Imperial Furniture Co. v. Commissioner

IMPERIAL FURNITURE CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Imperial Furniture Co. v. Commissioner Docket No. 16929. United States Board of Tax Appeals 9 B.T.A. 713; 1927 BTA LEXIS 2529; December 20, 1927, Promulgated *2529 Deduction of one-half of debt in 1921 held proper. Julius H. Amberg, Esq., and Frank E. Seidman, C.P.A., for the petitioner. John F. Greaney, Esq., for the respondent. SIEFKIN *713 This is a proceeding for a redetermination of a deficiency in income and profits taxes for the calendar year 1921 in the amount of *714 $33,082.69. The petitioner contests that portion of the deficiency due to the disallowance of a bad debt deduction in the amount of $52,936.27 in which is included $49,934.29, representing that part of a certain debt alleged to have been ascertained to be worthless and charged off within the year. At the hearing, petitioner stated the only question in controversy was a disallowance of the item of $49,934.29 as a bad debt and evidence pertaining to that issue only was submitted. FINDINGS OF FACT. Petitioner is a Michigan corporation, organized in 1913, with principal offices at Grand Rapids. It has continuously been engaged in the manufacture of furniture, principally dining and living-room furniture. Prior to 1921, it made phonograph cabinets but it had discontinued making this class of furniture by 1921, *2530 having organized another company, the Foote-Reynolds Co., which took over that end of the business. About 1919 petitioner started buying furniture from another manufacturer, the Davies-Putnam Co., to fill its orders as it could sell more furniture than it could produce. The Davies-Putnam Co. was a much smaller concern than the petitioner. F. S. Foote, who was secretary-treasurer and general manager of petitioner, was a small stockholder in and was vice president and a director of the Davies-Putnam Co., but took no active part in its management. The furniture made by the latter company for petitioner was made under contract between the companies and was sold outright to petitioner. Petitioner sold such furniture under its own name. The Davies-Putnam Co. had no panel or veneer plant and petitioner at first sold it veneered panels only for the products made for petitioner. By the year in question, petitioner was selling that company large quantities of panel stock needed in the manufacture of products made for other companies, principally phonographs manufactured for A. T. Emerson, Inc., and Pathe-Freres phonograph companies. Prior to 1920, petitioner paid the Davies-Putnam*2531 Co. for its products and were, in turn, paid for materials furnished. During 1920, each company gave acceptances for purchases from the other. The Davies-Putnam Co. paid their acceptances when due throughout 1920. During the year 1921 buying and selling between the companies continued. The materials furnished to the former by the latter exceeding the amount of furniture bought by petitioner. In March, 1921, the Davies-Putnam Co. began running behind in the payment of acceptances given to petitioner. Petitioner's managing officer, Foote, considered that company's credit good. Trade was good during the first half of 1921, and, as that company provided *715 petitioner with a needed source of supply of furniture, petitioner continued to advance it credit to keep it in operation with the expectation that it would ultimately be enabled to meet its obligations. Some of the trade acceptances accepted from that company by petitioner did not always represent merchandise. Foote knew some of the acceptances he approved were accommodation paper, though in form the acceptances purported to represent merchandise. In at least several instances, petitioner accepted trade acceptances*2532 offered as renewal obligations only, but offered in advance of the date on which the paper to be renewed came due, which were put in effect as original obligations without taking up the old paper, additional acceptances being offered and accepted by petitioner by way of renewal when the old obligations matured. The extent of the credit thus given the Davies-Putnam Co. was not realized until preliminary work on petitioner's audit for the year 1921 was begun in the fall of that year. The audits disclosed the Davies-Putnam Co.'s total indebtedness to petitioner to be approximately $100,000. This discovery was made about November 1, and thereafter no further credit was knowingly extended the debtor by petitioner, though the above-mentioned duplication in the process of renewing may have happened after the discovery. Renewals were perforce obtained by petitioner during the remainder of the year in question as well as after the close of the year. On December 31, 1921, the debt totaled $99,868.57, of which $82,400 was in form of trade acceptances, $17,845.99 in notes and $622.58 in open account. When Foote was informed of the discovery made by petitioner's auditor concerning the*2533 extent of the indebtedness of the Davies-Putnam Co. he immediately began an investigation. He demanded an audit of the debtor company by petitioner's auditor. This audit disclosed debts totaling about $250,000. A portion of that company's plant was under a mortgage, overdue for a number of years, in the amount of $23,500. The remainder of the debt consisted largely of bills and accounts payable. The principal assets consisted of plant properties, real estate, buildings and machinery carried on the books at $147,814.28 of which $54,108.32 represented appreciation entered following an appraisal made several years prior to 1921; accounts receivable, excluding those of the above named phonograph companies which had failed (one going through bankruptcy and the other through receivership) by November of 1921, amounting to $34,255.42 on December 31, all of which were pledged to banks as securities for loans; an account of $24,090.25 against Davies, the company's president, for excessive withdrawals by him; and stock on hand inventoried on a cost basis at $95,952.70 on December 31. Early in December, 1921, after the audit of the debtor company had disclosed its assets and liabilities*2534 substantially as set out above *716 as of December 31, Foote made a personal investigation of the assets. He had known of the existence of the mortgage but was not aware that the debtor had been pledging its accounts receivable. The commercial agencies' reports of the Emerson and Pathe phonograph companies indicated nothing could be collected from the approximately $23,000 owed by them to the debtor. Also a portion of the debtor's stock on hand was phonograph cabinets made for those companies, whose patronage had represented 40 per cent of the Davies-Putnam Co.'s business. Foote concluded after investigating Davies' affairs that the $24,090.25 withdrawals owed by Davies and carried as an asset on the debtor's books was worthless, as Davies owed large amounts on notes at the bank while his only property was a small amount of real estate held jointly with his wife. The stock on hand, aside from the above-mentioned phonograph cabinets, consisted largely of materials. The phonograph cabinets had little value and the materials were not prime stock. Market prices had dropped since the purchase of materials which were carried on the books at cost. The value of the stock on*2535 hand did not exceed 50 per cent of their book value. The recovery in subsequent years upon the accounts of the phonograph companies and Davies' overdraft was inconsequential. The Davies-Putnam Co.'s plant was located at the edge of the residential district, several blocks from railroad facilities. To the small original building, additions had been built from time to time. The buildings were on different levels and not well constructed, they were equipped with old machinery which had little value as some of it was obsolete and all of it was in a bad state of repair. The plant, including real estate, buildings and machinery, was estimated by Foote to be worth not more than $60,000, less the amount of the mortgage. The business was producing only at the rate of about $200,000 worth of goods per year while its capacity was about $500,000 in product worth. As a result of his investigation, Foote concluded that 50 per cent of the debt was worthless and late in December of the year in question, he instructed petitioner's bookkeeper to charge off at the end of the year that percentage of the total obligation as a bad debt. Petitioner was on the calendar year basis. Due to the*2536 fact that January was a busy selltng season in the furniture trade, it was a trade practice not to close the books on December 31. Petitioner's practice was to take a physical inventory about January 1. This inventory was put on the books without figures, which were added later in January or February after the rush was over. The closing bookkeeping entries were postponed until the final figures were in, which was sometimes too late to be submitted at petitioner's annual meeting *717 held on the first Tuesday in March, an estimated report being submitted to such meeting instead. The final entries for the year in question were not made until late in February or early in March, but were made as of December 31, 1921. Among such final entries was one charging off $49,934.29 or 50 per cent of the debt owed by the Davies-Putnam Co. The amount remaining on the books was reduced by about $500 when a renewal was made in January, 1922, and further reduced to $44,296.61 prior to the date of the below-mentioned reorganization in August, 1922, by means of credit given for merchandise taken over by petitioner from the debtor during 1922. The Davies-Putnam Co. did not better its financial*2537 condition during 1922. It continued to operate but made no money. Petitioner had not, at any time, considered attempts to force payment as a forced sale of the debtor's assets would have further reduced the probable percentage of recovery. As the year 1922 progressed, it became evident to the petitioner that a reorganization of the debtor company was necessary if anything like 50 per cent was to be realized upon the debt. Due to petitioner's efforts, a reorganization was effected in August, 1922. Petitioner was the largest creditor and held no security. The secured creditors, being in an advantageous position, agreed to the reorganization plan, under which they took preferred stock having par value equal to the amounts due them, only after petitioner agreed to take such stock of a par value equal to 40 per cent of its clatm, and no par value common stock for the remainder. Small creditors were paid in cash and the stockholders of the Davies-Putnam Co. were issued stock in the new company on the basis of a small percentage of their old stock. The new company, known as the Stuart Furniture Co., took over the business. Foote became the president and George LaBour the manager*2538 of the new corporation. It issued about $108,000 of preferred stock to the creditors of the Davies-Putnam Co. under the reorganization plan and said creditors released the security held by them, except for the mortgage which was paid off. Petitioner received about $38,000 par value of preferred stock and 7,000 shares of the no-par-value stock, which was worth $1about per share. The new company is still in operation but no profits were made until 1924, when Foote personally took over its management. Some profit was also made in 1926, in which year a 3 per cent dividend was declared on the preferred stock and some preferred stock was called in and canceled at 101 percent of par, in accordance with its terms. The plant has been closed down during the most of 1927. The new company has not yet attained a degree of success justifying a valuation of its preferred stock at a substantially larger figure than 50 per cent of par established as its worth by sales made at various times since the date of reorganization. *718 The Commissioner disallowed the bad debt deduction of $49,934.29, representing 50 per cent of the debt of the Davies-Putnam Co., on the ground that it was not*2539 ascertained to be worthless and charged off within the year. OPINION. SIEFKIN: We had occasion to consider what constituted ascertainment of worthlessness in , from which we quote: The ascertainment of the worthlessness of a debt, either in whole or in part, is the exercise of sound business judgment based upon as complete information as is practicably obtainable. Was petitioner's judgment, that the portion of the debt in controversy was worthless, formed on the basis of such information as was practicably obtainable? The evidence shows that as soon as the amount of the debt was revealed by the preliminary audit of its own books, petitioner caused an audit to be made of the debtor's books; that petitioner's principal officer immediately made a personal investigation of the various assets of the debtor; that he took up the matter of Davies' overdraft with Davies, who disclosed his assets and liabilities; that the account owed by the defaulting phonograph companies was considered practically worthless by Davies and Foote, both of whom were familiar with that class of trade and were supported by the commercial reports (it should*2540 be noted that this obligation was being investigated not as the debt in question but as an asset of the debtor); that the plant assets of the debtor were worth much less than book value in the opinion of Foote, who was well qualified to judge such values; and that the debtor's inventory was worth not more than 50 per cent of cost, due to a falling market and the condition of the goods on hand. Foote's judgment as to values as well as to the probable percentage of recovery is amply supported by the testimony of Davies and by subsequent developments. Accordingly, we can only conclude the debt was ascertained to be worthless within the year. There remains the question whether the charge off was made within the year in compliance with the statute. Prior to the close of the year the bookkeeper was instructed to charge off at the end of the year 50 per cent of the debt as worthless. He did so when the closing entries for the year were made in February or March of the succeeding year. With respect to the requirement that the debt be charged off within the year, in *2541 , we said: This language must be interpreted in the light of the ordinary course of business practice. It is not the physical act done within the year to which Congress has referred, but to the setting up of evidence of the ascertainment *719 of worthlessness substantially as of the date of such ascertainment and in confirmation thereof. And again, in : The purpose of the statute appears to be to require that some record be made of the ascertainment of worthlessness. An interpretation of the statute which would deny any deduction except when a charge-off was made upon books of account within the limits of the calendar year, especially when it is considered that closing entries are not usually made until after the close of the year, would work a hardship which we can not believe was intended or is required and would attach to acts which are merely clerical an importance as great is to be given to the substance of the situation. The statute must be given a reasonable interpretation, if possible. Clearly it was the intent that a deduction should be allowed for worthless*2542 debts in the year in which worthlessness was ascertained and that the charging off of the debt might take other forms than entries on the books of the taxpayer. We think the quoted excerpts are controlling in the case at bar. Within the taxable year worthlessness was ascertained and the bookkeeper was instructed to charge the debt off. The deficiency will be recomputed allowing the bad debt deduction as claimed in the amount of $49,934.29. Judgment will be entered on 15 days' notice, under Rule 50. Considered by MORRIS and MURDOCK.