Court Opinion

ID: 4628786
Source: CourtListenerOpinion
Date Created: 2020-11-21 03:04:02.644431+00
Date Added: 2024-06-11T07:57:15.948340
License: Public Domain

R. E. HUFF, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.  MRS. E. B. HUFF, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Huff v. CommissionerDocket Nos. 24594, 24595.United States Board of Tax Appeals20 B.T.A. 516; 1930 BTA LEXIS 2100; August 7, 1930, Promulgated *2100  1.  Petitioner's partner misappropriated funds held in trust by the partnership.  This was discovered in 1920 and the partnership assets were not sufficient to cover the defalcation.  Petitioner made good the amount embezzled in February, 1921.  Held, petitioner sustained no deductible loss in 1920.  2.  At the close of 1920 a debt was owing to the petitioner.  It was apparent that the debtor's business and source of income was, or very soon would be, ended.  The debtor had some assets but the amount of such assets was not determined until February, 1921.  Held, petitioner is not entitled to a deduction of a portion of such indebtedness in 1920.  Harry C. Weeks, Esq., for the petitioners.  J. Arthur Adams, Esq., for the respondent.  MARQUETTE *516  These proceedings, which were consolidated for hearing and decision, are for the redetermination of deficiencies in income tax, asserted by the respondent for the year 1920 in the amount of $3,857.88 against R. E. Huff, and in the amount of $2,577.48 against Mrs. E. B. Huff.  They arise from the disallowance of a deduction for a loss which petitioners claimed occurred in 1920.  FINDINGS OF*2101  FACT.  The petitioners were husband and wife, residing in Wichita Falls, Tex., during 1920.  The law of community property prevailed in that State in 1920.  Each petitioner had a separate estate, and in addition they had community property and income.  The transaction and loss here involved were in relation to such community property.  Mrs. Huff died before the hearing and R. E. Huff and William E. Huff, as executors of her estate, were substituted as petitioners.  R. E. Huff was a lawyer and banker.  In June, 1918, he entered into an agreement with W. M. McGregor and John S. Mabry for the *517  organization of a reciprocal fire insurance association to be known as Wichita Great Western Underwriters, hereinafter called the association.  The agreement further provided: The purpose of this association is to solicit and secure fire insurance contracts; The parties to this contract are to be known as managers and attorneys of this association, and their respective duties are to be as follows, to-wit: (a) The said W. M. McGregor to be Secretary and Treasurer of said partnership; (b) The said R. E. Huff and W. M. McGregor are together to handle all the funds of*2102  and manage all the finances connected with the association, and are to employ such office help as they see fit, look after the printing of stationery and other matters incident to the conduct of the office of the association; (c) The said John S. Mabry is to be manager of the sales department and is to canvass this state and any other state where business is sought to be secured, solicit fire insurance contracts, and have charge of and employ all men in the sales department; That the only party to this contract who is to draw a salary is the said John S. Mabry, who is to receive the sum of Fifty Dollars per week and expenses, said salary and expenses to be paid by the said W. M. McGregor and R. E. Huff until the finances of the association are in condition to allow of such being paid out of the funds of the association; and that salary shall remain fifty dollars per week until said Mabry secures one hundred underwriters or men who will guarantee the policies, and then for each one hundred underwriters that said Mabry shall secure up to one thousand his salary is to be increased fifty dollars per month, traveling expenses still being allowed.  The said McGregor and Huff are*2103  to advance the initial expenses for securing business in consideration of the ability of the said Mabry to make the association a going enterprise, and out of the first earnings that accrue from the operation of the business the amount that they have previously advanced will be deducted before a division of profits will be allowed.  The moneys collected by the said John S. Mabry are to be remitted direct to the said W. M. McGregor and the same are to be hold in trust for the people who pay it.  The expense ratio allowed for the organization is forty per cent of the gross premium income, and out of this forty per cent is to be paid the current expenses of the association, including the salary of the said John S. Mabry and his traveling expenses, and also any expenses incurred in employing agents at different towns.  After all these current expenses are paid, the remainder is to be divided share and share alike, one-third each to each of the parties to this contract.  The current expenses incident to the carrying on of the business are to be deducted from the first profits accruing from the operation of the business.  In case either party to this contract desires to withdraw*2104  from this partnership, he will give to the other parties hereto the privilege of buying his interest in the partnership as it may appear.  From any amount of money paid by underwriters at the time they become underwriters ten per cent is to be deducted by the attorneys and managers hereof, which is to be for organization purposes, said ten per cent to be equally divided between the parties hereto.  *518  The grand distribution of the earnings is to be made between the parties at such times as shall be hereafter agreed upon by them.  Before the association began business, McGregor Withdrew.  Huff and Mabry continued with the project.  The original agreement was further changed by reducing the amount of gross premium income to be used for expenses and profits from 40 to 25 per cent, and increasing the amount for the reserve fund from 60 to 75 per cent.  Under the plan of organization any person wishing to participate might become an underwriter by subscribing such amount as he might desire to invest, paying one-fourth such amount in cash.  Ten per cent of the cash payment was allowed to the managing attorneys, Huff and Mabry, and the balance was to constitute a reserve*2105  or trust fund which was to remain the property of the subscribers.  This fund was to be used only for the payment of fire losses in excess of the amount in the association's reserve fund.  An advisory board was created for protecting and safeguarding the interests of such subscribers, but this board took no active supervision until about the close of 1920.  The board looked to Huff to see that the association was properly conducted.  Huff was not very active in the business.  At first he had monthly statements made to him, and checked them up, but soon busied himself with other matters.  The management of the association was left almost entirely to Mabry, with no supervision at all during 1919 and the greater part of 1920.  Early in 1920 Mabry represented to Huff that there was needed $25,000 for working capital.  Thereupon Huff agreed to advance that amount and the following agreement was executed: THIS AGREEMENT entered into this 11th day of March, A.D. 1920, by and between Huff and Mabry, attorneys-in-fact for the Wichita Great Western Underwriters, the said Huff and Mabry being a partnership composed of R. E. Huff and John S. Mabry, herein styled parties of the first part, *2106  and R. E. Huff, of Wichita Falls, Texas, hereinafter styled party of the second part.  WITNESSETH: That, whereas, parties of the first part in their business of operating the Wichita Great Western Underwriters need working capital to the extent of approximately TWENTY FIVE THOUSAND DOLLARS ($25,000.00).  And, Whereas, party of the second part has agreed to advance to parties of the first part said sum, or as much thereof as in the opinion of the party of the second part is needed by the parties of the first part; And, Whereas, in their operations as attorneys-in-fact for the Wichita Great Western Underwriters parties of the first part receive as compensation for their services and expense in managing the Wichita Great Western Underwriters twenty-five per cent (25%) of the gross premium receipts, and ten per cent (10%) of the amounts received by the Underwriters joining the Wichita Great Western Underwriters; *519  NOW THEREFORE, it is agreed and understood between the parties hereto that parties of the first part have this day executed and delivered to party of the second part their five promissory notes, each in the principal sum of FIVE thousand DOLLARS ($5,000.00), *2107  each bearing even date herewith, and each due six months from date, and bearing interest at the rate of eight per cent (8%) per annum from maturity until paid, and containing the usual ten per cent attorneys fee clause, and payable to the order of the party of the second part, at the First National Bank, of Wichita Falls, Texas.  That party of the second part agrees to advance upon said notes such sums as in the opinion of party of the second part may be necessary for the operations of parties of the first part, in amounts of Five Thousand Dollars, or multiples thereof, but not exceeding the total of Twenty-five thousand Dollars, and when an amount is advanced by party of the second part, a corresponding amount of the notes above referred to shall then become the property of party of the second part, and he may sell, transfer, or dispose of same in any manner he may see fit, and same shall then become the obligation of parties of the first part for the full amount of such notes, and so on until party of the second part has advanced the full amount provided for hereunder.  To secure party of the second part in the payment of said notes as they mature, party of the first part agrees*2108  that all of the income derived by parties of the first part in their operations as attorneys in fact and managers of the Wichita Great Western Underwriters, less the amount actually paid out by them for the expense of managing said enterprise, shall be held intact, and shall not be distributed to parties of the first part or either of them, or to anyone else, and such sum is hereby pledged to secure said indebtedness, and shall only be distributed after said indebtedness is fully retired, or upon order of party of the second part to retire said indebtedness.  This agreement shall extend to and be binding upon the respective heirs and assigns of the parties hereto, and the security hereby granted shall inure to the benefit of the holder or holders of any of said notes above provided for.  The notes were signed "Huff & Mabry, by J. S. Mabry," and Huff advanced the money from time to time as Mabry called for it, upon these notes.  The entire $25,000 so advanced was repaid during the autumn of 1920 by a check or checks drawn by Mabry.  Huff & Mabry and the association occupied the same office and utilized the same office force.  The money used to pay off the Huff & Mabry notes was*2109  taken from the trust fund of the association held in reserve for the subscribing underwriters.  Huff and Mabry were not the owners of that fund, and no authority had been given to them or to either of them to use the fund or any part of it for any purpose except the payment of fire losses.  To cover the checks so given to repay Huff, a demand note for $25,000 was given to the reserve or trust fund.  The note was signed "Huff & Mabry, by John S. Mabry." Mabry had no authority to execute such a note.  Until near the end of the year Huff did not know that the note had been given, nor that the repayment to him had not been made from funds belonging to the firm of Huff & Mabry.  It was then also discovered *520  that Mabry had been drawing a monthly salary of $1,500, although he was only entitled to draw from $300 to $400 per month.  When the unauthorized use of the trust fund was discovered in December, 1920, Mabry was in Missouri.  Huff tried to get him back to Wichita Falls, but for a time Mabry would not return.  He did come back, however, in January, 1921, and was at once removed as one of the managing attorneys by Huff or at Huff's instigation.  The firm of Huff & Mabry then*2110  discontinued business.  Mabry promised to pay back the money he had taken, but never did so.  He owned no property and a judgment against him would have been worthless.  For that reason no action was brought against him to collect the amount.  Huff had put his son in the association's office in September or October of 1920 to check up on the management of its affairs.  This was after Mabry's defalcation, but before it was discovered.  While huff was trying to determine the exact amount of the defalcation, an inspector from Oregon came into the office to make an examination and report.  This greatly interfered with and delayed Huff's examination.  The Oregon inspector published a very damaging report in the latter part of December, 1920.  As a result of this report, many persons who had given notes for their insurance premiums refused to pay, suits against the association were filed, and it was forced into the hands of a receiver late in February, 1021.  Some collections from premiums were made in January and February, 1921.  Huff was unable to determine the amount of Huff & Mabry's assets before the close of 1920.  On February 16, 1921, the partnership assets amounted to $3,228.65, *2111  which Huff then turned over to the association, together with $21,771.35, which he furnished personally.  He has never received any reimbursement.  R. E. Huff did not keep any regular books of account for his affairs, but did keep memoranda of his income, losses, interest paid, and like matters.  From these he made his income-tax returns, upon a cash receipts and disbursements basis.  In making their returns for 1920, each petitioner took a deduction on account of the alleged embezzlement by Mabry of $21,771.35.  After audit, the respondent restored to gross income the amounts so deducted.  The firm of Huff & Mabry made no return for 1920.  OPINION.  MARQUETTE: The respondent disallowed the deduction claimed by the petitioners upon the ground that as the funds embezzled were *521  not the property of the petitioners, and as they were not called upon to make good the defalcation until 1921, no loss was sustained by them in 1920.  This precise question arose in . In that case an employee embezzled funds held by his employer in trust, and the Circuit Court of Appeals held that the employer sustained*2112  no loss until a subsequent year, when he was called upon to make good the amount embezzled.  Under authority of that decision we hold that the petitioner here did not sustain a deductible loss in 1920 by reason of Mabry's misappropriation of funds, which the petitioners replaced in 1921. The petitioners further contends that, if they are not entitled to a loss deduction by reason of Mabry's embezzlement, they are entitled to a deduction as a bad debt, of all or at least one-half the amount repaid by Huff to the association.  Under section 214(a)(7) of the Revenue Act of 1918, deductions are allowed for "debts ascertained to be worthless and charged off within the taxable year." At the close of 1920 the partnership of Huff & Mabry owed $25,000 to petitioner R. E. Huff.  Ostensibly, that debt had been repaid to him a few months earlier, but as that payment had been made without authority from founds not owned by the debtor firm, but held in trust by it, and for which funds Huff was at all times legally responsible, we must conclude that there was no real satisfaction of the debt.  At the close of 1920 an adverse and very damaging report had been published in the newspapers by the*2113  State Insurance Inspector of Oregon concerning the Wichita Great Western Underwriters.  In the judgment of the petitioner Huff, the business of the Great Western Underwriters was doomed from the day the report became public.  The only source of income to the firm of Huff & Mabry was the commissions paid to that firm by the Great Western Underwriters.  With the Underwriters out of business, the partnership of Huff & Mabry would also be out of business and without income.  The assets of the partnership at the close of 1920 were unknown and the amount thereof was not ascertained by petitioners until the following year.  No portion of the debt was ascertained to be worthless until that time and in our opinion the petitioners are not entitled to any deduction for the year 1920 upon the ground that the debt of Huff & Mabry was ascertained to be worthless in part in that year.  . Judgment will be entered for the respondent.