Farmville Oil & Fertilizer Co. v. Commissioner , 30 B.T.A. 1048 ( 1934 )

FARMVILLE OIL AND FERTILIZER COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Farmville Oil & Fertilizer Co. v. Commissioner

Docket No. 67600.

United States Board of Tax Appeals

30 B.T.A. 1048; 1934 BTA LEXIS 1235;

June 26, 1934, Promulgated

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">*1235 A charge to "reserve for inactive contingencies" which includes possible discounts and other subsequent adjustments of prices on sales, held, not to be deductible as such, and no part thereof, upon the evidence, to be deductible as an addition to a reserve for bad debts.

W. F. Evans, Esq., for the petitioner.

Samuel L. Young, Esq., for the respondent.

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STERNHAGEN

">*1048 Respondent determined a deficiency of $1,885.97 in petitioner's income tax for the fiscal year ended July 31, 1930. Petitioner assails the disallowance of a deduction of $20,859.70 out of $21,545.42, representing a reserve for inactive contingencies.

FINDINGS OF FACT.

Petitioner, a North Carolina corporation with its principal office at Farmville, is engaged in the manufacture, principally, of tobacco fertilizer and, to some extent, cottonseed oil. In the territory served by the petitioner tobacco is the principal crop grown. Its factory is located in the largest tobacco-producing county of North Carolina.

In, and prior to, the taxable year 1930 petitioner kept its books and made its income tax returns on an accrual basis. It kept a reserve for bad debts called">*1236 "reserve for doubtful accounts and losses." In 1932, with the consent of the respondent, it changed its accounting for bad debts from the reserve method to the charge-off method. It also kept an account called "fertilizer discount", to serve as a record of cash discounts, trade discounts, and price adjustments allowed to purchasers of fertilizer, which was annually cleared to profit and loss account as an offset to fertilizer sales.

In the fiscal years 1925, 1926, and 1927 the amounts added to the reserve for doubtful accounts and losses were approximately 6 to 8 percent of the outstanding accounts and notes receivable. In the fiscal year 1929, when the tobacco crop failed, the petitioner added to the reserve approximately 12 percent. Although this was more than its previous experience justified, the amount was allowed by the Commissioner as a deduction in computing taxable net income. The total accounts charged against the reserve in that year as worthless and uncollectible amounted to $78,597.57. The total accounts and notes receivable relating to the business of that year amounted to $439,310.39, of which only $210,416.49 was collected up to August 15, 1930, twelve and one">*1237 half months after the close of the year.

">*1049 In the taxable year there was a decline in the average market price of tobacco to 12 cents, from an average of 18 cents in fiscal 1929, and a decline in the average market price of cotton. The outstanding accounts and notes receivable as of the close of the year amounted to $990,736.08. The petitioner added $64,405.44 to the reserve for doubtful accounts and losses and deducted that amount in the return, and the deduction has been allowed by the respondent. Accounts charged off as worthless and uncollectible in the year amounted to $101,638.22. Collections during the year on accounts charged off as bad debts in prior years amounted to $6,502.72.

It is the petitioner's accounting practice to credit its fertilizer sales and charge its customers therefor according to its retail price schedule for credit sales of small losts. When the customers settle their accounts in the following year, adjustments thereof are made for cash, trade, quantity, dealers' and jobbers' discounts, and price corrections. The amount of the price corrections is dependent upon the prices established by petitioner's competitors. At the close of the">*1238 taxable year, the petitioner charged fertilizer discount account and credited reserve for inactive contingencies, in the sum of $21,545.42, for discounts and price corrections on a selected list of accounts. The amount thus added to the reserve, representing approximately 10 percent of the total of accounts to which it applied, was deducted from gross sales in the return, and the respondent has disallowed the deduction to the extent of $20,859.70. After the close of the taxable year the petitioner allowed in respect of the particular accounts total discounts of $5,252.70, and ascertained $57,778.43 of the accounts to be worthless and uncollectible.

Some undisclosed portions of the 1926, 1927, and 1928 additions to the reserve for doubtful accounts and losses were disallowed by respondent as deductions from the income of those years. The total bad debts charged off in 1932 exceeded the balance in the reserve and the $21,545.42 deducted from gross sales of the taxable year by approximately $10,000, and this excess was deducted from 1932 income. After the petitioner changed its basis of accounting for bad debts in 1932, additional accounts relating to business prior to the change">*1239 were ascertained to be worthless and uncollectible, and all such accounts have been deducted in its income tax returns.

OPINION.

STERNHAGEN: The petitioner, having for the fiscal year ended July 31, 1930, charged to "fertilizer discount account" and credited to "reserve for inactive contingencies" $21,545.42, which it deducted on its tax return, used this amount as a reduction of gross sales in arriving at the gross income shown upon its return. The Commissioner ">*1050 in effect disallowed $20,859.70 of this amount and restored so much to gross income. Strictly speaking, therefore, the disallowance of the Commissioner is not of a statutory deduction. The petitioner, however, in assailing the Commissioner's determination argues that the amount in controversy is properly a statutory deduction of either an addition to its reserve for bad debts or to its reserve for inactive contingencies, or partly both.

That a reserve for inactive contingencies such as possible repayments, price discounts, or price rebates, the amounts of which have not been fixed or were not fairly susceptible of ascertainment prior to the end of the taxable year in question, is not the basis of a">*1240 statutory deduction has now become a settled doctrine. . This general doctrine includes the disallowance of unascertained price discounts, for the Supreme Court expressly disapproved , which held to the contrary. Thus, by its title alone the reserve for inactive contingencies, reflecting as it did "fertilizer discounts" would be no basis for the deduction claimed.

The petitioner argues that, of the amount originally deducted, some part (said without supporting evidence to be $16,292.72) was an additional reserve for bad debts. Since the evidence fails to support this as a proper accounting classification and since also the amount of the allocation of such part is without supporting evidence, the petitioner must fail. The method of accounting for bad debts through a reserve does not found an absolute right in the taxpayer, for the statute expressly sanctions the Commissioner's discretion. Cf. ">*1241 . Here the Commissioner's determination has clearly not been arbitrary or capricious. The taxpayer has been permitted during the preceding years to make substantial increases in the ratio of its bad debt reserve to its receivables. First, it had established this ratio at an amount varying between 6 and 8 percent. Later this was increased to 12 percent. In the taxable year 1930, that now in question, the taxpayer was permitted to add a further $64,405.44, arrived at by its own estimate at the end of the taxable year of the collectibility of specific accounts. Apparently when this permissive increase was allowed by the Commissioner it was not suggested that the reserve for inactive contingencies might include any further reserve for bad debts. But the petitioner, after the end of the taxable year and after its return was filed, discovered that its collections would be even less than the amount contemplated when the return was filed. In this proceeding it sought by the evidence of actual subsequent collections to establish the propriety of treating its reserve for inactive contingencies as an additional reserve for bad debts. This">*1242 we think is contrary to the intendment of the statute and ">*1051 the regulations. While a bad debt reserve may and properly should be permitted to fluctuate from time to time in accordance with actual experience and well founded prophecy, cf. , the amount of the addition must be fixed at the approximate end of the taxable year. There is no support for the view that such a reserve may later be retroactively enlarged because the subsequent realization upon the debts has proved to be less than the estimate made at the close of the year. Such an unexpected development should be taken care of by the taxpayer, either by an enlargement of the subsequent annual additions to the reserve or by doing as this taxpayer did in 1932, giving up the reserve method entirely and deducting the debts as they are ascertained to be worthless and charged off.

Judgment will be entered for the respondent.