Kaltenbach & Stephens, Inc. v. Commissioner

KALTENBACH & STEPHENS, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Kaltenbach & Stephens, Inc. v. Commissioner

Docket Nos. 9426, 19702, 22231.

United States Board of Tax Appeals

12 B.T.A. 1009; 1928 BTA LEXIS 3420;

June 29, 1928, Promulgated

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">*3420 In the year 1916 the petitioner purchased the assets of a partnership and issued shares of its capital stock therefor in the amounts of $1,553,688.59 for the tangible assets and $325,000 for the good will. Under the evidence, held that the actual cash values of the tangible assets and good will of the partnership were $1,553,688.59 and $325,000, respectively; that the petitioner is entitled to include them in its invested capital at those amounts, and to compute the annual deduction for depreciation of the tangible property on the basis of $1,553.688.59.

Victor House, Esq., and Abbott P. Mills, Esq., for the petitioner.

James A. O'Callaghan, Esq., for the respondent.

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MARQUETTE

">*1009 This proceeding is for the redetermination of deficiencies in income and profits taxes asserted by the respondent in the amounts of $31,021.09 for the year 1919, $3,177.78 for the year 1920, and $12,207.56 for the year 1923. Only so much of the deficiencies is in controversy as arises from the exclusion by the respondent from the petitioner's invested capital of the amount of $161,200.47 claimed on account of tangible property paid in for stock, the exclusion">*3421 from invested capital of the amount of $198,028.74 claimed on account of good will paid in for stock, and the partial disallowance of deductions taken by the petitioner in each year for depreciation of its tangible property. The proceedings were consolidated for hearing and decision.

FINDINGS OF FACT.

The petitioner is a corporation organized under the laws of the State of Delaware with its principal office at Newark, N.J. It is ">*1010 and has been since its incorporation engaged in manufacturing silk ribbon.

In the year 1891 Ernest J. Kaltenbach and James B. Stephens formed a partnership for the purpose of engaging in the manufacture of silks in Brooklyn, N.Y. The capital of the firm was $5,000, the greater part of which was expended in the acquisition of some secondhand looms. After a short time the firm turned to the manufacture of narrow silk ribbon, to which it devoted itself exclusively during the remainder of its existence. No additional capital was ever paid in to the firm, its increased worth being due entirely to earnings. The firm occupied leased premises in Brooklyn until 1907, when it acquired a site and erected a weaving plant in Allentown, Pa., and">*3422 in 1911 it acquired a site and constructed a finishing plant in Newark, N.J. The partnership manufactured its goods and conducted its business in these two plants until the year 1916, when they were turned over to the petitioner as hereinafter set forth.

The partnership of Kaltenbach & Stephens prospered and by 1910 its assets as shown by its balance sheets had reached a value of $683,223 in excess of its liabilities. By the year 1916 the firm was twice the size of its largest competitor, and it produced about one-third of the narrow silk ribbon output of the United States. On January 1, 1916, its net worth as shown by its balance sheets was $1,335,152.43.

In the fall of 1916, largely at the instance of Charles E. Kaltenbach, a son of Ernest J. Kaltenbach, and now president of the petitioner, the petitioner was formed to take over the business of the partnership. The two original partners, Ernest J. Kaltenbach and James B. Stephens, though men of ability, conducted their business by rule-0f-thumb methods. They kept no books or records of account other than memoranda of the most temporary sort. From these memoranda, consisting of check stubs, a copy book list of accounts">*3423 payable, loose inventory sheets, and copies of invoices, Stephens, from time to time, constructed balance sheets of the business for submission to banks. These balance sheets, which were on file with the banks, were in 1916, at the time of the proposed incorporation, the only records of the operations of the partnership except for such of the memoranda mentioned as had been preserved, and sales records kept by Frederick, Vietor & Achelis of New York City, who had acted as factors for the partnership since 1899.

Ernest J. Kaltenbach and James B. Stephens conducted their business as a personal venture, closely bound by social as well as business ties, and from time to time they used the earnings of the partnership, which was their sole source of income, in real estate and other speculative ventures, practically all of which turned out to be unprofitable. ">*1011 In the annual balance sheets of the partnership prepared for the banks, none of the income invested in these outside ventures was reflected, except in so far as the withdrawals depleted the surplus shown. The balance sheets showed only the assets and liabilities of the ribbon business, and when the petitioner was formed">*3424 only the ribbon business and its assets were turned in to the petitioner, none of the outside investments being included. No accurate record of these outside investments was ever kept. They included a phonograph company, a gold mine, several real estate ventures, a steel foundry, and some stock purchases. During the period July 1, 1915, to June 30, 1916, $134,590.80 was withdrawn by Kaltenbach and Stephens from the partnership and invested in these outside ventures. The total amount withdrawn by the partners during the years 1911 to June 30, 1916, and invested in other enterprises was probably more than $350,000.

In the year 1916 the petitioner was formed with an authorized capital stock of $2,500,000, of which $500,000 was preferred stock and $2,000,000 was common stock, and in November, 1916, the petitioner acquired the ribbon-manufacturing plants and properties of Kaltenbach & Stephens by a written contract dated as of September 1, 1916, and paid therefor its capital stock of the par value of $2,100,000.

When the acquisition by the petitioner of the partnership property was under discussion, the directors of the petitioner held many meetings to determine the valuations">*3425 at which both the tangible property and the good will of the partnership should be purchased. In order to arrive at a proper valuation of the business the parties to the transaction had an appraisal made of the physical assets of the partnership. The appraisers reported that the assets had a reproduction cost, new, as of September 1, 1916, of $1,553,688.59, and a "sound value" of $1,392,488.12. This sound value represented the reproduction cost less depreciation for the time the assets had been in use. The reproduction cost and sound value were allocated to the partnership tangible assets as follows:

	Reproduction cost	Sound value	Difference
Allentown:
Land	$36,100.00	$36,100.00
Buildings	318,764.69	295,916.33	$22,848.36
Machinery and equipment	840,937.15	728,839.81	112,097.34
Newark:
Land	20,000.00	20,000.00
Buildings	173,985.95	164,999.38	8,986.57
Machinery and equipment	163,900.80	146,632.60	17,268.20
	1,553,688.59	392,488.12	161,200.47

The Allentown plant consisted of four major buildings and also a garage, repair shop, and boiler house. The machinery consisted ">*1012 almost entirely of looms, although there were">*3426 some winders and other weaving equipment. The Newark plant consisted of a three-story-and-basement main building where the finishing process was carried on, and also the drying house and heating department and boiler house.

The appraiser was not asked, in making the appraisal of the partnership property, to report the market or actual cash value of the plants, which included additional elements such as supply and demand, time required to build up and equip the plants and getting them running smoothly, etc. It would have taken at least two years to build up and equip the plants beginning in the fall of 1916, and some of the machinery, which was specially made in Germany, could not then be procured at all. Between September 1, 1916, and November 23, 1916, the date the petitioner acquired the assets of the partnership, prices of building material and of machinery had advanced materially. The petitioner's officers at that time determined that in view of the fact that the partnership was a going concern and that prices of material and equipment were increasing, the actual cash value of the plants was at least equal to the reproduction cost of $1,553,688.59 determined by the appraiser, ">*3427 and that in addition the good will of the partnership was worth at least $325,000. Other items not material here brought the total net value of the partnership, as determined by the petitioner's officers, up to $2,100,000, for which it issued its capital stock in that amount in full payment.

The partnership balance sheets show that its average net earnings from 1911 to 1915, inclusive, were $109,006.66. The balance sheets as above stated did not reflect the amounts withdrawn by the partners and invested in outside ventures. The average net value of the tangible assets during the years 1911 to 1915, inclusive, as shown by the balance sheets, amounts to $1,124,387.10. The average net earnings of the business for the years 1916 to 1920, inclusive, were $321,000.

The actual cash values of the tangible assets and good will which the petitioner purchased from the partnership of Kaltenbach & Stephens were $1,553,688.59 and $325,000, respectively.

The respondent, upon audit of the petitioner's income and profits-tax returns for the years 1919, 1920, and 1923, included the tangible assets and good will acquired by the petitioner from the partnership of Kaltenbach & Stephens in">*3428 the petitioner's invested capital at the amounts of $1,392,488.12 and $126,971.26, respectively. The respondent computed the value of the good will as follows:

Average earnings for five years 1911-1915, inclusive,
as shown by balance sheets of the partnership of
Kaltenbach & Stephens	$109,006.66
Average net assets for five years, 1911-1915, inclusive,
as shown by balance sheets	1,124,387.10
8% of the net assets equals $89,950.97 or the
amount of earnings applicable to tangible property.
The difference between this amount and the total earnings
represents the earnings attributable to intangible assets
and amounts to	$19,045.69
This amount capitalized at 15% amounts to	126,971.26

">*1013 The respondent also added to the petitioner's income for each year the amount of $11,210.21 depreciation taken on the disallowed value of the tangible property.

OPINION.

MARQUETTE: The issues that we are called upon to consider relate to the amounts at which the petitioner may include in its invested capital the tangible assets and good will it purchased from the predecessor partnership of Kaltenbach & Stephens, and the basis for computing the annual">*3429 deduction for depreciation of the tangible property. It is the contention of the petitioner that it acquired from the partnership tangible property of the actual cash value of $1,553,688.59 and good will of the actual cash value of $325,000, for which it issued its capital stock in the amounts of $1,553.688.59 and $325,000, respectively, and that it is therefore entitled to include them in its invested capital at those amounts. The respondent has heretofore determined that the tangible property so acquired by the petitioner had an actual cash value at the date of acquisition of $1,335,152.43, and the good will an actual cash value of $126,971.26, and he has included them in the petitioner's invested capital at those amounts. However, the respondent now urges that the good will in question had no value and that the petitioner's invested capital as heretofore determined by him should be reduced by the amount of good will allowed. The depreciation which the respondent has disallowed is the depreciation on the difference between the values of the tangible assets as claimed by the petitioner and allowed by the respondent.

Upon consideration of the evidence presented to us we are">*3430 of the opinion that the tangible assets acquired by the petitioner from the partnership of Kaltenbach & Stephens had an actual cash value at the date of acquisition of at least $1,553,688.59 as claimed by the petitioner, and that it is entitled to include them in its invested capital at that amount. The evidence shows that these assets were appraised on September 1, 1916, and their reproduction cost on that date determined to be $1,553,688.59, and their sound value, which represented reproduction cost with allowances for depreciation, at $1,335,152.43. The appraisers were, however, not asked to determine the actual cash value of the plant as a going concern and did not ">*1014 attempt so to do. In addition to the sound value of the assets, there were certain elements such as the fact that Kaltenbach & Stephens was a going concern; that it would take two years to reproduce the plant even if the material and machinery could be acquired at the so-called sound value, and the fact that certain machinery was made in Germany and could not then be procured at all. Furthermore, in November, 1916, the date the transaction was actually consummated, prices of material and machinery had">*3431 materially increased over the prices obtaining on September 1, 1916. The officers of the partnership and of the petitioner considered that the actual cash value of the tangible assets on that date was at least equal to their reproduction cost as shown by the appraisal, and the petitioner took them over at that value and issued its capital stock in amount therefor. The testimony of all the witnesses, one of whom made the appraisal mentioned, is to the effect that the actual cash value of the partnership plant as a going concern was at least the value now claimed by the petitioner, and we are satisfied that that value is conservative and that it should be allowed.

We are also satisfied from the evidence that the good will acquired by the petitioner from the partnership had an actual cash value of at least $325,000. The evidence shows that the partnership was formed in the year 1891 with a capital of $5,000; that no additional capital was ever invested therein, and that in January, 1916, the net value of its tangible assets as shown by its balance sheets was $1,335,152.43, all of which had been acquired out of earnings. The average earnings for the five years 1911 to 1915, inclusive, ">*3432 as shown by the balance sheets were $109,006.66. In addition to the earnings as shown by the balance sheets, large amounts had been withdrawn by the partners during that period. The exact amount of these withdrawals can not be ascertained, but the record does show that $134,590.80 were withdrawn during the period July 1, 1915, to June 30, 1916. Adding to the earnings as shown by the balance sheets only the amount withdrawn between July 1, 1915, and June 30, 1916, and capitalizing the earnings thus determined on the same basis adopted by the respondent, the good will would be of the value of $306,000. We are satisfied, however, that considerably more than $134,590.80 was withdrawn from earnings during the five-year period; that the average net earnings of the partnership during that period were at least $150,000, and that the good will was of the value of at least $325,000. This is the value placed on the good will by the petitioner and the partnership at the time of the transaction mentioned and it is, we think, entirely justified by the prior earnings in relation to the tangible assets, and the reasonable expectation for the future. That the value so determined at that time">*3433 was reasonable, is borne out by ">*1015 the fact that the earnings of the petitioner averaged $325,000 per year during the years 1916 to 1920, inclusive. It is our opinion, and we so hold, that the good will in question had an actual cash value of at least $325,000 when the petitioner acquired it.

The petitioner in computing its invested capital for the years 1919, 1920, and 1923, is entitled to include the tangible property and the good will involved herein in its invested capital at the amounts of $1,553,688.59 and $325,000, respectively, with proper adjustments for depreciation of the tangible assets. The basis for computing depreciation of the tangible assets is $1,553,688.59.

Other errors on the part of the respondent were alleged by the petitioner but they were abandoned at the hearing.

Judgment will be entered under Rule 50.