Douglas County Light & Water Co. v. Commissioner

*1053 Petitioner asks redetermination of deficiencies in income taxes of $2,762.88 for 1922, and $14,245.93 for 1923. It is alleged that the respondent erred (a) in refusing to allow as a deduction in the*2996 year 1922, $16,000 on account of a bad debt determined to be worthless and charged off in that year; (b) in determining for 1923 a profit of $59,413.17 to petitioner, resulting from cancellation of its own bonds at less than amount received; (c) in the determination of a profit of $39,975.32 upon sale of its assets in 1923 and that the amount of depreciation fixed by respondent was erroneous.

FINDINGS OF FACT.

The petitioner is a corporation organized under the laws of Oregon with its principal office at Roseburg, Oreg. It was organized June 20, 1912, with a capital stock of $300,000, divided into 3,000 shares, which was fully subscribed and paid for under the following circumstances:

At the first meeting of the board of directors of petitioner on July 8, 1912, A. Welch and Isaac W. Anderson, proposed to convey or cause to be conveyed to petitioner certain light and water systems owned by J. I. Kendall and wife, and S. A. Kendall and wife, in Douglas County, Oregon, upon terms substantially as follows: The properties were at that time encumbered by a first or underlying mortgage of $200,000 to secure bonds issued by the Umpqua Water, Light & Power Co. and these were to be*2997 assumed by petitioner and its entire capital stock was to be issued fully paid and nonassessable to Welch and Anderson or their nominees and in addition thereto the petitioner was to execute a mortgage on said property to a trustee to secure an issue of $600,000 25-year second mortgage bonds, $250,000 of which should be delivered to Welch and Anderson.

The proposition was accepted, proper conveyances were made to petitioner, the second mortgage was duly executed, and the stock and bonds were delivered to Welch and Anderson as agreed upon. A. Welch was elected president and petitioner started business.

Mr. Welch ceased to be president of the petitioner and severed his connection with it in 1915. In the following year the secretary of the petitioner discovered that $26,000 of the second mortgage bonds which had been retained in the treasury were missing and unaccounted for. Upon investigation it developed that $6,000 of the bonds was pledged as collateral to a loan to petitioner in a bank at Roseburg, Oreg., and that the remaining $20,000 had been appropriated by the president to his own use.

*1054 These facts were reported to the directors, who at once took the matter*2998 up with Welch in an endeavor to obtain restitution of the bonds or payment therefor. Welch at first agreed to obtain and return the bonds, but failed to do so and the matter drifted along until 1921, when petitioner obtained from Welch his note for $16,000 in payment for the $20,000 of bonds, after many unsuccessful efforts to obtain a settlement. Welch was a promoter and speculator, and petitioner's officers knew very little about his financial responsibility but expected the note to be paid and entered it on their books as an asset in 1921. It does not appear that it was returned as income.

In 1922 Welch filed his voluntary petition in bankruptcy and was duly adjudicated a bankrupt. The note above mentioned was listed as one of his unsecured liabilities. Petitioner received nothing from the bankrupt's estate, and now claims that it ascertained said note to be worthless as the result of the bankrupt proceedings. The note was charged off on books of account of petitioner as worthless in 1922. The requested deduction for that year was denied by the respondent.

On April 11, 1923, the petitioner and others entered into an option agreement with the California-Oregon Co. by*2999 which they agreed to sell and convey to the latter all of the properties, rights and franchises of the petitioner by warranty deed free of lien and encumbrance, except the lien of lease to Automatic Electric Brake Co., for the sum of $600,000, or as an alternative would sell all of the stock and bonds of the petitioner for said sum.

On June 13, 1923, the California-Oregon Power Co. exercised its option and notified petitioner as follows: -

SAN FRANCISCO, CALIFORNIA,

June 13, 1923.

DOUGLAS COUNTY LIGHT AND WATER CO.,

Mr. JOHN KIERNAN,

Mr. J. L. KENDALL,

Mr. S. A. KENDALL, and

KENDALL LUMBER CORPORATION,

Roseburg, Oregon.

GENTLEMEN: You, and each of you, will please take notice and are hereby advised by the undersigned, the California-Oregon Power Company, that it hereby exercises the option granted to it under the terms of that certain option agreement dated April 11, 1923, between yourselves and the undersigned, upon the following terms and conditions, each of which has heretofore been accepted and agreed to by you: the undersigned will purchase all of the properties of Douglas County Light and Water Company from said Company, subject to its outstanding*3000 bonds, which bonds the undersigned will buy on the basis of par for the underlying bonds and 80% of par for the overlying bonds upon terms already agreed upon with the holders of said bonds. A sum equal to the difference between $600,000 and the sums to be paid for said bonds by the undersigned, shall be paid to the Douglas County Light and Water Company. The *1055 purchase herein specified is contingent upon securing the order of the Railroad Commission of the State of California authorizing the same, if such order is required, and the undersigned agrees without delay to initiate the necessary proceeding to obtain such order.

All other terms of said agreement save as herein specifically modified remain in full force and effect, the agreement dated April 11, 1923, between J. L. Kendall, S. A. Kendall and Kendall Lumber Corporation and the undersigned also remains in full force and effect.

THE CALIFORNIA-OREGON POWER CO.,

By (Signed) JOHN A. MCKEE,

President.

[SEAL.]

By (Signed) P. H. SEITZ,

Assistant Secretary.

The purchase price of $600,000 was paid as follows:

*3001 Between the organization of petitioner and this transaction petitioner had issued and sold $82,000 of its second mortgage bonds at $80 in addition to the $250,000 originally issued and delivered to Welch and Anderson, making $332,000 in all. The respondent computed a profit of $59,413.17 for the petitioner on the cancellation of this bonded indebtedness by subtracting $465,600, the cost of canceling or redeeming the bonds, from $525,013.17, the amount it or its predecessor originally received. This was added to income for 1923.

The properties of the petitioner consisted of complete water and pumping and electric generating plants, together with necessary transmission and distributing pipes and lines adequate for serving certain territory in Douglas County, Oregon. The fair value of the original plant as of July 1, 1912, was $450,000, to which should be added additions to plant $228,023.35, construction in progress June 30, 1923, $6,903.49, and inventory of merchandise and fuel June 30, 1923, $9,921.67, making total cost of assets sold, $694,848.51.

In order to arrive at the profit or loss on the sale of the plant, respondent fixed the depreciation at $134,823.83, which he*3002 deducted from total cost, leaving $560,024.68 as cost less depreciation. The *1056 difference between this latter sum and the sale price of $600,000, amounting to $39,975.32, was found to be profit by the respondent and added to petitioner's income. We find that the depreciation was $110,943.74 as claimed by petitioner, that the depreciated cost of the property sold was $583,904.77, and that the difference between this depreciated cost and the sale price of $600,000 was $16,095.23, which is the profit on the sale of the plant.

During the time from its organization to the sale of the property petitioner's board of directors and managing officers agreed upon and adopted what they believed an adequate rate for depreciation. For the greater part of the time this averaged about 2 per cent but in the last three or four years was increased, but the total thereof was $110,943.74. Expenditures for maintenance were $98,474.20.

The useful life of the properties was between 30 and 40 years.

OPINION.

MILLIKEN: So far as the year 1922 is concerned the only question before us is the correctness of respondent's refusal to allow a deduction for the note of A. Welch for $16,000, *3003 as all other adjustments made by respondent for that year were agreed to by petitioner at the hearing.

The evidence shows and both parties agree that this claim of $16,000 represented by the note had its origin in an embezzlement or misappropriation of petitioner's bonds between 1912 and 1915. Section 234(a) of the Revenue Act of 1921 provides for deductions for "losses sustained during the taxable year and not compensated for by insurance or otherwise" and "debts ascertained to be worthless and charged off within the taxable year."

When these bonds were misappropriated, a "loss" occurred and entitled petitioner to a deduction therefor in the year when taken. We do not believe that the taking of a note six years later can have the effect of converting what was a "loss" into a "debt" or a tort into a contract.

In the case of , the treasurer of the company had embezzled $41,023.79 of its funds in 1914. In 1916 the company brought suit against the treasurer to recover the money. While the action was still pending, the treasurer in 1921 went into bankruptcy and the company received nothing on its claim. *3004 It claimed deduction as for a bad debt in 1921, but it was held that a "loss" occurred when the funds were embezzled in 1914, and that it could not be deducted in 1921 as a "bad debt." It was there said:

* * * The issue here presented has been decided by this Board in several cases adversely to the contention that the petitioner herein makes. In , the facts of which are very *1057 similar to those of the instant proceeding, we held that a fraudulent appropriation of petitioner's goods constituted "losses sustained," rather than "debts ascertained to be worthless." We think that the conclusion reached in that case is sound and applicable here and that the embezzlement by Budde from the Regan Printing House, Inc., constituted a loss to the company but did not create the relation of debtor and creditor. No doubt the company had a cause of action against Budde to recover the money he had embezzled, but the right to recover did not rest upon either an express or an implied contract.

A loss can only be deducted from income for the year when it was sustained. In *3005 , it was held that the petitioner's loss by embezzlement, as here, occurred when the money was taken although petitioner did not know of the embezzlement until a later year. The same holding was announced by the United States District Court for the Southern District of Ohio in the case of United Statesv. Cleveland, Cincinnati, Chicago & St. Louis Ry. Co., February 23, 1916, unreported. In that case the court said:

The time of the discovery of the loss bears no relation to the date the loss was sustained. The loss was sustained when the theft occurred, although the defendant did not know at the time of the depletion, of the depletion of its assets.

See also Appeals of J. A. Bentley and .

The record herein establishes clearly that the embezzlement by Budde took place in the year 1914. The resulting loss to the Regan Printing House. Inc., was therefore sustained in that year and it may not be deducted in computing net income for a later year.

See also the decision of the Court of Claims in *3006 . The action of respondent in disallowing the deduction of the $16,000 note of A. Welch for 1922 is approved.

The errors alleged for 1923 are the inclusion in income of the alleged profit made by petitioner in the redemption and cancellation of its second mortgage bonds, and the correct amount of depreciation to be allowed in determining profit on sale of petitioner's properties.

We have held in a number of cases that the redemption or cancellation of its own bonds, or payment of its indebtedness at less than par or the amount of the debt by a taxpayer did not result in taxable income. Cf. ; ; ; ; ; ; *3007 . The fact that in this case the purchaser did the actual purchasing of the bonds does not change the effect, for it was done with a part of the purchase money to which the petitioner was entitled. The legal effect was just the same as if the *1058 entire $600,000 had been paid to the petitioner and it had then paid off the bonded indebtedness out of the $600,000, or if petitioner had first settled the bonded indebtedness with its own funds and then received the entire $600,000. In any case the bonds were canceled with petitioner's funds and it is immaterial which party carried out the actual details of the transaction. The method adopted was probably the most convenient and economical for all concerned, and is of common occurrence in sales of encumbered real estate.

The inclusion of $59,413.17 alleged profit on cancellation of bonds in 1923 income was error.

Relative to the correct amount of depreciation to be allowed on sale of petitioner's assets, we believe $110,943.74, the amount fixed by the petitioner, fair and reasonable. It is in evidence that this amount was fixed by the directors and managing*3008 officers of the petitioner through a series of years and that in addition thereto it was the consistent policy of petitioner to keep repairs and maintenance up in the highest degree. These costs were $98,474.20 and of course prolonged the useful life of the property, which was from 30 to 40 years.

In , we said on page 363:

* * * Two of the three errors alleged by the petitioner relate to depreciation. The Commissioner increased depreciation for the years prior to 1918 and decreased it for the year 1918.

The depreciation written off on the books of petitioner, for the years 1912 to 1918, inclusive, results from an actual physical examination and inspection of its plant, machinery and equipment, made by the official in charge of production and one who, for over thirty years, had been in active touch with the business. He took into consideration the actual use and extent of operations of the plant, the cost and age of the various types of depreciable assets; had before him the experience of the company in the past, reflecting the useful life of its assets; and was intimately connected with repairs made to the machinery and equipment*3009 each year. With this information before it, the petitioner charged off depreciation. The amount to be charged off as depreciation has been changed by the respondent, both in years prior to and for the year 1918. We are of the opinion that the long experience of the official of petitioner and the relevant factors which he used in determining depreciation, are to be preferred to depreciation determined upon a straight-line basis. * * *

The depreciation as fixed by petitioner was the judgment of men of experience and familiarity with the property for a number of years and is accepted as reasonable.

Reviewed by the Board.

Judgment will be entered under Rule 50.

STERNHAGEN and TRAMMELL dissent.