Blanchard v. Commissioner

JOHN F. BLANCHARD, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Blanchard v. Commissioner Dockets Nos. 16365, 30767, 32384, 40264. United States Board of Tax Appeals 17 B.T.A. 1271; 1929 BTA LEXIS 2145; November 7, 1929, Promulgated *2145 1. Petitioner sold patents under a contract, by which the purchaser was obligated to pay certain sums annually upon the condition that the sales of the patented articles exceeded certain sums annually, and there was a failure to sell the specified amounts. Held that no liability resulted from purchaser to petitioner, and petitioner is not entitled to deduct said contingent annual payments either as a bad debt or a loss. 2. In order to entitle a taxpayer to deduct as a bad debt an item ascertained to be worthless, the item should have had an actual existence as a debt both in law and in fact. Melvin G. Palliser, Esq., for the petitioner. Bruce A. Low, Esq., and L. H. Rushbrook, Esq., for the respondent. LITTLETON *1271 The Commissioner determined deficiencies in income tax as follows: For 1921, $707.06 (Docket No. 16365); for 1922, $4,104.72, and for 1924, $1,569.38 (Docket No. 30767); for 1925, $949.70 (Docket No. 32384); and for 1926, $1,695.49 (Docket No. 40264). Petitioner alleges in Docket No. 16365 the following: "The Government has refused to permit a deduction of $15,000.00, which is a bona fide loss sustained by taxpayer*2146 during the year 1921. The failure to allow this loss is the only question involved and the additional tax of $707.06 is based upon the disallowance of said loss," and, again: "A bad debt of Fifteen thousand dollars disallowed by agent was a loss made by taxpayer in 1921, ascertained by him to be a loss in 1921, and so credited by him on his books, records and tax reports." The allegations of error in the other cases are practically the same except the year and the amount was $25,000 in each instead of $15,000. The petitions then allege that the petitioner was entitled to certain *1272 sums under a contract in certain contingencies, that said contingencies did not happen, and that as a result thereof petitioner lost the sums mentioned. At the hearing the cases were ordered consolidated for hearing and decision. FINDINGS OF FACT. Petitioner, during the years 1921 to 1925, was a resident of the City of New York. Since 1925 he has resided in Brewster, Putnam County, N.Y. He had been in the manufacturing business most of his life. In 1914 there was brought to his attention by the patentees certain devices, known in this record as Combusto Devices, to be attached to*2147 and used in connection with stoves, ranges, and furnaces for the purpose of adding to the combustibility of coal. Ordinarily in the combustion of coal in the average stove, range, or furnace about 70 per cent of the heat units escape in the form of gas. The object of Combusto Devices was to introduce air into the combustion chamber where it mixed with the coal gases and the mixture thus formed burned and was consumed as a gas fire. This added to heating power, and saved fuel and labor. Blanchard became interested and the Combusto Devices Corporation was formed for the purpose of manufacturing and marketing the devices. Blanchard became president and the majority stockholder and in 1920, when the corporation ceased business, he was its sole stockholder, representing an investment of $30,900 for stock. In addition he purchased $100,000 of the corporation's bonds at par during 1914 and 1915, and from 1914 to 1920 advanced it $45,832.59 on open account, making in all a total outlay by him in the enterprise of $176,732.59. The business was not successful and was terminated in 1920 by turning over all of its assets to petitioner, who was the sole stockholder and creditor. *2148 Immediately after the organization of the Combusto Devices Corporation, patents were acquired, manufacture of the devices began and an extensive sales organization was formed covering the larger cities and several States. Many orders were received and success seemed imminent, but when hard winter weather came it developed that instead of being an aid the devices put many fires out and great dissatisfaction resulted. The business suffered a serious set-back, but after certain additions and changes were made in the devices better results were obtained. From 1914 to 1920 about 20,000 devices were sold and about 5,000 of these were replaced on account of failure to render satisfactory service. The patents were obtained at a cost of $12,000. *1273 In 1920, on account of the failure to achieve success and difficulty of maintaining a sales organization, the Combusto Devices Corporation was liquidated by turning over all of its assets to petitioner. These assets consisted of accounts receivable, $6,110; notes receivable, $875; manufactured products, cost $2,841; foundry equipment and patterns, cost $22,512; shop equipment, cost $750; automobile, value $500; office furniture, *2149 value $500; printing and plates, value $750; and four United States and foreign patents, cost $12,000. The Combusto Devices Corporation never paid any dividends, did not earn any surplus, and lost money continuously during its existence. In 1920 and the taxable years in question the petitioner was the president of the Van Kannel Revolving Door Co. He owned 70 per cent of its capital stock. The stockholders and their holdings were as follows: Name Address Number of shares T. Van Kannel Yardville, N.J [5] M. G. Palliser 100 William Street, New York. [2] Campbell Carrington, J. F. 25 Broad Street, New York. 4,140 Blanchard, trustees. W. M. Dickinson Trenton, N.J [9] F. W. Roebling, Jr do [9] J. S. Broughton do [9] J. E. Lonergan do [31] N. A. K. Bugbee do [50] F. L. Silver do [47] B. M. Phillips do [7] W. A. Holcomb do [4] Jos. W. Swain do [7] T. D. Maurer do [14] Herbert Sinclair do [14] John H. R. Jamar Trenton, N.J [3] Wm. T. Reeves do [6] Ida H. Schweizer do [11] John Molitor do [3] John H. Ashton do [49] Frank Pringle 25 Broad Street [3] Lincoln Trust Co., trustee. New York, N.Y [300] W. F. Sadler Trenton, N.J [8] Mechanics National Bank. do [30] Compbell Carrington 25 Broad Street [40] Robert L. Blanchard New York, N.Y [40] J. F. Blanchard do [150] Total shares 5,000 *2150 An agreement dated March 1, 1919, was made between Campbell Carrington, a stockholder, and petitioner, by which for five years thereafter they transferred to themselves as trustees the controlling interest in the company. Carrington contributed 500 shares and Blanchard 3,645 shares. The agreement provided that the trustees should exercise their best judgment in the selection of directors and on any other matters coming before any stockholders' meeting, and that no salaries should be voted, no extra compensations granted, no contracts involving extraordinary expenditures, no purchases of property of any character, excepting necessary for the routine business of the company should be made, no dividends should be declared, no mortgage or bond issue should be issued, and that no change in the capital stock of the company should be made except with the consent of both trustees. The Van Kannel Revolving Door Co. was a business success doing a business of about $1,000,000 a year with a profit of from $10,000 to $150,000. *1274 It had a large selling organization and it was believed that with its organization and experiences it could successfully manufacture and market the Combusto*2151 Devices. The following contract was entered into between petitioner and the Revolving Door Co., viz: AGREEMENT made and entered into this 29th day of December, 1920, by and between JOHN F. BLANCHARD of the City of New York, party of the first part, and the VAN KANNEL REVOLVING DOOR COMPANY, a corporation organized and existing under the laws of the State of New Jersey, party of the second part, WITNESSETH: WHEREAS, the said John F. Blanchard is the owner of certain personal property and of certain patents, granted and pending on a device known as "Combusto Device" and WHEREAS, it is believed by the parties hereto that the gross business to be shown in the future is to be at least $200,000 and upwards per annum, in which, from the investigations made by the parties hereto and from past experience, there is a net profit of at least thirty-five (35%) per cent, and, WHEREAS, the Van Kannel Revolving Door Company is desirous of purchasing and acquiring said property and patents, PARAGRAPH 1. Now, THEREFORE, this agreement witnesseth that for and in consideration of the sum of One Dollar each to the other in hand paid, receipt of which is hereby acknowledged and of the mutual*2152 covenants herein contained the said Blanchard does agree to sell, assign and transfer to the Van Kannel Revolving Door Company the personal property and patents granted and pending set out in the Schedules hereto attached free and clear of all incumbrances whatever except the sum of $5,000 indebtedness owing which the Van Kannel Revolving Door Co. is to pay from the collection and inventory taken over by the Van Kannel Revolving Door Company as the sum so reduced to cash. The Van Kannel Revolving Door Company agrees to purchase said personal property and patents and to pay therefor the sum of $165,000.00 in installments as follows: On December 31, 1921, the sum of $15,000 provided, however, that the gross sales of Combusto Devices made during the year 1921 equal the sum of $200,000. On December 31, 1922, the sum of $25,000 provided that the gross sales equal $300,000. On December 31, 1923, the sum of $25,000 provided that the gross sales equal $400,000. On December 31, 1924, the sum of $25,000 provided that the gross sales equal $500,000. On December 31, 1925, the sum of $25,000 provided that the gross sales equal $650,000. On December 31, 1926, the sum of $25,000*2153 provided that the gross sales equal $800,000. On December 31, 1927, the sum of $25,000 provided that the gross sales equal $1,000,000. PARAGRAPH 2. IT BEING AGREED between the parties hereto that, if for any reason, the gross sales do not equal in any one year the amount mentioned above that then and in that event the said Blanchard is to receive and the Van Kannel Revolving Door Company is obligated to make payments in lieu of the amount set forth in the above table for the year covered by such *1275 accounting to an amount equal to ten (10%) per cent upon the gross sales as per the following table: On December 31, 1921, 10% on gross sales above $100,000 up to $199,000. On December 31, 1922, 10% on gross sales above $175,000 up to $299,000. On December 31, 1923, 10% on gross sales above $250,000 up to $399,000. On December 31, 1924, 10% on gross sales above $325,000 up to $499,000. On December 31, 1925, 10% on gross sales above $450,000 up to $649,000. On December 31, 1926, 10% on gross sales above $575,000 up to $799,000. On December 31, 1927, 10% on gross sales above $750,000 up to $999,000. and the Company is hereby released of any further liability*2154 to make further payments for the particular year covered and said amount is to be received by said Blanchard in full settlement for the amount to be paid under this contract for such year. PARAGRAPH 3. IT BEING AGREED that the said Blanchard accepts in full of the payments so to be made on December 31, 1921 and each year thereafter the sums mentioned herein provided the sales reach the aggregate mentioned in paragraph 1, herein and in case the sales do not reach the aggregate amount mentioned herein the said Blanchard is to receive in full settlement and liquidation of the various amounts agreed to be paid by the Company on December 31, in each year a sum equal to ten (10%) per cent per annum upon the amount of gross sales as per table set forth in paragraph, 2, but in no event is said Blanchard to receive more than the amount which the Van Kannel Revolving Door Company obligates itself to pay on December 31, in each year as hereinbefore stated in paragraph 1. The sales made by the Revolving Door Co. under the contract for the various years to the time of the hearing were as follows: Period Amount Year ended - Dec. 31, 1921 $10,233.90 Dec. 31, 1922 12,513.38 Dec. 31, 1923 22,023.47 Dec. 31, 1924 59,252.88 Dec. 31, 1925 129,324.82 Dec. 31, 1926 104,470.58 Dec. 31, 1927 $183,910.96 Dec. 31, 1928 189,525.82 January, 1929 17,114.00 February, 1929 13,823.15 March, 1929 7,619.70 *2155 The result of performance of the contract was that petitioner was not entitled to receive anything thereunder and was not paid anything. In making his tax returns he deducted as losses from gross income $15,000 for 1921, and $25,000 for each of the years 1922, 1924, 1925, and 1926, being the maximum amounts he might have been entitled to under the contract had it been successful. The respondent disallowed the deductions. OPINION. LITTLETON: A great deal of evidence was introduced relative to the value of the patents in 1920. Although the patents cost only $12,000 and had been the basis of an unsuccessful business for six years, the evidence was to the effect that they were worth $135,000. There is no complaint made in the petition that any error was committed by the respondent in valuing them and in fact he did not *1276 place a value upon them. Under these circumstances we do not consider it necessary to fix a value on the patents and, in addition, we regard it immaterial. In his petition and brief petitioner uses the terms "loss" and "bad debt" interchangeably, but in any event his right to a deduction for either for any year depends on the contract with the*2156 Van Kannel Revolving Door Co. Under the terms of the contract with the Van Kannel Revolving Door Co. it agreed to pay a lien indebtedness of $5,000 against the property transferred to it, and in addition agreed to pay the petitioner the sum of $165,000 in installments of $15,000 on December 31, 1921, and $25,000 each on December 31, 1922, to 1927, inclusive. These payments and the liability therefor were absolutely contingent upon the success of the enterprise and the amount of the gross sales of the Combusto Devices during the specified years: for instance, for the year ending December 31, 1921, the payment was fixed at $15,000 under paragraph 1, provided the gross sales during 1921 equaled $200,000, and if the sales did not equal $200,000, it was provided in paragraph 2 that petitioner should be paid 10 per cent on gross sales above $100,000 up to $199,000. By the terms of the contract petitioner was not entitled to anything for 1921 unless the gross sales were $100,000 or over. For the years ending December 31, 1922, to 1927, the payments were $25,000 yearly and gross sales ranged from $300,000 to $1,000,000, but the payments likewise depended entirely on the amount of gross*2157 sales and were purely contingent. In no year did the gross sales equal the required amount either under paragraph 1 or 2, and the petitioner never received anything, nor was the Revolving Door Co. under any liability to pay petitioner anything. No debt was created, and no loss was suffered by reason of this contract during the taxable years. A contingent debt or loss can not be deducted from gross income and a contingent liability is not a debt. With the performance of this contract the alleged payments ceased to be even contingent and at the time of the deductions taken by petitioner it had been demonstrated that he was not entitled to said payments and that none were due. In , petitioners had canceled certain policies of fire insurance on property, which was soon after burned. They claimed that they were still entitled to something under the policies and sought deduction for said amounts. In refusing the deduction the Board said: To entitle a taxpayer to deduct from gross income, as a bad debt, an item ascertained to be worthless, and charged off in a given year, such a debt must have had an existence in fact. A debt*2158 which never existed cannot be charged *1277 off. The right to a deduction arises from the discovery that something which had value has ceased to have it; a debt which never existed had no value to lose. The taxpayer has not shown a debt to have existed from the insurance company to it. It must follow that it is not entitled to take as a deduction from gross income, in the nature of a bad debt, the item of $4,728.97 here in question. , was a case in which the petitioner made advances to a reclamation district in California before it was legally organized. The district declined to pay him on the ground that it could not legally do so. He sought deduction from gross income for a subsequent year as a bad debt or loss. The Board disallowed it and said: So far as the money spent for the benefit of the proposed reclamation district is concerned, it is not contended that any legal debt was created, although at the time the money was expended taxpayer believed it created a debt. In this respect the appeal falls squarely within the decision of this Board in *2159 . If the deduction be claimed as a loss sustained rather than as a bad debt, it is clear that such loss, if any, accrued at the time the money was expended. In , the petitioner in 1919 put up $5,000 in cash to guarantee the performance of a contract, which was subsequently canceled because of failure to comply. The holder of the deposit refused to return it, on the ground that there was no liability and it was entitled to retain it. The taxpayer asked deduction in 1920. The Board disallowed it and said: We have held that before a deduction can be allowed on account of a debt ascertained to be worthless and charged off there must first be a debt. ; . In this appeal any amount due by Hoffberger & Co. was at all times collectible. It is not intimated that they were not financially responsible and able to pay the amount. They denied owing the taxpayer anything, and claimed that the taxpayer owed them damages in excess of the amount. This appears to have been the*2160 only reason that the claim was not paid in full in 1919, when the controversy arose. It is true that in 1921 Hoffberger & Co. did pay one-fourth of the amount to the taxpayer in settlement of the claim. If the debtor was not legally liable to the taxpayer, then there was no debt to become worthless. It can not become worthless because of inability to establish legally the liability for the debt, for in such a case there is not an ascertainment of worthlessness of an existing debt, but an ascertainment of the nonexistence of such a debt. If the taxpayer sustained a loss from the transaction, such loss is deductible only in the year in which the loss is sustained. It is sufficient for the purposes of this appeal to say that the loss was not sustained in 1920. The case of , was one in which the petitioner was engaged in the performance of a Government contract, and additions were ordered and made without authority. Petitioner sought deduction after efforts to collect were futile. The Board there said: *1278 In the instant case the petitioner*2161 has wholly failed to prove that there was ever a valid debt due it from the United States. On the other hand, the record shows that the United States at no time admitted any liability and that the Court of Claims judicially determined that the petitioner had no valid claim for the amount in controversy, or for any other amount, and that it rendered judgment against the petitioner and dismissed its suit. The petitioner declined to appeal from that judgment and it became final some time in 1920. The decision of the Court of Claims was the ascertainment of the nonexistence of the debt that the petitioner claims, and is binding upon this Board. It follows that since no debt existed there was nothing to charge off or deduct. In , the taxpayer had a contract to share in the profits resulting from a sale of real estate and upon a cancellation of the contract it was held that it was not such a property right as to entitle him to deduct as a loss sustained from the sale or other disposition of property the amount of the profits which he had hoped to realize had the contract continued in force and a sale been made. *2162 The case of (Court of Appeals, District of Columbia), is an instructive case from the opposite angle of the proposition. In that case the contingent obligor sought deduction for contingent liabilities before paying them and before the amount of the liability had become fixed or due. A contract was entered into by the taxpayer with certain of its employees by which the employees were to share in the profits and losses for a period of five years. It was further provided that their shares of the profits should remain in the business until the end of the five-year period, and no part thereof should be withdrawn except by permission of the president. For the year 1919 the first year of the agreement the employees were credited with $116,548.44 as their share. Taxpayer accrued this as a liability for 1919 and deducted it from gross income. In 1920 the taxpayer lost $90,000 and charged $41,765.68 of it against the employee's portion earned the previous year. In disallowing the deduction, the court reviewed a number of cases and concluded its opinion thus: It will be observed that under the contract as set forth*2163 in the resolution all sums to which the employees might become entitled during the period of five years should remain in the business, and should be subject to pro rata deductions in the event of losses incurred in the business during the 5-year period. Appellant paid out nothing. It took nothing from its business. The entry on the books represented only a possible future liability. In other words, the profits and losses credited and charged to the account of each of the employees should be accounted at the end of the 5-year period, and if the credits exceed the losses the excess would represent the amount to which the employee would be entitled. On the other hand, if the losses exceeded the credits, the employee would be entitled to nothing. It follows that the events which were to determine and fix appellant's liability to its employees could *1279 not occur until the expiration of five years; and, by the terms of the agreement, if an employee was discharged or left the employ during the period of five years, he should take nothing under the agreement, whether the credits were in his favor or not. It follows, therefore, that the events which were to determine and fix*2164 appellant's liability did not occur in the year 1919, and could not occur so as to admit of a final determination until the end of the 5-year period, at which time the definitely fixed and accrued expense could be deducted and credit taken on its tax in the current year. In the instant case the contingencies never happened that would entitle petitioner to the amounts claimed as deductions and it follows that their disallowance was proper. If they had been debts their worthlessness was not ascertained and could not have been, for the Revolving Door Co. was a prosperous concern, doing a $1,000,000 business and profits from $100,000 to $150,000 annually. Judgment will be entered for respondent.