Herder v. Commissioner

ESTATE OF GEORGE HERDER, DECEASED, MARY HERDER, ALMA WILLIAMS, VIDA ALLEN, AND GEORGE HERDER, JR., EXECUTRICES AND EXECUTOR, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. MARY HERDER, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. R. L. WILLIAMS, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. ALMA WILLIAMS, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Herder v. Commissioner Docket Nos. 84000, 84001, 84051, 84052. United States Board of Tax Appeals 36 B.T.A. 934; 1937 BTA LEXIS 635; November 24, 1937, Promulgated *635 1. Where funds derived from fire insurance on a rice mill, destroyed by fire, were received in March 1934 and were reinvested in another and similar rice mill in May 1935, and during the intervening period there was a continuing purpose accompanied by diligent efforts made in good faith to so reinvest such funds, no gain or loss will be recognized under section 112(f), Revenue Act of 1934, although the permission of the Commissioner was not obtained to establish a replacement fund. 2. Where interest was not paid and the obligors were insolvent and no reason existed for believing that it would ever be paid, it was erroneous to accrue it or include it in taxpayer's gross income. 3. Evidence examined relative to deductions for worthless debts. 4. Cost of rice mill determined. Charles T. Byers, Esq., for the petitioners. Edward A. Tonjes, Esq., and Allen T. Akin, Esq., for the respondent. HILL *934 In these consolidated cases the respondent determined deficiencies in income tax for the taxable period and for the calendar year 1934 as follows: Name Docket No. Year Deficiency Mary Herder, Alma Williams, Vida Allen, and George Herder, Jr., executrices and executor of the estate of George Herder, deceased. 84051 Period Jan. 1 to Mar. 29, 1934. $2,288.05 Mary Herder 84052 [1934] 2,650.21 R. L. Williams 84000 [1934] 447.06 Alma Williams 84001 [1934] 447.06 *636 *935 The proceedings in the above numbered dockets are for the redetermination of the deficiencies set forth. The deficiencies result from the determination by the respondent that the profit of fire insurance on the rice mill of the Herder Rice Milling Co. (a partnership composed of George Herder, deceased, and R. L. Williams) should be included in taxable income of the decedent, George Herder, and his wife, Mary Herder, and petitioners R. L. Williams and Alma Williams, his wife; the inclusion by the respondent of certain unpaid interest in gross income of decedent, George Herder and his wife Mary Herder; and the disallowance of certain claimed worthless debts to decedent, George Herder and Mary Herder. Several minor items will be mentioned in the findings and opinion. FINDINGS OF FACT. The decedent, George Herder, and petitioner May Herder, were husband and wife and resided in the State of Texas. Petitioners R. L. Williams and Alma Williams are husband and wife and reside in Texas, and Alma Williams is the daughter of decedent George Herder and May Herder. Community property laws prevail in the State of Texas. The petitioners in Docket No. 84051 are the executors*637 of the last will and testament and the personal representatives of George Herder, deceased, who died March 29, 1934. In 1918 the decedent, George Herder, purchased a rice mill at Bay City, Texas, for $33,000, of which $2,000 was for land and $31,000 for the mill and machinery. He made certain improvements and additions so that his entire investment amounted to $42,270. About May 1, 1919, the petitioner, R. L. Williams, purchased a one-third interest in the mill at cost for the sum of $14,090, and he and decedent, George Herder, became partners under the firm name of Herder Rice Milling Co. The mill was completely destroyed by fire on January 15, 1934, and insurance in the amount of $50,000 was paid to the firm on or about March 15, 1934, and at once divided and distributed two thirds to decedent George Herder and one-third to petitioner R. L. Williams. Both George Herder and R. L. Williams intended to reinvest these insurance funds in the purchase or establishing of another rice mill and to carry on the same partnership business, but Herder died March 29, 1934, before anything was accomplished and neither his heirs nor personal representatives made such a reinvestment. Williams, *638 who had been in the rice milling business for many years, deposited his share of the insurance money in bank, and in the summer *936 of 1934 associated himself with J. M. Chummey and one Wintermann, of Eagle Lake, for the purchase and operation of a rice mill. They contracted for the purchase of the Eagle Lake Rice Mill, but some trouble developed in the title. After endeavoring for about six months to clear the title without success, the purchase of the Eagle Lake Rice Mill was abandoned. Williams then went to Houston to investigate the Gulf Coast Rice Mill. This mill was purchased May 1, 1935, for $78,000 by Williams and others. Williams purchased a one-half interest and in paying therefor used his share of the insurance fund and more to make up for his half of $78,000. This mill is similar to the one destroyed, uses the same process, and produces a like product. Williams did not comply with Regulations 86, article 112(f) 1, 2, requiring the permission of the Commissioner to establish a replacement fund or give bond as therein required, as he did not know of these requirements. We find that Williams acted in good faith and that the insurance fund was forthwith*639 expended in the purchase of property similar to that destroyed. The ledgers of the Herder Rice Milling Co. for the period 1918 to 1926 were destroyed in the aforementioned fire. During the period 1925 to January 9, 1934, there was expended by the Herder Rice Milling Co. the sum of $27,501.53 for repairs to building and machinery and deductions were taken as expense items in the returns for the respective years in amounts aggregating the aforementioned $27,501.53. In the years previous to 1925 a like amount was expended for like expenses. During the period August 8, 1931, to September 11, 1933, there was expended, for machinery having a useful life of more than two years, and charged to capital account the sum of $6,563.70. No depreciation was ever set up on its books or taken by the Herder Rice Milling Co. on its assets. The depreciation sustained from 1918 to 1934 (as computed by the respondent, on the cost of the Herder Rice Milling Co.'s property at the rate of 4 percent) is $24,095.14. There was a small amount of salvage, valued at about $1,000, as a result of the fire. On the partnership return filed by the Herder Rice Milling Co. for the fiscal year ended*640 July 31, 1934, there was reported a profit of $7,695.49 on account of the destruction by fire of its rice milling plant, computed as follows: Insurance collected $50,000.00 Cost, 1918 $33,000.00 Additions 9,271.35 42,271.35 New machinery, 1931-1933 6,563.70 48,835.05 Added by revenue agent's report 803.94 49,638.99 Replacement and improvement in lieu of depreciation 8,693.24 58,332.23 Less depreciation allowable 14,027.72 44,304.51 Less real estate 2,000.00 42,304.51 Profit 7,695.49 *937 Upon audit the Commissioner increased the profit reported on the partnership return of the Herder Rice Milling Co. resulting from the fire loss to $28,799.26, computed as follows: Insurance collected $50,000.00 Cost, 1918 $33,000.00 Less land 2,000.00 31,000.00 Est. improvements 6,953.51 Additions, 1918-1934 8,342.37 Total cost 46,295.37 Less: Accrued depreciation 24,095.14 Depreciated balance 22,200.74 Less: Salvage value warehouse 1,000.00 21,200.74 Profit realized 28,799.26 The Commissioner increased the income reported by each petitioner in an amount equal to their pro rata share of*641 the additional gain computed by him as being the income in the partnership profit. We find the profit was $28,799.26. In the cases of the estate of George Herder, deceased, Docket No. 84051, and Mary Herder, Docket No. 84052, deductions for worthless debts are claimed in the total sum of $29,975.56, one-half thereof for each petitioner. At the time of the death of George Herder, debts owing him amounted to $44,425.56, which were appraised for estate tax purposes at $14,450, leaving $29,975.56 of such debts appraised at no value and not included in the value of the estate for estate tax purposes. These debts in the amount of $29,975.56 were claimed as deductions as bad debts on the income tax returns of Mary Herder for the year 1934 and of the estate of George Herder, deceased, for *938 the period March 30 to December 31, 1934. The latter period is not before us. They were not claimed as deductions on the income tax return of George Herder, deceased, for the period January 1 to March 29, 1934. Petitioners now claim thse debts became worthless with the death of George Herder on the last named date and that one-half thereof is properly deductible for the taxable period*642 January 1 to March 29, 1934, in the case of George Herder, deceased, and one-half for the calendar year 1934 in the case of Mary Herder. The debts so claimed as deductible are as follows: Wilbur Webb (4 notes) $6,744.87 J. W. Gates (dairy farm) 1,861.22 Emil Herder, deceased 2,298.53 Matthews Bros. (2 notes) 1,891.43 Jackson Bros 222.75 L. P. Bunge (2 notes) 8,884.71 Mrs. J. U. Frazar 2,143.50 W. R. Terrell (2 notes) 5,928.55 Total 29,975.56 At the hearing petitioners abandoned the claim for deduction of the debt of J. W. Gates (dairy farm) in the sum of $1,861.22. In 1934, subsequent to June 1, petitioners ascertained that the debts above described were worthless and claimed that they became worthless upon the death of George Herder. All of the debts in question were worthless. The debt of Emil Herder, deceased, for $2,298.53 and that of Jackson Bros. for $222.75 were worthless prior to the year 1934. The other debts listed above, except that of J. W. Gates (dairy farm) which has been eliminated from consideration, became worthless upon the death of George Herder. George Herder, deceased, during his lifetime, kept in his own name regular*643 books of account of the community composed of himself and Mary Herder, his wife. They were single entry books, kept on a cash receipts and disbursements basis and on them decedent at times charges off bad debts by entering credits for the amounts thereof. No reserve for had debts was set up on the books. After decedent's death the same books of account were kept by R. L. Williams for the executors of the estate of decedent and for Mary Herder. No other books of account were kept by or for the decedent, the executors of his estate, or Mary Herder. The debts here in question were never charged off nor credited on the books of account either before or after decedent's death. The income tax returns of Mary Herder for the year 1934 and of the estate of George Herder, deceased, for the period March 30 to December 31, 1934, were filed in March 1935 R. L. Williams, acting for the executors of the estate of George Herder, deceased, and for Mary Herder, made a list of the debts in question *939 and turned them over to the accountant when the latter made out these returns and told him they were worthless. They were deducted as bad debts in the returns named, in the amount of $14,987.78*644 on each return. The respondent disallowed the deductions in his deficiency determinations. The income tax return for George Herder (deceased March 29, 1934) for the period January 1 to March 29, 1934, was filed in October 1934. No part of the debts in question was deducted in that return. We find that these debts were never charged off either by the executors of the estate of George Herder, deceased, or by Mary Herder. In his determination of the deficiency against George Herder, deceased, Docket No. 84051, respondent added to his gross income one-half of $5,518.01, representing interest which had accrued to the community estate of decedent and his wife, Mary Herder, at the time of decedent's death but had not been paid. The interest so accrued and unpaid was as follows: Note Interest accrued Total interest accrued E. R. and Anna Franka $5,073.57 $411.24 4,460.38 350.88 $762.12 W. J. Wright 6,000.00 161.77 1,650.00 218.24 870.68 106.21 450.00 190.78 677.00 Matthews Bros 2,500.00 390.65 E. P. Schilling 365.00 12.25 Mrs. J. U. Frazar 11,500.00 3,324.93 4,143.50 80.23 755.00 270.83 3,675.99 Total interest accrued 5,518.01 *645 All of the obligors, except E. R. and Anna Franka, were insolvent and there was no reasonable expectation that the interest accrued on the debts of such insolvent debtors would ever be paid. On the Frnka note for $5,073.57 there was collateral security consisting of 50 shares of stock of the Garwood Lumber Co. of a par and book value of $5,000. There was reasonable certainty that the interest accrued on this note would be paid. The other Franka note for $4,460.38 was unsecured and it was reasonable certain that the interest accrued thereon would never be paid. We find that the interest accrued on the notes above listed, except the interest accrued on the secured Frnka note, was not income to the decedent. Relative to the sale of minerals on land in Andrews County, Texas, by petitioner Mary Herder, it was agreed by the parties hereto at the hearing that Mary Herder realized a profit of $1,498.50 to be taxed at capital gain rates. *940 OPINION. HILL: We shall take up first the cases of R. L. Williams and his wife Alma Williams, Docket Nos. 84000 and 84001. One of the errors alleged by them was that the respondent erred in including in their income certain salary*646 paid R. L. Williams. No evidence was taken on this issue and the finding of the respondent thereon is approved. These petitioners next object to the determination of the respondent fixing the amount of the profit resulting from the burning of the rice mill, and the inclusion of R. L. Williams' share of the proceeds as taxable profit or income. We agree that the findings of the respondent as to the cost of the mill and profit are correct, but we do not think the share of R. L. Williams is taxable. Williams collected his share of the insurance money in March 1934, and thereafter had the continuing purpose to reinvest it in similar property. Soon after the death of George Herder he endeavored to reinvest it in a mill at Eagle Lake. A flaw in the title caused a delay of six months, after which, with due diligence, Williams reinvested his part of the insurance money in the Gulf Coast Rice Mill on or about May 1, 1935. Under all the circumstances we think this was a reasonable time and hold that he made the reinvestment in similar property forthwith and in good faith. We hold, therefore, that under section 112(f) of the Revenue Act of 1934 no gain should be recognized for tax purposes, *647 notwithstanding no replacement fund was established and no permission for such fund was had from respondent under article 112(f)-2 of Regulations 86. In the recent case of August Buckhardt,32 B.T.A. 1272, we held that under the facts there the lapse of over two years between the conversion of taxpayer's property and reinvestment in similar property without the permission of the Commissioner to establish a replacement fund under article 580 of Regulations 74 was within the provisions of section 112(f) of the Revenue Act of 1928, and no gain should be recognized. Section 112(f) of the Revenue Act of 1934 is the same as section 112(f) of the Revenue Act of 1928. Article 112(f)-2 of Regulations 86 is the same as article 580 of Regulations 74 in respect to the requirement of permission of the Commissioner to establish a replacement fund. There is a sufficient parallelism between the facts of the instant case and those of August Buckhardt, supra, to justify our merely citing it in support of our holding here. We have examined the cases of *648 Eastern Steamship Lines, Inc.,17 B.T.A. 787, John J. Bliss,27 B.T.A. 803, and Frishkorn Development Co.,30 B.T.A. 8, cited and relied upon by the respondent, but we do not think they are applicable or decisive of this case, as in those cases the evidence was unsatisfactory as to the disposition and *941 reinvestment of the converted funds. In the instant cases the evidence is positive and uncontradicted that Williams deposited the money in bank and used it to reinvest in the new mill. The alleged gain on the insurance fund is not taxable to R. L. Williams or his wife, Alma Williams. As there was no reinvestment of the insurance funds collected by George Herder, his shareof the insurance fund is taxable as ordinary income for the period January 1 to March 29, 1934. Section 117(a) provides: "In the case of a taxpayer, other than a corporation, only the following percentages of the gain or loss recognized upon the sale or exchange of a capital asset shall be taken into account in computing net income." We hold that the involuntary conversion of the rice mill by its destruction by fire was not a sale or exchange. *649 John H. Watson, Jr.,27 B.T.A. 463; Arthur E. Braun, Trustee,29 B.T.A. 1161; M. P. Sturdivant,23 B.T.A. 1385; Echols v. Commissioner, 61 Fed.(2d) 191, and the profit derived therefrom is taxable as ordinary income. Deductions for bad debts are claimed in Docket Nos. 84051 and 84052 in the cases, respectively, of George Herder, deceased, and Mary Herder. The debts claimed as deductible are set forth in the findings of fact and total $29,975.56. One-half of this amount, or $14,987.78Is claimed as such deduction by each petitioner. However, at the hearing petitioners abandoned such claim as to the debt of J. W. Gates (dairy farm) for the amount of $1,861.22. Accordingly, the claim of deduction for the amount of this debt will be disallowed. The evidence shows that the other debts in question were worthless. The debtor, Emil Herder, died in 1932 or 1933, leaving no estate. Jackson Brothers were hopelessly insolvent in 1932 and their financial condition grew worse after that time. They had been rice farmers, but prior to 1934 had given up farming and moved away. These debts were unquestionably worthless*650 prior to 1934 and are, therefore, not deductible within the taxable periods here involved. The debtors Wilbur Webb, Matthews Brothers, L. P. Bunge, Mrs. J. N. Frazar, and W. R. Terrell were farmers who for many years had been financed in their operations by the decedent and to whom they were each indebted far beyond the value of their assets. There was some basis for believing that these debts would be paid in whole or in part provided the debtors could continue to produce crops. They could not continue their farming operations without the extension of credit for groceries and supplies and other financial support. Such credit had been furnished by George Herder up to the time of his death. He was their only source of credit and financial backing. Upon his death these debtors became hopelessly insolvent and the debts then became worthless. *942 The applicable provisions of the statute for deduction of bad debts is section 23(k) of the Revenue Act of 1934, and is as follows: (k) 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*651 satisfied that a debt is recoverable only in part, the Commissioner may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction. The statute is silent as to how and where or in what manner had debts are to be charged off. However, as was said by the court (C.C.A., 6th Cir.) in Fairless v. Commissioner, 67 Fed.(2d) 475: It was clearly the purpose of the Congress to condition allowance of deduction for bad debts upon the perpetuation of evidence that they were ascertained to be worthless within the taxable year, and upon some specific act of the taxpayer clearly indicating their abandonment as assets. In line with this expressed view of the court we adhere to our holding in Carl G. Stifel, Trustee,7 B.T.A. 1060, that: The charging off of bad debts should, in the case of a taxpayer keeping regular books of account, be evidenced by such book entries as will effectually eliminate the amount of the bad debt from the book assets of the taxpayer. See also *652 Britton Lumber Co.,20 B.T.A. 583. The debts in question were never charged off on the books of the petitioner, but are still carried as assets thereon. The deduction of the debts on the income tax returns of petitioners did not constitute a charge-off. Such deduction could only be allowable as the result of a previous ascertainment of the worthlessness of the debts and a charge-off thereof within the taxable period. The mere ascertainment of worthlessness is not sufficient to authorize the deduction. We hold that the debts were never charged off and that the claim of deductions for bad debts must be disallowed. There was interest in the amount of $5,518.01 earned, but unpaid, on debts owing the community of George Herder and Mary Herder, his wife, at the time of the death of the former. Respondent added one-half of this amount to the income of decedent in determining the deficiency against him under the following provision of section 34 of the Revenue Act of 1934: "In the case of the death of a taxpayer there shall be included in computing net income for the taxable period in which falls the date of his death, amounts accrued up to the date of his death if*653 not otherwise properly includible in respect of such period or a prior period." A list of the debtors, the debts on which the interest accrued, and the amounts of the interest so accrued is set forth in the findings of fact herein. Petitioners claim that respondent erred in adding the amount of interest in question to decedent's income for the reason, as they contend, that the interest so accrued was not collectible. The evidence *943 shows that E. R. and Anna Frnka owed Herder two notes - one for $5,073.57 and the other for $4,460.38. The first note had collateral security consisting of 50 shares of stock in the Garwood Lumber Co. of a par and book value of $5,000. The second note mentioned was unsecured. R. L. Williams testified that the interest accrued on these notes was uncollectible. No effort had been made, however, to subject the collateral security to the payment of the interest on the note it secured. Considering the substantial value of the security in comparison with the amount of the note, we can not find that there was not a reasonable expectation that the interest on that note would be paid. We hold, therefore, that one-half of the interest accrued*654 thereon up to the time of the death of decedent should be added to his income. As to the other and unsecured Frnka note the evidence is that there were no assets out of which payment of the interest accrued thereon could be made and that the debtors were unable to pay it. We think it clearly appears from the evidence that there was no reasonable expectation that such interest would ever be paid. The evidence shows that the debtors W. J. Wright, Mattews Brothers, E. P. Schilling, and Mrs. J. U. Frazar had no available assets out of which payment of the interest accrued on their debts could be realized and that the debtors were unable to pay such interest. It appears from the evidence that it was reasonably certain that such interest would never be paid. We hold, therefore, that the interest accrued, but unpaid, on these debts and on the unsecured Frnka note did not constitute income to George Herder and should not be so considered in determining the deficiency against him. There can be no accrual of income where there is no income. *655 Corn Exchange Bank v. United States, 37 Fed.(2d) 34; Turners Falls Power & Electric Co.,15 B.T.A. 983; Great Northern Railway Co.,8 B.T.A. 225. The agreement of the parties hereto at the hearing that Mary Herder realized a capital gain of $1,498.50 in the sale of mineral lands will be given effect in the redetermination of the deficiency against her. Judgment will be entered under Rule 50.