Docket No. 11093.
Rollin P. Rodolph, C.P.A., for the petitioner. Leonard A. Marcussen, Esq., for the respondent.
A taxpayer which in 1942 and 1943 computed its excess profits credit by the income method discontinued a contracting branch of its business in 1929, selling such branch to X. X purchased from it materials and used equipment aggregating in price $27,000, charged to an open account on the taxpayer's books, and over the succeeding eight years purchased very large quantities of materials, which were also charged to open accounts. Payments aggregating $281,000 were credited to the accounts. In 1937 the taxpayer charged off and deducted as a bad debt a debit balance of $12,000 in the remaining account of X, whose purchases were less in 1937 than in 1936. The taxpayer's total bad debt deductions for 1937 were abnormal in amount. Held:
(1) Such abnormality was not a consequence of an increase in the taxpayer's gross income for 1937, but a result of the worthlessness of the account of X, whose purchases diminished in 1937.
(2) Such abnormality was not a consequence of the taxpayer's change in business in 1929, but of an overextension of credit to a customer. Sec. 711(b)(1)(K)(ii), Internal Revenue Code, construed. Rollin P. Rodolph, C.P.A., for the petitioner. Leonard A. Marcussen, Esq., for the respondent.
The Commissioner determined deficiencies of $2,612.90 and $3,792.55 in petitioner's excess profits tax for 1942 and 1943, respectively, by disallowing the restoration to income for the base period year 1937 of the abnormal amount of the petitioner's bad debt deductions, on the ground that the petitioner had failed to establish that the abnormality was not a consequence of an increase in gross income or a change in business, as required by section 711(b)(1)(K)(ii), Internal Revenue Code. Petitioner contends that the abnormality was not a consequence of either.
FINDINGS OF FACT.
Petitioner, an Oregon corporation, with principal office at Klamath Falls, Oregon, filed its income tax returns for 1942 and 1943 with the collector of internal revenue for the district of Oregon. It was organized in May 1923, and thereafter engaged in the business of selling at wholesale hardware, plumbing and heating materials, electrical supplies, and like goods and also in the plumbing and heating contracting business. Its principal shareholder and president was G. C. Lorenz, and some of its stock was also owned by his brother, W. M. Lorenz (hereinafter called Lorenz), who acquired it in exchange for certain real estate. Lorenz was employed by petitioner to make estimates on construction jobs and to supervise work.
In the spring of 1929 petitioner sold its plumbing and heating contracting business to Lorenz, but continued in all other respects to engage in the same business as before. In acquiring the contracting business, Lorenz took over and completed a few contracts unfinished by petitioner, receiving compensation for this work. He operated his business from petitioner's premises, petitioner moving elsewhere. The materials and equipment which petitioner had on hand for use in the contracting business were divided, Lorenz picking out items as needed by him over a period of several months. In this way he acquired merchandise, stocks and dies, tools, electrical equipment, line belts, beading machines, pipe-threading machines, stove pipe crimpers, fire pots, melting pots, chain wrenches, two trucks, and a small amount of office equipment. For these items he was charged the regular price asked of customers in general, invoices covering them were prepared, and the amounts due were charged in detail to his open general account with petitioner. On May 15, 1929, this account showed a debit balance of $27,478.28, and on that date it was credited with $7,400, explained as ‘J-19 Certificates #2-14, Lorenz Stock returned.‘ Petitioner's books contain no indication that Lorenz paid anything for such items as business or good will.
After May 15, 1929, Lorenz continued to purchase hardware and supplies from petitioner, and he was charged therefor the prices normally asked of others. Under petitioner's customary practice, payment was expected in from 30 to 90 days, and Lorenz had no understanding or agreement that more favorable credit terms would be granted to him. Between May 15 and December 31, 1929, his general account was charged with $107,363.53 for purchases and was credited with payments of $108,635.11. In 1931 Lorenz encountered financial difficulties, and on July 30, 1931, petitioner's credit manager, not anticipating full collection of the amount due from him, transferred as doubtful $18,000 of the general open account's debit balance to a newly opened special account in his name. A debit balance of about $5,500 remained in the general account.
Petitioner continued, however, to sell supplies to Lorenz and continued to receive payments from him. The total amounts of Lorenz' annual purchases and his total payments for the years 1929=1937 were as follows:
+-----------------------------+ ¦Year ¦Purchases ¦Payments ¦ +-----+-----------+-----------¦ ¦1929 ¦$107,363.53¦$108,635.11¦ +-----+-----------+-----------¦ ¦1930 ¦58,498.17 ¦50,885.51 ¦ +-----+-----------+-----------¦ ¦1931 ¦33,978.45 ¦43,826.69 ¦ +-----+-----------+-----------¦ ¦1932 ¦12,905.25 ¦23,671.60 ¦ +-----+-----------+-----------¦ ¦1933 ¦4,554.99 ¦3,664.56 ¦ +-----+-----------+-----------¦ ¦1934 ¦8,699.27 ¦9,221.36 ¦ +-----+-----------+-----------¦ ¦1935 ¦15,897.20 ¦11,521.93 ¦ +-----+-----------+-----------¦ ¦1936 ¦15,861.93 ¦16,560.82 ¦ +-----+-----------+-----------¦ ¦1937 ¦8,922.22 ¦13,797.48 ¦ +-----+-----------+-----------¦ ¦Total¦266,681.01 ¦281,785.06 ¦ +-----------------------------+
For convenience in keeping trace of liens on materials sold, petitioner in later years set up separate accounts in Lorenz' name for each of his separate contracting jobs, but the general account was maintained, and the separate ones were eventually paid off or consolidated with it. All payments received from Lorenz were credited to the general account, and if a payment exceeded the debit balance in the general account, the excess was credited to the special account. Prior to October 1933 there were also charges to the special account which aggregated about $17,000 and were not for merchandise sold, but for moneys paid by petitioner to Lorenz' creditors or advanced for Lorenz to bonding companies and others to keep him ‘from going bankrupt.‘
By the end of 1937 Lorenz general account and all the separate accounts had been closed by payment credits, but a remaining unpaid indebtedness of $12,373.19 was reflected in the debit balance of the special account. Petitioner determined this debit balance to be uncollectible, charged if off the books as of December 31, 1937, by entry of March 26, 1938, and on its income tax return for 1937 included the amount in a deduction of $19,688.84 claimed on account of bad debts. The deduction was allowed by the Commissioner. Petitioner has consistently computed its bad debt deductions on the basis of bad debts actually ascertained to be worthless, and, in addition to the debt due from Lorenz, it also included in the 1937 deduction bad debts, aggregating $7,315.65, owed by 42 others in amounts ranging from 50 cents to $994.76. All of these debts were on trade accounts created in the normal course of petitioner's business. Petitioner's average bad debt deduction for the 4 years preceding 1937 was $6,561.14, 125 percent of which is $8,201.43, or $11,487.41 less than the 1937 deduction of $19,688.84.
Petitioner's gross sales, gross profits on sales, gross income, and bad debt deductions, as shown by its books and tax returns for the years 1929-1943, were as follows:
+----+ ¦¦¦¦¦¦ +----+
Year Gross sales Gross profit Gross income Bad debts on sales deducted 1929 $639,780.83 $135,215.14 $146,077.38 $10,804.02 1930 589,104.85 115,648.69 133,025.98 11,533.07 1931 434,275.41 91,150.81 109,374.80 2,791.57 1932 237,987.13 39,397.73 57,238.07 1,226.30 1933 293,110.61 74,246.34 79,112.01 1,368.05 1934 433,839.16 103,217.17 107,854.17 11,680.40 1935 662,160.26 128,046.90 130,030.08 8,514.93 1936 877,118.16 176,423.63 186,109.63 4,681.17 1937 1,067,410.27 223,324.66 235,845.80 19,688.84 1938 872,135.68 201,037.04 212,611.25 2,901.61 1939 1,059,755.96 213,588.52 228,855.86 8,350.75 1940 1,139,868.83 237,096.06 245,586.69 4,738.73 1941 1,566,663.43 336,741.37 358,713.37 8,956.11 1942 1,409,792.39 316,803.47 335,550.82 8,557.92 1943 1,539,030.91 340,664.30 362,348.76 653.57
For 1942 and 1943 petitioner claimed and was allowed bad debt deductions of $8,577.92 and $653.57, respectively.
The abnormally large bad debt deduction for 1937 was not a consequence of an increase in petitioner's gross income in the base period or of a decrease in some other deduction, or of a change at any time in the type, manner of operation, size or condition of petitioner's business.
Petitioner kept its books and prepared its income tax, declared value excess profits tax, and excess profits tax returns for 1942 and 1943 on an accrual basis. It computed its excess profits credit by the income method, and, in arriving at the base period income, it reduced the bad debt deduction of 1937 by $11,130.92 in its computation for 1942, and by $11,487.11 in its computation for 1943. The Commissioner allowed no reduction in the 1937 bad debt deduction for 1937 in arriving at base period income, on the ground that petitioner had ‘failed to establish that any abnormality or excess in bad debt deductions for the year ended December 31, 1937, is not a consequence of an increase in your gross income in the base period, and/or is not a consequence of a change at any time in the type, manner of operation, size, or condition of the business.
Petitioner charges respondent with error in computing its base period net income to reflect a full deduction of $19,688.84 for bad debts in 1937. It contends primarily that the deduction was abnormal in amount, exceeding 125 per cent of average bad debt deductions for the preceding four years by $11,487.41, and suggests rather than argues that $12,373.19 of the deduction, representing the bad debt due from Lorenz was abnormal in class. The determination of petitioner's average base period net income requires a computation of its excess profits net income for each year of the base period, section 713(e), Internal Revenue Code. By section 711(b)(1) the excess profits net income is defined as the normal tax net income, altered by specified adjustments. Among these adjustments is the elimination of abnormal deductions, subsection (J) providing that:
(i) Deductions of any class shall not be allowed if deductions of such class were abnormal for the taxpayer, and
(ii) If the class of deductions was normal for the taxpayer, but the deductions of such class were in excess of 125 per centum of the average amount of deductions of such class for the four previous taxable years, they shall be disallowed in an amount equal to such excess.
The parties are agreed that the bad debt deduction was mathematically abnormal in amount, but respondent defends his determination first on the ground that petitioner has failed to meet the requirements of section 711(b)(1)(K), which provides in part that:
(ii) Deductions shall not be disallowed under such subparagraphs unless the taxpayer establishes that the abnormality or excess is not a consequence of an increase in the gross income of the taxpayer in its base period or a decrease in the amount of some other deduction in its base period, and is not a consequence of a change at any time in the type, manner of operation, size, or condition of the business engaged in by the taxpayer.
It is settled that a taxpayer must sustain the burden of proving that the abnormality is not a consequence of any listed condition to be entitled to the adjustment which petitioner here seeks. E. B. & A. C. Whiting Co., 10 T.C. 102; R. C. Harvey Co., 5 T.C. 431; William Leveen Corporation, 3 T.C. 593. And respondent asserts that the evidence fails to establish that the abnormal bad debts of 1937 were not a consequence of an increase in gross income or a change in the type, manner of operation, size, or condition of the business.
We are unable to agree that this is so. As for the increase in gross income, the facts show that, while gross income rose from $186,109.63 in 1936 to $235,845.80 in 1937, bad debts increased from $4,681.17 to $19,688.84 in the respective years, fell to $2,901.61 in 1938, when gross income was $212.611.25, and were $11,680.40 in 1934, when gross income was only $107,854.17. There was hence no significant relation between the volume of gross income and the aggregate of bad debts, and no inference adverse to petitioner can be properly drawn from the suggested comparison. O. Hommel Co., 8 T.C. 383. But, as this Court has had occasion to remark, the most satisfactory and conclusive proof that an abnormal deduction is not a consequence of the listed conditions is affirmative evidence that it was the consequence of something else, City Auto Stamping Co., 7 T.C. 354; William Leveen Corporation, supra. The evidence here indicates conclusively that the abnormality in the amount of bad debts deducted in 1937 resulted from the charging off of Lorenz' special account as uncollectible. If that item be eliminated, petitioner's bad debts due on other customers' accounts aggregated only $7,315.65, which is within 125 per cent of its average deduction of $6,551.14 for the four preceding years. As no part of Lorenz' very large account had ever been charged off before, its deduction obviously caused the abnormality, cf. O. Hommel Co., supra, which was not, therefore, the consequence of increased gross income, for Lorenz' purchases declined sharply in 1937. Cf. Harris Hardwood Co., 8 T.C. 874.
Implicitly assuming that the abnormality did result from deduction of Lorenz' indebtedness, respondent next argues that this indebtedness originated in Lorenz' purchase of the contracting business from petitioner in 1929, and as petitioner's sale caused a change ‘in the type, manner of operation, size, or condition of the business,‘ the eventual worthlessness of the debt and the deduction thereof were a consequence of that change, or, at least, petitioner has not met its burden of proving that they were not. Taking note that after May 15, 1929, Lorenz purchased large quantities of materials and supplies from petitioner which were charged to his general account in an aggregate amount of $266,681.01, that he made aggregate payments of $281,785.06, and that the payment excess of $15,104.05, plus the debt of $12,373.19, deducted in 1937, equals $27,477.24 or just a dollar less than the charges to May 15, 1929, respondent would have us infer that the debt deducted in 1937 originated in petitioner's sale of the contracting business, and not in Lorenz’ later debts for materials and supplies or for advances made by petitioner to forestall Lorenz' bankruptcy. He fortified this contention by urging that payments were applied to the current purchases, and hence the oldest debt, being that for sale of the business, was never paid in full, but remained to be charged off; therefore, the 1937 deduction is a consequence of that sale, which worked a change in petitioner's business.
We are unable to accept the factual premise on which this argument rests. While the parties stipulated that petitioner ‘sold‘ the contracting business in 1929, Lorenz and petitioner's accountant testified that the $27,478.24 debit balance in Lorenz’ account on May 15, 1929, was not consideration for the going business, good will, or accounts receivable disposed of, but represented simply an accumulation of numerous detailed charges for items of used equipment, such as trucks, tools, and machines, and for materials which Lorenz required in performing contracts. The account sheet, introduced in evidence, indicates that the balance was composed of numerous items, that charges aggregating $107.363.54, for materials sold to Lorenz after May 15, 1929, were entered in the account in the same manner as items previously charged, and that Lorenz' payments of $108,635.11 were credited to it during the year. Under such circumstances it is immaterial whether or not the early entries of $27,478.24 should be deemed the selling price of the business. It is settled that payments on an open account should be applied to the earliest charges in the absence of any specific action or understanding between the parties to the contrary. Delaware Dredging Co. v. Tucker Stevedoring Co. (C.C.A., 3d Cir.), 25 Fed.(2d) 44; Bacon v. Dollar S. S. Lines (E. Dist. N.Y.), 290 Fed. 964. Petitioner and Lorenz had no understanding, and hence Lorenz' payments in 1929 must be deemed to have satisfied all charges prior to May 15.
It can not be said, therefore, that any part of the only amount which respondent suggests was connected with petitioner's change in business remained unpaid in 1937, or even in 1930. The $12,373.19 written off as worthless in 1937 must represent uncollected charges for sales of materials and petitioner then had no debt consequent upon the change in business such as the accounts receivable involved in Pacific Gas & Electric Co., 7 T.C. 1142. We hold, therefore, that petitioner's abnormal bad debt deduction of 1937 was ‘not a consequence of a change at any time in the type, manner of operation, size or condition of the business‘ within the meaning of section 711(b)(1)(K)(ii), but was a consequence of petitioner's overextension of credit to a customer.
In the concluding paragraph of his brief respondent cites Regulations 112, sec. 35.711(b)-2(b), which requires a taxpayer, claiming a disallowance under section 701(b)(1)(J) of the code to submit a full statement in support of the claim. Alleging that petitioner failed to do so, he states that the Court must sustain the determination because petitioner did not comply with the regulation. This allegation is not supported by any evidence, and, as the noncompliance is not set forth in either the deficiency notice or the pleadings as a ground for the determination, we shall not consider it. Wentworth Manufacturing Co., 6 T.C. 1201, and cases therein cited.
The Commissioner's determination is reversed.
Reviewed by the Court.
Decision will be entered under Rule 50.