Scovill v. Commissioner

ELLEN HYDE SCOVILL, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Scovill v. Commissioner Docket No. 81308. United States Board of Tax Appeals 36 B.T.A. 1214; 1937 BTA LEXIS 613; December 28, 1937, Promulgated *613 1. Where a person of ordinary prudence under similar circumstances would have ascertained the worthlessness of debts prior to the taxable year, held, that petitioner will be considered as having ascertained their worthlessness at that time. 2. Where a person of ordinary prudence under similar circumstances would have known that advances made by petitioner to a corporation during the taxable year would not be repaid, held, such advances were not loans and are not deductible as bad debts. Edgar J. Goodrich, Esq., and Neil Burkinshaw, Esq., for the petitioner. B. H. Neblett, Esq., for the respondent. KERN *1214 This proceeding arises on respondent's determination of a deficiency in petitioner's income tax for the calendar year 1931 in the amount of $7,260.62, which results from respondent's disallowance of $284,439.68 claimed as a bad debt ascertained to be worthless and *1215 charged off in that year. Petitioner's counsel, at the hearing and on brief, claimed the deduction of only $246,000, the principal of the debt. This is the sole issue. FINDINGS OF FACT. Petitioner is a wealthy woman, with an annual net income*614 in the decade before the taxable year ranging between $51,000 and $156,000. For 1931 her net income, exclusive of the deduction here in question, was around $76,000. The main source of her income was stock held in the Scovill Manufacturing Co., which fell greatly in value in 1930-1931. At the time of the hearing she was about 84 years old and had been an invalid for years, but still had a clear mind. In 1925 petitioner's son, H. Lamson Scovill, and one Pederson, the holder of certain patents, organized a corporation under the laws of New York, "The Oil Jack Co., Inc.", to manufacture and sell a hydraulic jack. The petitioner purchased all of the issued preferred stock of the company and paid for it in cash at par, but got none of the common stock, the stock holdings of the company being as follows from its organization until November 2, 1931: Shares held 1 Preferred stock Common stock Ellen Hyde Scovill [500] None H. Lamson Scovill None 187 1/2 T. W. Pederson None [25] L. C. Vannan None [25] Others None 12 1/2 Total shares issued [250] The controlling interest in the common stock was held by petitioner's son. *615 The Oil Jack Co. advertised widely and made some sales, but there was no particular demand for such a jack. Both Scovill and Pederson were at all times optimistic and believed that they had a basic patent and that the hydraulic jack would ultimately replace the mechanical jack then in use. Despite this confidence the company continued to lose money, its net losses through the years in question (the net loss for the next two preceding years being carried forward each year) being as follows: [1925] $38,443.64 [1926] 87,289.09 [1927] 123,642.47 [1928] 128,796.77 [1929] $132,563.76 [1930] 155,144.61 [1931] 311,861.96 *1216 Within a year after the corporation was formed and throughout its life petitioner made cash advances to it, and received from the company notes in amounts and payable as follows: Date Amount Payee Payable Jan. 19, 1926 $5,000 n1 Ourselves 6 months. Feb. 11 5,000 do Do. Mar. 25 5,000 do Do. May 6 5,000 do Do. June 16 5,000 do Do. July 13 5,000 do Do. Aug. 19 5,000 do Do. Sept. 21 10,000 do Do. Oct. 7 15,000 Oil Jack Co Do. Nov. 24 5,000 1 Ourselves Do. July 11, 1927 3,500 Mrs. E. H. Scovill. 12 months. Aug. 3 2,000 do Do. Sept. 13 3,000 do Do. Oct. 11 1,500 do Do. Oct. 15 1,000 do Do. Nov. 2 5,000 do Do. Dec. 1 4,000 do Do. Jan. 9, 1928 3,000 do Do. Feb. 28, 1928 $1,500 Mrs. E. H. Scovill. 12 months. Mar. 13 3,000 do Do. Apr. 4 2,500 do Do. Apr. 13 2,000 do Do. May 9 2,000 do Do. June 8 1,000 do Do. June 25 1,000 do Do. July 5 2,000 do Do. July 20 1,000 do Do. July 28 [500] do Do. Aug. 4 [500] do Do. Aug. 10 2,000 do Do. Aug. 17 2,000 do Do. Jan. 2, 1930 45,000 Ellen Hyde Scovill. Demand. Jan. 2, 1931 56,000 do Do. Nov. 2, 1931 36,000 do Do. *616 All of the notes were made by the company, H. L. Scovill signing, and were endorsed in blank by the corporation, H. L. Scovill, its president, and T. W. Pederson, its vice president, signing. None of them was ever paid in cash, nor did petitioner ever receive any assets of the corporation in payment therefor. No claim of deduction was made in respect of them until 1931. The notes were carried as "notes payable" on the company's books and interest accrued thereon. At the time petitioner made these loans to the company she gave no thought to the question of whether or not they would be repaid. Her reason for making the loans was to help her son in forming and financing the company. She regarded him and the company as synonymous and she did not expect to make any money from the loans. Several bankers, from the time in 1926 when the first loan was made, had told her that she was foolish, since the loans were worthless. After she understood that her son would not succeed in the business, *617 she continued to make the loans against her better judgment to help her son. In 1928 one Moore, trust officer of a Waterbury, Connecticut, bank which had an agency contract with petitioner, took over the financial management of her affairs. Petitioner was a borrower in substantial amounts from the bank. Moore thought in 1928 that petitioner's prior advances to the company were worthless when made and that the company was insolvent, *1217 but it was not until 1931, when the drop in market value of petitioner's Scovill Manufacturing Co. stock made it necessary to raise the question, that he felt he should discuss this matter of her loans with her. He did not advise petitioner to take any steps against the company for collection of the overdue notes or to follow the assets of the company when dissolved. Moore advised petitioner that her advance or loan of $36,000 to the company on November 2, 1931, was foolish, and a day or so thereafter he explained to her thoroughly the company's bad financial situation and told her that all her loans were therefore uncollectible and were bad debts. Petitioner made no effort to obtain repayment of the loans. On November 6, 1931, petitioner*618 charged off all her loans to the company, in the sum of $246,000, as bad debts. On December 11, 1931, the Oil Jack Co., hereinafter called "the old company", was dissolved. At that time its assets consisted of certain patents and machinery, more or less obsolete, for making jacks, not worth more than $25,000. On December 26, 1931, the "Oiljack Manufacturing Company, Inc.", a New Jersey corporation, hereinafter called "the new company", was organized, which took over the assets of the old company and assumed its liabilities, excluding the debts owed to petitioner. There was no positive act of forgiveness of this indebtedness of the old corporation by petitioner. The same persons controlled the new company as the old and they wanted to get a "fresh start", free from debt. The new company's assets had little value, the patents had none. The new company stopped manufacturing jacks and began a new line of manufacturing. It began to do business in December 1931 and is still in business. The stock in the new corporation was held as follows: Shares held 1 Preferred stock Common stock Ellen Hyde Scovill [105] H. Lamson Scovill [1] T. W. Pederson [10] None L. C. Vannan [1] T. F. Moore None [1] Total issued [108] *619 Petitioner exchanged her preferred stock in the old corporation for he preferred and common stock shown above in the new, but claimed no loss for income tax purposes on her stock investment by reason of the new stock's lower value. The new company made no profits in 1931, 1932, or 1933. In May 1932 petitioner lent some *1218 money to the new company, and within three or four years the sum lent by petitioner had grown to around $19,000. These new loans were made contrary to Moore's advice, who regarded them as speculative. A reasonably prudent person under similar circumstances would have known that said loans made prior to 1931 were worthless before 1931. A reasonably prudent person would have known that the advances made in 1931 would not be repaid and would not have expected repayment. OPINION. KERN: The only question here is whether petitioner may claim the deduction of $246,000 representing the principal of advances made to the Oil Jack Co. from 1926 to 1931, inclusive, as a debt ascertained to be worthless and charged off in 1931, under section 23(j) of the Revenue Act of 1928, set out in the margin. 1 The petitioner contends that the*620 advances by her to the company were bona fide loans to the corporation, not in the nature of gifts to her son, who held the major interest in the company, or capital contributions to his company; and that the time when the debt was ascertained to be worthless depended upon the judgment and discretion of the taxpayer. On the petitioner's deposition alone we should feel grave doubts in saying whether the advances made by petitioner to the Oil Jack Co. prior to 1931 were bona fide loans, or in the nature of gifts to her son, or capital contributions to his company. Our doubts are caused by the glaring contradictions contained in petitioner's deposition, from which we set out the following quotations: Q. While you were making these loans did you do*621 so with full faith that they would ultimately be repaid in full to you? A. Most certainly I did. My son was president. * * * Q. Do you recall whether or not you made any effort to collect these notes when they came due? A. I cannot recall. But you must know, Mr. Neblett, I loaned this money to my son, and I knew he couldn't pay me. Q. In fact, you knew at the time you loaned him this money that he couldn't pay you bank, didn't you, Mrs. Scovill? A. I didn't loan it to him personally; I loaned it to the Company and I thought the Company would repay me. * * * *1219 Q. As I understand it, Mrs. Scovill, you never made any effort to collect the money owed you in either 1926, 1927, 1928, 1929, 1930, 1931 from either your son or the Oiljak Corporation. A. You see, they were synonomous. He was the Company. What I wanted to do was to help him in forming the Company. Frankly, I had no idea of making money when I made the loans. And I wasn't mistaken. Q. And it was very doubtful in your mind whether you would ever collect at the time you made them? A. As far as I can remember, I never thought anything about whether I would collect. I wanted*622 to help my son. Q. And that was the main reason why these advances were made to the Corporation because you wanted to help your son? A. Certainly. * * * Q. And your main reason for making these advances was to help your son? A. Yes, I am not quite an idiot. If we assume, however, in petitioner's favor, that these advances made by petitioner were loans, we can not escape the conclusion that any reasonably prudent person, under similar circumstances, would have ascertained that such loans were worthless prior to 1931, the taxable year. Petitioner's financial advisor testified that he was aware of the worthlessness of petitioner's loans to the Oil Jack Co. in 1928, and petitioner herself testified that she was advised by a series of bankers in 1926 and subsequent years that these loans were worthless. The company had had consistent net losses from 1925 to 1930, inclusive. By the middle of 1930 petitioner had notes of the company in the amount of $109,000, all of which were past due, and a demand note for $45,000 upon which not a penny of principal or interest had been paid. It is the contention of counsel for the petitioner that only the time of petitioner's*623 personal ascertainment of worthlessness is relevant. In other words, it is said that, because of petitioner's maternal solicitude in the business welfare of her son, who controlled the corporation in question and was regarded by her as synonymous with the corporation, she might have disregarded the business aspects of the transaction and closed her eyes to the worthlessness of the obligations of the corporation until a time long subsequent to the time when an ordinarily prudent person would have ascertained their worthlessness. We do not conceive this to be the law. In the case of , the Circuit Court of Appeals (5th Cir.), in a case involving this question, used the following language: It is contended by petitioner that the evidence before the Commissioner and the board was undisputed, and that, having exercised an honest belief in ascertaining and charging off the debts sought to be deducted in the year 1919, both the Commissioner and the board were concluded by his judgment. *1220 The Revenue Act of 1918 (40 Stat. 1057), which applies to this case, permits a taxpayer, in computing net income, to deduct debts*624 ascertained to be worthless and charged off within the taxable year. The reasonable interpretation of the law is that, in order to secure a deduction of worthless debts, they must be charged off in the year they are ascertained to be worthless. A man is presumed to know what a reasonable person ought to know from facts brought to his attention. A taxpayer should not be permitted to close his eyes to the obvious, and to carry accounts on his boks as good when in fact they are worthless, and then deduct them in a year subsequent to the one in which he must be presumed to have ascertained their worthlessness. To do so woould enable him to withhold deductions in his less prosperous years, when they would have little effect in reducing his taxes, and then to apply the accumulation at another time to the detriment of the fisc. This would defeat the intent and purpose of the law. Honesty of belief in the taxpayer is not conclusive, nor binding on the board. It is the province of the board to determine, on a review of all the facts and circumstances surrounding the particular debt sought to be deducted, whether the taxpayer knew or ought to have known its worthlessness in a prior*625 year. If knowledge of the worthlessness of a debt sought to be deducted can thus be brought home to the taxpayer, it cannot be said that the worthlessness was ascertained in the subsequent year, when it is actually charged off. This case was cited with approval by the Circuit Court of Appeals (8th Cir.) in . This objective test laid down in the two preceding cases cited, is also partially recognized in the case of , where the Circuit Court of Appeals (7th Cir.), in holding that the taxpayer was justified in ascertaining the debt to be worthless during the taxable year, made use of the following language: We think that he ascertained this fact for the first time, to his own satisfaction, in 1921, and that in arriving at such conclusion he made reasonable investigation of the fact and drew reasonable inferences from the information thus obtained. The point upon which petitioner cites this case has no application in the present facts, that the business was such that for the first few years of its life a prudent business man might have hoped, despite its losses, *626 for ultimate success. The Oil Jack Co., with its increasing losses, raised no hopes in petitioner's advisers of any ultimate recovery. This is not a case of after-acquired knowledge presently applied as in the Jones case. Petitioner also relies upon the case of ; affd., . This case should not be taken as authority for more than it actually decided. The actual holding was that an obligation held by petitioner did not automatically and by operation of law become worthless in the year in which the operation of the statute of limitations barred petitioner's right of action on such obligation. The rest of the opinion in that case, which is dictum, apparently considers the case of , as *1221 authority for the exclusive application of the subjective test to the ascertainment of the worthlessness of debts on the part of taxpayers. No mention is made of the case of The Circuit Court of Appeals for the Ninth Circuit, in affirming the Burdette case, indicated that it might have held otherwise if this*627 Board had found as a fact, as we have done here, that an average prudent person would have ascertained the worthlessness of the debt in an earlier year, for the court quoted with approval the passage in the Avery case to the effect that it is the province of this Board to determine "whether the taxpayer knew or ought to have known its worthlessness in a prior year", and founded its judgment on our determination in the premises. In the circumstances we must consider what was said beyond the determination itself in our decision of the case as obiter dictum. The phrase "ascertained to be worthless" used in the statute involves two factors, actual worthlessness, or at least a state of facts from which a prudent business man would infer this ultimate fact, and actual knowledge of these facts obtained in that year by the taxpayer, or which he might have obtained had he used ordinary business sense. Since one step requires the exercise of a reasonable inference and the next step the exercise of reasonable diligence, the cases have not always clearly distinguished between the two standards of prudence, and some confusion therefore results. In the light of the decisions on*628 this question, however, we are of the opinion that a taxpayer, even when acting in all honesty, as the petitioner was in this case, can not shut his eyes to the real facts of the business transaction and determine a debt to be worthless in a taxable year long after the year in which an ordinarily prudent person would have reached the conclusion, on facts actually ascertained by him or which he might readily have ascertained if using normal business sagacity, that such obligations were worthless. Applying the objective standard applicable to the ascertainment of the worthlessness of obligations, as laid down in , we must conclude, with regard to the advances made by petitioner to the Oil Jack Co. in the taxable year 1931, that such advances were made with no reasonable belief at the time that they would ever be repaid to the petitioner. Since a reasonably prudent person, under similar circumstances, would have known at the time when the advances were made that they would not be repaid, we must conclude that such advances were either in the nature of a gift to the corporation or a contribution to its capital, and therefore were not*629 deductible as bad debts; . *1222 We have held that advances made by a taxpayer, even if a note is taken for their repayment, will be considered in the nature of a gift if, at the time the advances are made and the note taken, it is reasonable to believe that the note can not be enforced; ; also that advances obviously uncollectible when made, even though an understanding exists that they will be repaid, are not deductible as bad debts; . There is an implicit postulate in , and , construing the section of the act in question to the effect that the debts sought to be deducted as worthless must have had at some time a real commercial value. Accordingly, we hold that, according to the standard of conduct of an ordinarily prudent person under similar circumstances, petitioner should have ascertained, and therefore will be considered as having ascertained, that the advances made by her to the Oil Jack Co. during the years 1926 to 1930, inclusive, were*630 worthless prior to the taxable year 1931, and that by application of the same standard petitioner should have known, and therefore will be considered as having known, that the advancements made by her to this company during the taxable year 1931 would not be repaid to her, and that they were, therefore, in the nature of gifts or contributions to the company's capital. Reviewed by the Board. Judgment will be entered for the respondent. Footnotes 1. Par $100. ↩ 1. The word "ourselves" designating the payees in certain of the above notes referred to the officers of the corporation, who later endorsed the notes and delivered them to petitioner. ↩ 1. Par $100. ↩ 1. SEC. 23. DEDUCTIONS FROM GROSS INCOME. In computing net income there shall be allowed as deductions: * * * (j) Bad debts.↩ - 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); and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt to be charged off in part.