Black River Sand Corp. v. Commissioner

BLACK RIVER SAND CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Black River Sand Corp. v. Commissioner

Docket No. 19933.

United States Board of Tax Appeals

18 B.T.A. 490; 1929 BTA LEXIS 2031;

December 12, 1929, Promulgated

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1. Value of certain contract determined for exhaustion purposes.

2. The petitioner acquired the entire capital stock of the Gallup Sand & Gravel Co. in 1921, paying therefor cash, promissory notes, and shares of its stock. They merged in 1922, at which time a contract upon a certain sand deposit was written up in the petitioner's books of account from $1,000, as carried by that company, to $30,000. Held, the petitioner is entitled to exhaustion on said contract based on the value of $30,000.

3. The respondent erred in disallowing salaries for consultation services and amounts paid under a covenant to refrain from competition.

H. T. Dorrance, Esq., for the petitioner.

L. A. Luce, Esq., for the respondent.

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MORRIS

This proceeding is for the redetermination of a deficiency in income and profits tax of $3,259.98 for the calendar period ended December 31, 1922. While the petition states that the period involved is the fiscal year ended April 30, 1922, the parties stipulated that the deficiency is for the calendar period ended December 31, 1922.

The errors alleged to have been committed by the respondent are:

1. Disallowance of a depreciation deduction of $14,031.17 resulting from the reduction in value of a certain lease from $30,000 as carried upon the petitioner's books of account to $1,000; and

2. The disallowance of a deduction of $4,500 representing an amount paid by the petitioner to F. E. Gallup.

FINDINGS OF FACT.

The petitioner is a corporation organized and incorporated under the laws of the State of New York, and it is engaged in the business of excavating and shipping sand and gravel.

In October, 1919, Frank E. Gallup, by written agreement, purchased from Melissa E. Draper, of Boonville, N.Y., all the sand which he chose to remove from a certain sand pit on land owned by said Draper in Boonville during the term of eight years from February 26, 1920, at certain specified prices, to wit, for all sand shipped by boat, $4 a boat load, and all sand shipped by cars, 5 cents per net ton.

The foregoing Draper agreement was assigned to the Gallup Sand & Gravel Co., whose entire capital stock of $42,000 was owned in 1921, one-half by the Dale Engineering Co. and the other half by Frank and Anna Gallup.

At the first meeting of the board of directors of the petitioner, held on January 8, 1921, one Joerissen reported that prior to incorporation he had entered into an agreement with the Dale Engineering Co. for the purchase of 210 shares of the capital stock of the Gallup Sand & Gravel Co., and he having offered to sell the said stock to the petitioner, the following resolution was adopted:

* * *

WHEREAS, Joseph Joerissen has heretofore entered into a contract with the Dale Engineering Company for the purchase from said Dale Engineering Company of 210 shares of the capital stock of Gallup Sand & Gravel Co. Inc. and has offered to sell said stock to this Corporation and to transfer or cause the transfer thereof to this corporation, and to accept in payment therefor the interest bearing promissory note of this corporation for Seventy thousand ($70,000) Dollars, and 620 shares of the capital stock of this corporation of the par value of Thirty-one thousand ($31,000) Dollars, to be issued to him, or his nominees or assigns in such proportions as may be designated by him, and

WHEREAS, in the judgment of this Board of Directors the said stock is reasonably worth the amount of the consideration to be given therefor, and the same is necessary for the uses and lawful purpose of this corporation,

Now, THEREFORE, Be it

RESOLVED, That the treasurer of this corporation be and he is hereby authorized to purchase said 210 shares of the capital stock of the Gallup Sand & Gravel Co. Inc. from Joseph Joerissen and to execute and deliver to him in the name and on behalf of this corporation the interest bearing promissory note of this corporation for Seventy thousand ($70,000) Dollars, and be it further

RESOLVED, That upon the delivery to this corporation of the said 210 shares of the capital stock of the Gallup Sand & Gravel Co. Inc., the proper officers of this corporation be and are hereby authorized and directed to issue to Joseph Joerissen, or his nominees or assigned in such proportions as may be designated by him, 620 shares of the capital stock of this corporation.

The aforementioned stock was acquired by the petitioner and the said notes and stock were issued therefor.

Thereafter, in April, 1921, the petitioner purchased the remaining one-half interest in the said Gallup Sand & Gravel Co. from Frank and Anna Gallup, paying therefor $10,000 in notes and $11,000 in cash.

The total consideration for the purchase of the entire capital stock of the Gallup Sand & Gravel Co. was $122,000, and the stock was entered upon the books of account of the petitioner at that figure. The notes given by the petitioner for the purchase of the Dale Engineering Co.'s interest aforesaid were taken to the bank and discounted by the petitioner and it received the cash therefor which it turned over to the said Dale Engineering Co. The $31,000 worth of the petitioner's stock issued to the Dale Engineering Co. was pledged as collateral security for the said loan.

All of the notes issued for the purchase of the foregoing stock have been paid with the exception of $15,000 still outstanding.

The book entries recording the purchase of the stock from the Dale and Gallup interests were as follows:

	Debit	Credit
Gallup Sand & Gravel Co. stock	$101,000
Bills payable		$70,000
Unissued stock		31,000
Securities, Gallup Sand & Gravel Co. stock	10,000
Bills payable (3 months' note given to Frank E. Gallup for 100 shares of stock additional to purchase of Jan. 10, 1921; see cashbook for payment of $11,000 additional paid for stock)		10,000

On or about March 22, 1922, after the acquisition of the stock of the Gallup Sand & Gravel Co., that company merged with the petitioner.

The balance sheet of the Gallup Sand & Gravel Co. prior to merger with the petitioner was as follows:

ASSETS
Cash:
Peoples Bank	$1,021.23
National Exchange	4.01
Petty cash	700.00
		$1,725.24
Accounts receivable		1,405.76
Bills receivable, Denslow		50.00
Plant and equipment		18,863.53
Real property:
Peebles property	$5,000.00
Kent & Hart	22,000.00
Perry property	400.00
Stahl property	400.00
Stabb property	1,295.00
		29,095.00
Lease		1,000.00
Office furniture and fixtures		255.69
Insurance prepaid		150.00
Mortgage, shown on Denslow accounts		400.00
		52,945.22
LIABILITIES
Accounts payable		$3,925.24
B.R.S. Co	$2,501.15
H.V.O	1,554.85
J.H.W	1,203.00
		5,259.00
Capital stock		42,000.00
Surplus		1,760.98
		52,945.22

The assets of the Gallup Sand & Gravel Co., acquired through merger and the liabilities assumed thereby were entered upon the petitioner's books of account as follows:

Plant and equipment	$30,767.96
Kent and Hart farms	22,000.00
Peebles property	5,000.00
Stabb property	1,295.00
Stahl property	400.00
Perry property	400.00
Lease Draper pit	30,000.00
Furniture office	255.69
Mortgages	400.00
Accounts receivable trade, G.S. & G. Co	1,405.76
Cash: Peoples Bank	1,021.23
National Exchange	4.01
First Nat'l. (petty cash)	700.00
Bills receivable	50.00
Insurance prepaid - Utica Mutual	150.00
Good will	49,239.02
To -
Reserve for appreciation (depreciation)	11,904.43
Accounts payable, trade G.S. & G. Co	3,925.24
Accounts payable, Misc. G.S. & G. Co	2,757.85
Accounts receivable, Misc. G.S. & G. Co	2,501.15
Securities	122,000.00
Accounts payable - Misc.
H. V. Owens	1,554.85
J. H. Wagoner	1,203.00

The amounts set opposite the foregoing assets, except the item of good will, represent their fair market value.

Petitioner's balance sheet as of April 1, 1922, giving effect to the merger aforesaid, was as follows:

Assets		Liabilities
Plant and equipment	$31,731.18	Reserve for depreciation	$11,904.43
Furniture and fixtures	363.94	Accounts payable	5,582.11
Kent and Hart farms	22,000.00	Accounts payable - trade	8,183.09
Peebles property	5,000.00	Bills payable	87,500.00
Stabb property	1,295.00	Capital stock	31,000.00
Stahl property	400.00	Surplus	1,053.99
Perry property	400.00
Lease, Draper pit	30,000.00
Mortgage	400.00
Good will	49,239.02
Cash on hand	2,751.65
Accounts receivable - trade	1,440.75
Bills receivable - trade	50.00
Prepaid insurance	150.00
Adjustment	2.08
	145,223.62		145,223.62

At the time of the transfer of the assets from the Gallup Sand & Gravel Co. to the petitioner the so-called Draper lease was increased in value upon the books of account from $1,000, as theretofore carried upon the books of the Gallup Sand & Gravel Co., to $30,000. The item of good will of $49,239.02 was written into the books of account as a balancing entry to bring the assets up to the total consideration of $122,000 paid therefor.

The pit operated by the petitioner under the Draper agreement is located at Boonville, N.Y., on the New York Central Railroad and Black River Canal. Its depth was 200 feet from the working level to the top and the stripping consisted of about 2 feet on the top, which was a very small proportion of the total sand contained therein. It was unique in that it contained a number of different commercial grades of sand. Among others, it contained concrete sand for plain or reinforced concrete, brick masonry sand, asphalt paving sand, engine sand for use in locomotives, plaster sand, and core sand used by foundries. Those different grades occurred in different strata and they were reached by carving any certain grade of sand desired to the bottom where it was picked up and placed in the processing plant. On other words, the pit was in itself a storage pile and any grade was available at any time they wished to reach a particular grade for the market. There were no other producing pits at Boonville at that time, nor were there any other pits producing a like quality or grade of sand within the territory. The sand produced therefrom, known by the trade name of "Boonville Sand," was specified by that name by architects and engineers throughout central New York State for building construction.

At the time the Draper contract was acquired it was estimated that there were 3,000,000 tons of sand available.

After the merger of the Gallup Sand & Gravel Co. with the petitioner the Draper pit was operated by the Boonville Sand Corporation, which was organized as an operating company, and it leased the plant and properties of the petitioner for the remainder of the year 1922 and paid the sum of $36,000 therefor. At some time later the said Boonville Sand Corporation and the petitioner merged.

The Gallup Sand & Gravel Co. operated under the Draper contract from April, 1920, to March, 1922, and the Boonville Sand Corporation from that time on.

In addition to the Draper pit, the Boonville Sand Corporation operated what was known as the Forestport pit. The tonnage of production from the Draper and Forestport pits for the years 1920 to 1923 was as follows:

	Draper pit	Forestport pit
1920	1 129,586
1921	1 157,499
1922	190,476	22,598
1923	205,796	39,574

The total sales as they appear in the books of the Gallup Sand & Gravel Co. for the period ended April 30, 1921, were $77,957.61 and for the eleven months ended March 31, 1922, $83,630.01, and the profits for the fiscal year ended April 30, 1921, were $6,267.29 and for the eleven months ended March 31, 1922, $13,993.69. Those profits are after deducting royalty under the Draper contract.

The books of the petitioner showed a loss for the month of April, 1922, of $8,316.98, after deducting $5,000 amortization charge under the Draper contract, and they showed a profit for the period May 1, 1922, to December 31, 1922, of $12,849.96, which figure was arrived at after deducting an amount for amortization, and it included rental of $36,000 paid to the petitioner by the Boonville Sand Corporation.

The sales as they appear upon the books of the Boonville Sand Corporation for the years 1922 and 1923 were:

	Draper pit	Forestport pit
1922	$109,999.89	$11,647.74
1923	127,327.04	21,213.64

The profits, according to the Boonville Sand Corporation's books, for 1922 were $24,131.85, arrived at after deducting royalties and $5,000 amortization of Draper contract, and for 1923, $19,405.42, arrived at after deducting royalties, amortization, and Federal income tax for 1923 of $4,627.73.

Five thousand dollars was charged off on the Draper contract on April 30, 1922, and on December 31 of that year an additional amount of $5,000.

The fair market value of the Draper contract in April, 1921, when the stock of the Gallup Sand & Gravel Co. was purchased, was $35,000, and at March 31, 1922, $30,000.

Gallup had been engaged in the sand and gravel business for a great many years and it was he who developed the Boonville sand. On April 7, 1921, the Gallup Sand & Gravel Co. entered into an agreement with Frank E., Anna B. and Catherine C. Gallup providing in part as follows:

WHEREAS, the party of the first part [Gallup Sand & Gravel Company, Inc.] on or about the 22nd day of April, 1920 purchased from Frank E. Gallup, one of the parties of the second part, certain real and personal property in the Town of Boonville, N.Y. * * * and Anna Beach Gallup and Catherine C. Gallup, respectively, the wife and daughter of said Frank E. Gallup, were familiar with the affiairs of said sand and gravel business and assisted said Frank E. Gallup in the conduct of said business, and

WHEREAS, said Frank E. Gallup is about to resign as president of the party of the first part, and the party of the first part desires to secure the advice and co-operation of the parties of the second part in connection with the conduct of its business;

Now, THEREFORE, THIS AGREEMENT, Made in consideration of the premises and of the sum of One Dollar by each party hereto to each of the others in hand paid, the receipt whereof is hereby acknowledged, the parties hereto have covenanted and agreed as follows:

FIRST - The party of the first part hereby employs the parties of the second part severally and consecutively, as hereinafter provided, to act in an advisory capacity from the date hereof until and including the 31st day of December, 1925, as follows:

Frank E. Gallup, one of the parties of the second part will act in an advisory capacity to the party of the first part and give the party of the first part the benefit of his knowledge and experience relating to its sand and gravel business without being under any obligation to spend any specified part of his time attending to the Company's business, for which services he shall receive an annual salary of Six thousand ($6,000) Dollars, payable Five hundred ($500) Dollars at the end of each month.

In case of the death of said Frank E. Gallup, Anna Beach Gallup, one of the parties of the second part will assume the duties and obligations imposed upon Frank E. Gallup by the foregoing paragraph and will act in the same capacity and will receive the same salary from the party of the first part for so doing.

In case of the death of both Frank E. Gallup and Anna Beach Gallup, Catherine C. Gallup, one of the parties of the second part, will assume the duties and obligations imposed upon Frank E. Gallup by the terms of the second preceding paragraph and will act in the same capacity and will receive the same salary from the party of the first part for so doing.

SECOND - This contract is made upon the express condition that neither Frank E. Gallup, Anna Beach Gallup nor Catherine C. Gallup will engage in the sand and gravel business directly or indirectly, or sell sand and gravel within a radius of two hundred (200) miles from the Village of Boonville, N.Y. on or before December 31st, 1925.

* * *

The foregoing contract was assumed by the petitioner and the Boonville Sand Corporation, and the payments were made thereunder.

The operating season for the sand business was between about March 15 of each year and the first of December, during which time Gallup was available for consultation and he was consulted at the offices of the company on matters relating to credits and plans of operation. Gallup also refrained from competition in the sand and gravel business in accordance with his covenant in the foregoing agreement.

The fair value of the services rendered by Gallup after entering into the contract aforesaid was not over $3,000 per year, and the fair value of his covenant to refrain from competition was not less than $3,000 per year.

The petitioner and the Gallup Sand & Gravel Co. filed a consolidated corporation income and profits-tax return for the fiscal year ended April 30, 1922.

OPINION.

MORRIS: The first question presented for consideration is whether the respondent incorrectly reduced the basis for the computation of exhaustion on the so-called Draper lease, acquired through the acquisition of the Gallup Sand & Gravel Co., from $30,000, as carried on the petitioner's books of account, to $1,000.

Section 234(a)(7) of the Revenue Act of 1921 provides:

(a) That in computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions:

* * *

(7) A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence. * * *

The facts, briefly restated, are that the petitioner acquired the entire outstanding capital stock of the Gallup Sand & Gravel Co., in January and April of 1921, paying therefor cash, promissory notes, and shares of its own capital stock in the total amount of $122,000. In March, 1922, the Gallup Sand & Gravel Co. having total assets of $52,945.22, liabilities of $9,184.24, and total capital and surplus of $43,760.98, merged with and transferred its assets to the petitioner. Among its assets was the Draper contract, which it carried upon its books of account at $1,000. When the assets were transferred to the petitioner the Draper contract was written up in its books of account to $30,000, and good will of $49,239.02 was placed upon the books, admittedly, as a balancing entry.

In relation to this item the respondent contends that it was really an intercompany transaction, and that therefore the petitioner could not be allowed any cost for the lease greater than the predecessor paid for it. His contention is based on G.C.M. 1345A, C.B. VI-2, p. 154, in which it was held that the transfer of assets from one affiliated company to another was an intercompany transaction and the amount, if any, of consideration passing between the two subsidiaries can have no effect on the basis of the assets in the hands of the transferee for the purpose of depletion. That ruling held further that a transfer of assets between members of an affiliated group effected during the years for which consolidated income-tax returns were required - an intercompany transaction, is productive of neither taxable gain nor deductible loss in computing the net income of the affiliated group or of a new or independent basis for the computation of gain or loss on a subsequent sale.

It will be noted in this proceeding that the taxable period involved is that following the liquidation of the Gallup Sand & Gravel Co. In a recent decision, Riggs National Bank,17 B.T.A. 615">17 B.T.A. 615, we considered at some length a kindred question arising from a transaction which terminated the affiliated status and for a taxable period subsequent thereto. In that proceeding, as here, the petitioner owned all the stock of a second corporation and in the year 1922 took over the assets of that corporation, the value of which was less than the cost of the stock. The question there presented was whether the parent company sustained a deductible loss in computing income for the period following affiliation. On the authority of Remington Rand, Inc. v. Commissioner, 33 Fed.(2d) 77 (June, 1929), we held that the petitioner was entitled to deduct the loss from its income for that portion of its taxable year which fell outside the period of affiliation. Holding as we did that that transaction was closed for tax purposes, it would necessarily follow that a new basis for computing gain or loss on the subsequent sale of the assets acquired in the liquidation and for exhaustion purposes was established. Having found as a fact that the contract in question in this proceeding had a fair market value of $30,000 at the date it was acquired by the petitioner, that value represents cost and should be used as the basis for exhaustion over the remaining life of said contract.

The second allegation of error herein is with respect to the disallowance of the deduction of an amount paid by the petitioner to F. E. Gallup.

It appears that Gallup was a man with broad experience in the sand and gravel business and that he had engaged therein for a great number of years. In April, 1920, Gallup contemplated resigning his position as president of the Gallup Sand & Gravel Co. and in order, as the record shows, that the company might still have the benefit of his broad experience and knowledge of the business, it entered into a contract with him for the payment of a salary of $6,000 per annum in consideration of Gallup's acting in an advisory capacity to the company. That contract also contained an express condition that Gallup and the other parties thereto should refrain from competition in a specified territory until December 31, 1925.

The contract itself is a rather peculiar one in that it provides that in the case of the death of Gallup, Anna B. and Catherine C. Gallup should assume his duties and obligations and receive the same salary therefor. It does not appear that those other parties to the contract had any peculiar or unusual knowledge in the sand and gravel business, which would tend to indicate that the amount paid did not in fact represent salary. However, the record shows that Gallup himself performed services during the taxable year and that those services had a fair value of $3,000 and that the amount specified by the contract was actually paid. Therefore, as to the amount paid for services rendered, we are of the opinion that the respondent erred in the disallowance thereof.

Nor do we see any reason why the deduction of the amount paid Gallup for his covenant to refrain from competition should not be allowed. The record shows that Gallup in fact refrained from competition and that the fair value per year of his so doing was not less than $3,000, and furthermore, that payment was actually made on that basis.

In Boonville National Bank,2 B.T.A. 352">2 B.T.A. 352; General Equipment Co.,2 B.T.A. 804">2 B.T.A. 804; and Market Supply Co.,3 B.T.A. 841">3 B.T.A. 841, the question of the deductibility of sums paid under similar contracts was presented and the deductions were disapproved by this Board on the ground, however, of failure to make proper proof. Therefore, we get little or no help from those cases on the question at issue here, except that the language therein would tend to indicate that, had a proper showing been made, the deduction would have been approved.

We have held in Farmers Feed Co.,17 B.T.A. 507">17 B.T.A. 507, that the taxpayer there was entitled to amortize the cost of contracts similar to the one here. In that case the cost was paid upon the acquisition of the contract. In this proceeding payment was made ratably over the life of the contract and, therefore, the annual payment equals the amount of yearly exhaustion on the cost of the contract. We are, therefore, of the opinion that the petitioner is entitled to deduct $4,500 as salary and exhaustion for the taxable period in question. See Christensen Machine Co.,18 B.T.A. 256">18 B.T.A. 256.

Reviewed by the Board.

Judgment will be entered under Rule 50.

VAN FOSSAN

VAN FOSSAN, dissenting: I dissent on the allowance of the deduction under the covenant to refrain from competition. The contract did not provide for any payment for keeping the covenant, nor was the $6,000 payment divisible, as permitted by the opinion.

SMITH, STERNHAGEN, and BLACK agree with the above dissent.

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Footnotes

• 1. Tonnage produced during operation by Gallup Sand & Gravel Co.↩