1. Under the Revenue Act of 1918, to permit deduction of loss
incurred "in trade or business" or "in any transaction entered into
for profit," the loss must have been "sustained during the taxable
year" -- it must be actual and present in that year; the mere
existence of a liability, afterwards liquidated, is not enough. P.
288 U. S.
159.
2. One of two partners, in 1920, embezzled money from a trust
fund held by the firm, and paid it to the other (who was innocent)
in discharge of the firm's indebtedness to him. The other
discovered the theft that year, and, in the year following, when
the firm ceased business and was settled up, he restored to the
fund the full amount, paying part with the firm's remaining assets
and the rest from his own pocket.
Held:
(1) That, under the Revenue Act of 1918, the amount so repaid
was not deductible as a loss incurred by him in 1920. P.
288 U. S.
161.
Page 288 U. S. 157
(2) The amount due him from his firm was not deductible under §
214(a)(7), Revenue Act of 1921, a a debt "ascertained to be
worthless" during the year 1920, since the result of the firm's
business were not known prior to 1921, and no portion of the debt
was previously ascertained to be worthless. P.
288 U. S. 162.
56 F.2d 788 reversed.
Certiorari, 286 U.S. 541, to review the reversal of a decision
of the Board of Tax Appeals, 20 B.T.A. 516, which sustained the
Commissioner's ruling against a deduction in an income tax
return.
MR. CHIEF JUSTICE HUGHES delivered the opinion of the Court.
In computing net income for 1920, the respondents, R. E. Huff,
and his wife, E. B. Huff (now deceased), sought deduction of a loss
alleged to have been sustained in that year, in relation to
community property, through the embezzlement of trust funds. The
funds were held by a partnership of which R. E. Huff was a member,
and were embezzled by his copartner. The Commissioner disallowed
the deduction, holding that, as the funds were not the property of
the petitioners, and they were not called upon to make good the
amount embezzled until 1921, they sustained no loss in 1920. The
Board of Tax Appeals, upon the authority of
Farish v.
Commissioner, 31 F.2d 79, upheld this ruling. An alternative
claim, for the deduction of the amount in question as a worthless
debt was also disallowed. 20 B.T.A. 516. The Circuit Court of
Appeals, declining to
Page 288 U. S. 158
follow the
Farish case, reversed the decision of the
Board, 56 F.2d 788, and this Court granted certiorari.
The pertinent facts as found by the Board of Tax Appeals are
these: R. E. Huff, a lawyer and banker in Wichita Falls, Texas, and
J. S. Mabry were copartners engaged in managing the business of a
reciprocal fire insurance association known as Wichita Great
Western Underwriters. Under the plan of organization, 25 percent of
the gross premium income of the association was allotted to
expenses and profits, and the remaining 75 percent was to be set
apart as a reserve to pay fire losses. Any person might become an
"underwriter" by subscribing to the association such amount as he
wished to invest, paying one-fourth in cash. Ten percent of the
cash payment was allowed to the managing attorneys, and the rest
constituted a reserve or trust fund which was to remain the
property of the underwriters and to be used only for the payment of
fire losses in excess of the association's reserve. An advisory
board was created from safeguarding the interests of the
subscribers, but undertook no active supervision until about the
end of 1920. The board looked to Huff for the proper conduct of the
affairs of the association, but the management was left almost
entirely to Mabry. Early in 1920, on Mabry's representation that
the sum of $25,000 was needed for working capital, Huff advanced
this amount to the partnership upon partnership notes payable in
six months. The entire amount was repaid to Huff in the autumn of
1920 by checks drawn by Mabry, the money being 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
neither of them had authority to use it for any purpose other than
the payment of fire losses. To cover the checks, given to repay
Huff, Mabry gave a demand note signed in the firm name in favor of
the reserve fund. Mabry had no authority to execute the note, and
Huff did not know until near the end of 1920
Page 288 U. S. 159
that the note had been given or that the repayment to him had
not been made from funds belonging to the firm. The unauthorized
use of the trust fund was discovered, in the absence of Mabry, in
December, 1920. On Mabry's return in January, 1921, he was removed
as one of the managing attorneys, and the firm then discontinued
business. Mabry promised to pay back the money he had taken, but
did not do so, and a judgment against him would have been
worthless. Huff was unable to determine the amount of the assets of
the firm of Huff & Mabry before the close of 1920, and, in
February, 1921, these assets, amounting to $3,228.65, were turned
over by Huff to the association, together with $21,771.35 which he
paid personally. He has not been reimbursed. Huff kept no regular
books of account, and made up his income tax returns upon a cash
receipts and disbursements basis.
First. The Revenue Act of 1918 (40 Stat. 1057, 1066,
1067) provided for the deduction of losses incurred "in trade or
business" or "in any transaction entered into for profit," or
arising from theft of property "not connected with the trade or
business," when the losses were "sustained during the taxable year"
and were "not compensated for by insurance or otherwise." §§ 214(a)
(4-6).
The Government concedes that, if assets of the taxpayer used in
trade or business, or "in any transaction entered into for profit,"
are stolen in any year, the taxpayer sustains the loss in that
year, and the deduction must then be taken even though the theft is
not discovered or the amount ascertained until the following year.
This is said to be the import of the regulation adopted by the
Treasury Department under the Revenue Act of 1921. Regulations No.
45, Art. 111.
* But the
Government contends
Page 288 U. S. 160
that a different rule applies (at least where the taxpayer is on
a cash basis) when the property stolen is not that of the taxpayer,
but is held by him in trust, and the theft is not discovered until
the following year, as, in that case, "the taxpayer, being nothing
out of pocket, cannot be said to have
sustained' the loss in
the year of the theft." The Government also raises the question
whether Huff, in the absence of a finding of negligence, or of
improper delegation of the administration of the trust to Mabry,
can be regarded as legally bound to make restitution. Respondents
insist that Huff was "liable for the trust funds" from the moment
they were received by his firm, and that the loss was sustained at
the time of the embezzlement because it deprived him of assets with
which he could have discharged his obligation.
We find it unnecessary to discuss the question whether Huff was
bound to make good the amount taken from the funds of the
association by his copartner. We may assume that he was. But the
mere existence of liability is not enough to establish a deductible
loss. There is liability in the case of a breach of contract, but,
as the Court said in
Lucas v. American Code Co.,
280 U. S. 445,
280 U. S. 450,
"even an unquestionable breach does not result in loss if the
injured party forgives or refrains from prosecuting his claim." And
whether a taxpayer will actually sustain a loss through
embezzlement of trust funds of which he is trustee will depend upon
a variety of circumstances. If there is liability on his part for
the misappropriation, it does not create a certainty of loss, as
the defalcation may be made good by the one who caused it,
Page 288 U. S. 161
or the liability of the taxpayer may be enforced only to a
limited extent, or not at all. The requirement that losses be
deducted in the year in which they are sustained calls for a
practical test. The loss "must be actual and present."
Weiss v.
Wiener, 279 U. S. 333,
279 U. S. 335;
Lucas v. American Code Co., supra; Eckert v. Burnet,
283 U. S. 140,
283 U. S.
141-142.
The instant case aptly illustrates the importance of this
principle, and calls for its application. Huff himself received the
entire amount embezzled. He received this amount in payment of
notes given to him by his firm to cover his advances to the firm.
If he was liable to restore the amount taken from the trust fund,
he himself had the full sum that was to be restored. So far as his
individual estate was concerned, he had lost nothing by the
embezzlement. If Huff had learned of the embezzlement immediately
upon the payment to him, and had at once restored the entire amount
to the trust fund, he would have been in the same position as that
in which he was before he received the money -- that is, he would
have held the partnership notes, for his advances to the
partnership, which had not been properly discharged. Huff's
personal wealth would have remained the same as it was prior to the
embezzlement, and his individual gains or losses would have turned
not upon the embezzlement, but upon the result of the partnership
business. When, in 1921, on the liquidation of that business, Huff
turned over to the association the sum of $21,771.35, he was merely
restoring part of what he himself had received of the
misappropriated fund, and whatever loss he sustained was upon his
investment in, or his advances to, his firm. That loss was
determinable only through the winding up of the partnership
business.
The result of the partnership transactions was not known and
could not be ascertained in 1920. The firm did not discontinue
business until January, 1921. The
Page 288 U. S. 162
finding is explicit that "some collections from premiums were
made in January and February, 1921," and "Huff was unable to
determine the amount of Huff & Mabry's assets before the close
of 1920." In February, 1921, the firm assets were found to amount
to $3,228.65, and this sum was paid to the association, with the
amount paid by Huff as above stated. Upon these facts, we find no
basis for the conclusion that Huff sustained a deductible loss in
1920.
Second. The respondents make an alternative claim upon
the ground that the amount due Huff by his firm was a debt
"ascertained to be worthless," and hence deductible under §
214(a)(7) of the Revenue Act of 1921 (42 Stat. 240). This claim was
not passed upon by the Circuit Court of Appeals, but it was
considered and rejected, properly, as we think, by the Board of Tax
Appeals. The facts as found show that the results of the firm's
business were not known prior to 1921, and that no portion of the
debt was ascertained to be worthless within the preceding taxable
year.
Judgment reversed.
* Article 111 of Regulations No. 45 provides:
"A loss from theft or embezzlement occurring in one year and
discovered in another is deductible only for the year of its
occurrence. . . . If, subsequently to its occurrence, however, a
taxpayer first ascertains the amount of a loss sustained during a
prior taxable year which has not been deducted from gross income,
he may render an amended return for such preceding taxable year,
including such amount of loss in the deductions from gross income,
and may file a claim for refund of the excess tax paid by reason of
the failure to deduct such loss in the original return."
See also Regulations No. 62, Art. 111; No. 65, Art.
112; No. 69, Art. 112; No. 74, Art. 342.