1944 U.S. Tax Ct. LEXIS 120 | Tax Ct. | 1944
Lead Opinion
OPINION.
Respondent has determined a deficiency in personal holding company surtax for the year 1939 of $22,918.95 and a penalty of $5,729.74.
Petitioner has, since December 31, 1925, used a reserve system for treating bad debts. Consistently, during all of that period and without question by respondent, it has used a system of accounting whereby it deducted from gross income and added to this reserve balance the amount estimated as necessary to cover debts anticipated to become worthless during the year. As debts were actually ascertained to be worthless they were eliminated from accounts receivable and charged against the balance in this reserve. In the event of subsequent collection of those debts, the amount realized was included in gross income in the year of such collection.
In the taxable year petitioner collected debts in the sum of $25,510.28 which had been charged against its reserve in prior years. In accordance with its established custom it included these collections in gross income for that year and paid tax thereon. Of its gross income as thus computed, less than 80 percent represented “personal holding company income” as defined by, section 502 (a), I. R. C. If this income was correctly computed it did not fall within the definition of a personal holding company under section 501 (a), I. R. C. It consequently filed no personal holding company return for that year.
In determining the deficiency respondent eliminated from petitioner’s gross income the above item of $25,510.28, and added this sum to the balance in its reserve for bad debts. Because of the large amount in that reserve resulting from his action, respondent then disallowed a deduction taken by petitioner on its return for that year of $10,992.86 as an addition to this reserve. The result, was to decrease gross income by $25,510.28, and the net taxable income reported by petitioner by the amount of $14,517.42. The effect of this action was to carry into income of the taxable year in which the $25,510.28 was actually received, only $10,992.86. The balance of $14,517.42 was left to be reflected in net income for succeeding years through the reduction or elimination of deductions for additions to the reserve for those years. This resulted, for the taxable year, in a computation of gross income to petitioner of which more than 80 percent was personal holding income and respondent thereupon asserted the personal holding company surtax here in question plus a delinquency penalty for failure to file a personal holding company return.
We are not oblivious of another issue possibly lurking in item 2 of paragraph 4 of the stipulation. The parties, however, have definitely limited the issue for our consideration to the sole question of whether this item of $25,510.28 was properly included by petitioner in income for 1939, the year in which it was received. In view of that deliberate action of the parties, we confine our decision to the issue submitted.
Respondent’s position is that, as to the petitioner who is on a reserve charge-off system, the bad debt recoveries in dispute are not to be reported as income in the taxable year when received, but are to be credited as an addition to the balance in the reserve for bad debts. The petitioner maintains that its accounting for the recoveries as income for the year of their receipt was proper.
Under section 41, I. R. C., the net income of petitioner is required to be computed in accordance with its “method of accounting regularly employed.” Admittedly the petitioner regularly employed such a method and so reported its income. The suggested change of that method is therefore permissible, under that section, only if that system of the petitioner did not “clearly reflect * * * [its] income.” See Huntington Securities Corporation v. Busey, 112 Fed. (2d) 368.
Since 1925 petitioner has regularly employed a method of accounting upon the basis of which its Federal income tax returns were made. Under that system it has uniformly followed the practice of including in gross income bad debt recoveries instead of crediting them to the reserve in the respective years in which the recoveries were made. This action was not questioned by the respondent until the taxable year, 1939. Respondent does not point even now to any distortion of petitioner’s income caused by that practice. In fact, it is difficult to believe that, if the only receipts of petitioner during the taxable year had been bad debt recoveries, respondent would take the position that those recoveries were not to be returned as income, but merely added to the bad debt reserve. But here, the all important question is not net income, but gross income. It is upon the determination of that fact, alone, that the legal characterization of petitioner as a holding company rests. So, respondent proposes to change the petitioner’s method of accounting and reporting its bad debt recoveries for 1939. Based wholly upon a computation of gross income resulting from that change, he has determined a deficiency in taxes of $22,918.95, together with a penaltiy of $5,729.74.
The petitioner relies upon Regulations 103, applicable in the taxable year, secs. 19.42-land 19.23 (k)-l (d), (b), and (a). Those provisions are not expressly limited in their application to bad debt recoveries by those on the specific bad debt charge-off system. In so far as they purport to treat bad debt recoveries, those provisions have remained substantially unchanged since those appearing in the regulations issued under the Revenue Act of 1921, which first recognized the reserve system of charge-off.
Confronted by this record, therefore, we can not say that petitioner’s “method of accounting regularly employed” in 1939, the taxable year, did not “clearly reflect * * * [its] income.” We think that it did. Respondent therefore erred in changing the method for the taxable year. Consequently, the petitioner was not subject to a personal holding company tax for 1939. The deficiency thus falls, and with it the penalty.
Reviewed by the Court.
Decision will be entered for the petitioner.
Secs. 500, 501, 502, 508, 291,1. R. C., as amended.
Art. 151, Regulations 62, 65, and 69; art. 191, Regulations 74 and 77; art. 23 (k) — 1, Regulations 86, 94, and 101; and sec. 19.23 (k)-l, Regulations 103.
Regulations 111, sec. 29.22 (b) (12)-1 (a) (1).
Senate Finance Committee, S. Rept. No. 1631. 77th Cong., 2d sess., C. B. 1942-2, p. 563.
I. T. 1825, C. B. II — 2, July-Dee. 1923 (p. 144).