*1244 Petitioner, in order to enable one Smith to pay off his note to a bank, executed its note to Smith which Smith endorsed to the bank in payment of his own notes. In addition to other collateral, Smith pledged with petitioner the same collateral that had secured Smith's note, consisting principally of petitioner's capital stock. In the taxable year, Smith having no unpledged assets and no reasonably apparent ability otherwise to liquidate any of his debt, petitioner completed the payments on its note, liquidated the collateral pledged by Smith, applying the proceeds against Smith's debt, and charged off the balance as worthless. Held, petitioner is entitled to a deduction for the uncollectible balance of Smith's obligation as a debt ascertained to be worthless and charged off in the taxable year.
*32 This is a proceeding to redetermine a deficiency in income tax of $2,327.38 for the calendar year 1934. The sole issue is whether the petitioner is entitled to deduct the sum of $17,198.07 as a debt ascertained to be worthless and charged off within the*1245 taxable year.
FINDINGS OF FACT.
Petitioner is a corporation which was organized under the laws of Delaware in 1930. Its principal business, oil producing, is carried on in Oklahoma. The Kessler Petroleum Corporation, hereinafter referred to as "Petroleum", was organized in 1928, and carries on a similar but separate business. J. M. Kessler was president of both companies and had been since their organization.
Petitioner had contracted a loan of $600,000 in 1930 from the First National Bank & Trust Co. of Oklahoma City, hereinafter referred to as "the bank." In 1931, it renewed a portion of this loan ($525,000) and borrowed additional capital with which to finance its operations. The bank exacted a bonus as welll as interest for this renewal.
In the course of the 1931 negotiations, the bank called Kessler's attention to an unpaid note of one Walter W. Smith for $21,350 and asked Kessler either to purchase it or make some arrangement by which Smith could pay it. Smith was an officer and director of Petroleum and a director of petitioner. He had borrowed the amount evidenced by the note to finance his Nash automobile agency.
Kessler promptly conferred with Smith and*1246 they agreed that Kessler would take up Smith's note. The bank had not demanded Kessler's purchase of this obligation as an inducement for renewing petitioner's loan; Kessler decided to buy it on the ultimate behalf of the petitioner so as to preserve harmonious relations with Smith, who had been instrumental in raising capital for both Petroleum and petitioner.
The agreement between Kessler and Smith, dated June 16, 1931, provided that in consideration of Kessler's purchase of the note, Smith would leave with Kessler the following items: (1) $5,000 in bonus stock due Smith by petitioner; (2) claim for moneys due Smith on accounts receivable from Petroleum; and (3) the collateral attached to Smith's note at the bank. These items were to be used and sold from time to time in meeting payments on the notes which Kessler had agreed to make at the time of taking up Smith's note.
At the time of taking up the Smith note, June 16, 1931, Kessler executed five notes as follows: Four collateral notes at $1,000 each and one collateral note for $17,350. One of the $1,000 notes was renewed on August 15, 1931. Smith endorsed these notes, which were made payable *33 to him at the bank. *1247 The transaction was appropriately entered on Kessler's personal books of account.
Kessler took up Smith's note personally until such time as he could secure the approval of petitioner's board of directors. He and Smith understood that he was purchasing it, and that Smith would be carried for at least a year and possibly longer. The bank retained Smith's original note and also kept physical custody of the collateral originally deposited thereon. Kessler kept the other items of collateral, which had been given by Smith as additional security. Later on, he turned them over to petitioner to hold. Part of this additional collateral consisted of 500 shares of petitioner's stock, par $10, due Smith for commissions. Petitioner caused it to be combined with Smith's 10 qualifying shares into one certificate for 510 shares.
The original collateral consisted of 300 shares of Nash Motor stock, worth $25 per share at the time of Kessler's purchase of the note, and 954 shares of the stock of Petroleum, then worth $12.50 per share. On August 16, 1931, the 954 shares were transferred to Kessler, individually, to facilitate sales thereof. It was understood, however, that he received the*1248 stock only as trustee for the liquidation of Smith's account.
On December 17, 1931, petitioner took over the Smith note by executing, in substitution for Kessler's notes, five notes of $1,000 each and one for $16,142.79. The collateral securing them was the same as that which had secured Smith's original note. By appropriate book entries the obligation was transferred from Kessler to petitioner; and petitioner's purchase was approved by its board of directors on December 29, 1931. The collateral was thereafter physically located at the bank, but was understood to be in the name of Kessler as trustee.
Smith asked for extensions on his obligation after the first year and petitioner agreed to them. He never made any payments thereon.
The five notes for $1,000 each were paid off by petitioner in 1932.
The note for $16,142.79 was paid off partly by new notes which in turn were later discharged in cash and partly by petitioner endorsing to the bank and guaranteeing a note of the Lucey Products Corporation, with the understanding that the proceeds thereof would be applied to the balance due, as collected. The Lucey Products Corporation finished making the payments on January 15, 1934, and*1249 petitioner's obligation to the bank was thus paid.
The collateral originally deposited on Smith's note and subsequently securing petitioner's notes was treated in the following manner. Kessler sold the 300 shares of Nash Motor Co. stock in 1932, *34 as trustee, with the permission of the bank, and turned the proceeds over to petitioner for credit against the Smith debt. The journal entry on petitioner's books covering this transaction was as follows:
| Dec. 3, 1932 | |
| To record sale of 300 shares of Nash Motors stock at 12 1/8 for net return of $3575.50. | |
| Cost of 300 shares Nash Motors | $8448.61 |
| Selling price | 3575.50 |
| Loss on sale | 4873.11 |
Thereafter petitioner took a deduction for this loss in its 1932 return. This was done erroneously, and when it was brought to Kessler's attention, he caused the books of petitioner to be changed, in December, 1933, so as to credit Smith with the amount realized. No question was raised in the audit of the 1932 return as to this deduction. The 1932 return showed a net loss of over $320,000.
Petroleum and petitioner merged late in 1933 and, pursuant to an arrangement approved by the directors of both companies, *1250 and with Smith's consent, the above mentioned block of 954 shares of Petroleum stock was exchanged for 1,193 shares of petitioner's common stock in December of that year. The stock certificate was then issued to "J. M. Kessler, Trustee." In the early part of 1934, petitioner reduced the par value of all its common stock from $10 to $1 per share; and in April 1934 a second certificate for 1,193 shares was issued to "J. M. Kessler, Trustee." This represented the same block of stock, with a reduced par value.
On December 31, 1934, a journal entry was made in petitioner's books "to charge off un-collectible account due from W. W. Smith in amount of $18,901.07." This figure represented the Smith account after due credit had been given for dividends on and sales of collateral. The interest owed by Smith had been duly taken into the profit and loss account, and was included in the foregoing figure as part of the loan to Smith. The entry recited that Smith's financial situation made collection from him impossible, and proceeded to cancel the 1,193 shares standing in the name of Kessler as trustee and the 510 shares in the name of Smith (which had been left with petitioner by Smith as*1251 additional security and which had suffered reduction in par value along with the larger block), giving Smith credit therefor at par which was in excess of its fair market value at that time. Application of the credit resulted in a net charge-off of $17,198.07. The forfeiture and charge-off were made pursuant to Kessler's agreement with Smith of June 16, 1931, discussed above.
The year 1934 was selected as proper for the charge-off because in that year the Lucey Products Corporation completed payments on the note which petitioner had endorsed and guaranteed to the bank, *35 thus satisfying the obligation of petitioner's endorsement, and the market value of the remaining collateral was so low that petitioner realized it could no longer reasonably expect to sell the stock for the amount of the debt. No recovery of any part of Smith's debt has since been made.
When petitioner took over the Smith note, it made an entry in its books reading, so far as material, as follows:
To record the assumption of an obligation to the First National Bank & Trust Company originally assumed by J. M. Kessler, for W. W. Smith, involving the purchase of:
300 shares of Nash Motor Co. stock
*1252 954 shares of Kessler Petroleum Corp. stock
All of the above stock up as collateral at bank
The reverse side of this entry debited "Stocks and Bonds" $20,378.61, a sum which had been arrived at as the value of the above stocks.
On November 30, 1932, the following journal entry was made:
Transferring 954 shares Kessler Pet. Corp. stock, set up in "Stocks and Bonds" to "Investment in Kessler Pet. Corp."
In December 1933 the following entry was made.
To record the acquisition of 954 shares of Kessler Petroleum Corporation stock through exchange for kessler Oil and Gas Company stock on the basis of 50% of par value of Kessler Petroleum Corporation stock as follows.
| J. M. Kessler, Trustee 954 sh. at 25.00 | $23,850.00 |
| 50% | 11,925.00 or |
| 1193 shares at 10.00 per share | 11,930.00 |
(This stock was exchanged in Nov. 1932, but due to misunderstanding was not issued. This stock being held as collateral to account owed K O & G Co. by W. W. Smith.)
The foregoing three entries were made by petitioner's bookkeeper at a time when Kessler was in the east, without his authority. When they were called to his attention in late December 1933, he ordered a correcting*1253 entry made as follows:
In paying the note of W. W. Smith due First National Bank & Trust Company, to which Smith had attached as collateral 300 shares of Nash Motors Company stock and 954 shares of Kessler Petroleum Corporation stock, same was handled as if Kessler Oil and Gas Company had purchased the collateral stock for the amount of the note that it paid in behalf of Smith. This was an erroneous interpretation as while Smith's note was to be paid, this company looked for re-imbursement to Smith. As the matter was handled on the first, or erroneous interpretation, this entry is to readjust all accounts which were affected:
* * *
(Note - Nash stock was sold and credit given to Smith. Kessler Petroleum Corporation stock has been exchanged for stock of Kessler Oil and Gas Company, and same is held by Kessler Oil and Gas Company for delivery to Smith when he pays the above account.)
*36 The effect of the correcting entry was to credit Smith's note account with the amount realized on the sale of the Nash stock, as has already been stated, and to restore the Petroleum stock to its status as collateral, instead of leaving it recorded as an outright purchase by petitioner.
*1254 The book value of the Petroleum stock was $10.05 per share in 1931, $8.20 per share in 1932, and $8.09 per share in 1933. There was no active market for the stock. Petroleum had no outstanding indebtedness, except for current obligations, and its assets consisted mainly of royalties requiring no overhead or carrying charges. These assets were taken over, late in 1933, by petitioner as a result of the merger agreement. In 1935, petitioner sold one-fifth of them and realized $81,500.
The book value of petitioner's stock per share was as follows:
| 12/31/31 | $6.39 |
| 12/31/32 | 4.15 |
| 12/31/33 | 4.10 |
| After merger | 0.84 |
| 12/31/34 | 0.73 |
During 1931, petitioner's common stock sold at $10 per share. At the close of 1932, there was outstanding, ahead of the common, approximately $349,500 in preferred stock, and during that year the common had little actual market value. This condition of the common continued throughout 1933. The discrepancy between the book value and the market value of the common was caused by the oil proration requirements of the State of Oklahoma. Petitioner had oil underground, but was not allowed to produce it. In 1934, following the merger, *1255 the common stock sold at about 80 cents per share with no reasonable basis for expecting any substantial enhancement.
Petitioner's officers knew in 1931 that Smith did not have any assets that were not pledged, and charged off an unsecured loan of $75.41 of his in that year as a bad debt, taking a deduction therefor in the 1931 return. He had no other assets in 1934 and no reasonable prospects of paying his account to petitioner.
On December 31, 1934, Smith was indebted to petitioner in the sum of $17,198.07. On that date petitioner properly ascertained that debt to be worthless and charged if off as bad.
OPINION.
LEECH: Petitioner contends, in substance, that it borrowed from the bank and loaned the money to Smith, which loan was secured by collateral, part of which had been originally pledged with the bank on Smith's loan there, and that Smith used the proceeds of this loan from petitioner to pay his indebtedness to the bank. Petitioner *37 then argues it properly ascertained the then balance owing on this loan to have become worthless in 1934 and charged it off as a bad debt.
Respondent counters with the argument that petitioner bought the Smith note and*1256 collateral thereto but that, if this is not so, and petitioner did become a creditor of Smith by the transaction of the bank, the debt was worthless and reasonably ascertainable as such before 1934.
We agree with petitioner. After a thorough consideration of the evidence, we think that petitioner never acquired full legal title to the Smith note to the bank or the collateral securing it. Petitioner became a creditor of Smith and this collateral secured that debt. Kessler, petitioner's president, testified that he held title to the collateral, consisting of Petroleum stock and Nash Motors stock, only as trustee for the liquidation of Smith's account. The agreement between Smith and Kessler stated not that Smith assigned these securities to Kessler, but that he would leave them with Kessler to be sold to liquidate the obligation when, as, and if necessary. It is true that when petitioner took over the obligation from Kessler, the transaction was entered on its books three times as a purchase of the stocks comprising the collateral. But Kessler testified that this was done without his knowledge or authority, while he was away, and by a bookkeeper who did not know how to record*1257 the transaction. Respondent introduced no evidence to rebut this explanation except the entries themselves. On the third entry made without Kessler's knowledge it is expressly stated that the stock was held only as collateral on Smith's note account.
The allegedly mistaken entries were corrected by Kessler's order as soon as he learned of them, and this was done in December of 1933, prior to the taxable year. We are satisfied that the correction, which changed petitioner's records to show that the stocks were held and one of them disposed of only as pledged collateral, was made in good faith. The evidence independent of the book entries shows clearly that a pledge, rather than an outright transfer, of the securities took place, and the book entries can not control where they conflict with the actual facts. ; ; .
Respondent insists that petitioner knew Smith was insolvent in 1931, having charged off a debt of his in that year as worthless, and that the bad debt deduction, if such*1258 it was, should have been taken in that year. In support of this he cites . But this argument is beside the point, the Smith note account was at all times secured by collateral, which was not the case in Dexter v. Commissioner, where the notes in question were wholly unsecured.
*38 It may be conceded that petitioner could have reasonably ascertained a part of the Smith debt to have become worthless prior to 1934, but a partial charge-off is not compulsory under the act. Revenue Act of 1934, sec. 23(k). It may be true that neither Smith's asset position nor his worth as a debtor improved substantially between 1931 and 1934. It may likewise be true that the value of the collateral did not appreciate during that interval. However, on this record we can not say the basis for a reasonable expectation that such appreciation would occur did not exist throughout that period. And, in any event, the total worthless amount of the debt could not have been ascertained until the disposition and liquidation of the collateral, including the Lucey Products note. This did not occur until 1934, when that note was paid*1259 and the stock in petitioner was taken over by petitioner and Smith's account credited with its par value, which then exceeded its market value - under the contract of June 16, 1931. There is nothing in this record indicating that the petitioner was accumulating bad debts to deduct them in a year subsequent to the year of their becoming worthless, as was true in . We have, therefore, found as a fact that petitioner properly ascertained a debt to it in the sum of $17,198.07 to have become worthless in 1934 and charged the same off in that year. It is entitled to that deduction. ;
Decision will be entered for the petitioner.