International Shoe Co. v. Commissioner , 38 B.T.A. 81 ( 1938 )

INTERNATIONAL SHOE COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

International Shoe Co. v. Commissioner

Docket Nos. 82264, 82265, 83607, 87162.

United States Board of Tax Appeals

38 B.T.A. 81; 1938 BTA LEXIS 911;

July 19, 1938, Promulgated

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1. Amounts paid for lasts, dies, and patterns which have an average useful life of not to exceed one year are deductible from gross income as ordinary and necessary expenses of carrying on business.

2. In 1932 the petitioner paid an amount in compromise of a suit brought against it for damages. Held, that the amount paid is a legal deduction from gross income as an ordinary and necessary expense.

Richard O. Rumer, Esq., R. E. Blake, Esq., and Charles B. McInnis, Esq., for the petitioner.

Frank M. Thompson, Jr., Esq., and Joseph B. Harlacher, Esq., for the respondent.

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SMITH

These proceedings, consolidated for hearing, involve income and excess profits tax deficiencies as follows:

		Deficiency
Docket No.	Year	Income tax	Excess profits tax
82264	Fiscal year ended Nov. 30, 1932, as transferee	$33,659.13
82265	Fiscal year ended Nov. 30, 1932	138,007.96
83607	Fiscal year ended Nov. 30, 1933, as transferee	17,546.23	$1,716.24
87162	Fiscal year ended Nov. 30, 1933	44,220.40	16,080.14

In Docket Nos. 82264 and 83607 the petitioner appears as a transferee of the assets of the Illinois-International Shoe Co., which was a wholly owned subsidiary of the petitioner and was dissolved in 1934. It admits liability for any taxes which may be due from the Illinois-International Shoe Co. for the fiscal years ended in 1932 and 1933.

The questions in issue in these proceedings are:

(1) Did the respondent err in refusing to allow as expense deductions amounts paid for lasts, dies, and patterns and in requiring such amounts to be charged to capital account and depreciated over a two-year life?

(2) Did the respondent err in allowing depreciation on machinery and equipment on the basis of a useful life of 15 years instead of 11 1/9 years?

(3) Did the respondent err in allowing depreciation and obsolescence on brick buildings on the basis of a useful life of 40 years instead of 30 years?

(4) Did the respondent err in refusing to allow as a deduction, from gross income of the fiscal year ended in 1932, $150,000 paid in 1932 in settlement of a suit for damages and $500 for attorneys' fees in connection therewith?

FINDINGS OF FACT.

1. The International Shoe Co. was organized under the laws of the State of Missouri in December 1911. In 1921 it was reorganized under the laws of the State of Delaware.

2. The Illinois-International Shoe Co. was incorporated in 1922 as a wholly owned subsidiary of the International Shoe Co., for the purpose of operating the company's manufacturing plants in the State of Illinois. That company was in operation throughout the fiscal years 1932 and 1933 but was dissolved in 1934, the International Shoe Co. receiving all of its assets in liquidation.

3. The books and records of the Illinois-International Shoe Co. were operated throughout its existence as though that company were a mere department of the International Shoe Co. No distinction was made between the operation of plants owned by that company and plants owned by the International Shoe Co.

4. During the fiscal years 1932 and 1933 the International Shoe Co. owned 100 manufacturing plants, of which 93 were in operation and 7 were not in operation on January 1, 1933. These manufacturing plants consisted of shoe factories, tanneries, and other plants designated as subsidiary and auxiliary departments. Of the total, 45 were shoe factories, 7 of which were nonoperating.

5. The International Shoe Co. (hereinafter sometimes referred to as the petitioner) manufactured during the fiscal years 1932 and 1933 complete lines of men's, women's, children's, and infant's shoes in all of the generally recognized types of shoe construction. The company manufactured during the course of a 12-month period between 5,000 and 7,500 different styles of shoes.

Facts Relating to Lasts, Dies, and Patterns.

6. A last is a wooden form usually made of maple to conform to the shape of the human foot and determines, among other things, the fit of the shoe. The shoe is built over the last and remains on the last from one-half day to five days during the manufacturing process.

7. The dies used in the shoe industry are made of metal and may be generally classified as clinker dies, marker dies, cut-out dies, and perforated dies. Occasionally two or more of the different kinds of dies may be used in combination. The dies are used in cutting out the leather for the various parts of the shoe, cutting the lining, marking the places for stitching, and in making perforations on the upper parts of the shoe.

8. Patterns used in the shoe industry are usually made of fibre board with brass bindings on the edges. They are used to cut out various parts of the shoe by hand, and for rounding the out-sole and in-sole of the shoe to conform to the bottom of the last. They are also used as a guide for making the metal dies.

9. The petitioner remodels some of its lasts after they become useless in their original form. The company's ability to remodel a last is severely limited. The last, if it can be remodeled at all, must be remodeled into another last of the same size and width. From the company's standpoint the remodeled last is the same as a new last.

10. Separate dies and patterns are required for each different type and style of shoe. They provide the style features of the upper part of the shoe. A sufficient number of patterns and dies are required to provide for the variations in sizes and widths in which shoes are made.

11. Neither dies nor patterns can be remodeled after the particular style of shoe for which they were acquired has been discontinued. Their life is limited strictly to that particular style of shoe.

12. Beginning about the end of the World War, the style influence in shoes became increasingly important. During the fiscal years 1932 and 1933 it was and still is the greatest single factor in the sales appeal of a shoe.

13. With the exception of a relatively small number of work shoes the styles of shoes manufactured by the International Shoe Co. are changed every season and many styles are changed more frequently. The company is constantly introducing new styles and discontinuing old styles in order to keep up the sales appeal of its lines.

14. The petitioner is regularly required to make large expenditures for the purchase of lasts, dies, and patterns. Its experience over a 14-year period demonstrates that such expenditures are fairly constant in amount from year to year. The per pair cost of lasts, dies, and patterns of shoes produced is likewise fairly constant from year to year.

15. The total expenditures of the International Shoe Co. (Delaware) for lasts during each of the fiscal years 1930 to 1933, inclusive, divided between the cost of lasts purchased from outside manufactrers and lasts remodeled in the company's own last department were as follows:

Fiscal year	Cost of lasts purchased from outside manufacturers	Cost of lasts remodeled in company's own last department	Total cost of lasts
1930	$314,169.83	$90,614.79	$404,784.62
1931	335,530.12	107,156.28	442,686.40
1932	247,462.12	87,148.38	334,610.50
1933	193,177.00	30,143.74	223,320.74

16. In computing the deficiencies for the fiscal years 1932 and 1933 the respondent allowed as a deduction the cost of lasts remodeled in the company's own last department, as set forth above, and disallowed as a deduction the cost of lasts purchased from outside manufacturers.

17. The total expenditures of the Illinois-International Shoe Co. for lasts during each of the fiscal years 1930 to 1933, inclusive, divided between the cost of lasts purchased from outside manufacturers and lasts remodeled in the company's own last department were as follows:

Fiscal Year	Cost of lasts purchased from outside manufacturers	Cost of lasts remodeled in company's own last department	Total cost of lasts
1930	$93,756.48	$31,473.78	$125,230.26
1931	114,106.73	52,131.27	166,238.00
1932	74,042.47	30,989.23	105,031.70
1933	80,304.40	36,730.44	117,034.84

18. In computing the deficiencies determined against the Illinois-International Shoe Co. for the fiscal years 1932 and 1933, the respondent allowed as a deduction the expenditures made for the remodeling of lasts in the company's own last department, but disallowed the expenditures made for the purchase of lasts from outside manufacturers.

19. The combined cost of lasts, dies, and patterns purchased by the International Shoe Co. (Delaware) divided between the cost for staple and cost for style production for the fiscal years 1930 to 1933, inclusive, was as follows:

Fiscal year	Cost for staple production	Cost for style production	Total cost	Percentage of staple cost to total cost	Percentage of style cost to total cost
				Percent	Percent
1930	$9,579.50	$825,789.91	$835,369.41	1.1	98.9
1931	12,039.56	875,641.04	887,680.60	1.4	98.6
1932	34,581.34	623,274.48	657,855.82	5.3	94.7
1933	15,179.08	477,569.15	492,748.23	3.1	96.9

20. All of the expenditures made by the Illinois-International Shoe Co. for the purchase of lasts, dies, and patterns for each of the fiscal years 1930 to 1933, inclusive, were made for style production.

21. The lasts, dies, and patterns purchased by the petitioner during the fiscal years 1932 and 1933 were not used to expand the production facilities of the company; they simply replaced other lasts, dies, and patterns in the company's line.

22. During the period 1932 to 1936, inclusive, 13.7 percent of the total production of both shoe companies involved in these proceedings was staple production and 86.3 percent was style production. During the years 1930 to 1936, inclusive, 1.4 percent of the total amounts spent for lasts, dies, and patterns was for staple production and 98.6 percent for style production.

23. Petitioner has always treated lasts, dies, and patterns as one item and has never inventoried the number on hand at the end of any fiscal year. Such lasts, dies, and patterns as may be on hand at the end of any fiscal year have no resale value.

24. Since its incorporation in 1911 the petitioner has consistently followed the accounting practice of charging to expense all expenditures for lasts, dies, and patterns. This practice was followed by the company for the fiscal years 1932 and 1933. The respondent approved this practice for all years from 1911 up to the end of the fiscal year 1931.

25. The average useful economic life of the lasts purchased by the petitioner during the fiscal years 1932 and 1933 was not in excess of one year.

26. The amounts paid by the petitioner for lasts, dies, and patterns during the fiscal years 1932 and 1933 were legal deductions from gross income as ordinary and necessary expenses.

Facts Relating to Depreciation on Machinery and Equipment.

27. The petitioner has computed depreciation on all of its machinery and equipment for Federal tax purposes at a composite rate of 9 percent, based upon an average useful economic life of 11 1/9 years. This composite rate of 9 percent has been applied to all fiscal years since 1911 and has been approved by the respondent for all years up to and including the fiscal year 1931. For the two fiscal years 1932 and 1933 he reduced this composite rate to 6 2/3 percent, based upon an average useful economic life of 15 years.

28. The composite rate of 9 percent has been applied to the purchase price from the date of acquisition until the purchase price has been recovered. If be chance the particular machines or items of equipment have remained in the company's service after their cost has been recovered at the 9 percent rate, no further depreciation has been charged on them. On the other hand, if the particular machines or items of equipment have been discarded before their cost has been completely recovered, the unrecovered portion of their cost has been deducted as a loss in the year of their disposition and their cost has been eliminated from the depreciation base, with the result that no further depreciation has been taken on them.

29. The company's machinery and equipment account includes all owned machinery and equipment in its shoe factories and auxiliary plants, including stitching machines, various types of specialty machinery, motors, belting, wooden shoe racks, tannery machinery, cotton mill machinery, rubber plant machinery, chemical plant machinery, and box plant machinery.

30. The machinery and equipment used in the manufacture of shoes is constantly changing. There has been a transition from the steam driven centrally powered plant using a central drive shaft to separately powered line shafting for each department, and still later to independently motor driven machines.

31. Obsolescence is a material factor affecting the economic useful life of machinery in shoe factories. New and better machines are constantly being developed by manufacturers of shoe machinery. More efficient and more economical machines often replace machines previously used before becoming worn out.

32. The petitioner maintains a card record of all principal items of machinery acquired by it since its incorporation in 1911. These cards show the date of acquisition, cost, factory in which the machine was originally installed, record of all transfers of the particular machine from one factory to another, and the date of final disposition of the machine.

33. An analysis of the total of 9,231 machines discarded by the petitioner during the fiscal years 1925 to 1934, inclusive, indicates that the average lapsed life of each machine in the ownership of the company was 9.2853 years. In computing this average no deduction is made for the time when the machines might have been in storage or not in active use.

34. An analysis of $1,878,825.29 of equipment discarded by the company during the fiscal years 1926 to 1936, inclusive, shows that the equipment discarded had a weighted average life of 10.51272 years.

35. An analysis of all machinery and equipment discarded by the company during the fiscal years 1926 to 1936, inclusive, the cost of which was $4,210,688.35, indicates that such machinery and equipment had a weighted average life of 10.92623 years.

36. The average useful economic life of the petitioner's machinery and equipment in use during the fiscal years 1932 and 1933 was not to exceed 11 1/9 years. The correct rate to be used in the determination of the depreciation allowance is 9 percent.

Facts Relating to Depreciation of Brick Buildings.

37. During the fiscal years 1932 and 1933 the petitioner owned a number of brick buildings which were located in various cities and towns in Missouri, Illinois, Kentucky, Arkansas, Pennsylvania, and New Hampshire, and had been acquired at the time of its incorporation in 1911 and subsequent thereto.

38. With the exception of a warehouse building at Fifteenth and Delmar Streets in St. Louis and a building on Cherokee Street in St. Louis, these buildings were all brick and joist construction. The Delmar warehouse and Cherokee Street building were of brick and concrete construction.

39. For all years subsequent to 1911 up to and including the fiscal years 1932 and 1933 the petitioner used for income tax purposes a rate of 2 1/2 percent depreciation on its brick buildings. This rate was applied to the cost of the buildings, including the cost of sprinkler systems, plumbing, light and power wiring, heat equipment, etc.

40. The brick buildings which this petitioner used for shoe factory purposes were principally of multiple-story construction.

41. For several years prior to the fiscal years 1932 and 1933 the petitioner found it necessary to discontinue the use of several of its multiple-story buildings as shoe factories. About the same time its officers recognized that the rate of depreciation of 2 1/2 percent was not high enough to cover the obsolescence factor and the usual depreciation features.

42. During the latter part of 1926 and in 1927 one of petitioner's engineers recommended the use of a 3 1/2 percent rate on brick buildings instead of the 2 1/2 percent rate which was then being used. The company made no change in the rate at that time because the officers considered themselves bound to continue the use of the 2 1/2 percent rate which had been previously (1925) agreed upon with the respondent.

43. In computing its income for credit purposes and for the information of its stockholders, for the fiscal years 1932 and 1933, the petitioner deducted a greater amount of depreciation than it deducted in its Federal income tax returns.

44. During the fiscal years 1932 and 1933 it was recognized in the shoe industry that multiple-story buildings were no longer the desirable type of buildings for use as shoe factories and that the trend was quite definitely toward the one-story type. This trend was due in part to the fact that the additional machinery required to manufacture rapidly changing style shoes made a rearrangement of departments necessary and required more space for certain departments, particularly in the fitting or stitching room; in part because supervision was easier and better in a one-story building; in part because work could be conveyed between departments more readily in a one-story building; and in part because the multiple-story type buildings did not adapt themselves to the use of the new and high speed machinery.

45. The petitioner found it advisable to construct two new one-story type buildings just prior to and during the fiscal years 1932 and 1933, although it had several of the older multiple-story type buildings idle at the time.

46. A reasonable rate of depreciation on the buildings other than frame buildings owned by the petitioner during the fiscal years 1932 and 1933 is 3 1/3 percent, to be applied to petitioner's cost of those buildings on a straight-line basis.

Facts Relating to Deduction of $150,000 paid to Settle a Certain Suit and of $500 Paid for Services Rendered in Connection Therewith.

47. On August 18, 1930, the Menzies Shoe Co., a Wisconsin corporation doing business in St. Louis, brought suit against the petitioner and certain of its officers and directors for the recovery of damages, claiming actual damages of $6,785,000 and punitive damages in a like amount. It was alleged in the petition to the court that the defendants and each of them conspired together unlawfully and wrongfully to destroy the competition existing by reason of the plaintiff's operations in the shoe business; and that defendants resorted to unlawful devices, schemes, and acts, which acts were all and singular unlawful, wrongful, willful, and malicious, with the object of restraining and interfering with the operation of plaintiff's business.

48. No answer was filed by the petitioner to the charges made in the complaint filed by the Menzies Shoe Co. A motion to strike and to make the petition more definite and certain was filed, which was sustained and an amended petition was filed about March 1, 1931. A second motion to make the complaint more definite and certain and to strike was filed, which was largely sustained by the court. No second amended petition was, however, filed.

49. The petitioner and the codefendants now deny the truth of any of the allegations in the petition and deny that they did any of the acts or things charged in the petition.

50. The petitioner's counsel made an investigation of the counts alleged and came to the conclusion that there was no liability on petitioner's part on account of any matter alleged in the petition.

51. The case was never brought to issue and was never tried.

52. In connection with this suit petitioner employed J. M. Lashly, an attorney, who rendered certain services in connection therewith. For these services the petitioner paid $500.

53. By the end of 1931 the petitioner had been subjected to much annoying publicity with respect to the suit. The petitioner's president and certain other officers were of opinion that the publicity was harmful to the company and to its business. An informal conference of certain of its officers and directors was held to discuss the situation and to determine what should be done about it. At this meeting it was decided that W. S. Moulton, president of the petitioner, and A. W. Johnson, one of its vice presidents and its treasurer, should consult Charles Nagel, a well known attorney of St. Louis, to get his advice as to what should be done in the circumstances. They agreed to be guided by Nagel's opinion.

54. Nagel was consulted and agreed to investigate the matter and to give the petitioner the benefit of his advice. He spent about one month in making the investigation and reported to the petitioner that there was practically no merit in the charges made by the Menzies Shoe Co., but that there was one point that might be dangerous, particularly in view of the fact that a former president of the corporation, who was no longer living, was claimed by the Menzies Shoe Co. to have made certain statements or to have performed certain acts which might give rise to liability. Nagel, although of the opinion that there was no merit in the plaintiff's claim, thought that there might be some danger of an unfortunate result if the case went to a jury. This was largely owing to the fact that the former president of the corporation was no longer living. He advised the petitioner to attempt to settle the controversy.

55. Thereupon, the petitioner's managing officers, after a conference on the subject, authorized Nagel to negotiate with the plaintiff in an effort to effect a compromise or settlement.

56. After further conferences with the attorney for the Menzies Shoe Co., Nagel reported to the petitioner's officers and directors that the best basis upon which it could be settled was by a payment in compromise of $150,000. The petitioner's president thereupon offered a settlement and furnished drafts totaling $150,000 to Nagel, who delivered them to the plaintiff. In this manner and for this amount the compromise was effected on May 10, 1932.

57. The nature and form of the release were left entirely to Nagel's judgment. Neither the president of the petitioner nor any other officer made any suggestion with reference thereto. None of the individual defendants was consulted with reference to the kind of release which was to be taken, nor did any one ask that a release be procured for his benefit. No individual defendant was asked to or agreed to contribute to the settlement, nor did any individual defendant ask Nagel to act for him personally. No individual defendant was furnished with a copy of the release for his own benefit.

58. The payment of the $150,000 constituted ordinary and necessary expenses of the petitioner deductible from gross income of 1932.

OPINION.

SMITH: 1. The first question presented by these proceedings is whether the International Shoe Co. and the Illinois-International Shoe Co. are entitled to deduct from gross income of the fiscal years 1932 and 1933 the amounts paid out for lasts, dies, and patterns.

From the beginning of business of each company all amounts paid out for lasts, dies, and patterns have been charged to expense and deducted from gross income as ordinary and necessary expenses of operation. They have been charged to expense upon the company's books of account because lasts, dies, and patterns are continually being replaced by new purchases, have ordinarily a life of not to exceed one year, and have no resale value. The respondent never raised any question as to the right of each company to deduct the amounts thus charged to expense up to the time of an audit of the tax returns for the fiscal year ended November 30, 1932. He then held that the cost of lasts, dies, and patterns should be capitalized and such capitalized cost charged off over a two-year period, the assumed economic life of such items. In the absence of definite information as to dates of purchase during each year, the respondent assumed that the average date of purchase was June 1, that is, the middle of each year. He then determined that the cost should be charged off as follows: 25 percent in the year of purchase, 50 percent in the following year, and 25 percent in the third year. In his brief he states:

A simple illustration will probably show more clearly than in any other manner the position taken by the Commissioner in his treatment of petitioner's expenditures for lasts, dies and patterns. Assuming that the annual purchases in a single factory amount to an average of $50,000 a year, the following computation illustrates his method of handling the items based upon an average two-year life:

		Depreciation
	Cost	1932	1933	1934
1932	$50,000.00	$12,500.00	$25,000.00	$12,500.00
1933	50,000.00		12,500.00	25,000.00
1934	50,000.00			12,500.00
	$150,000.00	$12,500.00	$37,500.00	$50,000.00

Since the petitioner had charged off to expense the entire cost of lasts, dies, and patterns purchased up to the close of the fiscal year ended November 30, 1931, the only portion of the cost of such items accrued during the fiscal year 1932 is 25 percent of the cost - except that the respondent has allowed as a deduction the cost of remodeling lasts done by the petitioner's own employees.

The taxing statute provides that:

The net income shall be computed * * * in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income. * * * [Sec. 41, Revenue Act of 1932.]

The statute further provides for the deduction from gross income of "A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence." (Sec. 23(k), Revenue Act of 1932.)

Regulations 77 were promulgated under the provisions of the Revenue Act of 1932. In article 323 it is provided:

It is recognized that no uniform method of accounting can be prescribed for all taxpayers, and the law contemplates that each taxpayer shall adopt such forms and systems of accounting as are in his judgment best suited to his purpose. Each taxpayer is required by law to make a return of his true income. He must, therefore, maintain such accounting records as will enable him to do so. * * *

* * *

(2) Expenditures made during the year should be properly classified as between capital and expense; that is to say, expenditures for items of plant, equipment, etc., which have a useful life extending substantially beyond the year should be charged to a capital account and not to an expense account; * * *

Article 342 provides in part:

Each year's return, so far as practicable, both as to gross income and deductions therefrom, should be complete in itself, and taxpayers are expected to make every reasonable effort to ascertain the facts necessary to make a correct return. The expenses, liabilities, or deficit of one year can not be used to reduce the income of a subsequent year. * * * A taxpayer has the right to deduct all authorized allowances, and it follows that if he does not within any year deduct certain of his expenses, losses, interest, taxes, or other charges, he can not deduct them from the income of the next or any succeeding year. It is recognized, however, that particularly in a going business of any magnitude there are certain overlapping items both of income and deduction, and so long as these overlapping items do not materially distort the income they may be included in the year in which the taxpayer, pursuant to a consistent policy, takes them into his accounts. * * *

The evidence in these proceedings clearly disproves the respondent's contention that the lasts, dies, and patterns used in the business of the two shoe companies have an economic life of two years. The average life of those used in connection with the manufacture of style shoes was not in excess of one year and in many cases the lasts, dies, and patterns gotten out for a particular style of shoe had a life of less than six months. The International Shoe Co. has shown for a five-year period, including the fiscal years in question in these proceedings, the respective percentages of its staple and style shoes to its total production. The average respective percentages for this period were 13.7 percent staple and 86.3 percent style. It has further shown that during the fiscal years 1930 to 1936 the amounts spent for the purchase of lasts, dies, and patterns used in manufacturing staple shoes was only 1.4 percent of the total of such expenditures and that the remaining 98.6 percent was used in producing style shoes.

The petitioner does not contend that in no case did lasts, dies, and patterns have an economic value not to exceed one year. It admits that those used in the manufacture of staple shoes had a life somewhat longer than one year, but it insists and the proof shows that most of the expense for lasts, dies, and patterns for the fiscal years here in question was for style production and that they had a life not to exceed one year.

Substantially the same question as is presented by these proceedings was before the Board in . That case involved the taxable years 1919 and 1920 - a period when, according to the evidence in these proceedings, the style feature was of much less importance than it was during the fiscal years 1932 and 1933. In that case, the taxpayer had been engaged prior to 1920 in the production of the so-called standard style shoes. It had followed the practice of capitalizing its expenditures for lasts, dies, and patterns and depreciating such expenditures on the basis of 50 percent in the year of purchase and 50 percent in the following year. During 1920 the taxpayer changed its production from the standard style shoes to style shoes and wrote off as a deduction in the year 1920 its total expenditures for lasts, dies, and patterns in that year. In the same year it deducted the remaining 50 percent of its 1919 expenditures for lasts, dies, and patterns. The Commissioner approved the deduction of the taxpayer's 1920 expenditures, but refused to permit it to deduct the remaining 50 percent of its 1919 expenditures in the year 1920.

It will be noted that in that case the Commissioner was contending that the cost of lasts, dies, and patterns was an expense of the year of purchase. Hence, his contention that the taxpayer was not entitled to deduct, from the gross income of 1920, 50 percent of the cost of lasts, dies, and patterns acquired in 1919. The Board held, however, that the taxpayer was entitled to deduct in 1920 not only the amount spent for lasts, dies, and patterns in that year, but also the unamortized cost of the standard style lasts, dies, and patterns acquired in 1919.

The lasts, dies, and patterns purchased by the petitioner during the two fiscal years before us did not expand its production facilities. They merely enabled it to keep abreast of the times and to present merchandise to the public that had a sales appeal. The amounts spent merely served to replace obsolete lasts, dies, and patterns by new lasts, dies, and patterns. The evidence is all to the effect that they had no asset value in the sense that they could be sold for any amount whatever.

It appears to us that the situation here is much the same as that which obtained in ; ; ; ; Tennessee; ; . The question in the above cited cases was whether a coal mining company was entitled to deduct from gross income as an expense the cost of equipment which served to keep up the production of the mine. There was no question but that many of the assets acquired, such as electric locomotives, had a useful life of many years. The courts held, however, that the mere fact that they had a useful life of more than one year was not determinative of the question whether the amounts constituted ordinary and necessary expenses deductible from gross income. In each case the amounts spent for such assets were held to be ordinary and necessary expenses and deductible from gross income. Cf. also ; .

The action of the respondent in disallowing the deduction from gross income of the amounts spent for lasts, dies, and patterns is reversed.

2. The second question in issue is the rate of depreciation to be used in the determination of the depreciation allowance on machinery and equipment.

As the result of a conference between the petitioner and the respondent's counsel in 1925 it was agreed that a rate of 9 percent should be used in the computation of the depreciation allowance on machinery and equipment. This was the rate which was warranted by the very accurate records kept by the International Shoe Co. over a period of years. Depreciation allowances for prior years were adjusted upon that basis and the same rate of depreciation has been used in computing allowances for depreciation upon machinery and equipment since 1925. The petitioner's records tend to show that the 9 percent composite rate is less rather than more than the rate warranted. Its records for discarded machinery over a period of years warrant the finding that the average useful life of the machines discarded was not in excess of 11 1/9 years, which would warrant the 9 percent rate. There is no evidence whatever to support the respondent's determination of a useful life of machinery of 15 years. The action of the respondent in changing the rate of depreciation on machinery and equipment for the taxable years from 9 percent to 6 2/3 percent is reversed.

3. The next question relates to the depreciation rate on brick buildings. The petitioner agreed with the respondent in 1925 that a rate of 2 1/2 percent was the correct rate. Its subsequent experience, however, has shown that this rate does not provide for obsolescence actually sustained. With the advent of high speed machinery and changes in manufacturing processes it has been found that multiple-story shoe factories are less satisfactory and less profitable than the one-story type. The petitioner has found it advantageous to abandon and dispose of some of its multiple-story buildings. There is, however, a small market for such buildings and the petitioner's experience has shown that it has been unable to sell the buildings abandoned at the depreciated cost.

In its reports to its stockholders the petitioner deducted from gross income for the fiscal years 1932 and 1933 larger amounts for depreciation of brick buildings than were claimed on the income tax returns. This was for the purpose of presenting to the stockholders a true picture of its finances. The petitioner felt obligated, however, in filing income tax returns to continue with the 2 1/2 percent rate which it had agreed in 1925 was the proper rate to use. Beginning with the fiscal year 1934 the petitioner has claimed on its tax returns a depreciation allowance on its brick buildings based upon a 30-year life, or at the rate of 3 1/3 percent. The evidence supports the petitioner's contention for a rate of 3 1/3 percent of brick buildings for the fiscal years 1932 and 1933.

4. The final question presented by these proceedings is whether the petitioner is entitled to deduct $150,500 from gross income of 1932, $500 of which represents attorneys' fees and $150,000 the amount paid in settlement of a suit which was instituted against it and its officers and directors. In that suit the plaintiff alleged that the petitioner and its officers had acted illegally and had conspired to injure it. The petitioner never filed any answer to the suit, although it did file demurrers to certain allegations of the petition. The petitioner was receiving much unfavorable publicity as a result of the suit and its officers felt that its business was suffering therefrom.

The petitioner's officers deemed it advisable to consult Charles Nagel, a well known attorney of St. Louis, for the purpose of getting his advice in the matter. Nagel had represented the petitioner in former years. He was not, however, employed as the petitioner's attorney in the case. After spending about a month in investigating the situation Nagel reached the conclusion that there was practically no merit in the plaintiff's claims but that it might be advisable to negotiate a settlement by reason of the fact that a former president of the petitioner, no longer living, was implicated in the suit and if the case went to the jury it might not be possible to convince the jury that some of the contentions of the plaintiff were not well founded. Nagel was instructed to ascertain what arrangements could be made for a settlement of the suit and he advised the petitioner that the entire proceeding could be settled upon payment of $150,000. That payment was made. In addition to that, $500 was paid a prior attorney who had filed one or more motions with the court.

The respondent contends that the amount paid was not an ordinary and necessary expense of the petitioner in 1932, and cites in support of his contention . In that case it was held that where a consent decree had been entered in a suit brought by the United States against the National Outdoor Advertising Bureau, Inc., and others declaring that a certain contract was illegal, null, and void, the "Bureau" was not entitled to deduct from its gross income that part of the costs of defending the suit which appertained to the illegal contract.

We are of the opinion that the principle announced by the court in that case has no application to these proceedings. Here there is no evidence that the petitioner and its officers had entered into any conspiracy or committed any illegal act. The petitioner was, however, receiving unfavorable publicity from the suit and its officers considered that it might be advisable to pay a reasonable amount to settle the controversy.

By section 23 of the Revenue Act of 1932 a taxpayer is permitted to deduct from gross income "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." If an expense connected with litigation proximately results from the carrying on of a business, it is a legal deduction from gross income, , providing the expenses are not connected with a criminal prosecution or in connection with a proven illegal act. Cf. ; . In , the Board allowed the deduction from gross income of a compromise payment to settle litigation and attorney fees paid in connection therewith, both growing out of and being incidental to the taxpayer's business dealings. In its opinion the Board said:

Though the Kornhauser case [the case referred to above] involved only legal fees, we believe the reasoning employed applies equally to the compromise payment made to settle the lawsuit. This expense grew directly out of, and proximately resulted from, the business dealings between the parties. * * *

In , Mr. Justice Cardozo, speaking for the Court, said:

* * * Now, what is ordinary, though there must always be a strain of constancy within it, is none the less a variable affected by time and place and circumstance. Ordinary in this context does not mean that the payments must be habitual or normal in the sense that the same taxpayer will have to make them often. A lawsuit affecting the safety of a business may happen once in a lifetime. The counsel fees may be so heavy that repetition is unlikely. None the less, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack. Cf. . The situation is unique in the life of the individual affected, but not in the life of the group, the community, of which he is a part. * * *

In , the Board was affirmed in holding that an amount paid by a corporation for stock of an agency in order to procure the cancellation of an agency contract for the sale of the corporation's stock and thereby preserve the corporation's reputation and avoid a loss of business consequent on the agency's method, constituted an ordinary and necessary expense. The court said:

* * * In the instant case, the taxpayer's reputation was being injured by the conduct of its agent, and its primary motive in seeking the cancellation of the contract was to prevent the loss of earnings. Its contract with the agency proved to be unprofitable. This we think was an expenditure ordinary and necessary in carrying on the business, and deductible from the respondent's gross income.

In , the Circuit Court of Appeals for the Ninth Circuit affirmed a memorandum opinion of this Board that an amount paid by the taxpayer in settlement of a judgment obtained against him in an action involving fraud was deductible as an ordinary and necessary expense. In the course of its opinion the court said:

There is no analogy between expenses of the kind here involved and those incurred by one accused of a crime. A suit for damages against a lawyer or doctor by a client or patient arises directly out of the business or profession of such lawyer or doctor. A criminal action against a druggist for violation of the narcotic laws has no direct connection with the druggist's business. If the druggist, on the other hand, were sued for damages by reason of having improperly filled a prescription, the action would arise directly out of the business.

Upon the basis of the holding of the Board and of the courts in the above cited cases the Board holds in the instant proceedings that the amount paid in settlement of the suit brought against it by the Menzies Shoe Co. and the attorneys' fees totaling $150,500 are a legal deduction from gross income.

Reviewed by the Board.

Judgments will be entered under Rule 50.