*3449 The petitioner is entitled to deduct from gross income for 1920 as a debt ascertained to be worthless and charged off in that year, the amount of $7,041.12 involved herein.
*811 This proceeding is for the redetermination of a deficiency in income tax asserted by the respondent for the year 1920 in the amount of $2,062.26. Only so much of the deficiency is in controversy as arises from the disallowance by the respondent of a deduction taken by the petitioner in its return on account of a debt claimed to have been ascertained to be worthless and charged off within the taxable year.
*812 FINDINGS OF FACT.
The petitioner is an Illinois corporation with its principal office and place of business at Elmhurst, Ill. It is and was during the years 1920 and 1921 engaged in the business of manufacturing mill work. During the year 1920 the petitioner's capital stock was owned and held as follows:
| Shares | |
| F. W. M. Hammerschmidt | 167 |
| G. H. Franzen | 157 |
| Frieda Franzen | 10 |
| E. J. Bunge | 166 |
| Total | 500 |
Hammerschmidt, G. H. Franzen*3450 and E. J. Bunge were the officers of the corporation and constituted its board of directors.
The Schwalge-Smith Co., hereinafter called the Schwalge Co., was during the year 1920 and subsequent thereto, an Illinois corporation engaged in manufacturing incubators. During the year 1920 its capital stock was held as follows:
| Shares | |
| William Schwalge | 1,275 |
| G. H. Franzen | 250 |
| E. J. Bunge | 250 |
| Adolph Smith | 475 |
| F. W. M. Hammerschmidt | 220 |
| Albert Schwalge | 30 |
| Total | 2,500 |
William Schwalge was president; G. H. Franzen, vice president, and E. J. Bunge, secretary of the corporation. William Schwalge, Adolph Smith, and G. H. Franzen constituted its board of directors.
At the beginning of the year 1920 the Schwalge Company was indebted to the petitioner in the amount of $2,661.14 for mill work furnished on an open account. On December 31, 1920, the Schwalge Company's indebtedness to the petitioner on this account was $7,041.12. The last payment on the account was made on January 29, 1920, in the amount of $1,025.45. The balance sheet of the Schwalge Company on December 31, 1920, was as follows:
| Assets | Amount | Liabilities and capital | Amount |
| Cash | $537.23 | Accounts payable | $11,897.60 |
| Inventory | 1,910.85 | Capital stock | 25,000.00 |
| Equipment | 682.00 | ||
| Patents | 12,750.00 | ||
| Catalogues | 1,650.00 | ||
| Accounts receivable | 1,999.90 | ||
| Deficit | 17,367.62 | ||
| Total | 36,897.60 | 36,897.60 |
*3451 *813 Included in the accounts payable is the amount of $7,041.12, which the Schwalge Company owed the petitioner. Of the amount of the accounts receivable all was collected subsequent to December 31, 1920, except $430. The equipment and inventory were worth on liquidation basis 20 per cent less than the amounts set forth on the balance sheet. The patents and catalogs were considered by the petitioner's officers to have no liquidation value.
The business of the Schwalge Company consisted solely of the production of incubators under the patents listed in the above balance sheet. It had never made any profit in any year of its existence and its operations for the period 1915 to 1920 had resulted in a net loss of more than $17,000. On December 31, 1920, Schwalge-Smith Co. was financially unable either to make deliveries to its customers or to refund their money, and was unable to obtain further credit because of its poor financial statement and record. To all demands for payment made by the petitioner after January 29, 1920, William Schwalge, president of the Schwalge Company, stated that the company was unable to make any further payments until conditions turned for*3452 the better.
The petitioner kept a general ledger, a general journal, and a customer's ledger. The individual accounts receivable were carried in the customer's ledger, and the total balances of all accounts receivable were from time to time transferred from it to the general ledger. The balance of the Schwalge Company account of $7,041.12 was ascertained from the customer's ledger and on December 31, 1920, a special account was opened in the general ledger under the name Schwalge-Smith Co., with a balance on the debit side, in red ink, of $7,041.12 taken from the customer's ledger. An entry was then made in the general journal crediting this account and debiting profit and loss in the amount of $7,041.12. The net result of these entries, which were posted to the general ledger, was to deduct this item from gross income. However, no entries charging off or crediting the indebtedness of the Schwalge Company, were made in that company's account carried on the petitioner's customer's ledger, and accordingly the petitioner's accounts receivable were not reduced by the entries.
The petitioner's balance sheet made up at the close of 1920 from the general ledger, shows among the*3453 assets accounts receivable, $64,554.15, which included the amount of $7,041.12 due from the Schwalge Company. The charge-off entries mentioned above had, however, reduced the undivided profits to the extent of $7,041.12. Another entry was therefore necessary to make the petitioner's books balance, and the petitioner therefore entered on the liability side of *814 its balance sheet under the name of accounts payable, the amount of $7,041.12, the amount of the Schwalge Company account. It was not, however, an account payable and was not so considered by the petitioner.
In November 1920 William Schwalge, the president and majority stockholder of the Schwalge Company, and Messrs. Hammerschmidt, Franzen and Bunge, principal stockholders of the petitioner, agreed upon a reorganization of the Schwalge Company, which was finally consummated in January, 1921, by the transfer by Schwalge of all of the capital stock of the Schwalge Company, except three shares, to Messrs. Hammerschmidt, Franzen and Bunge, Hammerschmidt, Franzen and Bunge paid nothing for the shares so transferred to them by Schwalge. Schwalge was, however, employed by Schwalge Company on a royalty basis with a guaranteed*3454 salary of $50 per week as long as the inventions which had been patented by him were used by the Schwalge Company. After the reorganization was consummated and the petitioner's stockholders and directors had acquired the control and practically all of the stock of the Schwalge Company, further credit was extended by the petitioner to the Schwalge Company. Since December 31, 1920, the petitioner has continued to extend further credit to the Schwalge Company in the hope that Hammerschmidt, Franzen and Bunge, having acquired the ownership of all of its capital stock, would through increased efficiency and management restore the Schwalge Company to a sound and profitable basis, and that the petitioner might thus preserve a good customer and recover the amount due it from the Schwalge Company. The Schwalge Company is still in existence and is indebted to the petitioner in the further amount of $25,239.43, contracted since December 31, 1920.
The petitioner in its income-tax return for the year 1920 deducted from gross income as a debt ascertained to be worthless and charged off within the taxable year, the amount of $7,041.12 owing to it from the Schwalge Company. The respondent disallowed*3455 the deduction.
OPINION.
MARQUETTE: The only question presented by the record in this proceeding is whether the petitioner, in computing its net income for the year 1920, is entitled to deduct in that year the amount of $7,041.12 owing to it by the Schwalge Company. Upon consideration of the evidence we are of the opinion that the debt in question was, in fact, worthless in 1920 and that it was so ascertained and charged off by the petitioner in that year and therefore is a proper deduction. The evidence shows that the petitioner had furnished *815 the Schwalge Company mill work and that on December 31, 1920, the Schwalge Company was indebted to the petitioner in the amount of $7,041.12, and that no payments had been made on the account since January, 1920. William Schwalge, president of the Schwalge Company, had from time to time been requested to make payment on the account and had informed the petitioner that his company was unable to do so, at least until business conditions improved. The Schwalge Company had been operating at a loss during its existence, and on December 31, 1920, its assets were of little value and if forced into liquidation the company probably*3456 could pay little or nothing to its creditors. These conditions were known to the petitioner's officers and stockholders. We think that under the circumstances the debt was in fact worthless on December 31, 1920, and that the petitioner was justified in so considering it.
It is urged, however, by the respondent, that the debt was not charged off on the petitioner's books in December, 1920. It is true that the entries in regard to the debt were made in a rather unusual manner, but nevertheless they had the effect of reducing the petitioner's net income for 1920, and its net worth as shown by its balance sheet. The debt was still carried on the customer's ledger but that procedure is explained by the fact that although the petitioner considered the debt worthless and had effectually eliminated it from its balance sheet, it did not desire that Schwalge should be informed of these facts.
It is further urged on befalf of the respondent that the debt in question was not considered worthless by the petitioner in 1920 because in 1921 and subsequent thereto the petitioner extended further credit to the Schwalge Company. In view of the circumstances surrounding the extension of further*3457 credit, that argument does not impress us. In 1920 the Schwalge Company was largely controlled by William Schwalge. In the early part of 1921 Schwalge transferred all of his stock to the petitioner's stockholders, Hammerschmidt, Franzen and Bunge. Thereafter a majority of the stock of the petitioner and the Schwalge Company were both owned by Hammerschmidt, Franzen and Bunge, and the petitioner in extending further credit to the Schwalge Company was in effect extending credit to its own stockholders. In view of the conditions existing in 1921 and subsequent thereto, we do not believe that the extension of credit to the Schwalge Company in those years has any bearing on whether the debt in question was worthless on December 31, 1920.
Judgment will be entered under Rule 50.