*2341 1. The petitioner has failed to establish its right to special assessment for the year 1918.
2. The petitioner has not established that an alleged bad debt was ascertained to be worthless and was charged off during 1920. Under the Revenue Act of 1918 part of a debt may not be charged off and the balance retained on the books as having a value. Steele Cotton Mill Co.,1 B.T.A. 299">1 B.T.A. 299.
*163 These proceedings are for the redetermination of deficiencies in income and profits taxes as follows:
| Docket No. | Year | Deficiency |
| 8784 | 1918 | $47,144.14 |
| 10981 | 1920 | 37,837.06 |
The petitioner contests the alleged deficiency for 1918 to the extent of $35,045.31 and the alleged deficiency for 1920 in toto, asserting an overassessment for that year in the amount of $1,745.20.
The alleged errors of the respondent are, for the year 1918, failure to compute the petitioner's profits taxes under section 328 of the Revenue Act of 1918, and for the year 1920, the following:
1. Failure to allow the deduction of an alleged*2342 loss in the amount of $94,217.63.
2. Reduction of invested capital in the amount of the deficiency asserted for the year 1918.
3. Reduction of invested capital by the amount of $2,123.60, representing a prorated portion of the petitioner's tax liability for the year 1919.
The proceedings were consolidated for hearing. By agreement of the parties the hearing as to Docket No. 8784 was limited to the trial of the issue whether the petitioner is entitled to have its tax determined as provided in section 328 of the Revenue Act of 1918. See Rule 62(b), Rules of Practice.
FINDINGS OF FACT.
The petitioner is an Idaho corporation with its principal office at St. Maries.
The petitioner was organized in 1910 for the purpose of cutting timber and manufacturing the logs into lumber, in which business it has been engaged ever since its organization.
*164 During the years involved the capital stock of the petitioner was held as follows:
| Shares | |
| Scotch Lumber Co | 3,000 |
| Fred Herrick | 2,998 |
| Mr. Flagg | 1 |
| Mr. Palmer | 1 |
January 1, 1918, the invested capital of the petitioner consisted of paid-up capital stock of $100,000 and an earned surplus of $40,571.21, *2343 a total of $140,571.21. June 3, 1918, additional capital stock in the amount of $500,000 was sold to Herrick and the Scotch Lumber Co., equally. The petitioner's average invested capital for the year mentioned was $430,982.16.
Borrowed capital employed by the petitioner was follows:
| Dec. 31, 1917 | Dec. 31, 1918 | |
| Bills payable | $510,900.00 | $436,050.00 |
| Accounts payable | 892,273.35 | 288,423.46 |
| 1,403,173.35 | 724,473.46 |
Bills payable constituted the usual trade acceptance used in the lumber industry. Accounts payable were composed as follows:
| Accounts payable | Dec. 31, 1917 | Dec. 31, 1918 |
| Fred Herrick | $490,720.49 | $148,111.09 |
| Scotch Lumber Co | 259,855.38 | 5,058.54 |
| Others | 141,697.48 | 135,253.83 |
| 892,273.35 | 288,423.46 |
At December 31, 1918, the petitioner owed the Export Lumber Co. $4,829.94. The name "Export Lumber Company" was a trade name under which Fred Herrick operated individually.
A monthly schedule of the petitioner's indebtedness follows:
| Accounts payable | |||
| Date | Bills payable | Herrick | Scotch Lumber Co. |
| Dec. 31, 1917 | $510,900.00 | $490,720.49 | $259,855.38 |
| Jan. 31, 1918 | 492,900.00 | 501,151.26 | 259,855.38 |
| Feb. 28, 1918 | 481,400.00 | 514,291.66 | 259,855.38 |
| Mar. 31, 1918 | 499,200.00 | 523,021.24 | 259,855.38 |
| Apr. 30, 1918 | 502,450.00 | 506,775.72 | 259,855.38 |
| May 31, 1918 | 488,350.00 | 497,398.88 | 259,855.38 |
| June 30, 1918 | 482,550.00 | 469,734.71 | 259,855.38 |
| July 31, 1918 | 468,514.51 | 430,401.26 | 259,855.38 |
| Aug. 31, 1918 | 468,550.00 | 418,734.68 | 259,855.38 |
| Sept. 30, 1918 | 458,050.00 | 397,131.48 | 259,855.38 |
| Oct. 31, 1918 | 447,050.00 | 131,140.23 | 9,855.38 |
| Nov. 30, 1918 | 444,550.00 | 125,094.34 | 4,887.48 |
| Dec. 31, 1918 | 436,050.00 | 148,111.09 | 5,058.54 |
| Monthly average | 472,467.87 | 388,582.21 | 196,541.65 |
*2344 *165 The monthly average borrowed from stockholders was $585,123.86. The stockholders were paid interest upon their loans.
The prevailing interest rate upon such indebtedness as that of the petitioner during 1918 was 8 per cent. Interest debits and credits on the petitioner's books for the year 1918 totaled $59,462.04 and $28,545.14, respectively, leaving a net difference of $30,916.90. The petitioner's return for that year claimed a deduction for interest in the amount of $33,042.03, and reported interest as income in the amount of $2,025.13, the net difference being $31,016.90. There is no explanation of the differences in these figures.
The petitioner paid no dividends. During 1918 total salaries paid to officers and directors amounted to $8,500, of which $5,000 was paid to Herrick as president and $3,500 to E. B. Flagg, secretary-treasurer. These officers devoted substantially all of their time to the petitioner.
During the year 1918 petitioner had as a competitor the St. Maries Lumber Co., whose mill, which was approximately three-quarters the size of the petitioner's, was located about one mile away. The lumbering operations of the two concerns were in*2345 the same territory and related to the same species of timber. They had similar logging costs, freight rates, and the same market. Both companies operated saw and planing mills and neither did any other manufacturing.
Certain comparative data upon the petitioner and the St. Maries Lumber Co. follows:
| Petitioner | St. Maries Co. | |
| Invested capital (Dec. 31, 1917) | $140,571.21 | $560,000.00 |
| Invested capital (monthly average) | 425,906.08 | 560,000.00 |
| Borrowed capital (Dec. 31, 1917): | ||
| Bills payable | 510,900.00 | |
| Notes payable | 730,631.09 | |
| Accounts payable | 46,261.12 | |
| Herrick | 490,720.49 | |
| Scotch Lumber Co | 259,855.38 | |
| Others | 141,697.48 | |
| Interest paid | 59,462.04 | 47,657.80 |
| Officers' salaries | 8,500.00 | 10,400.00 |
| Total sales | 1 691,255.89 | 751,292.05 |
| Total cost of goods sold | 376,738.15 | 406,089.14 |
| Net income | 101,201.18 | 19,763.43 |
| Excess-profits tax | 44,082.37 | None. |
| Total tax liability | 50,696.63 | 2,132.21 |
| Percentage of profits tax to net income | 43,559 |
The cost of timber owned by the petitioner on January 1, 1918, and December 31, 1918, was $281,044.07*2346 and $205,130, respectively.
In 1912 the petitioner had timber lands in the Alder Creek basin. Because of the difficulties in acquiring rights of way for a private logging road the petitioner caused the organization of the Alder Creek Railway Co., which as a common carrier was able to secure condemnation of lands necessary for its road.
*166 The Alder Creek Railway Co., hereinafter referred to as the Railway Company, was an Idaho corporation, having an authorized capital stock in the amount of $25,000. Upon organization its stockholders were the officers of the petitioner, Fred Herrick, the petitioner's president owning 50 per cent of the stock. As a common carrier the Railway Company had to maintain tariff schedules and haul such freight as was offered it but its principal source of income was in carrying logs and supplies for the petitioner.
The railway was built largely from funds advanced by the petitioner. Under the rates prescribed by the Public Utilities Commission of Idaho, the Railway Company continuously lost money. The petitioner from time to time found it necessary to advance funds to the Railway Company for operating expenses and road repairs. The*2347 petitioner had determined that the amount of such advances would not be allowed to exceed $100,000.
By 1920 most of the petitioner's timber in territory served by the Railway Company had been cut and consequently the latter's principal source of income was stopped. The last yearly license secured by the Railway Company to do business expired June 30, 1920. Under date of October 25, 1928, the Secretary of State of the State of Idaho certified that the charter of the said Railway Company:
was forfeited December 1, 1920, because of its failure to comply with the provisions of the Idaho law relating to the payment of annual license tax, and that said forfeiture has never been relieved and remains in force and effect at this time.
By a complaint subscribed to November 23, 1920, the petitioner sued the Railway Company in the District Court of the Eighth Judicial District of the State of Idaho in and for Benewah County, the allegations, so far as material herein, being:
III.That the defendant is indebted to the plaintiff in the sum of $94,217.63, as a balance due upon a mutual, open and current account, where there have been reciprocal demands between the Plaintiff and Defendant, *2348 and the last items of indebtedness of which said account have accrued within the two years last past.
IV.That the defendant has not paid said sum of $94,217.63, balance of account due and owing therefrom to Plaintiff or any part or portion thereof, although often requested so to do, and that there is now due, owing and unpaid from the Defendant to Plaintiff, the said sum of $94,217.63, over and above all legal offsets or counterclaims.
V.Wherefore, Plaintiff prays judgment against the Defendant for the sum of $94,217.63, and for its costs and disbursements herein sustained.
*167 The date on which this complaint was filed does not appear.
Thereafter the State of Idaho, ex rel. Public Utilities Commission of the State of Idaho, was made party to the suit as an intervener. May 11, 1925, the said court gave judgment to the petitioner for the amount of $94,217.63 and judgment of nonsuit against the intervener. No part of the said judgment has ever been collected. So far as the record indicates there has been no attempt made to collect upon the said judgment.
Under date of December 31, 1920, the petitioner charged off its books as a loss on its account*2349 with the Railway Company the amount of $69,217.63. The difference between this sum and $94,217.63, which was the total of the account prior to the said charge, amounts to $25,000. Prior to the date last mentioned the petitioner had taken over the assets of the Railway Company consisting of rights of way, ties and other physical property, and rail leases, the rails having been rented by the Railway Company. Thereafter the petitioner operated the railroad, not as a common carrier, but as a logging spur for its timber operations, relaying the ties and rails as convenience of its lumbering operations required.
The petitioner continued to carry the $25,000 balance of the Railway Company account on the same ledger sheet in its books, just as it was after the charge-off of December 31, 1920, i.e., in the form of a debit balance against the Railway Company. From December 31, 1920, to December 31, 1921, no entries were made in this account. December 31, 1921, the account was credited with $10,000. The petitioner contends that subsequent to December 31, 1920, this account was not one with the Railway Company but was in fact merely a capital account for its Alder Creek spur and that*2350 the entry of December 31, 1921, was only to effect a reduction of that capital account through depreciation or exhaustion of the assets it represented. In its 1921 income-tax return the petitioner claimed a deduction of $10,000 as an expense of logging operations, by reason of its reduction of the account mentioned.
In its income-tax return for the year 1920, petitioner claimed a deduction of $69,217.63 as a bad debt arising from its account with the Railway Company. Subsequently, the petitioner claimed a deduction for 1920 of the entire amount of its claim against the Railway Company subsequent to the charge-off of December 31, 1920, i.e., a deduction of $94,217.63. The respondent has denied any deduction for the year 1920 by reason of the said account.
The respondent has reduced the petitioner's invested capital for the year 1920 by the amount of $47,189.45, representing the alleged deficiency for the year 1918.
The respondent has decreased the petitioner's invested capital for the year 1920 by the amount of $2,123.66, representing a prorated *168 portion of the petitioner's income tax for the year 1919. In the answer, the respondent asserts that the petitioner's*2351 invested capital for 1920 should be reduced by the sum of $5,038.94, the total income tax for the year 1919, instead of by $2,123.66, as was done.
OPINION.
LOVE: As relating to the year 1918 the sole question presented in this proceeding is the petitioner's right to determination of its excess-profits taxes in accordance with sections 327 and 328 of the Revenue Act of 1918 which, so far as material, provide:
SEC. 327. That in the following cases the tax shall be determined as provided in section 328.
* * *
(d) Where upon application by the corporation the Commissioner finds and so declares of record that the tax if determined without benefit of this section would, owing to abnormal conditions affecting the capital or income of the corporation, work upon the corporation an exceptional hardship evidenced by gross disproportion between the tax computed without benefit of this section and the tax computed by reference to the representative corporations specified in section 328. This subdivision shall not apply to any case (1) in which the tax (computed without benefit of this section) is high merely because the corporation earned within the taxable year a high rate of profit*2352 upon a normal invested capital * * *.
SEC. 328. (a) In the cases specified in section 327 the tax shall be the amount which bears the same ratio to the net income of the taxpayer (in excess of the specific exemption of $3,000) for the taxable year, as the average tax of representative corporations engaged in a like or similar trade or business, bears to their average net income (in excess of the specific exemption of $3,000) for such year. * * *
This petitioner contends that abnormalities affecting its capital or income existed in two particulars during the year 1918. They are, first, the use of borrowed capital in amounts far exceeding its invested capital and upon interest terms equaling approximately 50 per cent of the normal rate upon such borrowings, and, second, in respect to salaries paid its officers.
The monthly average amount of bills payable was $472,467.87. At 8 per cent, which was the normal interest rate upon such borrowings, interest upon trade obligations of the petitioner would amount to $37,797.43. The difference between this amount and $59,462.04, which is the total of debts to interest during 1918. amounts to $21,664.61 and, the petitioner contends, *2353 represents the interest credits on stockholders' loans. Upon the monthly average amount of loans from stockholders, i.e., $585,123.86, the $21,644.61 above mentioned would indicate an interest rate of less than 4 per cent (0.03699) upon stockholders' loans.
The figures and computations set forth in the paragraph last above are offered in the petitioner's brief, as the principal basis upon which *169 the claim for special assessment is made. The petitioner especially contends that it was able to borrow large sums of money from its stockholders at low rates of interest and that by reason thereof an abnormality was created in its income. Without expressing an opinion as to the soundness of the petitioner's theory, we desire to point out that upon the record its syllogism is unacceptable because the major premise has not been established.
While the rates of interest paid on stockholders' loans and the total amount of such interest are facts peculiarly within the knowledge of the petitioner, that is no evidence in the record relative thereto. The rate has been mentioned as "varying" and the crediting of it as "irregular," but we are asked to believe that the rate was less*2354 than 4 per cent. The total amount paid or credited stockholders as interest on loans we must find by computing the difference between the total of interest at the normal rate on bills payable and the total debits to interest during the taxable year.
We have no evidence that the petitioner paid the normal rate on its trade accounts. We would be as well justified in believing that the petitioner paid 6 per cent on both trade accounts and stockholders' loans as in believing that it paid 8 per cent on trade accounts and only 4 per cent on stockholders' loans.
While from the record it appears that the petitioner used large amounts of borrowed capital, this fact does not in itself necessarily create an abnormality. The petitioner alleged that in its case an abnormality of income was produced because the capital borrowed from stockholders was borrowed at an interest rate only one-half of the normal rate. The record fails to substantiate that allegation. The interest which was paid was a deduction from income, and whatever the difference between the legal rate and the amount paid was, it does not appear to have created an abnormality in income.
As a further basis for its allegation*2355 of an abnormality in income, the petitioner asserts that its officers, particularly Herrick, the president, were paid salaries not at all commensurate with the value of their services. Total salaries paid amounted to $8,500, of which Herrick received $5,000. Herrick was engaged in the affairs of the Scotch Lumber Co. and the Export Lumber Co., as well as those of the petitioner. We have little evidence of his services to the petitioner, certainly not sufficient to hold that his salary was so inadequate as to create an abnormality of income. See ; .
We conclude that the petitioner has failed to establish error in the respondent's denial of special assessment for the year 1918.
The principal allegation of error with respect to the respondent's determination of the deficiency for the year 1920 is the respondent's failure to permit the deduction of $94,217.63 as a bad debt.
*170 It appears that at December 31, 1920, the Railway Company was indebted to the petitioner in the amount of $94,217.63. The railroad had always operated at a loss and at the date mentioned, *2356 its source of business being about exhausted, it was apparent that the company would never have a sufficient income to permit liquidation of its debt.
The petitioner had theretofore taken over certain assets of the Railway Company and was operating them as a private logging spur. On December 31, 1920, the petitioner charged off its books as a loss $69,217.63, and claimed a deduction of this sum in its tax return as a bad debt. The balance of the account, amounting to $25,000, was permitted to remain on the petitioner's books retaining the form of an account receivable, but, being in fact, the petitioner now contends, an asset account of the Alder Creek logging spur.
In an affidavit dated July 21, 1925, and filed with the Bureau of Internal Revenue, J. C. Palmer, vice president of the petitioner, stated that he was:
Vice-President of the Milwaukee Lumber Company and as such officer had access to, and is familiar with the books and records and affairs of said company, and is qualified to make this affidavit.
That the Alder Creek Railway Company was incorporated December 27, 1912, with an authorized capital stock of $25,000, all of which was issued to officers of the Milwaukee*2357 Lumber Co. without consideration.
* * *
That the total account against the Alder Creek Railway Company in 1920 amounted to $94,217.63. That of this amount, $69,217.63 was charged off as a loss in 1920, leaving a balance of $25,000. That the entire amount of this account became a loss in 1920, and should have been charged off the books for the reason that in 1919 and 1920, the Milwaukee Lumber Company purchased all of the assets of the alder Creek Railway Company, and in 1920 took judgment for the balance of the account.
* * *
That at the time of charging off the $69,217.63 the officers of the Milwaukee Lumber Company did not understand that the entire amount would have to be charged off in that year in order to be deductible in the income-tax return of the company. That it is now understood that the entire amount of $94,217.63 should have been written off the books in 1920, the year in which judgment was taken, and that the entire amount is deductible in computing income for that year.
Mr. Palmer had access to the records to secure the information contained in the said affidavit.
By an affidavit dated October 23, 1925, the statement that judgment was taken in 1920*2358 was corrected.
In support of its contention that subsequent to December 31, 1920, the $25,000 balance of the Railway Company account was an asset account of the Alder Creek spur and not an account receivable, the petitioner has established that at December 31, 1921, it charged $10,000 *171 off this account and deducted that amount from income for 1921 as a logging expense and not as a bad debt or a loss. There has also been certain testimony in support of the petitioner's contention. We think, however, that upon the whole the petitioner's treatment of the Railway Company's account has not been such as to warrant our approval of the deduction claimed.
The statute involved in section 234(a)(5) of the Revenue Act of 1918, which provides:
SEC. 234. (a) That in computing the net income of a corporation * * * there shall be allowed as deductions:
(5) Debts ascertained to be worthless and charged off during the taxable year.
We have held that to constitute allowable deductions alleged bad debts must meet two tests: (1) That they were charge off during the taxable year, and (2) that they represent debts ascertained to be worthless. *2359 . The language of the statute is unambiguous and unmistakably requires compliance with both conditions before a deduction may be allowed. The first test mentioned requires the setting up of evidence of the ascertainment of worthlessness substantially as of the date of such ascertainment and in confirmation thereof. . Where a taxpayer keeps books the charge-off should be evidenced by such book entires as will eliminate the debt from its book assets. . Part of a debt may not be written off as worthless and the other part maintained on the books as having a value. , and .
After the charge-off of $69,217.63 on December 31, 1920, the Railway Company's account on the petitioner's books showed a debit balance of $25,000. This was in form an account receivable. The petitioner asserts that it was in fact a capital asset account of the Alder Creek spur and, on brief, its counsel states:
Any assumption that the balance in the Alder Creek Railway*2360 account represented an account receivable necessitates a second assumption that no entry was made on the acquisition of assets consisting of ties, rails, tools, equipment, etc., valued as $25,000, which is highly improbable.
Among the petitioner's witnesses was J. C. Palmer, vice president, who testified that he was familar with the petitioner's books. On direct examination he was asked:
Q. Now do you know, and I will ask you to refer to the books if you care to, to answer the question, whether the Milwaukee Lumber Company opened any other account when it acquired these assets in 1920, or whether it entered the *172 equipment, and so forth in any other account? You can refer to the books, if you care to, or answer from your own knowledge if you care to.
A. Not to my knowledge.The petitioner's books were not offered in evidence.
There are several other features inconsistent with the petitioner's claim that the $25,000 balance mentioned was not the balance of an account receivable. Palmer's affidavit of July 21, 1925, states that "the entire amount of the account became worthless in 1920 and should have been charged off the books." The petitioner's contentions*2361 before the Board are inconsistent with the theory that the $25,000 balance represented an Alder Creek spur account, because the petitioner is here claiming a deduction of $94,217.63, which sum makes no allowance for the $25,000 allegedly credited the Railway Company for the assets taken over. Furthermore, the petitioner's suit, and the judgment subsequently received, make no allowance for the assets acquired.
Other features might be discussed, especially whether or not the account was in fact worthless and actually ascertained to be so during 1920. We think, however, that such discussion is unnecessary as it would in no wise affect our ultimate determination, which is that the petitioner has not established that its account with the Railway Company was ascertained to be worthless and was charged off during 1920, or that the total account was worthless and only a part charged off. See .
The other errors alleged by the petitioner are reductions of invested capital for the year 1920 by (1) the amount of the deficiency determined for the year 1918, and (2) by the amount of $2,123.60, representing a prorated portion of the petitioner's*2362 tax liability for the year 1919. With respect to the first of these contentions the Board has held adversely to the petitioner's position and adheres to that ruling. ; .
The respondent's reduction of invested capital for 1920 by a prorated portion of the petitioner's income and profits taxes for 1919 is approved. His contention that the said invested capital should have been reduced at the beginning of the year by the entire amount of the petitioner's tax liability for the year 1919 is not in accord with our rulings and is denied. .
Judgment will be entered for the respondent.
Footnotes
1. Not including offsets of $199,161.28, representing discounts, commissions, freight, etc. ↩