Peoples Trust Co. v. Commissioner

PEOPLES TRUST CO., AND PEOPLES SAFE DEPOSIT CO., PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Peoples Trust Co. v. Commissioner Docket No. 9728. United States Board of Tax Appeals 10 B.T.A. 1264; 1928 BTA LEXIS 3914; March 9, 1928, Promulgated *3914 Certain purchases of notes by a bank held to create a debt dating from the transaction and, therefore, the amounts of such notes or debts, even though there may have been fraud in connection with their negotiation, are not deductible from gross income for tax purposes until the worthlessness thereof has been ascertained. W. H. Cloud, Esq., and Eugene M. Lunn, C.P.A., for the petitioners. L. A. Luce, Esq., for the respondent. LANSDON *1264 The respondent has asserted deficiencies for the years 1919, 1920, and 1921, in the respective amounts of $2,152.38, $4,808.29, and $7,133.43. The petitioner alleges that the respondent erred as follows: (a) In treating notes negotiated to the taxpayer in the years 1919, 1920 and 1921, and ascertained by the taxpayer to be worthless in the year 1922, as "bad debts" deductible only in the year 1922. (b) In refusing to permit the taxpayer to deduct as losses for the years 1919, 1920 and 1921, notes negotiated to the taxpayer in the years 1919, 1920 and 1921 under circumstances amounting to theft and/or embezzlement, the theft and/or embezzlements having been ascertained and discovered by the taxpayer*3915 in the year 1922. (c) In disallowing "bad debts" deducted by the taxpayer in the calendar year 1921, amounting to $40,000. (d) In refusing the taxpayer's request for a reexamination of its books and accounts after facts disclosing losses sustained by the taxpayer for the years 1919, 1920 and 1921 came into the possession of the taxpayer and others. (e) In calculating the taxpayer's excess profits taxes for the calendar years in question. (f) In calculating the taxable income of the taxpayer for the years in question in that the respondent included in his calculation of taxable income for each year interest and discount which was not collected until succeeding years. At the hearing the petitioner abandoned its assignments of error as set forth above under (a), (c), (d), and (e). The parties have agreed that the principle of , should be applied in the settlement of the assignment of error stated in (f) above, and that a redetermination of the petitioner's tax liability for the taxable years by the application of such principle will result in overassessments for the years 1919 and 1920 in the respective*3916 amounts of $363.82 and $627.78, and a deficiency for the year 1921 in the amount of $10,781.10. The only issue to be tried is set forth in (b) above. *1265 FINDINGS OF FACT. The petitioner was organized in 1917, under the banking laws of the State of Missouri, as a trust company. During the taxable years it was engaged in the general banking business in Kansas City. On January 5, 1920, the petitioner bought from the firm of Smith & Ricker, a partnership self-designated as "Financial Agents," six notes in the total amount of $19,443.31, all dated January 16, 1919. These notes were signed by Thomas W. Jones and J. H. Nations as individuals and were endorsed by C. A. Danielson and were secured by a chattel mortgage describing 519 head of high-grade Hereford and Durham cattle and 75 head of saddle horses, all described as bearing a "Wineglass Brand" and as being at that time on a ranch in Hudspeth County, New Mexico. This paper was subsequently renewed at June 26, 1920, December 23, 1920, June 1, 1921, and December 3, 1921, in the respective amounts of $20,466.70, $21,543.89, $22,683.05, and $20,205.86. At date of final renewal the notes were each signed by Thomas*3917 W. Jones, J. H. Nations, Alton Jones, Frank L. Bennett, and Thomas W. Jones, Jr., and were endorsed in blank by Smith and Ricker. The varying amounts at renewal dates represent additions on account of accrued interest or reductions on account of partial payment. At each renewal date there were some slight changes in the number of cattle enumerated in the chattel mortgage, due to the natural increase of the herd, but the number of saddle horses remained the same. None of the final renewal notes was ever paid. On March 14 and 15, 1921, the petitioner purchased from Smith & Ricker three notes signed by the "Nations Land and Cattle Company" in the respective amounts of $26,889.10, $19,860.75, and $19,860.75, or in the aggregate, $66,610.60. This paper was renewed from time to time and the last renewal with due date in March, 1922, was in the amount of $69,399.83, which represented principal and accrued interest. No part of either the principal or interest of this paper has ever been paid. When bought by the petitioner in March, 1921, the three notes were secured by chattel mortgages on certain specified cattle described in the instruments. When this paper was last renewed, it*3918 came into the possession of the petitioner without any collateral as security for its payment. On October 18, 1920, the petitioner received the following letter from Smith & Ricker: This letter refers to the various loans and paper you have taken from us, and in consideration of your granting renewals that might be necessary from time to time of a part of this paper till the loans may be advantageously collected, we hereby agree to save, hold and keep you harmless from all ultimate *1266 loss, damage, or expense that might be sustained by you. This same letter will apply to any new paper that you might have occasion to take from us after this date. When the petitioner renewed paper purchased from Smith & Ricker that was secured by chattel mortgages, it was necessary to surrender the old mortgages for release before the new instruments could be recorded. It was its custom to deliver the matured mortgages to Smith & Ricker, who would secure and record the renewal mortgages and turn them in to the petitioner. This procedure usually required about two weeks, during which time the petitioner had in its custody no instruments witnessing the chattel security for the renewed*3919 loans. Some time after the last renewal of the notes of the Nations Land & Cattle Co. the discount clerk of the petitioner advised the president thereof that the chattel mortgage collateral for such notes had not been received. Thereupon the president asked Smith & Ricker for the mortgages and was advised in reply in writing "that it's almost a certainty that the cattle in this loan do not now exist, and hence our unwillingness to negotiate that paper, accompanied by chattel mortgages." In the same letter it was stated "that that section of the country went through some mighty dry times, followed by two bad winters with the result that many of the cattle on that ranch do not now exist" and "that payment of this paper is guaranteed by the stockholders of that company." George E. Ricker and G. M. Smith each owned about 250 shares of the petitioner's stock. Ricker was chairman of the board of directors and chairman of the discount committee of the petitioner. The firm of Smith & Ricker owned 50 per cent of the stock of the Nations Land & Cattle Co. Early in the year 1922 the firm of Smith & Ricker failed, with liabilities in excess of $10,000,000. During the process of liquidation*3920 it was discovered that four different banks each held Jones' and Nations' notes in approximately identical amounts, and in each instance held as collateral a chattel mortgage on what appeared to be the same cattle and horses described in the chattel mortgage held by the petitioner as security for the notes purchased on January 5, 1920. The face value of the four sets of notes was several times the loan value of the live stock described in the apparently quadruplicate chattel mortgages. The petitioner lost about $650,000 in the failure of Smith & Ricker, and recovered by suits at law and otherwise less than 5 per cent of that amount. Smith and Ricker were each prosecuted criminally in the Federal court at Kansas City, without conviction in either case. The petitioner brought suit against Smith & Ricker for some $385,000, on account of the guarantee of that firm of the paper discounted *1267 by it, and obtained Judgment in 1924 for the full amount. Only $19,000 has been realized from such judgment. OPINION. LANSDON: The only issue to be determined here is whether in law the transactions in question resulted in immediate losses deductible in the taxable years in which*3921 sustained, or whether they created debts that became deductible from the petitioner's gross income in the year in which worthlessness was determined. It is alleged thefts or embezzlements occurred in 1919, 1920, and 1921, in connection with the original transaction or the renewals of the paper involved. The notes involved were not definitely known to be worthless until some time in 1922. The petitioner is a bank. During the taxable years it was managed by its president, who was the principal witness on its behalf at the hearing of this proceeding. Such president and manager testified that no loans were made or securities purchased except with his approval. It is a fair inference that he could have prevented any or all of the original transactions here involved. It must be presumed that he considered the financial responsibility of the makers of these notes and the value of the collateral before he approved the investment of the funds of the bank in such paper. The notes were secured by chattel mortgages, and by the guarantee of Smith & Ricker. They were negotiated by parties known to the president of the petitioner. Regardless of the collateral, the notes were the evidences*3922 of the debt and the responsibility for payment was in the first instance in the makers thereof. It is the theory of the petitioner that Ricker took advantage of his position as a stockholder and director of the bank to secure its funds by false and fraudulent transactions that amounted to theft or embezzlement. The offenses charged are crimes under the laws of Missouri. Neither the public prosecutor nor the officers or stockholders of the petitioner caused Ricker to be prosecuted for such alleged crimes. Ricker was not the custodian of the property of the petitioner in any capacity which gave him the care or control thereof. He was merely a director and officer of a corporation which had selected a president as the manager and custodian of its property. Nor can it be said, in our opinion, that money paid by the petitioner for the notes in question was converted to the use of Ricker merely because he was a partner in a firm that owned one-half the stock of one of the makers of such paper. It is urged that the president of the petitioner was not informed of the fact that the firm of Smith & Ricker owned 50 per cent of the stock of the Nations Land & Cattle Co. If this is true, *3923 he certainly made very little effort to discover the names of the stockholders of the company to which he was loaning *1268 large sums of money. Whatever moral obligation there may have been upon Ricker to disclose his connection with the cattle company, it is clear that petitioner exercised little of the usual business precaution necessary to establish the identity of the owners of an enterprise to which it was advancing large sums of money. Petitioner contends that the failure of Smith & Ricker to replace renewed chattel security for the notes involved in the second transaction was a fraudulent act that resulted in loss at that date and also that the cattle enumerated in the chattel mortgages taken as security for such notes probably did not exist at the date of the original transaction. This may be true without in any way affecting the issue here. The debt was created when the notes were negotiated, and the fraud, if any, affected only the security. This same state of facts and our conclusion therefrom applies also to the alleged duplication of collateral security for the notes involved in the first transaction Notwithstanding the probability of fraud in connection*3924 with the sale of the notes here involved, we are of the opinion that the transactions created debts which were not definitely known to be worthless until some time in the year 1922. . Reviewed by the Board. Judgment will be entered for the respondent.