*2940 1. Held, under the evidence, that the debts of the petitioners were not ascertained to be worthless in part in 1921.
2. Held, further, that one of the petitioner's debts due by an individual whose securities were held as collateral was not ascertained to be worthless because the securities during the taxable year fluctuated in value.
*1405 These proceedings, which were consolidated for the purpose of hearing and decision, involve deficiencies in income tax for the calendar year 1921 - in the case of Frank D. Stranahan, Docket No. 13027, in the amount of $61,744.19; and in the case of Robert A. Stranahan, Docket No. 13028, in the amount of $6,068.91.
In the case of Frank D. Stranahan the errors assigned are: (a) disallowance of a deduction for a bad debt in the amount of $98,604.84, (b) disallowance of Jeffery-DeWitt Insulator Co. loss of $15,000.
In the case of Robert A. Stranahan the error assigned is the disallowance of a loss sustained during the taxable year in the amount of $15,000. The $15,000*2941 loss in the Robert A. Stranahan proceeding is the same transaction and the same loss, if any, which is involved in the Frank D. Stranahan proceeding.
FINDINGS OF FACT.
Frank D. Stranahan, petitioner, was in 1920 and 1921 the treasurer of the Champion Spark Plug Co. During the year 1920 Clarence A. Earl, then vice president and general manager of the Willys-Overland Co., approached Stranahan and stated that he had purchased *1406 some stock of the Owens Bottle Co. and the Standard Oil Co. of New Jersey; that the brokers were requesting additional margin. He then requested a temporary loan of securities to meet the requirements of the brokers. Earl represented to Stranahan that the loan would be temporary and that as he had funds coming in from other sources the identical securities loaned would be returned in a short time.
The petitioner, after consultation with his attorney, loaned the securities to Earl for the purpose of depositing with the brokers as additional margin security. Petitioner arranged with the brokers, however, to have the account placed in his name in order that the securities might be segregated so that the particular securities deposited by him*2942 would not become confused or become liable for any other stock transactions carried on by Earl. The petitioner at that time and thereafter furnished securities consisting of $100,000 par value Liberty Loan bonds and $25,000 of Anaconda Copper Co. 6% notes. After petitioner had loaned his securities to Earl, the market price of the stocks purchased by Earl and for which the petitioner's securities were to be used as collateral continued to fall and the brokers insisted upon additional margin. Earl had had other transactions with the same brokers and the brokers claimed that the petitioner's collateral would be held to cover all of Earl's accounts instead of this particular account. They finally agreed, however, that the securities deposited by the petitioner were to be held as security only as originally intended and not to apply to Earl's account generally.
About October 1, 1921, the amount due Meeker & Co. as brokers on Earl's account was $141,547.50. The brokers insisted upon additional margin and threatened to close out the account and apply the petitioner's securities to make up the deficit if additional margin were not deposited. Shortly after October 1, 1921, the Owens*2943 Bottle Co. stock was sold on open market and was purchased by the petitioner at prevailing market prices. The selling price was not sufficient to satisfy the account and the brokers attempted to apply the securities of the petitioner to satisfy the difference. The petitioner, being desirous of securing back his identical securities, paid the brokers the sum of $95,743.39 in order to secure them. The petitioner was required to obtain a loan to finance the purchase of the stock on the open market. In addition to the amount of $95,743.39 paid in cash to the brokers, the petitioner's interest coupons were applied in the amount of $4,250, making his total outlay $99,993.39. Interest was paid by the petitioner on the transactions amounting to $1,232.05. However, during the year the petitioner received $2,621 in dividends, making his net outlay $98,604.84, which amount he deducted in his 1921 income-tax return as a bad debt.
*1407 The petitioner and Earl entered into a written contract dated October 22, 1921, the material part of which for the purpose of this proceeding is as follows:
AGREEMENT made this 22nd day of October, 1921, by and between CLARENCE A. EARL, of Jackson, *2944 Michigan, as Party of the First Part, and FRANK D. STRANAHAN, of Toledo, Ohio, as Party of the Second Part:
About April 27, 1920, Earl was carrying a considerable amount of Owens Bottle Company common stock and Standard Oil Company of New Jersey with Pynchon & Company, Brokers, Toledo, and finding the market declining to a point where he could not keep good his margins, he arranged to borrow collateral from Stranahan, who insisted, however, that if he loaned collateral, the acount, with a definite amount of Owens and Standard Oil stock should be transferred into his name so his security would stand alone and not be confused with or become liable for any other transaction with Earl.
According to this arrangement, the account was transferred into the name of Stranahan on the books of Pynchon & Company, who later sold out to Meeker & Company, and Stranahan put up $100,000 of Liberty Bonds and $25,000 of Anaconda six per cent notes as collateral.
Sales were made so that now there are carried in the account 5242 1/2 shares of Owens Bottle common.
The interest and charges against this account were to have been paid by Earl, but Meeker & Company appropriated and used interest coupons*2945 belonging to Stranahan, amounting to $4,250.00.
The market price of Owens Bottle common has now declined to $27.00 a share, so that the 5242 1/2 shares will only realize $141,547.50.
On September 20, 1921, there was due Meeker & Company on this account the sum of $237,290.89, so that the loss on the Owens stock amounts to $95,743.39.
| Amount due Meeker & Company, September 30 | $237,290.89 |
| Value of Owens Bottle stock, at $27.00 | 141,547.50 |
| 95,743.39 | |
| Interest coupons used | 4,250.00 |
| 99,993.39 |
(Note: To the foregoing must be added the interest and charges subsequent to October 1, 1920, less any dividends received on the Owens stock up to date of closing.)
From the foregoing it appears that in order to secure the return of his collateral, Stranahan must pay the Meeker account, and that by so doing he will get 5242 1/2 shares of Owens stock which at today's market will be worth only $141,547.50 or $95,743.39, less than the amount due Meeker & Company, and thereby Stranahan will lose that amount plus the value of interest coupons heretofore appropriated ($4,250.00), and his total loss will be $99,993.39, and such loss will be suffered if the Owens stock is*2946 sold on the market or if Stranahan buys it in order to secure the return of his collateral.
Meeker & Company have demanded payment of the account, and have give notice that if payment is not made they will sell the stock and collateral and hold Stranahan for any deficiency, and to protect himself against further loss it is necessary for Stranahan to either sell the Owens stock on the market or pay the Meeker account and take over the stock, his loss in either case being the amount above stated.
*1408 To prevent such sale Stranahan has deposited with Meeker & Company $10,000 additional security in the form of State of Louisiana Bonds.
Earl admits his obligation to make good said loss to Stranahan with interest, and he desires Stranahan to buy said Owens stock at the market and carry the same in the hope that he, Earl, may benefit by a rise in the price, and to induce Stranahan so to do, Earl has agreed to pay any and all interest and carrying charges incurred in carrying said stock, paying $300 a month on account of such interest and charges and paying any amount in excess of $300 a month on Stranahan's demand.
By so doing, Earl will keep his indebtedness to Stranahan*2947 from increasing by the accumulation of interest, and in consideration thereof he is to have an option to buy the Owens stock at any time, in part or as a whole, at $45.57 a share, subject, however, to prior sale.
A statement of the account of F. D. Stranahan with Meeker & Company is annexed.
In consideration of the premises and of the execution of this agreement, it is agreed:
1. Stranahan shall buy the 5242 1/2 shares of Owens stock from Meeker & Company for $141,547.50, plus any accrued interest, and shall have said stock transferred into his own name or into the name of some nominee.
2. Stranahan's loss on account of this transaction will be figured as follows:
| Amount paid Meeker & Company | $237,290.89 |
| 5242 1/2 shares of Owens stock at $27 | 141,547.50 |
| Difference will be loss | 95,743.39 |
| Add loss on account of interest coupons | 4,250.00 |
| Total loss | 99,993.39 |
3. Earl agrees to pay said loss to Stranahan on or before one year after date, together with interest at the rate or rates Stranahan is obliged to pay, or if Stranahan does not pay out any interest, then at current rates.
In consideration of the possible benefits of this contract, Earl further*2948 agrees to make good and pay to Stranahan any further loss he may be put to if the market price of Owens stock shall fall below the price at which it is bought by Stranahan from Meeker if the stock or any of it shall be sold at such lower price during the next year.
4. It is expected that the dividends will be paid on the Owens stock, which will reduce the carrying charges, and so long as Earl pays Stranahan's net accrued carrying charges monthly so that Stranahan is not obliged to pay out any money for interest, Earl shall have credit on his obligation to pay interest and charges to the extent of any dividends received on the Owens stock, but when Earl ceases to pay interest and charges in full each month, he shall not be entitled to such credit, and further, in such case, Stranahan may at his option declare the indebtedness from Earl to be immediately due and payable.
5. So long as he pays interest and charges monthly, Earl shall have the right to purchase any part or all said Owens stock at $45.57 a share, said option, however, to be subject to prior sale as Stranahan reserves the right to sell said stock when and as he deems best.
If, when said stock or any part thereof*2949 shall be sold, Earl shall have kept up his monthly payments, he shall have credit on his indebtedness to Stranahan to the extent of the difference between the price for the Owens stock by Stranahan and the price at which it is sold, but only to the extent of the shares sold.
*1409 6. Earl's rights under this agreement shall terminate at the option of Stranahan if he shall fail to keep up monthly payments, and in any event as to unsold stock at the end of one year from this date.
7. Earl will on demand execute a promissory note or notes to evidence his indebtedness to Stranahan as ascertained pursuant to paragraph two hereof.
Before the close of 1921 Earl became insolvent to such an extent that the indebtedness due to the petitioner was worthless.
During 1921 both petitioners, Frank D. Stranahan and Robert A. Stranahan, held notes of the Jeffery-DeWitt Insulator Co. each in the amount of $20,000.
On November 2, 1921, the Jeffery-DeWitt Insulator Co. was adjudicated a bankrupt. The total amount of liabilities shown by the schedule filed by the bankrupt was $895,909.39. The value of assets listed was $802,057.66. Assessors were appointed by the court and they*2950 appraised the assets at $302,518.50.
Prior to the adjudication in bankruptcy of the Jeffery-DeWitt Insulator Co. numerous creditors, under the direction of Robert A. Stranahan, had combined and formulated a plan whereby a new company was to be organized to acquire the assets at the bankruptcy sale and continue the business. All of the creditors joining in the plan had consented to accept preferred stock in such new company to be organized. These plans were all worked out prior to the adjudication in bankruptcy in 1921. It was agreed that the purchasers' committee would acquire the assets at the bankruptcy sale at such price as they might determine. Creditors who did not participate in this plan received cash in payment of their claims. Creditors whose claims were $100 or less received the full face amount of their claims while those with claims ranging from $100 to $400 received 25 per cent of the face value of their claims in cash. After the sale of the assets which the creditors' committee bought in at $150,000, the new company was organized on January 10, 1922, and shortly thereafter stock was issued to the participating creditors, including the petitioners herein, to the*2951 extent of the face amount of their claims. There were issued 69,872 shares of a par value of $10 each. This exceeded the value of the assets acquired. No stock was acquired by any one except creditors who received it in exchange of their claims and no stock was sold by any of the stockholders until after the company had operated for approximately a year. The first stock sale occurred on June 12, 1923, and the price paid was $3.50 per share, and the second sale was made on November 30, 1923, the price paid being $5 per share. The new company began to make profits and has consistently made profits.
Robert A. Stranahan, one of the petitioners, was elected president of the new corporation and has been in active charge and management *1410 thereof. He loaned the new company $120,000 soon after its organization in order to improve and modernize its plant, and the Champion Spark Plug Co., of which he was also president, also invested $50,000 or more in the new corporation. The Champion Spark Plug Co. was one of the creditors receiving stock in exchange for its indebtedness. The company's product was sold largely to the Champion Switch Co., a corporation organized and chiefly*2952 owned by Frank D. Stranahan and Robert A. Stranahan. The switch made by the latter company was used in connection with the insulator made by the Jeffery-DeWitt Insulator Co. Since the formation of the new company the earnings have been continuously put back in the business in the form of capital investments. In 1922, the first year of the new company, it reported net earnings of $60,494.94, equivalent to something in excess of 9 per cent of its outstanding capital stock. In 1927 a 6 per cent dividend was declared.
Robert A. Stranahan, in his original return for 1921, made the following notation with respect to the deduction which he claimed to the extent of $15,000 on account of this transaction:
This company is in bankruptcy and circumstances indicate that forced sale would not realize fifteen per cent for creditors; preferred stock of new company received for this claim and taxpayer feels justified in carrying this at a valuation of five thousand dollars until value of preferred stock has been established by sale or realization.
Robert A. Stranahan claimed a deduction in his original return of $15,000 on account of this transaction, which was 75 per cent of the amount*2953 of the indebtedness. Frank D. Stranahan did not claim a deduction in his return with respect to this indebtedness. He was, however, aware of all the facts. His failure to do so was an oversight. He did not keep any books of account.
OPINION.
TRAMMELL: In the case of Frank D. Stranahan two errors are assigned. First, the action of the Commissioner in disallowing as a deduction claimed for a bad debt in the amount of $98,604.84, arising out of the transactions that the petitioner had with one Earl. Second, the disallowance by the Commissioner of a deduction claimed for a loss in the amount of $15,000 with respect to the Jeffery-DeWitt indebtedness. The latter issue is also involved in the Robert A. Stranahan case.
In the Robert A. Stranahan petition the deduction with respect to the Jeffery-DeWitt transaction is claimed upon the theory that a deduction should be allowed as a loss sustained during the taxable year, not compensated for by insurance or otherwise. In the Frank *1411 D. Stranahan case the deduction is claimed apparently under the theory of a loss sustained during the year.
Since the Jeffery-DeWitt transaction is common to both cases, that assignment*2954 of error will be considered and disposed of first.
While in the Robert A. Stranahan case the petitioner relied upon section 214(a)(4), that is, the loss provision of the statute, instead of 214(a)(7), the bad-debt provision, in his brief the petitioner relied upon section 214(a)(7) and made no reference to section 214(a)(4), and in the Frank D. Stranahan case the petitioner does not state upon what provision of the statute he relies in support of his claim for the deduction with respect to the Jeffery-DeWitt transaction. From all the facts, however, it seems clear that if the deduction is allowable at all, it must be by virtue of section 214(a)(7) of the Revenue Act of 1921, that is, the bad-debt provision. The Jeffery-DeWitt Co. was indebted to each of the petitioners in the sum of $20,000, which was represented by promissory notes, which debts are claimed to have become worthless in part during the taxable year involved. In order for the petitioners to be entitled to a deduction under 214(a)(7), it is necessary to show that the debts were not only ascertained to be worthless, but were charged off.
If they were not ascertained to be worthless in part, the deduction is not*2955 allowable, and it would not require a discussion as to whether they were charged off within the meaning of the statute.
The first question, then, is whether the debts due by the Jeffery-DeWitt Co. were ascertained by the petitioners to have become worthless in part during the taxable year.
During 1921 each of the petitioners had a debt against the Jeffery-DeWitt Co. in the amount of $20,000, represented by promissory notes. The Jeffery-DeWitt Co. was in serious financial difficulties and was unable to pay its creditors except those having smaller claims. It agreed with its creditors during that year to pay those having debts to the amount of $100 or less in full, and to those having debts up to $400, 25 cents on the dollar in cash. Those having claims in excess of $400 agreed that a new company would be organized to take over the assets and business of the old company and to take preferred stock of the par value of the amount of the debts. These creditors, including the petitioners, organized a creditors' committee and acted through that committee. It was agreed that the Jeffery-DeWitt Co. should go into bankruptcy and that the assets should be sold and that they should*2956 be bid in by the creditors' committee. This was done and a new corporation was organized in the early part of 1922 to take over the assets and business of the old Jeffery-DeWitt Co. Robert A. Stranahan agreed to advance money and advanced $120,000, and the Champion Spark Plug Co. agreed to advance as much as $50,000 in *1412 addition to its claim against the company. Robert A. Stranahan was to be in active control of the new company. While the reorganization plan was agreed to in 1921, it was not actually consummated, and the reorganization of the new Jeffery-DeWitt Insulator Co. was not begun until February, 1922. After the arrangement had been made with creditors, the creditors agreed upon the bankruptcy proceedings by sale and purchase, that is to say, "a nominal sale and a nominal purchase satisfying the requirements of law."
The Jeffery-DeWitt Co. manufactured high tension insulators, a considerable portion of the product being sold to the Champion Switch Co., a company which was organized and operated by the Stranahans. In fact, the Champion Switch Co. was organized for the purpose of promoting the sale of the Jeffery-DeWitt insulators. The Jeffery-DeWitt Co. *2957 manufactured a superior product, and in the first year of its reorganization, viz, 1922, earned substantial profits, amounting to in excess of $60,000. These profits continued to increase from year to year. In one year dividends were declared. For the other years the profits were permitted to accumulate and were retained in the business in the way of substantial improvements.
Robert A. Stranahan estimated that the preferred stock of the new Jeffery-DeWitt Insulator Co. had no ascertainable value when they received it, but that its value was not in excess of 25 per cent of the par value thereof and upon this estimate deducted, in 1921, 75 per cent of the amount of the debts as having been ascertained to be uncollectible and worthless. Frank D. Stranshan was aware of all the facts, but omitted through oversight to take a similar deduction in his return.
The evidence in the case is not sufficient to convince us that the debts owing by Jeffery-DeWitt Insulator Co. were ascertained to be worthless in part in 1921. It is true that in that year the company was declared a bankrupt and its assets sold to the creditors' commitee, but prior to the bankruptcy proceedings and the sale*2958 of the assets under such proceedings, the creditors' committee had decided upon the entire plan of reorganization. It was known that the new company would be immediately organized and that creditors would receive preferred stock for their claims. It was known that Stranahan han who was president of the Champion Spark Plug Co., one of the organizers and directing officers of the Champion Switch Co. and other enterprises, would be in active charge and management of the reorganized company. He had already agreed to advance large sums of money, and it was known that the Champion Spark Plug Co. would advance considerable money. The market for the product of the reorganized company was already known and established and it was known before the close of 1921 that immediately thereafter *1413 the petitioners would receive preferred stock to the extent of the par value of their claim in this new company.
From all the evidence in the case we are of the opinion that there is not a preponderance of the evidence to the effect that the claims were ascertained to be worthless in part in 1921. The new stock to be received in the future had no ascertained or readily realizable market*2959 value in 1921. Nothing occurred in 1921, in view of all the facts and circumstances of the case, by which to determine the extent to which the indebtedness was uncollectible, if it was uncollectible to any extent.
The action of the respondent, therefore, in disallowing the deduction claimed with respect to the debt of the Jeffery-DeWitt Insulator Co. is approved.
With respect to the Frank D. Stranahan claim for a bad debt deduction on account of the Clarence Earl transaction, it appears that Stranahan first advanced collateral in order to protect Earl's account with his brokers, then later purchased from the brokers the stock which the securities had been deposited to cover on margin, leaving Earl indebted to Stranahan as the result of the transaction in the amount set out in our findings of fact. The contract between the petitioner and Earl is set out in our findings of fact. This contract indicates that Earl retained an equity of redemption in the stock which the petitioner purchased. In other words, the petitioner, in fact, held the stock which he acquired as security for Earl's indebtedness. It is true, the market value of the security during the taxable year involved*2960 did not equal the amount paid therefor together with the additional amounts paid by Stranahan to satisfy Earl's indebtedness. This security, however, had a fluctuating value and increased and decreased from time to time in market value and it was not ascertained during the taxable year whether the securities held by petitioner would not increase in value before the expiration of the contract between the parties. The contract was dated October 22, 1921, and ran for at least a period of 12 months, provided Earl kept up the interest payments. The agreement provided that Earl admitted his obligation to make good the loss to Stranahan, with interest, and he desired that Stranahan buy the stock and carry the same in the hope that he, Earl, might benefit by a rise in price. These facts lead us to the conclusion that Stranahan did not become the beneficial owner of the securities acquired by him, but that he held them subject to Earl's equity of redemption and that he acquired them as security.
Under the facts of this case, the difference between the amount of the debt and the market value of the securities at the end of the taxable year involved does not justify a deduction on account*2961 of a debt ascertained to be worthless in part under the 1921 Revenue Act. *1414 The petitioner did not dispose of the securities in order to ascertain or realize a definite loss. Before the expiration of the contract it may well be that the petitioner might have disposed of the securities at an amount sufficient to pay the entire indebtedness owing by Earl.
It is our opinion, from the evidence, that Earl was insolvent before the end of the taxable year and that the only means the petitioner had of collecting his indebtedness from him was the securities which he had, but in our opinion the evidence is not sufficient to warrant us in finding that the action of the respondent was erroneous in disallowing the deduction claimed.
Judgment will be entered under Rule 50.