*3258 LOSSES - BAD DEBTS - INHERITED PROPERTY - PROMISSORY NOTES. - Decedent was an accommodation endorser of certain notes secured by second mortgage on property of the maker. After decedent's death these were paid by his executor with estate funds, the notes being taken over and thereafter treated as an asset of the estate and no deduction taken on account of the expenditure in determining the gross estate for Federal tax purposes. In 1918 the administration of the estate was concluded and title to the notes in question taken by petitioners as distributees. In 1919, the maker of the notes having died, his estate was administered and its only asset, the property covered by the second mortgage securing the notes, was sold at foreclosure for less than the amount of the first mortgage. Held, that any loss to petitioners as a result of the happenings in 1919 must be measured by the value of the notes at the time distributed to them in 1918, and, there being no proof of such value, no deduction either as a loss or as a bad debt can be allowed.
*386 This proceeding involves deficiencies in income taxes asserted by respondent against petitioners for years and in amounts as follows:
| Year | O. N. Townsend | Harriet R. Burton | Mary T. Brown | Rufus C. Burton |
| 1919 | $1,370.27 | $1,563.76 | ||
| 1920 | $42,096.27 | 41,833.38 | 41,975.90 | |
| 1921 | 14,904.16 | 14,432.90 | $11,323.68 | |
| 1922 | 710.85 | 699.17 |
*387 Petitioners assign four errors on the part of respondent in his determination of the deficiencies involved:
(a) That he refused to allow any deduction for depletion on account of a bonus or overriding royalties received by them during the years 1919 to 1922, inclusive, as consideration for the leasing of certain oil lands.
(b) That he used an erroneous method in computing payments due them as reimbursed income tax under the provisions of the bonus agreement referred to.
(c) That he disallowed a deduction by them from gross income for the taxable year 1919 of a loss incurred on certain uncollectible notes.
(d) That a formal error of computation was made by him in determining petitioners' distributive shares of income from the estate of Thomas B. Townsend for the taxable year*3260 1922.
FINDINGS OF FACT.
Petitioners are residents of Zanesville, Ohio. O. N. Townsend, Harriet R. Burton, and Mary T. Brown are the children of Thomas B. Townsend, who died November 24, 1916, and are the heirs and distributees of his residuary estate under his last will. The petitioner, Rufus C. Burton, is the husband of Harriet R. Burton. The following are the provisions of the will of Thomas B. Townsend, affecting the issues herein presented:
Item first. I give and bequeath to my three children, Orville N. Townsend, Hattie R. Burton, wife of R. C. Burton and Mary T. Brown, wife of L. K. Brown, in equal portions, share and share alike, all my real estate, lands, tenements and personal property, of all kinds, including bonds, stocks, etc., and all property of every description and wherever situated. If any of my above children die before my death, their share shall go to their children, if they have no children, it shall then go to my own children that are still living, share and share alike.
Item second. I hereby appoint my son Orville N. Townsend, executor of my last will and testament, without bond, and request the court admitting this will to probate and record, *3261 and he is requested and to direct the omission of any bond, and to issue letters of administration to my son Orville N. Townsend without any bond or security in such behalf.
Item third. In case of the death of my son Orville N. Townsend, I appoint Rufus C. Burton to succeed my son as executor and to be governed without bond as stated in item second.
* * *
Item *388 fifth. My ranch property at Horners, Marion County, Kansas, known as Rockland Farm or Townsend Ranch is to be kept intact and not divided for ten years from the date of my death, before divided or sold. Then after the ten years, if the heirs decide to sell it or divide it they can do so. I also order and desire that one hundred thousand (100,000.00) dollars, of cash or values, must be kept for working capital, to run or manage said Farm or ranch, the one hundred thousand (100,000.00) dollars to be invested or as much as is necessary, to pay for the live stock, feed and tools, on said ranch if the one hundred thousand (100,000.00) dollars is not all needed for the live stock, feed and tools to run said ranch then the surplus to be loaned at not less than four per cent in such a way, if more capital is needed*3262 the surplus can be drawn upon immediately, but the one hundred thousand (100,000.00) dollars must be only used for capital to run said ranch. In January following the preceding year a dividend shall be declared from the profits of the preceding year, and divided equally between the heirs whether there is three heirs more or less. Said Orville N. Townsend is to manage or superintend ranch in and about the same manner I have done and he is to be allowed for his services his expenses, and not less than one thousand (1000.00) dollars per year salary, and he shall be allowed all legal fees allowed by the Probate Court for settling up estates.
The will of Thomas B. Townsend was duly admitted to probate in the proper court in Ohio and in January, 1918. The final account of the executor, O. N. Townsend, was approved by that court and he was discharged.
On June 16, 1919, O. N. Townsend, individually and as trustee under the said will, Harriet R. Burton, and Mary T. Brown, executed an oil lease to 880 acres of land in Marion County, Kansas, the lessee being Robert Watchorn. This lease provided for the payment to the lessors of a royalty of one-eighth of the oil produced. On the same*3263 date these several parties executed a formal written agreement in respect to the lease and the land referred to of which the following portions are pertinent to the issues herein presented:
THIS AGREEMENT made and entered into in triplicate the Sixteenth day of June, 1919, by and between O. N. TOWNSEND, as Trustee, under the last will and testament of Thomas B. Townsend, Deceased, and HARRIET R. BURTON, MARY T. BROWN, and O. N. TOWNSEND, and RUFUS C. BURTON, LOUIS K. BROWN and MARY TOWNSEND, husband and wife respectively of the last hereinbefore named three persons, all of Zanesville, Ohio, hereinafter called the first parties, and ROBERT WATCHORN, of Los Angeles, California, hereinafter called the second party:
WITNESSETH:
(1) That the first parties, for and in consideration of the sum or sums of money named in paragraph (2) hereof, and the further covenants and agreements hereinafter set forth, have made, executed and delivered to the second party a lease for the production of oil and gas upon the following described property and premises, to-wit:
The South Half (S 1/2) of Section Five (5), Township twenty-two (22) South, Range Four (4), East; The Northeast Quarter (N.E. *3264 1/4) of Section five (5), Township twenty-two (22) South, Range Four (4) East; the West Half (W 1/2) of Section six (6), Township twenty-two (22) South, Range four (4), East; and the West Half (W 1/2) of the *389 Northeast Quarter (N.E. 1/4) of Section six (6) Township twenty-two (22) South, range four (4) East; all in the County of Marion, State of Kansas, and containing eight hundred and eighty acres (880) more or less.
a copy of said lease is attached hereto and is made a part hereof, and is marked "Exhibit A" for identification.
(2) In consideration for said lease, the second party agrees to pay to the first parties the sum of six hundred thousand dollars ($600,000.00) payable in the manner as follows:
(a) There shall be paid to the first parties fifty per cent of the proceeds realized from all sales of oil and gas produced from the seven-eighths working interest under the lease aforesaid on the premises above described, the remaining one-eighth being the royalty interest to be delivered to first parties under the terms of said lease.
(b) There shall be paid to the first parties one-eighth of the proceeds realized from all sales of oil and gas produced by the*3265 second party from the following described premises, to-wit:
The West Half (W 1/2) of Section nine (9), Township twenty-two (22) South, Range four (4) East, Marion County, Kansas, containing 320 acres, more or less; The East Half (E 1/2) of Section seven (7) Township twenty-two (22) South, Range four (4) East, and the South Half (S 1/2) of the Northwest Quarter (N.W. 1/4) of Section seven (7), Township twenty-two (22) South, Range four (4) East, Marion County, Kansas, containing 400 acres, more or less.
Said second party owns the oil and gas mining leases in their entirety on said premises.
(c) There shall be paid to the first parties one-sixteenth (1/16) of the proceeds realized from all sales of oil and gas produced by the second party from the following described premises, to-wit:
The Southwest Quarter (S.W. 1/4) of section four (4) Township twenty-two (22) South, Range four (4) East, and South half (S 1/2) of the Northwest Quarter (N.W. 1/4) of section four (4), Township twenty-two (22) South, Range four (4), East, and the West Half (W 1/2) of the Northwest Quarter (N.W. 1/4) of section sixteen (16) Township twenty-two (22) South, Range four (4), East, Marion County, Kansas, *3266 containing altogether three hundred and twenty (320) acres, more or less.
Party of the second part owns an undivided one-half interest in and to said last above described premises, and this provision of one-sixteenth shall apply also to the well already drilled and completed on part of same, namely, in section four (4) above described.
This contract shall be construed as an assignment and transfer to the first parties of the respective interests in the production from said properties as above set forth.
(3) All of the oil produced from the property and premises above described shall be delivered to pipe lines selected by the second party hereto, and the pipe line companies purchasing said oil and gas shall remit and deposit the payments above provided for to the first parties as hereinafter provided.
(4) One of the three copies of this agreement, duly executed, together with the lease hereinabove referred to, shall be deposited with the Old Citizens National Bank, of Zanesville, Ohio, and all payments to first parties provided for herein shall be made to said bank for the benefit of first parties.
* * *
(6) *390 In addition to the payment of said six hundred*3267 thousand dollars ($600,000.00), in the manner herein provided, there shall be also paid to the first parties, in the same manner, such sum as may be necessary to pay all Federal Government Income Tax upon the sums payable to the first parties chargeable for each year to the first parties as their sole income until said sum, plus accrued interest thereon, is fully paid. Second party shall not be responsible for income tax that may be charged to the first parties upon any royalties which may be received by them, or any of them, under the terms of the said lease.
(7) Second party agrees that, out of the proceeds realized from the production of oil and gas as provided in Clause (2) hereof, the proceeds shall be remitted to and deposited in the said Old Citizens National Bank of Zanesville, Ohio, until the sum paid shall amount to six hundred thousand dollars ($600,000.00), together with interest at the rate of six per cent (6%) per annum from this date, said interest to be calculated on a basis of partial payments and income tax as provided for in paragraph (6) hereof. As soon as full payment shall have been made, said Bank is hereby authorized to deliver said lease to second party, *3268 or to his order, and is hereby made the joint agent of the parties hereto for that purpose. Second party shall not be obligated to pay any of the sums herein provided for, except out of production of oil and gas as stated in this agreement. Second party, however, shall have the right and option at any time during the term of this contract, to pay any or all of said six hundred thousand dollars ($600,000.00) or any balance remaining unpaid, together with interest calculated on a basis of partial payments from this date, at the rate of six per cent (6%) per annum, and income tax as herein mentioned, and upon the full payment of tender of such payment to said Bank, the Bank is hereby directed to deliver said lease to the second party, it being intended, however, that full payment shall be made hereunder on or before June 16, 1924.
At the hearing the parties, through counsel, filed the following stipulation of fact:
It is hereby stipulated and agreed by and between petitioners and respondent above named and their respective counsel:
1. That the $600,000.00 received during the years 1919 to 1922, inclusive, under that certain agreement duly executed and dated June 16, 1919, by*3269 and between O. N. Townsend as trustee, under the last will and testament of Thomas B. Townsend, deceased, and Harriet T. Burton, Mary T. Brown and O. N. Townsend and Rufus C. Burton, Louis K. Brown and Mary Townsend, all of Zanesville, Ohio, as the first party and Robert Watchorn as the second party, heretofore duly admitted in evidence and designated as petitioner's Exhibit 1 constitutes a depletable bonus and as such is subject to depletion in accordance with the provisions of section 214 of the Revenue Act of 1926 and T.D. 3938. Accordingly, petitioners are entitled to deduct in the computation of their net income, a certain amount representing depletion on bonus received during the years 1919 to 1922, inclusive. The calculation of the exact amount of depletion shall be made by the respective parties and duly fixed with the Board; thereafter, on notice the determination of the amount of depletion shall be fixed by the Board.
2. That the amounts to be reported as income by the petitioners representing reimbursements of theoretical income tax under Exhibit 1 is $60,000.00 for the year 1922, being the actual amount received under said Exhibit 1, and that any further*3270 amounts as might be determined payable under this agreement will be reported as income by petitioners as and when paid.
*391 3. That one, T. B. Townsend, died testate in the State of Ohio on the 24th day of November, 1916; whose last will and testament being Petitioner's Exhibit 2 was duly admitted to probate in the proper court in the State of Ohio and in the month of January, 1918, the administration of said estate having been completed for final account and duly approved by the Court, the executor thereof, was discharged; that prior to the death of the said T. B. Townsend he duly signed as an accommodation endorser certain promissory notes made by one F. N. Townsend; that said notes were binding obligations upon the said T. B. Townsend at the time of his death and were binding obligations on his estate; that subsequent to the death of T. B. Townsend, the holder of the said notes demanded payment thereof from the executor of the estate of T. B. Townsend who died on December 1, 1916, duly discharge said notes by paying the sum of $9,166.28; that the said notes were secured by a second mortgage on certain real estate in the State of Ohio; that the said executor of the estate*3271 of T. B. Townsend became the owner of said notes upon the payment thereof; that during the year 1919 the property of F. M. Townsend, covered by said mortgage securing said notes, was sold at foreclosure sale with the result that it did not bring a sufficient amount to pay off the first mortgage against the property, thereby leaving the said notes wholly unsatisfied; that the mortgaged real estate above referred to constituted the sole asset of the estate of the said F. M. Townsend, which estate was closed during the year 1919, no payment having been made by the said estate or any other person on said notes; that in determining the Federal estate tax on the estate of T. B. Townsend no deduction was allowed for the said notes or any part thereof.
O. N. Townsend, Mary T. Brown and Harriet R. Burton, Schedule showing payments received on Bonus of $600,000.00, during the years 1919 to 1922, also payments on interest and income tax:
| Year | Bonus | Interest 1 | Income tax |
| 1919 | $26,261.99 | $19,228.34 | |
| 1920 | 327,914.32 | 27,239.21 | |
| 1921 | 233,781.48 | 8,329.42 | |
| 1922 | 12,042.21 | 4,123.58 | $60,000.00 |
| Total | 600,000.00 | 58,920.55 | 60,000.00 |
*3272 The above amounts were distributed in equal parts to the three beneficiaries, named in the will, during the respective periods.
At the hearing it was agreed by counsel for respondent that the last assignment of error - (d), charging a formal error in computing distributive shares of income of O. N. Townsend, Harriet R. Burton, and Mary T. Brown for 1922, from property owned as tenants in common, was well taken and the distributive share of each should be $12,236.63 instead of $24,561.17.
OPINION.
TRUSSELL: Of the four errors assigned by petitioners, two of them, "b" and "d," are definitely disposed of by stipulation both as to principle and amount. As to issue "a," it was agreed that the bonus *392 in question was subject to depletion in accordance with section 214 of the Revenue Act of 1926, Treasury Decision 3938, and that a calculation by each party of the exact amount would be filed later for purposes of a final order under Rule 50.
This leaves for consideration the one issue, "c," which involves the allowability of deductions from gross income for 1919 of each of the three petitioners, O. N. Townsend, Harriet R. Burton, and Mary T. Brown of one-third of the*3273 amount represented by certain uncollectible notes.
The facts in respect to these notes as shown by the record are that Thomas B. Townsend, the father of these three petitioners, at some time prior to his death, signed certain notes as accommodation endorser. Thomas B. Townsend died November 24, 1916. Six days later, on demand of the holders of the notes, they having not been paid, O. N. Townsend, as executor of his father's estate, paid them in the sum of $9,166.28, and the estate thereupon became their owner, and following this the notes were considered as part of the corpus of the estate and in determining the gross estate for Federal tax purposes no deduction was claimed on account of the payment made.
These notes were secured by a second mortgage on certain real estate belonging to the maker. In January, 1918, the administration of the estate of Thomas B. Townsend, was concluded and the executor discharged. The maker of the notes died and the administration of his estate, the sole asset of which was the real estate mentioned, was concluded in 1919, this property being sold in that year at foreclosure under the first mortgage for an amount insufficient to satisfy that*3274 mortgage.
Each of these three petitioners claimed deductions from his gross income for 1919 of one-third of the amount of the notes, $9,166.28, plus accrued interest of $1,521.66, on the ground that the notes were losses for that year, as they then became worthless. Respondent takes the position that the notes represented a contingent liability of the estate upon the death of Thomas B. Townsend and that payment of this liability by the executor constituted a loss at that time and in that amount to the corpus of the estate. It is argued by him that if the liability had ripened into a fixed debt the payment of it was merely a discharge of the debt and decreased the estate to that extent.
With this view we can not agree. Upon payment of the contingent liability the executor of the estate was subrogated to all the rights of the holder of the notes. That this was the legal effect of such action is admitted by respondent.
However, the question before us is what loss, if any, has been suffered by petitioners as distributees of the estate by reason of the happening of certain events in 1919 whereby any value which the *393 notes may have had before that time was destroyed. *3275 The answer to this can only be made upon proof of the value of the notes in January, 1918, when received by them from the executor, as such value is the basis upon which loss or gain to them must be determined. See F. W. Matthiessen, Jr.,2 B.T.A. 921">2 B.T.A. 921, and F. W. Matthiessen, Jr., v. United States,65 Ct.Cls. 484. Nor can deduction be allowed for this item under section 214(a)(7) of the Revenue Act of 1918 as a "debt ascertained to be worthless and charged off within the taxable year" over and above the value of the notes at the time distributed to petitioners. Charles F. Ayer,7 B.T.A. 324">7 B.T.A. 324; affd., Ayer v. Blair, 26 Fed.(2d) 547. There is no evidence before us of the value of these notes at the time distributed to petitioners. Respondent's action in disallowing the deduction must be approved.
The deficiencies will be redetermined in accord with the facts as stipulated by counsel on the hearing and with the foregoing opinion.
Reviewed by the Board.
Judgment will be entered under Rule 50.
Footnotes
1. This interest was not actually paid until the year 1922 after the bonus of $600,000 had been fully paid. ↩