Cushman v. Commissioner

HENRY W. CUSHMAN, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Cushman v. Commissioner Docket No. 22152. United States Board of Tax Appeals 13 B.T.A. 41; 1928 BTA LEXIS 3327; July 24, 1928, Promulgated *3327 The deduction of part of the cost of unsold stock disallowed where the evidence does not show that the stock was worthless. William S. Cole, Esq., for the petitioner. L. C. Mitchell, Esq., for the respondent. MURDOCK *41 This is a proceeding for the redetermination of a deficiency in income tax for the calendar year 1923 in the amount of $1,705.58. It is alleged in the petition that "the amount of $20,000 has erroneously been added to (the petitioner's) taxable income as representing alleged loss on the common capital stock of the Bath Iron Works, Limited." FINDINGS OF FACT. The petitioner is a resident of Bangor, Me., and was during the years 1922 and 1923 and up to the date of hearing president of the Merrill Trust Co. of Bangor. In 1917 he purchased 701 shares of the common stock of the Bath Iron Works, Ltd., for the amount of $49,000. At this time he became a director in the company and continued to be a director up to and including the year 1923. The company was engaged in the business of building commercial and naval vessels. Prior to 1917 John S. Hyde, and after his death his estate, was the actual or beneficial owner of all*3328 the outstanding capital stock of the company consisting of 200,000 shares of common stock. Some time during the year 1917 a reorganization of the company was *42 effected and the Hyde stock was sold. At the same time the company issued $1,500,000 value first mortgage bonds, $500,000 par value preferred stock, and $800,000 par value additional common stock, the proceeds of all of which were used in the purchase of the Hyde stock and certain contracts and agreements and in the payment of certain expenses. During the preiod of the United States participation in the World War the company was chiefly engaged in building destroyers for the United States Government, and was operating at a profit during that time. Soon after the close of the war its business began to fall off and it was operated constantly at a loss up to and including the year 1923. During 1922 and 1923 its orders and its volume of business were constantly decreasing. In the year 1922 it became evident to the directors that in order to save the company more business would have to be procured and the company would have to be placed on a more sound basis. Some time in 1922 an issue of debenture bonds was authorized*3329 to be sold for the purpose of realizing funds for use in the business. These bonds were purchased by some of the directors in amounts totaling $76,220 for 1922 and $113,330 for 1923 up to September 29 of the latter year. They were subsequent in lien to the company's issue of first mortgage bonds. The Merrill Trust Co. was the trustee under the first mortgage bond issue and during the year 1922 this bank and certain other banks made loans to the company. Some loans were also made by banks to the company during 1923. The only security for these loans was a certain percentage of the payments due to the company under Government contracts and withheld by the Government until the completion of certain ships then under construction. The banks lending the money considered that they would be reimbursed by these amounts so withheld. In September, 1923, a protective committee of the first mortgage bondholders was formed, which examined the affairs of the company and acted in an advisory capacity to the board of directors. Under the direction of the committee an investigation of the accounting records of the company for the period from June 30, 1917, to September 29, 1923, was made by*3330 a firm of public accountants which rendered a report on November 9, 1923, containing, among other items, the following: 1st. - None of the cash paid for the $1,500,000 of bonds, $500,000 of Preferred Stock and $800,000 of Common Stock issued July 11, 1917, was paid to the corporation. The vote of Stockholders recorded July 11, 1917, copy of which is annexed hereto and marked Exhibit F, authorized the delivery of the said bonds and shares to H. M. Verrill in consideration of contracts with Messrs. Wetherbee, McInnes and McCarty and other considerations, he to dispose of said bonds and stock to certain banking and business interests and out of the *43 purchase price received to pay various expenses and to pay over the balance to the John S. Hyde Estate. We have examined the Wetherbee contract, one of the three hereinabove referred to. In essence it appears to constitute an agreement to accept a salary of $15,000 per annum for continued employment as superintending engineer. See Exhibit G. We find no record on the books reflecting a transaction of the sort thus authorized by Vote of the Stockholders. There is no accounting or account showing investment or value received*3331 as consideration for the stocks and bonds issued. The Treasurer, Mr. Furber, explains the absence of any accounting for these items as being due to instruction or suggestion of the auditors, Scovell, Wellington & Co., to the effect that the accounting records should be closed at the point shown in balance sheet of June 30, 1917, annexed hereto, and reopened in the form of balance sheet of July 1st, 1917, also annexed hereto. See Exhibit E. Thus the $2,800,000 increase in liabilities and capital stock was largely offset in the accounts and a showing of surplus maintained solely by increasing the book value of the assets. The description of the First Mortgage 6% Sinking Fund Gold Bonds published by Maynard S. Bird & Co., a copy of which is annexed hereto and marked Exhibit H, refers to appraisals by the Moulton Engineering Co. which we assume constituted the ground of justification for the above referred to writing up of took values. Thus, as before stated, there appears to have been no added capital acquired by the corporation in consideration of its increase of its Common Stock, Preferred Stock and Bonds but in substance the proceeds of the sale of such stocks and bonds were*3332 used in a transaction whereby the capital stock ownership was transferred from the Hyde Estate of others. 2d. - The profits realized during the period are accounted for in statement annexed hereto and marked Exhibit A. Also we have prepared a statement of operating results for the first nine months of the year 1923, marked Exhibit C. It will be observed that the burden of interest of the bond debt and dividends on the preferred and common stock together with federal taxes and recent operating losses explain the dispersion of profits earned since June 30, 1917. 3d. - The present financial position of the corporation is set forth in statement annexed hereto and marked Exhibit D. There is in addition to the recorded liabilities an outstanding claim by the Federal Government for $372,828.35 for income and war or excess profits taxes. * * * BATH IRON WORKS, LIMITED EXHIBIT D Balance sheet September 29, 1923 ASSETS CURRENT ASSETS 1. Cash in Banks $16,691.63 Petty Cash Account 1,500.00 Cash Deposit - U.S. Commissioner of Lighthouses 200.00 $18,391.63 2. Marketable Securities - At Cost 19,906.25 Less: Reserve for falling values 2,275.00 17,631.25 3. Accounts Receivable 74,377.67 Notes Receivable 3,479.52 77,857.19 Less: Reserve for Doubtful Accounts and Notes Receivable 5,210.78 72,646.41 4. Due from U.S. Government - Balance on Destroyers 131-134 $2,000.00 Accrued Interest on Securities 335.01 Inventories: Work in Process - 5. U.S. Light Vessels, 106-110 - Material and Labor Cost $874,646.43 Less: Payments received 640,040.00 $234,606.43 6. Bethlehem Ship Corporation - Turbines 94 and 95 78,356.52 Less: Payments Received 49,000.00 29,356.52 Hugh J. Chisholm - Yacht No. 96 1,544.91 7. Miscellaneous Contracts under Construction 97,498.29 Less: Payments received 23,500.00 73,998.29 9. Merchandise and Supplies 94,766.85 Total Inventories 434,273.00 Total Current Assets 545,277.30 It must be borne in mind that completion of the ship contracts now in process will entail additional cash losses and penalties. Deferred Charges to Operating: Taxes - Municipal $10,723.78 Insurance and Interest 2,223.93 12,947.71 Sinking Fund: 1st Mortgage Bonds - Bath Iron Works, ltd 5,700.00 Cash 380.00 6,080.00 Plant: Depreciated Appraised Value July 1, 1917, plus Additions at Cost to Sept. 29, 1923 2,163,620.29 Less: Reserve for Depreciation 741,185.90 1,422,434.39 Contracts and Goodwill 632,262.89 Total Assets 2,619,002.29 LIABILITIES CURRENT LIABILITIES Notes Payable - Bank $315,000.00 Accounts Payable $43,858.84 Municipal Taxes 32,400.00 Accrued Payroll 6,898.99 83,157.83 U.S. Light Vessel No. 111 - Payment Account 90,000.00 8. Less: Cost, Material, and Labor to date 52,954.44 37,045.56 Total Current Liabilities 435,203.39 Bonded Indebtedness: 1st Mortgage Bonds 6% - 1925 1,210,000.00 Debenture Bonds 6% - 1932 189,550.00 1,399,550.00 Reserves: 1st Mortgage Bond Interest 18,150.00 Debenture Bond Interest 6,160.38 24,310.38 Capital Stock and Surplus: Preferred Stock - 7% Cumulative 500,000.00 Common Stock 1,000,000.00 Deficit 740,061.48 759,938.52 Total Liabilities 2,619,002.29 *3333 BATH IRON WORKS, LIMITED EXHIBIT E Balance sheets before and after closing June 30, 1917. ASSETS As closed As reopened Cash $385,177.60 $385,177.60 Securities 159,204.18 154,412.50 Accounts Receivable 7,536.87 7,636.87 Notes Receivable 775.75 775.75 Merchandise and Supplies 194,973.22 194,973.22 Miscellaneous Orders - Cost Account 24,730.82 22,158.45 Employees' Liberty Loan Bond - Subscription Account 16,750.00 16,750.00 Plant and Equipment (Including outside Real Estate) $1,080,234.25 Less: Depreciation and Reserve 353,081.67 727,152.58 2,322,687.37 Deferred Charges 7,068.91 7,068.91 Contracts and Goodwill 350,000.00 1,523,369.93 3,461,640.67 LIABILITIES Accounts Payable 101,344.84 101.344.84 Accruals: Payroll $7,313.49 $7,313.49 Taxes 2,600.00 2,600.00 Insurance 1,631.53 1,631.53 11,545.02 11,545.02 Advance Payment on Contracts 1,743,206.70 1,743,206.70 Less: Cost of Work in Process 1,531,984.20 1,680,984.20 211,222.50 62,222.50 Capital Stock - Common 200,000.00 1,000,000.00 Capital Stock - 7% Preferred 500,000.00 First Mortgage 6% Sinking Fund Gold Bonds, 1932 1,500,000.00 Surplus 999,257.57 286,528.31 1,523,369.93 3,461,640.67 *3334 Exhibit B attached to the report shows a deficit as of December 31, 1922, in the amount of $556,902.17, and Exhibit C, also attached, shows an operating loss to September 29, 1923, excluding penalties for failure to deliver a light ship in the amount of $216,076.90. A comparative balance sheet as of December 31, 1921, and December 31, 1922, contained in an audit of the company's books made by another accounting firm was as follows: BATH IRON WORKS, LIMITED Comparative balance sheet as at December 31, 1922 and 1921 ASSETS Dec. 31, 1922 Dec. 31, 1921 Current: Cash $25,144.21 $60,146.43 Marketable securities (not in excess of market value) 17,957.50 58,296.09 Deposit on contract bid 825.00 Notes receivable (net reserve for doubtful notes) 119,068.26 Accounts receivable (net of reserve for doubtful accounts) - U.S. Government 2,000.00 2,000.00 Trade and other 37,161.83 19,333.16 Inventories - Raw materials and supplies $115,660.84 $121,991.12 Work in progress (net of payments on account and estimated loss accrued to Dec. 31, 1922) 264,229.57 109,575.80 Total current assets 462,978.95 490,410.86 First mortgage 6% sinking fund gold bonds, held for sinking fund 4,200.00 12,775.00 Cash in trustee's sinking fund 240.00 95.00 Plant assets (net of depreciation reserve) 1,476,638.89 1,579,324.82 Contracts and good will 632,262.89 632,262.89 Deferred charges 4,056.91 3,750.79 2,580,377.64 2,718,619.36 LIABILITIES Current: Notes payable 175,000.00 Accounts payable 33,758.01 26,716.61 Reserve for Federal income and profits taxes 8,433.51 Advance payment on light vessel contract 88,718.46 Total current liabilities 297,476.47 35,150.12 First mortgage 6% sinking fund gold bonds, due [1932] 1,214,000.00 1,282,500.00 Debenture gold bonds - 6% 76,220.00 CAPITAL Capital stock (authorized and outstanding): Preferred (7% Cumulative) 500,000.00 500,000.00 Common 1,000,000.00 1,000,000.00 Deficit 507,318.83 99,030.76 2,580,377.64 2,718,619.36 *3335 NOTES. - Five quarterly dividends on 7% cumulative preferred stock, amounting to $43,750.00, due November 1, 1921 to November 1, 1922, were in arrears at December 31, 1922. Losses will probably be sustained in 1923 in the completion of vessels now being constructed under contracts, but the amount thereof will depend largely upon business conditions. Federal income and profits taxes for 1917 to 1920 inclusive, have not been finally determined by the Treasury Department. *46 In February, 1924, the board of directors recommended a scheme of reorganization to the bondholders' committee providing, among other things, that interest upon the bonds should be waived for a period of five years, with the understanding that the interest waived would be paid if and when earned before any payment should be made on any other securities; that the sinking fund requirements of the present mortgage should be waived for the same period and the quick assets be released from the lien of the mortgage; that a new preferred stock should be issued in exchange for the debenture notes in like amount; that the preferred stock should remain as it was or the stockholders should receive in exchange*3336 therefor a like amount of new preferred stock, subsequent in lien only to the preferred stock to be issued to the debenture holders; that the common stock should receive in exchange therefor an equal amount of shares of new common stock without par value; that the bank creditors should be *47 paid one-half of the amount due and the banks continue the balance as a line of credit to the company, and that a majority of the board of directors be designated by the bondholders. This scheme was never adopted and at some time later not disclosed by the evidence, the company was placed in the hands of a receiver and its assets were sold. One of the directors of the company who was engaged in the investment banking and brokerage business on December 22, 1923, sold his 333 shares of the company's common stock at auction in the City of Boston for $21. The brokerage firm of which he was a member on December 1, 1923, purchased from one of its customers $12,500 debenture bonds and 500 shares of common stock for $100. The petitioner never attempted to sell any of the 701 shares of common stock which he owned. In his income-tax return for the year 1923 he claimed as a deduction for*3337 bad debts the amount of $20,000 which he explained in his return as "Capital Stock of Bath Iron Works, Inc.Bath, Me., Cost $49,000.00, charged off as reserve $20,000," and paid an income tax of $5.98 the amount shown to be due by his return. OPINION. MURDOCK: The petitioner in his return has charged off as a reserve $20,000 of the total amount of $49,000, the latter representing the cost to him of the common stock but he now claims that the stock was worthless in 1923 and that he was entitled to deduct the whole amount of the cost in that year. The Revenue Act of 1921 provides as follows: SEC. 214. (a) That in computing net income there shall be allowed as deductions: * * * (5) Losses sustained during the taxable year and not compensated for by insurance or otherwise, if incurred in any transaction entered into for profit, though not connected with the trade or business; * * * This does not authorize the deduction of a portion of the cost of stock or a deduction of shrinkage in value of stock, but in order to take advantage of this provision where the stock has not been sold, it must be shown that it was worthless. The deduction can only be allowed in that year when*3338 such stock had no longer any actual value. From its very nature such a loss can only occur at one time, and if it is shown that stock was worthless in one year a deduction for its loss can not be taken in any subsequent year. The date of the occurrence of such a loss is a question of fact. The sale by another person of the same kind of stock at a low price does not prove the worthlessness of the petitioner's stock. *48 The Bath Iron Works was operating at a loss and at the end of 1922 and in September, 1923, its liabilities apparently exceeded its assets. In addition to this on the asset side, its plant and equipment may or may not have been worth the value attributed to it in accordance with the reproduction cost ascertained in July, 1917, and depreciated to date, and it is doubtful whether its good will represented the value set forth in the balance sheets. The sales of common stock and debentures in December of 1923 are some indication that the market value of the stock at that time was very little, but it is apparent that during the year 1923 and for some time thereafter, the directors of the company had not given up hope of rehabilitating and of restoring the company*3339 so that it would be profitable. During this year no steps were being taken to liquidate or to discontinue the business. The condition of the company on September 29, 1923, differed from that at the end of the year 1922 only in the fact that an additional loss had occurred, smaller in amount than that suffered in 1922. It is conceivable that such an additional loss might represent the difference between some common stock value in 1922 and worthlessness in 1923, but from the evidence presented in this case if the stock were worthless in the latter year it might just as well have been worthless in the prior year. The petitioner has failed to convince us by the evidence that the stock became worthless during the taxable year and therefore the deduction of its cost or any portion thereof from income is disallowed. Judgment will be entered for the respondent.