1928 BTA LEXIS 3300">*3300 Held, that petitioner has failed to establish that alleged bad debts were ascertained to be worthless in the taxable years in which they were charged off.
13 B.T.A. 132">*132 This proceeding is for the redetermination of deficiencies in income and excess-profits taxes for the years 1919 and 1920 in the respective amounts of $2,833.58 and $3,027.53.
The alleged errors of the respondent may be classified in three groups: First, denial for each of the years involved of the deductions of certain debts alleged to have been ascertained to be worthless and to have been charged off; second, denial of the deduction for the year 1920 to losses alleged to have been sustained on bonds of the Kansas City Railroad Co. and the Globe Oil Co.; and, third, failure to make a proper adjustment of invested capital for the year 1920. The evidence reveals that the obligations of the Kansas City Railway Co. and the Globe Oil Co. held by the petitioner were promissory notes rather than bonds.
FINDINGS OF FACT.
The petitioner is a Wisconsin corporation with principal offices1928 BTA LEXIS 3300">*3301 at Coon Valley.
Because of the high rate of interest it carried, the petitioner was accustomed to buy what it termed "western paper"; i.e., unsecured promissory notes of individuals, bought from banks at western points.
13 B.T.A. 132">*133 In making its income-tax returns for the year 1919, the petitioner claimed deductions as bad debts of the amounts represented by the following described notes:
| Market | Date | Payable | Amount |
| M. [*] Flahan | Mar. 23, 1918 | On demand. | $200 |
| Ray and Albert Wilson (joint note) | Mar. 30, 1918 | Oct. 1, 1918 | 400 |
| Ray Wickersham | May 4, 1918 | do | 950 |
| Lution Dyer | May 14, 1918 | do | 300 |
| Wm. Galloway Co. | Feb. 7, 1918 | July 1, 1918 | 1 2,000 |
In making its income-tax return for the year 1920, the petitioner claimed deductions as bad debts of the amounts represented by the following described notes:
| Maker | Date | Payable | Amount |
| Ray Wilson | Mar. 22, 1918 | Oct. 15, 1918 | $700 |
| Thomas Taylor | Mar. 25, 1918 | Oct. 1, 1918 | 1,000 |
| Albert Wilson | Apr. 3, 1918 | Nov. 1, 1918 | 590 |
1928 BTA LEXIS 3300">*3302 All of the notes above described with the exception of that of the Galloway Company had been purchased by the petitioner for face value on May 23, 1918, from the original payee thereof, the Overly State Bank, of Overly, N. Dak. Each of the said notes bore the indorsement of the original payee "without recourse," and in addition they bore the personal unqualified indorsement of J. G. Dobbins, who was president of the Overly State Bank. These notes are hereinafter sometimes referred to as the "Overly notes."
In the fall of 1918, prior to maturity of the "Overly notes" they were all forwarded for collection to a correspondent bank at Overly, known as the Farmers & Merchants Bank of Overly.
The Farmers & Merchants Bank retained the notes until well into the spring of 1919, when it returned them to the petitioner uncollected. Accompanying the notes was a letter or report relative to them. The makers of these notes were farmers in the vicinity of Overly and they suffered through severe crop failures during 1918 and 1919.
Upon receipt of the notes from the Farmers & Merchants Bank the petitioner determined to carry them over until the fall of 1919 without further action.
1928 BTA LEXIS 3300">*3303 In the fall of 1919, the petitioner sent the father of I. N. Knutson, its cashier and general manager, to Overly for the purpose of collecting the "Overly notes." The gentleman described spent several 13 B.T.A. 132">*134 weeks in Overly endeavoring to make collections. Sometime prior to November 7, 1919, he returned to Coon Valley and reported that his efforts had been unsuccessful. It appears, however, that he obtained renewal notes from some of the debtors.
In 1918 and 1919, E. K. Knutson, a former official of the petitioner, and who was then engaged in the banking business in Chicago, made business trips to the vicinity of Overly. E. K. Knutson regularly but unofficially engaged in the petitioner's affairs in an advisory capacity. He had conducted negotiations on the petitioner's behalf in the purchase of the "Overly notes."
During his visits to Overly in 1918 and 1919, which were subsequent to default on the notes, E. K. Knutson investigated the financial situation of some of the note payors and secured information of the others. He reported to the petitioner during 1918, and again in 1919, that the notes were worthless. His report was based upon a knowledge of crop failures, 1928 BTA LEXIS 3300">*3304 and in some instances an acquaintance with the assets of the debtors and his ascertainment that such assets were subject to liens exceeding their values.
By entries dated November 7, 1919, the petitioner charged off its books as bad debts the notes of M. J. Flahan, Ray Wickersham, Lution Dyer and the joint note of Ray and Albert Wilson, totaling in all, $1,850. No payments of principal or interest on the said notes have ever been made.
By entries dated February 5, 1920, the petitioner charged off its books as bad debts the notes of Albert Wilson, Ray Wilson and Thomas Taylor, totaling $2,290. No payments of principal or interest on the said notes have ever been made.
When the joint note of Ray and Albert Wilson was charged off in 1919, the petitioner had no reason to believe that their individual notes retained value. The individual notes were not charged off until 1920, however, because the petitioner had sustained severe losses in 1919 and did not care to make further charges against such income as it had. The same is true of the note of Thomas Taylor, which was also held over and charged off in 1920.
The petitioner did not attempt to enforce collection of any of1928 BTA LEXIS 3300">*3305 the "Overly notes" by suit either against the makers or Dobbins. At the close of 1918 Dobbin's whereabouts were unknown and the Overly State Bank had been closed.
In 1921 the "Overly notes" or renewals thereof were restored to the petitioner's books to constitute a paper offset to certain losses sustained in that year. However, so far as the petitioner was aware, nothing had occurred to indicate a revival of value in the notes.
The William Galloway Co. was engaged in the manufacture of farm implements and tools at Waterloo, Iowa. The Company's 13 B.T.A. 132">*135 $2,000 note had been purchased by the petitioner at a net price after discount of $1,953.33. Payments had reduced the principal due on this note to $1,000. Subsequent to default on July 1, 1918, the payor made the payments above mentioned and thereafter the petitioner's repeated demands for payment were unavailing. E. K. Knutson made an investigation of the Galloway Company through banking connections. The inquiries indicated that the company was badly involved, and that it was unlikely that the petitioner would ever realize anything from its debt. The date of this investigation does not appear. The note was charged1928 BTA LEXIS 3300">*3306 off the petitioner's books as a bad debt in the amount of $1,000 by an entry dated April 19, 1919.
Subsequent to charging off the Galloway Company's note the petitioner was advised that creditors were attempting to reorganize the company. Sometime in 1919, the petitioner received and accepted a second mortgage income bond of the Galloway Company in retirement of the note. The petitioner has never realized anything from the said bond which was exchanged for stock of the Galloway Company in 1927.
November 12, 1918, coupon notes of the Kansas City Railway Co. in the amount of $3,000 were purchased on the open market at Chicago for the petitioner's account. They were dated May 15, 1918, bore interest at the rate of 7 per cent per annum, and were due May 15, 1921. Interest coupons duly presented at maturity in 1920 were dishonored.
E. K. Knutson made inquiries relative to the financial situation of the Kansas City Railway Co. and found that bus competition had made serious inroads on the revenues of the company which operated a street railway system.
August 18, 1919, coupon notes of the Globe Oil Co. in the amount of $2,000 were purchased on the open market at Chicago for1928 BTA LEXIS 3300">*3307 the petitioner's account. They were dated February 15, 1919, and bore interest at the rate of 7 per cent per annum. The maturity date does not appear but interest payments were due February 15, and August 15, of each year. Interest coupons duly presented in 1920 were dishonored and the petitioner has never collected any portion of the principal or interest from the obligor or maker. During 1927 the said obligations were sold for 20 cents on the dollar, face value.
E. K. Knutson conducted an investigation of the financial situation of the Globe Oil Co. subsequent to its default in payment of the interest coupons. He found that its assets were of doubtful value and that it was involved in serious litigation.
By entries dated February 19, 1921, the petitioner charged off its books as bad debts $3,000, on account of coupon notes of the Kansas City Railway Co. held by it and $2,000 on account of coupon notes 13 B.T.A. 132">*136 of the Globe Oil Co. held by it. Prior thereto efforts to sell the said notes had been unsuccessful.
With each of the said charge-off entries there was made a notation as follows: "Defaulted in 1920, and through oversight not charged off December 31, 1920." 1928 BTA LEXIS 3300">*3308 The default mentioned refers to interest payments.
As a result of his investigations of the Kansas City Railway Co. and the Globe Oil Co. it was the opinion of E. K. Knutson that the debts of those companies "could not be realized upon at the time that they were charged off, or soon after," and he so advised the petitioner.
The petitioner was a small bank and management of its affairs was largely informal. Such minutes as it maintained made no mention of the charge-offs last discussed herein.
OPINION.
LOVE: The issues presented in this proceeding arise from the respondent's disallowance of deductions for alleged bad debts. The statute involved is section 214(a)(7) of the Revenue Act of 1918, reading as follows:
SEC. 214. (a) That in computing net income there shall be allowed as deductions:
* * *
(7) Debts ascertained to be worthless and charged off within the taxable year.
Discussing the items in the order of our findings we shall first consider such of the "Overly notes" as were charged off during 1919. These notes had all matured in 1918.
E. K. Knutson was in 1918 a banker with approximately 15 years' experience. He testified that during 1918 he had visited1928 BTA LEXIS 3300">*3309 Overly and made investigations of the financial condition of each of the debtors. Some of the debtors he had personally visited and observed the condition of their farm equipment and other physical assets. He learned that such assets were subject to liens in excess of their values. He was also aware of the current crop failures and of the impoverished condition of farmers generally in the neighborhood and of the debtors in particular. E. K. Knutson further knew that the Overly State Bank had closed and that Dobbin's whereabouts were unknown. Referring to the Flahan, Dyer, Wickersham and joint Wilson notes, he testified that in his opinion these notes were worthless in 1918 and that he had so advised the petitioner during that year.
We are not advised of the contents of the report of the Farmers & Merchants Bank. While it appears that the representative whom 13 B.T.A. 132">*137 the petitioner sent to Overly in 1919 obtained renewal notes from some of the debtors, there is nothing to indicate in which instances such renewals were secured.
With reference to the notes of M. J. Flahan, Ray Wickersham, Lution Dyer and the joint note of Ray and Albert Wilson, aggregating $1,850, and charged1928 BTA LEXIS 3300">*3310 off in 1919, while the evidence is somewhat conflicting as to the exact date when those notes were ascertained to be worthless, whether in 1918 or 1919, and while the evidence seems clear that petitioner learned and knew in 1918 that none of the so-called Overly notes could be collected in that year, although past due, yet it did entertain hope that crop conditions would be more favorable in 1919, and if so, thus enable it to collect some of those notes. The crops of 1919, instead of being better, were worse than in 1918, and by reason thereof the worthlessness of those notes became a settled fact.
We believe and so hold that the four notes mentioned above, aggregating $1,850, are deductible in the 1918 return.
The same conditions applied to all the other Overly notes which petitioner carried over from 1919, and deducted same on its returns for 1920.
These notes were known by petitioner to be worthless in 1919, and hence may not be deducted from gross income on the return for 1920. The Galloway Company's note was deemed worthless in 1919 and charged off in that year. The company subsequently reorganized and substituted for the note other securities which also proved worthless. 1928 BTA LEXIS 3300">*3311 We do not construe the substitution of other securities in later years, as a refutation of the contention that the note was deemed worthless in 1919. We believe, and so hold that petitioner is entitled to deduct from gross income in 1919 the $1,000 remaining unpaid on that note.
We are not persuaded that the notes of the Kansas City Railway Co. and the Globe Oil Co. were ascertained to be worthless in 1920, even if in fact they were worthless in that year.
We can not accept default of interest payments as proof of worthlessness, and this it appears is substantially all that the petitioner had to rely upon. E. K. Knutson's investigations did not cause him to believe that the notes were worthless, but only that they could not be realized upon at the time they are alleged to have been charged off or soon after. . The physical charges on the books were made in February, 1921, and give rise to the question of their sufficiency to sustain the deductions in 1920.
No physical evidence of the charge-offs was made in 1920. We have held in 1928 BTA LEXIS 3300">*3312 , that the purpose in requiring that bad debts to be deductible must be 13 B.T.A. 132">*138 charged off as well as ascertained to be worthless within the taxable year, was to necessitate the setting up of evidence of the ascertainment of worthlessness, substantially as of the date of such ascertainment and in confirmation thereof. In the case cited we held a charge-off made as of December 31, 1918, but after the close of the books for that year to be a substantial compliance with the requirement that the charge-off be made within the taxable year. See also ; .
We do not consider, however, that the charge-offs here involved, made February 19, 1921, as of that date and subsequent to the close of the books for 1920, meet the requirement of the statute as we interpreted it in the Mason appeal and
The petitioner's claim of error in the adjustment of invested capital for 1920 is disposed of by our conclusions above.
Judgment will be entered under Rule 50.
Footnotes
1. The deduction claimed on the note of the Galloway Company was $1,000, the difference having been paid in installments of $500 each during July and August, 1918. ↩