Opinion
Docket No. 8541.
1948-02-25
AMERICAN BEMBERG CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
John F. Dooling, Jr., Esq., for the petitioner. William A. Schmitt, Esq., for the respondent.
During 1925 to 1928 petitioner built a large rayon plant not far from a river in Tennessee. The plant was built under the supervision of competent engineers. On March 27, 1940, a major cave-in took place in the spinning room, in which a large section of the floor fell in and one machine disappeared completely. Two days later another large hole 42 feet deep was discovered under the floor in the spinning room. Petitioner called in one of the well known engineering firms in the country. They devised a program which they thought would remedy the trouble, but it did not. On June9, 1941, without any warning another major cave-in occurred in the dirt tunnel under the floor between the two units of the textile room. Petitioner then retained a firm recommended to it for its work in subsoil engineering. This firm, with the acquiescence of the previous firm, recommended an elaborate program of drilling and grouting and making some replacements. Petitioner had to either accept this program or abandon its plant. It did the former. During the taxable years 1941 and 1942, petitioner expended $734,316.76 and $199,154.33, respectively, for drilling and grouting, and $153,474.20 and $79,687.29, respectively, for capital replacements. Petitioner charged the drilling and grouting expenditures to expense and the replacement expenditures to capital. It deducted the drilling and grouting expenditures on its returns as ordinary and necessary business expenses. The respondent disallowed the deductions on the ground that they too constituted capital expenditures. Held, petitioner is entitled under section 23(a)(1)(A) of the Internal Revenue Code to deduct the expenditures for drilling and grouting as ordinary and necessary business expenses. Illinois Merchants Trust Co., Executor, 4 B.T.A. 103, followed. John F. Dooling, Jr., Esq., for the petitioner. William A. Schmitt, Esq., for the respondent.
The respondent determined deficiencies for the calendar years 1940, 1941, and 1942, as follows:
+----------------------------------------------+ ¦ ¦ ¦Declared value¦ ¦ +----+-----------+--------------+--------------¦ ¦ ¦ ¦excess profits¦Excess profits¦ +----+-----------+--------------+--------------¦ ¦Year¦Income tax ¦tax ¦tax ¦ +----+-----------+--------------+--------------¦ ¦1940¦$140,104.59¦$9,638.08 ¦$167,710.48 ¦ +----+-----------+--------------+--------------¦ ¦1941¦90,280.27 ¦18,383.71 ¦426,873.86 ¦ +----+-----------+--------------+--------------¦ ¦1942¦ ¦ ¦225,266.83 ¦ +----------------------------------------------+
The respondent also determined an overassessment of income tax for the calendar year 1942 in the amount of $13,020.95.
Petitioner does not contest the deficiencies determined for the calendar year 1940. It does contest the entire deficiencies determined for the calendar years 1941 and 1942 and claims overpayments for those years.
In the statement associated with the deficiency notice the respondent made several adjustments to the net income as disclosed by petitioner's return for the year 1941, only one of which petitioner contests. The contested adjustment is an addition to the net income as disclosed by petitioner's return and is labeled ‘(a) Betterments and improvements $734,316.76,‘ which the respondent explains by saying ‘See item (d) of Explanation of Adjustments to Net Income for the year 1940.‘ The explanation of item (d) is as follows:
(d) Deductions claimed in the respective amounts of $74,000.00, $734,316.76 and $199,217.34 for the years 1940, 1941 and 1942, representing expenditures for exploring, drilling, grouting, etc., are disallowed. It is held that these amounts were expended for permanent betterments and improvements, and are not deductible, therefore, as ordinary and necessary expenses under Section 23(a), or as losses under Section 23(f), of the Internal Revenue Code.
Petitioner, by assignment of error (a), stated below, contests this adjustment for the year 1941.
In the statement associated with the deficiency notice the respondent also made several adjustments to the net income as disclosed by petitioner's return for the year 1942, only one of which petitioner contests in part. The contested (in part) adjustment is an addition to the net income as disclosed by petitioner's return and is labeled ‘(c) Betterments and improvements $200,779.47,‘,”’ which the respondent explains as follows:
(c) See item (d) of Explanation of Adjustments to Net Income of the year 1940. The total amount of $200,779.47 disallowed includes:
+-----------------------------------------------------------------------------+ ¦Exploring, drilling, grouting, etc. above ¦$199,217.34¦ +-----------------------------------------------------------------+-----------¦ ¦Credit Memorandum issued by you to North American Rayon ¦1,562.13 ¦ ¦Corporation ¦ ¦ +-----------------------------------------------------------------+-----------¦ ¦Total ¦$200,779.47¦ +-----------------------------------------------------------------------------+
Petitioner, by assignment of error (c), stated below, contests that part of the above adjustment for the year 1942 relating to exploring, drilling, grouting, etc., in the amount of $199,217.34. The errors assigned by petitioner are as follows:
(a) Respondent erred in disallowing as a deduction for the year 1941 the sum of $734,316.76 expended in that year by petitioner in connection with ground subsidence occurring at its manufacturing plant in Elizabethton, Tennessee.
(b) Respondent erred in disallowing as a deduction for the year 1941 the sum of $2,700,000 constituting a loss sustained by petitioner in that year by reason of ground subsidence occurring at its manufacturing plant in Elizabethton, Tennessee.
(c) Respondent erred in disallowing as a deduction for the year 1942 the sum of $199,217.34 expended in that year by petitioner in connection with ground subsidences occurring at its manufacturing plant in Elizabethton, Tennessee.
(d) Respondent erred in not allowing a deduction in 1942 for carry over of net operating loss sustained in 1941 in the amount resulting from correction of the errors hereinabove assigned.
(e) Respondent erred in not allowing an unused excess profits credit adjustment in 1942 for the unused excess profits credit carry over from 1941 in the amount of not less than $1,263,357.97.
FINDINGS OF FACT.
Petitioner was incorporated in Delaware on July 14, 1925, and it has its principal office at Elizabethton, Tennessee, and an executive office at New York, New York. The returns for the years here involved were filed with the collector for the district of Tennessee. Petitioner's books are kept and its returns are made on an accrual basis.
Facts Dealing with Location and Building of Plant.
The sole manufacturing establishment of petitioner is located at Elizabethton, Tennessee, where petitioner manufactures rayon yarn by the cuprammonium process. The plant is located about 1,000 feet east of a plant owned by the North American Rayon Corporation and about 1,000 to 1,600 feet south of the Watauga River. The river flows in a westerly direction until it reaches a point approximately directly north of petitioner's plant, and then veers irregularly to the southwest.
The North American Rayon Corporation produces rayon yarn according to the viscose process. Its plant was built in1927-1930 under the supervision of Lockwood, Greene & Co., the same engineering firm which supervised the construction of petitioner's plant, as referred to below.
At the time petitioner was organized in 1925, it had no plant or manufacturing facilities of any kind. Under contract dated July 31, 1925, petitioner acquired title to approximately 200 acres of land, including the site of the present factory building, from various owners.
On July 21, 1925, effective from July 15, 1925, petitioner engaged Myron S. Falk, in connection with the erection of its plant. Falk was elected second vice president and a director of petitioner on July 17, 1925. He was compensated at the rate of $25,000 per annum. Falk had graduated as a civil engineer from Columbia University in 1899 and as a mechanical engineer from Stevens Institute in 1900. He had received a degree of Ph.D. in engineering in 1903 from Columbia University, and had served as a teacher in the Civil Engineering Department of that university for the next ten years. He was coauthor with Professor William A. Burr of several books on bridge design, and, as head of the Columbia University Testing Laboratory, he also published a book on ‘Cements, Mortars and Concrete.‘ He died on November 26, 1945.
Petitioner's plant was erected in two units under the engineering supervision of Lockwood, Greene & Co. between July 1925 and September 1928. Falk represented petitioner in its relations with Lockwood, Greene & Co. and visited the site of the work several times at the beginning of the work and occasionally thereafter. Lockwood, Greene & Co. had been in business about 100 years, had designed and supervised the erection of many other industrial plants all over the eastern part of the country, and bore a high reputation. Petitioner's plant was erected in accordance with sound, accepted, and well established engineering practices. The cost of the plant as shown on petitioner's balance sheet as of December 31, 1941, was $7,925,289.62.
Facts Dealing with Original Soil Testing and Geological Data.
The practice in making soil tests is within the discretion and judgment of the particular engineering firm on the particular job. Lockwood, Greene & Co. had no established practice to which it conformed where better practice and experience dictated another method.
Lockwood, Greene & Co. tested the soil on which petitioner's plant was to rest by excavating surface test pits, and they determined the consistency of the soil and that it was satisfactory to bear the plant. The most dependable type of soil test, wherever it can be obtained, is a test pit. The test pits employed were about five to six feet square and were carried down to six to eight feet, and not further, because the soil encountered was a good clay. The soil tests disclosed no suspicious conditions. Had Lockwood, Greene & Co. thought the ground unsuitable or subject to subsidence, it would have made further appropriate tests and reported them.
There were in existence at the time the plant was built maps prepared by the United States Geological Survey indicating the existence of a fault traversing the Watauga River near petitioner's plant. The fault as located on the geological maps did not intersect the site of petitioner's plant, but intersected the site of the plant of North American Rayon Corporation. Recent exploration near the site of North American Rayon Corporation's plant confirms the fact that the fault shown on the geological map intersects the site of the North American Rayon Corporation's plant and not the site of petitioner's plant. As will appear more fully below, an unmapped synclinal fold fault was later discovered to intersect petitioner's plant site in a northeasterly to southwesterly direction. This discovery was made after petitioner's plant had been built.
Petitioner took every reasonable and proper precaution in the erection of its plant. So suspicion of an unstable subsoil condition existed at the time the plant was built. The existence of any abnormal subsurface condition under petitioner's plant at the time of its erection was not discoverable through the exercise of the care and diligence appropriate to the circumstances. No measure appropriate to the circumstances of the erection of petitioner's plant in connection with subsoil investigation was omitted or neglected.
Facts Dealing with Description of Plant Buildings.
Petitioner's main building consists of a chemical process building, divided into two units; a spinning, washing, and drying room, divided into two units; a textile room, divided into units; and main offices located on the first floor at the south end of both units. There is also a conditioning room located principally below ground level below a portion of the northerly section of the textile room; a storage room and cafeteria likewise located principally below ground level below the main offices at the southerly end of the main building; also principally below ground level and running along the easterly and westerly sides of the main shed building, from the southerly end of the main shed building to approximately the northerly end of the textile units, are corridors containing, in addition to the passageways, auxiliary shops, locker rooms, toilets, and miscellaneous storage rooms.
The chemical building units are of reinforced concrete construction, varying from two to six stories (exclusive of basement) in height and housing heavy process machinery, equipment, and tanks. The spinning, washing, and drying units, including a major portion of the textile units, constitute a single one-story building without basement of saw-toothed construction. The substructure, substructure walls, and floors are of reinforced concrete. The superstructure consists of structural steel framing, with brick walls and wooden spline sheathing roof covered with a four-ply bonded built-up roofing material. The main building foundations are soil-bearing spread footings, that is, reinforced concrete emplacements of larger outside dimensions than the columns, pedestals, or walls resting upon them. These foundations extend only to a depth of approximately nine feet on the average below the ground surface to the soil-bearing areas. The powerhouse is a structural steel frame building consisting of brick walls with reinforced concrete floors. The foundations are soil-bearing reinforced concrete footings; certain sections of the structure employ combined or strap footings.
The powerhouse stack, which is 200 feet high, rests on soil bearing a solid step-off reinforced concrete footing, carried to a depth of approximately seven feet below the top of the ground surface. The machine shop building is one story and basement, with a 500,000-gallon reinforced concrete reservoir underneath its westerly section. The foundation consists of soil-bearing reinforced concrete footings. The superstructural walls are of brick; the framing, including columns, beams, and roof sheathing, is of wood. The raw materials receiving and storage building is similar in construction to the machine shop and, like it, is one story in height, with partial basement sections.
The blue water settling basins to the west of the plant rest on soil and rock-bearing reinforced concrete foundation structures. The chemical storage tanks northeast of the main plant are supported on steel piles driven to rock and the tanks themselves rest on a reinforced concrete mat crowning the piles. The spray pond located north of the machine shop building is of concrete construction throughout and rests upon a foundation of soil. Minor outlying and auxiliary buildings and structures are of light frame construction either of steel, wood, or brick, and are supported on soil-bearing spread footings.
Since the plant has been operating it has had a network of underground and overhead fluid carriers comprised of sewers, process water carriers, and fire and city water lines, as well as lines carrying what is called ‘blue water‘ (namely, the discharge of the spinning machines, containing ammonia, sulphuric acid, and copper sulphate), ammonia, caustic, and similar materials. In general, the construction of these fluid carriers consisted of vitrified clay piping, with cement joints for sewers, and cast iron bell and spigot pipe, with leaded joints for water water and noncorrosive fluids, and in certain locations noncorrosive materials have been used for process lines. Concrete trenches in the floor of the spinning rooms carried the waste blue water from the machines to drainage sewers outside the building and thence to the blue water settling basins where the copper was reclaimed for reuse. The process and blue water systems handle large quantities of fluid, varying from 4 1/2 to 6 million gallons per day.
Facts Dealing with the March 1940 Cave-ins and the Stone & Webster Program.
In 1932 a cave-in occurred on petitioner's property near the salvage yard. Between 1933 and February 6, 1940, inclusive, 14 additional settlements or cave-ins occurred at different places on petitioner's property.
On March 27, 1940, in the spinning room of petitioner's plant a section of the concrete floor measuring 34 by 43 feet collapsed into a hole of larger dimensions that had formed under the concrete floor slab, precipitating 3 spinning machines into the hole, one of the machines disappearing completely. The hole was not less than 22 feet deep. On March 29, 1940, a second hole was discovered within the spinning room south and west of the cave-in of March 27, 1940, under the floor slab. The hole was 27 by 34 feet in area and 42 feet deep. The hole was directly under one of the main bearing columns supporting the roof. This supporting member hung in mid-air over the hole.
Upon the occurrence of the cave-in and subsidence just described, petitioner retained Stone & Webster Engineering Corporation, hereafter sometimes referred to as ‘Stone & Webster,‘ Chas. T. Main, Inc., experts on underground conditions affecting foundations (who were retained on the recommendation of Stone & Webster), and Professor H. C. Amick, of the Department of Geology of the University of Tennessee, at Knoxville, to advise and guide petitioner in dealing with the cave-ins and subsidence above described.
Stone & Webster, with which Chas. T. Main, Inc., acted in consultation, assumed complete charge of the engineering work. Stone & Webster undertook (a) to supervise investigation of subsurface conditions under the buildings with core borings or otherwise, (b) to locate points of weakness or incipient failure by cave-ins, (c) to make recommendations as to methods of testing sewer and drain lines, and advise as to the type of sewers and drains to use in replacing the existing system so as to obviate further difficulties from leaking fluid carriers, (d) to make recommendations regarding methods of overcoming points of weakness discovered in the subsurface investigation and, if possible, of preventing further difficulties, and (e) to set up a system of bench marks and elevation plugs throughout the plant. Petitioner carried out the work program recommended by Stone & Webster under its engineering supervision until June 1941.
Stone & Webster investigated the subsoil conditions at the plant, supervised the emergency repairs, the testing and repairing of fluid carriers, and other construction features recommended by them as a precaution against future failures of floors or foundations.
Stone & Webster advised that the continued operation of the plant might be considered reasonably insured against hazard from further major floor or foundation failures if (a) the fluid carrier system were kept tight, (b) settlement observations were made, and (c) immediate investigations were made of any evidence of subsidence and the necessary corrective steps taken. Stone & Webster characterized as unnecessary three alternative plans which contemplated (a) underpinning portions of the plant to rock at a cost in excess of $1,000,000, (b) eliminating all underground fluid carriers at a cost of over $750,000 and pumping to overhead lines (which would not have eliminated trench leakage and would have increased operating costs), and (c) attempting to stabilize the overburden to bedrock by drilling numerous holes and pressure-grouting areas of probable leakage at an expenditure of not less than $900,000.
Stone & Webster advised that any increase in the size of undiscovered openings in the soil under the plant so great that failure would be imminent would be evidenced by settlement a sufficient amount of time before collapse, so that necessary precautions and corrective measures could be taken. Chas. T. Main, Inc., joined in the recommendation and report of Stone & Webster. Amick in substance concurred in the Stone & Webster report and recommendations.
Stone & Webster and Chas. T. Main, Inc., were competent and experienced. Amick was a qualified geologist. Petitioner relied on the advice of Stone & Webster and Amick in the work done at the plant, relying more particularly on Stone & Webster.
In accordance with the recommendation of Stone & Webster and prior to June 9, 1941, methods had been established for determining whether or not further settlements occurred in the plant, and a regular inspection schedule had been set up for the checking of building and equipment elevations.
Facts Dealing with the June 9, 1941, Cave-In and the Proctor Program.
Without any prior warning and in spite of the system established under the guidance of Stone & Webster for detecting warning settlements which petitioner had been assured would precede any major cave-ins, on June 9, 1941, a major cave-in occurred in the dirt tunnel under the floor between the two units of the textile room. The cave-in measured 28 by 29 feet in area and was 25 feet in depth.
Petitioner then retained Moran, Proctor, Freeman & Mueser, recommended to it as one of the best subsoil engineering firms in the country, and, after consideration of the first reports made by Carlton S. Proctor, senior member of that firm, on prevailing subsurface conditions and his recommendations for dealing with such subsurface conditions, disclosed in consequence of the cave-in, petitioner instructed its officers to carry out and complete the remedical program recommended by Proctor, sometimes referred to herein as the ‘Proctor program,‘ subject to the acquiescence of Stone & Webster in such program, which acquiescence was obtained.
By June 1941 cavitations in the overburden underlying the petitioner's plant were so far advanced that their existence constituted a real danger to the continued operation of the plant. Large cavitations, the widespread existence of which was later established by the magnitude of grout acceptance, were points of incipient failure which, unless grouted, would have resulted in cave-ins like those already experienced. The hazard to life and property from the cavitations was very serious because the hazard could not be localized, since, although it was inevitable that cave-ins would occur, there was no way of knowing where they would occur except by prosecuting a large-scale drilling and grouting program on a close pattern.
In the circumstances no alternatives were open to petitioner except to prosecute the Proctor program or to abandon the plant.
The cave-in of June 9, 1941, was a sudden and unexpected physical occurrence of major importance in physical dimensions and location, which took place in spite of the existence of a well planned program intended to insure advance warning of such occurrences. It showed that no area in the plant was safe from the hazard of similar occurrences, whereas previously there had been assurance that such occurrences would not take place without warning and an opportunity to prevent them. It brought about a situation in which operation of the plant would have to be abandoned entirely unless a more effective remedial program could be devised, and the only recommended remedial program involved a large expenditure of money which could not completely remove permanently the element of hazard and which would entail continued expenses for maintenance and supervision not required in normal plant operation.
Facts Dealing with the Nature and Cause of the Cavitations.
According to the testimony of experts at the hearing, the cave-ins, settlements, and subsidences experienced at petitioner's plant were caused by the leaching or raveling of the soil overburden which underlay petitioner's plant into openings in the limestone bedrock. This leaching or raveling away left voids in the soil overburden immediately above the openings in the bedrock; the voids increased in size by upward development through the progressive loss of soil from the earth arch forming the roof of the void into the openings in the bedrock; when the voids had grown to the point at which the enlarged earth arch could not support its own weight or the weight imposed on it from above, the earth arch collapsed into the void.
The limestone bedrock underlying petitioner's plant was traversed by a synclinal fold which was faulted and breacherated so that fissures and crevices in this fault zone in the bedrock afforded openings, or solution channels, giving access to cavities in the bedrock itself. The condition of cavitation in the limestone bedrock underlying the plant (as distinguished from the condition of cavitation in the soil overburden) was probably age-old.
The growth of a condition of cavitation in the soil overburden lying between the bedrock and the floor of the plant could be either gradual or sudden. The rate of acceleration of the growth of such cavitation in the overburden was a function of the amount of fluids flowing through the overburden. Where the natural cover of the land provides a run-off for surface waters, cavitation in the overburden is a function of long periods of time; but where the cover of the soil is removed and fluids enter rapidly as storm water or by reason of leaking fluid carriers, the processes of raveling are rapidly accelerated over that which would occur when the soil has the protection of normal surface growths.
By June-July 1941 the cavitation in the overburden lying between the bedrock and the floor of the plant was in an advanced stage and constituted a real danger to the continued operation of petitioner's plant, particularly because, without extensive drilling and grouting on a close pattern, the location and precise extent of cavitation were not ascertainable. These cavitations in the overburden which the Proctor program dealt with, so far as all the indications show, occurred during the period of petitioner's occupancy of the plant site.
There was no omission of due care or diligence by petitioner in connection with the investigation of subsoil conditions or adoption of remedial measures with respect to subsurface conditions at any time from the time of the original construction of its plant to the close of the taxable year 1942. Neither the existence nor the nature nor the extent of any abnormality in the subsurface conditions affecting petitioner's plant was discoverable in the exercise of the diligence and prudence appropriate to the circumstances at any earlier date than they were actually discovered.
Leakage from the fluid carriers at petitioner's plant contributed to the cavitations in the overburden, but the unknown existence of the geological abnormalities in the subsurface conditions, that is, the absence of a shale mantel or other impervious soil layer and the presence of the fault zone in the synclinal fold of the underlying limestone bedrock, were necessary concurrent conditions for the production of the cavitations in the overburden. The fluid carrier lines in the plant which were responsible for leakage could not in standard engineering practice be expected to be tight.
No comparable occurrences took place at the nearby plant of North American Rayon Corporation (built in 1927-1930), where operating conditions were substantially the same but the geological circumstances were different.
The subsidences before March 27, 1940, took place along the line of discovered leaks or breaks in fluid carrier lines or blue water channels. They occasioned no unusual concern and, because of their association with such leaks and breaks, did not indicate the existence of an abnormal subsurface condition. All but three minor subsidences took place outside the main plant building; all were repaired in normal course by an experienced contractor, who had been engaged in business in the district since 1913.
Facts Dealing with the Scope and Prosecution of the Proctor Program.
The program recommended by Proctor and prosecuted by petitioner under his engineering supervision embraced (a) drilling through the overburden to bedrock within the limits of the building structures on a close pattern calculated to intercept all cavities in the overburden other than minor ones; (b) injecting a grout of low cement ratio at low pressures at the bedrock level, and at increasingly higher pressures as the lower reaches of the cavities in the overburden were filled with the grout and the grouting pipe was drawn upward, such grouting being intended to restore the lost soil which the cavities represented with a stable conglomerate; (c) avoiding any attempt to fill with grout cavities of possibly very great extent in the underlying bedrock itself; (d) keeping progress charts on the grouting so that progress could be ascertained at any time and the location of large cavities would become immediately known as an aid in determining the order and intensity of the pattern to be followed in drilling and grouting; and (e) drilling star drill holes through the floor slab throughout the entire plant structure on 10-foot centers to make possible physical examination of the earth under the floor in order to detect any evidence of settlement or subsidence below the floor slabs.
The Proctor program as executed embraced, in addition to the matters covered in the preceding paragraph, (a) incidental work on the plant structure itself, particularly at its southwestern corner, (b) excavating exploratory trenches to the north and to the south of the plant in order to locate the rock fault, and (c) the doing of incidental repair, moving, and cleanup work arising out of the prosecution of the Proctor program.
The Proctor program required for the achievement of its objectives which were removal of the risk of collapse of existing major cavities and elimination so far as possible of the risk of a recurrence of cavitation, the completion of the program initiated under Stone & Webster in the preceding year for making all fluid carriers within and in the neighborhood of the plant tight against leakage. The condition of tightness required of the fluid carriers at petitioner's plant was much more exacting than that normal to industrial installations.
So far as concerned maintenance measures and the future operations of the plant, the Proctor program required (a) that the star drill holes, drilled on 10-foot centers throughout the plant, be checked at regular intervals with plumb lines to determine whether or not the earth had fallen away from the floor slab, (b) regular checking of the system of elevation checks which had been established in order to determine whether there had been any settlement or movement of any element of the building structure or of the floor slab itself, and (c) periodical testing of fluid carriers throughout the plant for leakage and immediate repair upon the discovery of any leakage.
The precautionary measures of systematic inspection described in the preceding paragraph are not normal to plant operation or maintenance. Petitioner is unique in having to take these measures. They will probably have to be continued as long as the plant is used.
Every effort was made to prosecute the Proctor program as cheaply as possible. In the course of the prosecution of the program new techniques were developed effecting economies in operation, including developing new grouting machines and establishing a grout formula using a very low proportion of cement and utilizing local soils for grouting sand. For reasons of economy the close pattern of drill holes was limited to plant buildings and service roadways.
A complete shutdown of the plant was avoided by carrying out the drilling and grouting program sectionally, so that, although every portion of the plant was shut down at some time when actual drilling and grouting was going on, at no time was the plant as a whole shut down.
A complete contemporary record was kept of all of the details concerning the drilling and grouting of each drill hole and a complete contemporary record of the location of each drill hole was also kept.
The linear feet of drilling through the overburden to bedrock during each of the years 1941 and 1942 and the cubic feet of grout introduced into the overburden during each of the years 1941 and 1942 classified by location (a) within exterior walls of the various buildings comprising the whole of petitioner's plant, (b) outside the exterior walls of such buildings and within the immediately adjacent roadway area, and (c) outside both the limits of the buildings and the immediately adjacent roadway areas, were as set forth in the following table:
+---------------------------------------------------------+ ¦ ¦1941 ¦1942 ¦ +-----+---------------------------------------------------¦ ¦Item ¦ ¦ +-----+---------------------------------------------------¦ ¦ ¦Linear feet¦Cubic feet of¦Linear feet¦Cubic feet of¦ +-----+-----------+-------------+-----------+-------------¦ ¦ ¦of drilling¦grouting ¦of drilling¦grouting ¦ +-----+-----------+-------------+-----------+-------------¦ ¦(a) ¦80,632.0 ¦1,025,559 ¦7,773.7 ¦134,299 ¦ +-----+-----------+-------------+-----------+-------------¦ ¦(b) ¦11,877.4 ¦101,773 ¦1,821.5 ¦51,908 ¦ +-----+-----------+-------------+-----------+-------------¦ ¦(c) ¦9,491.0 ¦102,345 ¦5,591.1 ¦158,288 ¦ +-----+-----------+-------------+-----------+-------------¦ ¦Total¦102,000.4 ¦1,229.677 ¦15,186.3 ¦344,495 ¦ +---------------------------------------------------------+
Facts Dealing with Nature and Classification of Expenditures.
Since cavitation of the overburden was advanced to a stage at which it constituted a real danger to the continued operation of the plant and the magnitude of grout acceptance throughout the main plant building demonstrated the existence of major areas of incipient failure of the soil foundation of the plant, prosecution of the Proctor program was essential to the continued operation of the plant.
The Proctor program added nothing to the buildings themselves except to a negligible extent in connection with reinforcing columns in areas where the ground had failed and except in the shoring up and straightening of the southwest corner of the building.
The grout injected into the overburden possesses no regularity of contour nor preciseness of location; it simply filled the major cavitations in the soil overburden by irregularly filling those areas where the overburden leached and raveled into the cavitations within the bedrock.
Those portions of the amounts expended by petitioner in the years 1941 and 1942 in the prosecution of the Proctor program which petitioner charged to expense on its books and claimed as deductions in its returns and which respondent disallowed as deductions were $734,316.76 for the year 1941 and $199,154.33 for the year 1942.
Petitioner charged to capital and claimed no deduction for expenditures in the amount of $153,474.20 for the year 1941 and in the amount of $79,687.29 for the year 1942 which arose directly out of the subsurface difficulties encountered at the plant in the years 1941 and 1942. The total expenditures of petitioner arising out of the subsurface conditions encountered at its plant for the years 1940 to 1945 which were charged by petitioner to capital and to expense, respectively, were as follows:
+----------------------------------+ ¦ ¦Charged to ¦Charged to ¦ +-----+---------------+------------¦ ¦ ¦capital and not¦expense and ¦ +-----+---------------+------------¦ ¦Year ¦claimed as ¦claimed as ¦ +-----+---------------+------------¦ ¦ ¦deductions ¦deductions ¦ +-----+---------------+------------¦ ¦1940 ¦$82,157.24 ¦$74,000.00 ¦ +-----+---------------+------------¦ ¦1941 ¦153,474.20 ¦734,316.76 ¦ +-----+---------------+------------¦ ¦1942 ¦79,687.29 ¦199,154.33 ¦ +-----+---------------+------------¦ ¦1943 ¦213,231.29 ¦79,186.87 ¦ +-----+---------------+------------¦ ¦1944 ¦71,256.89 ¦28,095.00 ¦ +-----+---------------+------------¦ ¦1945 ¦119,077.01 ¦14,541.33 ¦ +-----+---------------+------------¦ ¦Total¦718,883.92 ¦1,129,293.29¦ +----------------------------------+
The expenditures so charged to capital and not claimed by petitioner as deductions were principally incurred in replacing and rebuilding the plant fluid carrier system, in replacing roadways and plant floors, and in grading and drainage work outside the plant buildings.
The expenditures of $734,316.76 and $199,154.33 charged to expense for 1941 and 1942, respectively, were directly connected with and pertained to petitioner's trade and business. They were made in the prosecution of a reasonable and appropriate program for dealing with the subsurface conditions encountered by petitioner. The work for which such amounts were expended did not add to the value of petitioner's property over and above what its value was at January 1, 1941. Such expenditures did not prolong the original useful life of petitioner's property. Neither the plant nor the property accounts of petitioner were increased by the amount of such expenditures. The work for which such expenditures were made did not arrest that deterioration of petitioner's property for which allowance is made under section 23(l) of the Internal Revenue Code nor make good the depreciation of petitioner's property for which a deduction had been theretofore claimed or allowed or was allowable. The depreciation rates established by the respondent in the determination of petitioner's tax liability reflected no allowance or provision on account of subsurface instability. The said expenditures did not increase the productive capacity of petitioner's plant nor its operating efficiency over the capacity and efficiency existing at January 1, 1941, nor diminish operating costs of petitioner's plant over what they had theretofore been.
Due and timely claims for refund based on loss incurred on June 9, 1941, were filed by petitioner through the filing of claims for refund on Form 843 and the filing of the petition to this Court. The basis of these claims is that petitioner allegedly sustained a loss deductible under section 23(f) of the Internal Revenue Code in the amount of $2,708,000 on June 9, 1941. The respondent rejected the claims.
The respondent also disallowed as deductions that portion of the amounts expended by petitioner in the years 1941 and 1942 in the prosecution of the Proctor program which petitioner charged to expense on its books and claimed as deductions in its returns in the amounts of $734,316.76 and $199,154.33, respectively. These respective amounts constituted ordinary and necessary expenses incurred in the conduct of petitioner's trade or business and are deductible under section 23(a)(1)(A) of the Internal Revenue Code.
OPINION.
BLACK, Judge:
As was mentioned in our preliminary statement, the Commissioner in his deficiency notice determined a deficiency of $140,104.59 in petitioner's income tax for the year 1940; a deficiency of $9,638.08 in petitioner's declared value excess profits tax for that year; and a deficiency of $167,710.48 in petitioner's excess profits tax for that year. The petitioner did not appeal from this determination. Its counsel stated at the hearing that petitioner's expenditures in 1940 for the purposes involved in the issues for 1941 and 1942 were relatively unimportant, and that the deficiencies for 1940 resulted mainly from adjustments which petitioner did not contest and, therefore, no appeal was taken from the determination of the Commissioner for that year. Thus we have only the years 1941 and 1942 before us.
We first consider petitioner's assignments of error (a) and (c) set out in our opening statement. For the year 1942 there is a slight discrepancy between the pleadings and the proof. The evidence shows that in 1942 petitioner expended $199,154.33 in connection with ground subsidences and not $199,217.34, as alleged in the petition. The respondent's determination is, of course, sustained as to the difference of $63.01.
Petitioner contends that the amounts of $734,316.76 for 1961 and $199,154.33 for 1942 are deductible as ordinary and necessary business expenses under section 23(a)(1)(A) of the Internal Revenue Code.
The respondent contends that the items for which these amounts were expended come within section 24(a)(2) and (3) of the Internal Revenue Code
SEC. 23. DEDUCTIONS FROM GROSS INCOME.In computing net income there shall be allowed as deductions:(a) EXPENSES.—(1) TRADE OR BUSINESS EXPENSES.—(A) In General.— All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business * * *
and are not deductible. The applicable regulations are Regulations 103 and 111. The material provisions of Regulations 111, which are substantially the same as those of Regulations 103, are set forth in the margin.
SEC. 24. ITEMS NOT DEDUCTIBLE.(a) GENERAL RULE.— In computing net income no deduction shall in any case be allowed in respect of—(2) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate;(3) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made.
SEC. 29.23(a)-1. BUSINESS EXPENSES.— Business expenses deductible from gross income include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer's trade or business, except the classes of items which are deductible under sections 23(b) to 23(z), inclusive, and the regulations thereunder. Double deductions are not permitted. Amounts deducted under one provision of the Internal Revenue Code cannot again be deducted under any other provision thereof. * * * Among the items included in business expenses are management expenses, commissions (but see section 29.24-2), labor, supplies, incidental repairs, * * *SEC. 29.23(a)-4. REPAIRS.— The cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted as expense, provided the plant or property account is not increased by the amount of such expenditures. Repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, should be charged against the depreciation reserve if such account is kept. (See sections 29.23(a)-1 to 29.23(1)-10, inclusive.)SEC. 29.24-2. CAPITAL EXPENDITURES.— Amounts paid for increasing the capital value or for making good the depreciation (for which a deduction has been made) of property are not deductible from gross income. (See section 23(1).) * * *
In deciding whether the expenditures of $734,316.70 in 1941 and $199,154.33 in 1942 may be classed as expenses of the business, as petitioner contends, or whether they were expended in the acquisition of capital assets, as respondent contends, we think it is appropriate to consider the purpose, the physical nature, and the effect of the work for which the expenditures were made.
In connection with the purpose of the work, the Proctor program was intended to avert a plant-wide disaster and avoid forced abandonment of the plant. The purpose was not to improve, better, extend, or increase the original plant, nor to prolong its original useful life. Its continued operation was endangered; the purpose of the expenditures was to enable petitioner to continue the plant in operation not on any new or better scale, but on the same scale and, so far as possible, as efficiently as it had operated before. The purpose was not to rebuild or replace the plant in whole or in part, but to keep the same plant as it was and where it was. Those expenditures, amounting to $153,474.20 in 1941 and $79,687.29 in 1942, which looked to replacing parts of the plant were capitalized by petitioner and are not here involved.
In connection with the physical nature of the work, the drilling and grouting was not a work of construction, nor the creating of anything new. It consisted (a) in drilling through the overburden so as to intercept the cavities in the soil overburden wherever they existed between the bedrock and the plant floor and (b) in filling the cavities with a low ratio cement grout by forcing the grout down through the drill holes. As the cavities were irregular in shape and location and sometimes interconnected under ground, no regular grout structure resulted. No effort was made to fill the possibly age-old and illimitable cavities in the bedrock; on the contrary, the program was designed to prevent that from happening and to limit itself to filling the cavities in the soil overburden which had occurred through the washing away of the soil during the period petitioner's plant was in operation. While the amount of grout introduced was large, it by no means represented a large percentage of the tremendous cube of earth standing between the plant floor and the bedrock, which lay at an average depth of over 50 feet below the plant floor. The work could not successfully have been of smaller scope. Drilling on a close pattern and grouting wherever and to the extent that the soil would accept grout was essential to prevent floor failures like that of June 9, 1941, because that cave-in demonstrated that until all cavities of any size had been intercepted and grouted there could be no assurance that all areas of incipient failure had been eliminated.
In connection with the effect of the work, the accomplishment of what was done forestalled imminent disaster and gave petitioner some assurance that major cave-ins would not occur in the future, provided the fluid carrier system was kept free of even the normal amount of leakage permissible in ordinary industrial establishments. All storm and surface waters were drained away from the plant. Any detection of settlement was promptly followed by drilling and grouting the situs of the settlement, and any material leakage was promptly repaired and the situs of the leakage checked for the presence of evidences of settlement.
We think a consideration of the above factors, which are more fully set out in our findings, shows that the expenditures in question fall into the ‘expense‘ class rather than the ‘capital‘ class. The original geological defect has not been cured; rather, its intermediate consequences have been dealt with. The required continuance of the three-fold inspection program and the requirement that even normal leakage be kept from the plant site show that the original defect still exists and that plant operation has had to be modified to take account of the continued existence of that original defect.
One of the leading cases in the field of what are capital expenditures and what are business expenses is Illinois Merchants Trust Co., Executor, 4 B.T.A. 103; acquiesced in, 2 C.B. 2. That case has been often cited and approved. In that case the taxpayer owned a warehouse resting on wooden piles. During the taxable year unprecedentedly low water exposed parts of the piles usually under water. Dry rot set in and the warehouse began to settle so badly as to threaten collapse. To prevent a total loss and halt this accelerated deterioration, the taxpayer had all piles sawed off below the low water mark and installed concrete sections between the stumps of the piles and the bottom of the building. Much of the floor was removed in the process and one exterior wall was considerably shored up. It was held in that case that the expenditures there involved were not for permanent betterments and improvements, but were repairs and deductible as ordinary and necessary business expenses. For similar holdings see Yakima Hop Co., 8 B.T.A. 441; John A. Schmid, 10 B.T.A. 1152; Tampa Electric Co., 12 B.T.A. 1102; Zimmern v. Commissioner, 28 Fed.(2d) 769, reversing 9 B.T.A. 1382; and Buckland v. United States, 66 Fed.Supp. 681.
In the Buckland case, supra, the cost of stopping leaks in the walls and roof of a factory building within 16 months of its purchase was held deductible as a repair expense and was not a capital expenditure, even though amounting to 35 per cent of the value of the building, where such repairs enabled a continuation of the existing use of the building by taxpayer's tenants. Notwithstanding the high cost, it was found that the nature of the work was the restoration of a damaged fabric not extending to the replacement of any sizeable unit of the building and conformed closely to the Board's definition of repairs in Illinois Merchants Trust Co., Executor, supra. In the Buckland case the court, among other things, said:
The Tax Court or its predecessor has in a number of cases, allowed work of substantial cost to be classified as repairs if the property was not placed in better condition or given a longer life expectancy than when originally constructed. (Citing cases.)
It has frequently denied the deduction when the work was undertaken in conjunction with alterations, additions or improvements either because the ‘repair‘ items were not clearly segregated from the cost of the improvements (citing cases), or because the repairs were part of a general plan of reconditioning, improving and altering the property as a whole, and were therefore lumped by the Board with the other expenditures as capital. (Citing cases.)
In the case at bar we have a restoration of damaged fabric, not extending to the replacement of any sizeable unit. In spite of the high cost of the work, the nature of the work fits closely the Board's definition of repair in Appeal of Illinois Merchants' Trust Co. 4 B.T.A. 103.
Defendant's (U.S.) contention appears to be that repairs are only those mendings of the fabric which recur year by year. This is not consistent with the meaning given ‘ordinary and necessary‘ in Welch v. Helvering, Commissioner, 290 U.S. 111. The work done at the instance of the taxpayer was a normal response to the need developed in the course of stopping the leaks in the walls and roof of the factory building, to enable the continuation of the existing use of the building by the taxpayer's tenants.
We make a holding similar to the above in the instant case.
The respondent, in support of his contention that the expenditures in question were capital in their nature, has cited and discussed a number of cases. We have examined the cases relied upon by the respondent and have found no case wherein the facts and circumstances may be said to parallel the facts and circumstances of the instant case to such a degree as to require a holding different from what we have made. We, therefore, hold that the expenditures in question were ordinary and necessary business expenses rather than capital expenditures and should be allowed as deductions in the respective taxable years, 1941 and 1942.
We turn now to petitioner's assignment of error (b), set out in our opening statement. Under this issue petitioner contends that upon the occurrence of the June 9, 1941, cave-in it sustained a loss deductible under section 23(f) of the Internal Revenue Code in the amount of $2,708,000. This amount is based upon a long, detailed appraisal made by W. V. Burnell, vice president of Stone & Webster, on or about April 15, 1944, and Burnell's testimony at the hearing. Briefly, the amount of $2,708,000 was arrived at in the appraisal as follows:
+----------------------------------------------------------------------------+ ¦Net value June 9,1941, prior to casualty ¦$6,558,000¦ +-----------------------------------------------------------------+----------¦ ¦Less fair market value immediately after casualty of June 9, 1941¦3,850,000 ¦ +-----------------------------------------------------------------+----------¦ ¦Amount of loss claimed ¦2,708,000 ¦ +----------------------------------------------------------------------------+
In its returns petitioner did not claim any loss by reason of the June 9, 1941, cave-in. It merely deducted as ordinary and necessary business expenses the expenditures for drilling and grouting. The disallowance of such expenditures as deductions is the principal reason for the deficiencies. After petitioner filed its returns it filed claims for refund in which it claimed it was entitled to a deduction for a loss in 1941 of $2,708,000 in addition to the deductions as expenses of the expenditures for drilling and grouting. The respondent rejected the claims and determined the deficiencies here contested. Petitioner's assignments of error (a), (b), and (c) are all made independent of each other, and in its prayers for relief petitioner prays that this Court find that there are no deficiencies and that there are overpayments in the amounts set out in our opening statement. Notwithstanding the independence of the assignments of error and the prayers for relief, counsel for petitioner, in his opening statement, said:
Now, I say alternatively, that if the government may, by some mischance, succeed in convincing the Court that these (expenditures of $734,316.76 and $199,154.33) are not ordinary and necessary expenses, then obviously in the year 1941 this company suffered a loss, a loss which we say, if you had to measure it in dollars, would be the sum of $2,700,000.
In its brief petitioner argued two points: (I) ‘The Petitioner Incurred a Deductible Loss of $2,708,000 on June 9, 1941,‘ and (II) ‘The Amounts Expended in Prosecuting the Drilling and Grouting Program Are Deductible as Ordinary and Necessary Business Expense.‘ Although these points are argued independently, petitioner in its brief states its ultimate conclusion as follows:
The amounts which the taxpayer expended in 1941 and 1942 as set forth in paragraph 85 (being the amounts of $734,316.76 and $199,154.38) of the Statement of Facts are deductible under Section 23(a)(1)(A) as ordinary and necessary expenses incurred in carrying on the petitioner's trade or business.
If, however, those amounts are held not to be deductible, then we submit that upon the occurrence of the June 9, 1941 cave-in the petitioner necessarily sustained a loss deductible under Section 23(f) and in the amount of $2,708,000.
Irrespective of the fact that assignment of error (b) was not made as an alternative to assignments (a) and (c), and irrespective of the prayers for relief, we regard the above quoted portion of the opening statement and the ultimate conclusion stated in petitioner's brief as waiving assignment of error (b) in the event we allow the expenditures of $734,316.76 and $199,154.33 as deductions from gross income in 1941 and 1942, respectively. Under assignments of error (a) and (c), we held the said amounts to be deductible as ordinary and necessary business expenses. We, therefore, regard assignment of error (b) as having been waived and we do not decide it.
We turn now to petitioner's assignments of error (d) and (e), set out in our opening statement. No evidence or argument was offered as to these assignments. If any automatic adjustments are to be made in the recomputation of petitioner's tax liabilities for the years in question along the line mentioned in these assignments of error, they should be made under Rule 50.
Reviewed by the Court.
Decision will be entered under Rule 50.