Opinion
No. K-508.
June 5, 1933.
Thomas G. Haight, of Jersey City, N.J. (J. Marvin Haynes and Robert M. Montgomery, both of Washington, D.C., on the brief), for plaintiffs.
Ralph C. Williamson, of Washington, D.C., and Charles B. Rugg, Asst. Atty. Gen., for the United States.
Before LITTLETON, WHALEY, WILLIAMS, and GREEN, Judges.
Suit by the Birdsboro Steel Foundry Machine Company and affiliated companies against the United States.
Judgment in favor of the plaintiffs.
Plaintiffs sue to recover $72,219.68, income and profits tax alleged to have been illegally collected for 1918. The question presented is whether the Birdsboro Steel Foundry Machine Company, hereinafter referred to as "plaintiff," was entitled to deduct $80,410.21 from gross income for 1918 as a debt ascertained to be worthless and charged off in that year.
Counsel for the defendant contends that there was no debt due the plaintiff, and if there was, it was worthless prior to the taxable year.
Special Findings of Fact.
1. The Birdsboro Steel Foundry Machine Company, E. G. Brooke Iron Company, and the Birdsboro Water Company, all Pennsylvania corporations, were affiliated during 1918 and filed a consolidated income and profits tax return for that year. Prior to 1906 the name of the Birdsboro Steel Foundry Machine Company was Diamond Drill Machine Company.
May 18, 1898, John H. Brown and Harvey M. Munsell entered into a contract with the United States for the manufacture of twenty-five 5-inch and twenty-five 6-inch segmental guns, including gun mounts, for use during the Spanish-American War. These guns were known as "Brown segmental" guns and were covered by patents secured and owned by Brown and Munsell. May 23, 1898, plaintiff entered into a contract with Brown and Munsell, which provided as follows:
"Witnesseth: That for a consideration hereinafter named the party of the first part agrees to build or cause to be built all the guns and mortars that the party of the second part may contract for and the party of the second part hereby agree that the party of the first part shall build or cause to be built all of the guns and mortars they may contract for at the following prices: On all machine work, including vise, floor, and drafting, at fifty-five cents ($0.55) per hour, and for common labor twenty-five ($0.25) per hour; this includes all costs of rentals, superintendence, and supplies, such as oil, waste, power, etc., and in addition to have one fifth (20%) of the net profits on all work done under said contracts. It being understood that payments are to be made to the said party of the first part as the money is received from the governments or parties for whom the work is being done. The party of the first part are to furnish the bail bond satisfactory to the parties from whom the contract for work is received. When the blue prints are ready for the mounts for the guns or mortars the parties of the first part are to have the first chance to do this work. It being understood that the above prices for work are based on present prices for labor; any change in labor, this agreement to be made to conform to the actual difference paid. It being understood that the trustees will draw the money and hand the government drafts, or other moneys, properly endorsed over to the Diamond Drill Machine Co. as soon as received by them, out of such moneys received, the Diamond Drill Machine Co. shall pay for all steel and other material used in the construction of the guns and the sums due to themselves for labor, etc., as specified herein to the extent of the amounts received under the contracts and after retaining their twenty percent of the net profits the balance to be immediately turned over to the trustees of the Brown Segmental Tube Wire Gun. Such settlements to be made upon receipt of payments for each gun. It is hereby understood and agreed that the parties of the second part are to have the use of land enough on which to erect temporary building for assembling the cores for the guns and mortars, said land not exceeding 50 × 100 feet. If Mr. Brown finds it necessary to have assistants he is at liberty to employ them at the best terms possible and charge same to construction account. It is further agreed that for all night work there shall be an additional charge of twenty-five cents ($0.25) per hour. It is further agreed that the parties of the second part shall save the parties of the first part harmless from any claims on patent or patents. It is further agreed that all work is to be done after the plans and specifications upon which the contracts rest. It is hereby understood and agreed that the parties of the second part waive the clause for forfeiture of five dollars, or any other sum, per day, if the parties of the first part fail to make and deliver the fifty guns on time under this particular order and will also be waived on future orders provided the fifty guns under this contract are made and delivered on time."
Brown and Munsell were not strong financially, and this was the reason for the terms of the foregoing contract — that plaintiff could not be paid until the War Department had paid Brown and Munsell. Any money received from the government was to be turned over to plaintiff, and after it had deducted its costs and profit provided by the contract the balance was to be turned over to Brown and Munsell.
2. Between May 23, 1898, and December, 1905, plaintiff made expenditures of $80,410.21 under its contract with Brown and Munsell for labor and materials in connection with the production and testing of the aforementioned guns, which expenditures were entered upon its books by plaintiff in an account entitled "Gun Account," showing in detail the amounts expended, segregated as to the various items of work performed, and material acquired, totaling the following amounts:
5-inch guns ....................... $50,979.75 6-inch guns ....................... 571.41 Gun mounts ........................ 14,845.88 Machinery built for the contract .. 14,013.17 __________ $80,410.21
The aforesaid amount was carried on the books of plaintiff's predecessor as an account receivable.
3. One of the 5-inch guns was completed and tested in August, 1899. November 9, 1899, the Chief of Ordnance submitted to the Secretary of War the report of Captain MacNutt on the test of the gun with an official indorsement thereon, stating, in substance, that while the gun had met the contract requirements certain defects had developed during the test which should be remedied before acceptance, and suggesting that the gun be submitted to one hundred additional rounds and that the guns called for by the contract be modified so as to remedy these and further defects which might develop in these additional firings. This report was approved by the Secretary of War November 30, 1899, and Brown and Munsell were notified of the approval February 6, 1900. Brown and Munsell immediately protested the action of the Secretary of War and requested a suspension until they could be heard. A board of experts was appointed to make a report in regard to the guns. While the board was engaged upon this matter, the Chief of Ordnance, on January 11, 1901, recommended that he be authorized to declare the contract of Brown and Munsell of May 18, 1898, void because the parties had failed to comply with the requirements of the Secretary of War, in accordance with the provisions of the contract. This recommendation was approved by the Secretary of War and although Brown and Munsell appealed from the decision of the Chief of Ordnance, the Secretary of War refused to revoke his action in approving the recommendation. Subsequently the board of experts referred to above made its report, which, on the whole, was favorable to the gun, but material defects were pointed out and modifications were suggested. The contract with Brown and Munsell was annulled by the Chief of Ordnance and the Secretary of War pursuant to the right reserved to the government in a clause of the contract giving them the right to do so if, in the judgment of the Chief of Ordnance and the Secretary of War, Brown and Munsell had failed to furnish a gun meeting the tests required by the contract. See Brown v. United States, 51 Ct. Cl. 22; Saalfield v. United States, 246 U.S. 610, 38 S. Ct. 397, 62 L. Ed. 895, Ann. Cas. 1918E, 1. Brown and Munsell were accordingly notified January 17, 1901.
4. Plaintiff's predecessor, as subcontractor, did not institute suit against Brown and Munsell under its contract with them for collection of $80,410.21, but induced Brown and Munsell to sue the government because plaintiff could not be paid for its expenditures until Brown and Munsell received payment from the government.
Brown and Munsell filed suit in this court in 1907 and expenditures of approximately $80,000 for labor, materials, and equipment by plaintiff's predecessor were included in this suit. This court decided the case in favor of the government December 6, 1915, and dismissed the petition. An appeal was taken to the Supreme Court and the decision of the Court of Claims was affirmed April 22, 1918.
5. Brown and Munsell died insolvent prior to 1918. After the Supreme Court had handed down its opinion in 1918, plaintiff's predecessor charged off on its books in that year the account receivable from Brown and Munsell of $80,410.21 as a worthless debt. This amount was deducted by plaintiff in its tax return for 1918. It was not charged off or deducted in any tax return prior to 1918.
The account receivable of $80,410.21 stood on the books of the plaintiff's predecessor at March 1, 1913, and was carried at its full value and was a good and collectible account from Brown and Munsell until April 22, 1918, the date of the decision of the Supreme Court adversely to their claim. No portion of the amount of $80,410.21 has been collected by plaintiff; the material and equipment manufactured by plaintiff by said expenditure had no scrap value and no amount was realized therefrom.
Plaintiff and its affiliated corporations filed a consolidated return for 1918 showing a total tax of $591,491.48, which was assessed; $544,595.40 of this tax was paid in four installments of $132,082.92 on March 26, 1919, $163,899.67 on June 12, 1919, $147,872.87 on September 12, 1919, and $100,739.94 on December 12, 1919. In 1921 the Commissioner upon audit of the return disallowed the deduction of $80,410.21 and, after making certain other adjustments in the income reported in the return, assessed an additional tax of $14,745.54 which was paid October 13, 1921, making the total tax paid for 1918, $559,340.94. The balance of $46,896.08 assessed was abated.
6. Plaintiff and its affiliated corporations filed waivers for 1918 and also duly filed claims for refund.
October 6, 1928, the Commissioner determined upon audit of the return that there had been an overpayment of $83,555.88, which was duly refunded with interest. He rejected the claim for refund in so far as it claimed a refund on account of the disallowance of the deduction of $80,410.21 as a worthless debt. It is agreed that if plaintiff is entitled to this deduction the overpayment is $72,219.68.
This case involves an alleged tax overpayment of $72,219.68, for 1918, by reason of the disallowance by the Commissioner of a deduction from gross income of $80,410.21 determined to be worthless and charged off by plaintiff in 1918. This alleged debt from Brown and Munsell to plaintiff arose and accrued between May, 1898, and December, 1905, under a certain contract between Brown and Munsell and plaintiff's predecessor, the Diamond Drill Machine Company, for the manufacture by plaintiff of certain guns and gun mounts for which Brown and Munsell had a contract with the United States.
Plaintiff contends that this debt was due it by Brown and Munsell and, although they were insolvent prior to 1918, it was entitled under its contract with them to be paid for the work performed and the machinery and equipment purchased and installed for the manufacture of guns out of any amounts paid by the government to Brown and Munsell under their contract with the government; that the debt was not worthless and that it was not determined to be worthless and charged off until 1918 when it was finally decided by the Supreme Court on April 22, 1918, in Saalfield, Administrator of Brown, Surviving Claimant, v. United States, 246 U.S. 610, 38 S. Ct. 397, 62 L. Ed. 895, Ann. Cas. 1918E, 1, that Brown and Munsell were not entitled to recover from the government under their contract with it.
It is also contended by plaintiff that if the amount of $80,410.21 was not properly deductible as a bad debt, it was deductible as a loss sustained in 1918.
It is suggested by counsel for the defendant that no indebtedness from Brown and Munsell to plaintiff ever existed and that plaintiff never became possessed of an asset or a debt which could be charged off and claimed as a deduction from gross income, but, in our opinion, this position cannot be sustained under the contract.
The expenditures were made under a contract between plaintiff's predecessor and Brown and Munsell which provided that the former would build the guns for certain specified prices for labor and overhead, together with a certain percentage of profits, and should be reimbursed "for all steel and other material used in the construction of the guns." The contract provided further that "payments are to be made to said party of the first part (the company) as the money is received from the governments or parties for whom the work is being done"; and also that Brown and Munsell should "draw the money and hand the Government drafts, or other moneys, properly endorsed over to the Diamond Drill Machine Company as soon as received by them," and that the latter should then reimburse itself for all steel used in the construction of the guns and money due for labor, overhead, profits, etc., as provided in the contract, and then turn over the balance to Brown and Munsell. This was referred to as a "settlement," and the contract provides that "such settlements to be made upon receipt of payment for each gun." Under this provision of the contract the time of payment by Brown and Munsell of amounts due plaintiff for work performed by it under its contract with them did not arise until the money was received from the government or until it was determined that the government was not indebted to Brown and Munsell under their contract with it. But we think it is clear that when the company made the expenditures and performed the work which the contract called for, the contract then created between the parties the relationship of debtor and creditor; and, had Brown and Munsell not died insolvent prior to the time that it was finally determined that the government was not liable to them for any amount, plaintiff would have had a valid and collectible debt from them. The facts establish that the parties to the contract intended to and did construe the above-quoted provisions to provide only that the time for payments should not initially arise until the government had paid Brown and Munsell. This, however, did not prevent the relationship of debtor and creditor from attaching and we think there was a complete obligation on the part of Brown and Munsell under their contract to pay the plaintiff's predecessor at some time for the work performed for them. The relationship of debtor and creditor arises where one person, by contract or law, is liable or bound to pay another an amount of money, certain or uncertain, and it is not necessary that the debt shall be due in the sense that it is then collectible; it must be an outstanding obligation, which, if not due at the time, will certainly become due at some future date.
Had Brown and Munsell been paid by the government, or had recovered any amount from it by suit, their obligation to pay the company would have become due.
The contract contained no provision and, we think, is not susceptible of construction that if Brown and Munsell did not receive anything from the government they should be relieved from the obligation to pay the moneys which they expressly agreed to pay to the company for labor, material, and overhead costs. There was no provision that the parties should share any losses that might arise from building the guns, and, although the contract did not contain any provision as to when the company should be paid, if the government should not pay Brown and Munsell or it was determined that no payments could be recovered from the government, the law would imply a stipulation for payment on demand or within a reasonable time.
The contract between Brown and Munsell and plaintiff was made in the light of the contract between Brown and Munsell and the government, and the parties must necessarily have contemplated that the guns might not come up to the tests required by the contract between Brown and Munsell and the government, and that, in that event, the latter would decline to pay anything for them. If it had been the intention of the parties that, in the event of this contingency, the Diamond Drill Machine Company was not to receive anything for the expenditures made by it under its contract with Brown and Munsell, a provision to that effect would certainly have been incorporated in the contract.
Little need be said with reference to when the debt became worthless for the purpose of deduction from gross income for tax purposes. Inasmuch as the time for payment of the amounts due the company did not arise until the government had paid Brown and Munsell, or it had been decided that there was no obligation on the part of the government to pay them, the debt was not worthless within the meaning of the revenue acts and it was impossible to ascertain that it was worthless in any year while it was in litigation and prior to the decision of the Supreme Court in 1918. Broadway Savings Trust Co. v. United States, 66 Ct. Cl. 429; Daniels Fisher Stores Co. v. United States, 56 F.2d 477, 480, 74 Ct. Cl. 233. At the time the Supreme Court finally settled the question Brown and Munsell had died insolvent, consequently there was no possibility of collecting anything from either of their estates. Thus the debt was in truth and in fact determined to be worthless in 1918 and was charged off in that year.
The decisions are uniform that a debt cannot be determined to be worthless, or a loss cannot be taken with respect thereto so long as it is in litigation and has not been finally decided.
Even if the amount of $80,410.21 was not deductible as a worthless debt in 1918, we think it was deductible in that year as a loss sustained under section 234(a)(4) of the Revenue Act of 1918 ( 40 Stat. 1078), which provides that in computing net income there shall be allowed as deductions not only bad debts, but, also "Losses sustained during the taxable year and not compensated for by insurance or otherwise." If under the contract between plaintiff and Brown and Munsell the right, as distinguished from the time of payment, of plaintiff to receive anything was dependent upon the payment of Brown and Munsell by the government, the plaintiff must be considered to have embarked on a joint venture with Brown and Munsell in the carrying out of its part of which it expended $80,410.21 for labor, material, and equipment. As it was eventually decided that there was no liability on the part of the government to Brown and Munsell, plaintiff must be held to have lost the funds which it had thus invested. Lewellyn v. Electric Reduction Co., 275 U.S. 243, 48 S. Ct. 63, 64, 72 L. Ed. 262. In that case the loss was claimed as a deduction in 1918. Three separate suits with respect thereto were instituted in 1919. In 1922 all three suits had been decided against the company. These facts were mentioned by the court to show that the loss had not been sustained in 1918. The court also emphasized that the company "did not charge off the $27,000 on its books in 1918, but continued to carry it as an item in its `bills receivable' account." The court also further stated that "it claimed no loss on account of the payment in its tax return for that year." While the court in the Electric Reduction Case held only that the deduction could not be had for 1918, the opinion clearly indicates that the loss was deductible in 1922.
In Lucas v. American Code Co., Inc., 280 U.S. 445, 449, 50 S. Ct. 202, 203, 74 L. Ed. 538, the court held that "generally speaking, the income tax law is concerned only with realized losses, as with realized gains," and held that even where the books were kept on an accrual basis it was improper to take as a loss damages for breach of a contract in the year in which the breach took place where the amount was not determined or paid until later and at the time of the breach liability was denied and strenuously contested. When liability is contested the institution of a suit does not, of itself, create certainty of loss.
In Daniels Fisher Stores Co. v. United States, supra, this court said "We think that losses which depend on the result of a contested action in court cannot be said to be definitely fixed prior to the rendition of judgment therein. * * *"
The deduction of the debt involved results in an overpayment of $72,219.68 for 1918 which the plaintiff is entitled, in our opinion, to recover with interest. Judgment will be entered accordingly. It is so ordered.
BOOTH, C.J., did not hear this case on account of illness and took no part in its decision.
I concur on the second ground stated in the foregoing opinion, but I am inclined to the view that the contract between Brown and Munsell and the plaintiff made the liability of the former merely a contingent one depending upon whether anything became due from the government. When the Supreme Court, in 1918, decided that Brown and Munsell could not recover from the government, it thereby in effect adjudicated, as it seems to me, that there was no liability on the part of Brown and Munsell to the plaintiff, and that the contingency upon which such liability might have been founded had never existed. There is no question but that the plaintiff sustained a loss, and, as stated in the majority opinion, the loss occurred in 1918 regardless of whether the relation of debtor and creditor existed between the plaintiff and Brown and Munsell.