*3859 1. Where a corporation kept its books upon a partnership basis, and stockholders' accounts were credited with profits, appreciation of assets, contributions of capital, and were charged with losses and withdrawals, and corporate affairs were confused with stockholders' personal affairs, the debit balances against the stockholders' accounts, resulting from the establishment of the books upon a corporate accounting basis and an adjustment of their personal accounts, are not valid accounts receivable, but represent distributions of corporate property and can not be included in invested capital.
2. Under the facts of this case the debit balance against one of such stockholders, which is written off the books as uncollectible, is not a debt ascertained to be worthless and charged off in the taxable year, and no deduction therefor can be allowed.
*138 The Commissioner has determined a deficiency of $2,399.44 in income and excess-profits taxes for the calendar year 1920. The petitioner alleges that the Commissioner erred (1) in refusing to allow a*3860 deduction of the entire account, as adjusted, of one of its stockholders, ascertained to be worthless and charged off within the taxable year, and (2) in excluding from invested capital the full indebtedness, as adjusted, of its three stockholders at the beginning of the taxable year.
FINDINGS OF FACT.
The petitioner is a New York corporation with offices at Buffalo. It was incorporated in 1901 by John Feist, who held 980 share of the total 1,000 shares of capital stock until his death in 1907. Upon his death all the stock, except 200 shares left in trust for his widow, was distributed to his five children. About a year after the death of John Feist his three sons bought the stock held by their two sisters, and thereafter the stock was held in equal shares by Joseph, Henry and Charles Feist, until 1920 when Joseph and Henry bought the shares held by Charles. The widow of John Feist assigned all rights to dividends on her 200 shares to the three boys, who agreed to pay her $15 per week for the rest of her life. Charles Feist kept the books of the company and had charge of all financial matters until September, 1916, when he resigned and withdrew from active participation*3861 in the business.
*139 The books of the company were not kept upon an accurate corporate accounting basis, but were maintained as if the business were a partnership. There was no surplus account set up, and all profits were credited and all losses were charged to the individual accounts of the three stockholders. Various items of corporate expense and personal expenses paid by the company were charged directly to their individual accounts. Withdrawals of funds and contributions of capital by the stockholders were charged and credited, respectively, to them. Appreciation in the value of plant assets in the sum of $16,352.60 also was credited to their personal accounts, as was an item of $8,000 appearing on the books as a charge against demand loan account. The payments to Mrs. Feist under the agreement with the three boys were charged on the books to corporate expense. There also appeared on the books a charge of $1,000 to the account of Joseph Feist and a credit of a like amount to the account of Charles Feist.
About August or September, 1916, the books of the company were audited at the direction of a bank with which the petitioner dealt, for the purpose of verifying*3862 a financial statement submitted to it. For the purposes of the audit a surplus account, a special profit and loss account, and a special expense account were created, but not then entered upon the books, and items that, in the opinion of the auditors, had been improperly credited or charged to the personal accounts of the stockholders were reallocated to corporate accounts. Later in the year 1916 the petitioner had a more complete audit made by the same auditors. In accordance with this audit there were opened on the books a surplus account, special profit and loss account, and a special expense account. Expenses totaling $16,243.57, which had been charged to the personal accounts of the stockholders, were eliminated from those accounts and charged to the special expense account. The item of $8,000, charged to demand loan account and credited to the stockholders, was charged to the special profit and loss account.
In the latter part of 1920 the books again were audited by another firm of auditors and the accounts were adjusted as of December 31, 1920, reversing the adjustments made by the second audit in 1916. In the opinion of these auditors the sums charged to special expense*3863 account, and demand loan account, and payments made to Mrs. Feist for 1917, 1918, and 1919, totaling $2,355, charged to corporate expense, represented personal obligations of the stockholders and should be charged to their individual accounts. It was decided that appreciation of plant assets in the sum of $16,352.60 had been erroneously credited to the stockholders and should be charged back to their accounts, and that the credit of $1,000 to Charles and the charge of $1,000 to Joseph were erroneous entries, and should be reversed. *140 Between September 1, 1916, and December 31, 1918, Joseph and Henry paid in to the company $4,538.72, which was credited to their accounts in the respective amounts of $2,100 and $2,438.72. On December 31, 1920, the company declared a dividend of $12,500, which was credited to the accounts of Joseph and Henry in equal amounts.
The appreciation in the value of plant assets in the sum of $16,352.60 was entered upon the books from an appraisal made in 1909, and at that time was charged to the asset account and credited to the stockholders. The $8,000 charged to demand loan account and credited to the stockholders represented a loan obtained*3864 by the stockholders from a bank in 1908 or 1909 for the purpose of buying the stock then owned by their sisters. The $1,000 charged to Joseph and credited to Charles represented the sum obtained by Charles in 1909 for the purchase of an automobile.
Prior to the 1920 audit the individual account of Charles Feist, as adjusted by the second 1916 audit, showed a debit balance of $2,261.53. In accordance with the 1920 audit an additional charge of $15,170.91 was made to Charles' account, which then showed a debit balance of $17,432.44, as of January 1 and December 31, 1920. There was charged back to the individual accounts of all the stockholders the aggregate sum of $37,632.45, as additional personal obligations to the corporation as of January 1, 1920.
Charles Feist discontinued active participation in the affairs of the company in September, 1916. Thereafter, he became indebted to others for large sums of money and has been unable to pay anything on his account and has had no property from which it could be collected. The petitioner has made no attempt to collect or enforce payment on the account, for his financial condition was well known to it at all times. In July, 1920, *3865 Joseph and Henry purchased his stock, which had been pledged as security for a loan and forfeited to the bank on default in payment.
The adjusted debit balance of Charles Feist as of December 31, 1920, in the sum of $17,432.44 was written off the books as worthless, pursuant to the resolution of the directors dated December 31, 1920. The debit balances of the accounts of the three stockholders were increased in the aggregate sum of $37,632.45.
In its income-tax return for the year 1920 the petitioner claimed a deduction of $17,432.44, the adjusted debit balance of Charles Feist's account, as a bad debt and claimed $37,632.45, the aggregate additional charges to the accounts of all stockholders, as accounts receivable and additional invested capital. The respondent, in his determination of the tax liability, allowed a bad debt deduction of $2,261.53, the debit balance of Charles Feist's account prior to the 1920 adjustment, and excluded from invested capital the alleged accounts receivable in the sum of $37,632.45.
*141 OPINION.
VAN FOSSAN: The petitioner contends that the adjusted debit balances of the stockholders' accounts represent accounts receivable, which*3866 should be included in the computation of its invested capital, and that the adjusted debit balance of Charles Feist's account was a debt ascertained to be worthless and charged off within the taxable year, which is deductible from gross income. The respondent urges that the adjusted accounts are not valid accounts receivable which may be included in invested capital, and that the adjusted account of Charles Feist was not in fact a debt ascertained to be worthless within the taxable year and is not deductible from gross income.
Prior to 1916 the petitioner conducted its affairs as if it were a partnership and its property owned by the individual stockholders. Profits and losses were credited and charged to the stockholders, appreciation of corporate assets and contributions by the stockholders were credited to their accounts, and in some instances corporate expenses were charged directly to them. Personal transactions affecting the stockholders only were credited or charged, as the case might be, to their accounts on the company's books. In 1916 the books were audited and the accounts were adjusted and established upon a corporate accounting basis. In December, 1920, another*3867 audit of the books and further adjustments of the accounts were made, charging back to the stockholders expenses eliminated from their accounts in 1916 and various items credited to them in prior years. The aggregate amount charged back to the stockholders as due to the company on January 1, 1920, was $37,632.45, of which $15,170.91 was charged to one of the stockholders, who had withdrawn from the business in 1916, and was written off the books as of December 31, 1920, as uncollectible. It is these amounts that the petitioner claims as invested capital and bad debt deduction, respectively.
The fact that stands out most clearly in this record, replete with incoherent and inconsistent testimony, is that the relation of the stockholders to the business always has been that of partners and not merely stockholders of a corporation. Prior to 1916, when these charges were incurred, the corporation as a separate legal entity, which owned the business and property, was ignored. The audits and adjustments of the accounts made in 1916 and 1920 established the books upon a corporate accounting basis, but there is no indication that the stockholders altered their relationship to the company. *3868 Subsequent to these audits the business transactions of the company were entered in corporate accounts and not confused with the personal *142 accounts of the stockholders, but so far as is disclosed the stockholders still were considered the owners of the business and the profits therefrom. Not until December 31, 1920, was there any formal corporate action declaring dividends or otherwise distributing profits or property of the corporation, and the dividend then declared was simply credited to the stockholders' accounts, as profits in prior years had been credited. Payments to the corporation by two of the stockholders between September 1, 1916, and December 31, 1918, were credited to their accounts, just as contributions in prior years were credited, and there is no evidence that such payments were made specifically in recognition or reduction of any debit balance that might have appeared against them. The audits may have established a more accurate system of bookkeeping, but it does not follow that the adjusted debit balances against the stockholders represent valid accounts receivable.
The stockholders treated the business and its assets as their individual property. *3869 They contributed capital when required by the business and paid the losses when sustained. Their personal accounts were credited with the profits and contributions and were charged with the withdrawals and losses. There is no evidence that either the corporation or the stockholders considered the charges to their accounts as obligations to the corporation and that payment thereof would be made in cash or other property from independent sources. The stockholders' accounts apparently were maintained only as bookkeeping entries to show the disposition of corporate property and keep the books in balance. There is no evidence of an intention or expectation that the stockholders would pay the debit balances to the company or that they recognized them as debts. The charges against the stockholders' accounts represented distributions of corporate property and not loans or advances to the stockholders.
Under the facts of the case the debit balances against the stockholders, resulting from the adjustments made in 1920, are not valid accounts receivable of the corporation, and can not be allowed as invested capital. *3870 ; ; ; ; ; and . The evidence does not show that these accounts constitute invested capital under any provision of section 326(a) of the Revenue Act of 1918. They are not property paid in for stock and there is nothing in the record to indicate that they represent paid-in or earned surplus or undivided profits. (See cases above cited.)
The alleged bad debt in the sum of $15,170.91, for which the petitioner claims a deduction in the taxable year, is one of the accounts *143 claimed as invested capital, which we have held are not valid accounts receivable. As above indicated, this account was not an obligation or debt of the stockholder to the corporation. In , we said:
To entitle a taxpayer to deduct from gross income, as a bad debt, an item ascertained to be worthless and charged off in a given year, such*3871 a debt must have had an existence in fact. A debt which never existed can not be charged off. The right to a deduction arises from the discovery that something which had value has ceased to have it; a debt which never existed had no value to lose.
And in , we said:
If the debtor was not legally liable to the taxpayer, then there was no debt to become worthless.
The circumstances surrounding this particular account demonstrate its nonexistence as a debt, even more clearly than the facts pertaining to the combined accounts which we already have discussed. This account arose from bookkeeping adjustments made more than four years after the alleged debtor had severed all connection with the affairs of the petitioner, and apparently without his knowledge, at least without his acquiescence. The account was merely a bookkeeping adjustment and not a valid account receivable or a debt. It follows that this account is not an allowable deduction as a debt ascertained to be worthless and charged off in the taxable year. It should be added that the account was known to be worthless several years before the taxable year.
*3872 We pass without comment other grounds appearing in the record, upon which the claims of petitioner would have to be denied. Among the items charged back to the stockholders, resulting in the alleged accounts receivable, was one for appreciation in the value of plant assets previously credited to the stockholders, which can not be allowed as invested capital. . The evidence pertaining to the other items comprising the alleged accounts receivable is vague and indefinite and wholly insufficient to satisfy the requirements of section 326(a) of the Revenue Act of 1918, which specifically defines invested capital.
Since no issue was raised as to the allowability of the item of $2,261.53 as a bad debt, we do not rule on the propriety thereof.
We find no error in the action of the respondent.
Reviewed by the Board.
Judgment will be entered for the respondent.