Mitchell v. Commissioner , 13 T.C. 368 ( 1949 )

John F. B. Mitchell, Petitioner, v. Commissioner of Internal Revenue, Respondent

Mitchell v. Commissioner

Docket No. 17461

United States Tax Court

13 T.C. 368; 1949 U.S. Tax Ct. LEXIS 87;

September 26, 1949, Promulgated

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Decision will be entered under Rule 50.

Where petitioner partially charged off two sets of demand notes and then sold both sets later in the same taxable year at a price equal to their reduced value, held, that petitioner was entitled to capital loss deductions on the sales rather than partial bad debt deductions on the notes.

W. Mason Smith, Jr., Esq., for the petitioner.

Walt Mandry, Esq., for the respondent.

Hill, Judge.

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HILL

The Commissioner determined a deficiency in petitioner's income tax for the year 1944 in the amount of $ 19,820.78. The only issue raised by petitioner is the correctness of respondent's disallowance of partial bad debt deductions totaling $ 35,798.54 claimed by petitioner in his 1944 tax return. We must determine whether petitioner was entitled to either partial bad debt deductions under section 23 (k) of the Internal Revenue Code or to long term capital losses under section 117 of the code on six promissory notes which he charged off in part and then sold during the year 1944.

FINDINGS OF FACT.

Parts of the facts were stipulated and are so found.

Petitioner is an individual whose business office is in Wall Street, New York, New York. He kept his accounts on a calendar year basis and filed his income tax return for 1944 with the collector of internal revenue for the second district of New York. From 1931 through 1944 petitioner, C. O. M. Sprague and John Whipple were general partners in successive partnerships engaged in the stock brokerage business in New York City, first under the firm name of Wood, Low & Co., and after June 1941 under the name of Wood, Walker & Co.

During the period 1931-40 the various partnership agreements provided that the general partners should receive stated percentages of the net profits of the partnerships, and should assume stated percentages of the net losses. These agreements also contained a provision setting forth fixed sums which might be drawn each month by each general partner from the partnership and charged to his personal drawing account.

In the period from 1931 through 1940 the successive partnerships sustained losses and at other times failed to have sufficient profits for the shares of Sprague and Whipple therein to equal the amounts withdrawn by them respectively. As a result Sprague and Whipple became indebted to the partnerships for their shares of the partnership losses sustained and for the amounts withdrawn by them in excess of their shares of the profits during this period. To eliminate these indebtednesses to the successive partnerships the other general partners, including petitioner, in 1936, 1937, and 1938 made payments to the partnerships equal to the amounts of respective indebtednesses of Sprague and Whipple. In return, in 1936, 1937, and 1938 Sprague and Whipple gave to each of the general partners, including petitioner, their respective demand notes in amounts equal to the portion of their respective indebtednesses each of the general partners had paid.

The amounts of the demand notes given by Sprague to petitioner in 1936, 1937, and 1938 and all payments thereon follow:

Notes
			Amount not
		Part payments	repaid
Date	Amount
June 1, 1936	$ 8,734.85	$ 599.56 -- 12/29/36	$ 8,175.29
Dec. 31, 1937	5,716.81	None	5,716.81
Sept. 30, 1938	9,245.01	976.03 -- 12/31/38	8,268.98
Total amount not repaid			22,161.08

The amounts of demand notes given petitioner by Whipple in 1936, 1937, and 1938 and all payments thereon are listed below:

Notes
			Amount not
		Part payments	repaid
Date	Amount
June 1, 1936	$ 8,022.74	$ 203.62 -- 12/29/36	$ 7,352.04
		467.08 -- 12/ 2/37
Dec. 31, 1937	2,730.23	None	2,730.23
Sept. 30, 1938	6,830.68	1,775.49 -- 12/31/38	5,055.19
Total amount not repaid			15,137.46

From 1936 through 1943 petitioner made no attempt to obtain any further repayments on the Sprague and the Whipple notes held by him. On November 14, 1940, petitioner obtained from Sprague a statement of his financial position, which disclosed assets valued at $ 20,563 and liabilities of $ 176,260.85. On the same date he received a similar statement from Whipple disclosing assets of $ 7,229.25 and liabilities of $ 89,336.85.

In 1944 petitioner held conferences with both Sprague and Whipple in an effort to enforce collection on their notes. At these meetings both debtors stated they were unable to make substantial payments on their obligations to petitioner, and Sprague expressed his intent to retire at the end of 1944. On December 1 of that year, pursuant to petitioner's request, Sprague sent petitioner a statement of his financial condition, listing as his assets cash of approximately $ 5,000, stock worth not over $ 2,480, personal belongings valued at $ 3,000, partnership profits of several thousand dollars, and a life insurance policy of $ 20,000. On the same date petitioner charged off on his books in the amount of $ 21,161.08 the three notes of Sprague on which a total balance of $ 22,161.08 was owing. Later that same day, when Irving Sprague, brother of the debtor, offered to buy the three notes for $ 1,000, petitioner accepted the offer before the close of the business day and received payment.

On December 4, 1944, Whipple mailed petitioner a financial statement disclosing as his only assets $ 2,000 in cash, realty worth $ 3,000, stock valued at no more than $ 900, personal belongings worth $ 1,200, and partnership profits of several thousand dollars. On December 5, 1944, the three notes of Whipple on which a total balance of $ 15,137.46 was owed were charged off on petitioner's books in the amount of $ 14,637.46. At a subsequent hour that day petitioner accepted an offer made by an attorney representing Lawrence Whipple, the debtor's brother, to buy the three Whipple notes for $ 500, received the payment, and delivered the notes to Lawrence Whipple.

On his income tax return for 1944 petitioner claimed partial bad debt deductions in amounts of $ 21,161.08 and $ 14,637.46 on the notes of Sprague and Whipple, respectively.

In his notice of deficiency the Commissioner stated in part:

It is held that the amounts of $ 21,161.08 and $ 14,637.46 claimed as bad debt deductions in your income tax return for the year 1944 do not constitute allowable deductions from gross income under the provisions of Section 23 (k) of the Internal Revenue Code.

The debts in question were not wholly worthless at the beginning of the year 1944.

OPINION.

On December 1, 1944, petitioner charged off on his books to the extent of $ 21,161.08 three demand notes of his partner, C. O. M. Sprague, upon which a total balance of $ 22,161.08 was owing. Later the same day petitioner sold these notes to Irving Sprague, brother of the debtor, for $ 1,000. Similarly, on December 5, 1944, petitioner charged off on his books in the amount of $ 14,637.46 three demand notes of his partner, John Whipple, upon which a total balance of $ 15,137.46 was owed. At a subsequent hour that day he sold these obligations to Lawrence Whipple, brother of the debtor, for $ 500. The sole question for our determination is to what, if any, deductions the above transactions entitled petitioner for the taxable year 1944. Petitioner contends that he should have been allowed partial bad debt deductions of $ 21,161.08 on Sprague's three notes and $ 14,637.46 on Whipple's three notes. In the alternative, he argues that he should be granted long term capital loss deductions on the sales of the notes to the extent he is denied bad debt deductions. Respondent maintains petitioner is not entitled to partial bad debt deductions on three grounds: First, because the petitioner released the debtors from their obligations for business reasons; secondly, because the debts became worthless prior to the taxable year; and, finally, in the alternative, because the sales of the notes resulted in capital losses.

We are not persuaded by respondent's first two reasons for disallowing the partial bad debt deductions claimed by petitioner, because the evidence fails to show that petitioner released Sprague and Whipple from their obligations on the notes. Yet we are in accord with respondent's view that the sales of the Sprague and Whipple notes in 1944 did foreclose petitioner from taking partial bad debt deductions on them. It is settled that where a taxpayer sells or exchanges an obligation for less than the amount owing thereon and later in the same taxable year charges off the difference on his books, he is not entitled to a partial bad debt deduction on the obligation. See McClain v. Commissioner, 110 Fed. (2d) 878; affd., 311 U.S. 527">311 U.S. 527; Ralph Perkins, 41 B. T. A. 1225; affd., 125 Fed. (2d) 150; Leslie H. Reed, 45 B. T. A. 1130; affd., 129 Fed. (2d) 908; Maurice Levy, 46 B. T. A. 423; affd., 131 Fed. (2d) 544; certiorari denied, 318 U.S. 780">318 U.S. 780. We are convinced that the result is the same even though the charge-off of the debt takes place prior to its sale, as long as both events occur in the same taxable year.

Petitioner's argument that a partial bad debt deduction is not defeated by sale of the debt within the same taxable year where the charge-off precedes the sale runs contrary to the system of annual accounting required by Federal income tax law. Petitioner would have us judge the partial deductibility of a bad debt upon the occurrence of partial worthlessness and charge-off without regard to the effect of a subsequent sale of the debt before the close of the taxpayer's accounting period. But the appropriateness of an income tax deduction is not based upon a separate examination of each of the taxpayer's transactions in the order of their occurrence during the taxable year; rather it is determined by viewing the net result of all the taxpayer's transactions taking place during the twelve-month period. As the Supreme Court said in Burnet v. Sanford & Brooks Co., 282 U.S. 359">282 U.S. 359, 363:

All the revenue acts which have been enacted since the adoption of the Sixteenth Amendment have uniformly assessed the tax on the basis of annual returns showing the net result of all the taxpayer's transactions during a fixed accounting period * * *.

In the instant case petitioner sold all six notes during 1944 and so no indebtedness to him existed on these obligations at the close of his accounting period; yet an essential prerequisite of a bad debt deduction is the existence of a debt owing to the taxpayer. See Luke & Fleming, Inc., 1 B. T. A. 12, and Emil Weitzner, 12 B. T. A. 724. Without the notes, petitioner had nothing on which to base a bad debt deduction at the close of 1944. True, the charge-offs were made earlier in the year, but their effectiveness for deduction purposes must be judged at the close of 1944, at which time they had lost their significance, due to the disposal of the obligations to which they were related. Cases cited by petitioner in support of his proposition are readily distinguishable from the instant case on the facts. We hold that petitioner was not entitled to partial bad debt deductions on these notes.

Both parties agree that in 1944 all six notes constituted capital assets in the hands of petitioner within the meaning of section 117, that he held them over six months, and that their sale in December was bona fide. We therefore hold that petitioner was entitled to long term capital losses on the sale of Sprague's three notes and the sale of Whipple's three notes, based in each instance on the difference between the face value of the notes minus all repayments and the sale price.

Decision will be entered under Rule 50.