Opinion
No. 42799.
February 6, 1939.
John A. Selby, of Washington, D.C. (Lawrence A. Baker and Henry Ravenal, both of Washington, D.C., and Athearn, Chandler Farmer, of San Francisco, Cal., on the brief), for plaintiff.
Daniel F. Hickey, of Washington, D.C. (James W. Morris, Asst. Atty. Gen. (Robert N. Anderson, Fred K. Dyar, and J.W. Blalock, all of Washington, D.C., on the brief), for defendant.
Before BOOTH, Chief Justice, and WHALEY, LITTLETON, GREEN, and WILLIAMS, Judges.
Suit by Pacific Fruit Exchange against the United States to recover back income tax paid by plaintiff.
Judgment for plaintiff.
This case having been heard by the Court of Claims, the court upon a stipulation makes the following special findings of fact:
1. Plaintiff during all of the years hereinafter mentioned was and now is a California corporation engaged in the business of growing, harvesting, furnishing supplies for packing and marketing fruit and other crops on a commission basis. As an operating feature of this business and solely in the furtherance of this business, plaintiff enters into mortgage-marketing contracts with growers in the State of California whereunder the crops and real estate of the grower are mortgaged to plaintiff under terms whereby plaintiff secures the valuable privilege of packing for shipping and marketing at commission for a stated number of years the entire crop of such grower and in return advances certain funds for the protection, growing, and harvesting of such crops.
2. During the years 1922-1928 inclusive and up to January 15, 1929, Hiawatha Farm, a California corporation, was engaged in the business of growing fruits on lands owned by it in the State of California.
3. As of April 1, 1922, Hiawatha Farm executed and delivered to First Federal Trust Company, as Trustee (which First Federal Trust Company was later succeeded by Crocker First Federal Trust Company), a certain first trust indenture upon all its real and personal property to secure an issue of its first mortgage seven per cent serial gold bonds.
4. Pursuant to a permit dated May 12, 1922, issued by the Commissioner of Corporations of the State of California and the first trust indenture heretofore mentioned, Hiawatha Farm issued and sold its first mortgage seven percent serial gold bonds in the principal amount of $250,000, none being purchased by plaintiff.
5. On February 7, 1923, Hiawatha Farm executed in favor of plaintiff a mortgage-marketing contract. By the terms of this instrument Hiawatha Farm agreed to market through plaintiff its entire crop of deciduous fruits for the years 1923-1932, inclusive, grown upon certain lands owned by it at certain agreed commissions and likewise mortgaged to plaintiff as security for any and all advances made or to be made by plaintiff its entire crop of deciduous fruits grown or to be grown by it on said premises during that period of time.
On November 18, 1924, Hiawatha Farm executed a second mortgage-marketing contract for additional advances and in every way the same as that previously executed. Copies of the mortgage-marketing contracts are attached to the petition as Exhibits "A" and "B" and made a part hereof by reference.
6. Pursuant to the contracts, plaintiff made advances to Hiawatha Farm and also pursuant to the contracts plaintiff harvested the fruit, sold the same and credited the proceeds received from sales against advances so made. On January 15, 1929, the advances so made exceeded the credits received in the sum of $174,017.71, so that there was a net balance due from Hiawatha Farm to plaintiff in this amount.
7. Hiawatha Farm defaulted in payment of interest on its first mortgage bonds (referred to in Finding 4) and on October 1, 1928, likewise defaulted in payment of principal amounts then due. Thereupon the trustee, Crocker First Federal Trust Company, declared the first trust indenture to be in default and pursuant thereto elected to sell the property covered by the indenture. The sale was duly held on January 15, 1929, at which time the property was offered for sale at public auction to the highest bidder for cash. Plaintiff bid for the property the sum of $186,123.47, which was the highest bid offered. Plaintiff thereupon paid the sum to the trustee in cash and was given a deed to the property. The amount for which the property was sold did not exceed the principal of the bonds then outstanding plus accrued interest and the necessary costs of sale. In making such purchase plaintiff had no agreement forgiving or reducing the indebtedness with Hiawatha Farm and received no preference by reason of the indebtedness due it from Hiawatha Farm and none of the indebtedness was credited on its bid. At no time has plaintiff held any stock in Hiawatha Farm nor had any means of controlling the farm except in respect of the mortgage-marketing contracts referred to in Finding 5.
8. By reason of the foreclosure sale Hiawatha Farm was from and after the date thereof without any assets or property with which to pay its indebtedness to plaintiff and was likewise incapacitated from in any way carrying out or fulfilling any of the other terms of the mortgage-marketing contracts or of either of them. The fact of this inability to pay and incapacity to carry out the terms of these contracts was known to plaintiff at the time of the sale. Hiawatha Farm has made no payment since that date to plaintiff on account of the indebtedness nor acquired any assets with which to make any payment on account thereof or to comply with the other terms of the contracts.
9. Under date of April 15, 1929, credit entries were made on plaintiff's books of account and original records whereby its account with Hiawatha Farm was balanced and closed. Preceding that date and after the purchase of the property of Hiawatha Farm at foreclosure sale on January 15, 1929, entries reflecting the cost of the property were made on plaintiff's books. Other entries were made in the assets accounts of plaintiff charging as capital cost the amount of the bid at the foreclosure sale (see Exhibit 3) and also the open account (see Exhibit 1) already balanced and closed. The bookkeeping record both of the account and the purchase is herewith submitted as follows:
Exhibit 1. — Photostatic copies of ledger pages of the Hiawatha Farm account beginning in 1923 and ending April 15, 1929, on which date the account then amounting to $174,017.71 was balanced and closed. The items of accrued interest were included by petitioner as income in its Federal tax returns.
Exhibit 2. — Photostatic copy of Pacific Fruit Exchange journal voucher dated January 29, 1929, reflecting the purchase of the property of Hiawatha Farm from the Crocker First Federal Trust Company.
Exhibit 3. — Photostatic copy of Pacific Fruit Exchange ledger page 1 setting up as an asset as of January 29, 1929, the property of Hiawatha Farm at the amount of the bid at the foreclosure sale and showing the transfer of the amount so set up to another account as of April 15, 1929.
Exhibit 4. — Photostatic copy of Pacific Fruit Exchange ledger account No. 1-A reflecting the liability to Crocker First Federal Trust Company for $186,123.47, being the purchase price owing on account of the purchase of the property of said Hiawatha Farm.
Exhibit 5. — Photostatic copy of Pacific Fruit Exchange journal voucher dated April 15, 1929, crediting and closing out Hiawatha Farm account $174,017.71 (see Exhibit 1) and the Hiawatha Farm bank claim account $186,123.47 (see Exhibit 3) and setting up as assets Building — Hiawatha Farm $125,000 and Real Estate — Hiawatha Farm $235,141.18.
Exhibits 6 and 7. — Photostatic copies of Pacific Fruit Exchange ledger sheets reflecting the entry of Buildings and Real Estate Hiawatha Farm in the ledger of Pacific Fruit Exchange in consequence of the entries made in journal voucher dated April 15, 1929 (see Exhibit 5).
Exhibit 8. — Photostatic copy of Pacific Fruit Exchange journal voucher dated July 1, 1931, crediting real estate and debiting surplus as of January 15, 1929, with $174,017.71, the amount of the Hiawatha Farm account, which had been balanced and closed on April 15, 1929 (see Exhibit 1).
10. On or about March 15, 1930, plaintiff filed with the Collector of Internal Revenue for the First District of California a return of income for the calendar year 1929 and paid on March 15, June 16, September 16, and December 15, 1930, the quarterly installments of tax shown to be due by the return, the total amount paid being $14,106.34. In computing net taxable income on the return plaintiff did not deduct either as a bad debt or as a loss the sum of $174,017.71.
11. Under date of August 7, 1931, plaintiff filed an amended return for the year 1929 and a claim seeking refund of the entire tax paid by it for that year, the amended return and claim being based upon the plaintiff's claim of the right to deduct from gross income the sum of $174,017.71. Copies of both original and amended returns are attached to the stipulation as Exhibit 9. A copy of the claim is attached to the petition as Exhibit "C" and made a part hereof by reference.
12. Under date of September 23, 1932, the Commissioner of Internal Revenue rejected the claim for refund, a copy of the letter of rejection being attached to the petition as Exhibit "D" and made a part hereof by reference.
13. No action upon the plaintiff's foregoing claim has been had before Congress or either House thereof, or any of the Departments of the Government, other than the Treasury Department, or in any other court.
This tax case is submitted upon an agreed statement of facts. The plaintiff, a California corporation, is engaged in growing, packing, and marketing deciduous fruits and other crops. Its business activities embrace growing crops upon its own account, and entering into mortgage-marketing contracts with other growers. It is this last phase of activities which gave rise to this litigation.
A mortgage-marketing contract is an indenture of dual character, and is intended to secure to the mortgagee the exclusive right to furnish the supplies essential for packing the crops and the right to market the same on a commission basis. The contract creates a lien in favor of the mortgagee upon the realty of the mortgagor as well as upon his growing and harvested crops.
The consideration moving to the mortgagor consists of money advances to provide for the cultivation, etc., of the designated crops, and other outlays connected with the enterprise, as well as the acquisition of a marketing agent interested and engaged in a similar business.
The terms of the indenture provide that the mortgagee is to receive payment of advances and interest thereon out of the proceeds of the sale of the crops, accounting to the mortgagor for any surplus remaining after deducting, in addition to the advances, the agreed-upon commission due the mortgagee. Incidental expense of supplies for packing the crops was to be paid for by the mortgagor.
The Hiawatha Farm, a California corporation engaged in growing fruits and other crops, and the plaintiff entered into two mortgage-marketing contracts. The first one is dated February 7, 1923, and the other November 18, 1924, to run until 1932. From time to time plaintiff advanced money to the Hiawatha Farm until on January 15, 1929, it owed the plaintiff $174,017.71, which it could not pay.
The Hiawatha Farm corporation in April 1922 lawfully executed a first trust indenture upon all its assets to secure an issue of its first mortgage seven percent serial gold bonds, and in May 1922 issued and sold $250,000 of such bonds. October 1, 1928, Hiawatha Farm defaulted in payment of the principal and interest due upon the bonds, and the Crocker First Federal Trust Company, under the first trust then owned by it, foreclosed the same.
All the assets of the Hiawatha Farm corporation were sold January 15, 1929, under the first trust indenture and the plaintiff being the highest bidder purchased the same for $186,123.47. The plaintiff at no time owned any of the stock of the Hiawatha Farm corporation; it paid in cash to the trustee the purchase price mentioned, and it is conceded that no agreement of any kind existed wherein the plaintiff covenanted to either forgive or reduce the amount of Hiawatha Farm indebtedness to it as a part consideration for the purchase.
Upon completion of sale of the assets of Hiawatha Farm under the first trust, the above-mentioned amount, $174,017.71, stood on plaintiff's books as a debt due from Hiawatha Farm for loans theretofore made by plaintiff. Upon foreclosure of the trust, Hiawatha Farm was without assets and the debt to plaintiff was worthless.
Plaintiff in entering upon its books this transaction with reference to the first trust foreclosure charged as the cost of the property of Hiawatha Farm the purchase price paid in cash, and added thereto the amount of the indebtedness due from the corporation. At the same time an entry was made balancing and charging off plaintiff's account with Hiawatha Farm and closing the same. Plaintiff knew then and knew at the time of the sale that the debt was worthless and treated it as such by balancing and closing its account with the corporation.
Plaintiff on March 15, 1930, filed its income tax return for the calendar year 1929, which disclosed a tax due in the sum of $14,106.34, which was paid in installments. In the return filed the plaintiff computed its net taxable income in accord with the book entries noted above, and as to the transaction involved did not take a deduction from gross income of the unpaid debt due it from the Hiawatha Farm corporation.
August 7, 1931, plaintiff filed an amended return for 1929, claiming the deduction, and a refund claim seeking the refund of its entire income tax. It is conceded that if plaintiff is entitled to recover, the judgment should be for the sum of $14,106.34 and interest thereon.
The Revenue Act of 1928 ( 45 Stat. 791, 799, 800) is as follows:
"(f) Losses by corporations. In the case of a corporation, losses sustained during the taxable year and not compensated for by insurance or otherwise. * * *
"(j) Bad debts. Debts ascertained to be worthless and charged off within the taxable year (or, in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts); and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt to be charged off in part." Sec. 23, 26 U.S.C.A. § 23(f), (j) note.
The plaintiff contends that it is entitled to deduct the amount of the indebtedness due it from Hiawatha Farm, either as a bad debt or a business loss. It is true that plaintiff's business relations under the mortgage-marketing contracts with the Hiawatha Farm corporation obligated it to make certain advancements, and it is asserted that it was an indispensable feature of the transaction in order to procure the rights and earn any possible profits from the same. It is said in the brief that financing transactions of this character was an established custom of the trade.
The defense interposed is seemingly rested upon a contention that recognizes the $174,017.71 due the plaintiff from the Hiawatha Farm corporation as a bad debt, but insists that the record establishes the fact that it was not ascertained to be worthless and charged off within the taxable year. To sustain this contention, the fact of plaintiff's treatment of the transaction, reflected in its book entries, and the period of time elapsing between the first and the amended return filed by plaintiff, are cited as proof that plaintiff intended to treat the indebtedness as part of the cost price of the assets of the corporation, and when the property was disposed of compute its gain or loss upon this basis.
Tested by business experience, it is manifest that the plaintiff had reason to doubt its ability to collect the sum due from the Hiawatha Farm corporation on the date the corporation defaulted in paying the interest on and the sums due upon the principal of the bond issue. However, the corporation possessed assets, continued in business, and the absolute worthlessness of the debt was not ascertained until the sale of the assets was made. On that date the plaintiff ascertained the essential facts exacted by the revenue law.
It is conceded that legal precedents establish the rule that no particular form of charge off is required. It is sufficient if the book entry discloses that the debt is worthless and has not been paid. Plaintiff's books did show that the debt had not been paid; they reflected its worthlessness. The adding of the debt to the purchase price of the property of the Hiawatha Farm as was first done was, as plaintiff states, "inept bookkeeping." That entry however had no effect upon the closing of the account with the corporation in connection with the other entry which exhibited the worthlessness of the debt. Stapley Co., Inc. v. Commissioner, 13 B.T.A. 557, American Cigarette Cigar Co. v. Bowers, 2 Cir., 92 F.2d 596; Appeal of Huning Mercantile Co., 1 B.T.A. 130, 132; Appeal of Mason Machine Works Co., 3 B.T.A. 745, 750, 751; Chas. E. Fenner v. Com'r, 5 B.T.A. 772, 778; United States v. S.S. White Dental Mfg. Co., 274 U.S. 398, 47 S.Ct. 598, 71 L.Ed. 1120.
The determination of worthlessness and the charge off were not rendered ineffective by the entry which plaintiff made in its real estate account. The property in the real estate account belonged to plaintiff absolutely, and the Hiawatha Farm corporation had no interest therein. For tax purposes the plaintiff could not at any future time have added the indebtedness of the Hiawatha Farm to the purchase price of the property purchased and paid for under the foreclosure, either for the purpose of depreciation or for gain or loss. Such indebtedness was not a part of the bid or purchase price of such property. It remained after the foreclosure as before — a debt to plaintiff from Hiawatha Farm, and the facts clearly show that plaintiff determined the same to be worthless and charged it off as worthless within the taxable year.
Plaintiff paid cash for the assets of the Hiawatha Farm corporation. The indebtedness of the corporation to plaintiff did not enter into the sale in any way. The bank's foreclosure of its prior lien and the sum received by the trustee for the corporation's assets absolutely precluded the plaintiff from collecting the debt involved, and it is our opinion that the book entries, although erroneous as to the sale transaction, were sufficient to constitute a proper charge off within the taxable year, and the plaintiff is entitled to the deduction claimed.
Judgment will be awarded the plaintiff in the sum of $14,106.34, with interest thereon as provided by law. It is so ordered.
WHALEY, LITTLETON, and GREEN, Judges, concur.
WILLIAMS, Judge, took no part in the decision of this case.