*42 Decision will be entered under Rule 50.
Petitioner entered into a contract for the strip mining of coal, under which he advanced moneys to contractors for payroll and other operating expenses. He canceled the contract in April 1949; and he thereafter charged off part of the advances and claimed a partial bad debt deduction for the same in his 1948 return. Held, respondent did not err in disallowing the partial bad debt deduction for 1948, since in that year there was no change in the contractors' ability to repay the advances in the manner provided in the contract and no abandonment or charge-off of any part of the obligation as an asset.
*311 The respondent determined a deficiency of $ 61,037.31 in the income tax of the petitioners for the year 1948. 1
*43 Not all the adjustments of the respondent have been contested; and one of the issues raised in the pleadings, respecting loss of a down payment of $ 6,000 on machinery purchased from Terra Coal Company has been conceded by the respondent in his brief.
The sole issue remaining for decision is whether respondent erred in disallowing a deduction of $ 41,831.51 for the year 1948, claimed as a partially worthless debt.
FINDINGS OF FACT.
The petitioners are husband and wife residing in Carnegie, Pennsylvania. They filed a joint income tax return for the year 1948 with the collector of internal revenue for the twenty-third district of Pennsylvania.
H. W. Findley (hereinafter referred to as the petitioner) had for several years been active in producing coal by both the stripping and deep mining processes. The actual mining was done under arrangements with independent contractors, whereby he supplied the coal tracts and tipples, and credited the contractors with certain amounts per ton for coal loaded. His operations were extensive, and during the period here involved were carried on at various locations over an area ranging from about 300 miles south of Pittsburgh, Pennsylvania, to about*44 150 miles north of Pittsburgh. His sales of coal in 1948 and 1949 were approximately $ 3,740,000 and $ 2,300,000, respectively.
*312 In May 1948, petitioner made arrangements with two partners, Harry M. Wilkinson, Jr., and George A. Booth (hereinafter sometimes called the contractors), to strip and load coal from a portion of a 1,000-acre tract in Elk County, Pennsylvania, which he held under lease. It was estimated that the tract contained from 1 to 2 million tons of coal and that the mining thereof would involve "a couple of years' work."
The arrangement with the contractors involved two related and contemporaneously made contracts. First, petitioner redeemed from the Corn Exchange National Bank & Trust Company, Philadelphia, certain coal mining equipment which said contractors had theretofore pledged to the bank as collateral security for a loan, and which the bank had thereafter attached by reason of default of the contractors in making certain payments on their note. Petitioner then, under date of May 24, 1948, sold this equipment to the contractors for $ 56,000 on a conditional sale contract and promissory note of said amount, which provided for no down payment but *45 for 12 monthly installments of $ 4,666.67 each, plus interest, beginning August 15, 1948. This equipment had been purchased originally by the contractors in 1946 and 1947 at a cost of approximately $ 71,500, and had been paid for in part with the proceeds of the bank loan of $ 56,000 against which the equipment had been pledged, leaving the contractors with an equity of about $ 15,500.
The second part of the arrangement between the petitioner and the contractors was embodied in a written operating agreement between the parties, which also was executed on May 24, 1948. Under this agreement the contractors agreed, among other things, to move their equipment to the Elk County tract at the earliest possible date, with a view to commencing coal stripping operations within a period of 30 days from the time that the moving of the equipment commenced; to build and maintain all roads on the tract which would be necessary for trucks to have access to the pit operations; to strip and remove all merchantable and marketable coal that could be profitably removed by the strip mining method; and to load said coal in a clean and marketable condition into trucks to be supplied by the petitioner. *46 The agreement further provided that petitioner would advance to the contractors, for a period of 45 days from the time when the moving of the equipment commenced, moneys necessary to cover the contractors' direct operating costs, such as payrolls, fuel, insurance, repairs, and replacement parts (the latter of which to be requisitioned by the contractors through petitioner), and also a drawing account for each of the contractors in an amount not to exceed $ 100 per week. It was provided also that petitioner would pay to the contractors monthly $ 2.50 per net ton of all merchantable and marketable coal *313 loaded, subject to the further provision, however, that petitioner would retain all moneys accruing and becoming due to the contractors, other than amounts required to cover the contractors' actual and direct operating costs as above mentioned; and that petitioner would apply and credit such retained moneys, first, against all advances made by him to the contractors, and, secondly, toward payment of the contractors' obligation under the above-mentioned conditional sale contract, until all of the contract price, plus accrued interest thereon, had been paid in full. The agreement*47 contained the following provisions respecting termination:
ELEVENTH: Findley shall have the right to terminate this agreement on and after ninety (90) days from the date hereof in the event Contractor's production and loading of coal as contemplated herein has not reached and is not maintained at a minimum of 6000 tons per month unless prevented by strikes, lockouts or other intervening causes completely beyond the control of Contractor, and in addition thereto Findley shall have the right to terminate and end this Agreement at any time in the event operations hereunder result in an operating loss on the part of Findley.
The operating agreement contained no provision respecting any payments to be made to petitioner other than through the above-mentioned credits for coal produced; and it also contained no provision respecting settlement of accounts between the parties in the event of petitioner's termination of the agreement under the above-quoted paragraph ELEVENTH.
Pursuant to said operating agreement, the contractors moved the equipment which they had purchased from petitioner to the Elk County tract and began operations. Petitioner had a field supervisor in Elk County, E. W. Nies, *48 who operated petitioner's tipple at a nearby town and who reported monthly to petitioner regarding the amounts of coal passing through the tipple from two mining operations being conducted in that area. Under arrangements made with Nies, the present contractors devoted their initial efforts toward construction of one access road and improvement of another. Their actual stripping operations were delayed for considerable time by the necessity of relocating one of the access roads by reason of petitioner's inability to procure a right-of-way through adjacent land. Also, some initial effort was expended in investigating an unproductive seam of coal.
Once regular operations had commenced, the contractors proceeded to strip the overburden from the coal and to load it into petitioner's trucks as provided in the contract. The first credit which petitioner allowed to the contractors for coal loaded was on October 31, 1948. The coal seam was covered with overburden ranging from 18 to 22 feet in depth. The width of the seam did not average less than 60 feet, and it was approximately 4 feet thick. The seam had one or *314 two binders consisting of slate and rock of an average thickness*49 of 2 inches, which had to be removed.
The amount of coal which the contractors loaded per month was controlled by petitioner. He advised Nies at the tipple of the orders which he had for the purchase of coal, and Nies would then arrange with the contractors to load only sufficient coal to fill these orders. The operations were delayed from time to time by mechanical failures; but trade conditions affecting the market for coal were the principal factor which curtailed loadings. The contractors' shovel was capable of loading approximately 1,000 tons per day.
On December 1, 1948, petitioner wrote the contractors, in part, as follows:
You will doubtless bear in mind that this undertaking has become one of sizeable proportions. The amount involved in the purchase of the equipment was $ 56,000.00. The amount of money, in addition to this sum, which we have advanced for your account amounts to an additional $ 44,000.00 as of November 30. You may perhaps remark that the coal has not been disposed of, however, I might remind you that this has come about through trade conditions rather than thru lack of effort on our part to dispose of the particular type of coal produced in the area *50 in which you are operating. The matter of disposing of the coal has been pursued diligently and you may rest assured that it has not been, nor is it my intention to build up an investment of this nature for the small rate which would eminate [sic] from an operation of this kind. Since we have such a large investment there is only one answer, and that is, to keep on plugging until such time as we can see daylight.
At some time in December 1948, petitioner had Nies visit the pits to determine how much coal had been uncovered in advance of loadings; and Nies reported that there were 1,000 to 1,200 tons uncovered. For a considerable period in December 1948, the contractors' operations were, under orders of petitioner, confined to loading coal already stripped, without any additional stripping. During the Christmas holidays of 1948, operations were shut down pursuant to directions from the petitioner. Thereafter, full operation continued until about the middle of April 1949, when petitioner canceled the operating contract and also notified the contractors by registered letter that he intended to repossess the equipment which he had sold them under the above-mentioned conditional*51 sale contract. Shortly thereafter, in 1949, he did repossess the equipment.
The following table shows the amounts of the advances made by petitioner to the contractors, pursuant to the coal stripping agreement of May 24, 1948; the amounts of additional charges made by petitioner for replacement parts invoiced and for interest on the conditional sale obligation; and the amounts of the credits which petitioner allowed to the contractors for coal loaded. *315
| May 24 to December 31, 1948 | ||||||
| Debits | ||||||
| Mdse., and | ||||||
| int. on | Credits | |||||
| Cash advances | cond. sales | Net tons | Credit for | |||
| 1948 | Payroll | Other | contract | 1948 | loaded | coal loaded |
| May | $ 2,314.35 | Oct. 31 | 162.70 | $ 406.75 | ||
| 29 | $ 547.44 | Nov. 30 | 896.65 | 2,241.63 | ||
| June | 173.47 | Dec. 31 | 1,602.45 | 4,006.13 | ||
| 12 | 1,550.88 | |||||
| 19 | 140.42 | |||||
| 26 | 1,760.32 | $ 194.70 | ||||
| July | 882.36 | |||||
| 10 | 2,018.86 | 1,251.29 | ||||
| 24 | 1,942.24 | |||||
| August | 907.17 | |||||
| 7 | 1,993.15 | 2,596.94 | ||||
| 21 | 2,203.61 | 626.85 | ||||
| September | 3,325.14 | |||||
| 4 | 2,860.69 | 73.44 | ||||
| 18 | 2,442.35 | 1,106.70 | ||||
| October | 1,440.45 | |||||
| 2 | 3,657.56 | 85.33 | ||||
| 16 | 2,385.06 | 3,746.38 | ||||
| November | 701.19 | |||||
| 27 | 684.90 | 1,798.30 | ||||
| December | 342.92 | |||||
| 11 | 561.08 | 1,367.51 | ||||
| 25 | 600.36 | 3.01 | ||||
| Totals | $ 25,348.92 | $ 12,840.45 | $ 10,087.05 | $ 6,654.51 | ||
| Total charges | $ 48,286.42 | |||||
| Total credits | 6,654.51 | |||||
| Net charges | $ 41,631.91 |
| January 1 to May 31, 1949 | ||||||
| Debits | ||||||
| Mdse., and | ||||||
| int. on | Credits | |||||
| Cash advances | cond. sales | Net tons | Credit for | |||
| 1949 | Payroll | Other | contract | 1949 | loaded | coal loaded |
| January | $ 504.19 | Jan. 31 | 773.00 | $ 1,932.50 | ||
| 8 | $ 600.94 | $ 1,950.59 | Feb. 28 | 1,617.95 | 4,044.89 | |
| 22 | 595.81 | 475.21 | Mar. 31 | 1,576.20 | 3,940.50 | |
| February | 341.96 | Apr. 30 | 470.20 | 1,175.50 | ||
| 5 | 715.34 | 18.68 | May 31 | 856.55 | 1 1,884.41 | |
| 19 | 1,030.03 | 583.06 | ||||
| March | 1,539.35 | |||||
| 5 | 1,254.76 | 662.31 | ||||
| 19 | 2,125.18 | 17.91 | ||||
| April | 873.48 | |||||
| 2 | 2,396.17 | 2,145.46 | ||||
| 16 | 1,904.99 | 929.47 | ||||
| Totals | $ 10,623.22 | $ 6,782.69 | $ 3,258.98 | $ 12,977.80 | ||
| Total charges | $ 20,664.89 | |||||
| Total credits | 12,977.80 | |||||
| Net charges | $ 7,687.09 |
The contractors had no substantial assets at the time of making their initial arrangements with petitioner on May 24, 1948, except their interests in the two contracts. They had sought financial assistance from petitioner at the time when their equipment had been attached by the bank. There*53 was no material change in their asset position during the balance of the year 1948, or until the termination of the two contracts at about the middle of April 1949.
On April 14, 1949, petitioner wrote to his tax adviser as follows:
Dear Mr. Wallerstedt:
Agreeable to the request made by you in our telephone conversation of even date, I am attaching hereto:
1. Coal Stripping Agreement entered into with Harry M. Wilkinson & George A. Booth dated May 24, 1948.
*316 2. Conditional Sales Contract covering four pieces of Construction and Stripping Equipment.
These agreements are self-explanatory.
Due to the fact that none of the conditions embodied in either of the contracts have been carried out by Wilkinson and Booth, we have cancelled the Stripping Contract, and will replevin the equipment as of April 15, 1949.
On the Stripping Contract we have advanced for Wilkinson and Booth the sum of $ 62,360.75. The credit for coal stripped and loaded at the contract price amounts to $ 16,673.40. The difference between the amount of money advanced and the credit for coal is $ 45,687.35. On the Conditional Sales Contract no rental of any kind has been paid by Wilkinson and Booth, however, *54 the bank interest has been charged to their account.
It might be in place to mention the reason I have carried this business deal on so far beyond the date set up in the contract. At the end of the forty-five day period set up we were unable to sell the coal, and it was therefore considered expedient to continue to advance money because I was informed they had a considerable amount of coal stripped. Considering the production during the months since the inception of the agreement, it would be deemed that at the end of March, Wilkinson and Booth should have thirty to forty thousand tons of coal stripped, after giving them credit for coal actually loaded. Apparently this has not been the case inasmuch as Mr. Nies, who is in general charge of my operation, reported on Wednesday, [sic] April 12, that Booth and Wilkinson only have between three and four thousand tons of coal stripped in advance. I sent a certified engineer to measure this coal on Wednesday April 13 and he reports that Wilkinson and Booth have only about twelve hundred tons of coal stripped in advance of loadings. It therefore appears that the information we have in our files has been erroneous.
To provide for *55 the payment of the accounts of Wilkinson and Booth, I appointed an Agent to disburse the funds for their operation. The Agent presented an invoice for the amount required from month to month and I advanced the stipulated amount. You will note that the amount advanced as of March 31, is $ 45,687.35. The accounting as of Dec. 31, 1948 shows an advance of $ 42,411.58. If we give them credit for twelve hundred tons of coal stripped in advance at $ 2.00 per ton, which probably would be the prevailing price at the moment, they would receive an additional credit of $ 2,400.00. Since we have a definite accounting on this picture as of December 31, it would appear to me that this business loss, which is definitely a money loss, should be incorporated in our Federal Tax Return. I do not say that this is the entire loss, since no doubt the equipment at this writing will not have the value that was invested in same as of May 24, 1948.
From this information and the agreements it is requested that you formulate an opinion as to what our procedure should be in completing our Federal Tax Returns for 1948.
Very truly yours,
H. W. FindleyOn May 5, 1949, petitioner and his wife filed their joint*56 1948 income tax return. On this, they reported as income the amounts charged to the contractors for repair parts and interest; and they claimed a deduction of $ 41,851.31 for a partially worthless debt of the contractors, stated to represent the difference between advances made to the contractors *317 as of December 31, 1948, in the amount of $ 48,187.92, and credits due them as of said date of $ 6,356.41. 2
The amount of the claimed deduction corresponds with that of a charge-off credit entry in petitioner's ledger account with the contractors, dated December 31, 1948. Actually this charge-off entry in the ledger was not made until petitioner's books were closed at or about the time of filing the 1948 return on May 5, 1949.
In the 1949 income tax return of petitioner and his wife, which was filed on or about March 9, 1950, another bad debt deduction was claimed in the*57 amount of $ 31,123.24, representing the balance of petitioner's account with the contractors.
Petitioner's books and records were kept, and his income tax returns were filed, in accordance with the accrual method of accounting. He did not use the reserve method of accounting for bad debts.
Respondent, in his audit of the 1948 return, disallowed the partial bad debt deduction claimed for the year 1948, with the statement: "* * * even the taxpayer did not consider it worthless as of December 31, 1948, in view of the continued advancement of funds." However, respondent did allow, in his audit of the 1949 return, not only the amount claimed as a bad debt deduction for the year 1949, but also the amount which had been claimed and disallowed as a partial bad debt deduction for the year 1948.
OPINION.
The foregoing findings of fact show that for a period of approximately 1 year from May 24, 1948, the petitioner and the contractors, Wilkinson and Booth, were engaged in stripping coal from a tract in Elk County, Pennsylvania; and that these operations involved outlays of money by petitioner under two contracts, both executed on said date. Under one contract, the petitioner redeemed mining*58 equipment from a bank and sold it to the contractors on a conditional sale agreement and promissory note for $ 56,000, payable in monthly installments. Under the other contract, which provided for the stripping and loading of coal, the petitioner advanced moneys to cover the contractors' direct operating costs; agreed to allow them credits of $ 2.50 per ton of coal loaded into his trucks; and further agreed to apply such credits, first against the advances and then against the conditional sale contract, until both accounts had been balanced. It is only the advances made for payroll and other operating costs, the charges for merchandise sold, and certain items of interest (not the amounts of principal due under the conditional sale contract) which are directly involved in this proceeding.
*318 Petitioner contends that the amounts due him for the items here involved constituted a business debt, and that for the year 1948 he should be allowed a partial bad debt deduction of $ 41,831.51 in respect of the same, under authority of section 23 (k) (1) of the Code. Respondent does not dispute petitioner's contentions regarding the character of the debt and the applicability of said*59 statute, but he does deny that the deduction claimed for 1948 is allowable on the basis of the facts here present.
Section 23 (k) (1) provides, so far as here material, as follows:
SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
* * * *
(k) Bad Debts. --
(1) General rule. -- Debts which become worthless within the taxable year; * * * and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction. * * *
It will be observed that where a specific debt has become wholly worthless, deduction therefor is allowable only in the year that it finally became worthless; and since actual worthlessness is the test, the dates of charge-off, ascertainment, or eventual "giving up" by the taxpayer on the possibility of recovery, are in effect immaterial. On the other hand, where a debt is claimed to have become only partially worthless, the scheme of the statute is otherwise. There the deduction is limited to an amount "not in excess of the part charged off within the taxable year"; and even as to such *60 amount, a deduction is allowable only to the extent that the taxpayer is able to demonstrate to the satisfaction of the Commissioner that a part of the debt is not recoverable. Regs. 111, sec. 29.23(k)-1(b). The use of the word "may", in connection with the allowance of partial bad debt deductions by the Commissioner, implies a certain amount of discretion on his part; and the courts have recognized that his determinations, made in the exercise of such discretion, should not be disturbed unless they are plainly arbitrary or unreasonable. ; ; , certiorari denied .
This does not mean that a taxpayer who has not made a partial bad debt charge-off, or who after making one has failed to procure the Commissioner's approval, is forever foreclosed from obtaining a deduction. The statute does not require that partial bad debts must be charged off or deducted in the year when the partial worthlessness*61 occurs, or indeed in any other year prior to the time when the debt becomes wholly worthless. Thus, the taxpayer may, if he chooses, pass over the partial worthlessness in the current year, and charge off the same in some later year while the debt is still valuable in part; or on *319 the other hand, he may wait and take a deduction for the entire debt (or the portion thereof for which no deduction has previously been allowed) in the later year when the debt has become wholly worthless. ; ; and .
The purpose of the charge-off, in the case of a debt claimed to have become worthless in part, is to perpetuate evidence of taxpayer's election to abandon part of the debt as an asset (cf. ) -- a procedure which is unnecessary in the case of wholly worthless debts, where total worthlessness is the sole test. But the physical charge-off in itself is not sufficient to establish that part of the debt has*62 either become worthless or been abandoned as an asset. The taxpayer has the burden of proving these facts -- and it is in passing upon the sufficiency of such proof that the Commissioner has been given the discretion above mentioned. It seems obvious that partial worthlessness of an obligation must be evidenced by some event or some change in the financial condition of the debtor, subsequent to the time when the obligation was created, which adversely affects the debtor's ability to make repayment.
Applying these principles in the instant case, we are unable to conclude that the Commissioner's determination in disallowing the partial bad debt deduction for the year 1948 was either arbitrary or unreasonable.
It is our opinion that petitioner's proof falls short of establishing that the obligation of the contractors to repay the advances became partially worthless in 1948. When petitioner entered into the coal stripping arrangement on May 24, 1948, he knew that the contractors were without substantial assets; and the contract between the parties reflects an intention that repayment of petitioner's advances for operating costs would be made through credits at the rate of $ 2.50 per*63 ton for coal loaded into petitioner's trucks. The first of such credits were not made until October 31, 1948, due to the necessity for transporting the equipment to the tract, opening access roads for trucks, and removing the overburden in preparation for actual coal digging. The credits made against the advances were as follows:
| Oct. 31, 1948 | $ 406.75 |
| Nov. 30, 1948 | 2,241.63 |
| Dec. 31, 1948 | 4,006.13 |
| Jan. 31, 1949 | 1,932.50 |
| Feb. 28, 1949 | 4,044.89 |
| Mar. 31, 1949 | 3,940.50 |
| Apr. 30, 1949 | 1,175.50 |
| May 31, 1949 | 1,884.41 |
There was ample coal in the tract which, if removed and loaded, would have provided sufficient credits to wipe out all the advances; *320 and the contractors had the equipment for digging the coal. There is no indication of any substantial change in their financial condition between May 24 and December 31, 1948, which adversely affected their ability to make repayment in the manner specifically provided. Also, there is no indication that the contractors had repudiated their agreement to dig the coal; to the contrary, petitioner's letter to them of December 1, 1948, infers that they wanted to load more, but that trade conditions in the coal market were*64 curtailing his acceptance of greater loadings. Thus, the difficulty lay, not in obtaining coal from the contractors with which to make the credits, but rather in marketing the coal at an adequate price. The mere fact that the market had slacked off and thereby caused a slow-down of the loadings does not warrant the conclusion that repayment in the manner provided could not be made, and that the obligation had become partially worthless. Cf. .
The evidence also fails to establish that petitioner partially abandoned the contractors' obligation as an asset prior to April 1949. As shown by the tables in our Findings of Fact, petitioner began making his advances in May 1948; and, although he was not obligated to make them for longer than 45 days, he actually continued to make them regularly on a bi-weekly basis until April 16, 1949. In his letter to the contractors of December 1, 1948, he directed attention to the large amounts of these advances; pointed out that adverse conditions of the coal market were limiting the amount of coal which he was taking; and suggested that the only solution was "to keep on plugging until such*65 time as we can see daylight." Thereafter in another letter, written to his tax adviser on April 14, 1949, petitioner suggested "It might be in place to mention the reason I have carried this business deal on so far beyond the date set up in the contract." Also in this letter, he pointed out the amounts of the advances made through March 31, 1949; suggested that the then prevailing price for coal was only $ 2 per ton, as compared with the price of $ 2.50 per ton to be paid to the contractors; informed his tax adviser that he had on Wednesday, April 13, 1949, sent a certified engineer to measure the coal; and stated, "we have cancelled the Stripping Contract, and will replevin the equipment as of April 15, 1949." All these facts and statements negative any conclusion that, prior to April 1949, petitioner had partially abandoned as an asset, either the coal stripping agreement or the contractors' obligation to repay the advances through coal loadings.
Under paragraph ELEVENTH of the coal stripping agreement, petitioner had the right to terminate such agreement, either when the loadings did not reach a minimum of 6,000 tons per month, or "at any time in the event operations hereunder *66 result in an operating loss on the part of Findley." In April 1949 he exercised not only this right, *321 but also his right to repossess the contractors' mining equipment. Such action deprived the contractors of their opportunity to load coal with which to repay the advances. And it was thereafter, at some time between April 15 and May 5, 1949, that petitioner made the partial charge-off entry. Thus, the worthlessness of the obligation, the abandonment of the obligation as an asset, and the charge-off to perpetuate evidence of such abandonment, all occurred in 1949 and not in 1948. The statute contains no provision whereby a debt which has become worthless in one taxable year by reason of events or circumstances occurring in such year may be related back in part to a prior taxable year for deduction as a partially worthless bad debt.
We hold that the respondent did not err in disallowing the partial bad debt deduction for the year 1948.
Decision will be entered under Rule 50.
Footnotes
1. The respondent, in his notice of deficiency, also determined a deficiency of $ 11,297.54 in petitioner's income tax for the year 1950; but such determination was not challenged.↩
1. This credit reflects an allowance of $ 2.20 per ton, instead of $ 2.50 per ton as provided in the agreement.↩
2. All of the above figures vary from those shown in the foregoing table, which is based on an exhibit submitted in evidence by petitioners.↩