Clay Drilling Co. v. Commissioner

The Clay Drilling Company of Texas, Petitioner, v. Commissioner of Internal Revenue, Respondent Clay Drilling Co. v. Commissioner Docket No. 6927 United States Tax Court 6 T.C. 324; 1946 U.S. Tax Ct. LEXIS 279; March 4, 1946, Promulgated *279 Decision will be entered under Rule 50. Petitioner had certain accounts on its books for money advanced to two individuals who were its stockholders at the time the advancements were made. In 1938 these stockholders sold their stock to two other individuals and at the time of sale it was agreed by all parties, including petitioner, that the two debtors would be released from personal liability to pay the accounts and that in the future a certain percentage of commissions due to these two debtors by petitioner on oil drilling contracts tendered by them to petitioner should be applied as credits to the accounts. Thereafter the accounts remained on petitioner's books as before, and in the following year, 1939, considerable amounts were collected on the accounts in this manner. In 1941 the operating oil company of which these two debtors were the principal stockholders went into bankruptcy, and the two individuals were thereby put out of business and thereafter tendered no more drilling contracts to petitioner. Held, the debts were not canceled or forgiven by the 1938 agreement and continued to be debts within the meaning of the applicable statute and regulations, although*280 the method of their payment was restricted, and became worthless in petitioner's fiscal year ended April 30, 1942, and are deductible as bad debts. A. E. Brooks, Esq., and Brandon Stone, Esq., for the petitioner. Donald Abbey, Esq., for the respondent. Black, Judge. BLACK *325 The Commissioner has determined a deficiency of $ 4,143.16 in petitioner's income tax for the fiscal year ended April 30, 1942, and a deficiency of $ 904.62 in declared value excess profits tax for the same taxable year. These deficiencies are due to four adjustments made by the Commissioner in the net income as reported by petitioner on its return. Only one of these adjustments is contested. *281 It is adjustment (c), which is explained in the deficiency notice as follows: (c) The deductions claimed for the following bad debts are disallowed for the reason that it has not been shown that you are entitled thereto: Anthony & Rice $ 1,098.38 C. J. Simoneit 437.55 John L. Herschbach 11,563.67 E. Fred Herschbach 2,383.31 $ 15,482.91 Petitioner contests part of the foregoing adjustment by the following assignment of error: "The Commissioner erred in holding that the petitioner was not entitled to deduct bad debt losses in the amount of $ 13,946.98." FINDINGS OF FACT. The petitioner is a Texas corporation, with its business address at Fort Worth, Texas. It is engaged in the business of drilling and development of oil properties. Its return for the fiscal year ended April 30, 1942, was filed with the collector of internal revenue for the second district of Texas at Dallas, Texas. Petitioner's capital stock is $ 1,000. Its name was formerly Herschbach Drilling Co., but was changed to "The Clay Drilling Company of Texas" by charter amendment dated June 20, 1940. It will sometimes hereinafter be referred to as the corporation. On November 25, 1938, Herschbach Drilling*282 Co. owed debts amounting to approximately $ 300,000, including a debt of approximately $ 265,000 to the Continental Supply Co. on which John L. Herschbach and E. Fred Herschbach were individually liable. They will sometimes hereinafter be referred to as the Herschbachs. Prior to *326 the execution of the contract referred to in the next succeeding paragraph, John L. Herschbach was individually indebted to Herschbach Drilling Co. in the sum of $ 12,758.16, and E. Fred Herschbach was individually indebted to Herschbach Drilling Co. in the sum of $ 3,577.82. Subsequent thereto the indebtedness of each was increased in the sum of $ 302.08. On November 25, 1938, the Herschbachs entered into a written contract with R. G. Clay by the terms of which the two parties first named transferred to R. G. Clay all of the capital stock of Herschbach Drilling Co., which contract provided in part as follows: First, Herschbachs, for the considerations hereinafter recited, do hereby agree to transfer and assign all and singular the capital stock of Herschbach Drilling Company, said company being a Texas corporation, having a paid up capital stock of One Thousand ($ 1,000.00) Dollars, divided into*283 one hundred (100) shares, unto said Clay. * * * The consideration for said transfer of stock by said Herschbach to the said Clay is that the said Clay will manage and operate said Herschbach Drilling Company, or its successor in name, to the best of his ability, to the end that all liabilities of the corporation may be legally discharged. Further it is the intention and agreement that Herschbach Drilling Company, under the management of said Clay, will assume all and singular the payment of the liabilities of Herschbach Drilling Company, or its successor, save and except that amount due Continental Supply Company, over and above the sum of Two Hundred Thousand ($ 200,000.00) Dollars; that is to say, Herschbach Drilling Company and R. G. Clay, as to the Continental Supply Company indebtedness, will assume payment of the sum of Two Hundred Thousand ($ 200,000.00) Dollars Of the amount due by Herschbach Drilling Company to Continental Supply Company. * * * * As a further consideration the said Clay and the said Herschbach Drilling Company agree that as to each drilling contract which may be hereafter tendered to the said Herschbach Drilling Company by the said John L. Herschbach and/or*284 E. Fred Herschbach and/or the Illinois Oil Company and/or Anderson-Pritchard (Anderson-Pritchard being joint owners with the Illinois Oil Company on certain leases in the state of New Mexico), which tender is accepted by Herschbach Drilling Company or said Clay (it being agreed by the said Clay that he will not arbitrarily or without just reason refuse to accept such tender), the said Herschbach Drilling Company and Clay will pay in the form of commissions the sum of fifty cents (50 cents) per foot on each drilling operation; provided, however, that thirty-seven and one-half (37 1/2 cents) cents of such fifty (50 cents) cents per foot will be applied by the said Clay or by the said Herschbachs or by the Herschbach Drilling Company or by the Illinois Oil Company toward the payment of the residue which may be due and owing to Continental Supply Company; that is, after eliminating the sum of Two Hundred Thousand ($ 200,000.00) Dollars above described as being assumed by Herschbach Drilling Company and the said Clay; and provided further that the other twelve and one-half (12 1/2 cents) cents of said fifty (50 cents) cents per foot shall be retained by Herschbach Drilling Company and *285 said Clay until there shall accrue in said item the sum of Sixteen Thousand Five Hundred ($ 16,500.00) Dollars; and thereafter said twelve and one-half (12 1/2 cents) cents per foot and the thirty-seven and one-half (37 1/2 cents) cents per foot, making a total of fifty (50 cents) cents per foot, shall continue to be paid upon whatsoever residue of indebtedness is now owing to Continental Supply Company until said debt *327 plus interest is fully discharged. When said debt is discharged, as herein provided, by Clay or Herschbach Drilling Company, the obligation herein recited to pay commissions shall be at an end. It is further provided, however, that should Herschbachs liquidate the aforesaid residue payable to Continental Supply Company before same is liquidated by Clay or Herschbach Drilling Company as herein provided, such monies so paid by Herschbachs on such residue shall be reimbursed directly to Herschbachs by Clay or Herschbach Drilling Company in the same manner here provided for such payment to be made to Continental Supply Company. It is further agreed and understood that the aforesaid sum or item of Sixteen Thousand Five Hundred ($ 16,500.00) Dollars is payable*286 only as above set out and shall not be construed as a money or personal obligation payable by Herschbachs. The stockholders of Herschbach Drilling Co. ratified and confirmed the contract of November 25, 1938, thereafter paying $ 10,000 in cash to Continental Supply Co. and executing notes for the remaining $ 190,000 of the $ 200,000 debt. Shortly before the execution of the contract on November 25, 1938, Herschbach Drilling Co. had completed 2 or more wells for the joint account of Anderson-Pritchard Oil Corporation and Illinois Oil Co. on a lease of 1,280 acres, known as the Wells Tract, in Lea County, New Mexico. The spacing pattern in effect in New Mexico allowed 1 well per 40 acres, and therefore approximately 29 locations were available for other wells on this lease. Each well would have been approximately 3,600 feet deep, and the drilling company would have made a profit of from $ 5,000 to $ 5,500 on each well, including the commissions. Eight wells were drilled on this tract after November 25, 1938, some of which were drilled by Herschbach Drilling Co., but drilling was then suspended because of water intrusion. Part of the credits on the accounts of the two Herschbachs*287 mentioned below was derived from commissions for the drilling of these wells. By letter dated April 13, 1939, and accepted by the two Herschbachs on April 21, 1939, Herschbach Drilling Co. agreed to pay them a commission of 50 cents per foot on all wells theretofore commenced or thereafter drilled by it for Aloco Oil Co., in consideration of services theretofore rendered and thereafter to be rendered by the two Herschbachs in obtaining drilling contracts from Aloco Oil Co. The letter stated that 12 1/2 cents per foot of the commissions would be credited on the indebtedness then due Herschbach Drilling Co. by the two Herschbachs and that 37 1/2 cents per foot would be paid by delivering to them notes of Aloco Oil Co. The letter also stated that it did not change the agreement of the parties in regard to the drilling of wells on the Wells Tract in New Mexico, and that it confirmed a verbal agreement. There was some discussion of drilling contracts for Aloco Oil Co. at the time the contract of November 25, 1938, was executed. It was contemplated that a minimum of 32 wells would be drilled, at an *328 average depth of 5,200 feet each. Five or 6 wells were actually drilled by *288 Herschbach Drilling Co. for Aloco Oil Co. after November 25, 1938, and part of the credits on the accounts of the 2 Herschbachs hereinafter mentioned was derived therefrom. Additional wells were not drilled because the price for drilling was reduced, and the Herschbach Drilling Co. did not feel that it could meet the price cut. There were paid to Herschbach Drilling Co. under the foregoing contracts the following amounts on the dates indicated: John L. E. Fred Date Herschbach Herschbach June 30, 1939 $ 221.44 $ 221.44 Nov. 30, 1939 221.25 221.25 Nov. 30, 1939 220.56 220.57 Nov. 30, 1939 312.50 312.50 Nov. 30, 1939 312.50 312.50 Herschbach Drilling Co. (Clay Drilling Co.) accepted all of the contracts tendered to it that it could accept with good judgment. Illinois Oil Co., sometimes hereinafter referred to as Illinois, was adjudicated a bankrupt on November 24, 1941. The two Herschbachs owned the majority of the capital stock of this company, the balance thereof being owned by their immediate families. It was the sole operating medium of the Herschbachs, and its bankruptcy had the effect of putting them individually out of the oil business. Thereafter*289 Herschbach Drilling Co. (Clay Drilling Co.) drilled no more wells under the contract dated November 25, 1938, or the agreement evidenced by the April 13, 1939, letter. When the contract of November 25, 1938, was made R. G. Clay, president of petitioner, considered that the accounts of the two Herschbachs were collectible in the method described therein. In his opinion Illinois, owned and operated by the Herschbachs, was a substantially sized concern, apparently well financed. Prior to its bankruptcy it was involved in the acquisition and development of leases in a number of fields and Clay thought that he might be able to conclude a deal that would have involved drilling a large number of wells for it. He did not have this opinion after its bankruptcy. The account of John L. Herschbach in the sum of $ 11,563.67 and the account of E. Fred Herschbach in the sum of $ 2,383.31 were charged off the books of the Clay Drilling Co. of Texas (formerly Herschbach Drilling Co.) on April 30, 1942. These accounts became worthless during petitioner's fiscal year ended April 30, 1942. The sum of $ 16,500 appearing in the contract of November 25, 1938, includes the account of John L. Herschbach*290 in the sum of $ 12,758.16 and the account of E. Fred Herschbach in the sum of $ 3,577.82, and certain other accounts which are not here in controversy. After November 26, *329 1938, the corporation made no demand on the Herschbachs for payment of their accounts and no suit for collection of the accounts was brought or contemplated. Any facts embodied in the stipulation of facts which has been filed which are not included in the foregoing findings are incorporated herein by reference. OPINION. We are not here concerned with the amounts which the Herschbachs owed the Continental Supply Co. or what petitioner owed the Supply Co. Considerable of the language of the agreement included in our findings of fact relates to that indebtedness, but it is in no way involved in this proceeding. We have but one issue to decide here, and that is whether petitioner is entitled to a bad debt deduction in the taxable year aggregating $ 13,946.98. This aggregate is made up of an alleged account against John L. Herschbach of $ 11,563.67 and against E. Fred Herschbach of $ 2,383.31. The applicable statute and regulations are printed in the margin. 1 *291 The Commissioner concedes that petitioner charged off its books as a bad debt loss during its fiscal year ended April 30, 1942, accounts aggregating $ 13,946.98 which were carried on its books against John L. Herschbach and E. Fred Herschbach. The Commissioner contends, however, that these two accounts did not represent "debts" which were due petitioner at the time they were charged off within the meaning of the statute and the applicable regulations. The Commissioner does not dispute that these accounts when originally incurred by the Herschbachs represented debts owing by them to petitioner. He contends, however, that when the contract of November 25, 1938, was entered into by John L. Herschbach, E. Fred Herschbach, and R. G. Clay, which account was subsequently ratified and *330 confirmed at a stockholders' meeting of the corporation, the indebtedness of the Herschbachs to the corporation was canceled and forgiven and no longer existed as debts. The basis for this contention is that the contract in question provided a method of payment by the Herschbachs to the corporation of their indebtedness by means of commissions on certain drilling contracts which were to be tendered*292 to the corporation by the Herschbachs and that this contract further provided: "It is further agreed and understood that the aforesaid sum of $ 16,500 is payable only as above set out and shall not be construed as a money or personal obligation payable by Herschbach." Respondent lays great stress in his brief on this latter provision. He says: "In agreeing that the Herschbach accounts were not to be construed as a personal obligation, they ceased to be debts." If that is true, respondent should prevail, because petitioner would have no debts against the Herschbachs to become worthless in the taxable year and therefore nothing to deduct. Respondent in support of his contention cites Emil Weitzner, 12 B. T. A. 724, and quotes from that case as follows: It is elementary that one of the essential prerequisites to a bad debt deduction is that the debt must have an existence in fact. Luke & Fleming, Inc., 1 B. T. A. 12. There are many different transactions out of which the relation of debtor and creditor may arise and so there are many definitions of the word "debt." It is a word that is not susceptible of definition so as*293 to fit every situation and as far as we know there has been no comprehensive judicial determination of the meaning of the word. However, in all of the definitions that are given there is the underlying thought of an obligation to pay. The existence of an obligation is the sine qua non of a debt. * * * Respondent also cites Ambrose D. Henry, 8 B. T. A. 1089, and quotes from that case as follows: * * * The word "debt" * * * has been defined to mean "that which is due from one person to another, whether money, goods, or services; that which one person is bound to pay to another, or to perform for his benefit; that of which payment is liable to be exacted; due; obligation; liability." * * * The word "debt" has been defined to mean "every claim and demand upon which a judgment for a sum of money, or directing the payment of money, could be recovered in an action." * * * As we have already pointed out, certainly the debts against the Herschbachs on petitioner's books at the time the November 25, 1938, contract was entered into represented "debts" within the meaning of the applicable statute and Commissioner's regulations. We do not understand respondent*294 to contend otherwise. These debts were not, in our opinion, canceled or forgiven by the terms of the contract which was entered into. That there was no intention by the parties that the debts should be canceled or forgiven seems to be shown by the fact that the corporation continued to carry the accounts on its books after the contract of November 25, 1938, as before, and in 1939 $ 1,288.25 *331 on each acount was paid to petitioner in the manner which had been agreed upon and was duly credited to each account. Also in the supplemental agreement entered into by petitioner and the Herschbachs on April 21, 1939, relating to certain wells to be drilled by petitioner for Aloco Oil Co., it was agreed: "All monies accruing from these payments shall be disbursed as follows: Twelve & one-half cents per foot (12 1/2 cents per foot) on each well (but in no event to exceed $ 625.00 on each well) is to be credited to the indebtedness now due this Company by yourselves." It seems to us that the debts of the Herschbachs to petitioner continued to exist, payable, it is true, only in the manner agreed upon. We know of no law which is to the effect that a debt is canceled and forgiven merely*295 because the manner of its payment is restricted and it is agreed that the debtor shall not be personally liable if the debt is not fully paid in that manner. Both parties concede that they know of no case exactly in point. Our search has not disclosed any. In Riverview State Bank, 1 T. C. 1147, we held, following several circuit court decisions cited in our report, that interest on special tax bills issued by the city of Kansas City, Kansas, which was levied and assessed by the city as a tax and was payable to the holders of the tax bills by the city, but was not payable out of the general funds of the city, was tax exempt as interest upon the obligations of a political subdivision of the state. In that case it was the Commissioner's contention that, since no obligation for payment of either principal or interest on the tax bills rested directly upon the city, they were not "obligations" of the city within the meaning of the statute. We held against such contention. Of course the question we have here to decide is entirely different from the question which was present in the Riverview State Bank case, and yet we think the underlying reasoning*296 in that case is of some help here. In some earlier cases involving the same question of exemption from taxation which we had in the Riverview State Bank case we had held that the bonds were not exempt because they were payable only out of special taxes and not unconditionally payable by the municipality -- therefore, were not "obligations" of the municipality within the meaning of the applicable statute. We were reversed in some of these cases, the Circuit Court of Appeals holding that the bonds were "obligations" of the municipalities even though payable only out of special tax bills and in no other manner. See the cases cited in Riverview State Bank, supra. Along somewhat the same line of reasoning, we think it is reasonable to hold that these accounts due by the Herschbachs to petitioner continued to be debts or obligations owed by the Herschbachs to petitioner, even though payable only in a special way and not out of the debtor's "general funds," so to speak. We therefore sustain petitioner *332 on this phase of the issue. Petitioner not only has the burden of proof to show that it had valid and existing debts against the Herschbachs*297 in the amounts claimed, but that these debts became worthless in the taxable year. Respondent contends that petitioner has not sustained its burden of proof in this respect and lays emphasis upon the fact that petitioner did not make demand upon the Herschbachs for payment and did not institute legal action against them for payment. Respondent on this point cites Edward H. Moore, 22 B. T. A. 366; petition for review dismissed, 59 Fed. (2d) 1069. In reply to this contention petitioner points out that the Illinois Oil Co. was the sole operating medium of the Herschbachs and that it went into bankruptcy November 24, 1941, and the Herschbachs were thereby put out of the oil business. Petitioner's president testified at the hearing to the effect that up until the time that Illinois went into bankruptcy he considered there was a reasonable prospect that petitioner would collect all or at least a good part of its debt against the Herschbachs in the manner which had been agreed upon. He said that, after Illinois went into bankruptcy and the Herschbachs were thereby put out of the oil business, he concluded that nothing more would*298 be collected on the accounts and he directed that the accounts be charged off as worthless. Subsequent events verified his judgment, because nothing more was collected on the accounts. We do not see where suit by petitioner against the Herschbachs would have availed anything. They were not personally liable for the debts and, since they were put out of the oil business by the bankruptcy of their operating company, there was no reason to expect they would tender any further oil drilling contracts to petitioner on which they could collect a commission. Under such circumstances we think it is reasonable to hold that the debts became worthless in petitioner's fiscal year ended April 30, 1942. Cf. Robert S. Dennison, 4 T. C. 806. We have, therefore, concluded that on the evidence in the record the debts in question became worthless in the taxable year and petitioner is entitled to the deduction claimed. Decision will be entered under Rule 50. Footnotes 1. SEC. 23 [I. R. C.]. DEDUCTIONS FROM GROSS INCOME. In computing net income there shall be allowed as deductions: * * * * (k) Bad Debts. -- (1) General Rule. -- Debts which become worthless within the taxable year; * * * Sec. 29.23 (k)-1 [Regulations 111]. Bad debts. -- (a) Bad debts may be treated in either of two ways -- (1) By a deduction from income in respect of debts which become worthless in whole or in part, * * * * * * * (b) * * * Where the surrounding circumstances indicate that a debt is worthless and uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment, a showing of these facts will be sufficient evidence of the worthlessness of the debt for the purpose of deduction. * * * * * * * (d) The provisions of subsections (a) and (b↩) of this section apply to all taxpayers, except that * * * (3) in the case of taxpayers other than banks as defined in section 104, the term "debts" as used in such subdivisions means obligations to pay fixed or determinable sums of money which are not evidenced by securities as defined in section 29.23(k) -- 4.