 B. T. A. 612; affd., 51 Fed. (2d) 644; certiorari denied, 284 U.S. 664">284 U.S. 664; if on its own property and used in its business, it is entitled to recover its investment therein by ratable annual deductions from income. * * *

However, we held for the Commissioner because of a failure of proof. The Court of Appeals for the Fourth Circuit reversed us on that point on the ground that expenditures were made on private property. The court distinguished the Hubbell case, supra, and in effect agreed with us in principle. Union Electric Co. of Missouri, 10 T. C. 802 (1948), the other case relied on by petitioner, is clearly distinguishable on its facts.

Accordingly, we uphold the respondent on these adjustments subject, of course, to any concessions made by him in his brief on this point.

(c) Allocation of indirect costs. -- Petitioner allocated the indirect costs to all of the direct costs except the land cost. Respondent has adjusted this by allocating a portion of the indirect costs to the land. As pointed out by petitioner, the respondent's allocation contains certain mathematical inconsistencies. Aside from that, we think that respondent was in error in allocating a portion of the indirect costs to basic land cost.

A mere glance at the items listed as indirect costs shows that they relate only to the improvements. In these circumstances it is difficult to see why any of them should be allocated to the basic land cost. We, therefore, think the indirect costs should be allocated proportionately to all of the direct costs except the basic land cost. Of course, under this holding some of the indirect costs will be allocated to the other items which we have held to be nondepreciable.

Decision will be entered under Rule 50.

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Footnotes

• 1. Seven contracts other than Forest Hills and Loxley Annex were completed in 1953; six resulted in a total gross profit of $ 775,461.84 and one resulted in a gross loss of $ 73,360.89.↩

• 1. There is no question over the rate of depreciation. Also there is no question over the amount of depreciation to be eliminated because of the intercompany profit involved. The amount, however, will depend upon the determination of Issue 1, supra↩.

• 2. Forest Hills acquired vacant land within the city limits of Paducah, Kentucky. The land was plotted into city lots, and streets, sidewalks, curbs, gutters, sewers, and water mains were constructed concurrently with the erection of the housing units. Upon completion of the project the City of Paducah took over from the corporation all of the functions of maintenance with respect to the streets, sidewalks, curbs, gutters, sewers, and water mains, and they became a part of the street system of Paducah for public use and convenience.

  The Loxley Annex project is located outside but adjacent to the city limits of Portsmouth, Virginia. Upon completion of this project the streets, sidewalks, and storm sewers were incorporated in the county road system for all maintenance and public use purposes.↩

• 1. The result of respondent's breakdown of direct costs was as follows:

  	Amount	Per cent
  Depreciable	$ 2,508,817.50	75.65
  Nondepreciable	807,447.52	24.35
  Total direct costs	3,316,265.02	100.00

  Indirect costs were then allocated to the direct costs in each category as follows:

  	Amount	Per cent
  Depreciable	$ 566,413.41	75.65
  Nondepreciable	182,315.49	24.35
  Total indirect costs	748,728.90	100.00

  The allocation of indirect costs results in $ 182,315.49 being treated as nondepreciable. However, as can be seen from the main table above, the respondent, contrary to his allocation, treated $ 205,764.91 as nondepreciable. The difference of $ 23,449.42 ($ 205,764.91 minus $ 182,315.49) is the portion of the depreciable indirect costs (i. e., portion of $ 566,413.41) which the respondent allocated to land. Having allocated it to land, he treated it as nondepreciable even though it was a part of the depreciable indirect cost under his basic allocation.↩

• 2. Allocated to direct costs.↩

• 3. Allocated to general improvements.↩

• 1. The items constituting the supplemental costs do not appear in the record.↩

• 2. The result of respondent's breakdown of direct costs was as follows:

  	Amount	Per cent
  Depreciable	$ 671,832.26	80.86
  Nondepreciable	158,991.74	19.14
  Total direct costs	830,824.00	100.00

  Indirect costs were then allocated to direct costs as follows:

  	Amount	Per cent
  Depreciable	$ 215,925.41	80.86
  Nondepreciable	51,110.71	19.14
  Total indirect costs	267,036.12	100.00

  The allocation of indirect costs results in $ 51,110.71 being treated as nondepreciable. However, as can be seen from the main table above, the respondent, contrary to his allocation, treated $ 61,647.87 as nondepreciable. The difference of $ 10,537.16 ($ 61,647.87 minus $ 51,110.71) is the portion of the depreciable indirect costs (i. e., portion of $ 215,925.41) which the respondent allocated to land. Having allocated it to land, he treated it as nondepreciable even though it was a part of the depreciable indirect cost under his basic allocation.↩

• 3. Unless otherwise noted, all section references are to the Internal Revenue Code of 1939, as amended.↩

• 4. See Regs. 118, sec. 39.42-4.↩

• 5. See American Institute of Accountants, Accounting Research Bulletin No. 45 (1955).↩

• 6. Compare Finney and Miller, Principles of Accounting -- Advanced (4th ed. 1952), p. 391:

  "What is the intercompany profit? Should the amount of the deduction for intercompany profit be based on the gross or the net profit of the selling company? The gross profit is the generally accepted basis. It has been suggested by some accountants that the amount of the deduction should be determined by using the selling affiliate's ratio of net income to sales rather than its rate of gross profit. This procedure would, of course, result in a smaller deduction. The use of the ratio of net income to sales might be justified if all expenses varied in exact proportion to the sales; this, however, is not the normal condition. Many expenses are fixed; others vary, but not in direct proportion to the sales; and it is therefore incorrect to assume that the elimination of the intercompany sales would result in a corresponding reduction in the expenses. Neither is it practicable to undertake to allocate expenses between intercompany and outside sales. Under the circumstances, therefore, the expedient and conservative procedure is to compute the deduction for intercompany profit on the basis of the rate of gross profit."

  with Wixon, Accountants Handbook (4th ed. 1956), at page 23-30:

  "Under an ideal treatment, in fact, all charges actually incurred from the standpoint of the consolidated entity, and reasonably applicable to goods on hand in the group as opposed to goods sold to the outside, should be deferred. In other words, the amount to be eliminated as unrealized is the element of net income, not gross markup over assigned production cost."

  Also see Moonitz, The Entity Theory of Consolidated Statements (1951), p. 69.

  The above-quoted accounting materials deal with the sale of merchandise rather than the sale of multiple-housing units. However, the problem, we think, is essentially the same.↩

• 7. See Regs. 65, art. 636; Regs. 69, art. 635; and Regs. 74, art. 734, providing for the elimination of intercompany transactions (whether or not resulting in any profit or loss to the separate corporation) and Regs. 75, art. 31 (a), providing for the nonrecognition of gain or loss in intercompany transactions.↩

• 8. See the views expressed in Accountants Handbook and The Entity Theory of Consolidated Statements, footnote 6, supra↩.