Mechanics Bank of Brooklyn v. Commissioner

MECHANICS BANK OF BROOKLYN, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Mechanics Bank of Brooklyn v. Commissioner Docket No. 9755. United States Board of Tax Appeals 9 B.T.A. 1; 1927 BTA LEXIS 2682; November 8, 1927, Promulgated *2682 1. Loss on sale of real estate determined. 2. Adjustment determined for accounts partially written off in prior years, but not ascertained to be worthless until 1921 and 1924. 3. Duplicate reduction of petitioner's invested capital restored. 4. Adjustment to surplus for depreciation sustained in prior years but not set up on petitioner's books determined. H. A. Mihills, C.P.A., for the petitioner. J. E. Marshall, Esq., and H. D. Thomas, Esq., for the respondent. LITTLETON *1 This proceeding arises as the result of deficiencies in income and profits tax determined by the Commissioner for 1919, 1920, and 1921 in the respective amounts of $9,729.44, $2,676.04, and $13,867.64. The principal issues raised relate to the disallowance of certain losses and the impairment of invested capital on account of an alleged insufficiency of depreciation taken in prior years. FINDINGS OF FACT. The petitioner is a corporation organized under the laws of the State of New York, with its principal place of business in Brooklyn, where it is engaged in the general banking business. Prior to 1915, petitioner made a loan of $2,825 to one Sherer, *2683 which loan was secured by a piece of improved real estate at 303 Schermerhorn Street, Brooklyn, N.Y. The foregoing property was subject to a mortgage of $9,500. In 1915, Sherer defaulted on the loan and, in consequence, the petitioner took over the Schermerhorn property, assuming the mortgage of $9,500. Prior to 1919, the mortgage was paid off by the petitioner and a charge made to the cost of the property on account thereof. The property was sold in *2 1919 for $8,392.38. The depreciation which accrued on this property from date of a acquisition to date of sale was $466.67. In 1914, the petitioner took over the assets and assumed the liabilities of the Nassau Trust Co. through a merger in which stock of the petitioner was issued for stock of the Nassau trust Co., share for share. Among the assets so acquired were certain lots, referred to as the Rockaway Avenue property, which appeared on the books of the Nassau Trust Co. at $19,500. The assets were taken over as they stood on the books of the trust company without any attempt to value the separate properties or to apply the purchase price to any classes of assets. The Rockaway Avenue property was sold in 1919 for*2684 $15,000. A commission was paid on the sale of $300 and the depreciation accrued on the property from date of acquisition to date of sale was $291.67. Petitioner maintained accounts with various correspondent banks which included the Lafayette Trust Co. and the Union Bank. The two aforementioned banks were placed in receivership in 1912 and taken charge of by the State Banking Department. The amount of the accounts against these banks which the petitioner carried as an asset at the date of their closing was: Union Bank, $33,842.47, and Lafayette Trust Co., $8,769.79. The former account was carried in three amounts as follows: $26,853.37, $5,069.17, and $1,919.93. It was the policy of the petitioner to transfer all slow or past due accounts to a special suspense ledger into which was carried a separate account with each customer and correspondent banks from whom payment was expected to be delayed. The method pursued was to transfer the entire account from the active ledger to the suspense ledger and if further delay ensued in payment of the account, another entry would be made upon the books transferring to profit and loss all of the account with the exception of $1. The*2685 suspense account did not contain accounts which the petitioner deemed to be worthless, but the policy was pursued in anticipation of further recovery. When accounts were determined to be worthless, they were charged off in their entirety. The policy of keeping accounts on which further recoveries were expected in suspense, either as to whole account or as to $1, assisted the petitioner in keeping the account before its officials and employees. In pursuance of the foregoing policy, petitioner, on May 22, 1912, and after it had learned that the State Banking Department, Liquidation Bureau, had assumed control of the aforementioned insolvent banks, charged each of the aforementioned accounts to a suspense account and at the same time charged profit and loss and credited surplus with the entire amount of each account except $1 for each account, thus eliminating the accounts from both its main accounts *3 and the suspense account except for the $1 retained in each instance in the suspense account. Petitioner filed its claim against the Lafayette Trust Co. and the Union Bank immediately upon receipt of information as to the insolvent banks. Petitioner discussed with the State*2686 Banking Department the prospective dividends which might be received and also knew, in a general way, from its acquaintance and business dealings with the banks, what assets were to be liquidated. As collections were made by the debtor banks on account of assets held, the funds were placed with designated depositories, who held them until the State Banking Department deemed it proper to declare dividends. Petitioner acted as one of the depositories in the case of the Lafayette Trust Co. and in this manner was aware of the possibilities of future recoveries on the Trust Company account. Payments were made by the liquidation manger on the account of $26,853.37 with the Union Bank as follows: August, 1916 $1,342.67 March, 1917 1,342.67 June, 1918 1,342.67 Junuary, 1919 1,342.66 January, 1924 (final dividend) 1,342.66 Total 6,713.33 On the account of $1,919.93 with the Union Bank, payments were as follows: August, 1916 $95.99 March, 1917 95.99 June, 1918 95.99 January, 1919 95.99 January, 1924 (final dividend) 95.99 Total 479.95 On the account of $5,068.17 with the Union Bank, recoveries were as follows: August, 1916 $255.55 March, 1917 255.55 June, 1918 253.46 January, 1919 253.46 January, 1924 (final dividend) 253.46 Total 1,271.48 *2687 On the account of $8,769.79 with the Lafayette Trust Co., recoveries were as follows: August, 1913 $920.92 June, 1919 5,525.56 May, 1921 (final dividend) 876.97 Total 7,323.45 *4 Based upon the knowledge of the officers of petitioner of the amount of available funds for dividend purposes which had been deposited with the depository bank, and in recognition of information secured from the liquidating manager that a final dividend of 5 per cent only remained to be paid on the Union Bank account, petitioner provided an estimated future recovery as of December 31, 1921, in the amount of $1,015.30, representing a 3 per cent dividend. The rate of 3 per cent instead of 5 per cent was used by petitioner to be conservative and the remaining portion of the account considered to be worthless at December 31, 1921, and deductible in its entirety at that date. The actual recovery which was made in January, 1924, was in the aggregate amount of $1,692.11, with reference to the three separate accounts against the Union Bank. In 1921 petitioner was informed that it had received the final liquidating dividend during the year 1921, on the account of Lafayette Trust*2688 Co., and did thereupon regard the remaining amount of $1,446.34 as being uncollectible at December 31, 1921, and accordingly closed out the account. The Commissioner held that the above obligations were wholly worthless and uncollectible prior to the calendar year 1918, and upon this basis has disallowed as deductions the amounts above stated. In pursuance of the determination by the Commissioner that the above accounts where wholly worthless and uncollectible prior to the calendar year 1918, he has failed to restore to the surplus account of the petitioner the amounts of the above obligations in determining the invested capital of the years 1919, 1920, and 1921. Respondent has included in taxable income for the year 1919 the amount of dividend recoveries from the Lafayette Trust Co. and Union Bank made in that year in the amount of $6,956.07 and in the year 1921 the amount of $876.97, received as a final liquidating dividend from the Lafayette Trust Co. During the years 1914 and 1915, petitioner wrote down certain notes owing by P. J. Murray & Co. by charges to profit and loss in the amount of $13,489.96. The notes were finally determined to be worthless in 1918, when*2689 a deduction was claimed for the entire amount of the debts from gross income in petitioner's return for that year, and the entire accounts were written off the books. No portion of the original "writedown" had previously been restored and the balance sheet at December 31, 1918, did not contain any part of the foregoing amount of $13,489.96. When the respondent determined petitioner's invested capital for 1919, surplus as shown by its books was reduced on account of the foregoing a accounts in the amount of $13,489.96. *5 Petitioner owned and used in its business various bank buildings of brick construction as well as equipment and office furniture and fixtures. Respondent computed depreciation for prior years on buildings and equipment at 2 per cent and on furniture and fixtures at 10 per cent, which are the rates claimed by the petitioner and allowed by the Commissioner for the years on appeal, and in determining invested capital for the years on appeal, made the following reductions in invested capital: YEAR 1919 Depreciation on outside real estate sold in 1918, from date of acquisition to December 31, 1917 $16,108.96 Depreciation on bank buildings, to January 1, 1917 289,962.09 Depreciation on furniture and fixtures, January 1, 1917 34,207.99 340,279.04 Depreciation allowed by Commissioner during 1917 and 1918 and not written off: Buildings, 1917 $21,288.03 Buildings, 1918 21,288.03 $42,576.06 Furniture and fixtures, 1917 7,639.91 Furniture and fixtures, 1918 7,639.91 15,279.82 57,855.88 Total deducted from invested capital 398,134.92 YEAR 1920 Deduction of year 1919 carried forward 398,134.92 Depreciation allowed in 1919 28,781.20 Less: Amount written off on books 23,999.14 4,782.06 Total deducted from invested capital 402,916.98 YEAR 1921 Deduction of year 1920 carried forward 402,916.98 Depreciation allowed in 1920 29,553.86 Less: Amount written off on books 25,122.09 4,431.77 Total deducted from invested capital 407,348.75 *2690 The buildings and equipment were carried upon the books at cost and no specific charges were ever provided upon same by petitioner. In 1914 petitioner made a reduction of $108,045.04 in the value of some of its improved real estate, though this was principally on property which had been taken over and was done for the purpose of reducing the book value to a conservative valuation. This entry was arbitrary in its nature and did not contemplate depreciation on the assets. Of the property on which the foregoing reduction was *6 made, property was on hand on January 1, 1919, to which the reduction applied to the extent of $66,243.08. While no depreciation was taken on office equipment prior to January 1, 1917, the policy of the company was to charge many items of office quipment to expense which should have been capitalized. In the case of safe deposit boxes, the rentals charged were credited to the permanent asset account, thus reducing the value as shown by the books. OPINION. LITTLETON: The first point presented relates to losses claimed on the sale of certain real estate. In the petition, errors were assigned on account of seven pieces of property, but at the*2691 hearing petitioner abandoned its claim with respect to five of the properties, thus leaving only the Schermerhorn and Rockaway Avenue properties for consideration. As to the Schermerhorn property, we have found that it was acquired by the petitioner in 1915 when a customer defaulted on a loan of $2,825 which was secured by this property. The property when taken was subject to a mortgage of $9,500 which the petitioner assumed. Its cost, therefore, was $12,325. The difference between the selling price of $8,392.38 and the foregoing cost, less accrued depreciation of $466.67, represents a deductible loss in 1919 when the sale was made. With respect to the Rockaway Avenue property, the evidence we have as to its cost is that it was taken over in 1914 at its book value when the assets of the Nassau Trust Co. were acquired through a merger in which stock of the petitioner was issued for the stock of the Trust Company. We have no segregation, showing the cost applicable to the various assets. Nor do we know anything as to the value of the various assets at this time. We regard the foregoing evidence insufficient to establish cost to the petitioner and, therefore, any loss on account*2692 of the sale of this property must be denied. The next issue relates to the status of the accounts which the petitioner had with the Union Bank and the Lafayette Trust Co. when these banking institutions were placed in receivership in 1912. We are satisfied from the evidence that the petitioner's practice of charging "slow" accounts to a suspense account, which was the method pursued in these instances, was not because of a determination of the worthlessness of the accounts and that so long as the petitioner retained one dollar in the suspense account it indicated that the petitioner did not consider the accounts worthless, and had not effectively charged them off. The evidence is also conclusive to the effect that the accounts with the Union Bank in the amounts of $26,853.37.*7 $5,069.17, and $1,919.93 were not determined to be worthless until 1924 and that in 1921 the petitioner was justified in considering an estimated future recovery of only 3 per cent thereon. The balance remaining in the accounts, after taking into consideration prior recoveries and this estimated future recovery, is deductible from gross income in 1921 under the provisions of section 234(a)(5), *2693 Revenue Act of 1921. Since these accounts had not been determined to be worthless in their entirety prior to 1921 and since under the revenue acts prior to the Revenue Act of 1921, a partial write-off of a debt is not permissible (, and ), the balance remaining in these accounts, after considering prior recoveries, should be restored to invested capital for each of the years on appeal. We are likewise satisfied that the account with the Lafayette Trust Co. in the amount of $8,769.79 was not determined to be worthless until 1921, at which time the remainder then outstanding, after considering prior recoveries, was a proper deduction from gross income. Invested capital should also be adjusted in a manner similar to that outlined for the accounts with the Union Bank. In view of the above conclusions, it was obviously erroneous for the Commissioner to treat recoveries on the foregoing accounts as taxable income for the years on appeal. In the next place the petitioner contends that the respondent has made an erroneous reduction of its invested capital to the extent of $13,489.96*2694 on account of certain debts owing by P. J. Murray & Co., which were partially written off prior to 1918. The entire loans were determined to be worthless in 1918 when a loss on the entire account was claimed. In claiming the loss in 1918, petitioner made no restoration of the amounts previously written off, and petitioner's balance sheet at December 31, 1918, contained no part of this account. A reduction of petitioner's surplus on this account as it appeared in the balance sheet at December 31, 1918, was erroneous, since it meant a reduction which had already been effected. The petitioner's contention on this point is, therefore, sustained. The final issue arises on account of a reduction of petitioner's surplus because of an alleged insufficiency of depreciation taken in prior years. Prior to 1918, petitioner made no provision for depreciation as such on its books of account. The evidence shows that at least major capital items with respect to buildings were properly capitalized, but that in the case of furniture and fixtures many items of a capital nature were charged to expense which should have been capitalized. The evidence fails to show that repairs and maintenance*2695 *8 tended to offset depreciation sustained on buildings or that the building account was understated on account of a failure to include therein proper capital items. On one occasion - in 1914 - a reduction was made in the value of assets as they appeared on the books, but this was done for reasons of conservatism and applied largely to properties recently taken over which, one of petitioner's witnesses stated, was valued in this way, in order to make the property more salable. Petitioner's vice president, upon being cross-examined in regard to depreciation, made the following statements: Q. Why didn't you write the bank buildings down from year to year for depreciation purposes? A. We did not write them down, but our bookkeeping methods were wrong. Q. You do not deny the fact that depreciation occurred on these buildings from year to year? A. Appreciation? Q. Depreciation? A. Depreciation did occur on the buildings, but we did not change our book value of buildings by charging depreciation. We have not done that. At the hearing petitioner presented a schedule with costs and dates of acquisition of buildings and equipment as shown by its books, in*2696 which depreciation to December 31, 1916, was computed at the same rates as used by the revenue agent whose examination formed the basis of the respondent's reduction. This showed certain errors on the part of the revenue agent as to dates of acquisition and otherwise, with the net result that instead of accrued depreciation on buildings and equipment to December 31, 1916, of $289,962.09 as claimed by the respondent, there is shown an amount of $197,248.50. On a consideration of the evidence, we are of the opinion that petitioner's surplus for the years on appeal should be adjusted by considering accrued depreciation on buildings and equipment to December 31, 1916, as $197,248.50 and the depreciation allowed the petitioner in determining taxable income for 1917 and subsequent years. In addition, the adjustment should take into consideration an amount of $16,108.96 which was deducted by the respondent as depreciation to December 31, 1917, on outside real estate which was sold in 1918 and, therefore, was not an asset subject to reduction in 1919 and subsequent years. The Commissioner concedes that his adjustment was erroneous in this respect, and the reduction computed above of*2697 $197,248.50 does not take into account this item. To the extent, therefore, that depreciation allowed the petitioner for 1917 and subsequent years does not take into account this item, adjustment should be made therefor in a determination of petitioner's invested capital for the years on appeal. *9 With respect to the reduction made in petitioner's surplus on account of depreciation accrued on furniture and fixtures to January 1, 1917, in the amount of $34,207.99, the evidence shows that the petitioner followed a policy of charging many items of this character to expense which should have been capitalized, and that in the case of safe deposit boxes rentals therefrom were credited to the asset accounts and thus served to reduce the cost as shown by petitioner's books. We are convinced that a true statement of the furniture and fixture account at January 1, 1917, would not show an asset value less than that reflected by petitioner's books and, therefore, the action of the Commissioner in making a reduction of $34,207.99 on account of alleged accrued depreciation to January 1, 1917, is reversed. The remaining issues relate entirely to the reduction of invested capital for*2698 payment of taxes within the taxable periods for preceding periods and as to these the petitioner admits that proper adjustment should be made therefor under the provisions of section 1207, Revenue Act of 1926. Judgment will be entered on 20 days' notice, under Rule 50. Considered by SMITH, TRUSSELL, and LOVE.