Meade Cycle Co. v. Commissioner

MEAD CYCLE CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Meade Cycle Co. v. Commissioner

Docket No. 5756.

United States Board of Tax Appeals

10 B.T.A. 887; 1928 BTA LEXIS 4006;

February 20, 1928, Promulgated

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1. The respondent was correct in allowing invested capital from October 28, 1918, when subscription to stock of the Mead Manufacturing Co. and indebtedness of its stockholders were recorded in books of account of the petitioner.

2. The action of the respondent in reducing the invested capital of the petitioner for the year 1918 on account of 1917 income taxes was correct and complies with section 1207 of the Revenue Act of 1926.

3. Taxes accrued in the fiscal year ended October 31, 1918, to the government of Great Britain and later paid to that government are allowable as a credit against taxes paid to the United States for the year ended October 31, 1918.

4. Petitioner is entitled to deduct in the taxable year in question, as exhaustion, a proportionate part of the March 1, 1913, value of his leasehold.

5. The value of good will acquired by the petitioner for stock determined. Said good will having been charged to profit and loss although still existing in fact, will be included in invested capital to the extent of the statutory amount.

6. Petitioner is entitled to have its tax determined as provided in section 328 of the Revenue Act of 1918, the recomputation thereof to be under Rule 62(c) of the Board's Rules of Practice.

John E. Hughes, Esq., for the petitioner.

C. H. Curl, Esq., for the respondent.

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MORRIS

The respondent's notice of deficiency of June 11, 1925, asserted a deficiency in income and profits taxes for the fiscal year 1918 of $9,146.40. The allegations of error are:

(1) Failure on the part of the respondent to include in petitioner's invested capital for the fiscal year ended October 31, 1918, the sum of $100,000, representing capital stock of the Mead Manufacturing Co.

(2) The action of the respondent in holding that the petitioner's tax liability for the fiscal year ended October 31, 1918, should not be computed under the provisions of sections 327(d) and 328 of the Revenue Act of 1918 and also under the provisions of section 210 of the Revenue Act of 1917.

(3) The action of the respondent in deducting the sum of $1,832.74 from the petitioner's invested capital for the fiscal year ended October 31, 1918, which sum represented a part of income taxes for the year 1917.

(4) Failure of the respondent correctly to compute the petitioner's invested capital for the fiscal year ended October 31, 1918.

(5) Failure of the respondent to allow as a credit in the fiscal year ended October 31, 1918, certain taxes paid by the petitioner to the government of Great Britain.

(6) Failure of the respondent to allow the petitioner to deduct, in the computation of its net income for the fiscal year ended October 31, 1918, depreciation on the March 1, 1913, value of a lease owned by petitioner.

FINDINGS OF FACT.

The business now conducted by the petitioner was originally organized in July, 1895, by James L. Mead for the purpose of selling bicycles at retail and by mail and was then conducted under the name of Mead Cycle Co. It continued from July, 1895, until 1898, when the petitioner was incorporated to take over the business theretofore operated by Mead. During the two and one-half years of operation prior to incorporation the business was successful, having earned profits for the period July 1, 1895, to December, 1897, in the following sums:

July to December, 1895	$1,206.30
January, 1896, to December, 1896	13,683.02
January, 1897, to December, 1897	54,665.89

During this period of time Mead drew no salary for his services. A reasonable salary for the services performed by him would be $2,500 per year.

On January 11, 1898, the petitioner was incorporated under the laws of the State of Illinois with an authorized capital stock of $100,000. On March 10, 1898, the board of directors of the petitioner met for the purpose of receiving a report of the committee appointed to investigate the business of James L. Mead. At that meeting the following report was tendered:

We have made a very thorough investigation of the business and assets of James L. Mead & Company, which is offered to your company by James L. Mead, in full payment for 994 shares of full paid and non-assessable stock of Mead Cycle Company, and we consider that the business is worth the full price that Mr. Mead asks for it and we unanimously recommend that his proposition be accepted.

We have investigated all the books, accounts and transactions of the business from its beginning and acquainted ourselves fully with its past history, present standing and future prospects; also with the methods on which the business has been and is being conducted, which we particularly recommend.

We find the business was started in July, 1895 at 287 Wabash Ave., Chicago, Ills., that the net profits above all expenses have been as follows:

July, 1895, to Dec. 31st, 1895	$1,206.30
Jan. 1st, 1896, to Dec. 31st, 1896	13,683.02
Jan. 1st, 1897, to Dec. 31st, 1897	54,665.89

The business is conducted on a strictly cash basis both in buying and selling, no bad debts being made and practically no risks being taken. It has been the policy of the business to pay cash for everything and incur no indebtedness, except for the purpose of storing bicycles just previous to the busy season.

We also find that the prospects for the future are very bright and that an immense amount of advertising, work and preparation has been done for the coming season's business.

We find that the statement of assets and liabilities presented to you by Mr. Mead on Feb. 23rd, 1898, is correct and the values named therein conservative.

The following is a statement showing condition of the business Monday morning March 7th, 1898: -

Assets:
6,989 wheels, (stripped)		$79,520.00
Tires		3,217.52
Accessories		3,099.32
Furniture and Fixtures		909.45
J. R. Mead		1,067.79
W. D. Hodson		300.49
J. H. Phillips		631.05
W. H. Holsteen		125.00
C. W. Hertel		187.25
J. E. Smith		250.00
A. L. Perrottet		185.00
Unsettled C.O.D.'s		7,575.15
		$97,068.02
Liabilities:
Bills Payable	$38,098.00
Deposits on unfilled orders	1,076.35
Jas. L. Mead Personal Account	27,250.86
Cash Overdrawn	3,475.32
		$69,900.53
	$69,900.53
Assets over liabilities		$27,167.49

We consider that the established business and good will are abundantly worth the difference between the actual assets and the face value of 994 shares of stock, viz: - $72324.51.

Moreover, should the BOARD OF DIRECTORS decide to accept Mr. Mead's offer, we recommend that the books be run the same way as before, and that they be opened up with the same balances. All of the 6968 wheels have been charged with equipment and Tire and Accessory accounts credited, which makes bicycle account in the ledger show more than the actual money put in them, but also makes the Tire and Accessory accounts show a greater credit, so the actual difference between the three accounts agrees with the stock on hand.

(Signed) J. H. PHILLIPS,

JAMES L. MEAD,

MYRON E. VANCE.

CHICAGO, ILLINOIS, March 10, 1898.

The offer of James L. Mead was accepted and accordingly a bill of sale was executed on March 10, 1898, conveying to the petitioner (in consideration of 994 shares of capital stock, par value $100 per share), "the entire assets, good will, contracts, accounts, all monies, goods, chattels and property now belonging to said James L. Mead, and used by him in the business known as Mead Cycle Company, James L. Mead, proprietor and James L. Mead & Company, also all leases now owned by the firm known as James L. Mead & Company, the Mead Cycle Company, James L. Mead, proprietor."

Mead, prior to the incorporation, owned a number of trade names such as "Ranger," "Sentinel," "Monitor," "Pathfinder" and "Iroquois," which were turned over to the petitioner together with the other assets and have been used by the petitioner up to the year in question.

To record the issuance of $100,000 of capital stock of the petitioner at the time of the acquisition of the above assets, an entry was made in the books of account debiting tangible assets, $24,400, and good will, $75,000. The six remaining shares of stock were sold to other persons at par. The tangible assets were entered on the books of account at a figure of $24,400 instead of the book value of $27,167.49, simply for the purpose of using a round figure.

The actual cash value of the good will conveyed to the petitioner was not less than $72,232.51. The outstanding capital stock of the petitioner on March 3, 1917, was $100,000. The good will of $75,000 originally set up on the books was charged off between the period of January 14, 1908, and October 10, 1910.

Petitioner advertised very extensively during its entire existence, having spent in newspaper and magazine advertising, printing and paper, and postage from 1901 to 1918 the following sums, all of which were charged to expense:

Year	Newspaper and magazine advertising	Printing and paper	postage	Total for year
1901	$44,135.96	$17,654.82	$20,725.90	$82,516.68
1902	42,693.83	16,115.86	22,866.40	81,676.09
1903	28,813.43	11,935.69	13,732.84	54,481.96
1904	33,501.11	8,910.23	8,269.24	50,680.58
1905	25,152.92	12,937.29	9,409.30	47,499.51
1906	43,490.68	12,524.09	12,346.25	68,361.00
1907	33,285.04	20,654.11	18,106.30	72,045.45
1908	46,217.89	21,202.21	19,659.41	87,079.51
1909	70,172.70	35,911.83	29,422.85	135,507.38
1910	101.833.54	54,135.40	44,797.19	200.766.13
1911	105,284.93	56,975.99	52,710.88	214,971.80
1912	100,588.58	52,278.57	54,527.42	207,394.57
1913	113,201.14	70,905.50	60,228.96	244,335.60
1914	125,461.61	74,176.17	58,714.29	258,352.07
1915	102,341.58	68,987.81	44,944.24	216,273.63
1916	91,666.11	68,603.95	65,909.85	226,179.91
1917	108,960.99	93,994.53	69,305.16	272,260.68
1918	112,792.59	76,705.79	63,536.11	253,034.49
				2,773,417.04

James L. Mead was engaged, in addition to the business of the Mead Cycle Co., in the bicycle business under the firm name of Mead & Prentice, a partnership. In 1899 this partnership was dissolved, the cash was divided between the partners, and Mead purchased other assets of the business, including good will, trade-names, trade-marks, a great number of card indexes containing the names of prospective customers, and 2,000 or 3,000 inquiry letters asking for catalogues. These trade-names, trade-marks, indexes, etc., were turned over to the petitioner in 1899 without consideration, as well as a number of bicycles valued at $20 each, which were divided between the two partners upon dissolution of the partnership. No record appears in the books of account regarding the receipt of these assets or the value thereof.

In 1917 the stockholders of the petitioner decided to organize a corporation known as the Mead Manufacturing Co., which was organized and incorporated under the laws of the State of Illinois in December, 1917, for the purpose of engaging in the manufacture and sale of bicycles, motor-cycles, automobiles and other motor vehicles and accessories. Capital stock of that corporation was $100,000. A consolidated return was filed for the Mead Manufacturing Co. for the taxable year 1918 with the petitioner. The stockholders of the petitioner subscribed for the entire authorized capital stock in the Mead Manufacturing Co. in practically the same proportion as their holdings in the petitioner. Settlement for the purchase of the stock of the Mead Manufacturing Co. by the stockholders of the petitioner was made by crediting that corporation with the amount of each individual subscription, and by charging the personal accounts of the subscribers with a like amount. This entry was made on October 28, 1918, four days prior to the close of the fiscal year of the petitioner. It was the intention to have the entries made promptly and Mead told the treasurer to have it done and left for California shortly thereafter. Toward the end of the fiscal year it was found the entries had not been made. These personal accounts of the stockholders, which were in excess of the amount of their total subscriptions to the capital stock of the Mead Manufacturing Co., had been accumulated in the books of the petitioner and as had been the custom the petitioner credited these accounts with one-half of one percent a month interest up to October 28, 1918. The interest credited to the stockholders from the date of incorporation of the Mead Manufacturing Co. to October 28, 1918, was not charged back to them.

The Mead Manufacturing Co. occupied the same quarters with petitioner, and had the same officers. It never did any business. No stock certificates were ever issued. Its accounts were ketp on the books of the Mead Cycle Co. They consisted solely of a credit of $100,000 which was left on the books for a time, and then the $100,000 was redistributed to the original subscribers.

The respondent allowed the petitioner to include in invested capital a pro rata share of the sum of $100,000 capital stock of the Mead Manufacturing Co. for the four days remaining in the fiscal year ended October 31, 1918.

On May 5, 1910, petitioner leased from the Northern Trust Co., Receiver, from September 1, 1910, to and including August 31, 1925, the four upper floors of the five-story building situated at the southeast corner of Washington and Canal Streets in the City of Chicago; also the east 83 1/6 feet of the first floor (together with an entrance way from Canal Street about 8 1/4 feet wide with elevator and stairway leading therefrom), excepting the mezzanine floor in the rear portion of the first floor; also the upper basement in the above-described premises, except the west 79 1/12 feet of the north 34 1/6 feet, being, all told, 69,193 square feet.

The petitioner's lease provided that the lessor should furnish steam heat. There was also a provision in the lease requiring the petitioner to pay $3,500 toward the cost of the installation of a sprinkler system which was installed and in operation on March 1, 1913. At the time the lease was made a track ran close to the building which resulted in saving truckage expense. The rental of these premises as provided in the lease was the total sum of $207,579 to be paid in equal monthly installments of $1,153.22 during the life of the lease. At the date of making this lease the neighborhood in which the building was located was very badly torn up and the surrounding buildings were in bad repair. Between the period 1910 to March 1, 1913, there were considerable improvements made in the locality of this building and real estate values were greatly enhanced. Washington Street was made a boulevard and the Washington Street bridge was opened. The Northwestern Station, representing an investment of approximately $29,000,000, was erected and opened in June, 1911. A large percentage of the passengers using this station entered and left through the Canal Street entrance. The building occupied by the petitioner was across the street from this station. There was also erected between 1910 and 1913 the new Butler Brothers Building, also the Sharples Building. The latter building was opened in 1912. The petitioner had a large sign outside of its building advertising a bicycle known as "Ranger," which was daily seen by a great number of people.

The profits from the retail business of the petitioner for the years 1911 to 1913 were as follows:

1911	$15,049.18
1912	16,644.34
1913	19,365.17

The surrounding buildings had a rental value of from 30 cents to $1 per square foot in the year 1913. The fair value of this lease on March 1, 1913, was 33 cents per square foot, or a total fair market value of $62,800.95.

The petitioner owned and operated a branch at Birmingham, England. Under the laws of Great Britain this branch was required to pay taxes to the government of Great Britain for the fiscal year in question, which taxes were accrued on the books of account of the petitioner. The amount of the taxes was 482 pounds, 14 shillings, which was paid in two equal installments of 271 pounds, 7 shillings, on January 7, 1920, and July 24, 1920. The rate of exchange on January 7, 1920, between New York and London was $3.81 per pound sterling, and on July 24, 1920, was $3.80 per pound sterling. No part of this tax has ever been refunded.

The books of account of the petitioner were kept on the accrual basis. In 1918 the petitioner had in its books of account to the credit of its stockholders, subject to withdrawal at any time, personal accounts aggregating $289,690.74. The respondent disallowed this sum as invested capital on the theory that it constituted borrowed money. The petitioner paid $18,898.80 interest on borrowed money in 1918.

The petitioner developed during the years preceding the fiscal year ended October 31, 1918, and owned valuable patents, one of which was its sprocket patent. This patent enabled the petitioner to save one and one-half pounds of steel on every sprocket manufactured, which was equivalent to a saving of between 9 and 10 cents a sprocket, depending upon the market price of steel. This device was also patented in England. Petitioner also owned during the taxable year a patent on a frame head fitting which was a fitting of a single assembly to replace the previous head and connection to the frame, composed of a number of parts. There was considerable saving on account of this device. These patents were not capitalized but development expenses thereof were charged to expense.

The H. P. Snyder Manufacturing Co. of Little Falls, N.Y., was engaged in the manufacture of bicycles and parts during the year 1918. Its income-tax return was made on the calendar year basis. Its percentage of excess-profits tax to net income for the calendar year 1918 was 4.1 per cent. Petitioner had no Government cost-plus contracts.

OPINION.

MORRIS: The first assignment of error is the failure of the respondent to include in invested capital $100,000 for capital stock of the Mead Manufacturing Co. under the facts hereinabove set forth. The petitioner contends that this amount should have been allowed from the date of the original subscription, while the respondent allowed it only from the date of the entry on petitioner's books charging the personal accounts of its stockholders with the amount of their subscriptions.

Section 326(a) of the Revenue Act of 1918 provides: "That as used in this title the term 'invested capital' for any year means (except as provided in subdivision (b) and (c) of this section) (1) actual cash bona fide paid in for stock or shares; (2) actual cash value of tangible property, other than cash, bona fide paid in for stock or shares, at the time of payment, * * *." Tangible property referred to in section 326(a)(2) above is defined in section 325(a) to mean "stocks, bonds, notes and other evidences of indebtedness, bills and accounts receivable, leaseholds, and property other than intangible property." As far as the Mead Manufacturing Co. is concerned, the only evidence of cash or other tangible property having been paid in for stock was a credit to it on the books of another corporation of $100,000. It issued no stock, did not engage in the conduct of any business, nor did it need or use any cash or other property. The petitioner contends, however, that the $100,000 was used in and was at the risk of the consolidated business during this entire period, and that the only reasonable conclusion to be drawn therefrom is that the money was actually paid in for the stock at the time it was subscribed therefor and that the omission of the bookkeeper to execute an order to make an entry on the books has no effect on petitioner's right to include this sum in invested capital from December 8, 1917, to the close of its taxable year. We are unable to agree with the conclusion drawn from the petitioner's premise. The only way the amount in controversy could be included in invested capital would be through its conversion from borrowed capital into cash paid into the business. The facts do not support such a conversion. The stockholders' accounts were not charged with the amounts of the subscriptions until October 28, 1918, and interest was credited on these amounts until that date in accordance with the petitioner's practice of paying interest on the stockholders' credit balances. Even after discovery that prior entries were not made, the stockholders' accounts were not charged back with the interest credited to them from December 8, 1917, to October 28, 1918. The respondent's determination on this item is therefore approved.

The second assignment of error involving sections 327 and 328 of the Revenue Act of 1918 will be hereinafter discussed.

The third assignment of error relates to the action of the respondent in deducting from its invested capital for the year 1918 the sum of $1,832.74 representing 1917 income tax. It appears that this deducrion was made in accordance with the regulations in force for the period under consideration; therefore, under the provisions of section 1207 of the Revenue Act of 1926, the action of the respondent must be approved. .

The fourth assignment of error is to the effect that the respondent incorrectly computed the petitioner's invested capital in that the petitioner's good will had been excluded from said computation. The business of the petitioner was organized as a proprietorship in July, 1895, and was owned by James L. Mead. The proprietorship continued to operate as such until it was incorporated, in January, 1898. During that period the profits were $69,555.21. Mead's testimony disclosed that these profits were determined without taking into consideration any salary for himself. A fair salary for his services for the period July, 1895, to December 31, 1897, would be about $6,250 for the entire period, or $2,500 a year. Deducting this salary, the net profit for that period was $63,305.21. However, the business was increasing steadily in worth. Prior to the purchase of the business by the petitioner, a committee was appointed to investigate the advisability of accepting the offer of sale which had been made by Mead, and, as a result of the report of that committee, the business was purchased, the petitioner paying therefor 994 shares of its capital stock. When the assets were taken over, the petitioner's books were charged with tangible assets of $24,400 and good will of $75,000. The petitioner's witness stated that the reason for not entering the entire net assets in the books of account at $27,167.49, their true book value, was that they were desirous of using a "round figure," From January, 1908, to November, 1910, the entire good will account of $75,000 was written off the books to profit and loss. In computing the petitioner's invested capital for the year ended October 31, 1918, the respondent failed to allow any portion of the good will of the company as invested capital.

We are satisfied from the evidence the company acquired a very substantial good will when it purchased the business of James L. Mead in 1898. This conclusion is borne out by a consideration of the earnings for the period July, 1895, to December 31, 1897. We realize, of course, that a period of two and one-half years is an exceedingly short time within which to determine the worth of a going business, but we do not rely entirely upon the test of profits. The committee appointed to investigate and determine the advisability of purchasing the assets in question considered that the established business and good will were abundantly worth the difference between the actual assets and the par value of 994 shares of stock, viz, $72,324.51. We are satisfied that this value is amply supported by the evidence, and should be included in invested capital for the taxable year in question, subject to the limitation on intangibles. See .

Under this assignment of error the petitioner is also claiming additional invested capital through the purchase of good will for cash based on expenditures made for advertising over a series of years and charged to expense. The situation presented on this item is the same as that appearing in the , in which we recognized that some part of the cost of advertising may be a capital investment which may be included in invested capital, but in the absence of any evidence upon which an allocation can be predicated, no additional invested capital was allowed by reason of such expenditures. As no allocation of the advertising expenses has been made in the instant proceeding, invested capital may not be increased thereby.

The fifth assignment of error is the failure of the respondent to allow as a credit against its taxes for the fiscal year ended October 31, 1918, certain taxes paid to Great Britain in 1920 on its income for the fiscal year in question from sources within that country.

Section 238 of the Revenue Act of 1918 provides as follows:

(a) That in the case of a domestic corporation the total taxes imposed for the taxable year by this title and by Title III shall be credited with the amount of any income, war-profits and excess-profits taxes paid during the taxable year to any foreign country, upon income derived from sources therein, or to any possession of the United States.

If accrued taxes when paid differ from the amounts claimed as credits by the corporation, or if any tax paid is refunded in whole or in part, the corporation shall at once notify the Commissioner who shall redetermine the amount of the taxes due under this title and under Title III for the year or years affected, and the amount of taxes due upon such redetermination, if any, shall be paid by the corporation upon notice and demand by the collector, or the amount of taxes overpaid, if any, shall be credited or refunded to the corporation in accordance with the provisions of section 252. In the case of such a tax accrued but not paid, the Commissioner as a condition precedent to the allowance of this credit may require the corporation to give a bond with sureties satisfactory to and to be approved by him in such penal sum as he may require, conditioned for the payment by the taxpayer of any amount of taxes found due upon any such redetermination; and the bond herein prescribed shall contain such further conditions as the Commissioner may require.

Section 200 of the same Act provides that the term "paid," for the purpose of the deductions and credits under Title II, means paid or accrued. The petitioner kept its books and made its returns on the accrual basis. The taxes in question were for the fiscal year 1918, and were accrued on its books of account. They were subsequently paid and the evidence shows that no refund thereof has been made. We are therefore of the opinion that the petitioner is entitled to a credit of 482 pounds 14 shillings against its taxes for the year in question at the rates of exchange, as set forth in the findings of fact, prevailing at the date of payment of said tax to Great Britain. .

The sixth assignment of error raises the question whether the petitioner is entitled to an allowance for the exhaustion of a certain leasehold. We have found from a consideration of all the evidence that this lease had a value on March 1, 1913, of $62,800.95. Its life extended to August 31, 1925. The petitioner is therefore entitled to an allowance for the exhaustion thereof for the taxable year in question based on the March 1, 1913, value, and its remaining life from that date. .

Reverting to the second assignment of error, namely that pertaining to the petitioner's right to have its tax computed under section 328 for the portion of the fiscal year subject to 1918 rates, relief under section 210 of the Revenue Act of 1917 having been waived, the petitioner contends that it comes within the provisions of section 327 in that its invested capital can not be accurately determined and abnormal conditions existed affecting its capital and income. Upon the dissolution of the partnership of Mead and Prentice, Mead turned certain valuable assets into the petitioner without consideration, but no record appears in the books of account regarding the receipt of these assets or the value thereof. The evidence also shows that valuable patents were developed, which were not capitalized. See . The petitioner used in its business a large amount of borrowed capital. Over a period of years it spent over $2,700,000 for advertising which was charged to expense. The petitioner reaped the benefits of whatever good will was built up by this expenditure, but, as we have hereinabove held, may not include the cost thereof in its invested capital. These conditions, in our opinion, clearly bring the petitioner within section 327, and its profits tax should accordingly be computed under section 328 of the Revenue Act of 1918.

This proceeding having been heard prior to the decision of the Supreme Court in , the respondent refused to comply with the subpoena to produce certain documents. The petitioner introduced in evidence the deposition of Edward H. Teal, vice president and general manager of Homer P. Snyder Manufacturing Co., which is engaged in the manufacture of bicycles and bicycle parts. His testimony disclosed that that company's percentage of excess-profits tax to net income for the calendar year 1918 was 4.1 per cent. We do not know what volume of business that company did nor the amount of capital employed. It was not shown whether that company was doing a retail business exclusively, or wholesale, or both, as in the instant case. Sufficient evidence was not introduced for us to determine whether that company is a proper comparative or not; therefore, we can not, as requested by the petitioner, order the respondent to use it as such.

Recomputation of the deficiency should be made under Rule 62(c).