*2899 1. The petitioner's income from commission notes should be recomputed upon the basis of the fair market value of said notes when received in order to more clearly reflect its net income.
2. For failure on the part of the petitioner to adduce sufficient evidence in support of its allegation that capital stock of the Benton Land Co., its subsidiary, should be included in the computation of its invested capital, the findings of the respondent are approved.
*797 This proceeding is for the redetermination of deficiencies in income and profits taxes for the calendar years 1917, 1918, and 1919, amounting to $3,353.65, $201.52, and $773.87, respectively.
The issues raised by the original and supplemental petitions filed by the petitioner are:
(1) Whether the book value or the fair market value should be used as the basis for determining the income derived from certain so-called commission notes; and
(2) Whether the value of the capital stock of the Benton Land Co., a subsidiary of the petitioner, should be included in the computation of the petitioner's invested*2900 capital for the several years in controversy.
FINDINGS OF FACT.
The petitioner is a corporation, organized and incorporated under the laws of the State of Missouri, with its principal offices at Clinton, where it is engaged in the mortgage investment and banking business. Its authorized capitalization is $105,000.
Loans are made by the petitioner, upon application therefor by its clients, at a specified rate of interest. Documents are prepared with *798 a first deed of trust securing a note in the amount of the principal of the loan, and the rate of interest is fixed at that amount which petitioner hopes to be able to sell the loan to an investor. A second deed of trust is prepared, and is taken to secure an installment note for the difference between the rate of interest to be paid by the borrower and the rate provided in the first deed of trust. These notes, denominated by the petitioner as commission notes, were for many years prior to August 1, 1918, recorded in the petitioner's books of account at 75 per cent of their face value, as commissions earned on said transactions, and the remaining 25 per cent thereof was recorded in a sinking fund account. The method*2901 of handling these transactions was changed after August 1, 1918, and thereafter said commission notes were recorded at their entire face value.
Frequently, borrowers apply for excessive loans which the petitioner is unwilling to sell to its investors upon the security offered. In such cases it includes in its second deed of trust a portion of the principal, in a separate note from the installment or commission note above referred to. For instance, in 1917 the petitioner arranged a loan with B. N. Brown for $110,000, a first deed of trust was taken for $100,000 at a stated interest rate, either 5 1/2 or 6 per cent. A second deed of trust was taken for $10,000 of the principal which was covered by an interest-bearing note and for the amount of the noninterest-bearing commission note. When that loan was closed in May or June of 1917 the then holder of the first deed of trust refused to accept payment unless he was paid interest to the date of maturity, which was January 1, 1918. Not wishing to work a hardship upon the borrower it was agreed to let him have all of the funds except $66,000 to be retained until the previous loan matured on or after January 1, 1918. This was a 10-year*2902 loan. The entire amount of the commission note, $29,165, was reported as income in the petitioner's return for the calendar year ended December 31, 1917, and a deduction of $19,050 was claimed, supported by the following notation: "In May 1917 a loan for $100,000 for 10 years was put on books and whole of commission and profits were entered up as $29,165, but $65,000 of loan not paid until after January 1918 and therefore 65 per cent or $19,050 is taken off as it was not really earned until after close of year 1917."
Although the foregoing deduction of $19,050 was made by the petitioner in 1917, for the reason, as stated in its return, that the transaction was not closed and completed until 1918, that amount was overlooked and was not reported as income for 1918.
The 5-year noninterest-bearing commission notes taken by the petitioner as hereinabove described had a fair market value of 50 *799 per cent of their face value and the 10-year notes had a fair market value of 40 per cent of their face value.
In 1917, 5-year commission notes having a face value of $38,445 were recorded at 75 per cent of said face value, or $28,834; a 7-year commission note having a face value*2903 of $632.50 was recorded at 75 per cent of its face value, or $474.38; and three 10-year commission notes having a face value of $1,232 were entered at 75 per cent of their face value, or $924.
In an examination made by the revenue agent as shown in his report dated August 16, 1924, the net income of the petitioner for the years 1918 and 1919 was reduced, and the income for 1917 was adjusted by the amounts stated below, for the reason as stated that "deferred interest notes taken as commission are not income until the year paid as the notes have no market value; the deduction from income is not the notes taken during the year but the amount of notes taken in excess or similar notes collected."
| Year | Income |
| 1917 | $13,048.70 |
| 1918 | 6,132.32 |
| 1919 | 6,399.88 |
The foregoing amounts were restored to income by the revenue agent in his examination of July 24, 1925, for the reason, as stated, that "Commission notes deducted in prior examination are restored to income in order to compute the tax on the basis of the method of bookkeeping used by the taxpayer."
The amounts of net income for each of the years 1917 to 1919, both inclusive, as reported by the revenue agent in*2904 his examination of August, 1924, and as finally examined and reported in July, 1925, giving effect to the foregoing adjustments, are:
| Examination | |||
| Year | August, 1924 | July, 1925 | Difference finally added to income |
| 1917 | $23,612.75 | $36,661.45 | $13,048.70 |
| 1918 | 9,246.62 | 15,378.94 | 6,132.32 |
| 1919 | 18,660.67 | 25,060.55 | 6,399.88 |
The adjustments to net income made by the revenue agent in his examination of July, 1925 (except for the income of Benton Land Co.), were adopted by the respondent and made the basis for the deficiencies here in controversy.
The Benton Land Co. was organized in connection with the petitioner with a capitalization of $25,000 to take title to land until it could be disposed of. The net income of that company was reported for tax purposes upon separate returns.
*800 OPINION.
MORRIS: The first question urged by the petitioner for our consideration is whether the book value or the fair market value should be used as the basis for determining the amount of income derived by it from commission notes, or, differently stated, whether its net income has been properly computed on the basis provided in subdivision (b) of section*2905 212 of the Revenue Act of 1918 which provides that:
The net income shall be computed upon the basis of the taxpayer's annual accounting period * * * in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income. * * *
It appears from statement of counsel for the respondent made at the hearing of this proceeding that the net income from these commission notes was computed upon the basis of their face value when received. The petitioner has adduced satisfactory evidence which convinces us that these notes could not possibly have been disposed of at their face value. In fact, one witness testified definitely that there was no market for them. The evidence shows that the 5-year noninterest-bearing commission notes had a fair market value of only 50 per cent of their face value and that the 10-year notes had a fair market value of only 40 per cent of their face value.
In the face of the*2906 undisputed testimony it is obvious to us that the basis used by the respondent does not clearly reflect the petitioner's true net income and that its net income has been overstated. We, therefore, hold that the net income should be recomputed for the years in controversy, substituting for the face values formerly used the fair market values incorporated in our findings of fact herein. The recomputation for 1917 should also include the commission note in the B. N. Brown transaction described in our findings of fact which, it appears, was returned by the petitioner in that year at $29,165, but from which a deduction of $19,050 was claimed for the reason that 65 per cent of the total amount thereof was not earned until after January, 1918.
The evidence offered by the petitioner in support of its second allegation of error is wholly insufficient to overcome the prima facie correctness of the respondent's findings which we must approve.
By a supplemental petition the petitioner further alleged that during the years in controversy all of the losses sustained by the Benton Land Co. were not claimed as deductions in the computation of its net income. It is stated in that petition, *2907 and its counsel also stated at the hearing of this proceeding, that the additional allegation is *801 only for the purpose of demonstrating the good faith on the part of the petitioner in the payment of its income tax and that it was not for the purpose of claiming the deductions at this time, the amounts of which it could not determine. Considering the purpose for which this supplemental petition was offered, and the fact that no evidence was adduced to support the allegation that the Benton Land Co. sustained losses which were not claimed or allowed as deductions in the computation of its net income, we deem it unnecessary to consider the question further.
Judgment will be entered under Rule 50.