1934 BTA LEXIS 1174">*1174 1. An account owing to petitioner for goods sold was not in fact worthless and was not ascertained to be worthless in whole or in part in 1929 and petitioner is not entitled to a bad debt deduction therefor.
2. Petitioner's reduction of income by charges to commissions and taxes was erroneous and the respondent properly disallowed the deductions.
3. Amounts paid in settlement of a royalty claim and bonuses to employees allowed as expense deductions.
4. Petitioner's understatement of income was fraudulent, with intent to evade tax, and the imposition of a fraud penalty is sustained.
31 B.T.A. 64">*64 The respondent determined a deficiency in income tax for the year 1929 of $3,302.23, to which he has added a 50 percent penalty, making a total of $4,953.34. The principal matters in dispute are (1) whether petitioner is entitled to a bad debt deduction in the amount of $19,291.27, which it charged to its sales account for 1929 but did not then claim as a bad debt deduction, (2) whether respondent erred in restoring to 1929 income the amount of $5,148.051934 BTA LEXIS 1174">*1175 arising out of a sale of machinery; (3) whether there was fraud with intent to evade tax. Other matters in issue are the propriety of deductions for bonuses to employees and an amount paid in settlement of royalty claims. An issue as to depreciation has been abandoned by petitioner.
FINDINGS OF FACT.
Petitioner is a North Carolina corporation, organized in 1925, with its plant and office at Burlington, where it is engaged in the manufacture of hosiery. Petitioner was organized by C. F. Foster, 31 B.T.A. 64">*65 who in the taxable year owned between 70 and 75 percent of the capital stock and was secretary and treasurer of the petitioner. Foster has been secretary and treasurer since the organization of petitioner and has been in active charge of all buying, selling, and financing. His office, which was also the general office of petitioner and in which petitioner's books were kept, was in the mill building. The books were kept and the entries therein were made by a bookkeeper. The books were kept on the accrual basis and petitioner's income tax returns were made on that basis.
In 1929 petitioner sold a large portion of its manufactured goods to the Southern Commission Co., 1934 BTA LEXIS 1174">*1176 an unincorporated agency operated by John Schoffner. C. W. Gordon was associated with Schoffner in the operation of the Southern Commission Co. Schoffner and Gordon were both officers of the Standard Hosiery Mills, which was larger than the petitioner corporation and has been a successful corporation. The Southern Commission Co, furnished yarn to the petitioner, which was manufactured into hosiery and delivered to the Southern Commission Co. That company charged or invoiced the yarn to the petitioner and the petitioner charged or invoiced the manufactured hosiery to the Southern Commission Co. The transactions between the two were recorded in an account on petitioner's books entitled "Southern Commission Company", which at the close of 1929 showed a balance of $19,291.27 due to the petitioner. The account was an open account and was neither guaranteed nor secured by collateral. Some time near the close of 1929 Schoffner informed petitioner's officers that he had lost money in the operation of the Southern Commission Co. and intended to discontinue the business.
Foster and the other stockholders of petitioner held a meeting one evening at or about the end of the year 19291934 BTA LEXIS 1174">*1177 for consideration of petitioner's financial situation, including the disposition to be made of the Southern Commission Co. account, and the preparation of the income tax return for 1929. An accountant attended the meeting at Foster's invitation, and the stockholders inquired of him whether the Southern Commission Co. balance could be deducted as a bad debt. The accountant had no information concerning the debtor or the account and refused to advise a charge-off and deduction. His advice was that the account, if bad, could be charged off and a deduction taken. At Foster's suggestion the accountant telephoned an internal revenue agent for information as to whether a deduction might be taken for the account under discussion. He was not advised of the facts concerning the account, and his advice was that a deduction could be taken if the account was ascertained to be worthless and charged off, and further that any collections on the account 31 B.T.A. 64">*66 in later years should be reported in income. The account was not charged off the books of petitioner as a bad debt, but instead the "Sales" account was reduced in the sum of $19,291.27, and the Southern Commission Co.'s account was1934 BTA LEXIS 1174">*1178 credited in a like amount. The accountant advised Foster before petitioner's return was filed for the year 1929 that to reduce "Sales" in the manner related was improper.
Some time after the close of the year 1929 the accountant who attended the meeting above described was employed to prepare petitioner's income tax return. He was not employed to and did not make an audit of petitioner's books. He was handed a trial balance by Foster or petitioner's bookkeeper and from this he prepared the return. The trial balance did not disclose the reduction of sales that had been made on account of the Southern Commission Co. item.
Petitioner's sales as reported in that return, which was duly filed, were $19,291.27 less than actual sales, and that amount was restored to income by the respondent.
Credits to the Southern Commission Co. account were entered each month during 1929. As far as the record shows such credits represent actual payments on the account. In December 1929 there were 6 debit entries and 14 credit entries to the account. The credit entries, other than the $19,291.27 here involved, amounted to $10,736.46, of which $2,118.17 bears the date of December 31, 1929. 1934 BTA LEXIS 1174">*1179 Between January 15, and September 15, 1930, credits aggregating $16,004 were entered, of which $15,650 represented cash payments made by the Southern Commission Co., and the balance of $354 represented adjustments. Nine of the cash payments, aggregating $9,250, were made prior to March 15, 1930, when petitioner's income tax return was filed. In its income tax return for 1930 petitioner reported, as an item of income, $1,050, as "Collections, Bad Debts (Southern Commission Company)." The excess of credits over debits, amounting to $14,786.50, was credited directly to surplus and was not returned as income.
When petitioner's return for 1930 was being prepared Foster's attention was called to the fact that collections on the Southern Commission Co. account had been omitted from income and he was advised to have the books corrected. This was not done and the collections, in the amount of $14,786.50, were not reported. The Southern Commission Co. account was finally closed in 1933 by a stock transaction, whereby Foster acquired stock of another hosiery company.
In December 1928 the petitioner, through an agent, E. H. Scott, sold certain machinery to the Walton Hosiery Mills for1934 BTA LEXIS 1174">*1180 $9,000. The purchaser paid $5,000 in cash, remitting through the Bank of 31 B.T.A. 64">*67 Commerce at Burlington, North Carolina, and gave its note for the balance of $4,000. On January 10, 1929, petitioner paid Scott a commission of $1,000 for making the sale. The $5,000 paid through the Bank of Commerce was credited by the bank on notes of petitioner which it held, but that amount was not entered on petitioner's books at that time. Petitioner entered the selling price of machinery on its books on December 31, 1928, as $8,000 and at the same time charged a like sum to Scott's account. In 1929 petitioner credited Scott's account with $8,000 and charged $4,000 to the Walton Hosiery Mills, and $4,000 to commissions, with the explanation in the journal that it was a correcting entry to cover the sale of machinery to the Walton Hosiery Mills. The $4,000 charged to commissions was taken as a deduction in petitioner's 1929 income tax return. The $1,000 commission paid to Scott was charged to petitioner's tax account in its ledger and was included in the deduction claimed for taxes in its 1929 income tax return.
Petitioner did not adjust its notes payable account on account of the $5,0001934 BTA LEXIS 1174">*1181 credited by the bank until 1930, when it charged $5,148.05 to notes payable and credited an equal amount to surplus. The respondent added the $5,148.05 to income for 1929.
In February 1929 petitioner purchased a number of spiral float machines from Scott & Williams in New York City, at a net cost of $16,072. After purchasing and paying for the machines petitioner was advised by the holder of so-called Hirner patents that it was liable for a royalty on all goods manufactured on the machines. Petitioner took the matter up with Scott & Williams and thereafter a committee was appointed to investigate the matter, and as a result of the committee's recommendations an agreement was reached whereby the holder of the Hirner patents agreed to cancel all claims upon payment of the sum of $30,000. Of this sum Scott & Williams paid $15,000 and the balance was made up by manufacturers who were using the machines, one of whom was petitioner.
The pro rata share paid by petitioner in 1929 amounted to $568.40 and subsequently it received a refund of $137.55, making a net amount of $430.85. The payment of $568.40 and the refund of $137.55 were entered on petitioner's books in an account entitled1934 BTA LEXIS 1174">*1182 "Legal Expenses" and the net amount thereof was claimed as a deduction for such expenses in its 1929 return. The respondent disallowed the deduction so claimed, on the ground that it represented a part of machinery cost.
In December 1929 the petitioner purchased from the Standard Hosiery Mills $186.35 worth of hosiery which it gave to its employees as a Christmas bonus. The amount so paid by petitioner was included in a claimed deduction of $229,85 for donations which the respondent disallowed.
31 B.T.A. 64">*68 Petitioner's understatement of income for 1929 was due to fraud with intent to evade tax.
OPINION.
ARUNDELL: On the facts as related the Commissioner charges fraud with intent to evade tax. He bases his charge primarily on the erroneous reduction of sales in the amount of $19,291.27, and also the improper treatment of machinery sales, whereby petitioner took and unauthorized deduction of $5,000. The Southern Commission Co. had a running account with petitioner and payments thereon were being made in due course, with a substantial payment of over $2,000 made on the last day of December 1929. Around the close of the year petitioner's stockholders, among whom were its1934 BTA LEXIS 1174">*1183 officers, met one evening in their office to discuss the petitioner's general situation and the making of its income tax report. They invited to the conference an accountant, who testified, however, that he was a listener rather than an adviser at the meeting. The account of the Southern Commission Co. was discussed and the accountant was asked if it might be charged off as a bad debt, At the instance of Foster the accountant called up an internal revenue agent to inquire as to the proper method of charging off a bad debt. But neither the revenue agent nor the accountant were advised of the true condition of the Southern Commission Co.'s account, and their advice to petitioner was simply that, if a debt is ascertained to be worthless and is charged off, it constitutes a proper deduction from gross income. With this advice before them the officers of petitioner did not charge off the account as a bad debt, and in fact it is very clear from the evidence that the account was not bad, for not only were payments made thereon regularly as late as December 1929, but the account by the time the return was filed in March 1930 had been further reduced some $9,000. The same end was achieved1934 BTA LEXIS 1174">*1184 by petitioner by resorting to the device of reducing the amount of its sales in an amount equal to the debit balance of the Southern Commission Co. account as it stood on the books on the last of December 1929. Clearly there was no justification for such procedure. In view of the discussions had by the officers of the corporation with reference to this account, and in view of the advice sought not only of their own accountant but of a revenue agent, both of whom had advised that the account could only be charged off if in fact the debt was worthless, we cannot but regard what was done as a deliberate attempt to avoid the tax. The fact that Foster, the principal stockholder and manager, testified that he did not know that such action was taken is not a sufficient answer in the light of what was done and the facts 31 B.T.A. 64">*69 surrounding the entire transaction. It is also an important consideration that for the following year, when substantial sums were collected on this account, totaling over $15,000, only one payment of $1,050 was ever returned for tax purposes, despite the advice of both the accountant and the revenue agent that subsequent collections should be reported as income.
1934 BTA LEXIS 1174">*1185 The Walton Hosiery Mills transaction did not belong in a report of 1929 income at all. The petitioner was on the accrual basis and the evidence is that the sale of machinery was made in 1928. It appears that there was a $5,000 item on petitioner's books which should have been charged to notes payable when that sum was paid to petitioner's bank and applied against its notes. Failure to make a proper entry at the time and the necessity of a later correcting entry might of course be attributed to faulty bookkeeping. But petitioner did not stop with that. It split the $5,000 into two amounts, one of $4,000 and one of $1,000, and charged both to accounts bearing misnomers. No commission of $4,000 was incurred or paid on the sale and there was no $1,000 tax in connection with it. No attempt was made to explain these improper entries, and the evidence convinces us that they were made and deductions taken with fraudulent intent to evade tax. The imposition of the fraud penalty is accordingly sustained.
What has been said above indicates our view on the claimed bad debt deduction. Payments were received in substantial amounts in December 1929, and more than $9,000 was received1934 BTA LEXIS 1174">*1186 in 1930 prior to the filing of petitioner's 1929 return. Petitioner's only witness was its secretary-treasurer, Foster, and his testimony establishes that there was no ascertainment of worthlessness. The substance of his testimony is that he and other officers discussed the account after being advised that the debtor was going to discontinue business, and, quoting Foster, "We did not know whether we would be able to collect it or not. * * * We did not think we would be able to collect it all, that is what we decided." No facts are given to support even the doubt expressed by Foster, much less to affirmatively establish worthlessness. The bad debt deduction claimed is accordingly disallowed.
We have pointed out above that petitioner's method of treating the sale of machinery to the Walton Hosiery Mills as a 1929 transaction was erroneous. The net result of the erroneous bookkeeping entries was to overstate commissions and taxes by $5,000 and notes payable by $5,148.05 for 1929. The respondent has restored the $5,148.05 to income for that year. Obviously $5,000 was an erroneous deduction from income and was properly restored to income. The $148.05 item is not so clear, but1934 BTA LEXIS 1174">*1187 it appears from the revenue agent's report in evidence that 1929 income was reduced by that amount and petitioner 31 B.T.A. 64">*70 has not shown why it should not be restored to income. The respondent is sustained on this issue.
The amount of $430.85 which petitioner paid in settlement of royalty claims is an allowable deduction. The payment was not made to obtain the machines nor to secure title thereto, and respondent erred in treating it as a part of machinery cost.
The amount of $186.35 paid for hosiery and distributed to employees as a Christmas bonus is allowable as a deduction for additional compensation. It was originally claimed as part of a larger deduction for contributions and as such was disallowed by the respondent. The evidence satisfactorily establishes the amount of $186.35 paid for the purpose stated and that amount is allowable.
Reviewed by the Board.
Decision will be entered under Rule 50.