*1940 Deductibility of bad debts determined.
*7 These proceedings, which have been duly consolidated, are for the redetermination of deficiencies of $2,549.36, $4,723.99, and $4,112.47 in the petitioner's income taxes for the calendar years 1924, 1925, and 1926, respectively. The only issue is the deductibility of the amount of a partial charge-off of a debt, alleged to have been worthless to that extent, in each of the years in controversy.
FINDINGS OF FACT.
The petitioner is a national bank engaged in the general banking business at Huntingdon, Pa.
On January 1, 1923, the Huntingdon & Broad Top Mountain Railroad & Coal Company, hereinafter referred to as the Railroad, owed the petitioner $106,000, evidenced by two notes for $20,000 each, dated October 13, 1921, and September 28, 1922, and an overdraft of $66,000 in its checking account, for which the Railroad gave its demand note. The overdraft arose from the deposit on December 23, 1922, of two checks totaling $66,000 drawn by the Railroad on the Pennsylvania Company of Philadelphia. The Railroad*1941 immediately checked out the proceeds and on December 26, 1922, the two checks for $66,000 were protested and returned unpaid to the petitioner. The Railroad had been a depositor of substantial amounts with the bank for over 40 years and the petitioner had no reason to suspect that the checks would be protested.
During the years 1923 to 1926 the Railroad had an unfunded debt of $993,628.86, which included the $106,000 due the petitioner. In November, 1924, the Railroad petitioned the Interstate Commerce Commission for authority to issue demand notes in the amount of $993,628.86 to take the place of notes previously executed in 1920, 1921, and 1922 in payment for additions and betterments and for money advanced during those years; the notes then outstanding had been issued without the authority of the Interstate Commerce Commission, as required by law. The Railroad also desired to consolidate this unfunded debt with its bonded debt of $2,280,500 when the latter became due in the early part of 1925. On December 5, 1924, the Interstate Commerce Commission authorized the issuance of the *8 new demand notes bearing interest at 6 per cent and, as of January 1, 1925, the petitioner*1942 and other unsecured creditors received the new demand notes.
On January 29, 1925, the Interstate Commerce Commission authorized the Railroad to extend its three issues of mortgage bonds, maturing in February, March, and April, 1925, to 1940. These bonds were originally dated in 1854, 1857, and 1865, respectively, and the maturity date of each issue had been extended on two prior occasions. The outstanding bonds were as follows:
| First mortgage | $416,000 |
| Second mortgage | 367,500 |
| Third Mortgage | 1,497,000 |
| Total | 2,280,500 |
Under the terms of the mortgages the property and all the profits of the Railroad were hypothecated to the trustees for the bondholders and had been so hypothecated throughout the years 1923 to 1926, inclusive.
On March 13, 1926, a minority group of bondholders, having refused to agree to extend the maturity of their bonds, filed a petition in the Court of Common Pleas in the County of Huntingdon, Pa., requesting the appointment of receivers for the Railroad. The majority of the bondholders, the trustee for the holders of common and preferred stock, and the unsecured creditors, including the petitioner, petitioned the court to dismiss the*1943 temporary receivers as being detrimental to their best interests in that those best qualified to run the Railroad were its officers. On final hearing the court dismissed the bill for the receivership because the majority of the bondholders had not so requested, as provided by the trust instruments, and this action was sustained on appeal by the Supreme Court of Pennsylvania in January, 1929. In consideration for joining in the petition to dismiss the bill for a receivership the petitioner was paid in the year 1926 the amount of $12,000 to apply on overdue interest on the notes of the Railroad totaling $106,000. No other interest and no part of the principal amount of the notes had been paid up to August, 1930.
The Railroad possessed no property of any nature or character which had not been pledged to the trustees of its three outstanding mortgages. All of its tolls, issues, incomes, and profits derived from the operation of its railroad were also hypothecated under the mortgages.
The quick assets and current liabilities of the Railroad at the end of each of the years in which the petitioner charged off the debt in question, were as follows:
| Year ended December 31 - | Quick assets | Current liabilities |
| 1923 | $454,314.09 | $1,426,566.62 |
| 1924 | 323,714.21 | 1,400,287.34 |
| 1925 | 307,783.39 | 1,419,663.66 |
| 1926 | 359,131.86 | 1,462,659.44 |
*1944 *9 The operating income of the Railroad showed a net profit of $45,020.63 for 1923, but net losses for the other years as follows:
| 1924 | $180,819.80 |
| 1925 | 96,835.88 |
| 1926 | 43,762.06 |
The Railroad's bonds (par value $1,000 each) and stock (par value $50) were quoted on the Philadelphia Stock Exchange during these years as follows:
| 1923 | 1924 | 1925 | 1926 | |
| First 4's (now extended 6's) 1940 | 90 bid | 85 bid | 80 bid | 75 |
| Second 4's (now first extended "B" 6's), | ||||
| 1940 | 70 bid | 50 bid | 75 bid | |
| Consolidated gold 5's extended to 1940 | 45 bid | 50 bid | 35 | 38 1/4 |
| 7 per cent preferred - $50 par | 14 1/2 | 10 1/2-9 | 1 | 6-1 1/2 |
| Common - $50 par | 3 bid | 5 1/8-5 | 1/2 | 3-1 |
At various times during the years 1923 to 1926, inclusive, the directors and officers of the petitioner conferred with the officials of the Railroad regarding this indebtedness. The debt was discussed at various meetings of the petitioner's board of directors and the directors authorized the charge-off of the debt during these years. In accordance with the general policy of the national bank examiners and the Comptroller of the Currency, and with their approval, the petitioner*1945 charged off the indebtedness of the Railroad in the years and amounts as follows:
| 1923 | $20,000 |
| 1924 | 20,000 |
| 1925 | 36,000 |
| 1926 | 30,000 |
| Total | 106,000 |
In its income-tax returns for these years the petitioner claimed as a bad debt deduction the amount of the charge-off in each year. After the office audit, the 1923 return was accepted as filed. A field examination was made with respect to the returns for the years 1924, 1925, and 1926 and the Commissioner disallowed the claimed deductions for these years.
OPINION.
SMITH: The statute (section 234(a)(5) of the Revenue Acts of 1924 and 1926) authorizes the deduction of debts ascertained to be *16 worthless, in whole or in part, and charged off within the taxable year. There is no question in this case as to the existence of the debt or the actual charge-off in the amounts claimed. The only issue is the ascertainment of partial worthlessness in each of the years under consideration. While "the taxing act does not require the taxpayer to be an incorrigible optimist," (*1946 ), it does require the use of sound business judgment in the ascertainment of the worthlessness of a debt, in whole or in part, and the taxpayer must "take reasonable steps to determine that there is no probability of payment or collection and have prima facie evidence to prove that the debt has no value." (.)
The petitioner submits evidence that the bank examiners directed the charge-off of the debt in question, the balance of the debt in 1926 being designated as "actually a determined loss." While we do not accept as determinative of worthlessness the reports and directions of bank examiners and the requirements of State and Federal banking departments (, and cases since), the evidence in this case supports their view of the Railroad's debt.
We would not be inclined to substitute our judgment as to the worthlessness of the debt in question for that of the petitioner's officers, who, by reason of the long business relations with the debtor, were in a position to and did determine its financial condition, *1947 its ability to pay, and the probability of collection. There was doubtless a perennial hope of collecting the debt, but in each year (1923 to 1926, inclusive) the petitioner's officers conferred with officials of the Railroad and then directed the charge-off of the debt in the amount claimed. The evidence supports their ascertainment of the progressive worthlessness of the Railroad's debt.
In only one of the four years of the charge-offs did the Railroad earn a profit, and that was in 1923, a year which is not in controversy. For the other years the Railroad operated at a loss. During all of this time the property and profits of the Railroad were hypothecated as security for its bonded indebtedness. Even though the Railroad managed to pay the interest on its bonds, it was unable to pay the interest on or reduce the amount of its unsecured debt, and the bonds were quoted at declining bid prices, as low as 35 per cent of par value, on the Philadelphia Stock Exchange. The Railroad's common and preferred stock also declined on that exchange, being quoted as low as one-half for the common and one for the preferred. During the years under consideration the Railroad's current liabilities*1948 were more than four times its quick assets.
*11 In the statement attached to the deficiency notice, the respondent based the disallowance of the claimed deductions upon the receipt by the petitioner in 1926 of $12,000 as interest on the debt and the continued operation of the Railroad. The $12,000 was paid to the petitioner in consideration for joining with the majority bondholders, trustee for the stockholders, and other unsecured creditors in the petition to dismiss the receivership. Among the facts found by the court in the receivership proceedings, , were the following:
13. Said judgment creditors refused to further extend their overdue bonds, which although previously due March 1, 1895, had been extended by agreement to March 31, 1925. Upon defendant's refusal to pay said bonds, said creditors obtained their aforesaid judgments and issued attachment executions thereon naming two of the banking depositories wherein defendant maintained cash balances. Another of said judgment creditors issued an attachment execution naming the Pennsylvania Railroad Company as garnishee, *1949 and sought thereby to attach defendant's share of certain passenger, freight and car service rates which had been paid to said railroad garnishee in consideration of continuous service over the lines of the defendant and the garnishee railroad. Another of said judgment credotors issued a fieri facias on his judgment, and under it a levy was made on defendant's office furniture and equipment at defendant's executive offices. The executions of the said judgments by fieri facias and attachment were restricted to that property of defendant corporation which was not subject to the lien of defendant's third mortgage. The restriction on the executions was affirmed by the Supreme Court of Pennsylvania, and the attachments were set aside.
14. The defendant's third mortgage pledged to the mortgagee-trustee and subjected to the lien thereof the whole of defendant's property, real and personal, its corporate rights and franchises and all the tolls, issues, incomes and profits of defendant derived from the operation of its railrod. The defendant possesses no property which is not subject to the lien of said mortgage, and said judgment creditors are unable to enforce payment or satisfaction*1950 of their judgments.
The court found as a conclusion of law that the Railroad was insolvent. In the face of the financial condition of the Railroad the court held that "the continued operation of * * * [the] railroad intact and as a going concern in required in the public interest for those communities it now serves." Thus it is apparent that it would have been futile for the petitioner to have sued the Railroad on the debt here in question.
The petitioner's ascertainment of worthlessness "must be viewed in the light of the surrounding facts and circumstances, which must be such as to cause a reasonably prudent business man to conclude that the debt is worthless to the extent so ascertained. A remote hope of ultimate salvage is not sufficient to deny a deduction." *12 . The circumstances of this case support the petitioner's claim and show that the respondent erred in disallowing the deductions in question. The deficiencies should be recomputed accordingly. ; *1951 ; ; ; ; ; and .
Judgment will be entered under Rule 50.