Opinion
Civil Action Nos. 14891 and 15459
March 2, 1959
William R. Spofford, Fred L. Rosenbloom, Charles S. Jacobs, Thomas R. Glassmoyer, Philadelphia, Pa., for plaintiff.
Joseph G. Hildenberger, 29 East Fourth Street, Bethlehem, Pa., for defendant.
Petitioner has also shown that under the applicable regulations the agents who examined David's returns should have recused themselves because of the extent of their relationship with the taxpayer. United States Treasury Department, Internal Revenue Service Manual, Audit and Investigation Section, Part IV, § 4031(3) (indebtedness to taxpayer, or business or social relationships); United States Treasury Department, Rules of Conduct for Employees of the Internal Revenue Service, §§ 29, 35 (business and financial transactions, and receipt of favors forbidden). I do not find that respondent knew of these regulations. If this were a trial of respondent for fraud it is possible that this conduct of the agents might be inadmissible as in the nature of hearsay so far as he is concerned. I do not reach this question, as hearsay is not an objection in this proceeding. Draper v. United States, 358 U.S. (Jan. 26, 1959). Barring that objection, it seems to me some relevancy that the agents were sufficiently willing to work on David's returns that they risked disciplinary action or dismissal from the service in order to do so. Respondent argues that he could not know what particular agents would work on his returns. I so find, I would also find reasonable ground to believe that he continually endeavored to be "friendly" with as many agents as possible for just that reason. A situation where a taxpayer unduly cultivates agents, and agents find the advantages such to warrant deliberate infractions of instructions, reasonably suggests more serious improprieties.
It is true, as respondent stresses, that the Commissioner is unaware of any specific omission or error in David's returns. "In dealing with probable cause, . . . as the very name implies, we deal with probabilities." Brinegar v. United States, 338 U.S. 160, 175, quoted in Draper v. United States, supra. It seems to me it is also proper, in appropriate cases, to deal in generalities. While this case may be characterized as close, I rule that the Commissioner's suspicions are reasonable, and that he has shown probable cause to require the respondent to obey the summons with respect to the closed years. This ruling, obviously, takes equal care of the still open year.
I will hear the parties further as to the form of order.
[¶ 9322] United Engineers Constructors, Inc. v. Francis R. Smith, Former Collector of Internal Revenue for the First District of Pennsylvania. United Engineers Constructors, Inc. v. Leslie R. Miles, Director of Internal Revenue, Philadelphia.
[ 1939 Code Sec. 23(k)(1) — substantially unchanged in 1954 Code Sec. 166(a)]
Bad debts: Advances to subsidiary: Subsidiary's assets acquired on liquidation: Partially worthless debts: Amount undetermined. — Advances to a subsidiary, before an audit of its books revealed that it was insolvent, created a bona fide indebtedness which entitled taxpayer to a bad debt deduction when taken in 1949. The latter was the year in which taxpayer caused its subsidiary to be dissolved and its assets (consisting of securities which had doubled in value during the years of insolvency) distributed to it. The distribution was applicable in reduction of that portion of the advances determined by the court to represent a genuine indebtedness. Advances after insolvency was discovered did not create a genuine debt and were not deductible. Back references: ¶ 1619.021 and 1619.5945.
1939 Code Secs. 22(b) and 23(k)(1) — substantially unchanged in 1954 Code
Sec. 163(a) and 166(a); 1939 Code Sec. 141(c) — substantially unchanged in 1954 Code Sec. 1503] Bad debts: Accrued interest: Subsidiary's liability: Deducted on consolidated returns. — Where taxpayer filed consolidated returns with its subsidiary during the years in which it had made advances to the latter, it was not entitled to deduct as a bad debt the interest accrued on the debt when it became worthless since it was able, in the same returns, to deduct the same expense accrued by it as an expense of the debtor. Back references: ¶ 1416. 1275, 1619.017 and 4911.27.
Sur Pleadings and Proof
These are actions to recover income tax in the amount of $1,078,555.13, plus an amount not presently ascertained, paid by the plaintiff as a result of the Commissioner's disallowance of a bad debt deduction in the amount of $4,453,508.82 claimed by the plaintiff in its 1949 income tax return. The alleged bad debt arose from payments made by the plaintiff, mostly during the years 1929-1932, to Dwight P. Robinson and Company, Inc., a subsidiary of the plaintiff, having identical officers and directors.
[ Issues]
The principal questions involved are (1) whether the payments created a bona fide indebtedness, (2) if so, whether the plaintiff had the right to postpone its claim for deduction until 1949 and (3) whether the interest accrued by the taxpayer on its books on these advances is a deductible item.
The case was tried to the Court without a jury, most of the relevant facts having been stipulated. The answers to the requests cover all other facts which have any bearing on the issues, and an extended recital of them in this opinion is not needed.
[ Advances to Subsidiary]
In 1928 United acquired all of the common stock of Robinson and more than one-half of its preferred stock. Robinson was and had been since 1920 engaged in construction work, mostly apartment houses and office buildings in New York City. In many cases it was not only the contractor but participated as a member of syndicates financing the projects. In every year from the time of its incorporation through 1930, it made money.
In 1929 United began to make payments in large amounts to Robinson and continued to do so until November 30, 1932, when the payments were discontinued. The amount of $4,236,881.42 of the alleged indebtedness was evidenced by demand promissory notes and $323,425.14 was an open account. The notes and open account were regularly entered as obligations, respectively payable and receivable, on the books of Robinson and United. The notes given prior to July 1, 1931, were generally noninterest bearing. Those given after that date bore interest, and beginning January 1, 1932, interest was charged on all the notes. The total amount of interest included in the bad debt deduction was $253,677.69, which amount had been accrued on United's books but was never paid.
[ Subsidiary's Insolvency]
Having lost a great deal of money during the depression years, Robinson in the latter part of 1931 decided that it would not enter into any more syndicate ventures and began gradually to give up its construction work, the last job being one which it took in 1934. In 1939 it disposed of its entire equipment and went out of the building business permanently. It had been insolvent ever since sometime prior to July 1, 1931, a condition of which United became fully aware not later than July 31 of that year, as the result of an independent audit of Robinson's affairs ordered by United. In 1939, Robinson was holding cash and securities in an amount of approximately $150,000 together with its interest in a few syndicate ventures on which a total of approximately $30,000 was ultimately realized by it.
[ Dissolution]
In 1949 United caused Robinson to be dissolved and, after complete liquidation of the latter's assets, received $360,475.43 (nearly all derived from the securities, which had greatly increased in value) in the form of payment on its indebtedness and $13,736.94 for services performed subsequent to 1939. The difference between the amount received by United and the amount of Robinson's obligations to United as carried on the books of the two companies was the basis of the bad debt deduction which is the subject of this suit.
[ When Advance Creates a Debt]
(1) Whether an advance for which a bad debt deduction is claimed gives rise to a debt or something else (for example, a contribution to capital or a gift) is a question of fact depending entirely upon the intention of the parties to the transaction. The fact that transactions of this nature are between a parent company and its subsidiary is not of itself enough to prevent them from being regarded as loans if that was the intention of the parties, and there is nothing to show that the relationship between United and Robinson of parent and subsidiary was a mere sham to avoid taxes or that it was entered into for anything but legitimate business reasons. In the present case direct testimony as to the intention of the officers immediately concerned with the payments made prior to July 1, 1931, is unavailable because of their deaths and we must turn to objective considerations. In resolving a question of pure fact like that of intention, opinions of courts dealing with other cases are not likely to be of very much assistance. No one circumstance has ever been held conclusive. However, one of the most important considerations and one which comes very close to being conclusive is whether the party making the advance could have had any reasonable expectation that it would ever be repaid or any intention that it should be.
[ Advances After Insolvency]
In the present case I believe that, up to July 31, 1931, when the hopeless insolvency of Robinson was disclosed by the independent audit, United expected and intended the advances which it made to be repaid as money lent, and, taking all the circumstances into consideration, I find that prior to that date a debtor-creditor relationship was created by United's payments and that Robinson's obligations were genuine debts. After July 31, 1931, there could have been no expectation or hope of repayment and no intention that there should be. Advances made "in the knowledge that they could never be repaid . . . are of course not deductible as bad debts. Advances made in such circumstances have been aptly characterized as being either gifts or contributions to capital but not as debts." Reading Co. v. Commissioner of Internal Revenue, 132 F.2d 306, 310 [42-2 USTC ¶ 9700]. Nor can advancing money to a debtor with no possibility of its being repaid, but in the hope that if he can be kept in business for a limited time some part of an earlier indebtedness may be salvaged, be treated as a loan and made the basis of a bad debt deduction. "In Eckert v. Burnet, 283 U.S. 140, 141, 51 S.Ct. 373, 75 L.Ed. 911 [2 USTC ¶ 714], the Supreme Court said that, where a debt is worthless when acquired, there is nothing to charge off, and that the words of the statute cannot be taken to include a case of that nature." Reading Co. v. Commissioner, supra.
There was one payment of $250,000 made by United on May 16, 1932. It was made pursuant to an obligation to the Chase National Bank incurred by United by reason of its guarantee of a note of Robinson, and this guarantee was given prior to knowledge of Robinson's insolvency. In this instance a true debtor-creditor relationship was created, and Robinson's note was properly deductible as a bad debt. With this exception, the payments made after July 31, 1931, did not create a true debtor-creditor relationship and did not give rise to a deductible bad debt.
[ Year of Worthlessness]
(2) The next issue is raised by the defendant's contention that, even if there was a valid debt, it became worthless prior to 1949 (the year in which the taxpayer caused Robinson to be dissolved and its assets distributed) and was not deductible in United's return for that year. Here it is necessary to note the distinction, as affecting the time of their deductibility, between debts wholly worthless and debts in which the recovery of a part is a reasonable certainty. A debt totally bad must be deducted in the year in which it becomes worthless and in no other, but a taxpayer may claim a deduction for a partially worthless debt in any year in which he can satisfy the Commissioner that it is recoverable only in part, and failure to do so will not prevent deduction in a subsequent year for partial or complete worthlessness. In Eljer Co. v. Commissioner, 134 F.2d 251 (3rd Circuit) [43-1 USTC ¶ 9305], the Court decided that a taxpayer in the case of a partially worthless debt might at his option either deduct that part of it ascertained to be worthless or wait until final settlement and then deduct the uncollectible portion. In Loewi v. Ryan, 229 F.2d 627 (2nd Circuit) [56-1 USTC ¶ 9235], the Court applied this principle to a secured debt and held that the taxpayer's forebearance to foreclose until a year when it was to his advantage for tax purposes to do so did not prevent him from claiming the deduction in that year.
In the present case, as early as July 31, 1931, it was certain that the debt would never be recovered in its entirety. However, no one could with any degree of certainty know how much of it could be. In this situation, the taxpayer made no attempt at that time to claim a deduction for any part of the debt. Even after Robinson had practically ceased business, the amount of possible recovery was uncertain. From 1939 on, Robinson did no business other than to hold and invest securities and from time to time dispose of some remaining interest that it had in syndicate ventures. Even so, it very nearly doubled its assets and upon dissolution had some $380,000 to distribute. True, United could at any time have caused Robinson to dissolve and thus determine the amount of its loss, but this is just what the Loewi decision says that a taxpayer does not have to do. To all intents and purposes United was in the position of a creditor having a debt secured by collateral.
I am also of the opinion that the indebtedness in the present case is but one indebtedness. It was, of course, evidenced by a great many notes and an open account containing many items, but no tax case that I have found has broken an indebtedness up into its separate items and compelled a creditor to select such of them as he believes could not be paid off and deduct them in advance of the final settlement. To do so would practically defeat the provision of the act allowing the deduction of partially worthless debts since much of the indebtedness of the business world consists of a multiplicity of separate and often unrelated items.
[ Accrued Interest on Advances]
(3) The third question in the case is the matter of interest. The taxpayer included in its deduction for bad debts something over $250,000 for interest due on the indebtedness from Robinson for the years 1931 and 1932, which it had accrued on its books. It did not accrue interest after that year.
Of course, the interest accrued on transactions which did not create a bad debt could not be allowed in any event.
In view of the fact that United filed consolidated income tax returns with its subsidiary Robinson for 1931 and 1932, this claim must be disallowed. By filing a consolidated return with its subsidiary who was the debtor, United was able in the same return to deduct the same interest accrued by it as an expense of the debtor. Consequently, United has never paid any income tax on this bookkeeping accrual of interest. Whatever its books may have shown, United showed no taxable gain in the return filed and it cannot now say that it lost that which it did not show. An item that has never been taken into income and subjected to tax cannot be the subject of a bad debt deduction.
[ Services to Subsidiary]
(4) One other matter requires discussion. When Robinson was dissolved and its assets distributed, United received (in addition to the sum of approximately $360,000 which it applied to the partial payment of Robinson's debt to it) the sum of about $13,000 in payment for services rendered by it to Robinson for the preceding ten years. This, of course, reduced the amount to be applied to the debt and increased the amount of the deduction by that amount. These services were rendered by United to its insolvent subsidiary. They, it seems to me, should be treated as a part of the open account between the two companies and, as such, since they were rendered at a time when there could be no hope of payment for them, must have been in the nature of gifts. I can make no distinction between advancing money without hope of repayment and rendering a service without hope of being payed anything for it. The fact that United caused Robinson to apply this money as it did does not change the nature of what really happened. What really happened was that a part of the assets of the insolvent subsidiary, which should have been applied to the reduction of a valid and deductible debt owed the parent corporation, was applied to satisfy a bookkeeping entry which recorded a transaction that did not give rise to the kind of debt which the tax law allows to be taken into account.
Orders for judgment in favor of the plaintiff in accordance with the foregoing may be submitted.