*574 The taxpayer, parent company, filed a consolidated return of income for 1929, which included the income of its subsidiary, Macdonald Engineering Co. of California. The latter company was the creditor of the Western Milling Co. In 1929, after a final judicial determination that Western Milling Co. had lost all its property by an earlier foreclosure, Macdonald Engineering Co. of California transferred the debt of Western Milling Co. to the taxpayer, without consideration therefor. Thereupon, the taxpayer credited the amount of the debt on the open account of the Macdonald Engineering Co. of California, to the taxpayer, and immediately charged off the debt of Western Milling Co. Held, since the taxpayer's tax liability here depends on the taxable income of Macdonald Engineering Co. of California for 1929, the deduction of the debt of the Western Milling Co. to Macdonald Engineering Co. of California is allowed in the computation of that income, because (a) Macdonald Engineering Co. of California ascertained the debt to be worthless in 1929, and (b) charged it off in that year.
*5 These two consolidated cases involve deficiencies in income tax for the years 1928 and 1929 in the respective amounts of $3,338.72 and *6 $10,894.66, and an overpayment of $141.19 for the year 1927. Since there was no deficiency determined for 1927, the Board has no jurisdiction to consider the overpayment for that year and the petition in Docket No. 61148, so far as it relates to the year 1927, is dismissed.
The petitions in both cases allege that the respondent erroneously refused to allow a deduction for a bad debt of the Western Milling Co. in the amount of $94,418.66. In Docket No. 61148, it is claimed the deduction should have been allowed in 1928, while in Docket No. 62319 it is asserted the deduction should have been allowed for 1929. Both petitions also allege that the respondent erroneously failed to allow depreciation on an elevator and mill in Oakland, California, and the petition in Docket No. 62319 alleges that the respondent erroneously refused to allow a deduction for reserve for bad debts in the case of the Coastal Construction Co., an affiliate of the petitioner, for the year 1929 in the amount of $27,708.07 instead of $19,708.07.
*576 At the hearing all issues were waived except that involving the deduction of the alleged worthless debt of the Western Milling Co. in the amount of $94,418.66 for the year 1929. Respondent's position at the hearing was that the debt became worthless in 1926 and was deductible then, if at all.
FINDINGS OF FACT.
The petitioner is an Illinois corporation engaged in the business of designing and building flour mills, grain elevators, feed mills, and cement plants. During the taxable years it had three subsidiaries, namely, Macdonald Engineering Co. of California, Coastal Construction Co. and Coastal Dredging Co., and for the year 1929, the Macdonald-Spencer Engineering Co., also. Petitioner was the owner of all of the capital stock of the Macdonald Engineering Co. of California. Consolidated returns were filed in each year for the petitioner as parent with its affiliated subsidiaries. The Macdonald Engineering Co. of California was organized about 1919 for the purpose of designing and constructing a large warehouse, grain elevator, and mill for the Western Milling Co. on ground owned by the Western Milling Co. in Oakland, California. At the time of acquisition of the land*577 by the Western Milling Co., it was encumbered by a mortgage and a deed of trust amounting to $90,000.
The operation of the Western Milling Co. was not a financial success and by 1925 its property was heavily encumbered with mechanics' liens, attachments, mortgages, and deeds of trust necessitating refinancing.
On March 21, 1925, the various sets of creditors conferred with Western Milling Co. for the purpose of adjusting their claims, and *5 obtaining payment or security therefor. As a result of the conference it was agreed (1) that the Western Milling Co. should give its note to the Webster Manufacturing Co. for $210,000 payable January 1, 1926, secured by a deed of trust upon all of the real and personal property of the debtor; (2) that the Western Milling Co. should give its note for the sum of $153,894.33 payable May 1, 1927, to the Macdonald Engineering Co. of California and E. H. Nielson Co. secured by a second deed of trust on all the debtor's property; and (3) the debtor should give a third deed of trust and note for $200,000 due February 11, 1926, to three individuals, Williams, Hawkins, and Wholey. This last deed of trust was given for advances made and to*578 be made by the persons named, for the purpose of clearing the property of all other claims. The interest of the Macdonald Engineering Co. of California in the second note and deed of trust was $96,094.33, which was reduced to $94,418.66 by partial payments. It was agreed that the deeds of trust should have priority in the order above mentioned and they were so recorded.
Under the laws of California the Western Milling Co. was engaged in the operation of a public utility, and it was required to obtain the consent of the state railroad commission before issuing certain kinds of obligations, or encumbering its properties.
On or about February 24, 1926, the beneficiaries under the third deed of trust assigned their note and security to Charles W. Byrnes, who, on that date, abandoned the security for the debt and filed an action at law against the Western Milling Co., had an attachment issued and levied upon the real property. The case proceeded to judgment and on May 25, 1926, the sheriff sold the real property under execution, and Byrnes became the purchaser.
On March 30, 1926, the Western Milling Co., which had changed its name to Oakland Terminal & Elevator Co., filed suits*579 in the Superior Court of Alameda County, California, praying for an injunction against the Webster Manufacturing Co. to restrain the selling of its property under the first deed of trust, and like relief against the Macdonald Engineering Co. of California and E. H. Nielson Co. from selling the property under the second deed of trust. The asserted ground of these proceedings was that the two notes and deeds of trust were void because the debtor, a public utility, had not obtained the consent of the railroad commission to execute such notes and deeds of trust. The injunctions were refused by the trial court and the trustees under the first and second deeds of trust proceeded to sell the debtor's property. The sale under the second deed of trust occurred on May 10, 1926, and the property was bid in by the holder of that trust for $100,000. The sale under the first deed of trust, held by the Webster Manufacturing Co. "after due notice given", occurred May 11, 1926, and the property was bid *6 in by the holder of that trust for $221,150. No cash was paid in either instance, but the bid was credited on the debts.
Subsequently Webster Manufacturing Co. instituted an action*580 against Byrnes to clear its title to the property, in which Byrnes filed a cross-complaint alleging that the Webster Manufacturing Co.'s claim was invalid because not authorized by the railroad commission. The trial court decided against Byrnes and held that Webster Manufacturing Co. had a good title. This case and that of the Oakland Terminal & Elevator Co. v. Mercantile Trust Co. were appealed to the District Court of Appeals, which decided that the first deed of trust and note, under which Webster Manufacturing Co. claimed, were void because not approved by the railroad commission. Both cases were then appealed to the Supreme Court of California, which reversed the Court of Appeals, and affirmed the lower court holding that the note and first deed of trust were valid and Webster Manufacturing Co. had absolute fee simple title to the property. (; .) These decisions became final August 15, 1929.
During the pendency of these actions the case of the debtor against Macdonald Engineering Co. of California and E. *581 H. Nielson Co., under the second deed of trust, lay dormant awaiting the determination of the Webster and Byrnes cases. The Webster Manufacturing Co. had acquired the two underlying mortgages, amounting to $90,000, that encumbered the property when Western Milling Co. purchased it. The fair market value of the property of the milling company as of March 1925, was $600,000 and approximately the same in July 1929.
The debt of the Western Milling Co. to the Macdonald Engineering Co. of California was not charged off in 1926, nor in 1928. But on December 1, 1929, that debt was transferred to the petitioner, the Illinois corporation, which credited the California subsidiary with the amount of the debt in controversy and some additions making $100,162.12 in all. On the same day petitioner charged it off to profit and loss. The milling company had no other property, than that sold under the foreclosure to the Webster Manufacturing Co. In filing its consolidated return for 1929 for itself and its affiliated subsidiaries, petitioner deducted the milling company debt of $94,418.66 as a worthless debt, which respondent disallowed solely on the ground that it was deductible in*582 1926. In 1927 a corporation was formed to which the milling company property was conveyed. The petitioner became the owner of three-fourths of the stock of this new company for which it obligated itself to pay $300,000 and which it has paid in part.
*7 The Western Milling Co. debt to Macdonald Engineering Co. of California, in the amount of $94,418.66, was ascertained to be worthless less and charged off by that company in 1929.
OPINION.
LEECH: The only question left for our determination is whether the debt of the Western Milling Co. to Macdonald Engineering Co. of California is deductible in computing the present deficiency.
The applicable Revenue Act of 1928, in section 23(j), allows the deduction of "Debts ascertained to be worthless and charged off within the taxable year * * *."
It may well be that the disputed deduction would not be allowable here if petitioner had filed a separate return for 1929, on the ground that the debt was worthless when petitioner received it in that year. .
But that is not the situation here.
Petitioner, the parent company, filed a consolidated return of income for*583 1929, which included the taxable income of a subsidiary, Macdonald Engineering Co. of California. That consolidated income is the basis for the pending deficiency. Thus, here, though we may not have jurisdiction to determine the tax liability of the Macdonald Engineering Co. of California for 1929, as such, we do have the authority and duty to decide what that consolidated income was. That fact is necessarily premised partially upon the net income of Macdonald Engineering Co. of California for that year. The validity of the present deduction to that company in 1929 is clearly required in that computation. See .
Did Macdonald Engineering Co. of California "ascertain" the debt to be worthless and "charge it off" in 1929? We think it did.
Here was a debt of approximately $95,000, secured by real estate of a value exceeding $600,000. The only indebtedness against such property prior to the debt in question was a first mortgage of $210,000 and an underlying mortgage of $90,000. It is true that in 1926 the holder of a third trust for $200,000 sued upon the debt, secured judgment, and sold the property*584 under execution. But the title transferred under such sale was apparently subject to the prior mortgage and did not diminish the security for the debt in dispute. But, whether that conclusion is correct or not, in view of the value of the security and the litigation involving the title to the property constituting that security, which was not terminated until 1929, we think Macdonald Engineering Co. of California had a right, and, in fact, a duty, to wait until the termination of that litigation before it *8 could be said to have ascertained the debt to be worthless and charged it off. .
The taxpayer in such cases may not be an incorrigible optimist, nor yet a confirmed pessimist. He must follow the middle course, and exercise only the judgment of the ordinary person under the circumstances. As this Board said in ; affd., :
It is obvious that the statute here applicable intended that the taxpayer, and not the law, should determine when bad debts were to be considered worthless in his hands, requiring only that good faith be shown. *585 The provision here discussed has been many times construed by the courts and this Board, and it has been always held that it is the date of ascertainment of worthlessness by the taxpayer, and not of the worthlessness as later f acts might develop, which governs. ; ; ; ; ; ; ; ; . In , No. 15,172, this identical provision, then a part of the income-tax law of 1864, came before the United States District Court for the Northern District of Illinois for construction; the question being whether or not the judgment of the taxpayer, in respect to a similar claim, should prevail as against facts indicating worthlessness at*586 a different date. Respecting the language used in that law, which was identical with the recitals here considered in section 214, supra, the court, among other things, said:
The language is "to ascertain to be worthless." By whom or how? The law is silent on this important point, and, therefore, there must be a discretion given to the person making his return, and if that discretion is used fairly and honestly there would seem to be no just ground for complaint.
There has been no change of opinion expressed by the courts in respect to the construction put upon this provision of the tax laws since the early decision just cited; and in , the court, in recognition of the fallibility of human judgment, held that, to entitle the taxpayer to take such a deduction, the ascertainment need not be absolute and that a claim may be duly ascertained to be worthless though later it may prove to be in fact collectible.
It follows, from this holding, that in a reverse situation, where an over optimistic taxpayer erred in judgment, the same good faith when exercised in ascertainment of worthlessness must be the*587 only criterion by which we can determine his rights. In support of this view, the court in , said:
In the light of subsequent events, it is quite easy now to determine that the debt was worthless before 1921; but the real question with which we are concerned is, not when did the debt become worthless, but when did decedent ascertain it to be worthless.
Thus, the disclosure of reasonably material facts, establishing the uncollectibility of the debt, did not occur until 1929. Then, and *9 not before, did Macdonald Engineering Co. of California ascertain its worthlessness.
Moreover, Macdonald Engineering Co. of California effectively charged the debt off in 1929 for income tax purposes.
The obligation was obviously worthless when the debt was transferred by Macdonald Engineering Co. of California to petitioner. It was then known by both parties to be so. Petitioner gained nothing and Macdonald Engineering Co. of California received nothing for it. No consideration passed. True, petitioner credited the open account of Macdonald Engineering Co. of California with the amount of the debt. But neither the adventitious*588 similarity between the debt and credit, nor the book entries reflecting them, changed the fact of worthlessness. .
In such transfer, Macdonald Engineering Co. of California actually and absolutely eliminated the worthless debt from its assets, and received nothing therefor. This was an effective charge-off. ; .
When petitioner credited the account receivable of Macdonald Engineering Co. of California, in the amount of the debt, the petitioner merely increased its investment by that amount in the stock of its subsidiary.
The right to a possible second deduction predicated upon this item will be presented and denied, if and when a loss in that stock occurs. See ;; . But that circumstance does not preclude the allowance of the present bad debt deduction. See *589
Respondent argues that the transaction was an intercompany one, and therefore not effective here. But, the debt, which is the subject of the contested deduction, was not an intercompany debt, and the intercompany transaction with reference to that debt has been effectually eliminated. The purported intercompany transfer of the debt was, in fact, and we have so held, a transfer of nothing. It was intended to be and was an effective charge-off of the bad debt by Macdonald Engineering Co. of California.
Respondent contends supplementally that the case of , concludes petitioner here. The answer is that the Hawkins case involved a fundamentally different question - whether a loss was sustained by a debtor whose property was sold under foreclosure. Our inquiry is, When was a debt ascertained to be worthless and charged off?
We are deciding here that Macdonald Engineering Co. of California could not and did not, reasonably, ascertain the worthlessness *10 of the Western Milling Co. debt and charge it off until it was conclusively determined that the Western*590 Milling Co. had lost its only property from which the debt could have been paid.
The loss on that property by Western Milling Co. may have been sustained in 1927 at the conclusion of its redemption period. But the fact of that loss, upon which the contested debt became worthless, was not reasonably ascertainable by Macdonald Engineering Co. of California until 1929 when it was so ascertained and charged off.
Decision will be entered for the respondent in Docket No. 61148, and under Rule 50 in Docket No. 62319.