Dillon Supply Co. v. Commissioner

DILLON SUPPLY CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Dillon Supply Co. v. Commissioner Docket No. 26913. United States Board of Tax Appeals 20 B.T.A. 404; 1930 BTA LEXIS 2131; July 30, 1930, Promulgated *2131 Method of handling accounts ascertained to be worthless held sufficient to effect substantial compliance with statute with respect to charging off bad debts. A. L. Cox, Esq., and B. W. Biggs, C.P.A., for the petitioner. J. L. Backstrom, Esq., for the respondent. MATTHEWS *404 This proceeding involves deficiencies in income tax for the calendar years 1922 and 1923 which the Commissioner has determined in the respective amounts of $2,030.27 and $2,811.73. The errors assigned in the petition relate to deductions claimed for depreciation and bad debts disallowed by the Commissioner, but at the hearing the error with respect to depreciation was abandoned by the petitioner. The Commissioner, in his answer, admitted that the deficiency for 1923 should be reduced to $2,341.17 on account of collections in 1923 of debts which were claimed, but not allowed, as deductions in 1922. FINDINGS OF FACT. The petitioner is engaged in the business of selling mill supplies and machinery at wholesale and retail, in Raleigh, N.C. It was organized March 1, 1914, by C. A. Dillon, who conducted it as an individual business for several years, and then*2132 took in his brother and brother-in-law as partners. In 1919 the business was incorporated under the same name. In its income-tax returns for 1922 and 1923 the petitioner claimed deductions from gross income for bad debts in the amounts of $16,083.04 and $21,685.63, respectively. The amount claimed as a *405 deduction for 1922 includes an amount of $832.54 representing bad debts actually charged off the books against profit and loss by reduction of the specific accounts receivable. The balance of the deduction for 1922, $15,250.50, represents the sum of 123 specific accounts receivable, which C. A. Dillon, president and manager of the petitioner, determined to be worthless at December 31, 1922. Each of the 123 specific accounts receivable going to make up the above amount was marked "Reserved, December 31, 1922," with the amount standing in the account on that date. A list of the specific acconts charged off and those reserved, showing the amount in each account, was attached to the return for 1922. The amount claimed as a deduction was the total of the accounts listed. The following entries were made on petitioner's cash journal as of December 31, 1922: General Ledger Bad debts $ 15,250.50 Reserve for bad debts $ 15,250.50 Accounts reserved per attached list *2133 Pasted to the page on which these entries appear, is a slip containing the following notation: List of accounts reserved at December 31, 1922, will be found with financial statements of December 31, 1922. In the closing entries for 1922 on the cash journal, profit and loss is debited and bad debts credited with $16,083.04, the sum of the accounts receivable actually charged off and the accounts receivable reserved. The account in the general ledger to which the amount of the reserved accounts was credited, was designated "Reserve for bad debts, 1922." The amounts collected during 1923 on the accounts reserved were debited to this account and credited to a general ledger account designated "Collections on Reserve Accounts, 1922." This latter account was charged out on December 31, 1923, by a debit entry of the amounts credited during the year, namely, $3,764.46, and the "Reserve for bad debts 1922" account, was closed out by a debit entry on December 31, 1923, of the balance in the account on that date. The amounts collected during 1923 were credited to the specific accounts receivable and the balances in such accounts on December 31, 1923, were charged off by credit entries. *2134 The amounts collected in 1923 were included in 1923 income. The amount of the accounts reserved on December 31, 1922, is reflected in the accounts receivable item shown in the balance sheet on the income-tax return for 1922, but such item is offset by a liability account of the same amount under the heading "Reserve for bad debts." The specific accounts receivable marked "Reserved, December 31, 1922" were taken out of the loose-leaf accounts receivable ledger *406 and held in reserve, so that petitioner's officers would have them before them to try to collect if possible. A list of such accounts was made on large sheets with columns to show as to each account the name, amount, date of account, date and amount of last payment, amount collected in later years, and reasons for charging off. After the close of the taxable year, C. A. Dillon and his brother went over the accounts appearing on the list and, under the column headed "Reason for charging off," made notations of the reasons why the account had been determined to be worthless. These notations were put there solely for the benefit of the officers in determining what efforts to make in trying to collect the bad*2135 debts. The amount deducted for bad debts in 1923 $21,685.63, is the sum of 125 specific accounts receivable which petitioner determined to be worthless on December 31, 1923, and which were marked "Reserved December 31, 1923," with the amount standing in the accounts on that date. These accounts were also taken out of the accounts receivable ledger and held in reserve and were treated in all respects in a similar manner to the accounts reserved, December 31, 1922, except that the final charge-off was not made on such accounts until April 25, 1925, when the balance standing in each account on that date was actually charged off. The accounts going to make up the accounts reserved as of December 31, 1923, are reflected in the accounts receivable item in the balance sheet as shown on the return for 1923, but such item is offset by a liability account of the same amount under the heading "Reserve for bad debts." Of the accounts reserved as of December 31, 1923, $4,283.87 was collected in 1924. The determination of the worthlessness of debts due petitioner was made by C. A. Dillon, president and executive head of the company. At the close of each year he personally went over the*2136 accounts receivable ledger and, on the basis of his personal knowledge of the financial condition of the debtors and of the unsuccessful efforts of petitioner to collect, as shown by its records, determined which accounts were worthless. It was his purpose to eliminate from the books all accounts known to be worthless. The usual practice was to charge off bad debts at the close of the year and only in exceptional cases were bad debts charged off during the year. There were 123 accounts ascertained to be worthless as of December 31, 1922, and 125 as of December 31, 1923, in all of which accounts every possible effort to collect by means of personal calls and writing letters had been made. In some instances, the accounts had been in the hands of attorneys for collection, without results. In others, the accounts had been reduced to judgment, but petitioner had been unable to realize on the judgment. In a number of cases, the *407 debtors were bankrupt, in receivership, insolvent, or had no assets. In others, the accounts were disputed or questioned, and in a number of cases the petitioner had been unable to locate the debtor. In two cases, the debtors were in the penitentiary. *2137 Petitioner in 1921 deducted bad debts ascertained to be worthless and charged off during that year, the amount of such bad debts being charged to profit and loss and credited to the specific accounts receivable. These accounts were taken out of the accounts receivable ledger and filed away, but lists of such accounts similar to the lists prepared for 1922 and 1923 were made which petitioner used in trying to collect on such accounts. The petitioner never requested permission to change the basis of reporting bad debts and considered that the method followed in 1922 and 1923 was as effective a charge-off as that followed in 1921. The respondent in his determination disallowed the amounts of $15,250.50 and $21,685.63 as being reserves for bad debts set up for 1922 and 1923, respectively, for the reason that the petitioner, for the year 1921, had elected to report bad debts on the actual bad debt basis and the change in the method of reporting was not made in accordance with article 151 of Regulations 62. Respondent allowed a deduction for bad debts in 1922 in the amount of $832.54, the amount of the specific accounts receivable actually charged off in that year, and reduced*2138 income of 1923 by $3,764.46, the amount collected in 1923 on bad debts claimed as a deduction in 1922 but not allowed. OPINION. MATTHEWS: The issue raised by this proceeding is whether the amounts claimed by petitioner as deductions for bad debts in 1922 and 1923, and disallowed by the respondent, represent bad debts ascertained to be worthless and actually charged off by the petitioner, or whether the amounts disallowed represent amounts set up as a reserve for bad debts. The petitioner in 1921 had elected to claim as a deduction for bad debts, the bad debts actually charged off. It had no intention of changing the method of reporting as bad debt deductions the debts ascertained to be worthless and charged off. It made no request to change to a reserve method of claiming bad debt deductions, as is required by the regulations of the Treasury Department, and we are satisfied that petitioner, in closing its books for 1922, intended merely to change the method of charging off the debts ascertained to be worthless. The Board has had occasion to consider what the ascertainment of worthlessness means. In *2139 , we *408 said: "The ascertainment of worthlessness is the exercise of sound business judgment, based upon as complete information as is practicably obtainable." In , we further said: "Such an ascertainment must be viewed in the light of surrounding facts and circumstances, which must be such as to cause a reasonably prudent business man to conclude that the debt is worthless to the extent so ascertained. A remote hope of ultimate salvage is not sufficient to deny a deduction." See also . In , we said: * * * The words "debts ascertained to be worthless," used in the statute, must be given a reasonable interpretation. The possibility that a small part of the debt may ultimately be recovered will not prohibit the writing off of the debt as worthless for income-tax purposes when every consideration of good business directs that it be charged off. As we have said in the *2140 : "In adjusting their accounts and debts business men are called upon to use sound business judgment and prudence and are justified in eliminating from their assets such accounts and debts as are past due and which they are satisfied that they can not realize upon within some reasonably determinable period. They do not have to await uncertain and future events, nor are they called upon to wait until some turn of the wheel of fortune may bring their debtors into affluence, to enable the receivers of a bankrupt institution to eke out a liquidating divident." * * * The Courts have also had occasion to consider the meaning of the words "debts ascertained to be worthless." In , the defendant was indicted for false return of income. The Act involved in that case permitted a deduction of "debts ascertained to be worthless" and the court said on this point: "The language is, 'ascertained to be worthless.' By whom or how? The law is silent on this important point, and, therefore, there must be a discretion given to the person making his returns and, if that discretion*2141 is used fairly and honestly, there would seem to be no just ground of complaint." This case was cited with approval in , in which the meaning of the words "debts ascertained to be worthless and charged off within the taxable year," as used in the Revenue Act of 1918 was considered. The court said on this point: * * * The statute prescribes no method by which such fact shall be ascertained, and we must not become wiser than the statute, and attempt to substitute some method of ascertainment not prescribed, and therefore presumably not contemplated by Congress. The statute contemplates a situation with *409 which the taxpayer is confronted, and certainly he is made, in the first instance, judge of the worthless character of the debt. When he, in good faith, believes that the legal situation of the debt is such, considering all the surrounding and attendant circumstances, that the debt is not in fact recoverable, and that legal action to enforce payment would in all probability not result in obtaining any substantial part of the debt, although there might be a remote possibility that a small part thereof might ultimately*2142 be recovered, in this situation, he is justified in treating the debt as worthless and charging the same off on his books. He is certainly not required to do a vain thing, to institute some expensive proceeding to legally ascertain what he already knows. * * * C. A. Dillon was the one in authority authorized to determine what accounts of petitioner were worthless. His action in determining that certain specific accounts receivable were worthless was the exercise of sound business judgment and prudence. An analysis of the accounts receivable which were submitted in evidence, and the reasons for charging off each account, together with testimony of Dillon, convince us that at the time he examined the accounts receivable ledger at the close of each year he was justified in considering the accounts in question worthless. We conclude that the debts had been ascertained to be worthless within the degree of certainty required by the statute. The statute does not prescribe any particular method of charging off bad debts. The method followed by petitioner in handling the accounts determined to be worthless as of December 31, 1922, and December 31, 1923, is substantially the same*2143 as that which was before this Board in , and in . In both cases we held that there was a substantial compliance with the statute with respect to charging off the accounts in question. See also , , and . In view of the facts in this case, and on the authority of the above decisions, we hold that the method followed by the petitioner constitutes a substantial compliance with the requirements of the statute respecting the charge-off of debts ascertained to be worthless, and that it is entitled to a deduction for bad debts for 1922 in the amount of $15,250.50 in addition to what the respondent has allowed, and for 1923 in the amount of $21,685.63. The amount collected in 1923 on the accounts charged off in 1922 and deducted by the respondent, will be restored to income for 1923. Judgment will be entered under Rule 50.