*2239 BAD DEBTS - CHARGING OFF - PRIVATE LEDGER. - An entry made and kept in a private ledger only, for time being, if used in making balance sheets, which entry shows that a "charge-off" of bad debts has effectually eliminated such accounts or bills receivable from the available assets, is held a sufficient charge-off to meet the requirements of the statute.
*1317 This proceeding is for the redetermination of a deficiency in income tax asserted by the Commissioner for the fiscal year ended June 30, 1923, in the amount of $9,676.07. Of the total deficiency asserted by respondent, only $7,500.97 is in controversy. In the petition, petitioner sets forth two assignments of error: (a) disallowance as deductions from income of special charges for accrued expenses in an amount of $154.66, and (b) disallowance as deductions from income of bad debts in an amount of $60,007.77. At the hearing, counsel for petitioner definitely abandoned the first assignment of error, and in substance, a part of the second.
FINDINGS OF FACT.
*2240 Petitioner, a domestic corporation with its principal office at 347 Madison Avenue, New York City, was incorporated on July 1, 1921, on which date it took over the assets and business of the partnership of Poel & Kelly. Prior to, and during the taxable year on appeal, petitioner was engaged in importing crude rubber and in dealing in rubber futures.
From its incorporation in 1921 petitioner has maintained, as an integral part of its accounting system and records, a private ledger in which there were recorded accounts such as capital stock, surplus, profit and loss, inventory, personal accounts of principal stockholders, and such other accounts as the management deemed it inadvisable to make accessible to, or subject to the scrutiny of its subordinate employees. Accounts maintained in the private ledger were not kept in any of the other general books. All entries or postings in the private ledger were made by a public accountant who was employed by petitioner to make periodical audits of its books.
Among the accounts maintained in the private ledger was one entitled "reserve for bad and doubtful accounts." When the semiannual audit of the books of petitioner was made by its*2241 public *1318 accountant, he scrutinized each of the accounts receivable and segregated them as due or past due accounts. The management and, in some instances, the directors, were interrogated in regard to the accounts that were past due and if it was thus ascertained or made certain to the minds of the management of petitioner and its accountant, that the account was uncollectible or partly uncollectible, the exact amount so ascertained to be worthless was charged to the profit and loss account in the private ledger; otherwise, the accountant would have refused to certify the statement prepared for petitioner's bank. At the same time a corresponding credit was made in the private ledger to the titular "reserve for bad and doubtful accounts." It does not clearly appear from the testimony whether petitioner maintained a sales, or customers', ledger, or whether a separate account with each customer was kept in what is commonly referred to as the "general ledger"; but, in any event, when such entries were made in the private ledger no corresponding entries were made in any of the ledgers that were open to the inspection of any employee other than the management of petitioner, *2242 or its public accountant who alone kept the private ledger and made all the entries therein. Later, when it was generally known in the trade that such accounts were bad, either through the debtor's failure or when proceedings in bankruptcy were begun, such accounts theretofore retained on the ledger kept in the general office were closed on that ledger by the transfer to it of the correspondingly equal and offsetting credit which had until then been carried in the private ledger as a credit in the account captioned "reserve for bad and doubtful accounts"; but that procedure might not take place for six months or a year or two years after that same amount had been charged to profit and loss.
The accounts of this character that are here involved are:
| Keystone Rubber Co | $20,143.36 |
| Edward Maurer, Inc | 5,250.00 |
| Racine Auto Tire Co | 33,167.88 |
| Francis Peek | 946.53 |
| New York Rubber Co | 500.00 |
| Total | 60,007.77 |
representing balances of accounts, or notes overdue or about to become due.
The indebtedness of the Keystone Rubber Co. to the partnership at the time petitioner took over its assets and business was $26,303.61. On September 6, 1921, there was charged to*2243 the debtor's account interest in the amount of $1,967.77, bringing the debit balance of the account to $28,271.38; and on the same day the debtor paid $7,067.84, leaving a debit balance of $21,203.54, in liquidation of which the debtor gave two notes in the principal sum of $10,601.77 *1319 each, one note maturing on October 1, 1922, and the other on October 1, 1923. When the earlier of these two notes became due, which was within the taxable year on appeal, the maker paid $1,010.68 and gave a renewal note for the remainder of $9,541.59 maturing May 1, 1923, a date also within the taxable year on appeal. Between October 1, 1922, and May 1, 1923, the debtor suffered a disastrous fire which practically destroyed its plant. The fire insurance collected by the debtor was paid to the mortgagees of the property and there was nothing left for the payment of unsecured claims. On June 30, 1923, there was charged to profit and loss, the indebtedness of the Keystone Rubber Co. to petitioner, amounting to $20,143.36, no part of which has ever been recovered. The fire, which occurred within the taxable year on appeal, destroyed the only thing against which petitioner could have had*2244 recourse for the collection of the indebtedness due to it.
The account of Edward Maurer, Inc., originated in May, 1922. The charges to the account were for merchandise purchases and transactions in rubber futures in May and June, 1922, which amounted to $24,261.56. The total payments on account were $13,977.60, resulting in a debit balance on July 1, 1922, the beginning of the fiscal year on appeal, of $10,283.96. The debtor company issued its promissory notes to petitioner for the amount of that debit balance. By October 17, 1922, after crediting partial payments and adding interest, petitioner held a total of the debtor's notes amounting to $8,904.32. Five of these notes were disposed of by partial payments and renewals, so that the group of $8,904.32 was resolved into two notes; one a demand note for $4,300, and the other a 90-day note, due April 4, 1923, of $3,045; a total of $7,345. On June 7, 1923, the maker paid $300 on the demand note for $4,300, and $45 on the 90-day note for $3,045. At June 30, 1923, the balance due and unpaid on the two notes amounted to $7,000. Petitioner's accountant examined the facts and questioned the management in regard to the collectibility*2245 of the account. The matter was considered in detail and it was authoritatively determined that 25 per cent, or $1,750 as a conservative and true figure, of the amount of these notes might be collected. Accordingly, 75 per cent, or $5,250, was charged to profit and loss as of June 30, 1923, and credited to the account termed "reserve for bad and doubtful accounts," in the private ledger. Nothing further was ever received from this corporation. Maurer as an individual, as to whom there is nothing to show that petitioner had a legal claim on June 30, 1923, paid petitioner $600 in cash in December, 1925, and turned over 400 shares of stock of the old corporation which petitioner then regarded, as it has since proved to be, worthless. In 1927 Maurer was again in difficulty as *1320 an individual, and all of his creditors forced him into liquidation, about which time petitioner received $1,628 from the liquidator, with the possibility that it may eventually receive about $66 more.
The indebtedness of the Racine Auto Tire Co. to the partnership when on July 1, 1921, the petitioner took over the assets and business, amounted to $60,335.77, which was evidenced by three notes*2246 of $15,000 each and one note of $15,335.77. These notes were renewed on September 7, 1921, and again on November 21, 1921; the renewal notes of the latter date falling due on February 4, 1922. Between the date last mentioned and March 10, 1922, the Racine Auto Tire Co. went into bankruptcy, and a creditors' committee was appointed to formulate plans for its recapitalization and reorganization. On March 10, 1922, that committee submitted such a plan to the creditors for their approval, which plan, with some modification, was accepted. In an effort to recover some substantial part of the $60,335.77 which was due to it, petitioner subscribed and paid on June 26, 1922, $6,000 in cash for $6,000 par value of the reorganized company's collateral trust notes, with which it received a bonus in preferred and common stock. The original notes of the bankrupt maker were turned over to the reorganization committee and charged back on the books of petitioner to bills receivable, with the notation, "Deposited with Committee." As security for the notes so turned over, petitioner received about $36,700 in the reorganization collateral trust notes, and $18,300 in its preferred stock.
At the*2247 time of this transaction, the petitioner's management were of the opinion that they had thus fairly secured the amount due it from the bankrupt; but on May 15, 1923, petitioner received notice from the creditors' committee that they were unable to pay either the principal of the notes or the installment due on June 1, 1923, or the interest; and under the agreement, it was automatically extended for one year. Petitioner's management thereupon determined that their claim against the bankrupt and the collateral trust notes for which they had subscribed and paid were not worth more than onehalf of their book value and, accordingly, on or as of June 30, 1923, 50 per cent of the claim against the debtor company, to wit, $30,167.88, and 50 per cent of the collateral trust notes of the reorganized company, to wit, $3,000, were charged to profit and loss and credited to the account denominated "reserve for bad and doubtful accounts" on the private ledger. Nothing whatever has been recovered, either on the debt of the Racine Auto Tire Co., or on the collateral trust notes of the reorganized company for which petitioner paid cash.
No evidence was introduced regarding the accounts of Francis*2248 Peek or the New York Rubber Co.
*1321 The respondent added to petitioner's income for the fiscal year ended June 30, 1923, the amounts set up by petitioner as credits to "reserve for bad and doubtful accounts" in the private ledger; thus canceling the effect, as deductions, of the identical and equal amounts charged by petitioner to profit and loss.
OPINION.
LOVE: Petitioner's claim in regard to the accounts of Francis Peck and the New York Rubber Co. was tacitly abandoned at the hearing and as we are without evidence that they were ascertained to be worthless in the fiscal year ended June 30, 1923, we must sustain the Commissioner's action in disallowing them. There are thus left for our consideration the accounts of the Keystone Rubber Co., Edward Maurer, Inc., and the Racine Auto Tire Co., amounting in all to $58,561.24.
The pertinent provisions of the Revenue Act of 1921 here involved are as follows:
DEDUCTIONS ALLOWED CORPORATIONS.
SEC. 234. (a) That in computing the net income of a corporation subjec to the tax imposed by section 230 there shall be allowed as deductions:
* * *
(5) Debts ascertained to be worthless and charged off within the taxable*2249 year (or in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts); and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt to be charged off in part.
The questions for our determination are (1) whether these debts were ascertained to be worthless in whole or in part, within the taxable year; and (2) whether they were "charged off" within the taxable year in the meaning and intent of the statute. We have consistently held that bad debts, to be deductible in computing net income, must not only be determined to be worthless, but must be charged off, and that both actions must be performed by the taxpayer within the taxable period. ; .
In regard to the first question, we believe that it is clear from the findings of fact that none of the three accounts remaining for our consideration could have been ascertained to be worthless prior to the beginning of petitioner's fiscal year, which ended June 30, 1923. We believe that it is equally clear that during that year petitioner in good faith and in the exercise of the*2250 careful business judgment and discretion of its management and in the opinion of its professional accountant, ascertained, so far as it was possible then to ascertain such things or to make them certain in the minds of the management, that by June 30, 1923, the account of the Keystone *1322 Rubber Co. was worthless; that no more than 25 per cent of the account of Edward Maurer, Inc., was recoverable; and that no more than 50 per cent of the account of the Racine Auto Tire Co. was recoverable, and subsequent events have fully sustained petitioner's judgment in these cases. Therefore, we hold that petitioner was entitled, for income-tax purposes, to charge off all or such portions of such accounts as had been ascertained to be worthless within the taxable year; that is to say, the sum of $58,561.24.
It remains for us to determine whether the somewhat peculiar method of bookkeeping pursued by petitioner in connection with these accounts constituted such a "charge off" within the meaning and intent of the statute.
In , we said:
The right of the taxpayer to the deduction provided in the statute above quoted is not to be destroyed*2251 because of its initial failure to put its claim on the technically proper ground. .
The initial failure of the petitioner in this proceeding to put its claim on the technically proper ground can not operate to destroy its right to deduct the amount of debts ascertained to be worthless and charged off in each taxable year.
The circumstances in , differed somewhat from those in the case that we are now considering, in that, in the earlier case, the taxpayer had for the year 1921 taken a deduction for all debts ascertained to be worthless and charged off within that year, while in 1922, without obtaining permission from the Commissioner, it had set up on its books a reserve for bad debts, and made subsequent additions thereto, which amounts were claimed as deductions in computing net income for the years affected. We sustained the Commissioner in disallowing the deductions claimed by the taxpayer as additions to its reserve for bad debts; but we reversed his refusal to allow as deductions the amounts of debts ascertained by the taxpayer to be worthless*2252 in the respective years, and in reaching that conclusion we said:
* * * The statute does not provide any particular manner or method for the charging off of a bad debt. . Whether a charge-off has been effected is not dependent upon any special form of bookkeeping, but must be determined from the circumstances in each case. The fundamental purpose in requiring the charge-off is to evidence the worthlessness of the debt, or, in other words, to establish the loss sustained by the taxpayer, and this end is accomplished and the charge-off effected by the elimination of the bad debt from the taxpayer's assets. If the debt is in fact ascertained to be worthless, it should no longer be treated or considered as an asset. The effective elimination of the debt as an asset meets the statutory requirement as to charge-off. [Italics supplied.] Cf. ;; .
*1323 In the instant case it is not clear what method, if any, petitioner had adopted to provide for its bad debts prior to its fiscal year under*2253 consideration which ended June 30, 1923. The first entry concerning a bad account appears to have been made, so far as the record shows, under date of December 31, 1922, when the account of the St. Louis Robber Co. was disposed of exactly in accordance with the procedure followed with respect to the other accounts which we are considering, although that account is not here in question. Why that is so, we do not know, for it fell within the taxable year before us, but in the statement accompanying the deficiency notice the Commissioner adds to net income the "increase in reserve for bad debts and special charges, $60,162.43," which does not include the St. Louis Rubber Co.'s account of $10,000.
Direct charges to profit and loss had been made of the exact amounts of the accounts here involved which had been ascertained within the taxable year to be worthless, but instead of placing those amounts to the credit of the various accounts as they appeared on the general office books, the credit was made in the private ledger (where also the profit and loss account was kept) in an account denominated "reserve for bad and doubtful accounts"; so that while these accounts receivable were, *2254 for the purposes of the management, permitted to stand on the general office books at their undiminished value, they were in fact and in effect offset and counterbalanced to the full amount of their ascertained worthlessness by the credit carried in the private ledger. We think that the fact that a private ledger is just as much an integral and essential part of the general books of account as though the accounts contained therein were spread upon such general books is so well recognized and understood that it is hardly necessary to emphasize that fact or to enter an argument in support of it beyond the statement that no balance sheet could be prepared if the accounts in the private ledger were omitted from it.
Whether a charge-off has been effected must be determined from the circumstances in each case and is not dependent upon any special form of bookkeeping. We hold that petitioner ascertained to be worthless and charged off within the taxable year ended June 30, 1923, the debts of the Keystone Rubber Co. in the amount of $20,143.36, of Edward Maurer, Inc., in the amount of $5,250, and of the Racine Auto Tire Co. in the amount of $33,167.88 - a total of $58,561.24, and that*2255 it is therefore entitled to take that total amount as a deduction from gross income in its income-tax return rendered for its fiscal year ended June 30, 1923. The tax will be recomputed accordingly.
Judgment will be entered under Rule 50.