Schaff v. Commissioner

PHILIP H. SCHAFF, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Schaff v. Commissioner Docket No. 101775. United States Board of Tax Appeals 46 B.T.A. 640; 1942 BTA LEXIS 841; March 13, 1942, Promulgated *841 1. BAD DEBT DEDUCTION. - Petitioner, a junior partner of a bro kerage firm, handled a trading account for a customer on a discretionary basis, without financial responsibility on his part. In 1929 he departed for Europe and during his absence the so-called stock market crash occurred, resulting in considerable losses in the account. Feeling a moral obligation to the customer for lack of personal attention to the account, he voluntarily guaranteed it and continued to handle it with the hopes of bringing it back to a favorable position. In 1934 petitioner was required to make good his guarantee and in 1935 requested the customer to reimburse him for the amount paid on the account. The customer declined to assume any responsibility. Counsel advised petitioner that he had a very slight chance of winning a suit against the customer and no action was ever brought. Held, petitioner has not established the existence of a debt and is not entitled to a bad debt deduction for 1935. 2. Id. - When petitioner returned from Europe he found that his interest in the firm, amounting to approximately $250,000, had been completely lost. He accused one of the senior partners of improperly*842 managing the business affairs of the firm and demanded reimbursement for his share of the losses. The senior partner denied responsibility, but later stated that he would pay petitioner after some other matters were straightened out. Still later he offered petitioner his promissory note in the amount of $50,000 in full settlement of the claim. Petitioner declined to accept it, resigned from the firm, and threatened suit. The controversy continued without legal action until 1936, in which year the senior partner died, leaving no estate. Held, that petitioner has not established the existence of a valid debt under said claim and is not entitled to a deduction for 1936 of the said $50,000 as a bad debt. John W. Ford, Esq., for the petitioner. Thos. F. Callahan, Esq., for the respondent. TURNER *640 The respondent determined deficiencies in income tax for the years 1935 and 1936 in the respective amounts of $3,723.25 and $3,211.06. The issues are whether petitioner is entitled to bad debt deductions, one claimed for each of the respective years. *641 FINDINGS OF FACT. Petitioner, a resident of Youngstown, Ohio, in 1929 was*843 a junior partner in the firm of Wick & Co., a brokerage partnership engaged in buying and selling securities for customers. The firm maintained offices in Youngstown, Ohio, and was a member of the New York Stock Exchange. In 1929 Marie Campbell Ravelli of Youngstown owned a trading account with Wick & Co. under an arrangement whereby petitioner agreed to handle the account on a discretionary basis, without any financial responsibility on his part. She deposited as collateral certain shares of stock in the Youngstown Sheet & Tube Co. Petitioner had no financial interest in the account other than his share of the commissions which the firm would earn from transactions in the account. Petitioner handled the account for Mrs. Ravelli until about August 1929, when due to his wife's illness he found it necessary to take her to Europe, and for the time being to give up personal attention to his business affairs. Before leaving he gave a power of attorney to a lawyer to handle his affairs and left instructions that, if necessary, his personal securities be used to protect a number of trading accounts with Wick & Co., including that of Mrs. Ravelli. When petitioner left for Europe*844 Mrs. Ravelli's account was in excellent condition. During his absence the so-called stock market crash occurred and when he returned in November 1929 he found her account had a debit balance of approximately $51,179 and the collateral had depreciated to the extent that the account was in a very bad condition. Some of his personal securities had been put up to secure the account. During petitioner's absence Wick & Co. had ceased doing business and a new partnership was formed. Petitioner joined the new firm as a partner in the latter part of November 1929 and remained a partner until June 30, 1930. The second Wick & Co. partnership ceased doing business in December 1931, and was merged with another firm which continued under the name of Butler, Wick & Co. Mrs. Ravelli's account was taken over by each of the successive firms and was guaranteed by petitioner. Petitioner continued to handle Mrs. Ravelli's account and in 1930 it improved to the extent that the securities deposited by him to secure it were returned to him. Later the securities in the account declined until they became substantially worthless, at which time the account showed a debit balance in excess of $72,000. *845 Petitioner was called upon to make good his guarantee and on July 8, 1933, he made a payment on the account in the amount of $25,000 and on January 12, 1934, made a further payment on the account of $20,000 *642 Petitioner felt that he had a moral obligation to Mrs. Ravelli because of the fact that he was away when the stock market crash occurred and could not give the account the personal attention that she might have expected. On September 29, 1934, Mrs. Ravelli's account showed a debit balance of $30,195.55, which was secured by a credit balance in petitioner's personal account. Petitioner was advised by the firm that on account of certain rules of the New York Stock Exchange his credit balance would have to be transferred to her account. On that date petitioner caused his credit balance of $30,195.55 to be transferred to Mrs. Ravelli's account. At that time it was orally understood between petitioner and Butler, Wick & Co. that petitioner thereby acquired all right and interest the firm had in Mrs. Ravelli's account. Mrs. Ravelli had never asked petitioner to guarantee her account and his action in doing so was voluntary. Petitioner always kept Mrs. Ravelli informed*846 as to the condition of the account and she was aware that it was going from "bad to worse." He informed her that he was willing to assume about 60 percent of the losses sustained on account of being unable to give the account his personal attention during the stock market crash in 1929. Petitioner did not request Mrs. Ravelli to reimburse him at the time he made the last payment in September 1934, nor did he make any such request during the remainder of that year, and she did not refuse to pay him. She did, however, lead him to believe that she was going to decline to pay any part of the losses. Petitioner made no request for payment in 1934 because he did not think she was able to pay him and, since the market was recovering, he thought she could reimburse him with less inconvenience later on. Mrs. Ravelli's father had died in 1933 and petitioner thought that he was a very wealthy man and that upon the settlement of his estate she would receive a substantial inheritance. In 1935 petitioner requested Mrs. Ravelli to reimburse him for the last payment made to Butler, Wick & Co. in the amount of approximately $30,000. In response thereto Mrs. Ravelli wrote petitioner on July 20, 1935, as*847 follows: Dear Phil: I feel that I must write to you definitely and finally about the loss in my trading account which you handled for me with Wick and Company. While I appreciate the fact that you assumed no liability when you agreed to handle the account, I naturally assumed that you would give the account your constant attention. I know you will agree that you did not do so. While I realize that Jane's illness compelled you to be out of the country during the last months of 1929, and appreciate that your own illness took you away from your business in 1930, I do not feel that I should suffer thereby. It is enough to have lost my Sheet and Tube Co. stock which I gave you as collateral. I do not doubt that in your own mind you are convinced of the fairness *643 of your offer to assume about sixty percent of the loss (you say that you have already charged off this amount) as recognition of and settlement for your lack of attention to my affairs. If I were in different circumstances I would be glad to pay the difference and close the chapter. But as you know, I have barely enough to get along on. I have no earning power as you have, and my family must depend on what*848 I have. We would almost have to go on relief if I should pay you thirty thousand dollars, or anything like that sum. While I hesitate to say this, I must tell you that I have consulted my attorney, who advises me that under all the circumstances you could not hope to win in the courts if you should attempt to collect from me in that way. I hope that you will understand my position and that this will not make any. difference in our friendship. I know what you have been through with this and other things, but I must tell you definitely that I decline to accept the responsibility for any of this loss or to make any payment whatsoever. Very sincerely yours, [Signed] MARIE CAMPBELL RAVELLI. Upon receipt of this letter from Mrs. Ravelli, petitioner not believing her statement as to her financial condition, investigated the matter with the attorneys handling her affairs and the estate of her parents. They told petitioner that Mrs. Ravelli's brother had taken over the handling of his parents' and sisters' affairs and had lost practically all of their holdings, that Mrs. Ravelli was very much in debt, and that they were advancing her all they could for her living expenses. *849 Thereupon petitioner consulted counsel, showing them Mrs. Ravelli's letter. They advised petitioner that, regardless of the merits of the case, he would have only a slight chance of winning a lawsuit, because of the fact that under the circumstances a jury would favor a woman who had lost money in the stock market over a broker who sued her, and that he would be follish to bring any action. Petitioner concluded that his claim against Mrs. Ravelli was worthless and abandoned any further attempt to collect. In his income tax return for 1935 he deducted as a bad debt the sum of $30,195.55 representing the amount of his last payment to Butler, Wick & Co. in respect of Mrs. Ravelli's account. When petitioner left for Europe in August 1929 he had a 15 percent interest in the profits or losses of Wick & Co. He had a capital investment in the firm of $75,000 and undrawn profits of approximately $175,000. Under the partnership agreement Philip Wick and one Swartswelter were senior managing partners with full authority and responsibility for all firm transactions over $25,000. When petitioner returned from Europe in November 1929 he learned that his interest in the firm had been*850 completely lost. Upon investigation he learned that during his absence the firm had sustained total losses in the amount of approximately $1,500,000, said losses resulting from cash withdrawals by the partners, the carrying *644 of partners' and customers' accounts, and various underwriting and investment losses, all of which transactions were authorized by Philip Wick or Swartswelter. These two partners had made cash withdrawals from the firm and had permitted a junior partner, Chrystal, to make cash withdrawals in the aggregate amount of approximately $158,000. The personal trading account of Wick and Swartswelter had been carried to the point where there was a net unpaid debit balance due the firm of approximately $182,000. The personal trading accounts of Jessie Guy, an employee of the firm, and Richard Brown, and one Chrystal, junior partners, showed net debit balances of about $82,000, $145,000, and $147,000, respectively. Personal trading accounts of several customers, personal friends of Wick and Swartswelter, showed debit balances aggregating about $365,000. The firm had sustained investment and underwriting losses aggregating about $314,000. Other unidentified*851 losses amounted to over $100,000. Upon ascertaining the condition of the firm's affairs, petitioner consulted the firm's attorney, who advised petitioner that in his opinion he had a valid claim against Wick for the amount of his losses. Petitioner thereupon demanded payment from Wick. Wick refused and petitioner threatened to submit the matter to the New York Stock Exchange. Wick was anxious for petitioner to become a member of the new firm which he was organizing and was also concerned over petitioner's threat to submit this matter to the New York Stock Exchange. Shortly thereafter petitioner and Wick held a joint conference with the firm's attorney, after which Wick told petitioner that he would reimburse him for his losses. Petitioner estimated his losses to be about $200,000, but the record does not show whether they ever agreed on any specific amount. Thereafter and about the end of November 1929, petitioner entered the second Wick & Co. firm as a partner. On two occasions during the following months petitioner requested Wick to settle the obligation, but the latter put him off, saying that he had other matters to get straightened out. About the first or June 1930*852 petitioner again requested Wick to settle the matter and Wick offered him his note for $50,000 in full settlement. Petitioner refused, resigned from the firm, and informed Wick that he would sue to recover the full amount. A brother of Philip Wick, and a close friend of petitioner, died in the summer of 1930 and petitioner informed Wick that he would defer his suit in order to save Wick's mother any further family trouble. During the following few years petitioner continued to defer suit because of family influence resulting from close acquaintance and relationship between the Wick family and the family of petitioner's wife. *645 In the latter part of 1934 petitioner decided to bring suit. He consulted counsel, related the facts to him, and left it with him to consider. Counsel considered the case and finally advised petitioner that he would handle it on a contingent basis, 15 percent if it was settled out of court and 25 percent if they had to go to court. Petitioner agreed to this arrangement. Wick became ill early in 1935 and died the following October, apparently before any action had been filed. The inventory of Wick's estate was filed in January 1936 showing*853 assets valued at about $400,000. Several months later petitioner learned from the court records that the debts of the estate were about $1,200,000 and that the assets had been hypothecated to secure some of the debts. Up until that time petitioner had believed that Wick was financially able to pay his claim of about $200,000. He thought that Wick was a wealthy man and that his financial condition had improved from 1930 to 1934. After learning of the condition of Wick's estate, petitioner considered his claim to be worthless and did not press it further. Petitioner kept certain personal records showing income and expenses, but did not keep a full set of books on which he charged off bad debts. In his original income tax return for 1936 petitioner claimed no deduction in respect of his claim against Philip Wick, but in 1938 he filed an amended 1936 return claiming a bad debt deduction in the amount of $50,000, representing the amount of the promissory note Wick had offered in settlement of the claim. OPINION. TURNER: Petitioner contends that under section 23(k) of the Revenue Acts of 1934 and 1936 he is entitled to bad debt deductions in the amount of $30,195.55 for 1935*854 and $50,000 for 1936, representing the debts of Marie Campbell Ravelli and Philip Wick, respectively, which debts were ascertained to be worthless in those years. The respondent contends that no debts were due the petitioner from Mrs. Ravelli or Wick and that there was accordingly nothing for petitioner to charge off or deduct as bad debts in the respective years. Respondent contends and petitioner concedes that before a deduction can be allowed on account of a worthless debt it is essential that the existence of a valid debt be established, ; ; and ; and most of the argument presented centers around the question whether the facts here establish the existence of valid debts. We think that in both instances petitioner has established the existence of unadjudicated claims rather than valid debts. With respect *646 to the Ravelli matter, petitioner's own attorney advised him that he had only a slight chance of winning a lawsuit against her. If, as petitioner contends, a valid debt existed, he would be concerned not*855 so much with the question of obtaining a judgment, but rather with the matter of collection. Petitioner may or may not have had a meritorious claim against Mrs. Ravelli. The facts do show, however, that petitioner was not required or requested to assume any personal liability in handling the account and that he felt a moral obligation on account of the losses sustained while he was absent and unable to give the account his personal attention and for that reason voluntarily guaranteed her account. A mere voluntary assumption of an obligation is not sufficient to create a basis for a bad debt deduction. See ; cf. . Assuming as correct petitioner's contention that when he made the last payment to the firm in 1934, he acquired whatever rights the firm had in the account, the fact remains that the record does not establish that Mrs. Ravelli had a definite legal liability to pay a specified sum of money to the firm. The record does not show to what extent the firm or the petitioner was authorized to make commitments for Mrs. Ravelli or any other terms and conditions of the arrangement*856 except that in the beginning it was a "discretionary" account. After petitioner guaranteed her account the firm seemed to look to him for payment of the losses, and apparently made no effort to collect from her. In her letter to petitioner Mrs. Ravelli declined to assume any liability for the losses sustained. On this record we can not conclude that a valid debt existed. Moreover, even if we assume the existence of a valid debt, we do not think petitioner has established its worthlessness. He had reasons of his own not to press the matter and on the basis of the record here we could not conclude that a judgment in the amount claimed could not be collected. The respondent is sustained on this issue. With respect to the second issue, we also think the facts disclose the existence of an unadjudicated claim against Philip Wick rather than a valid and subsisting debt. Petitioner does not contend that any claim which he might have had against Wick for breach of the partnership agreement constituted a "debt" within the meaning of the act. Cf. *857 ; and . His contention is that such claim was converted into a valid and subsisting debt by reason of certain oral statements made by Wick to the effect that he would reimburse petitioner for his losses. Petitioner expressly disavows any implication that Wicks misappropriated or embezzled any funds, yet his authority for his above contention consists of several cases involving embezzlement. Douglas*647 , ; and . Those cases are clearly distinguishable. Once embezzlement is admitted, as in those cases, there is no question as to legal liability and a promise to repay merely amounts to an admission of the legal obligation. In the instant case we have not seen a copy of the partnership agreement and on the basis of the record before us we could not, as a question of law, determine that Wick's management of the firm's*858 business was such as to make him legally liable to petitioner for his losses, and moreover, we can not determine that Wick's statement to petitioner amounted to an admission of legal liability under the contract. The record indicates that Wick may have had a number of reasons for making that statement and another fact which indicates that Wick did not regard his statement as having any binding effect is that he subsequently offered to settle the matter by giving petitioner his note for $50,000. Petitioner does not contend that this latter offer, which was rejected, created a valid debt for $50,000, apparently preferring to rely on his contention that there was a debt for the full amount of his losses, the exact amount of which is not shown by the record. On this point he states on brief that a deduction for only $50,000 was claimed because it represented the "minimum" amount he was entitled to deduct. Petitioner's negotiations with his attorney with respect to his handling the matter might indicate that petitioner himself did not regard his claim as having been converted into a valid debt. The record does not disclose whether petitioner's counsel contemplated an action on the*859 alleged debt or an action on the contract, but the negotiations and arrangements, together with other facts of record, suggest the latter. Finally, assuming that a valid debt was created by Wick's oral statement, petitioner has not shown what value, if any, the debt had at the time of acquisition. ; ; and . We conclude that at the time of Wick's death petitioner had nothing more than an unadjudicated claim for breach of the partnership agreement, and that does not constitute a valid debt within the meaning of the act. , and The respondent is sustained on this issue. Another issue raised in the petition for 1935, involving the taxability of certain dividends received by petitioner from the Consolidated Freight Handling Co. has been abandoned by petitioner. Decision will be entered under Rule 50.