Lutz
v.
Comm'r of Internal Revenue

Tax Court of the United States.Dec 20, 1957
29 T.C. 469 (U.S.T.C. 1957)

Docket No. 56663.

1957-12-20

O. P. LUTZ, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Marcus T. Hickman, Esq., for the petitioner. Hubert E. Kelly, Esq., for the respondent.


Marcus T. Hickman, Esq., for the petitioner. Hubert E. Kelly, Esq., for the respondent.

1. In 1934, 1935, and 1936, petitioner, a furniture and appliance retailer who did approximately 95 per cent of his business on a credit basis, went through his individual accounts receivable ledger and selected certain doubtful accounts to be charged off as worthless debts. He set up a bad debt reserve account, to which he added the total amount of such alleged chargeoffs. He claimed a like amount for worthless debts on his income tax returns for each of those years. In the years following 1936, he claimed no further deductions on his returns for worthless debts or for additions to a reserve for worthless debts. From 1935 to 1945, inclusive, he received substantial recoveries on many of the accounts used in arriving at the bad debt deductions claimed in 1934, 1935, and 1936, but did not report as income any of the amounts so recovered. In 194l, certain other of the accounts used in arriving at those deductions were charged off against the reserve since all efforts to collect them were abandoned in that year. In 1943 and 1945, the bad debt reserve account was considered excessive and was reduced. The respondent determined that the amounts of the reduction constituted taxable income to the petitioner in those years. Held, petitioner was on the reserve method of accounting for bad debts, and reductions of his bad debt reserve account, because it was excessive in 1943 and 1945, constituted taxable income to him in those years.

2. Held, petitioner failed to show that he permanently abandoned a building in 1943, or that its salvage value on December 31 of that year was less than its adjusted basis, and the respondent properly denied a claimed abandonment loss.

This proceeding involves the following deficiencies in income tax:

+------------------+ ¦Year ¦Amount ¦ +------+-----------¦ ¦1943 ¦$11,189.65 ¦ +------+-----------¦ ¦1945 ¦11,483.32 ¦ +------------------+

The issues are: (1) Whether the amounts of $21,684.36 and $12,181.98 by which petitioner reduced an account designated ‘Reserve for Uncollected Accounts Receivable’ in 1943 and 1945, respectively, because such reserve account was determined to be excessive, constituted income to him in those years; and (2) whether petitioner sustained a $4,140 abandonment loss in 1943.

The petitioner claims a refund of income and Victory taxes paid in 1943.

Some of the facts were stipulated.

FINDINGS OF FACT

The stipulated facts are so found and are incorporated herein by this reference.

During the years in issue petitioner was a resident of Lenoir, North Carolina. He filed his individual income tax returns for such years with the former collector of internal revenue for the district of North Carolina.

From sometime in 1932 until August 7, 1'46, petitioner owned and operated a retail furniture and appliance store in Lenoir. He maintained his books and records and filed his income tax returns on an accrual basis. On August 7, 1946, the petitioner incorporated his sole proprietorship and transferred its assets and liabilities to the corporation in exchange for its capital stock.

Approximately 95 per cent of petitioner's business during the 1930's was on a credit basis. At the end of the calendar year 1934, he had approximately 2,200 accounts receivable outstanding; at the end of 1935, there were about 3,000 accounts outstanding; and at the end of 1936, there were in excess of 3,000 such accounts outstanding. The average amount of an account receivable was between $20 and $30. The average weekly payment which petitioner required on such accounts was between $1 and $2.

During the entire period in which petitioner operated his store as a sole proprietorship, he maintained on his books an accounts receivable control account which reflected the total of the individual accounts receivable outstanding. In addition, he kept a subsidiary accounts receivable ledger which consisted of individual cards or ledger sheets for each customer.

Petitioner filed delinquent income tax returns for the years 1932 and 1933 on which he did not take deductions for bad debts ascertained to be worthless and charged off or for any additions to a reserve for bad debts.

The same accountant prepared petitioner's returns from the time he began business until 1945. Toward the end of 1934, petitioner consulted the accountant with respect to claiming deductions for debts which became worthless and the accountant advised him that the better method was for petitioner to use the direct chargeoff system.

In collecting the information for the accountant's use with respect to the preparation of his 1934 income tax return, petitioner prepared a list of accounts which he proposed to charge off as worthless on his return for that year. In making the list he went through the cards which were kept in the subsidiary accounts receivable ledger. The accounts selected for chargeoff totaled $15,31/.94. Petitioner made no notation or memorandum on the various subsidiary accounts showing why he considered them to be worthless. They were not segregated from the file of regular outstanding accounts. On the return which petitioner filed for 1934, he claimed a deduction for bad debts in the amount of $15,310.94.

In the general journal which petitioner maintained, the deduction for bad debts was represented by a closing journal entry which the accountant made on December 31, 1934, which debited profit and loss in the amount of the deduction and credited accounts receivable in the same amount with the explanation that such entries were ‘To charge off bad accounts at December 31, 1934.’

In collecting the information for the accountant's use in the preparation of his 1935 return, the petitioner prepared a new list of accounts which he proposed to charge off as worthless. He compiled the list by going through the individual cards in the subsidiary ledger, as he had done the previous year. In preparing the list of accounts which he proposed to charge off, petitioner did not have available any list, record, or other memorandum showing the accounts charged off on his 1934 return. The new list totaled $38,616.47. When the accountant examined it, he discovered that it contained the accounts previously charged off on the 1934 return as well as additional accounts. The accountant, therefore, deducted the accounts previously charged off and made other minor adjustments and arrived at the sum of $21,664.08, as representing the total amount of accounts which petitioner proposed to charge off as worthless in 1935. Petitioner again did not remove the individual ledger cards or make any notes or memorandum thereon indicating that they had been charged off. The amount of $21,664.08 was deducted by petitioner on his return as representing bad debts sustained in 1935.

In preparing the 1935 return, the accountant discovered that there had been no physical chargeoff or segregation of individual cards charged off the previous year. Therefore, the accountant made a reversing journal entry on petitioner's books dated December 31, 1935, which debited accounts receivable in the amount of $15,310.94 and credited a reserve for uncollected accounts receivable in the same amount. The entry was explained: ‘To set up Reserve for Bad Accounts Charged Off December 31, 1934.’ The accountant also made a closing journal entry on December 31, 1935, which debited profit and loss in the amount of $21,664.08 and credited the reserve for uncollected accounts receivable by a like amount (plus minor additional amounts not here material) to reflect the deduction for bad debts claimed on petitioner's return for that year.

In collecting the information for the preparation of his 1936 return, petitioner again went through his subsidiary accounts receivable ledger and selected those accounts which he proposed to charge off as worthless. The total of such accounts again included duplications of accounts charged off in earlier years. After correcting the list, the accountant determined that the amount of the deduction was $26,878.93, and such sum was claimed by petitioner on his return for 1936. The accountant made a closing journal entry on December 31, 1936, which charged profit and loss for bad accounts in the amount of $26,878.93 and credited the reserve for uncollected accounts receivable in a like amount, with the explanation ‘To charge off Bad Accounts for Period.’ Petitioner again did not make any notation or memorandum on the individual subsidiary accounts or segregate them in any way to indicate that they had been charged off.

On the returns which petitioner filed for the years 1937 to 1942, inclusive, he took no deductions for bad debts charged off or for additions to a reserve for bad debts.

From 1935 to 1944, inclusive, petitioner recovered the following amounts from the accounts which he had used in arriving at the bad debt deductions claimed on his returns for 1934, 1935, and 1936:

+-----------------+ ¦Year ¦Amount ¦ +------+----------¦ ¦1935 ¦$3,550.32 ¦ +------+----------¦ ¦1936 ¦14,650.43 ¦ +------+----------¦ ¦1937 ¦18,422.40 ¦ +------+----------¦ ¦1938 ¦7,342.96 ¦ +------+----------¦ ¦1939 ¦4,450.71 ¦ +------+----------¦ ¦1940 ¦1,848.83 ¦ +------+----------¦ ¦1941 ¦2,258.57 ¦ +------+----------¦ ¦1942 ¦533.83 ¦ +------+----------¦ ¦1943 ¦203.26 ¦ +------+----------¦ ¦1944 ¦122.33 ¦ +-----------------+ Petitioner never included or reported as income any of the amounts recovered.

Set forth below are the outstanding balances, as reflected by petitioner's books, in his accounts receivable control account and his reserve for uncollected accounts receivable, from 1935 to 1945, inclusive:

+----------------------------------+ ¦ ¦Accounts ¦Reserve for¦ +-----------+----------+-----------¦ ¦Year ended ¦receivable¦uncollected¦ +-----------+----------+-----------¦ ¦December 31¦control ¦accounts ¦ +-----------+----------+-----------¦ ¦ ¦ ¦receivable ¦ +-----------+----------+-----------¦ ¦1935 ¦$96,466.77¦$40,850.28 ¦ +-----------+----------+-----------¦ ¦1936 ¦131,868.95¦67,729.21 ¦ +-----------+----------+-----------¦ ¦1937 ¦138,897.08¦67,729.21 ¦ +-----------+----------+-----------¦ ¦1938 ¦115,791.21¦67,729.21 ¦ +-----------+----------+-----------¦ ¦1939 ¦89,485.17 ¦67,729.21 ¦ +-----------+----------+-----------¦ ¦1940 ¦108,048.73¦67,729.21 ¦ +-----------+----------+-----------¦ ¦1941 ¦107,190.54¦56,501.44 ¦ +-----------+----------+-----------¦ ¦1942 ¦60,762.45 ¦56,501.44 ¦ +-----------+----------+-----------¦ ¦1943 ¦34,817.08 ¦34,817.08 ¦ +-----------+----------+-----------¦ ¦1944 ¦29,773.40 ¦29,773.40 ¦ +-----------+----------+-----------¦ ¦1945 ¦23,726.03 ¦12,267.21 ¦ +----------------------------------+

Petitioner's returns for 1935, 1936, and 1937 were examined by internal revenue agents who made minor adjustments in the reserve for uncollected accounts receivable.

The accountant made an entry in petitioner's general journal on December 31, 1941, which charged the reserve for uncollected accounts receivable in the amount of $11,227.77 and credited accounts receivable by a like amount with the explanation ‘To charge off bad accounts.’ Such entry was made to finally write off various accounts totaling such amount which had become uncollectible at the end of 1941. Such accounts were among those which had been used in arriving at the amount of the deductions for bad debts which petitioner had claimed in his 1934, 1935, and 1936 return.

The accountant made a closing journal entry in petitioner's general journal on December 31, 1943, which debited the reserve for uncollected accounts receivable in the amount of $21,684.36 and credited profit and loss in a like amount. The entry was explained: ‘To reduce reserve to cover the full amount of Uncollected Accounts Receivable.’ The accountant included such sum in petitioner's income for that year, but petitioner refused to sign and file the return because he claimed that such sum did not represent taxable income. Petitioner filed a tentative return on March 15, 1944, which simply showed a net profit from his business of $35,000. He did not complete any of the schedules provided on the return nor attach any supplemental schedules to show how he had arrived at such net profit figure.

Toward the end of 1945, petitioner changed accountants. The new accountant prepared amended returns for the year 1943. In doing so, he decided that the reserve for uncollected accounts receivable should not exceed 43.037 per cent of the total accounts receivable outstanding. Of the amount of $21,684.36 by which the old accountant had originally reduced the reserve account, the new accountant decided that $11,166.11 represented income and that the remainder did not, and he accordingly credited such sum to the net worth account. The petitioner filed an amended 1943 return including the amount of $11,166.11 as income, but now claims a refund of the amount of tax paid on such sum.

The new accountant prepared petitioner's 1945 income tax return. Again, any amount in the account designated reserve for uncollected accounts receivable in excess of 43.037 per cent of the total accounts receivable was considered to be excessive. The new accountant thereupon made a closing journal entry on December 31, 1945, which reduced the reserve account and increased net worth in the amount of $12,181.98. The following explanation was noted: ‘To adjust Accounts Receivable to agree with list, and Reserve to equal 43.037% of Receivables at December 31, 1945.’

The respondent determined that the amounts of $21,684.36 and $12,181.98 by which petitioner's reserve for uncollected accounts receivable had been reduced in 1943 and 1945, respectively, by corresponding credits to profit and loss and net worth, constituted taxable income in those years.

Petitioner used the reserve method in accounting for bad debts sustained in his furniture and appliance business during the years in issue.

Sometime in 1938, petitioner purchased a textile mill building in the town of Mortimer, North Carolina. He intended to and did use the mill to manufacture full-fashioned hosiery. The adjusted basis of the building on December 31, 1943, was $4,140.

The town of Mortimer was a relatively isolated community in the mountains of North Carolina. It had no railroad connections and only a stone road let into it. It was located about 25 to 30 miles from the town of Lenoir.

In July 1940, the area in and around Mortimer was inundated by a flash flood. At that time petitioner was using the building as a hosiery mill. During the flood, water stood 7 feet deep in the building. The floors were raised and a substantial deposit of mud was left throughout the structure. The petitioner did not thereafter use the building as a hosiery mill. He packed the machinery in oil and stored it in the building. He contemplated tearing the building down and using the materials for other purposes, but abandoned the idea because of the cost involved. The building was sold on October 25, 1946, for $5,933.02. The petitioner was not compensated by insurance or otherwise for any loss to the building sustained as a result of the flood.

Petitioner claimed an abandonment loss of the building on his return for 1943 in the amount of $4,500, which he now concedes should have been in the amount of $4,140. The respondent denied the deduction.

OPINION

RICE, Judge:

The issue in this case with respect to the reductions made in 1943 and 1945 in petitioner's account designated reserve for uncollected accounts receivable is whether he used the reserve method or the direct chargeoff method in claiming deductions for worthless debts. =the respondent determined that petitioner was on the reserve method; petitioner argues that he was on the direct chargeoff method.

From the time petitioner began business in 1932, and throughout all of the years here material, the Code and previous revenue acts have permitted taxpayers to claim deductions in computing their income for accounts that become worthless. Two systems or methods are permitted in determining the amount of such deductions. One system is the direct chargeoff method which, in 1934, 1935, and 1936, required a taxpayer to ascertain which of his accounts receivable were, in fact, worthless, and, specifically, to charge them off during the year when they became so. Under the reserve system of claiming deductions for worthless accounts, a taxpayer is permitted to estimate what percentage of his total accounts receivable would become worthless; to set up a reserve to cover such accounts; and to deduct each year the net addition to the reserve which is necessary in order to maintain it at an adequate level to cover those accounts which he expects to become worthless. Under the reserve system, a taxpayer may not be entitled to claim a bad debt deduction every year because of the fact that the amount of his reserve, as it stands at the end of the year, may be adequate to cover all outstanding accounts which reasonably could be expected to become worthless in the light of his recovery experience. Platt Trailer Co., 23 T.C. 1065 (1955); Krim-Ko Corporation. 16 T.C. 31 (1951); Geyer, Cornell & Newell, Inc., 6 T.C. 96 (1946). When using the reserve method, a taxpayer does not make any chargeoffs of specific accounts receivable until such time as he finally determines an account to be worthless. At that time the account is removed from the subsidiary accounts receivable ledger and the amount thereof charged against the reserve, reducing it by that amount.

Under the direct chargeoff method, a taxpayer is required to include in income any recovery of a previously charged off bad debt in the year in which the recovery is received. Under the reserve system, collections on accounts receivable are also required to be included in income, but only if the specific account on which collection is received is one which has been removed from the subsidiary accounts receivable ledger and charged off against the reserve.

With this general description of the two methods of accounting for bad debts in mind, we turn to the facts of the record before us. Petitioner claims he was using the direct chargeoff method for his worthless debts. In support of that argument, he cites the fact that at the end of each of the years 1934, 1935, and 1936, he went through his entire subsidiary accounts receivable ledger and selected the accounts which he proposed to charge off as worthless, and that he did, in fact, charge off as worthless debts the total amount of such selected accounts during those 3 years. He argues that the account designated reserve for uncollected accounts receivable was only the control or inventory account which he maintained for the purpose of showing the amount of worthless debts which he had incurred.

The respondent, on the other hand, argues that the facts of this record demonstrate conclusively that petitioner used the reserve method of accounting for bad debts. We agree with the respondent that while the petitioner's system may have been somewhat irregular, it was essentially the reserve system of claiming bad debt deductions.

To determine the amount of an adequate reserve for bad debts, taxpayers generally use a percentage of sales or accounts receivable. The petitioner here did not use any such percentage figure, and argues that because he did not do so, but, instead, selected individual accounts for his alleged chargeoffs, it proves that he was on the direct chargeoff method. The respondent argues, first of all, that the petitioner has not shown that he really considered the accounts which he used in determining his bad debt deductions in 1934, 1935, and 1936 to be actually worthless. We agree with the respondent that petitioner has not made that showing. The best that can be said is that he considered them doubtful or slow collections. No notation or memorandum was made on the individual accounts allegedly charged off; the individual cards were not segregated in any way from the current subsidiary accounts receivable ledger; and the list of alleged worthless accounts which petitioner prepared for his accountant contained substantial duplications of accounts which had already been charged off the previous year.

Since petitioner did not show the accounts were truly worthless, it would seem that he was actually establishing a reserve for bad debts rather than using a direct chargeoff method, and that he established such reserve by referring to the actual ‘doubtful’ accounts, as distinguished from the really worthless ones, instead of trying to estimate what percentage of his accounts receivable would eventually become worthless. While the use of specific accounts receivable ordinarily indicates the adoption of the direct chargeoff method and therefore may have been a somewhat unusual method for determining the amount to be established as a reserve for bad debts, and the annual additions necessary to keep it at a proper level, we do not find that petitioner's use of such a system here was improper or incompatible with the basic requirements of the reserve method. See Platt Trailer Co., supra.

Aside from the somewhat unusual method of selecting the amounts which were added to the bad debt reserve in each of the years 1934, 1935, and 1936, which amounts were in turn claimed as bad debt deductions on the returns for such years, the petitioner's whole system of accounting for bad debts convinces us beyond doubt that he was using the reserve method. For instance, in 1941 his accountant decided that certain accounts receivable, totaling approximately $11,000, became truly worthless in that year since all efforts to collect them had been abandoned, and he quite correctly made a charge against the reserve account and reduced it by that amount to finally write them off the books. In 1943, and again in 1945, the accountant decided that petitioner's reserve for uncollected accounts receivable was excessive, and when petitioner's old accountant, in 1943, first reduced the reserve, he properly included the amount of the reduction in income for that year despite the petitioner's protest. Clearly, in the year when such a reserve account is found to be excessive, it must be reduced by an appropriate amount, and the amount of the reduction must be taken into income. That is so because additions to such a reserve were originally permitted as deductions against income. Wichita Coca Cola Bottling Co. v. United States, 152 F.2d 6 (C.A. 5, 1945), ‘certiorari denied 327 U.S. 806 (1946); Morris Plan Ind. Bank v. Commissioner, 151 F.2d 976 (C.A. 2, 1945), affirming a Memorandum Opinion of this Court dated October 5, 1944; Boston Consol. Gas Co. v. Commissioner, 128 F.2d 473 (C.A. 1, 1942), affirming on this point 44 B.T.A. 793 (1941); Fort Pitt Brewing Co., 20 T.C. 1 (1953), affd. 210 F.2d 6 (C.A. 3, 1954), certiorari denied 347 U.S. 989 (1954); Geyer, Cornell & Newell, Inc., supra; Creamette Co., 37 B.T.A. 216 (1938). See also Maryland Casualty Co. v. United States, 251 U.S. 342 (1920).

Despite the old accountant's testimony that it was petitioner's intent, and his also, to claim bad debt deductions in 1934, 1935, and 1936 under the direct chargeoff system, the accountant admitted at the hearing that he considered the amount of the reduction of the reserve in 1943 to be income at that time, and that he still believed it was. If he thought that, he must have known the reserve account was a true reserve account and not just an inventory or control account.

Petitioner relies on such cases as Dillon Supply Co., 20 B.T.A. 404 (1930); and O. S. Stapley Co., Inc. 13 ,.T.A. 557 (1928), for the proposition that the maintenance of a reserve account does not necessarily show that a taxpayer is on the reserve system in claiming bad debt deductions. Those cases are clearly distinguishable from the facts here. There, the Court found that the taxpayers ascertained that the bad debts which they claimed were, in fact, worthless, and that they were properly charged off. The Court also found that the taxpayers in those cases were consistent in the handling of their bad debts in that any recoveries of debts previously charged off were included in income in the year in which such recoveries were received. Consistency here would have required petitioner to have taken the recoveries on the accounts which he claims to have charged off as worthless into income in the year in which received, if he were on the direct chargeoff system as he claims. He did not do that and under the reserve system he need not have done so unless some of the small recoveries received after 1941 represented recoveries on those specific accounts which were charged off against the reserve in that year. No showing was made that such was the case and, consequently, we can only conclude that by not including recoveries in income, petitioner was consistently following the reserve method of accounting for his bad debts.

The petitioner advanced another argument to the effect t at he commenced using the direct chargeoff method in 1934, and even if his subsequent treatment of bad debts was essentially a reserve system, he made the change without the Commissioner's consent, contrary to the regulations, and that he must therefore be held to his original choice of the direct chargeoff method. We think that a specious argument. It is tantamount to saying that the petitioner should profit from his own inconsistencies. Suffice it to say that we are satisfied that in 1943 and 1945 the account designated reserve for uncollected accounts receivable was, in fact, a true bad debt reserve account within the meaning of the statute, and that the amounts of the reduction in that account, because it was considered excessive in those years, were taxable income.

So, also, we find no merit in petitioner's argument that if he were on the reserve system he should have reduced his bad debt reserve prior to 1943, and that because he failed to do so, he may not now be forced to include the reductions in income in years now open when, in fact, the reductions should have been made and the amounts thereof taken into income in earlier years now barred by the statute of limitation citing Geyer, Cornell Newell, Inc., supra. The simple answer to that argument is that petitioner did not show that the reserve was excessive in some earlier year. He evidently thought not, because he made the reductions in the years before us. All the respondent demands here is that such reductions, whenever made, be included in income.

We conclude that the respondent properly determined that the reductions of the reserve for uncollected accounts receivable in 1943 and 1945 in the respective amounts of $21,684.36 and $12,181.98 constituted taxable income to the petitioner in those years. Wichita Coca Cola Bottling Co. v. United States, supra; Morris Plan Ind. Bank v. Commissioner, supra; ,boston ‘consol. Gas Co. v. Commissioner, supra.

We think petitioner failed to show that he sustained a loss in 1943 from the abandonment of a building which he formerly used as a hosiery mill. We are not convinced from his testimony that he permanently abandoned the building in that year. Mere nonuse of property is not sufficient to constitute an abandonment. Citizens Bank of Weston, 28 T.C. 717 (1957), on appeal (C.A. 4, Sept. 18, 1957). In any event, the respondent argues, and we think correctly so, that even assuming the petitioner abandoned the building, he did not show that its salvage value was less than its depreciated basis on December 31, 1943. We therefore conclude that the respondent properly disallowed the deduction claimed.

Decision will be entered for the respondent.