Brandtjen & Kluge, Inc. v. Comm.

Decision will be entered under Rule 50.

William R. Busch, Esq., for the petitioner. Leonard A. Hammes, Jr., Esq., for the respondent.

PAGE 416

--

PAGE 417

The respondent determined deficiencies in income tax against the petitioner for the taxable years 1952 and 1953 in the respective amounts of 26,463.09 and 21,780.07. By amended answer, the respondent has made claim for deficiencies in amounts increased to 29,661.25 and 25,534.47. The years 1954 and 1955 are involved only because of a claimed operating net loss carryback from the year 1954 to the year 1952, and from the year 1955 to the year 1953.

The only adjustment involved in the year 1952 relates to the operating net loss carryback from the year 1954.

The questions presented are (1) the amount of deduction allowable, if any, for salary of Henry A. Brandtjen, Jr., for the period extending from May 19, 1953, to December 31, 1955; (2) whether deductions in 1954 and 1955 in the respective amounts of 28,000 and 12,000, for partial worthlessness of accounts receivable from petitioner's Canadian subsidiary, were properly disallowed by respondent; (3) whether petitioner is entitled to a worthless stock loss deduction in 1954, in the amount of 5,000, on the capital stock of its Canadian subsidiary; (4) whether petitioner is entitled to a deduction in 1953 for depreciation in the amount of 2,298.17; and (5) whether petitioner should have reported in 1955 accrued interest on loans to its president in the amount of 5,500, as income. FINDINGS OF FACT. Some of the facts have been stipulated and are found as stipulated.

Petitioner is a Minnesota corporation, with its principal place of business in St. Paul, Minnesota, having been incorporated on November 7, 1919. It filed its income tax returns for the years 1952, 1953, 1954, and 1955 with the director or district director of internal revenue for Minnesota.

Petitioner was organized by John Brandtjen, his son, Henry A. Brandtjen, sometimes referred to hereafter as Henry, Sr., Abel Kluge, and the latter's brother, Eneval Kluge. During the years material herein, it was engaged in the manufacture of platen printing presses in two sizes and in selling them to large and small users of printing presses. It was the originator of the use of air as a means of feeding paper through the process of printing. It designs and manufactures the presses it sells, including the parts, except castings and automatic screw machine parts, which are purchased. Its basic patents relating to its presses have expired.

PAGE 417

--

PAGE 418

Abel Kluge and his brother were joint inventors of the Kluge printing press. Abel, though not an engineer, is an expert in printing equipment as well as an outstanding machinist. He is one of petitioner's vice presidents and is responsible for most of the mechanical work, discoveries, improvements, design changes, and patents in connection with the Kluge press.

At all times material herein, if not from the date of its organization, members of the Brandtjen family, originally Henry, Sr., and his father, John Brandtjen, owned and controlled petitioner corporation through the ownership of a majority of its stock. During the years 1952 through 1955, petitioner's outstanding stock was held as follows:

                                     Stock publicly held

John Brandtjen and Henry A. Brandtjen were respectively petitioner's president and secretary-treasurer from 1919 through November 1, 1950. Each drew the same salary, which ranged from 12,000 from 1929 through 1935, to 14,400 from 1935 through 1946, to 17,280 in 1947, and 19,008 in 1948 to November 1, 1950. Similarly, Abel and Eneval Kluge were paid identical salaries. Each was paid 5,200 in 1929 through 1935, 6,240 in 1936 through 1939, and 7,000 in 1940. Thereafter only Abel was on the payroll, and

PAGE 418

--

PAGE 419

he was paid 7,000 through 1946, 8,400 in 1947, and 9,240 to November 1, 1950.

Henry A. Brandtjen and his wife, Gladys, had two sons, John Brandtjen II, hereafter referred to as John II or John, and Henry A. Brandtjen, Jr., hereafter referred to as Henry, Jr., or Junior. John was born in 1927, and Henry, Jr., on November 29, 1928.

Henry, Sr., acquired a farm of approximately 520 acres in or about the year 1933. At some undisclosed date, John became the owner of a farm of 160 acres, and in 1940 Henry, Jr., became the owner of a farm also of 160 acres. ¹ Henry, Sr., rented his sons' farms and with his operated the three as one 840-acre farm. The operation consisted of growing grain, raising purebred Guernsey cattle, running a dairy, and raising horses. All of the acreage was located near Farmington, Minnesota, 20 miles south of St. Paul, and was known as the Brandtjen farms. The family home was located on one of the farms. From the acquisition of his farm in 1933 through the years herein, Henry, Sr., never realized a profit from his farming operations.

On June 7, 1938, Henry, Sr., purchased 300,000 of life insurance on a 10-year term plan, the policies, their respective amounts, and the gross premiums being as follows:

 Policy                                          Amount       Gross

On some undisclosed date the insurance agent suggested to Henry, Sr., that the policies be transferred to his wife and two sons, if they were in a position to "meet" the premiums. He told Henry, Sr., that if the ownership of the policies should be so transferred the insurance proceeds would not be includible in his estate for estate tax purposes. Acting on the suggestion, Henry, Sr., on June 7, 1945, made assignments of the Bankers Life Company and the National Life of Vermont policies to his wife and two sons. At the time of

PAGE 419

--

PAGE 420

the transfers, the policies were converted from term policies to "life plan" policies. On June 7, 1948, the State Mutual Assurance Company policy was similarly assigned and converted. After assignment and conversion, the wife and sons became equal owners of policies on the life of Henry, Sr., in amounts and with gross premiums as follows:

 Policy                                            Amount       Gross

There was no assignment of the New England Mutual and the Phoenix Mutual Life Insurance Company policies, the ownership of those policies being retained by Henry, Sr. He renewed the Phoenix Mutual policy for a 10-year term from June 7, 1945, at an annual premium of 3,067. He renewed the New England Mutual policy on June 7, 1948, for a further 10-year term, at an annual premium of 2,175.

On some undisclosed date between November 1, 1950, and June 19, 1951, John Brandtjen, the father of Henry, Sr., died, and at a meeting of petitioner's board of directors on June 19, 1951, Henry, Sr., was elected to succeed his father as president of petitioner. He was 61 years old at that time. At the same meeting, John Brandtjen II was elected secretary and treasurer. Other officers elected were: Abel Kluge, vice president; R. E. Barnes, vice president; A. N. Haugen, vice president and assistant secretary and assistant treasurer. According to the minutes, the directors present and participating

PAGE 420

--

PAGE 421

at the meeting were Henry, Sr., John II, Abel Kluge, R. E. Barnes, and A. N. Haugen.

John's salary as secretary-treasurer was fixed at 1,742.40 per month, or 20,908.80 per year, effective June 19, 1951. This was the same salary Henry, Sr., had been receiving as secretary-treasurer, and was the same salary he was to receive from June 19, 1951, as petitioner's president. The directors also voted to each of the officers for the year 1951 as additional compensation 20 per cent "of his annual salary, being the same rate as in effect for the nine preceding years, 1942 to 1950, inclusive." They also declared a dividend to the holders of common stock of 25 cents per share.

Haugen was first employed by petitioner in 1923 as a bookkeeper. His formal education had consisted of work in high school and 2 years each at Hamline University and Nichols Business School. In the way of business experience, he had worked for 2 years as a clerk for the Omaha Railroad Company. After becoming an employee of petitioner's, he took a correspondence course in accounting with the Walton School of Commerce in Chicago, completing the course in 1932. He became the assistant secretary of petitioner in 1928, was elected vice president in 1943, and became assistant treasurer in 1951. His salary, not including the 20 per cent bonus, was 6,336 in 1947, 7,187.40 from 1948 to November 1, 1950, and 7,906.20 during the rest of his employment with petitioner. During the years material herein he was in charge of petitioner's accounting department.

R. E. Barnes was employed by petitioner shortly after he concluded his schooling, and continued as an employee between 20 and 25 years. He worked for a period in the parts department and was then advanced to the purchasing department. He had no engineering training. He became vice president in 1947, and his salary thereafter was the same as that of Haugen. He was in charge of production, which consisted of supervising the production schedules, the purchasing of materials and equipment, and the supervising of the men employed in the service department.

At the time John was elected secretary-treasurer he was approximately 24 years of age. He had attended grade and high schools at St. Paul Academy, and had studied pre-law and law at the University of Minnesota. He left the law school in June of 1950. His grades were below the standard required for continuing in law school, and he had decided that he was not interested in the study of law. For about 6 months in 1949 he had worked for petitioner, checking salesmen's reports, corresponding with the salesmen, and rearranging their territories. His compensation was approximately 170 per month. He again began work for petitioner in the late

PAGE 421

--

PAGE 422

summer of 1950. On that occasion his work was in petitioner's foreign sales department which was directing its efforts to the building up of business in South America. He was paid 300 or 400 per month. He continued to work for petitioner at the same salary until early April of 1951. From that time until early June, he devoted his time to the management of the Brandtjen farms, although he continued to draw his salary from petitioner. When he returned to work for petitioner in June, he had been elected secretary-treasurer and had been voted a salary of 1,742.40 per month, plus added compensation as shown above. His duties, however, remained the same as they had been when he had last worked for petitioner.

Before John was elected secretary-treasurer his father told him the position had always been held by a member of the family and that he wanted it to remain that way; that his salary was not to be used as he wished; that he had an obligation to his father and the salary was to be used to the extent necessary to pay the premiums on insurance carried on the life of his father and, except for a small, reasonable amount for his personal use, the salary should be kept for the payment of taxes on his father's estate, when that time arrived, so as to prevent the necessity of any of the family stock in petitioner being sold.

As secretary-treasurer of petitioner, responsibilities within a limited scope were delegated to John by his father, who made the company policies and retained close control over all matters of importance. Any matter which was not routine was taken by John to his father, who gave his ideas, and if a letter was required to be written, indicated how he thought the letter should be phrased. After John had drafted the letter and it was typed, he took it to his father, who permitted it to go out only if it expressed his policies and views accurately.

About December 31, 1951, John was advised by Henry, Sr., that he would have to leave the employ of petitioner if he married the girl he had indicated he intended to marry. By letter, Henry, Sr., informed him that he had been placed on leave of absence status from December 31, 1951. John thereafter performed no services for petitioner and received no compensation.

At or about the same time, domestic troubles had developed between Henry, Sr., and his wife. As a result of these difficulties and the placing of John on leave of absence without pay, neither John nor his mother was able to continue the payment of their shares of the premiums under the insurance policies on the life of Henry, Sr., which had been assigned to them and Henry, Jr., in 1945 and 1948. Negotiations were had, with the representative for

PAGE 422

--

PAGE 423

the insurance companies acting as intermediary. These negotiations resulted in an assignment by John and his mother of their interests in the said policies to Henry, Jr., for which they were to receive and did receive their portions of the cash surrender value of the policies. The transfers were consummated on or about May 12, 1952.

Shortly after acquiring the interests of his mother and brother in the above policies, Junior also became the owner and beneficiary of insurance in the amount of 100,000 Henry, Sr., had theretofore carried with the Phoenix Mutual Life Insurance Company, after which Junior was the owner of four policies of insurance on the life of his father, as follows:

 Policy                                          Amount     Gross        Loan

On May 19, 1953, Henry, Jr., was elected secretary-treasurer at a salary of 1,742.40 per month, or 20,908.80 per annum, effective as of that date, and with additional compensation of 20 per cent of the fixed salary. At that time he was 24 years of age. The directors present and voting were Henry A. Brandtjen, Sr., Abel Kluge, Henry A. Brandtjen, Jr., R. E. Barnes, and A. N. Haugen.

Henry, Jr., had attended grade school and high school at St. Paul Academy, and in September 1946 had entered the University of Minnesota to study mechanical engineering. He received his degree of bachelor of mechanical engineering in July of 1952. The extended period consumed in obtaining the degree was due to poor grades during the earlier years of his attendance at the university.

As a boy, Junior had understood that he would at some time be an employee of petitioner and ultimately an officer and part owner. In October of 1952, he had attended a Graphic Arts Show at Montreal, Canada, at which petitioner had a display. While there he rendered some assistance in setting up and attending the display. Also prior to his election as secretary-treasurer he had done some work at petitioner's offices and plant in St. Paul. He received no compensation for such services.

PAGE 423

--

PAGE 424

During the summer of 1952 and up to October, he had worked on his father's farm and received 3,150 as compensation. That was the first time he had received pay for any work done. On his 1952 income tax return, he stated his business as that of "Farm Manager." On this return he reported a net rental of 736.42 from his own farm. On his returns for 1953, 1954, and 1955, he reported income as "Farm Manager" of 4,180.40, 4,200.04, and 4,200.04. In all 4 years social security tax was paid on his income from farm wages.

On or about June 15, 1953, Junior contracted to buy John's farm for 21,000. He received an advance of 2,000 from Henry, Sr., as the downpayment on the purchase price.

Just prior to the directors meeting on May 19, 1953, Henry, Sr., had informed Haugen that Junior was to be elected secretary-treasurer, but perhaps would be required to serve a period in the Army. He asked Haugen what would be the result if Junior continued to receive his compensation as secretary-treasurer of petitioner while in the Army. Haugen advised Henry, Sr., that upon audit of petitioner's income tax returns, it could be that the deduction of Junior's salary would be challenged in whole or in part; that the determination could be that the salary was excessive, resulting in a disallowance of the deduction, which further would result in an assessment of additional tax which would have to be paid, with interest at 6 per cent. Henry, Sr., then stated, "Well, if that's it, let's go ahead."

After Junior was elected secretary-treasurer and was placed on the payroll, he reported to work daily during the remainder of May, but after that and until he went into the Army on August 20, 1953, he was seldom at the plant. During that period he requested the draft board for a deferment on the grounds that he was managing the Brandtjen farms and was working for petitioner. Pursuant to draft, he was inducted into the Army on August 20, 1953, and continued on full duty until June 16, 1955.

For the purpose of paying a substantial part, if not all, of the net premiums on the life insurance policies on the life of Henry, Sr., Junior from time to time received substantial loans from petitioner. He also received advances from his father. For that purpose, he received 14,000 from petitioner on June 30, 1953, 10,000 on June 30, 1954, and 13,490.80 on May 31, 1955. After he was named secretary-treasurer of petitioner in May of 1953 and during the period he was in the Army, petitioner deposited his salary checks in petitioner's account and credited them against his loans. The checks received by Junior from his father as compensation for farm management were returned to his father and applied on advances made by his father or directly to the payment of insurance premiums.

PAGE 424

--

PAGE 425

Some of Henry, Sr.'s advances were repaid by the crediting of gifts against the advances.

After entering the Army on August 20, 1953, Junior received 9 weeks' basic training at Fort Knox, Kentucky. He was thereafter assigned as an instructor in track vehicle maintenance at Aberdeen Proving Grounds, Maryland, where he remained until his discharge from the Army in June of 1955. Two weeks prior to his discharge he was promoted to the rank of corporal.

While in the service, Junior had telephone conversations with his father from time to time. Included in these conversations were discussions concerning the farms and petitioner. The cost of the calls was charged to petitioner as business expense.

On some of his weekends while in Baltimore, Philadelphia, or Washington on pass from Aberdeen Proving Grounds, Junior would stop at print shops he happened to find in operation on the weekends. During such stops he would ascertain if they were using petitioner's products, and if not, he would undertake to learn why not. He also made some effort to sell a press, but was unsuccessful.

Periodically during his Army service he made trips by plane to St. Paul, and while at home had discussions with his father on matters pertaining to both the company and the farms. He also filled social engagements. On one trip in the latter part of 1954, he was married. The expenses of the trips were charged to petitioner as business expense.

While still in the Army, Henry, Jr., on February 13, 1954, attended a meeting in Philadelphia of petitioner's sales personnel in that area. The purpose of the meeting was to promote a sales organization and to discuss the conditions in the area as they might relate to petitioner. He made a written report of the meeting to his father. The "sound" sales organization hoped for did not materialize. While in Philadelphia, Junior saw some advertising material of petitioner's products of which he did not approve, and mailed it to his father for his attention.

Petitioner became involved in a lawsuit in New York City, the trial of which was to be held in April of 1954. Being fearful that Henry, Sr., could not attend the trial, petitioner's attorney made arrangements for Junior to be available as a witness. He was not needed, however, as his father was able to attend.

On July 1, 1954, just prior to his wedding, Junior failed to make payments of 5,000 on principal and 750 in interest then due under his contract with John for the purchase of John's farm. On July 2, 1954, John notified Junior, by letter, that unless payment of the debt was made within 30 days, he would repossess the farm, in accordance with the terms of the contract. Junior was able to make

PAGE 425

--

PAGE 426

arrangements which permitted him to pay John the full amount due on the contract.

Henry, Jr., attended none of the meetings of petitioner's directors during the period of his service in the Army. All meetings of the directors were attended by Henry, Sr., Abel Kluge, Barnes, and Haugen. Haugen, as assistant secretary, acted as secretary of the meetings and signed all the minutes.

Upon being discharged from the Army on June 16, 1955, Henry, Jr., returned to St. Paul and reported for duty at petitioner's office. He took over part of the duties of Barnes in the purchasing department and some duties in the sales department. He did not supervise either Barnes or Haugen as to their respective duties, but he was their superior. The duties taken over by him had been performed by employees who received salaries of 500 to 600 per month.

In September of 1955, Junior visited the offices of petitioner's subsidiary in Toronto, Canada. His purpose was to reorganize the operation and obtain sales personnel. At that time the only employees were the secretary and a serviceman. On a trip to Quebec, he conferred with a former salesman, obtaining his views with respect to petitioner's sales problems with printers. He returned to Toronto in October and conferred with the personnel of the subsidiary and employed a unit manager. The man so employed worked until March of 1956. On one of the trips Junior also supervised or participated in the repossession of a machine.

During 1955 and after he started work for petitioner, Henry, Jr., made trips to Chicago, Dallas, and Los Angeles to investigate conditions and to interview prospective employees. In addition to the district or branch managers, it was planned to hire unit managers. At that time petitioner had no unit managers. During the period in question six branch managers were hired but only one has continued to work with the company. After investigating the conditions encountered by him, Junior sent reports of his findings to his father. One man interviewed was hired for the purpose of promoting the sales in South America, but he did not remain with petitioner. Other applicants were also interviewed by Junior and some of them were hired.

At a special meeting of the board of directors on October 5, 1955, petitioner was authorized to purchase for the treasury 5,000 shares of stock held jointly by John and Henry, Jr., at a cost of 13.50 per share, and to sell 2,500 shares to Henry, Jr., at the same price.

During the years 1953 through 1955, petitioner had approximately 50 employees. It did not in those years operate a union shop, and no retirement program or fringe benefits were provided for its employees. On February 29, 1956, Haugen resigned on request. Whether by

PAGE 426

--

PAGE 427

request or on his own volition, Barnes' employment with petitioner was terminated about April 1956.

The names and titles of the officers of petitioner and the salaries, including bonuses, paid to them, for the years 1952 through 1955, were as follows:

                                                      Amounts paid

                                                                Distributions

Reasonable compensation for services rendered to petitioner by Henry, Jr., during the years 1953, 1954, and 1955 is respectively 750, 1,200, and 5,100.

Prior to 1949, sales of petitioner's products in Canada were made through a dealer. To take the place of the dealer petitioner on January 24, 1949, organized an Ontario corporation under the name of Brandtjen & Kluge (Canada), Ltd., which was to be operated in a manner similar to its branches in the United States. From its organization, the Canadian corporation has been a wholly owned subsidiary of petitioner and petitioner's officers have been its officers.

The only place of business maintained by the subsidiary was in Toronto and was leased space, consisting of a room and a half and a basement. The leased premises were sufficient to provide space for an office and a room for the display of petitioner's products.

The subsidiary carried no inventory of presses for sale, but two presses were usually on hand for display and demonstration purposes. A stock of parts for servicing presses which had been produced by petitioner and which were in use in the area was carried,

PAGE 427

--

PAGE 428

but numerous sales of parts were made on orders sent to petitioner and filled by it from St. Paul. Presses sold in Canada were shipped by petitioner from St. Paul only when it had received the orders therefor. On receipt of an order at the office in Canada, an invoice listing the merchandise ordered, the name of the customer, and the date for shipment would be sent to petitioner. When sent to petitioner the invoice would not show the sales price. Petitioner, on acceptance of the order, would price the merchandise and mail a copy of the invoice showing the price to the customer.

The only funds available for use at the office of the subsidiary in Canada was a petty cash fund of 50. A bank account was maintained in a Toronto bank in the name of the subsidiary, but the account was controlled from petitioner's offices in St. Paul, where checks were drawn by personnel authorized to do so. If a check was drawn in favor of a payee in Canada, it would be sent direct from St. Paul to such payee. The books and records of the subsidiary were kept by an employee of petitioner at petitioner's offices in St. Paul, and were audited by its auditors, Haskins & Sells, and the Canadian affiliate of that accounting firm.

During 1953 the only employees of the subsidiary were an office girl, a serviceman, and a salesman. The salesman left the subsidiary in 1954. A manager was employed in the fall of 1955, but quit in March of the next year.

For the merchandise sold in Canada, the subsidiary was charged petitioner's f.o.b. St. Paul price, less a discount of 25 per cent on parts and discounts of 25 per cent and 5 per cent on presses. These prices were in accord with the prices at which petitioner had made prior sales to the dealer who had handled its merchandise in Canada. The subsidiary handled the products of the petitioner exclusively.

Although charges were regularly made against the subsidiary on petitioner's books for the merchandise sold in Canada and appropriate entries were also made therefor on the books of the subsidiary as accounts payable to petitioner, there was no regularity in the making of payments therefor. Only six payments were made on the account from the date of organization of the subsidiary through 1955, and there were no payments in any amount in 1949, 1950, and 1953. The only other credits to the account during the period were by credit memorandums. According to petitioner'sbooks, the total charges against the subsidiary for merchandise from the date of its organization to December 31, 1954, had amounted to 192,444.39. The total of the credits to the account had amounted to 30,684.74, and the balance still owing was shown as 161,759.65. Of the 30,684.74 which had been credited, 12,492.96 represented the credit memorandums. The remaining 18,191.78 represented five cash payments or transfers of 13,902.04 on May 8, 1951, 3,553.09 on

PAGE 428

--

PAGE 429

October 28, 1952, 324.91 on December 9, 1952, 125 on October 16, 1953, and 286.74 on December 22, 1953. During 1955 the charges for merchandise amounted to 18,346.03. The credits made to the account on the basis of credit memorandums amounted to 2,997.72. There was one payment or transfer of cash on September 22, 1955, of 50,585.93, and the balance shown as due petitioner on the account at December 31, 1955, was 126,522.03.

According to the balance sheets of the subsidiary, its assets, other than cash, were comparatively quite small in amount. Of total assets of 130,838.60 at December 31, 1953, 101,506.01 was in cash. At December 31, 1954, 109,097.38 of total assets of 129,846.40 was cash, and as shown for December 31, 1955, 70,255.79 of total assets of 88,235.22 represented cash. The substantial reduction both in total assets and in cash on hand at December 31, 1955, had resulted from the above payment or transfer of 50,585.93 in cash to petitioner on September 22, 1955. Against these assets, the liabilities of the subsidiary, other than its liability to petitioner on accounts payable and for capital stock, ² were relatively very small, and aside from a reserve for fluctuations in foreign exchange and amounts representing unearned interest and unearned gross profits on installment sales, which unearned items in 1953, 1954, and 1955 were never as much as 5,000, the liabilities other than the amounts shown as due petitioner were only 1,203.06 at December 31, 1953, 869.97 at December 31, 1954, and 974.98 at December 31, 1955.

As shown by petitioner's account with the subsidiary, the charges for merchandise, the credits to the account, and the balance at the end of each year, for the period from December 31, 1949, through December 31, 1957, were as follows:

                                Credits

PAGE 429

--

PAGE 430

 Year     Number           Press sales     Total net       Profit (or

Upon examination of the books of petitioner and those of its Canadian subsidiary for 1954, the auditors recommended that petitioner charge off as a partially worthless debt 28,000 of its accounts receivable from the subsidiary and as worthless stock the 5,000 representing its investment in the subsidiary's capital stock.

At December 31, 1954, petitioner had in its general ledger two accounts for reflecting bad debts and doubtful notes and accounts. Account No. 11 was entitled "Reserve for Doubtful Notes and Accounts." Account No. 55 was entitled "Bad Debts." The balance in Account No. 11 was 10,000, which had been brought forward from December 31, 1953, and during 1954 and 1955 no debits or credits were made to that account. ³ The first entry made in Bad Debt Account No. 55 in 1954 was a credit entry of 1,018.75, under date of December 31, the nature and source of which are not shown. This credit entry was followed by four debit entries also bearing the date of December 31, of which an entry of 1,790.11 was described as bad debts; a second entry referred to R. E. Vaughn and the amount was 770; and the third entry referred to Jerry Alt and

PAGE 430

--

PAGE 431

was 453.22. The fourth entry of 28,000 was without description or reference to any account, but in fact represented the 28,000 petitioner's auditors had recommended for chargeoff from petitioner's accounts receivable with the Canadian subsidiary. Giving effect to the credit entry of 1,018.75, the net debits to the account amounted to 29,994.58, and that amount was listed as "Bad debts" in the "Closing Journal Entries, December 31, 1954," as prepared for petitioner by its auditors. No chargeoff of the 28,000 was in fact made from petitioner's accounts receivable with the subsidiary, but pursuant to an "adjusting journal entry" prepared by the auditors the 28,000 was credited to a new ledger Account No. 11-A, entitled "Reserve for Loss on B & K Canada," the explanation being "To charge bad debts with loss from Canadian operation." ⁴

Petitioner's 5,000 investment in the stock of the Canadian subsidiary was carried in ledger Account No. 8-A, entitled "Brandtjen & Kluge (Canada) Ltd." In the "Closing Journal Entries, December 31, 1954," the 5,000 stock investment was listed as a loss. The corresponding credit entry was not used to close Account 8-A, but was made to the new Account 11-A, thereby bringing the total credits to that account at December 31, 1954, to 33,000.

On its income tax return for 1954, the petitioner, under Bad Debts, deducted 28,542.79. In explaining this deduction in its Bad Debt Schedule F, it listed no amounts in the column headed "Bad Debts of Corporation if No Reserve is Carried on Books," but under the heading "If Corporation Carries a Reserve," it listed 28,542.79 in the column "Gross Amount Added to Reserve" and the same amount in the column "Amount Charged Against Reserve." The Schedule F explanation of the Bad Debts deductions had been in the same form in both the 1952 and 1953 returns. ⁵ The 28,542.79 so deducted as bad debts represented the total of the debits made to the general ledger Account No. 55, entitled "Bad Debts," less 2,470.54, listed in "Closing Journal Entries, December 31, 1954," as bad debts recovered, the ledger account reference in respect of the recoveries being Account No. 56.

At December 31, 1955, and along with four other items, an additional 12,000 was debited to general ledger Account No. 55, entitled "Bad Debts," under the closing journal entries of that date, with the 12,000 thereafter being credited to general ledger Account No. 11-A, as the 28,000 had been in the preceding year. On its 1955 return,

PAGE 431

--

PAGE 432

the amount deducted by petitioner as bad debts was 18,749.19, which amount included the said 12,000. As in the case of the 1954 return, the Bad Debts Schedule F reported petitioner as being on the reserve method of accounting for bad debts, and not on the direct chargeoff method. 18,749.19 was reported as the amount added to the reserve, and similarly that amount was listed as the amount charged against the reserve.

The 1954 return was shown as having been prepared by B. F. Geib, a member of the firm of Haskins & Sells. The 1955 return was shown as having been prepared by E. F. Bohne, likewise shown as a member of the firm of Haskins & Sells.

In his determination of operating net loss for 1954, the respondent disallowed 28,000of the bad debt deduction claimed. He also disallowed the claimed deduction of 5,000, described as "Capital stock of wholly-owned subsidiary considered worthless."

In his determination of operating net loss for 1955, the respondent disallowed 12,000 of the bad debt deduction claimed.

At December 31, 1954, petitioner's accounts receivable from its Canadian subsidiary were worthless to the extent of at least 28,000, and at December 31, 1955, were worthless to the extent of at least 40,000.

Petitioner acquired property in the latter part of 1928 on which was an L-shaped building that had been built in 1910. The building, hereafter referred to as the old building, had been erected by a manufacturer of men's shirts and had been used to house the operations of the manufacturer and its sewing machines and other light equipment. In 1936, petitioner erected on the remaining part of its property a new building, which was an extension of the short wing of the old building. The new building consists of concrete floors and sidewalls, a brick superstructure above the foundation, steel beams, and crisscross hardwood floors. Heavy manufacturing machinery is housed in the new building.

The old building consists of a foundation below the ground of flagstone and concrete and above the ground the walls are of sandstone brick. It has a flat, tar and gravel type of roof. The floors, joists, beams, and support posts are of wood, except for some supports that have been reinforced with steel. It has a basement, a first or ground floor, and a second or top floor.

When petitioner moved into the old building it established its offices on the second floor of the main section of the building and has maintained them there since. Adjoining the offices is petitioner's printshop, in which it had as many as five printing presses at one time, although rarely more than two were operated at the same time. On the top floor of the short wing of the old building are petitioner's

PAGE 432

--

PAGE 433

parts department, paint shop, a rebuilding of presses department, and its engineering department.

On the first floor of the old building the space under the offices was used for the operation of various machines, a toolroom, a bench assembly, and an office for Kluge. On the same floor in the other wing of the old building there were housed some small lathes and milling machines.

In the basement of the main section of the old building were some heavy machines that were anchored to the concrete floor, and space that was used for the storage of steel, rough forging, and rough elbow castings. In the basement of the other wing of the old building is the blacksmith department and also there are three small turret lathes.

In 1946, it was deemed unsafe for some heavy machinery on the first floor under the office space to remain there, and it was transferred to the new building. A powersaw and some other light machinery were not moved. In or about 1946 or 1948, a crack appeared in one of the walls of the building and a process of tying in was done in order to prevent the walls from bulging or buckling. During rainy weather water seeps through the basement walls. Due to the unevenness of the ground when the basement concrete floor was poured, the floor is not level and the racks used for the storage of steel are at a tipped position. The building is heated by steam and many of the pipes have rusted and leaked. As the leaks appeared, they were corrected by replacement of the pipes. Some window sills had rotted and were repaired. Mortar between the bricks became powdery and repairs were made by scraping out the powder and putting in new mortar. The floors of both the first and second floors slope toward the center of the length of the building. In addition to the office furniture, two heavy safes were kept in the office space. In 1951, a crack in the wall was repaired and cracks have since reappeared in the walls. At the end of the year 1953, the only heavy machines in the old building were those that were in the basement. In 1957, the offices were redecorated, but after additional supports had been placed beneath the entrance of the building. Rods had been inserted over the entrance so as to bind the wall and to prevent bulging. During the same year a medium sized turret lathe was moved because accuracy could not be maintained on it. The floor had developed a sag, the machine could not be kept level and the floor structure was such that it vibrated during the operation of the machine.

The work done on the old building during 1953 and later was nothing more than ordinary maintenance, there being no repairs of any major extent.

PAGE 433

--

PAGE 434

All space in the old building during 1953 and into 1958 was used according to the requirements of petitioner's operations. During those years the building was an integrated part of petitioner's business.

In 1958, petitioner had no plan for replacing the old building. At that time the sales volume of the company had declined and petitioner was operating at less than full capacity.

After acquiring the property in 1928 petitioner, through its chief accountant and its auditing firm, estimated that for depreciation purposes the probable remaining useful life of the old building was 25 years, and from 1928 through 1953 it computed its depreciation on the building on that basis.

On petitioner's income tax return for 1938 the cost basis of the old building was stated as 39,216.86, before depreciation was taken; in its return for 1948, as 39,233.11; in its return for 1949, as 42,692.11; and in its return for 1953, as 42,692.11.

On January 1, 1953, the undepreciated cost for the old building was 2,298.17, and petitioner claimed on its 1953 return a depreciation deduction in that amount.

Respondent disallowed the depreciation deduction of 2,298.17 claimed. He explained the disallowance as follows:

Inasmuch as the salvage value of this building is in excess of 2,298.17, it is determined that you are not entitled to claim depreciation thereon, in the amount of 2,298.17 for the year 1953, in accordance with the provisions of section 23(1) of the Internal Revenue Code of 1939. * * *

From time to time, petitioner made loans or advances to its officers and employees, and although the borrower usually signed a standard note form such as petitioner used with its customers, which form contained a provision for the payment of interest at the annual rate of 6 per cent, it was a well-established and unvaried practice that no charge of interest be made against petitioner's officers and employees on such loans or advances.

On February 28, 1955, Henry, Sr., obtained two loans from petitioner, one of 100,000 and the other of 10,000, to evidence which he signed two of petitioner's standard note forms, and as in the usual case where loans had been made to an officer or employee, the clause indicating that the notes were interest bearing was not stricken from the note forms so signed. The proceeds of the loans were used by Henry, Sr., in connection with the divorce proceedings between him and his wife, the 100,000 being used in settlement with his wife and the 10,000 being used for payment of fees to the attorneys representing her.

In keeping with its established and unvaried practice, petitioner charged no interest on the loans so made to Henry, Sr., nor did it accrue any interest thereon on its books, and Henry, Sr., paid no interest thereon.

PAGE 434

--

PAGE 435

The respondent determined that interest at the rate of 6 per cent from February 28, 1955, the date of the loans, to December 31, 1955, and in the amount of 5,500, had accrued to petitioner, and increased petitioner's taxable income by that amount. OPINION

Under section 23(a)(1)(A) of the Internal Revenue Code of 1939 and section 162(a)(1) of the Internal Revenue Code of 1954, it is provided that deductions are to be allowed for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including "a reasonable allowance for salaries or other compensation for personal services actually rendered."

The petitioner, on its returns for 1953, 1954, and 1955, claimed deductions of 13,532.24, 25,090.56, and 20,908.80, being the full amounts paid by it as compensation to Henry, Jr., in the said years as its secretary-treasurer. The respondent in his determinations herein allowed 3,750 of the amount claimed for 1953, 7,200 of the amount claimed for 1954, and 8,400 of the amount claimed for 1955, and disallowed as deductions the balances of the amounts claimed. The amounts allowed appear to be at the rate of 500 per month from May 16 to December 31 of the first year, 600 per month for the second year, and 700 per month for the third year.

By amendment to his answer, the respondent has now claimed that no deduction as compensation to Henry, Jr., is allowable for either of the years 1953 or 1954, and that the allowance for 1955 should be reduced from 8,400 to 4,350. His explanation of the amount now regarded by him as allowable for 1955 is that the per month rate is the same as originally allowed in his determination of deficiency, but that the amount allowed is now reduced to the compensation applicable to the period from June 16, 1955, to December 31, 1955, which represents the period after Henry, Jr., returned to work upon his discharge from the Army. In such circumstances, it would appear that the respondent in applying the rate to the period served has made a mathematical error of 200, and that at a rate of 700 per month for a period of 6 1/2 months, the amount would be 4,550, rather than 4,350.

It is the position of the petitioner that it has submitted proof which fully supports the reasonableness of the compensation paid to Henry, Jr., during the years in question, and the presumption of correctness of the respondent's determination has thus disappeared. As will hereafter appear, however, our decision on this issue rests on the facts of record and not on any application of the doctrine of presumptive correctness of the respondent's determination.

PAGE 435

--

PAGE 436

For establishing its contention, the petitioner relies almost wholly upon the oral testimony of Henry, Jr., and upon numerous copies of letters which he testified were written by him in performance of his employment, together with the copies of some reports which also were prepared by him to reflect his views of petitioner's operations in certain geographical areas. Most of this testimony, in the judgment of the Court, was rather patently self-promoting, if not self-serving, the petitioner here being the corporation, and not Henry, Jr., himself. We listened attentively during the period he was on the witness stand and we observed him carefully during the course of his testimony, and we are completely satisfied that no one who heard him testify and who with reasonable objectivity considered his testimony in the light of other evidence and the record as a whole, could or would have reached any conclusion other than that his account of such services as he did perform and the substance and importance thereof was greatly inflated and grossly exaggerated. In short, in his assertions as to the time consumed by him in the doing of things in petitioner's behalf and the importance and effectiveness thereof in the operation of petitioner's business, he was neither persuasive nor impressive.

The facts show that, at intervals, Henry, Jr., had spent some time at petitioner's plant, had written some letters, for the approval of his father, and had possibly had some discussions relating to the business with his father and some of petitioner's personnel prior to May 19, 1953, when he was elected to the office of secretary-treasurer. When John had worked for petitioner prior to his election as secretary-treasurer he had been paid a modest salary, but whether the work of Henry, Jr., was not in substance comparable or whatever the reason, no compensation was allowed or paid to him for services prior to his election as secretary-treasurer. The facts further show that the election of John to the office of secretary-treasurer and later the election of Henry, Jr., to that position and the fixing of the compensation was not based upon any particular duties of the office or the duties which they were to perform, but primarily on the fact that Henry, Sr., during his incumbency as secretary-treasurer during the period his father had lived and was president of the petitioner, had received the same salary as his father, and he desired that the same be continued between him and his sons. There was no intention that upon their election they were to succeed to or take over the duties and responsibilities which had been those of Henry, Sr., while he had been secretary-treasurer. As for John, he was given some duties in the sales department and made some trips to Canada in connection with the operations of the Canadian subsidiary. As for Henry, Jr., the record shows that at the time he was named secretary-treasurer it was anticipated that very shortly thereafter he would

PAGE 436

--

PAGE 437

be called under the draft for service in the Army. In fact, Henry, Sr., had discussed the matter with Haugen, asking what the result would be if Junior should be elected to the office and received the voted salary while in the Army, and upon being told that deduction of the salary in whole or in part might be disallowed, resulting in an additional assessment of tax, with interest at 6 per cent, had said, "Well, if that's it, let's go ahead." The evidence further shows that after his election as secretary-treasurer on May 19, 1953, Henry, Jr., regularly reported to work at petitioner's offices and plant during the remainder of May, but after that until he was inducted into the Army on August 20, he was seldom at the plant. He requested the draft board for deferment on the grounds that he was managing the Brandtjen farms and was working for petitioner.

There were some periodic long-distance telephone conversations between Henry, Jr., and his father, and on periodic visits to St. Paul, Junior participated in some discussions and decisions relating to the conduct of the petitioner's business. There was also testimony by Junior and his father purporting to indicate that during the period of his Army service, and in addition to the performance of his duty as instructor in track vehicle maintenance at Aberdeen, and his participation in petitioner's operations, Henry, Jr., also made most, if not all, important decisions relating to the operation of the farms and their management. It was Henry, Jr.'s further testimony that he spent most of his time while on pass from Aberdeen in working in promotion of petitioner's business in the Washington, Baltimore, and Philadelphia areas.

Frankly, we were not impressed with either the importance of his efforts or the accomplishments, nor as to the ratable portion of his time on pass expended in matters relating to the petitioner's business. As to such time as he did spend with printers, we think one of his first statements from the witness stand, namely, that the visits had with printers in those areas was to "kill time," probably more nearly represents the truth. It could be, of course, that he did borrow from his time and efforts as a soldier while at Aberdeen. He did have at the time of his induction into the service a degree in mechanical engineering from the University of Minnesota. He was assigned to duty as an instructor in track vehicle maintenance, which it would seem reasonable to conclude would have provided a very good opportunity for the display and utilization of his capabilities and training as a mechanical engineer. It is to be noted, however, that it was not until some 2 weeks prior to his discharge that he attained the rank of corporal.

We are satisfied and convinced that the salary voted and paid to Henry, Jr., during the years here in question not only was not representative

PAGE 437

--

PAGE 438

of reasonable compensation for services actually rendered by him, but that it was not intended to be. The facts show that when John became secretary-treasurer he was frankly told that, even though voted the salary of the office, the salary was not to be his to do with as he pleased, but that, in the main, it was to be applied to carry the insurance which Henry, Sr., had set upon his life to provide the funds for satisfying the estate tax liability on his estate. After his election, John did not have any specified duties but, as indicated above, such duties as he did have were in the sales department, and while the monthly pay he was permitted to have for his own use was greater than it had been, it was still a comparatively small percentage of the salary of the office. Certain it is that the evidence supplies no basis for a conclusion that such services as Henry, Jr., did perform were of any greater importance than the duties John had been performing when he was elected to the office of secretary-treasurer, or those which John had continued to perform after such election and until he was placed on an absence without pay status by his father. Furthermore, we are satisfied on the evidence that at the end of May and for the remainder of the period preceding his induction into the Army, such work as he had been doing for petitioner was substantially discontinued.

We have not overlooked the testimony of both Henry, Sr., and Henry, Jr., tending to indicate that there were no such restrictions on Henry, Jr.'s right to receive payment of the compensation voted or of its use, such as had been the case with John. Be that as it may, however, the facts show that from the time of the assignments by Henry, Sr., in 1945 of certain of the insurance policies on his life to his wife and his two sons, Junior had been able to pay his share of thepremiums only through gifts made to him, from time to time, for that purpose, allowance being made for the rent which he did receive on his farm and which was applied to the insurance payments.

The evidence further shows that after John's dismissal and he and his mother had assigned their interests in the insurance policies to Henry, Jr., that Henry, Jr., was thereafter able to pay the premiums on the policies through loans obtained largely from petitioner, and that the salary checks made payable to him as secretary-treasurer were deposited back to the account of the petitioner and applied on its books in satisfaction of loans or advances which had been made by petitioner for the purpose of meeting these insurance premiums. The evidence further shows that checks were regularly issued by Henry, Sr., to Henry, Jr., during the period of his service in the Army, for managing the farms. But as in the case of the salary checks issued by petitioner, the farm checks were likewise applied to the payment

PAGE 438

--

PAGE 439

of the insurance premiums, or used in repaying loans obtained from Henry, Sr., for insurance premium payments.

Based on the record as a whole, and considering the testimony of Henry, Jr., and that of Henry, Sr., in the light of other evidence, we are not even moderately persuaded that reasonable compensation for the services actually rendered by Henry, Jr., during the years 1953, 1954, and 1955 was even as much as was allowed by the respondent in his determination of the deficiencies herein. To the contrary, we think that the evidence convincingly shows that the respondent did in his determinations allow amounts greater than reasonable compensation for the services actually rendered.

The evidence does show, however, that Henry, Jr., did expend some time and effort in petitioner's behalf which he regarded as being of value, and we do not think that the respondent, by his proof, has shown that such services as were rendered by him at intervals during the period of his Army service were completely valueless and did not supply some basis for the payment of some compensation. He did, to use his own words, do some "snooping" around some printing establishments in Washington, Baltimore, and Philadelphia, and he did attend a meeting in Philadelphia and write a report thereon. He did make the trip to New York at the request of petitioner's attorney, although he was not called upon to do anything more. And having heard, in the course of his testimony, his own description of his doings for petitioner's account, we are satisfied that in his long-distance telephone conversations and on his trips to St. Paul there was at times some discussion of petitioner's affairs with his father. Taking into account the services performed by John while he was working for petitioner under the title of secretary-treasurer and the amount of compensation allowed to him therefor, and considering the work of Haugen and Barnes, two important and seasoned employees of petitioner, and the compensation paid to them, which patently was fixed at arm's length, and giving due consideration to the record as a whole, we are satisfied and convinced from the evidence that for 1953, reasonable compensation for the services rendered by Henry, Jr., and for which he was paid did not exceed 750; for 1954, did not exceed 1,200; and for 1955, did not exceed 5,100. The amounts in question have been arrived at as representing 100 per month for the period for which he was paid in 1953 and for 1954 and that part of 1955 up to his return to St. Paul, after his dischargefrom the Army. With respect to the remainder of 1955, the evidence, we think, fully justifies only the allowance of 700 per month.

To support its contention that deduction of the full salary paid Henry, Jr., was justified, the petitioner, on brief, makes much of the fact that a majority of the directors participating in the board meetings

PAGE 439

--

PAGE 440

at which the salary voted and paid to Henry, Jr., as secretary-treasurer were men who had no stock interests in the petitioner, and, on that basis, contends that the voting of the salary must be regarded as having been at arm's length. The argument, we think, merits little attention. At the time in question, Henry, Sr., controlled and ran the company. Abel Kluge may or may not have owned stock of petitioner, but, if so, his stockholding, insofar as control was concerned, was inconsequential. As for Barnes and Haugen, they were employees, subject to the will of Henry, Sr., and may not be regarded as independent participants. Haugen's employment, for instance, ended in 1956, when his resignation was requested, and at or about the same time Barnes' employment was terminated, whether of his own volition or by request.

The petitioner, on brief, also cites and relies on the decision of the Supreme Court of the United States in Lucas v. Ox Fibre Brush Co., 282 U.S. 115, pointing out that prior to his election as secretary-treasurer, Henry, Jr., had done some work for petitioner for which he had received no compensation. It is pointed out that in Lucas v. Ox Fibre Brush Co., the Supreme Court held that reasonable compensation voted and paid for past services is deductible from gross income for income tax purposes. Unlike the situation dealt with in that case, however, there was in this instance no voting of compensation for prior services, and that case is not in point, even if it be assumed that the prior services by Henry, Jr., would have merited some pay.

Having concluded as we have that Junior's election as secretary-treasurer of petitioner and the fixing of the amount of salary voted to him were based on considerations other than services which had been performed or were to be performed by him, Ware Knitters, Inc. v. United States, 168 F. Supp. 208, and Berkshire Oil Co., 9 T.C. 903, cited and relied on by petitioner, are, in our opinion, distinguishable and not controlling, and that aside from the fact that those cases had to do with officers or employees absent in Government service during a period when the United States was actually at war.

With respect to bad debts, it is provided by section 166(a) of the Internal Revenue Code of 1954 that (1) "[there] shall be allowed as a deduction any debt which becomes worthless within the taxable year," and (2) that "[when] satisfied that a debt is recoverable only in part, the Secretary or his delegate may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction." In section 166(c), it is provided that "[in] lieu of any deduction under subsection (a), there shall be allowed (in the discretion of the Secretary or his delegate) a deduction for a reasonable addition to a reserve for bad debts."

PAGE 440

--

PAGE 441

By section 1.166 of the Income Tax Regulations, ⁶ promulgated under section 166(a), supra, it is provided that a deduction "on account of partially worthless debts shall be allowed with respect to specific debts only," that in the case of a partially worthless debt, "the amount which has become worthless shall be allowed as a deduction under section 166(a)(2) but only to the extent charged off during the taxable year," and that "[before] a taxpayer may deduct a debt in part, he must be able to demonstrate to the satisfaction of the district director the amount thereof which is worthless and the part thereof which has been charged off."

Where, under section 166(c), supra, bad debts are accounted for by the reserve method, the deduction is in the form of an addition made at the end of a taxable year to a reserve to cover losses which it is anticipated will occur during the coming year by reason of worthlessness or partial worthlessness of accounts and notes receivable existing at the beginning of such coming year and of accounts and notes which will arise during the year. In the case of a taxpayer using the reserve method, the regulation, section 1.166-4(c), requires with the taxpayer's return a statement showing, among other things, the total amount of notes and accounts receivable at the beginning and close of the taxable year; the amount of debts which have become wholly or partially worthless and have been charged against the reserve account during the year; and the computation of the addition to the reserve. Stated otherwise, the deduction is the amount added to the reserve at the end of the year in anticipation of bad debt losses which will occur during the coming year. The deduction is not of specific debts which have become worthless in whole or in part and which, not to exceed the worthless portion, have been charged to the reserve during the year. Such charges against a bad debt reserve are of importance in arriving at the amount of the allowable bad debt deduction only because the amount by which the credit balance of the reserve has been reduced by the said charges may become a factor in arriving at the amount of the addition to be made to the reserve to provide for anticipated bad debt losses for the next year, which addition to the reserve, not the debts specifically charged, becomes the bad debt deduction on the return.

Neither the statute nor the regulations prescribe a particular method for making a chargeoff of a bad debt or a partially worthless debt from books of account. But, generally speaking, an effective chargeoff has been made if the entries relied upon have effectually

PAGE 441

--

PAGE 442

eliminated the amount of the debt, or that part which is worthless, from the book assets of the taxpayer. See Hamlen v. Welch, 116 F. 2d 413, 419; H. W. Findley, 25 T. C. 311, affirmed per curiam 236 F. 2d 959.

In the instant case, the petitioner for the year 1954 deducted 28,000 as representing that to that extent its accounts receivable with its Canadian subsidiary were worthless in that year, and for 1955, 12,000 as being an added portion of the said accounts receivable which was worthless in 1955. Both deductions were disallowed by the respondent.

The respondent, in support of his determination, does not contend or suggest that the indebtedness in question was not bona fide, or not in the amount reflected by petitioner's books, it being his contention that the indebtedness has not been shown to have been worthless, as claimed by petitioner, and that there was no chargeoff of the said amounts of 28,000 for 1954 and 12,000 for 1955 within the meaning of the statute.

In the testimony of two of petitioner's witnesses, one a member of petitioner's bookkeeping staff and the other a member of the accounting firm which audited petitioner's books and who had been responsible for the preparation of petitioner's 1954 return, we have the stated conclusion that petitioner, in accounting for worthless debts, used the direct chargeoff method, and not the reserve method. The evidence relating to the accounts themselves and the method by which the claimed bad debt deductions were reflected on the income tax returns is not so definite or clear. The facts show that petitioner did, through the taxable years, carry on its books a ledger account entitled "Reserve for Doubtful Notes and Accounts," which account at the beginning and end of 1952, and up to December 31, 1953, had a credit balance of 70,000, and after that, a credit balance of 10,000, even though the ledger sheets for the years 1954 and 1955 and the income tax returns for 1952 and 1953 indicate that during those years there were no charges and no credits to the reserve, except a charge of 60,000, with a corresponding credit to earned surplus at December 31, 1953. It does appear likely, however, that the various receivables which were in comparatively small amounts and were deducted as worthless for the years 1954 and 1955, were charged off, or at least effectually eliminated from petitioner's book assets, since there is no indication in any of the accounts shown of record or in petitioner's balance sheets that they were carried to and reflected in any of the reserves carried on petitioner's books. On the other hand, the petitioner's income tax returns on their face stand in contradiction, in that Bad Debts Schedule F for each year listed for deduction no bad debts by the direct chargeoff method, but to the contrary, explained

PAGE 442

--

PAGE 443

the bad debt deductions claimed by entries in the schedule for use "If Corporation Carries a Reserve," listing the amount of the bad debt deduction claimed as the amount added to the reserve and an identical amount as having been charged against the reserve.

While there is no indication of the use or maintenance of a reserve by petitioner on its books in accounting for miscellaneous bad debts, and there is the indication, as outlined above, that miscellaneous bad debts were in fact cleared from petitioner's book assets, the same may not be said with respect to the 28,000 in 1954 and the 12,000 in 1955 claimed as deductions on the returns for those years as representing the partial worthlessness of petitioner's accounts receivable with its Canadian subsidiary. No chargeoff was in fact made of the 28,000 in 1954, nor of the 12,000 in 1955, but by adjusting journal entries prepared by its auditors, petitioner carried the said amounts as credits to a new ledger account entitled "Reserve for Loss on B & K Canada," and the only method which suggests itself for the elimination in fact of the said amounts from petitioner's book assets would be by crediting the accounts receivable account and charging the reserve account, as in the case of the usual chargeoff of partial worthlessness where bad debts are accounted for by the reserve method. It is, to say the least, difficult to see that there has been a chargeoff where the entry made does not in fact eliminate any amount from the asset account itself, but, to the contrary, is a credit entry to a reserve, which term itself implies the setting up of a fund to absorb a loss which it is anticipated will in all likelihood occur in the future.

It is a fact, however, that the book entries here made, however they may have been described or limited, were related or restricted to one specific indebtedness, as the regulation requires. It is also true, as petitioner points out, the net result, for balance sheet purposes, is the same as if a direct chargeoff had been made from the asset account. On the other hand, the same statement could be made as to the balance sheet net result of any amount credited to a regularly established reserve for anticipated losses in accounts receivable generally. There are, however, these differences. In this instance the evidence indicates that the basis for the action taken was that there actually was an existing partial worthlessness of the accounts receivable with the Canadian subsidiary at least equal to the amount sought to be deducted for each year, and the purpose sought to be accomplished was an allowable deduction for partial worthlessness for each year. It is also true that the title of the new account, even though designated a reserve, was in the terms of a loss which had in fact been incurred by reason of existing partial worthlessness, and not of an anticipated future loss. On this basis, it is the contention of the petitioner that under sound accounting principles there was in

PAGE 443

--

PAGE 444

fact an effective chargeoff, namely, that the credit to the new reserve account, limited as it was to the receivables from the one debtor, should be read as if it were a credit to the receivables account itself. In support of this position, petitioner relies on the opinion testimony of the accountant who had supervision of the 1954 audit of its books and the preparation of its 1954 income tax return. In the light of the apparent contradiction between the opinions expressed in the course of his testimony and the form of the Bad Debts Schedule F of the 1954 return, it may be observed that the logic of petitioner's argument is much more persuasive than the opinion testimony of the man responsible for the setting up of the account in the manner shown and for the return itself.

While the question is not free from doubt, and the accounting forms indulged in appear at first blush to point in the other direction, we are disposed to accept what was done as an effective chargeoff for the purposes of the deductions claimed. The entries were definitely limited to the one account. They were intended to accomplish the purpose contended for, and were described in words indicating a sustained loss, and not an anticipated future loss, in the one specific account. In these respects, the situation here is distinguishable from that which existed in International Proprietaries, Inc., 18 T. C. 133, where a contra conclusion was reached. We accordingly hold that the entries made in petitioner's accounts, on the facts in this case, satisfied the statutory requirement of a chargeoff.

There remains the question of existing partial worthlessness in each of the years in an amount at least equal to the amount charged off. As we have already noted, the respondent does not contend that the indebtedness was not bona fide, and the evidence shows petitioner had charged the subsidiary for merchandise at the same discount from its f.o.b. St. Paul prices as had been the case with the Canadian dealer in prior years. The facts also show that the Canadian subsidiary dealt in petitioner's products exclusively and that the volume of business had steadily deteriorated. And whether by better planning and management the losing venture could ultimately become a profitable one, we are satisfied, on the evidence, that in the years in question the receivables were in fact worthless to the extent claimed. On the partially worthless debt issue, we accordingly hold for the petitioner.

There remains, however, the question of the deduction of 5,000 as representing the worthlessness of petitioner's capital stock investment in Brandtjen & Kluge (Canada), Ltd. Unlike the partially worthless debt, the deduction for worthless stock falls in the year the stock became worthless. At least generally, it is reasonable to conclude that worthlessness of corporate stock precedes the worthlessness

PAGE 444

--

PAGE 445

of a corporate debt, since a credit liability has priority over liability for investment capital. See Estate of James N. Gamble, 32 B.T.A. 892. Certain it is that if the stock in the instant case was worthless in 1954, there is no showing that it was not worthless in a prior year. The respondent's disallowance of the claimed deduction is accordingly sustained.

When petitioner acquired its old building in 1928, it estimated its remaining useful life as 25 years, and thereafter computed its depreciation deduction for each year on that basis, taking into account no amount as salvage value of the property at the end of the 25-year period. At the beginning of 1953, which was the 25th year after the building had been acquired, the undepreciated cost or other basis, as shown by petitioner's books, was 2,298.17, and that amount was deducted on the 1953 return as the depreciation on the building for that year. The respondent, in his determination of deficiency, determined that the salvage value of the building was in excess of the undepreciated cost of 2,298.17, and disallowed the deduction claimed.

The facts show that although the building was anything but modern, was in many respects in poor condition, and was no longer suited for housing petitioner's heavier operating machinery, it was nevertheless still in substantially full use by the petitioner and continued to be so used through all of the years herein, and at the time of the trial had been in use some 30 years.

It is the contention of the petitioner that in claiming a flat rate depreciation covering the entire cost basis of the property on a 25-year basis, the effect was a determination that the building, when acquired, had a zero salvage basis; that the respondent not having made any changes in the depreciation deductions so claimed for prior years, and not having determined at the beginning of 1953, the year in question, or at the beginning of some prior year, that the useful life of the building was greater than 25 years, he is barred from questioning the depreciation deduction claimed for 1953, the 25th year. And as we understand it, the position of the petitioner is the same whether the old building at January 1, 1953, did or did not have a salvage value equal to the amount of its then undepreciated cost.

As provided by section 23(l) of the Internal Revenue Code of 1939, the depreciation deduction allowable for 1953 is "[a] reasonable allowance for the exhaustion, wear and tear * * * of property used in the trade or business." In section 39.23(l)-1 of Regulations 118, relating to the depreciation deduction allowable, it is provided that "[the] proper allowance for such depreciation is that amount which should be set aside for the taxable year in accordance with a reasonably consistent plan (not necessarily at a uniform rate), whereby the aggregate of the amount so set aside, plus the salvage value, will, at

PAGE 445

--

PAGE 446

the end of the useful life of depreciable property, equal the cost or other basis of the property." In section 39.23(l)-4, it is provided that "[the] capital sum to be replaced by the depreciation allowances is the cost or other basis of the other property in respect of which the allowance is made." In section 39.23(l)-5, it is provided that "[the] reasonableness of any claim for depreciation shall be determined upon the conditions known to exist at the end of the period for which the return is made. If the cost or other basis of the property has been recovered through depreciation or other allowances no further deduction for depreciation shall be allowed. The deduction for depreciation in respect of any depreciable property for any taxable year shall be limited to such ratable amount as may reasonably be considered necessary to recover during the remaining useful life of the property the unrecovered cost or other basis. The burden of proof will rest upon the taxpayer to sustain the deduction claimed."

From the above regulations, it is thus apparent that when the depreciation allowance, plus the salvage value at the end of the useful life of the depreciable property, is such as to return to the taxpayer its cost or other basis for the said property, no further allowances therefor may be had. In the instant case, the petitioner prior to 1953 had deducted the entire cost or other basis for its old property, except 2,298.17. The respondent in his determination of deficiency determined that the salvage value in the building at the end of its useful life was in excess of 2,298.17, which was the entire amount of the undepreciated cost at the beginning of the taxable year, and that such being the case, no further deduction under section 23(l) was allowable.

While the petitioner has introduced evidence to show that the old building was not in good shape, and that undoubtedly its useful life was drawing to a close, it has offered no proof directed to the existence or nonexistence of the building's salvage value, the burden of proving which was clearly its own. To allow the deduction claimed, in the face of respondent's determination and without proof that his determination of salvage value was erroneous, would be to approve a recovery as depreciation of an amount in excess of petitioner's cost or other basis for the old building, which under the statute and the regulations thereunder may not be done.

On brief, the petitioner directs a substantial part of its argument to section 1.167(a)-1(c) of the Income Tax Regulations, to the effect that "[salvage] value shall not be changed at any time after the determination made at the time of acquisition merely because of changes in price levels. However, if there is a redetermination of useful life under the rules of paragraph (b) of this section, salvage value may be redetermined based upon facts known at the time of

PAGE 446

--

such redetermination of useful life." It is to be noted, however, that the regulation referred to was promulgated under section 167 of the 1954 Code, which section and the regulations thereunder are applicable to taxable years ending after December 31, 1953. The tax year here involved is 1953.

Petitioner's claim for the 1953 depreciation deduction on its old building is not well founded, and is denied.

The respondent in his determination of petitioner's net loss carryback from 1955 determined that petitioner had failed to report 5,500 representing interest which had accrued in 1955 on loans by petitioner to Henry, Sr., its president. At the time the loans were made, Henry, Sr., had signed two notes on forms used by petitioner with its customers, which forms contained provisions for 6 per cent interest per annum. Although these forms were regularly used when on occasions petitioner made loans to its officers and employees, it was petitioner's established and unvaried practice to charge no interest on such loans. In keeping with that policy, it neither accrued on its books nor collected from Henry, Sr., any interest on the loans made to him in February of 1955. That such was petitioner's settled practice with respect to loans to officers and employees was shown by the testimony of Haugen, a former employee of petitioner, who had been in charge of petitioner's books for many years, but who in 1956 had resigned his position by request.

It appearing that there was never any intention that Henry, Sr., would be liable for interest on the notes, that this intention was in keeping with settled and unvaried practices of petitioner, and that no interest was in fact accrued on petitioner's books as a charge against Henry, Sr., and no interest was collected from or paid by him on the loans, we conclude and hold that the respondent erred in his determination with respect thereto. Wilbur Security Co., 31 T. C. 938; Society Brand Clothes, Inc., 18 T. C. 304; Combs Lumber Co., 41 B.T.A. 339.

Decision will be entered under Rule 50.

¹ John was put on an indefinite leave of absence on Dec. 31, 1951, and thereafter received no salary. No salary paid to secretary-treasurer from Jan. 1, 1952, to May 19, 1953. ² Prior to May 19, 1953, no payments were made to Henry, Jr.

² As shown by the books of the subsidiary, its capital stock liability was 5,500, instead of 5,000, the amount paid in by petitioner. This difference according to the minutes of the subsidiary at the time of its organization was to allow for the premium on American dollars.

¹ Net sales are gross sales less returns and discounts.

³ No explanation appears of record for Account No. 11. The balance sheets appearing in petitioner's income tax return for 1952 show that the amount of the reserve both at the beginning and end of the year was 70,000. The balance sheet at Dec. 31, 1953, as shown in the 1953 return, discloses that at that date the reserve had been reduced to 10,000, and Schedule M. -- "Reconciliation of Net Income for Analysis of Earned Surplus and Undivided Profits" -- shows a credit of 60,000 to earned surplus as representing a "Reduction in Reserve for Bad Debts." No adjustment of 1953 income by such reduction of the bad debt reserve and the corresponding credit to earned surplus was indicated, and for income tax purposes the increase of earned surplus by the transfer from the bad debt reserve was apparently ignored.

⁴ Presumably the other items debited to Bad Debt Account No. 55 were in fact charged off on petitioner's books and completely eliminated from petitioner's book assets, since they were not credited to either of the reserve accounts 11 or 11-A, which, so far as appears, were the only reserve accounts on petitioner's books in respect of bad debts.

⁵ From Schedule F of the 1952 return, it appears that the same was true of the 1949, 1950, and 1951 returns, but may not have been true of the 1948 return.

⁶ While this regulation was not promulgated until July 31, 1959, it does not in any substantial respect vary the procedures and requirements for the deduction of a partially worthless debt from that prescribed by section 39.23(k)-1 of Regulations 118, promulgated under section 23(k) of the Internal Revenue Code of 1939.