Harlan v. United States

• Decision Date: 11 January 1963
• Docket Number: No. 546-57.,546-57.
• Citation: 312 F.2d 402
• Parties: Sherman B. HARLAN, Receiver for General Credit Corporation v. The UNITED STATES.
• Court: U.S. Claims Court

312 F.2d 402 (1963)

Sherman B. HARLAN, Receiver for General Credit Corporation v. The UNITED STATES.

No. 546-57.

United States Court of Claims.

January 11, 1963.

H. Cecil Kilpatrick, Washington, D. C., and Charles H. Dickmann, Anderson, Ind., for plaintiff. Evan Howell, Washington, D.C., was on the briefs.

S. Laurence Shaiman, Washington, D. C., with whom was Asst. Atty. Gen., Louis F. Oberdorfer, for defendant. Edward S. Smith, Lyle M. Turner and Philip R. Miller, Washington, D. C., were on the brief.

DAVIS, Judge.

This is an unusual income tax refund suit in which the taxpayer's receiver claims that, under its former management, the corporation deliberately overstated its income, and overpaid its taxes, for 1949 and 1950. We find the charge true, but not to the extent claimed by the plaintiff.¹

The taxpayer, General Credit Corporation, is an Indiana corporation engaged during the taxable years in the discount and small loan business in the northern part of the state. It was under the control of the Anderson family which largely staffed its main office and held the more important positions. At that time taxpayer had outstanding 14,717 shares of regular common stock, the only voting stock so long as dividends were paid regularly on the Class A non-voting common stock; there were 100,000 outstanding shares of this Class A common,² which was wholly non-voting unless and until four semiannual dividends were passed. The Andersons held ownership control of the voting stock but had no substantial interest in the Class A shares, which were widely distributed throughout Indiana. The plaintiff asserts that the Andersons, then in control of the company, improperly reported non-existent income for 1949 and 1950 so that they could, concomitantly, continue paying dividends on the Class A common and thus ensure their remaining in control.

The alleged overpayments of federal income taxes came to light after the company's board of directors appointed a management committee in July 1952. On this committee's recommendation, the Andersons resigned their offices and new management was installed to attempt to salvage the corporation. This effort was unsuccessful and plaintiff was subsequently appointed receiver by an Indiana state court. Meanwhile, the new management hired new accountants to review the company's financial condition. This suit was brought as a result of those accountants' studies.

The several different types of alleged overstatements of income require separate treatment. They are not all governed by the same principles or the same facts.

1. For both 1949 and 1950, plaintiff claims that the "Accounts Financed" shown on the taxpayer's books were fictitious and/or worthless accounts, and therefore that the interest accrued on those accounts, on the company's books, was fictitious or nonexistent income. These "Accounts Financed" items represented debts owed to General Credit on various loans made by it to merchants who sold goods on credit. Since the taxpayer was on the accrual basis, it recorded, at the end of the fiscal year, the accrued interest rightfully earned on those loans, whether or not any such interest was actually paid or received during the year. Spring City Foundry Co. v. Commissioner, 292 U.S. 182, 184-185, 54 S. Ct. 644, 78 L.Ed. 1200 (1934); Estate of Putnam v. Commissioner, 324 U.S. 393, 399, 65 S.Ct. 811, 89 L.Ed. 1023 (1945); Commissioner v. Hansen, 360 U.S. 446, 464, 79 S.Ct. 1270, 3 L.Ed.2d 1360 (1959). The plaintiff challenges this accrual of interest, to some extent on the ground of insufficient proof that such loans were ever really made by the taxpayer (i. e., that the loans were entirely "fictitious"), but primarily on the ground that in the taxable years the loans, even if initially valid, were so delinquent that they had become wholly "worthless" and therefore no longer validly capable of earning interest. Insofar as plaintiff charges that these accounts were purely fictitious, we find that he has failed to carry his burden of proving that valid loans were not made at the inception by General Credit to real debtors. There are a number of external materials supporting the existence of those loans — contracts, confirmations received, ledger cards, record entries, etc. Plaintiff points to the absence of affirmative confirmation from the individual customer-debtors (rather than the company selling the product) and to gaps in the corporation's incomplete records for the taxable years; but in our view these factors are inadequate to vitiate what otherwise appear to be valid loans which were unexceptionable at their outset.³ The alternative claim of invalidity-through-worth-lessness (in 1949 and 1950) must also be rejected because it largely rests on a misconception of the principles of accrual accounting for tax purposes. Under the accrual system a taxpayer should accrue interest on a debt (admittedly owed to him) which he has a right to receive, even though no interest payments were actually received; such interest can be accrued until the debt is declared worthless and deducted as a bad debt. See Spring City Foundry Co. v. Commissioner, supra, 292 U.S. at 185-186, 54 S.Ct. at 645-646, 78 L.Ed. 1200. This taxpayer did not declare the challenged debts to be worthless in 1949 or 1950, nor did it deduct them as bad debts or charge them off. Under the law it had a certain discretion in the treatment of these items. See Reed v. Commissioner, 129 F.2d 908, 912-913 (C.A. 4, 1942); Moock Electric Supply Co. v. Commissioner, 41 B.T.A. 1209, 1211-1212 (1940); 5 Mertens, Law of Federal Income Taxation, Secs. 30.30, 30.65, ch. 30, pp. 57, 95. Although the judgment exercised by the then management may not have been the preferable course, it cannot be attacked by a subsequent management unless the prior choice was so erroneous that it could not in fairness be made. That cannot be said here. There is an insufficient showing by plaintiff (who has the burden) that the debts were definitively worthless in the taxable years. There is evidence, on the other hand, of bona fide attempts to collect in later years from two of the important debtors whose accounts are now said to have been completely worthless in 1949 and 1950.⁴ Hindsight may suggest that the Andersons were too optimistic in deeming the debts alive enough in 1949 and 1950 to warrant the accrual of interest, but hind-sight does not show the prior management to have been arbitrary or unreasonable in taking this action. New management, be it a receiver or a new board of directors, cannot obtain a refund of income taxes simply by showing that the treatment of bad debts adopted by the earlier management, although lawful and reasonable, did not lead to as great a tax saving as some other plan. See In the Matter of Florida Rock Products Co., S. D.Fla., decided April 28, 1933, 15 A.F. T.R. 887.

2. In 1949 the taxpayer made a bookkeeping entry transferring $5,000 from the capital surplus account to the earned surplus account, thereby reflecting or creating an income item of $5,000 which was incorporated in its return. The books give no clue to the nature of this item, but the accountant for the former management, who testified for the Government, did give an explanation. He said that originally this part of capital surplus arose from the reevaluation of assets purchased in 1944 from the American Security Company; by 1949 these particular assets had been liquidated and the gain or loss absorbed in current operations; therefore, according to this accountant, the balance in the capital surplus account should be transferred to earned surplus. One conclusive difficulty with this explanation is that the witness admitted, on cross-examination, that the assets in question were not liquidated in or before 1949, but instead in 1950. The item, if it existed at all, could not have represented income to the corporation in 1949. Plaintiff is therefore correct that in that year this amount of $5,000 represented non-existent income.

3. The corporation made book-keeping entries on June 30, 1950, debiting an asset account designated "Discounts" and crediting an income account called "Discounts Collected," thus showing an income item of $17,000. The Government says that this income reflected discounts earned and accrued in that year on customer's obligations, such as instalment sales financed by the taxpayer for various retail establishments. For support, the defendant relies on the accountant who contemporaneously went over the company's books for that year; he testified that he did not go behind these summary items as shown on the books but assumed them to be correct since they were consistent with what might be expected in a loan and discount business like General Credit Corporation's. Plaintiff presented the accountant chiefly responsible for the review made under the auspices of the new management in 1952; he testified that these entries were not backed by any other data in the corporation's files, of the kind usually demanded by accountants, and that in his opinion the company had simply attempted to create a wholly fictitious item of income. In this instance we are constrained to agree with the plaintiff that the entire absence of normal supporting data (or indication that any existed) means that this income item was created by the former management out of whole cloth — that it was truly fictitious in the elemental sense. The fact that the company's records are now incomplete in some respects is not enough to sustain an item so wholly lacking in foundation.

4. The same holding must be made with respect to entries on June...