*1363 1. Deduction allowed for amount paid for cancellation of a contract.
2. Petitioner loaned money on open account to a corporation the stock of which was owned by its stockholders. At the close of the year the book value of the debtor corporation's assets exceeded its liabilities. By placing a liquidating value upon the assets, petitioner's officers concluded that the debtor's liabilities exceeded its assets and after the close of the year wrote off a part of the account. Held, the evidence does not establish an ascertainment of worthlessness which will support a claim for a bad debt deduction.
*114 This proceeding was initiated to test the correctness of respondent's determination of a deficiency for the calendar year 1929 in the sum of $4,334.65. Two issues are involved: (1) The claimed loss on the cancellation of a contract, and (2) the deductibility of an alleged bad debt.
*115 FINDINGS OF FACT.
Petitioner was organized in 1924 by five brothers (hereinafter called the Anderson brothers), *1364 to engage in the operation of a sawmill at Olympia, Washington. The stock of petitioner was owned in equal proportions by the five brothers. The Anderson brothers also owned in equal parts all of the stock of the Tumwater Lumber Mill Co., which was also located at Olympia and which they had operated since 1919.
In 1928 petitioner entered into a contract with the Rockway Mill Wood Co. whereby the latter company agreed to build certain equipment to dispose of the waste from petitioner's sawmill. The Rockway Mill Wood Co. installed a portion of the equipment but failed to carry out its agreement to dispose of the slab wood and other waste material, with the result that the operations of the petitioner's mill were being very materially interfered with. Rather than declare the contract at an end by reason of the failure of the Rockway Mill Wood Co. to perform, petitioner started negotiations with the Rockway Mill Wood Co. to the end of terminating the contract amicably. The contract was terminated in March 1929 by the payment to the Rockway Mill Wood Co. by petitioner of $7,900 and as a part of the settlement the Rockway Co. relinquished to petitioner all of its equipment then on*1365 petitioner's property, which was of a value at that time not in excess of $2,500. The difference of $5,400 represented consideration paid for the cancellation of the contract and this item (plus $3.92 which is unexplained) was claimed as a deduction by petitioner in its 1929 tax return.
In 1928 the Anderson brothers were interested in the installing of a Swedish gang-saw mill, which had for its purpose the utilization of lumber under 12 inches in diameter, which sizes were generally being wasted at the time. The Tumwater Mill at this period was not engaged in sawmill operations but was working on various real estate contracts as well as other related activities in and around Olympia. The Anderson brothers decided to make the experiment and selected the Tumwater Co. for that purpose. At that time the Tumwater Co. had no funds which it could utilize for the purpose and accordingly the Anderson brothers agreed that the petitioner would advance whatever funds were needed, the funds so advanced to be repaid by the Tumwater Co. out of income from operations.
The new mill was a pure experiment and difficulties were soon encountered, with the result that the estimated cost of some*1366 $55,000 was exceeded and petitioner found it necessary to advance $84,722 in 1928 and 1929 to put the mill in shape and adapt it to conditions in the Puget Sound country.
*116 On or about December 27, 1929, the Anderson brothers, as trustees of petitioner, discussed the question of the large amount owing to petitioner by the Tumwater Lumber Mill Co., and reached the conclusion that the latter, due to the high cost of installing the new mill, the drop in prices of lumber, and the curtailed business due to the depression and consequent depreciation in the value of the assets of the Tumwater Co., including certain real estate contracts, building lots, garage, stock in other lumber companies, etc., would not be able to pay the petitioner the sum advanced to it. It was accordingly decided to charge off approximately 40 percent of the advance to the Tumwater Co. as a bad debt.
No actual charge-off was made on the books in 1929 and not until some time in February or March, 1930, at which time there was a charge to surplus and a credit to "special reserve for possible loss" of the Tumwater Lumber Mill Co. account. This charge-off was in the amount of $33,594.65. This entry*1367 was so made because the books had been closed and the profits theretofore closed into surplus. The loan made to the Tumwater Lumber Mill Co. was with the idea that that company would be able to repay from the earnings of its business. The petitioner had the money available and used it in the other business and expected to get it back. No notes were given for the advances and there was no understanding between the two corporations as to how long the account would run. Some time after the book entries were made the assets of the Tumwater Lumber Mill Co. were valued as of December 31, 1929, based on their liquidation value, and the result of that valuation placed the assets as worth $142,523.30, with liabilities outstanding of $186,894.92, which latter sum included what had been advanced by petitioner to the Tumwater Lumber Mill Co. as well as certain mortgages on some of the properties. The current assets as of December 31, 1929, were $57,316.38 and the current liabilities $126,995,62, including the sums due petitioner. The Anderson brothers did not intend that the outside creditors of the Tumwater Co. should lose any money and intended that they should be paid through petitioner.
*1368 OPINION.
ARUNDELL: The evidence establishes to our satisfaction that of the sum of $7,900 paid to the Rockway Mill Wood Co. at least $5,400 was in fact paid to get rid of an unsatisfactory contract and not more than $2,500 was paid for the assets taken over. Even assuming that petitioner was warranted in abrogating the contract because of the breach by the Rockway Mill Wood Co., it is not to be denied the loss it actually suffered because it sought the more amicable course and thus avoided almost certain litigation. The fact *117 that petitioner may have hastened matters because of a proposed plan of various mill owners to join in an operation for the handling of their waste material does not change or affect the transaction between petitioner and the Rockway Mill Wood Co. On this issue the respondent is reversed.
The evidence does not convince us that the advances made to the Tumwater Lumber Mill Co. should be allowed as a bad debt deduction in 1929. Undoubtedly a large portion of the sum was not advanced until that year and the entire sum was loaned for frankly experimental purposes and could be repaid only through income from the operations of the Tumwater Co. *1369 At the end of 1929 it was in regular operation, although it had experienced the pinch of the depression, as had business generally. Its balance sheet showed it entirely solvent. It is true that its liquid assets were limited, but that was known when the advances were made by petitioner and was the occasion for its action. By placing a liquidating value on its assets, including the new gang-saw mill which had recently been completed, a value was reached of $142,523.30, and as the outstanding liabilities, including the sum due petitioner and various mortgages on the property, equaled $186,894.92, claim is made that the Tumwater Co. was insolvent and that petitioner was warranted in making the charge-off that it did. Petitioner's president testified that in the light of subsequent events the entire account should have been charged off, but the testimony goes no further than this, and no facts are given to support the general statement.
In deducting 40 percent of the indebtedness due by the Tumwater Lumber Mill Co. petitioner evidently did not consider it was dealing at arm's length with that company, for, even on its own calculation of the assets and liabilities of the "Tumwater*1370 Co., it would have recovered more than 60 percent of the amount due. Petitioner's answer is that the Anderson brothers did not intend that the outside creditors of the Tumwater Co. should lose anything. However commendable such a course may be, it does not follow that petitioner may at one and the same time treat itself as a true creditor and also as ready to relinquish its right to payment and by so doing charge off the item as a bad debt against its income. Except for the close relationship that existed between the two corporations, it is not likely that the Tumwater Co. would have borrowed such a large sum as it did from petitioner, which sum was payable on demand. The two corporations had in earlier years been in the habit of filing consolidated returns, but that was not permitted under the revenue act in force in 1929. If it had been the accounts could not have reflected under any guise the sum now sought to be deducted. The evidence is far from satisfactory that there was a charge-off within *118 the year 1929, but, passing that matter over unanswered, we are of the opinion that the debt due to the petitioner by the Tumwater Lumber Mill Co. was not ascertained to*1371 be worthless to the amount of $33,594.65 and that the charge-off should not be allowed as a deduction from petitioner's 1929 income.
Decision will be entered under Rule 50.