Athol Mfg. Co. v. Commissioner

ATHOL MANUFACTURING COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Athol Mfg. Co. v. Commissioner Docket No. 30388. United States Board of Tax Appeals 22 B.T.A. 105; 1931 BTA LEXIS 2173; February 6, 1931, Promulgated *2173 1. Petitioner held not entitled, under the provisions of section 206 of the Revenue Act of 1924, to deduct in 1924 the net losses of a predecessor corporation for 1922 and a part of 1923. 2. Amounts paid out by the petitioner upon obligations of a predecessor corporation, which it assumed as part consideration for the purchase of the assets of the predecessor corporation, constitute capital items and are not deductible from gross income as business expenses. 3. A reasonable addition to petitioner's reserve for bad debts in 1924 determined. Ralph E. Tibbetts, Esq., for the petitioner. Bruce A. Low, Esq., for the respondent. SMITH *105 This proceeding is for the redetermination of a deficiency for the calendar year 1924 in the amount of $3,027.49. The petitioner alleges that the respondent erred in denying a deduction on account of the net losses of its predecessor company for 1922 and the first six months of 1923; in denying the deduction of amounts paid in 1923 and 1924 upon the obligations of the predecessor company, which were assumed by the petitioner in consideration for purchase of the predecessor company's assets; and in*2174 refusing to permit the petitioner to deduct in 1923 and 1924 its actual bad debts ascertained to be worthless and charged off within the year, rather than the additions to a bad debt reserve. FINDINGS OF FACT. The petitioner was organized under the laws of the Commonwealth of Massachusetts on June 28, 1923. It is the successor in business of a corporation of the same name, hereinafter referred to as the old company, whose assets and liabilities it took over upon organization. The old company had issued and outstanding as of June 30, 1923, 13,815 shares of common stock and 10,408 shares of 7 per cent preferred stock. Approximately 94 per cent of both the common and preferred stock outstanding was held by the Laroy S. Starrett estate. The petitioner had an authorized capital stock of $600,000, divided into 6,000 shares of 6 per cent preferred stock of a par value of $100 each, and 15,000 shares of common stock of no par value. The common and preferred stock of each company carried voting rights. *106 At a special meeting of the stockholders of the old company held on June 23, 1923, the following resolution was adopted: Voted that this corporation be reincorporated*2175 under the same name; that the president be authorized and directed in the name and on the behalf of this corporation, in such form as he by his signature thereto may approve, to offer to sell, assign and transfer to said new corporation, when formed, the entire business now carried on by this company as a going concern, with all the property, rights, assets and liabilities of all kinds wherever situate belonging to it in consideration of the issue to this company. (1) of fifty-eight hundred and eighty 5880 shares of preferred 6% cummulative stock of the new corporation; (2) of 10,408 shares of the new corporation's common stock, without par value, and (3) the delivery to this company of an agreement of the new assuming and agreeing to pay as and for its own debt, all debts and liabilities of this company whatsoever. The agreement referred to in paragraph (3) above was submitted and approved July 1, 1923. It reads as follows: KNOW ALL MEN BY THESE PRESENTS that the Athol Manufacturing Company, a corporation duly incorporated under the laws of the Commonwealth of Massachusetts June 28th, 1923, and located at Athol in said Commonwealth as part of the consideration for the*2176 corporation of the same name incorporated and doing business at said Athol, hereby covenants and agrees to undertake, pay, satisfy, discharge, perform, and fulfill as and for its own debts or obligation, all the debts, liabilities, contracts, engagements and obligations of the said transferor, the said Athol Manufacturing Company organized and doing business prior to June 28th, 1923, whatsoever and shall indemnify the transferor against all actions, proceedings, claims and demands in respect thereof. It was later agreed that the old company upon receipt of the shares of stock of the petitioner would immediately distribute 5,800 shares of the preferred stock to the estate of Laroy S. Starrett in payment of its indebtedness to the estate, and would transfer the common stock of the petitioner to the holders of the preferred stock of the old company share for share. The old company was then to cancel its preferred stock and dissolve. This agreement was later modified to authorize the petitioner to issue 5,880 shares of its preferred stock directly to the afministrators of the Laroy S. Starrett estate in full satisfaction of the old company's indebtedness to the estate in the amount*2177 of $588,000. Upon the petitioner's organization, which was carried out substantially according to the terms of the above agreement, it continued with the business formerly carried on by the old company with the same directors and officers. For the taxable year 1922, the old company sustained a net loss in excess of $100,000. During the period of its operation in 1923, from January 1 to July 1, 1923, it sustained a net loss of $425,979.24. Also, in the first six months of its operation, from July 1 to December 31, 1923, the petitioner sustained a net loss. *107 During the last six months of 1923 and during 1924, the petitioner paid out certain amounts on account of the obligations of the old company which it had assumed upon organization as part consideration for the assets of the old company (see clause (3) of the resolution of June 23, 1923, and the agreement of July 1, 1923, above). In its returns for the last half of 1923 and 1924, the petitioner claimed the deduction of these amounts as ordinary and necessary expenses. The respondent has denied the deductions, holding that they constitute additions to the cost of the assets of the old company and are therefore*2178 capital items. For several years prior to its dissolution the old company had made a practice of setting up in its books in a reserve for bad debts an amount equal to 1 per cent of its sales. In making its income tax returns, however, it claimed the deduction of the actual bad debts ascertained to be worthless during the taxable year. The petitioner continued the practice of the old company in setting up the bad debt reserve equal to 1 per cent of its sales, but in its first return for the six-month period ended December 31, 1923, it claimed the deduction of the additions to the reserve for that period and did not claim a deduction on account of the specific bad debts. The additions to the reserve amounted to $3,338.75, while petitioner's books showed only $52.30 of actual bad debts. The return was prepared by an employee of limited experience who was unfamiliar with the method of treating bad debt deductions followed by the old company in its income tax returns. Correcting book entries were made in the following year by thepetitioner's regular accountant. In all subsequent years, including 1924, the petitioner has continued to set up the bad debt reserve equal to 1 per*2179 cent of its sales and has claimed a deduction in its returns for the actual bad debts ascertained to be worthless and charged off during the year. The additions to the bad debt reserve in 1924 amounted to $8,434.75, while in its return for that year the petitioner claimed a deduction on account of actual bad debts in the amount of $28,266.05. An examining revenue agent who made an audit of the petitioner's books during 1926 reduced the amount of the allowable bad debts for 1924 to $20,895.21. The agent recommended that the bad debts ascertained to be worthless and charged off in 1923 and 1924, rather than the additions to the bad debt reserve, be allowed as deductions in those years. The respondent admits that the correct amount of bad debts for 1924 is $20,895.21. OPINION. SMITH: The petitioner contends that it is entitled, under the provisions of section 206 of the Revenue Act of 1924, to deduct from its *108 gross income of that year the net losses of its predecessor company for the first half of 1923 and for 1922. There is no dispute between the parties as to the fact of the losses or the amounts thereof. The controversy is over the question whether the petitioner*2180 here is the taxpayer entitled under the statute to the benefits of the deduction. Section 206 of the Revenue Act of 1924 provides in part as follows: (b) If, for any taxable year, it appears upon the production of evidence satisfactory to the Commissioner that any taxpayer has sustained a net loss, the amount thereof shall be allowed as a deduction in computing the net income of the taxpayer for the succeeding taxable year (hereinafter in this section called "second year"), and if such net loss is in excess of such net income (computed without such deduction), the amount of such excess shall be allowed as a deduction in computing the net income for the next succeeding taxable year (hereinafter in this section called "third year"); the deduction in all cases to be made under regulations prescribed by the Commissioner with the approval of the Secretary. The evidence shows that the petitioner is a separate and distinct legal entity from its predecessor company. It was created under a new charter issued by the Commonwealth of Massachusetts in June, 1923. Its existence as a legal entity dates from that time. Upon organization it acquired the business and assets of the old company*2181 in exchange for its own shares of stock. These facts are not disputed, but the petitioner contends that for the purpose of granting the relief sought the separate legal entities should be disregarded. The burden of petitioner's argument rests upon this point. We discussed this question in substantially similar form in , where we said: So here we have corporations organized under the laws of different States and presumably having different rights and powers, and, while both had the same amount of preferred stock, there was a change in common stock from 12,201.5 shares or $100 par to 80,000 shares of no par. These changes are matters of substance and not to be lightly disregarded. See . In our opinion they are conclusive against the claim that the new corporation is the same taxable entity as the old. Cf. , and . It is worthy of note in passing that the petitioner's views, if accepted, would have far-reaching effects on other tax questions. The result would be that many*2182 corporations upon reorganization would be deprived of the benefits arising from a revaluation of assets acquired from predecessors. * * * The only material difference in the facts between this case and The Maytag Co. case is that in the latter case the new corporation was organized in a different State from the predecessor corporation, whereas the petitioner was organized in the same State as the old company. We do not think that this fact is material in considering the question before us, that is, whether the petitioner *109 is "the taxpayer" that sustained the loss in the prior year. Rein-corporation in another State might have resulted in a greater or lesser change in the rights and interests of the stockholders, creditors, and others, than reincorporation in the same State (see ), but it can not be said that the one would have been less effective than the other in creating a new legal entity. Unquestionably the intent of the parties and the consequence of their acts was to create a new corporation. The petitioner, in his brief, relies strongly upon *2183 , and . These are both cases in which the courts found it necessary to disregard a change of legal entities. Neither of the cases, however, involved the section of the statute here under consideration. In , the question was whether the new company was entitled to deduct an amortized portion of the discount on bonds issued by the old company. The new company was a consolidated company which had taken over by agreement all the assets and liabilities of the old company. The Court held, reversing the decision of the Board, that the new company stood in he place of the old with respect to the bonds and was entitled to the deduction. In , the question was whether upon a reincorporation in the same State the stockholders received a gain upon the exchange of shares of the old company for shares of the new The court held that there was no gain meeting the definition of "income" as given in *2184 ; , and others. In the instant case, the question is more limited. The quoted section of the statute clearly restricts those entitled to the benefit of the net loss provisions to "any taxpayer" who sustained a net loss. It is undeniable that the petitioner here is a separate legal entity and is a different taxpayer from its predecessor company. Cf. . There is no question here of the rights of other parties and we see no requirement under the circumstances of this case for invocation of the rule pronounced in , that "courts will not permit themselves to be blinded or deceived by mere forms or law but. regardless of fictions, will deal with the substance of the transaction involved as if the corporate agency did not exist and as the justice of the case may require." The petitioner further contends that it is entitled to deduct certain amounts paid out by it in 1923 and 1924 upon the obligations of the old*2185 company. Since, however, and petitioner assumed these obligations *110 of the old company as part consideration for the purchase of its assets, it is apparent that the amounts paid out upon such obligations are a part of the cost to the petitioner of the assets and constitute capital rather than business items, as the respondent has determined. See Thomas H. Mastin, & B.T.A. 72; affirmed in ; ; affirmed in . In its first income tax return, which covered the period July 1 to December 31, 1923, the petitioner deducted an amount set up in its books as a reserve for bad debts. This amount was considerably in excess of the debts ascertained to be worthless in that period. In its return for 1924 the petitioner, without having obtained the consent of the Commissioner to change its method, deducted the amount of debts ascertained to be worthless and charged off within the taxable year, which amounted to considerably more than the additions to the*2186 bad debt reserve made upon the petitioner's books of account for that year. The Commissioner, following Regulations 65, article 151, has permitted the petitioner to deduct in 1924 only the additions to its bad debt reserve shown by its books of account in that year. Article 151 of Regulations 65 reads in part as follows: Bad debts. - Bad debts may be treated in either of two ways - (1) by a deduction from income in respect of debts ascertained to be worthless in whole or in part, or (2) by a deduction from income of an addition to a reserve for bad debts. Taxpayers were given an option for 1921 to select either of the methods mentioned for treating such debts. See article 151, Regulations 62. The method used in the return for 1921 must be used in returns for subsequent years and for returns under the Revenue Act of 1924 unless permission is granted by the Commissioner to change to the other method. A taxpayer filing a first return of income may select either of the two methods subject to approval by the Commissioner upon examination of the return. If the method selected is approved, it must be followed in returns for subsequent years, except as permission may be granted*2187 by the Commissioner to change to another method. We said in : * * * It is our opinion that the requirement of the regulations that a taxpayer who exercised an election for 1921 as to he method of treating bad debts shall be bound by such election for all subsequent years, unless it asks the permission of the respondent to change to the other method and has a reasonable right to obtain it, is a valid exercise of discretion by the respondent. We think that the respondent has properly held here that the petitioner, not having first obtained permission to change from the reserve method used in its prior return, may not deduct its actual bad debts in 1924. ;; ; . *111 It is apparent, however, that the additions to the bad debt reserve in 1924 amounting to 1 per cent of the petitioner's sales were inadequate to meet the bad debt contingencies of that year. Under the provisions of section 234(a)(5) of the Revenue Act of*2188 1924 a taxpayer is permitted to deduct the "debts ascertained to be worthless and charged off within the taxable year (or in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts)." We think that a reasonable addition to the petitioner's reserve for bad debts in 1924 is $17,608.76, the difference between $3,286.45, the amount of the bad debt reserve on the petitioner's books at January 1, 1924, and $20,895.21, the amount of the debts which the examining agent found, and which the respondent admits, became worthless in 1924. See ; . Reviewed by the Board. Judgment will be entered under Rule 50. TRUSSELL dissents.