Opinion
Docket No. 1680-68.
1970-06-9
UNITED SURGICAL STEEL COMPANY, INC., PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Bishop N. Barron, for the petitioner. Robert W. Goodman, for the respondent.
Bishop N. Barron, for the petitioner. Robert W. Goodman, for the respondent.
1. The petitioner claimed deductions for additions to its reserve for bad debts for guaranteed debt obligations in its returns filed for its taxable years ending before Oct. 22, 1965. The petitioner initially agreed to the respondent's determination that disallowed the claimed deductions, however, it subsequently claimed that it was entitled to maintain a reserve for guaranteed debt obligations pursuant to sec. 2 of Pub. L. 89-722. Held, that the petitioner is not entitled to claim the benefits of Pub. L. 89-722 for its taxable years ended Nov. 30, 1962 and 1963, as the assessment of a deficiency in those years was barred at the time of its claim. Held, further, that the petitioner is entitled to maintain a reserve pursuant to sec. 2 of Pub. L. 89-722 for its taxable year ended Nov. 30, 1964, as the assessment of a deficiency would be timely.
2. The petitioner assigned installment obligations that arose from the the sales of cookware on the installment plan to a bank as collateral for a loan. Held, that the petitioner did not dispose of the assigned installment obligations and, therefore, is entitled to report its income from the sale of cookware on the installment method of accounting, sec. 453, I.R.C. 1954, for its taxable years ended Nov. 30, 1965 and 1966.
3. Held, further, that the petitioner's reserve for bad debts is to be recomputed on the basis of loss ratios determined from the stipulations.
QUEALEY, Judge:
The respondent determined deficiencies in petitioner's income taxes as follows:
+------------------------------+ ¦TYE Nov. 30— ¦Deficiency ¦ +-----------------+------------¦ ¦1962 ¦$39,766.58 ¦ +-----------------+------------¦ ¦1963 ¦21,370.80 ¦ +-----------------+------------¦ ¦1964 ¦27,331.79 ¦ +-----------------+------------¦ ¦1965 ¦22,393.53 ¦ +-----------------+------------¦ ¦1966 ¦24,577.46 ¦ +------------------------------+
The issues for decision are:
(1) Whether with respect to the years ended November 30, 1962, 1963, and 1964, the petitioner is entitled to compute a reserve for bad debts pursuant to section 166(g)
with respect to guaranteed debt obligations.
Notes receivable do not include certain miscellaneous receivables.
All section references are to the Internal Revenue Code of 1954, as amended, unless otherwise indicated. 2. The respondent did not elect to assess the deficiencies for the taxable years ended Nov. 30, 1962, 1963, and 1964, resulting from the tentative carryback adjustment ‘as if it were due to a mathematical error’ under sec. 6213(b)(2). 3. Sec. 166(g)(1) provides as follows:(g) RESERVE FOR CERTAIN GUARANTEED DEBT OBLIGATIONS.—(1) ALLOWANCE OF DEDUCTION.— In the case of a taxpayer who is a dealer in property, in lieu of any deduction under subsection (a), there shall be allowed (in the discretion of the Secretary or his delegate) for any taxable year ending after October 21, 1965, a deduction—(A) for a reasonable addition to a reserve for bad debts which may arise out of his liability as a guarantor, endorser, or indemnitor of debt obligations arising out of the sale by him of real property or tangible personal property (including related services) in the ordinary course of his trade or business; and(B) for the amount of any reduction in the suspense account required by paragraph (4)(B)(i).
(2) Whether petitioner ‘disposed of’ installment obligations during its taxable years ended November 30, 1965 and 1966, so as to preclude its reporting income on the installment method under section 453.
(3) The determination of the loss ratio to be used in computing allowable additions to the petitioner's reserve for bad debts for those years in which the petitioner properly maintained such a reserve.
FINDINGS OF FACT
Some of the facts have been stipulated. The stipulation of facts and exhibits attached thereto are incorporated herein by this reference.
The petitioner, United Surgical Steel Co., Inc., is an Alabama corporation. Its principal office, both now and at the time the petition was filed in this case, is located in Montgomery, Ala.
The petitioner filed its corporate income tax returns for its taxable years ended November 30, 1962, through November 30, 1966, with the district director of internal revenue, Birmingham, Ala.
The petitioner was incorporated on April 1, 1962. At all times from that date until November 30, 1966, Mr. John O. Hope owned over 96 percent of petitioner's outstanding common stock.
During the taxable years involved in this case, petitioner was engaged in the business of selling cookware, china, and related items to consumers. Most of petitioner's sales were made on conditional sales contracts with installment notes where a 10-percent downpayment was made by the customer and the balance of the contract was secured by a note payable in monthly installments over a period of 12, 15, 18,or 24 months.
Issue 1. Reserve for Bad Debts for Guaranteed Debt Obligations
On April 1, 1962, petitioner entered into an agreement with United Discount Co., Inc., an Alabama corporation in which Mr. John O. Hope also had a controlling interest, whereby the latter company agreed to purchase the conditional sales contracts entered into by petitioner. The agreement provided that all conditional sales contracts purchased by United Discount Co., Inc., were ‘with recourse’ against the petitioner and that the petitioner would, on demand, repurchase all contracts that became ‘delinquent in payment by a period in excess of ninety (90) days.’
During its taxable years ended November 30, 1962, November 30, 1963, and November 30, 1964, nearly all conditional sales contracts petitioner entered into upon the sale of cookware and related items were sold to United Discount Co., Inc. The total amount owing on December 1, 1964, on the conditional sales contracts that the petitioner had sold to United Discount Co., Inc., was $721,777.32. On May 31, 1965, the petitioner repurchased all the conditional sales contracts it had previously sold to United Discount Co., Inc.
After entering into the agreement with United Discount Co., Inc., on April 1, 1962, the petitioner set up an account entitled ‘Provision for Repurchase of Notes Discounted’ and added $59,887.27 to this account by the end of its taxable year ended November 30, 1962.
During its taxable year ended November 30, 1962, the petitioner provided $730.83 for bad debts arising from accounts receivable other than those where conditional sales contracts were sold to United Discount Co., Inc.
During its taxable year ended November 30, 1962, the petitioner repurchased conditional sales contracts with installment notes from United Discount Co., Inc., in the total amount of $1,040.30 which had become worthless by November 30, 1962.
In its income tax return filed for its taxable period from April 1, 1962, to November 30, 1962, inclusive, the petitioner elected to use the reserve method for deducting its bad debts and deducted $61,526.16 as bad debts, consisting of $59,887.27 as a provision for repurchase of notes discounted, $1,040.30 for repurchased notes, and $598.86 as a provision for bad accounts.
During its taxable year ended November 30, 1963,the petitioner added $15,054.31 to its account entitled ‘Provision for Repurchase of Notes Discounted.’
During its taxable year ended November 30, 1963, the petitioner repurchased conditional sales contracts with installment notes from United Discount Co., Inc., in the total amount of $10,774.26 which had become worthless by November 30, 1963.
During its taxable year ended November 30, 1964, the petitioner reduced its account entitled ‘Provision for Repurchase of Notes Discounted’ by $14,578.41 as it actually had bad debts totaling $49,504.96 during that taxable year.
The petitioner's returns for its taxable years ended November 30, 1962, 1963, and 1964, were received by the respondent on February 18, 1963, on February 17, 1964, and on February 16, 1965, respectively. On December 17, 1965, the petitioner signed a Form 872, Consent Fixing Period of Limitations upon Assessment of Income and Profits Tax, for its taxable year ended November 30, 1962, extending the period for assessment for that year to February 15, 1967.
As a result of an examination by the respondent of the petitioner's tax returns for its taxable years ended November 30, 1962, November 30, 1963, and November 30, 1964, which examination was completed on or about February 1, 1966, the respondent made certain adjustments to the deductions claimed by the petitioner on those tax returns including the following:
+----------------------------------------------------------------------------+ ¦Taxable year ended Nov. 30, 1962: ¦ ¦ +----------------------------------------------------------------+-----------¦ ¦ ¦ ¦ +----------------------------------------------------------------+-----------¦ ¦Decrease in deduction for amount claimed as an addition to ¦ ¦ +----------------------------------------------------------------+-----------¦ ¦account entitled “Provision for Repurchase of Notes Discounted” ¦$59,887.27 ¦ +----------------------------------------------------------------+-----------¦ ¦Decrease in deduction claimed for repurchased notes on ¦ ¦ +----------------------------------------------------------------+-----------¦ ¦conditional sales contracts entered into and discounted ¦ ¦ +----------------------------------------------------------------+-----------¦ ¦prior to the petitioner's incorporation ¦1,040.30 ¦ +----------------------------------------------------------------+-----------¦ ¦Increase in amount claimed as a provision for bad debts ¦(131.97) ¦ +----------------------------------------------------------------+-----------¦ ¦ ¦ ¦ +----------------------------------------------------------------+-----------¦ ¦Taxable year ended Nov. 30, 1963: ¦ ¦ +----------------------------------------------------------------+-----------¦ ¦ ¦ ¦ +----------------------------------------------------------------+-----------¦ ¦Decrease in deduction for amount claimed as an addition to ¦ ¦ +----------------------------------------------------------------+-----------¦ ¦account entitled “Provision for Repurchase of Notes Discounted”—¦15,054.31 ¦ +----------------------------------------------------------------+-----------¦ ¦Decrease in deduction claimed for repurchased notes on ¦ ¦ +----------------------------------------------------------------+-----------¦ ¦conditional sales contracts entered into and discounted ¦ ¦ +----------------------------------------------------------------+-----------¦ ¦prior to the petitioner's incorporation ¦10,774.26 ¦ +----------------------------------------------------------------+-----------¦ ¦ ¦ ¦ +----------------------------------------------------------------+-----------¦ ¦Taxable year ended Nov. 30, 1964: ¦ ¦ +----------------------------------------------------------------+-----------¦ ¦ ¦ ¦ +----------------------------------------------------------------+-----------¦ ¦Increase in deduction for bad debts ¦(14,578.41)¦ +----------------------------------------------------------------------------+
The respondent also made other adjustments that are not in dispute.
The petitioner's taxable income as adjusted by the respondent and the resulting adjustments in the petitioner's tax liability were as follows:
+-----+ ¦¦¦¦¦¦¦ +-----+
Taxable Tax TYE Nov. 30— income Income tax disclosed Deficiency Overassessment adjusted liability on return 1962 $87,984.36 $39,766.58 $6,480.83 $33,285.75 1963 51,738.09 21,370.80 7,939.94 13,430.86 1964 66,035.06 27,331.79 34,450.26 $7,118.47
The petitioner agreed to the adjustments made by the respondent and executed a Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment, which was received in respondent's office in Montgomery, Ala., on February 1, 1966. The deficiencies resulting from those adjustments in the net amount of $39,598.14 were assessed on April 1, 1966.
On February 16, 1966, the petitioner filed Form 1139, Application for Tentative Carryback Adjustment, for its taxable year ended November 30, 1965, which stated that the petitioner had a net operating loss of $170,489.18. The petitioner requested that this loss be applied to reduce taxable income for prior years, as follows:
+------------------------------------------------------------------------+ ¦ ¦Deficiency carryback ¦ +-------------------------------------------------+----------------------¦ ¦TYE Nov. 30— ¦adjustment ¦ +-------------------------------------------------+----------------------¦ ¦1962 ¦$87,984.36 ¦ +-------------------------------------------------+----------------------¦ ¦1963 ¦51,738.09 ¦ +-------------------------------------------------+----------------------¦ ¦1964 ¦30,766.73 ¦ +-------------------------------------------------+----------------------¦ ¦Total carryback adjustment for taxable year ended¦ ¦ +-------------------------------------------------+----------------------¦ ¦Nov. 30, 1965 ¦170,489.18 ¦ +------------------------------------------------------------------------+
On April 11, 1966, a tentative allowance of the requested net operating loss carryback was made pursuant to section 6411(b) whereby the respondent redetermined the petitioner's total income tax liability for its taxable years ended November 30, 1962 through 1964, as follows:
+--------------------------------------------------+ ¦ ¦Income tax¦Redetermination¦Net ¦ +------------+----------+---------------+----------¦ ¦TYE Nov. 30—¦liability ¦of income ¦income tax¦ +------------+----------+---------------+----------¦ ¦ ¦ ¦tax liability ¦liability ¦ +------------+----------+---------------+----------¦ ¦ ¦ ¦ ¦ ¦ +------------+----------+---------------+----------¦ ¦1962 ¦$39,766.58¦$39,766.58 ¦0 ¦ +------------+----------+---------------+----------¦ ¦1963 ¦21,370.80 ¦21,370.80 ¦0 ¦ +------------+----------+---------------+----------¦ ¦1964 ¦27,331.79 ¦15,953.95 ¦$11,377.84¦ +--------------------------------------------------+
On February 13, 1967, the petitioner filed Form 1139 for its taxable year ended November 30, 1966, setting forth a net operating loss of $133,879.81 for that taxable year. The petitioner requested that $35,268.33 of this loss be applied to reduce its remaining taxable income of $35,268.33 for its taxable year ended November 30, 1964, to zero.
On March 17, 1967, a tentative allowance of the requested net operating loss carryback was made pursuant to section 6411(b) whereby the petitioner's income tax liability for its taxable year ended November 30, 1964, was reduced from $11,377.84 to zero.
On an examination of the petitioner's returns, the respondent determined that the petitioner had realized income for its taxable year ended November 30, 1965, in the amount of $57,613.99, and for its taxable year ended November 30, 1966, in the amount of $62,080.46. The respondent's determination was based mainly on his contention that the petitioner had disposed of its conditional sales contracts during its taxable years ended November 30, 1965 and 1966, when it assigned those contracts to a bank pursuant to a loan agreement.
The respondent further determined that the amounts applied and refunded under section 6411(b) with respect to the petitioner's applications for tentative carryback adjustments should not have been so applied and refunded. Therefore, on January 18, 1968, the respondent issues a notice of deficiency in which he redetermined the petitioner's tax liability and assessed deficiencies for the petitioner's taxable years ended November 30, 1962, 1963, and 1964, as follows:
+----------------------------------+ ¦TYE Nov. 30—¦Income tax¦Deficiency¦ +------------+----------+----------¦ ¦ ¦liability ¦ ¦ +------------+----------+----------¦ ¦ ¦ ¦ ¦ +------------+----------+----------¦ ¦1962 ¦$39,766.58¦$39,766.58¦ +------------+----------+----------¦ ¦1963 ¦21,370.80 ¦21,370.80 ¦ +------------+----------+----------¦ ¦1964 ¦27,331.79 ¦27,331.79 ¦ +----------------------------------+
On January 25, 1968, the petitioner filed claims (Form 843) for the refund of taxes for its taxable years ended November 30, 1962, 1963, and 1964. In a statement attached to these claims, the petitioner stated, in substance, that it was claiming its rights under section 166(g) to maintain its account entitled ‘Provision for Repurchase of Notes Discounted’ for those years.
Issue 2. Disposition of Installment Obligations
On May 31, 1965, a loan agreement was entered into by and between petitioner as the borrower, Modern China & Table Institute, Inc., and United Discount Co., Inc., as the guarantors, and the First National Bank of Montgomery, Montgomery, Ala. (the bank). The agreement provided, in part, that:
1. Subject to all the terms of this agreement and concurrently with assignment to the Bank by the Borrower of collateral acceptable to the Bank and during the life of this agreement. Bank shall lend to the Borrower from time to time, such amounts as the Borrower may request, provided, (a) That Borrower is not insolvent; (b) That the debit balance of the Borrower's loan account calculated upon promissory notes secured by conditional sales contracts or chattel mortgages assigned to the Bank, after reflecting such requested loan, shall not exceed 88% of the outstanding balance of such notes so secured, and (c) that at the time of the requested loan the Borrower and Guarantors are not in default in any respect hereunder.
5. This loan agreement and the financing arrangement contemplated hereunder is based on the following method of operation:
a. Notes and conditional sales contracts or chattel mortgages securing said notes will be transferred, assigned and delivered to the Bank. Said transfers and assignment shall be in form and substance satisfactory to bank and shall be with full recourse.
b. There will be attached to each contract evidence showing delivery of merchandise, and a credit statement on the individual buyer.
c. The Bank will advance 88% of the unpaid balance on the note and assigned collateral and place 12% of the unpaid balance in a dealer reserve account. The advance of 88% of the unpaid balance shall be considered ‘money in use’ as mentioned herein;
d. The dealer reserve account will be built up to and then shall be maintained at 35% of aggregate unpaid balance of assigned collateral; any excess shall be paid to Borrower.
f. Collections on assigned collateral shall be deposited daily in kind to a collection account subject to withdrawal by Bank only, which account shall be the property of the Bank. Borrower shall maintain an impounded balance of $1,000.00 in said account. On Monday of each week borrower will send bank a recapitulation of payments deposited to the Collection Account the previous week. From this recapitulation, bank will withdraw the collected funds and apply as a credit to borrower's loan account. Returned checks shall be charged back to this account.
g. Any account represented by collateral which is three payments past due is to be bought back in cash by Borrower for the full unpaid balance. This repurchase is to take place no later than five days before the fourth payment falls due.
The loan agreement further provided that the petitioner was to keep its records in a manner satisfactory to the bank; the bank was to have the right to audit the books of petitioner; the petitioner was to furnish the bank periodically with financial statements of its operations; the petitioner was to pay all its taxes as such taxes came due; the petitioner was to keep its property insured; the petitioner was not to purchase any additional fixed assets other than automobiles and individual purchases of less than $1,000 without prior approval of the bank; the petitioner was not to change the compensation of certain employees and officers, or pay dividends, without prior approval of the bank; and, the petitioner was not to allow its property to become subject to liens.
The bank initially extended a line of credit up to a maximum of $650,000. On October 8, 1965, the line of credit was increased to a maximum of $850,000.
On October 8, 1965, petitioner executed its demand promissory note in the amount of $850,000 to the bank. The demand promissory note was described as a ‘draw’ note. That is, petitioner did not owe the full amount of the note, but it was permitted to draw a percentage of the collateral assignments made by the petitioner to the bank. As a matter of practice, the petitioner did not borrow up to the maximum amount allowable.
Petitioner handled all collections of the assigned conditional sales contracts, without coordination with or approval of the bank. None of petitioner's customers were even notified of the fact of the assignment of their respective conditional sales contracts to the bank, and all communications with petitioner's customers concerning their accounts were made by petitioner. The bank did not maintain individual records on the assigned conditional sales contracts but accounted for such assigned contracts only in the total amount thereof.
After the loan agreement was entered into on May 31, 1965, petitioner assigned nearly all the consumer cookware contracts to the bank. It continued to so assign those contracts through November 30, 1966.
In its return for its taxable year ended November 30, 1965, the petitioner elected to report the income from cookware sold on the installment plan on the installment method of accounting. Based on this method of accounting, the petitioner reported $560,891.54 as gross profits on the collection of conditional sales contracts in its taxable year ended November 30, 1965, and $562,939.65 as gross profits on the collection of such contracts in its taxable year ended November 30, 1966.
On an examination by the respondent of the petitioner's returns, the respondent increased the petitioner's gross income for its taxable years ended November 30, 1965 and 1966, in the amounts of $224,889.65 and $169,726.32, respectively. The respondent's adjustments were based on his determination that the petitioner disposed of its conditional sales contracts when it assigned those contracts to the bank under the loan agreement of May 31, 1965.
Issue 3. Loss Ratio
The petitioner used the reserve method for deducting its bad debts in its taxable years ended November 30, 1965 and 1966.
The petitioner computed its additions to its reserve for bad debts for its taxable years ended November 30, 1965 and 1966, using as a basis the unrecovered cost of goods sold rather than the face amount of the installment notes subject to the loan agreement with the bank.
The petitioner deducted $90,363.60 in its return for its taxable year ended November 30, 1965, as an addition to its reserve for bad debts based on a loss ratio of 10.39 percent. The petitioner deducted $85,175.11 in its return for its taxable year ended November 30, 1966, as an addition to its reserve for bad debts based on a loss ratio of 8.12 percent.
The respondent redetermined the petitioner's deductions for additions to its reserve for bad debts and allowed deductions for such additions for the petitioner's taxable years ended November 30, 1965 and 1966, in the amount of $84,615.08 and $55,018.87, respectively, using as a basis for his computation the face amount of the installment notes subject to the loan agreement with the bank and loss ratio of 8.13 percent. The loss ratio of 8.13 percent was furnished to the respondent by the petitioner during the respondent's examination of the petitioner's returns.
For the purposes of resolving their dispute as to reasonable additions to the reserve for bad debts, the parties have stipulated that the petitioner held notes receivable and had incurred bad debts on the last day of its taxable year, as follows:
+--------------------------------------+ ¦TYE Nov. 30—¦Notes ¦Net bad ¦ +------------+--------------+----------¦ ¦ ¦receivable 1 ¦debts 2 ¦ +------------+--------------+----------¦ ¦ ¦ ¦ ¦ +------------+--------------+----------¦ ¦1963 ¦$653,943.18 ¦$46,096.64¦ +------------+--------------+----------¦ ¦1964 ¦721,777.20 ¦50,444.48 ¦ +------------+--------------+----------¦ ¦1965 ¦913,501.66 ¦71,643.03 ¦ +------------+--------------+----------¦ ¦1966 ¦924,235.14 ¦65,622.32 ¦ +------------+--------------+----------¦ ¦1967 ¦1,075.454.28 ¦49,929.22 ¦ +------------+--------------+----------¦ ¦1968 ¦1,361.085.46 ¦113,234.48¦ +------------+--------------+----------¦ ¦Total ¦5,649,996.92 ¦396,970.17¦ +------------+--------------+----------¦ ¦ ¦ ¦ ¦ +--------------------------------------+
Petitioner's loss ratios for its taxable years ended November 30, 1964, 1965, and 1966, computed on the basis of the average of the net bad debts (bad debts less subsequent recoveries thereof) to the average amounts of the petitioner's installment notes receivables for the periods between November 30, 1963, and November 30, 1964, November 30, 1963, and November 30, 1965, and November 30, 1963, and November 30, 1966, respectively, were as follows:
+------------------------------+ ¦TYE Nov. 30— ¦Loss ratio ¦ +-----------------+------------¦ ¦ ¦ ¦ +-----------------+------------¦ ¦1964 ¦7.010 ¦ +-----------------+------------¦ ¦1965 ¦7.034 ¦ +-----------------+------------¦ ¦1966 ¦7.275 ¦ +------------------------------+
OPINION
Issue 1. Reserve for Bad Debts for Guaranteed Debt Obligations
In its returns for the taxable years ended November 30, 1962, 1963, and 1964, the petitioner deducted additions to its reserve for bad debts on account of conditional sales contracts sold to United Discount Co., Inc., payment of which was guaranteed by the petitioner. In the examination of those returns, the deductions of the additions to the reserve were disallowed by the respondent and the resulting deficiencies were assessed on April 1, 1966.
In the meanwhile on February 16, 1966, the petitioner filed an Application for Tentative Carryback Adjustment (Form 1139) for the taxable year ended November 30, 1965, showing a net operating loss carryback in an amount sufficient to offset its taxable income, as determined by the respondent, for the taxable years ended November 30, 1962 and 1963, and to reduce substantially its taxable income for the year ended November 30, 1964. Thereafter, on February 13, 1967, the petitioner filed an Application for Tentative Carryback Adjustment (Form 1139) for the taxable year ended November 30, 1966, showing a net operating loss carryback sufficient in amount to offset the balance of its taxable income, as determined by the respondent, for the taxable year ended November 30, 1964.
Upon later examination of the petitioner's returns for the taxable years ended November 30, 1965 and 1966, the respondent determined that the petitioner had realized taxable income for such years.
In a notice of deficiency dated January 18, 1968, the respondent asserted deficiencies for the taxable years ended November 30, 1962, 1963, and 1964.
The respondent also asserted deficiencies for the taxable years ended November 30, 1965 and 1966, resulting from the recomputation of the income (loss) for such years. The petitioner has sought a redetermination of those deficiencies.
Net bad debts do include the net chargeoffs for miscellaneous receivables.
The notice of deficiency set forth a recomputation of the tax liability for the taxable years ended November 30, 1962 to 1966, inclusive, commencing with the tax liability shown in the return for each of those years and setting forth all prior adjustments, credits and/or refunds.
In its petition, the petitioner put in issue not only respondent's determination with respect to the taxable years ended November 30, 1965 and 1966, but also the prior adjustments with respect to the years ended November 30, 1962, and 1964, whereby the respondent disallowed the deduction of the additions to the reserve for bad debts on account of the guaranteed obligations discounted with United Discount Co., Inc. The petition states:
The disallowance of bad debts for the fiscal years ended November 30, 1962, November 30, 1963, and November 30, 1964 as a result of a prior examination (February 11, 1966) was prior to the enactment of Section 166(9)(sic), U.S.I.R.C., and, consequently, the disallowance of such amounts by the Commissioner is erroneous. The deduction for addition to Reserve for Bad Debts for the fiscal years ended November 30, 1965 and November 30, 1966 as shown by Petitioner's returns for such respective years is correct.
Tax Settlements previously agreed upon between Petitioner and the Commissioner for the fiscal years ended November 30, 1962, November 30, 1963, and the U.S.I.R.C. as to Bad Debt Reserves carried on Petitioner's books for any taxable year ending before October 22, 1965. Petitioner did have a Reserve for Bad Debts on their (sic) books as of the end of the fiscal year 1964, November 30, 1964. The subject addition to the Internal Revenue Code affects all the periods here involved.
The respondent contends that the petitioner's claim to the allowance of a reserve for bad debts under section 166(g) is barred by the statute of limitations and, in any event, is not before the Court for decision.
With respect to this issue there is thus presented for decision (1) whether the petitioner qualifies for the adjustment under section 166(g) and (2) whether the petitioner's claim for the adjustment is timely and before this Court.
Section 1 of Pub. L. 89-722 (Nov. 2, 1966), 80 Stat. 1151,amended section 166 by adding section 166(g) to allow deductions for additions to reserves for guaranteed debt obligations.
With respect to taxable years ending before October 22, 1965, section 2 of Pub. L. 89-722 provides as follows:
Sec. 2. (a) Except as provided in subsections (b) and (c), the amendments made by the first section of this Act shall apply to taxable years ending after October 21, 1965.
(b) If
(1) the taxpayer before October 22, 1965, claimed a deduction, for a taxable year ending before such date, under section 166(c) of the Internal Revenue Code of 1954 for an addition to a reserve for bad debts on account of debt obligations described in section 166(g)(1)(A) of such Code (as amended by the first section of this Act), and
(2) The assessment of a deficiency of the tax imposed by chapter 1 of such Code for such taxable year and each subsequent taxable year ending before October 22, 1965, is not prevented on December 31, 1966, by the operation of any law or rule of law, then such deduction on account of such debt obligations shall be allowed for each such taxable year under such section 166(c) to the extent that the deduction would have been allowable under the provisions of such section 166(g)(1)(A) if such provisions applied to such taxable years.
In the report accompanying the bill, the Committee on Ways and Means explained this provisions as follows:
Taxpayers claiming deductions for years ending before October 22, 1965.— The bill provides that if a taxpayer before October 22, 1965, claimed a deduction (for a taxable year ending before that date) for an addition to a reserve for bad debts (section 166(c)) on account of debt obligations of the guaranteed type referred to with respect to the new reserve, then this deduction is to be allowed (under the existing general bad debt reserve) for the prior year in question to the same extent that it would have been allowable, if the new reserve had been available in the earlier year or years. However, such a deduction is to be available for one of these prior years only if the statute of limitations has not run (by December 31, 1966) for either this or any subsequent year. Thus, for example, if the taxpayer claimed a deduction under the existing general bad debt reserve for guaranteed obligations for the year 1960 and that year and all subsequent years are open, deductions may be taken for the year 1960 and all subsequent years ending before October 22, 1965 (whether or not the taxpayer claimed the deduction for all of the subsequent years). However, if the taxpayer claimed the deduction for the year 1960 and that year is still open but the year 1961 is not open, no deduction can be taken for the year 1960 or 1961. In such case, if the taxpayer also claimed a deduction for 1962, deductions can be taken for 1962 and subsequent years ending before October 22, 1965 (if all of these years are open). (H. Rept. No. 2157, 89th Cong., 2d Sess., p. 5.)
In the technical explanation, the same report states:
The taxpayer may have claimed the deduction in his original return for the taxable year, in an amended return, or in a claim for refund, if such return, amended return, or claim for refund was filed before October 22, 1965. If such a claim was made and the assessment of a deficiency of any tax imposed by chapter 1 for the taxable years involved is not prevented on December 31, 1966, by the operation of any law or rule of law, then the taxpayer's deduction under section 166 of the code is to be computed under subsection (c) by making a reasonable addition to his reserve for bad debts. The taxpayer's balance in his reserve for bad debts under section 166(c), to the extent that it is attributable to obligations described in section 166 (g)(1)(A), is his opening balance of his reserve for bad debts under paragraph (1)(A) of section 166(g) of his first taxable year ending after October 21, 1965. Accordingly, his balance of his reserve for bad debts under section 166(c) is reduced by a corresponding amount. (H. Rept. No. 2157, 89th Cong., 2d Sess., p. 9,)
In its returns for the taxable years ended November 30, 1962, 1963, and 1964, the petitioner maintained a reserve for bad debts with respect to the conditional sales contracts it sold to United Discount Co., Inc. The statute of limitations for the assessment of any deficiency for the petitioner's taxable years 1962 to 1964, inclusive, had not run as of December 31, 1966. Initially the petitioner met the conditions required in order for a taxpayer to establish a reserve for guaranteed debt obligations for the taxable years ended before October 22, 1965.
While the petitioner initially met the required conditions, it does not follow that the petitioner had an unlimited period of time within which to claim the benefits of Pub. L. 89-722. To avail itself of the deduction be open for the assessment of a deficiency as of December 31, 1966, but also at the time that the taxpayer seeks to claim the benefit.
The petitioner's returns for its taxable years ended November 30, 1962, 1963, and 1964, were examined, and the respondent disallowed any deductions for a reserve for bad debts on account of guaranteed debt obligations. That determination was accepted by the petitioner on February 1, 1966, and the resulting deficiencies were assessed on April 1, 1966. These deficiencies were offset on April 11, 1966, and March 17, 1967, by the carryback adjustment from the petitioner's taxable years ended November 30, 1965 and 1966, pursuant to section 6411(b).
By notice of deficiency dated January 18, 1968, respondent subsequently determined that the amounts credited pursuant to section 6411(b) were excessive and asserted deficiencies for the petitioner's taxable years ended November 30, 1962, 1963, 1964. When the respondent took this action, the petitioner first claimed the right under section 2 of Pub. L. 89-722 to deduct a reserve for guaranteed debt obligations for its taxable years ended November 30, 1962, 1963, and 1964.
As of January 18, 1968,
The date of the notice of deficiency.
the general statute of limitations barred the assessment of a deficiency for the taxable years ended November 30, 1962 and 1963. Since, however, the proposed deficiencies for such years were attributable to the application to the taxpayer of a net operating loss carryback, the additional period for assessing a deficiency on that ground had not expired. Sec. 6501 (h).
The date of the filing of the claim for refund.
This did not toll the statute of limitations with respect to a deficiency resulting from any other adjustments for the barred years. Bunn's Auto Sales, Inc., 35 T.C. 861 (1961). See also Ione P. Bouchey, 19 T.C. 1078; Edward G. Leuthesser, 18 T.C. 1112 (1952).
Sec. 6501(h) provides:(h) NET OPERATING LOSS OR CAPITAL LOSS CARRYBACKS.— In the case of a deficiency attributable to the application to the taxpayer of a net operating loss carryback or a capital loss carryback (including deficiencies which may be assessed pursuant to the provisions of section 6213(b)(2)), such deficiency may be assessed at any time before the expiration of the period within which a deficiency for the taxable year of the net operating loss or net capital loss which results in such carryback may be assessed. In the case of a deficiency attributable to the application of a net operating loss carryback, such deficiency may be assessed within 18 months after the date on which the taxpayer files in accordance with section 172(b)(3) a copy of the certification (with respect to the taxable year of the net operating loss) issued under section 317 of the Trade Expansion Act of 1962, if later than the date prescribed by the preceding sentence.
When the notice of deficiency was issued and the petitioner filed a claim for the benefits of Pub. L. 89-722, the taxable years 1962 and 1963 were not open for the assessment of a deficiency which might result from a change in the method of deducting losses on account of guaranteed obligations under section 2 of Pub. L. 89-722. The petitioner's claim for the adjustment under that section with respect to the years ended November 30, 1962 and 1963, was not timely and is disallowed.
The general statute of limitations had not run with respect to the taxable year ended November 30, 1964, when the notice of deficiency was mailed and the petitioner filed a claim for the benefits of Pub. L. 89-722. By reason of the filing of the petition, the assessment of a deficiency for the taxable year 1964 is still open. Sec. 6503(a)(1). Thus, the petitioner is entitled to claim the adjustment under section 2(b) of Pub. L. 89-722 with respect to that taxable year.
The jurisdiction of this Court to consider that claim can hardly be open to question. The notice of deficiency with respect to the taxable year ended November 30, 1964, was mailed within 3 years from the filing of the return. The respondent was not limited to the tentative carryback adjustment under section 6501(a). No basis exists for limiting the jurisdiction of this Court.
Having made a timely claim, the petitioner is entitled to a deduction for additions to a reserve for bad debts with respect to guaranteed debt obligations for its taxable year ended November 30, 1964, to the extent provided in section 2(b) of Pub. L. 89-722.
Issue 2. Disposition of Installment Obligations
With respect to the transaction with the First National Bank of Montgomery, the respondent argues, first, that the agreement with the bank ‘amounted to much more than a mere pledge’ of the installment obligations and, secondly, even assuming that the transaction was a ‘pledge’, that there was a disposition of the installment obligations within the meaning of section 453(d)(1) on the authority of Rev. Rul. 65-185, 1965-2 C.B. 153.
Section 453(d)(1) provides as follows:
(d) GAIN OR LOSS ON DISPOSITION OF INSTALLMENT OBLIGATIONS.
(1) GENERAL RULE.— If an installment obligation is satisfied at other than its face value of distributed, transmitted, sold, or otherwise disposed of, gain or loss shall result to the extent of the difference between the basis of the obligation and
(A) the amount realized, in the case of satisfaction at other than face value or a sale or exchange, or
(B) the fair market value of the obligation at the time of distribution, transmission, or disposition, in the case of the distribution, transmission, or disposition otherwise than by sale or exchange.
Any gain or loss so resulting shall be considered as resulting from the sale or exchange of the property in respect of which the installment obligation was received.
The respondent does not contend that the installment obligations were ‘satisfied,’ ‘distributed,’ ‘transmitted,‘ or ‘sold.’ Rather the respondent argues that the transactions were ‘otherwise disposed of.’ The respondent recognizes, however, and this Court has held, that the pledge of an installment obligation as collateral security for a loan is not generally a ‘disposition’ of that obligation within the meaning of section 453(d)(1). Town & Country Food Co., 51 T.C. 1049, acq. 1969-2 C.B. XXV.
The respondent contends, nevertheless, that where the amount borrowed on the collateral is ‘substantially equal’ to the obligation, there is a disposition of the obligation. Rev. Rul. 65-185. Without expressing any opinion with respect to that ruling as applied to the example set forth therein, which materially differs from the facts in this case, there is no basis in law upon which to conclude that merely because the amount borrowed is substantially equal to the face amount of the collateral, the taxpayer has thereby disposed of the collateral. This might follow under the facts of a particular case, such as where the transaction was found not to be loan, but cannot be advanced as a rule of law. Town & Country Food Co., supra; cf. Joe D. Branham, 51 T.C. 175 (1968).
In Town & Country Food Co., supra, this Court had under consideration a financing plan somewhat similar to that in the case before us. The Court said:
Section 453(d) predicates its application upon a sale or exchange or other disposition of installment obligations. We think it is obvious that a disposition involves the relinquishment of the substantial incidents of ownership of the obligations. It may well be that in some instances involving claimed borrowing arrangements the taxpayer parts with such a substantial portion of his ownership rights in the obligations as to require the conclusion that he has, in effect, sold or otherwise disposed of the obligations. On the other hand, if it is clear that the taxpayer has merely subjected the obligations to a lien for the payment of indebtedness, he does not lose the privilege of reporting the income from the installment method. As stated in Elmer v. Commissioner (C.A. 2) 65 F.2d 568, affirming 22 B.T.A. 224:
‘If a merchant discounts his customer's note at a bank, endorsing it, but getting immediate credit for its discount value, it would be a most unnatural thing to consider it a loan from the bank. He remains liable if the customer defaults, but the collection is in the bank's hands, and the transaction is closed in the absence of a default. If on the other hand, a merchant pledges his accounts to a ‘finance’ company and collects them himself, paying the loan out of his collections, it is clearly a loan, and has always been so considered. * * * '
The facts here clearly establish that the transaction between the petitioner and the bank was in form, as well as substance, a loan and not a sale of the collateral. The petitioner and its guarantors entered into an agreement with the bank pursuant to which the bank agreed to extend a line of credit up to a maximum of $650,000, subsequently increased to $850,000. The petitioner executed a note payable to the bank for the full amount of its authorized borrowings, or the sum of $850,000. The note was described as a ‘draw’ note by the lender which meant that the note itself did not represent the amount owing but was intended, along with the collateral, to secure loans by the bank to the petitioner.
Pursuant to the terms of the loan agreement, the petitioner assigned its installment obligations to the bank and became entitled to borrow up to 88 percent of the face amount of such obligations. The petitioner continued to make all collections on the obligations, which were deposited daily in a special bank account. The funds thus deposited could not be withdrawn by the petitioner but the total amount on deposit would be credited to the petitioner's revolving account on a weekly basis. In the case of a default on any installment obligation, the petitioner was required to reduce its account with the bank by an equal amount and the obligation was released from escrow.
While the procedures, pursuant to which the petitioner financed its installment obligations, may not have differed in some respects from the procedures which are followed where a taxpayer discounts or sells its trade obligations to a bank subject to recourse, other duties and restrictions imposed on the petitioner served to distinguish the transaction from a sale or disposition of the installment obligations.
The bank did not realize any income from the installment obligations but only realized interest charges measured by the actual balance owing by the petitioner. Thus, while the bank assumed no risk, other than as a lender of money to the petitioner, the bank could realize no gain except as interest on that loan.
The petitioner continued to handle all collections and otherwise to service its customers. In fact, there was no contact between the customer and the bank. As far as the customer knew, the petitioner was the person to whom he was indebted.
The bank did not look to the debtors under the installment obligation for payment. The obligation to pay the bank remained at all times an obligation of the petitioner and its guarantors. The loan agreement makes this clear.
The loan agreement imposed restrictions on the operations of petitioner which are wholly inconsistent with the view that the transaction was not a loan by the bank to the petitioner. For example, the petitioner was required to keep its records in a manner satisfactory to the bank; the bank had the right to audit the books of petitioner; the petitioner had to furnish the bank periodically with financial statements of its operations; the petitioner had to pay all its taxes as such taxes came due; the petitioner had to keep its property insured; the petitioner could not purchase any additional fixed assets other than automobiles and individual purchases of less than $1,000 without prior approval of the bank; and, the petitioner was restricted in the payment of compensation, the creation of other indebtedness, and the payment of dividends.
In applying Rev. Rul. 65-185 to this case, respondent would ignore the particular facts upon which that ruling was predicated. The ruling states:
X, an automobile dealership, sells most of its automobiles under an arrangement in which the customer makes a cash down payment and executes a conditional sales contract providing for installment payments on the principal balance due and for the payment of interest.
Following the sale of an automobile under this arrangement, X applies to Y, an unrelated finance company, for a loan in an amount substantially equal to the face amount of the customer's contract. If Y grants the loan, X executes an installment note for the full amount of the loan. The note provides for the repayment of the loan by X over a term and at intervals identical with the term and intervals at which the customer will make payments pursuant to his installment contract.
Under the loan agreement, X assigns the customer's installment contract to Y as collateral security for the repayment of its own note. The agreement designates Y as X's agent to collect the installment payments from the customer for X's benefit. The customer is informed that payments are to be made to Y and is furnished a payment book by Y.
Under the terms of the loan agreement between X and Y installment payments received from the customer are applied by Y to the payment of X's note. However, if the customer's payments are not made to Y on a basis permitting their timely application to X's obligation, X is required to make the payments on its own note to Y in accordance with the terms of the loan agreement. If X should fail to make a payment under such circumstances, it is considered in default and Y may demand payment of the total amount remaining due from X under the agreement.
The ruling refers to a transaction whereby the dealer assigned the obligation to the finance company on practically a ‘dollar for dollar’ basis. The dealer's payments to the finance company are scheduled at identical intervals with the customer's obligation under the note. The finance company took over the collection of the obligation. The payment book and other indicia of indebtedness were issued in the name of the finance company, and the customer made payments directly to the finance company.
On the other hand, the petitioner did not borrow up to the face amount of the installment obligations. The loan agreement provided for a ‘reserve.’ As a matter of practice, the petitioner did not even borrow up to the maximum amount allowable. The petitioner's customers were not aware of any assignment. The petitioner collected the funds in the first instance and paid over those collections to the bank. There was no distinction insofar as the petitioner's customers were concerned between the accounts pledged with the bank and those accounts not subject to the loan agreement.
For reasons stated, and on the authority of Town & Country Food Co., supra, it is our opinion that the petitioner did not dispose of its installment obligations within the meaning of section 453(d)(1). Accordingly, the petitioner is entitled to use the installment basis in reporting the gain on the sales represented by such obligations.
Issue 3. Loss Ratio
Our decision that the petitioner did not dispose of the installment obligations within the meaning of section 453(d)(1) makes it necessary to recompute petitioner's reserve for bad debts for its taxable years ended November 30, 1965 and 1966, using as a basis the unrecovered cost of the goods sold rather than the face amount of the installment notes subject to the loan agreement with the bank. See Estate of Maurice S. Saltstein, 46 B.T.A. 774 (1942); Wilbur Glenn Voliva, 10 B.T.A. 911 (1928), affd. 36 F.2d 212 (C.A. 7, 1929); see also Investors Discount Corp., 48 T.C. 767, 771 fn. 6 (1967); I.T. 3957, 1949-1 C.B. 65.
Petitioner's loss ratios for its taxable years ended November 30, 1964, 1965, and 1966, have been determined as 7.010 percent, 7.034 percent, and 7.275 percent, respectively. The petitioner's reserve for bad debts for its taxable years ended November 30, 1964, 1965, and 1966, are to be recomputed using those loss ratios.
Decision will be entered under Rule 50.