Eaton v. Commissioner

Estate of Clarence B. Eaton, Deceased, Murl P. Eaton, Executrix, Petitioner, v. Commissioner of Internal Revenue, Respondent. Murl P. Eaton, Petitioner, v. Commissioner of Internal Revenue, Respondent. James M. Smith, Petitioner, v. Commissioner of Internal Revenue, Respondent. Minnie I. Smith, Petitioner, v. Commissioner of Internal Revenue, Respondent

Eaton v. Commissioner

Docket Nos. 12099, 12100, 12101, 12102

United States Tax Court

10 T.C. 869; 1948 U.S. Tax Ct. LEXIS 183;

May 18, 1948, Promulgated

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Decisions will be entered under Rule 50.

1. Composite rates of depreciation claimed on machinery and motor vehicles used in construction work, held, on the evidence to be proper.

2. A contracting firm in 1941 rented machinery and equipment to the United States Government at a stipulated monthly rental under a contract providing that the Government could elect to purchase any or all items on completion of certain work by paying the difference between the agreed value of the items (plus 1 per cent a month) and the total rentals paid. In April 1942 the Government made purchase of the items pursuant to the contract.

(a) Amounts paid for use of the equipment prior to April 1942, held, rentals and taxable as ordinary income.

(b) Amounts paid pursuant to the election to purchase in April 1942, held, purchase price and taxable as capital gain.

3. Two taxpayers, married and residents of California, engaged as partners in construction work prior to 1927, and continued their partnership through the years 1941-1943. Some capital was used in the business, but their personal efforts and business ability constituted the primary income-producing factor.

(a) Business capital of the partnership on July 29, 1927, remaining in business, held, properly treated for tax purposes as separate property of the partner-husbands under California law.

(b) Income attributable to the partner-husband's separate capital, held, taxable wholly to the husband and remaining profits, held, taxable as community income.

(c) On the evidence, held, that 7 per cent of the separate capital of the husband-partner in the taxable years should be deemed earnings of his capital and the remaining partnership income should be deemed community income.

Clyde C. Sherwood, Esq., and John V. Lewis, Esq., for the petitioners.

W. J. McFarland, Esq., for the respondent.

Johnson, Judge.

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JOHNSON

The Commissioner determined the following deficiencies in petitioners' respective income taxes for 1941 and 1943, including the unforgiven portion of tax on 1942 income, as follows:

	Docket
Petitioner	No.	Year	Tax	Deficiency
Estate of Clarence B. Eaton	12099	1941	Income tax	$ 8,727.71
		1943	Income tax and victory tax	35,387.23
Murl P. Eaton	12100	1941	Income tax	1,675.01
James M. Smith	12101	1941	Income tax	8,473.67
		1943	Income tax and victory tax	36,101.43
Minnie I. Smith	12102	1941	Income tax	1,572.48

Petitioners assail the Commissioner's determination, and charge that he erred in the following particulars:

(1) By increasing petitioners' income from the partnership of Eaton & Smith by disallowing deductions for depreciation in the amounts of $ 35,607.86, $ 28,715.35, and $ 31,109.89 in the years 1941, 1942, and 1943, respectively.

(2) By including in the ordinary income of the partnership of Eaton & Smith the amounts of $ 53,505.55 and $ 69,575.49 received in the years 1941 and 1942, respectively, under a cost-plus-a-fixed-fee construction contract with the United States Government, instead of treating such amounts as long term capital gain under the provisions of section 117 (j) of the Internal Revenue Code.

(3) In the determination of the amount of community income derived by petitioners from the partnership of Eaton & Smith during the taxable years 1941, 1942, and 1943.

A fourth issue, involving disallowance of a claim by petitioners in connection with the cancellation of the sale of a paving machine, was stipulated in petitioners' favor at the hearing.

FINDINGS OF FACT.

These proceedings were consolidated for hearing and consideration and submitted upon a stipulation which we adopt, together with exhibits and considerable oral testimony, from which we find that:

Petitioners Clarence B. Eaton ^{*187 revenue for the first district of California. The individual petitioners filed their income tax returns on a cash basis, while the firm of Eaton & Smith kept its books and filed its partnership returns on an accrual basis. The Eatons were married in 1913, and the Smiths in 1912, and both couples have lived continuously since said dates as husband and wife and during all of said time have been residents of the State of California.}

The firm of Eaton & Smith was formed in 1914 and continued until 1944, with headquarters in San Francisco. It was engaged generally in heavy construction, involving the moving of earth and paving work, installation of drains, sewers, etc. It was successful and did a large volume of contracting, many of its contracts being with the State of California, municipalities therein, the Federal Government, and different railroads. It had several large war contracts for the Government during the taxable years involved, the completion of which had to be expedited.

Issue No. 1 -- depreciation. -- In the course of its construction work Eaton & Smith used a large number of pieces of machinery, most of it heavy, and also used trucks and automobiles. To the partnership returns for 1941, 1942, and 1943 an itemized schedule was attached, showing the date of acquisition, cost, depreciation previously allowed, life of the item, and amount of depreciation claimed for the taxable year in respect of the machinery, and on a separate itemized schedule the same data was supplied in respect of the trucks and automobiles. To each item of machinery and to each motor vehicle acquired new the partnership assigned a total useful life of four years; to each item acquired in a used condition it assigned a total useful life of two years. Rejecting petitioners' general use of the four-year and two-year periods, the Commissioner assigned to a very large number of the machinery items and a few of the motor vehicles a longer life than that reported on the return, and thereby reduced the amount of depreciation currently deductible. For 1941 he thus recomputed depreciation on items for which the partnership had claimed an aggregate allowance of $ 80,877.64, reduced such aggregate to $ 45,269.78, and disallowed the difference of $ 35,607.86 as a depreciation deduction, restoring it to income. For 1942 claimed deductions of $ 81,049.03 were so reduced to $ 52,333.68 and the difference of $ 28,715.35 was disallowed. For 1943 claimed deductions of $ 99,309.73 were so reduced to $ 68,199.84, and the difference of $ 31,109.89 was disallowed.

Among the larger items owned and here involved were 30 tractors, most of which were of the caterpillar variety, aggregate cost over $ 200,000; 7 carry-alls with scrapers, aggregate cost over $ 70,000 (each equipped with 8 rubber tires costing $ 3,680); 3 bulldozers; compressors; Lorraine shovels; 7 buckets for drag-line; pumps; welders; vibrators, etc. Much of the machinery equipment was of the type ordinarily used in highway and levee construction, and its aggregate cost in each of the taxable years was in excess of $ 300,000; and the aggregate cost of the trucks and automobiles in each of the taxable years was in excess of $ 100,000.

During the years 1941, 1942, and 1943 the equipment owned by Eaton & Smith sustained abnormal depreciation from wear and tear at a rate from one and one-half to two times as great as that sustained by it under normal conditions, or in the years prior to 1941. The reasons for such abnormal and accelerated rate of depreciation in those years, each and all of which contributed thereto, were, to wit: (1) The increased volume of work over that of normal years caused the continuous use of all equipment. (2) Increased hours of use -- prior to 1941 the equipment was used on an average of 40 hours per week. In 1941, due to the imminence of war, requiring early completion of war contracts, 60 hours per week was the minimum week's work, until Pearl Harbor, and thereafter 3 shifts of 8 hours each day for 6 and 7 days a week (144 to 168 hours per week) were frequent, and a minimum of 120 hours per week (2 shifts of 10 hours each) obtained. (3) Night work, which was required almost constantly after Pearl Harbor, was harder on the machinery, due to imperfect conditions of artificial lighting and the further fact that only inferior workmen could be obtained for the night shifts. (4) Scarcity and incompetency of labor available -- due to war conditions, manpower shortage became acute, especially after Pearl Harbor, and untrained and unskilled workers had to be employed, resulting in unskillful handling of the machines, which increased the wear and tear thereon. (5) Character of terrain -- in several major contracts the ground where the required excavations were made was such as to cause abnormal wear and tear to the equipment used. Among these were the Alameda Naval Air Base, the Naval Supply Depot, and the Oakland Port of Embarkation, all of which were in the tideland area, and when the tide was in the equipment had to be operated on ground submerged in salt water, and parts of the equipment were also submerged, which was greatly damaging to the machinery and its parts. A quicksand condition at times caused even the large caterpillars to become almost completely submerged. Forty pumps were installed, which alleviated this condition to some extent, but the sand and salt water which was sucked into the pumps caused them to wear out and become practically worthless in 90 days, and under normal conditions they would have lasted 2 years. This deleterious effect in a lesser degree was inflicted on the vital parts of all of the machinery there used, which included the caterpillars, tractors, carry-alls, shovels, etc., and practically all types of machinery here involved.

The large amount of machinery used under the conditions above detailed required many repairs to be made in order to keep it in operating condition, and petitioners maintained a large repair shop, which remained open 24 hours daily. The sums expended by petitioners in repairs and maintenance of the machinery here involved were: 1940, $ 54,025.36; 1941, $ 50,841.81; 1942, $ 71,160.79, and 1943, $ 108,751.73. The sums expended for repairs and maintenance did not materially add to the value of the equipment nor appreciably prolong its life, but were necessarily made to keep it in an ordinarily efficient operating condition.

For many years prior to the taxable years in question, Eaton & Smith had followed the same method and rate of depreciation used by them in 1941, 1942, and 1943, and the Commissioner had acquiesced therein.

From the record as a whole we find, in view of the abnormal use and accelerated depreciation of the equipment of Eaton & Smith during the taxable years, that the general average useful life of four years for machines and motor vehicles acquired new, and of two years for those acquired in used condition, as claimed by petitioners, was reasonable.

Issue No. 2. -- On June 18, 1941, the partnership of Eaton & Smith and H. P. Moran jointly and severally entered into a contract with the United States Government for the construction of various buildings, magazines, and other facilities at the Benicia Arsenal, Benicia, California, for a fixed fee of $ 119,645. The partnership's participation was 80 per cent; Moran's, 20 per cent. Article II of this contract provided in part:

1. Reimbursement for Constructor's Expenditures. The Constructor shall be reimbursed in the manner hereinafter described for such of his actual expenditures in the performance of the work as may be approved or ratified by the Contracting Officer and as are included in the following items:

* * * *

c. Rental actually paid by the Constructor, at rates not to exceed those approved by the Contracting Officer * * *.

2. Rental for Constructor's Equipment. Rental shall be paid at the rates indicated in the Contractor's Equipment Rental Schedule, War Department, Office of The Quartermaster General, dated May, 1941, for such plant or parts thereof as he may own and furnish * * *. * * * When and if the total rental paid to the Constructor for any such part shall equal the valuation thereof, plus one per cent (1%) per month for each month or fraction thereof such part has been in use, the Constructor shall convey title to the Government free of all liens and encumbrances; at the completion of the work or upon termination of the contract as provided in Article VI, the Government may at its option purchase any part of such construction plant by paying to the Constructor the difference between the valuation of such part or parts, plus one per cent (1%) per month for each month or fraction thereof such part or parts have been in use and the total rental theretofore paid for such part or parts.

The contractors entered upon performance and fully completed the contract. In performing it, the partnership furnished and used machinery, equipment, trucks, and automobiles, and pursuant to the above provision the Government paid to it for the use of certain of these items $ 53,505.55 in 1941 and $ 52,716.30 in 1942. After giving notice of election to exercise its option, the Government on April 30, 1942, purchased those items of the machinery, equipment, trucks, and automobiles. The partnership on that date had held them more than six months. Their agreed valuation was $ 242,436.57; the 1 per cent for each month of use was computed at $ 19,147.63, making a total of $ 261,584.20. The rentals paid in 1941 and 1942, aggregating $ 106,221.85, were subtracted from this figure, and the resulting difference of $ 155,362.35 was paid by the Government to the partnership.

In its income tax return for 1941 the partnership included the $ 53,505.55 in income as rentals received. On an amended return for 1941 and on its 1942 return it treated the amounts paid it by the Government for use of the equipment as payments of selling price. On September 15, 1943, petitioners filed claims for refund of income taxes attributable to the inclusion of $ 53,505.55 in the partnership's ordinary income for 1941. In determining the partnership's income for 1941, the Commissioner treated the $ 53,505.55 as rental, including it in ordinary income; for 1942 he treated the $ 52,716.30 as rental and also included in ordinary income $ 16,859.19, computed as follows:

Additional contract income received		$ 172,912.35
Less construction costs:
Cost of equipment	$ 289,278.84
Depreciation to April 30, 1942	133,225.68
		156,053.16
Net		16,859.19
Rental		52,716.30
Total contract income		69,575.49

Issue No. 3. -- Allocation of separate and community income. During the entire existence of the partnership of Eaton & Smith (1914-1944, inclusive) Clarence B. Eaton and James M. Smith were both duly licensed civil engineers and both actively managed, conducted, and carried on its construction and contracting business. Its business was highly successful and very profitable. The partnership continued until January 1945, when it was dissolved, due to Eaton's ill health. Both Eaton and Smith were well prepared by education, training, and experience to conduct the business. Eaton was a graduate of Stanford University, with degrees in both mechanical and civil engineering. He became prominent in his profession and helped to organize, and for a long time was director of, the Associated General Contractors of America, being associated therein with Henry J. Kaiser and other nationally known contractors. Smith, the other partner, graduated in 1910 from Saint Mary's College, with a degree of bachelor of science in civil engineering, and he also received a master's degree. Shortly thereafter he was employed by the Bureau of Engineering in the Department of Public Works in San Francisco, where he was in charge of estimating costs and payments for contractors, and he also did inspection work. While working there, he became acquainted with his future partner, Eaton, who was in charge of inspecting and of engineering contractors' operations for the city engineer's office, and Smith worked under him. They both continued working for the city until 1914, when they formed their partnership. The experience and association there contributed materially to their success in the contracting business. Additional factors contributing to the firm's success and the resultant earnings of its profits were: (1) Application and hard work of both Eaton and Smith. Smith customarily worked from 7 in the morning until 6 at night, having charge of field work and construction. Eaton, who also worked hard, handled the office work, supervised the office crew and attended to the financing, and worked on both its bids and its estimates; (2) their work was well coordinated, each was specially qualified for his assignment, and their cooperation with each other made it an ideal partnership combination; (3) they possessed the ability to "pick good men" and to keep them, and they had an efficient and well integrated organization; (4) they had ingenuity and ability, planned their work in advance, "kept apace of the times," and knew how to analyze a job, estimate its cost, and bid it properly, and they thereby averted losses which the ordinary contractor frequently sustained; (5) their long residence in San Francisco (Smith was born there) made them familiar with the local terrain and problems of construction and gave them a wide personal acquaintance with engineers and many others; (6) their contracts were completed in an efficient, expeditious, and first-class workmanlike manner; (7) their efficiency and fair dealing won for them the confidence of the contracting public, and also of other contractors who at times associated Eaton & Smith with them; (8) many of Eaton & Smith's contracts were for the City and County of San Francisco, the State of California, the Golden Gate Bridge, the highway district and other incorporated cities and counties, and also for the Federal Government. They performed work for private corporations such as the Southern Pacific Railroad, Santa Fe Railroad, and others; (9) they had the confidence of the banks in San Francisco and could borrow money in large amounts as needed at interest rates as low as 3 per cent, with no security other than an assignment of amounts to become due them under their contracts. Credit rather than invested capital was required in their business.

However, liberal progress payments prevailing in California made it unnecessary, ordinarily, to secure loans for large sums, even when the contract involved very large amounts. The State of California paid 90 per cent of that portion of the contract performed each month, and the City and County of San Francisco paid 85 per cent in monthly progress payments. The Federal Government in the Benicia contract paid 90 per cent of the fixed fee in monthly installments, based upon percentage of completion. A total expenditure of approximately $ 4,000,000 was finally made by Eaton & Smith and Moran in the Benicia contract, but neither Eaton & Smith nor Moran actually contributed any cash to the job. They arranged a bank loan at 3 per cent for such amounts as needed, secured by assignment of moneys to become due them, but, due to progress payments, at no one time did the advances by the bank on the Benicia contract exceed an aggregate of $ 300,000. Ordinarily, after operating a job six or seven weeks the progress payments were sufficient to pay the operating costs of the job. Other contractors without capital, having a good reputation and ability to perform work, were at times granted similar bank credit.

As young men having no funds, Eaton & Smith began their business without capital. Their first contract was the construction of a railroad in San Francisco. Smith's father agreed to back him, but he had to put up only $ 7,000 for his part. The evidence fails to show whether Eaton had this amount or borrowed it, but after a few months, progress payments were sufficient to repay the bank for the sums advanced and the job carried itself. They made a profit of $ 35,000 on this contract and left it in the business, as they did with profits from contracts thereafter, and neither Eaton nor Smith ever contributed funds to the partnership except such funds as were earned by it.

The firm's accumulated assets and capital all came from its profits.

A summary of the firm's assets (cents omitted) as shown by its balance sheets is as follows:

	1941	1942	1943
Current assets:
Cash on hand and in banks	$ 38,137	$ 15,166	$ 64,017
Accounts receivable	177,487	223,965	503,284
Interest receivable on bonds owned			1,895
Securities owned (market value)	36,940	11,150	263,520
Deposits	2,235	3,550	18,640
Inventories, material and supplies	87,061	507,195	36,600
Due from joint ventures	50,347	8,812	704
Advances to Pacific and Eaton & Smith Co		32,743
Total	392,209	802,582	888,662
Investments:
Street assessment bonds	12,554	6,702	4,545
Real estate sales contracts and notes
securing deeds and mortgages	23,128	21,938	20,040
Real estate and improvements 95,655	93,260	82,851
Total	131,338	121,902	107,437
Fixed assets Automobiles	3,225	1,483	1,489
Equipment	158,877	168,562	88,937
Trucks	43,942	27,317	12,117
Plant	149	149	149
Furniture and fixtures	1,321	1,165	1,029
Total	(a) 207,516	(b) 198,678	(c) 103,723
Total assets	731,064	1,123,163	1,099,822

The table below shows for the years therein indicated (cents omitted) (1) profits of the firm, (2) withdrawals, (3) percentage of profits derived from business of firm, and (4) percentage of profits derived from firm's investments.

			Percentage of profits
Year	(1)	(2)	(3)	(4)
	Profits	Withdrawals	From	From
			business	investments
			Per cent	Per cent
Dec. 31, 1939	$ 74,979	$ 58,900	84.	16.
Dec. 31, 1940	76,238	53,436	85.	15.
Dec. 31, 1941	117,575	17,522	92.	8.
Dec. 31, 1942	336,709	124,281	99.98	0.016
Dec. 31, 1943	282,675	278,840	99.974	0.026

Exhibit 3, from which figures in 1 and 2 above were taken, was jointly compiled by petitioners' accountant and internal revenue agent from the firm's books. Exhibit 3 covers a 20-year period (1924 to 1943, inclusive). Only 2 years, 1930 and 1936, disclose a loss, both small, $ 4,000 in 1930 and $ 587 in 1936, and in the remaining years, with one exception, the profits each year were materially large, ranging from $ 10,000 to $ 124,000, or an average annual profit in excess of $ 60,000 prior to the taxable years here involved.

The firm's partnership returns for the taxable years disclose in its gross income sizable sums designated as "received from the rental of equipment." While a small portion of this represented receipts from other contractors for equipment rented to them by Eaton & Smith, and some of it was rental received from the Benicia contract, etc., the major portion of such sums was a mere matter of bookkeeping or accounting on which the partnership charged itself rent for its own equipment on its own jobs.

The earnings and profits of the partnership during all of the taxable years here involved were due primarily to the personal character, energy, ability, capacity, skill and business acumen of the individuals, Eaton and Smith, composing the firm. While equipment and other capital assets were required and used in operations, capital was relatively a minor factor in the success of the enterprise.

The prevailing rate of return on capital invested in general business comparable to the risk involved in Eaton & Smith's business in the San Francisco area during the taxable years was approximately 7 per cent. Of the net income of petitioners' business in each of the taxable years here involved, 7 per cent on the separate capital invested therein is attributable to the use of capital, while the remainder of such income is attributable in equal parts (one-half to each) to the personal services of Clarence B. Eaton and James M. Smith.

In 1942 each partner's average capital investment in Eaton & Smith was $ 365,776.46. Of this, $ 236,232.27 was separate property and the remaining $ 129,544.09 was community property.

All of each partner's income from his separate invested capital in 1941, 1942, and 1943 was left in the business and all withdrawals from Eaton & Smith were from the partners' community income.

Each partner's separate invested capital in 1941 was the same as in 1942, less the 1941 separate income which was left in the business and became part of the 1942 separate invested capital.

Each partner's separate invested capital in 1943 was the same as in 1942, plus the 1942 separate income which was left in the business and became part of the 1943 separate invested capital.

OPINION.

Issue No. 1. -- The first issue relates to depreciation. In computing deductions for depreciation on items of machinery and motor vehicles in each of the taxable years the partnership followed its established practice of prior years, theretofore acquiesced in by the Commissioner, in assigning a four-year useful life to each item acquired new and a two-year useful life to each item acquired in used condition. Petitioners admit that there was in fact no such uniformity in depreciation as to each item individually, but contend that their experience over the years demonstrated its accuracy as a convenient and general method, and that, since the accounting practice truly reflects the average useful life of their equipment, it should be approved. Although he had always accepted it for preceding tax determinations, the Commissioner, for the taxable years in question, rejected petitioners' composite rate as inaccurate, and determined a useful life for each item. He compiled new depreciation schedules which reflect the difference between the individual amount claimed as depreciation on the schedules of the tax returns and the lesser amount which he has computed and allowed. He added the aggregate excess to income for each of the taxable years.

From the evidence adduced we are unable to accept the determined changes. The partnership accounting method, fortified by experience with use of equipment, is not to be lightly set aside. See Lake Charles Naval Stores, 25 B. T. A. 173, wherein we said:

The reasonableness of a deduction for any particular year depends to some extent upon what has been done in former years. Ordinarily the uniform methods applied in former years should not be abandoned in later years, but should be followed in those years unless there is a cogent reason for a change.

Petitioners introduced much persuasive evidence on this issue, while respondent offered none to rebut it except Bulletin F and a compilation of the large sums expended for repairs of the equipment in the taxable years. He argues that useful life was materially extended thereby, but offered no evidence that this was so or that his computation as to useful life conformed to the schedules in Bulletin F. Petitioners' evidence convinces us that the large amounts expended for repairs kept the machinery and equipment in working condition, but did not extend useful life. Under pressure of the war emergency, the equipment was put to continuous use under adverse conditions. Between 20 and 25 per cent of its cost had already been written off as depreciation, and, while normally unusual repairs might have prolonged this use, this advantage, in our opinion, was more than offset by the abnormal depreciation in the taxable years. We find that average life was no greater than the partnership's estimate and hold that the Commissioner erred in disallowing any part of the depreciation claimed by petitioners.

Issue No. 2. -- The second issue is whether amounts received by the partnership during 1941 and 1942, under the terms of the so-called Benicia contract with the United States Government, constituted ordinary income or, as contended by petitioners, represented capital gain.

In computing income of the partnership for 1941, the Commissioner treated $ 53,505.55 as rental for the use of equipment, automobiles and trucks. For 1942 he so treated $ 52,716.30, and for the same year added to income, $ 16,859.19 representing the excess of $ 172,912.35 (now stipulated as $ 155,362.35), which the partnership received from the Government upon transferring to it the rented equipment, over the equipment's cost ($ 289,278.84) less depreciation ($ 133,223.68). The three payments were made pursuant to the construction contract's provisions relating to reimbursements and rentals for plant and equipment used in performance. The Commissioner determined that the $ 53,505.55 received in 1941 and the $ 69,575.49 ($ 52,716.30 plus $ 16,859.19) received in 1942 were taxable as ordinary income derived from the contract. Petitioners assail this determination, contending that the three payments constituted the selling price of the several items of equipment, and that, as the partnership had held these items over six months, that part of the receipts which represents profit from the sale is taxable as a capital gain.

This issue results from the Government's exercise of an option. Under article II of the contract the Government agreed to make reimbursement for certain expenditures incurred in performance and to pay rental for the constructor's equipment used. It was provided, however, that:

Art. II, sec. 2: * * * at the completion of the work or upon termination of the contract as provided in Article VI, the Government may at its option purchase any part of such construction plant by paying to the constructor the difference between the valuation of such part or parts, plus one per-cent (1%) per month for each month or fraction thereof such part or parts have been in use and the total rental theretofore paid for such part or parts * * *.

It is stipulated that Eaton & Smith furnished certain machinery, equipment, trucks, and automobiles used in performance; that the Government paid them the amount in controversy "for the use" of the several items in 1941 and 1942, and on April 30, 1942, exercised its purchase option. The parties agreed that the equipment here involved then had a value of $ 242,436.57, to which $ 19,147.63 was added, representing 1 per cent for each month of use. The total of $ 261,584.20 was then reduced by $ 106,221.85 already paid as rentals in 1941 and 1942 ($ 53,505.55 in 1941 and $ 52,716.30 in 1942), and the Government paid the remainder of $ 155,362.35.

Respondent defends the theory on which the determination is based, arguing that the Government was not interested in acquiring equipment, but included the optional purchase provision in the contract as a measure to forestall abuses and as an incentive for the constructor's dispatch and efficiency; that, viewed on this background of intent, the transfer of the equipment and the payment of April 30, 1942, lose their character as elements of a sale transaction, and that the full amount received by petitioners was ordinary income from the contract, while cost of the equipment was merely a factor in its computation. He points out that if the contract date, June 18, 1941, be deemed the date of sale, then the property is not depreciable; that if April 30, 1942, be deemed the date of sale, then petitioners are confronted "with an insurmountable problem" in characterizing the amounts previously received, a part of which was actually reported as rentals in the partnership's 1941 return. He aptly cites Burnet v. Sanford & Brooks Co., 282 U.S. 359">282 U.S. 359, to the effect that each year of accounting must stand by itself. In case this argument be rejected, he suggests alternatively that in any event the amounts received as "rentals" prior to the Government's exercise of the purchase option must be taxed as ordinary income, citing Indian Creek Coal & Coke Co., 23 B. T. A. 950.

Petitioners argue to the contrary that the payments were received and the items of equipment were transferred pursuant to a contract of sale and purchase, and that the transaction falls within the "plain and unambiguous" language of section 117 (j), Internal Revenue Code. Inferentially conceding that the sale occurred on April 30, 1942, they assert that the amounts already paid as rentals "were applied by the Government on the agreed purchase price," and conclude that such payments then "lost their character as rentals and were properly reported by Eaton & Smith as receipts from the sale of machinery and equipment used in its business and held for more than six months prior to the time of sale."

The contentions advanced by each party do not, in our opinion, take adequate cognizance of the wording of the contractual provision under which the payments were made and the equipment transferred. Each has postulated an identity of character in the amounts paid before exercise of the option and in the amount paid simultaneously therewith. We find no justification for this assumption in the language of the contract. Article II, section 2, clearly and consistently provides for the leasing of the equipment by the partnership and the payment of rentals by the Government. But section 2 provides further that on completion or termination of the contract, the Government may elect to purchase for a price computed as the difference between valuation plus 1 per cent for each month of use and the total rentals theretofore paid. Clearly then the rentals are not an element of the purchase price, but constitute merely one of several factors in its computation. They were not "applied" to that price, but, on the contrary, were expressly excluded from it under the prescribed formula. The $ 53,505.55 was received by the partnership in 1941; the $ 52,716.30 in 1942. As rentals they were taxable as ordinary income. No provision of the contract relating to the purchase option purports to alter this character. When the Government exercised that option, the parties agreed on a valuation of $ 242,436.57 for all the equipment items here involved; they agreed on $ 19,147.63 as the addition representing 1 per cent for each month of use. But the sum of these figures, $ 261,584.20, was not the purchase price. That price was the difference between $ 261,584.20 and "the total rentals theretofore paid," $ 106,221.85, which difference was $ 155,362.35. This last amount and only this was paid to the partnership as consideration for purchase of the machinery and equipment.

Each party has quoted extensively from Congressional committee reports, invoking legislative intent as giving color and support to each of the conflicting contentions. But, as the wording of the contract presents no inconsistencies or conflicts, we perceive no necessity for any tortuous construction of section 117 (j) or other applicable sections of the code. We hold that the machinery and equipment was first leased, and the rentals received for their use constituted ordinary income. On April 30, 1942, they were sold for a price which expressly excluded amounts already paid as rentals. This price of $ 155,362.35 represents the sale proceeds, and, as the assets had been held over six months, the profit from the sale is taxable as a capital gain.

Issue No. 3. -- What portion of the partners' income from Eaton & Smith during 1941, 1942, and 1943 was income from their separate property, and what portion of it was community income of the individuals, Eaton and Smith, and their respective wives?

In California the property of spouses is held subject to the law of community property. By section 161 (a), Civil Code of California, effective July 29, 1927, the wife acquired an immediate half interest in acquisitions of the community so that each spouse became thereafter taxable on one-half of the community income. United States v. Malcolm, 282 U.S. 792">282 U.S. 792; J. Z. Todd, 3 T. C. 643. Property of the community owned on that date is to be treated for income tax purposes as the husband's separate property. Hirsch v. United States (C. C. A., 9th Cir.), 62 Fed. (2d) 128. The firm Eaton & Smith was formed long prior to 1927, was a going concern on that date, and the capital then employed in the firm's business was the separate property of the partners. Since the partners were then married, and remained so, the income which the firm earned thereafter, under the law of California, was subject to allocation between the separate and the community estate of the firm members. That portion of such income attributable to capital was separate property, while that attributable to the "personal character, energy, ability and capacity of the husband" was community property of the two partners and their respective wives. See Pereira v. Pereira, 156 Cal. 1">156 Cal. 1; 103 Pac. 488; McDuff v. McDuff, 48 Cal. App. 175">48 Cal. App. 175; 191 Pac. 957; In re Gold's Estate, 170 Cal. 621">170 Cal. 621; 151 Pac. 12; Cozzi v. Cozzi (Aug. 1947), 183 Pac. (2d) 739; In re Caswell's Estate, 288 Pac. 102; Witaschek v. Witaschek, 132 Pac. (2d) 600.

The parties are agreed that the income for the taxable years is attributable in part to capital and in part to the personal services of the partners Eaton and Smith; they are in disagreement, however, as to the amounts of such allocation and the method of determining same.

Petitioners contend that the earnings and profits of Eaton & Smith for the taxable years were due in part to the capital invested, but were primarily due to the personal activities, management, skill, judgment, experience and hard work of the two partners, and therefore that 7 per cent on the capital invested is all that should be attributed to capital or separate property, and that the entire balance of the income should be attributed to the personal services of the two partners and hence constitutes community property income of them and their wives. They cite Lawrence Oliver, 4 T. C. 684, and Ashley Manning, 8 T. C. 537, wherein we upheld that method of allocation. Such method of apportionment also finds support in Pereira v. Pereira, supra, wherein the Supreme Court of California held that "when the principal part of the income was due to the personal character, energy, ability and capacity of the husband," that portion of the income was the community property of the husband and wife, but that the separate property reflected in the capital invested should also be credited with some part of the income as profit on capital, same to be determined from the facts of the case, but in an "amount equal to the usual interest on a long investment well secured."

Respondent's contention, on the contrary, is that the capital and equipment of the partnership of Eaton & Smith were the vitally important factors in producing the firm income, and that the efforts, ability and resourcefulness of the partners were not primarily responsible for the partnership earnings, and hence, in determining the apportionment, the formula prescribed in G. C. M. 9825 is applicable here, and cites Todd v. Commissioner, 153 Fed. (2d) 553; J. Z. Todd, 3 T. C. 643, and 7 T. C. 399; and Clara B. Parker, Executrix, 31 B. T. A. 644.

Whether capital or personal services predominate in the production of a firm's income is always more or less difficult to determine. Each case must be decided upon its own particular facts and circumstances. The facts in no two cases are ever identically alike, and it is conceivable that, where two different firms are engaged in the same kind of business, the difference in the way the businesses are conducted and the difference in the character, energy, and capacity of the members of the two firms will be such that in one capital predominates in producing income, while in the other personal services are mainly responsible therefor. The aggregate assets of Eaton & Smith during the taxable years were about a million dollars, and of this amount the working capital constituted normally a minor part, the fixed assets accounting for only $ 100,000 to $ 200,000, invested principally in equipment. Respondent says that without this equipment the firm could not have carried on their business and, therefore, no profits would have been received, and hence capital played the major role in the production of income.

In Pereira v. Pereira, supra, the California Supreme Court, in its opinion, likewise said that without capital the business could not have been carried on, and yet it held under the facts of that case that capital played a minor part, even though it was essential to the conduct of the business. Such we think is the case here.

Continuous and profitable operation of a general construction and contracting business for more than 30 years is so unusual as to constitute proof of the competency of its founders and administrators. The stipulations recite that both Eaton and Smith, throughout the entire partnership, "actively managed, conducted and carried on the business." Oral testimony supplemented and elaborated in detail their fitness and qualifications for the work and the vital part they played personally in the firm's success.

Typical of the testimony of five competent and disinterested witnesses is that of Paul B. Fay, director of the Bank of America, a paving contractor and competitor who knew Eaton and Smith from the time that they worked for the city of San Francisco and was familiar with their work from long observation. Answering the question as to what factor he attributed the success of the firm, he said:

I attribute it to a fine combination. They built a good foundation in the Engineering Department of the City and County of San Francisco, acquiring by observation just what should be the proper procedure to follow in contracts. Then Jim Smith went in for what you call the "long hours of work" and the hard part of it, and Clarence went in for the engineering and the financial end of it. It was a wonderful combination. That is what I would say.

* * * *

* * * the thing that made for the success of Eaton and Smith also was their ability to pick out the right men and put them on the job.

Further, he testified that their work was always efficiently done and that:

* * * they enjoyed a reputation of always finishing up their work in good workmanlike way. They had the confidence of all the engineers, whether it was in the City or County of San Francisco or in the State. Lots of times we had parallel jobs and I would hear the comments from the different engineers.

Capital was never a major factor in the production of the firm's income. The partnership was formed when Eaton and Smith were young men, without funds to contribute. They made a profit of $ 35,000 on their first contract, which was left in the business, and such capital and assets as they used were derived from profits accumulated over the years from their business. Although their construction contracts during the taxable years involved the expenditure of many millions of dollars, the balance sheet summary indicates very small working capital, of which $ 100,000 to $ 200,000 only was invested in equipment; little cash was kept on hand, and less inventory of supplies. The partners' financial and commercial standing enabled them to procure large monthly advances from the customers or bank loans to meet current costs and expenses. Without this personal standing, the firm might well have required a large amount of working capital to tide over until payment for the contract was received, but confidence in their ability and integrity made this unnecessary. The witness, Fay, a bank director, testified that the banks would advance pay roll funds to contractors such as Eaton & Smith, who were known to have ability and character and had shown by experience what they could do, even if they had no capital. In most contracts credit for the first month was about all that was required, as thereafter progress payments alone were sufficient to carry on. "I would put capital as a very small item" said he.

We think the respondent's allocation was in error, and hold that the profits of the partnership for the taxable years 1941, 1942, and 1943 were due primarily to the personal services of Eaton and Smith; that 7 per cent of the separate capital invested should be attributed to the earnings of capital; that the remainder of the earnings and profits of the partnership should be allocated to the personal services of the individuals, Eaton and Smith; and that such remainder should be allocated as community property of Eaton and Smith and their wives.

Decisions will be entered under Rule 50.

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Footnotes

• 1. Clarence B. Eaton died on October 16, 1947, and his estate has been duly substituted as the petitioner in Docket No. 12099, but for convenience he is referred to herein as the petitioner.↩

• 1. Only real estate used in firm's business was one $ 7,000 parcel, location of firm's headquarters. The balance is 50 or 60 lots acquired by default on paving bonds.↩

• 2. Items under "fixed assets" were more essential in the firm's business than others listed, but they constituted a minor portion of the total assets or accumulated capital, to wit: (a) 28% of 1941 total assets, (b) 17% of 1942 assets, and (c) 9% of 1943 assets.↩