Cotton v. Commissioner , 25 B.T.A. 866 ( 1932 )

G. E. COTTON, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Cotton v. Commissioner

Docket Nos. 46673, 51456, 59655.

United States Board of Tax Appeals

25 B.T.A. 866; 1932 BTA LEXIS 1463;

March 14, 1932, Promulgated

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1. Respondent's action in (1) rejecting petitioner's method of computing his taxable income derived from a short loan business, and (2) in denying deductions from gross income claimed for expenditures made in prospecting a mining lease, approved.

2. Petitioner's claim of right to deduct from the taxable income for 1929 an amount representing a loss sustained in that year of money invested in a corporation, sustained.

M. A. Matlock, Esq., for the petitioner.

Nathan Gammon, Esq., for the respondent.

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LANSDON

The respondent asserts income-tax deficiencies for the years 1927, 1928 and 1929 in the respective amounts of $1,614.66, $1,816.21 and $2,285.57. For each year in review the petitioner contends the respondent committed error (1) in rejecting his method of computing his taxable gains derived from a short loan business; and (2) in disallowing deductions from his gross income of expenditures made in the exploration of a mineral lease. A third error is alleged for 1929, which is based upon respondent's denial of a claim for deduction of a loss of petitioner's investment in a pump and well company which failed in that year.

FINDINGS OF FACT.

The petitioner is a resident of Houston, Texas, and during the taxable years, was engaged in the development of a mining lease in the State of Colorado. The lease was never developed beyond the stage of exploration. Practically all of the work done in these years was directed to the driving of tunnels into the side of a mountain to locate a vein of ore never found. Petitioner's expenditures in these efforts were: $3,000 for 1927, $6,000 for 1928, and $5,850 for 1929.

In addition to his other business the petitioner owned an industrial loan business at Norfolk, Virginia, which he operated through an agent to whom he paid a salary and part of the profits. The agent had full charge of this business and made all loans and collections, rendering daily reports by mail to the petitioner. The loans, which ranged in amounts from $50 to $300, were usually made payable through monthly installments spread over a 10-month period, with interest at 3 1/2 per cent on the unpaid balance. All collections, whether of principal or interest, were deposited in a general capital fund from which all funds for making loans and paying the expenses of the business were drawn. From time to time the agent remitted to the petitioner such excess of the capital on hand as he deemed not required for immediate loans, or for other current needs of the business. When additional capital was needed, he drew upon his principal. On all sums remitted to the petitioner the agent first charged out 10 per cent commission to himself which he retained.

In making out his income-tax returns for each of the years here involved, the petitioner computed his income from the loan business in the following manner: Without regard to outstanding loans - the petitioner treated all collections of both principal and interest as gross income for the year made. From their total he deducted all loans made and business expenses incurred in the year, and reported the remainder as the net income of the business. Under this method of accounting the petitioner reported income from his loan business as follows: For 1927, $14,226.69; 1928, $18,686.75; and 1929, $22,832.55.

In 1927 the petitioner and two associates organized the Nicholas Pump and Well Company, which they incorporated under the laws of the State of Arkansas. Under their preorganization agreement, the petitioner and one associate, named Moody, were to advance $3,000 each to finance the corporation and the third, who owned certain patent rights, patterns and drawings, was to allow the corporation their free and exclusive use so long as it should continue to exist and operate as a corporation. No capital stock was issued by the corporation, but in consideration for his contribution each associate was to own an undivided one-third interest in it. Moody failed to make good his part in financing the corporation and the petitioner, to save his own interest, voluntarily advanced to the corporation, from time to time, during 1927 and 1928, a total of $11,490.64. The corporation operated, in a way, during these two years, but only upon the money advanced to it by the petitioner and at a loss. In the meantime Moody incurred debts to the corporation which he refused to pay. Nicholas, the third associate, who owned the patents and was to have charge of the manufacturing of pumps, proved incompetent. In 1928 suits were filed against the corporation and the petitioner, being unable to get Moody to either contribute his part or pay his indebtedness to it, decided to get out and quite the company. Accordingly, the petitioner refused thereafter to advance any more money to the corporation.

Early in 1929 a foundry company brought suit, which resulted in a receiver being appointed on March 19 of that year. Soon after the appointment of the receiver the court issued its order directing the return to Nicholas of the patent rights, patterns and plans held by the corporation under license from him. After cancellation of that license the only assets left the corporation consisted of some pump castings which had not been paid for and were in the hands of the foundry that had brought the suit and a speculative claim against Moody. The receiver brought suit against Moody and in June, 1931, after it was finally determined, he liquidated the corporation, paying 4 per cent on debts and nothing to its shareholders. The petitioner received nothing in return for the money he advanced to finance the corporation. After the appointment of the receiver in 1929 the petitioner determined that his entire investment in the corporation was lost and charged it off on his books as such in that year.

In making out his income-tax return for each of the years in review, the petitioner reported his income derived from his industrial loan business, computed as hereinabove described; and claimed as deductions from gross income his expenditures made in connection with his mining lease, as described. For 1929 the petitioner claimed the further deduction from gross income of $11,490.64 as a loss sustained in that year of his investment in the Nicholas Pump and Well Company. The respondent rejected the petitioner's method of computing income from his loan business, disallowed the deductions claimed as aforesaid, and recomputed his tax for each year as shown in the deficiency letter.

OPINION.

LANSDON: It is obvious that the respondent properly rejected the petitioner's method of reporting income from his short loan business. That method took no account of capital gains retained in the business through outstanding loans at the beginning and end of each tax year, or for actual losses through bad debts. All collections, whether of principal or interest, were treated as income and all loans as expenses of the business. Petitioner concedes the novelty of his system, but insists that it is one consistently employed by him over a number of years and that it is justified under article 323 of Regulations 74 and 75, which provides that "each taxpayer shall adopt such forms and systems of accounting as are in his judgment best suited to his purposes." It is true that the regulation cited contemplates that a liberal latitude be allowed to the taxpayer in keeping his books, but it does not waive the requirement that any system adopted must truly reflect income. Where the system used does not do this the regulations require the Commissioner to reject it and to make his own computation in such a manner as in his opinion shall so do. The Commissioner has made such computation of the petitioner's income in respect of this business for the years involved. The petitioner has offered no proof to show that such determinations are incorrect. In such circumstances we must sustain the determination of the respondent. .

Respecting the deductions claimed by the petitioner of expenditures made in prospecting his mineral lease, such, this Board and the courts have uniformly held, must be classed as capital expenditures and added to the cost of the mine when brought to production. If the development results in discovery of commercial ores, the cost may be recovered through depletion and depreciation deductions; if the prospect is abandoned, loss should be claimed in the year of the abandonment. The respondent's action in rejecting petitioner's claim for the deductions from his income as expenses is in accord with Regulations 69, article 222, and is approved. .

We think the petitioner's venture in the Pump and Well Company resulted in a deductible loss which he was entitled to take in the year claimed. The petitioner and Moody undertook to supply the necessary cash to start this company in business in payment for their respective interests. Moody failed to fulfill his part of the agreement and the petitioner voluntarily supplied the entire amount in order to save his own interest. This was tantamount to a voluntary assessment against himself as a contributor to the capital of the corporation. . Respecting the loss, the record shows that the corporation could live only so long as the petitioner continued his contributions, and when these ceased it ceased to function. When the receiver was appointed in that year its only visible assets consisted of some castings in the possession of the foundry which had cast them and held claims against it for the cost thereof. It is true that the receiver brought suit against Moody, which deferred final liquidation of the corporation until 1931, but the petitioner was no party to that suit and could in no way be benefited by its outcome. Being the sole financial supporter and entirely familiar with all of its affairs, the petitioner realized that his investment in the corporation was a loss in 1929 and decided to abandon it in that year. The result of the court proceedings which followed only confirmed his judgment respecting his loss as a stockholder. Obviously, to continue further advances would have increased his loss; and, we think, in the circumstances, that he was justified in the facts and charging the sum of his advances off as a loss in 1929. In respect to this claim for deduction the contention of the petitioner is sustained. ; ; ; ; ; and .

Decision will be entered under Rule 50.