*1077 1. Taxpayer was engaged in the business of adjusting insurance losses. It made representations that it operated at no profit and rendered services at cost. Approximately 85 percent of its customers were stockholders. From 1929 to 1935, inclusive, all charges in excess of "cost", except a dividend of $12 a share, were credited to a reserve for contingencies and expansion. From time to time amounts therefrom were expended for new equipment and the establishment of new branch offices. Undistributed net receipts for 1936 and 1937 were held and disposed of by taxpayer for its own use and benefit. Held, the undistributed net receipts for 1936 and 1937 constituted income taxable to taxpayer in 1936 and 1937, respectively.
2. A bylaw of taxpayer limiting the amount of dividends declarable each year, together with the representations made by taxpayer that it operated at cost and not for profit, Held, not a "written contract executed by the corporation" within the meaning of section 26(c)(1) of the Revenue Act of 1936.
3. An amount representing an accumulation of expense items incurred by taxpayer in adjusting losses over a period of years prior to 1936 which taxpayer*1078 failed to charge or bill to customers, held, not allowable as a bad debt deduction in 1936.
4. Rebates received in 1937 on purchases made and accrued as expense on the books of account in 1933 and 1935, respectively, in which years the taxpayer had net losses, held not taxable to taxpayer in 1937.
*722 The respondent determined a deficiency in petitioner's income and undistributed profits taxes for the years 1936 and 1937 in the amounts of $4,512.87 and $6,912.32, respectively. The questions presented for determination are (1) whether the petitioner received taxable income in 1936 and 1937; and, in the alternative, (2) whether petitioner is entitled in both 1936 and 1937 to any credits for contracts restricting payments of dividends under section 26(c)(1) of the Revenue Act of 1936; (3) whether petitioner is entitled to a claimed bad debt deduction of $10,517.05; (4) whether the amounts of $563.18 and $657.50, representing rebates received by petitioner in 1937 on supplies purchased by it in 1933 and 1935, respectively, and the amount of $550.59, *1079 representing recoveries in 1937 on deductions taken in 1936, constitute taxable income in 1937.
FINDINGS OF FACT.
The petitioner was incorporated under the laws of Illinois on February 24, 1885, by a small group of men engaged in the insurance business in Chicago. It had an authorized capital stock of $5,000, represented by 50 shares of the par value of $100 a share. The capital stock was increased on May 4, 1894, to $10,000, represented by 100 shares of the par value of $100 a share, and again on February 6, 1908, to $20,000, represented by 200 shares of the par value of $100 a share.
The purposes of its incorporation as stated in its charter are "the equitable adjustment of losses, whether fire, marine, tornado or wind storm; the storage, handling and sale of all kinds of property under claim for damage, the survey and inspection of all classes of Insurance hazards and the making and publishing of maps, surveys and diagrams."
The petitioner's main office is in Chicago, Illinois. It filed its income tax returns for the years involved with the collector of internal revenue for the first district of Illinois.
The petitioner is engaged in the business of adjusting claims*1080 on account of insured losses for insurance companies, the greater number of which are stockholders of petitioner. The percentage of business transacted with stockholder companies and nonstockholder companies in 1936 and 1937 was as follows:
| 1936 | 1937 | |
| Stockholders | 84.4968% | 83.8921% |
| Other companies | 15.5032% | 16.1079% |
The nonstockholder companies were companies which were interested in risks in which stockholder companies were interested. In 1936 and 1937 the outstanding stock consisted of 133 shares. Two of such *723 shares were issued as qualifying shares; the remaining shares were held by insurance companies, each company holding one share, except three companies which held two shares each. The stockholders paid $200 for each share of stock, $100 of which was credited to capital stock and $100 to paid-in surplus.
In 1895 the following amendment to article 14 of the bylaws of petitioner was adopted:
Whenever dividends are hereafter declared payable out of the surplus of this company arising from earnings other than interest earnings there shall be first declared and paid an amount equal to six percent per annum on the par value of the outstanding*1081 Capital Stock, and this six percent shall constitute all the dividend that shall be thus declared and paid in any one Calendar Year upon such Capital Stock. All other dividends declared payable out of surplus earnings shall be known as promoters dividends, and shall be paid to Stockholders in the proportion that the amount paid by each Stockholder for earnings during the current dividend period bears to the total amount paid by all Stockholders for earnings during the current dividend period.
A dividend period shall be the time between two successive dividends becoming payable except that the first dividend period shall commence on the 3rd day of January A.D. 1895.
This bylaw was amended on December 22, 1936, by the board of directors to read as follows:
The Board of Directors may from time to time declare and the Corporation may pay dividends on its outstanding shares upon the terms and conditions provided by law but not in any year exceeding 6% of the par value of its paid in capital and paid in surplus.
From 1895 to 1937, inclusive, the petitioner paid each a dividend of 6 percent on its paid-in capital and paid-in surplus, or $12 a share. In 1936 and 1937 it paid dividends*1082 in the total amounts of $1,584 and $1,596, respectively. These amounts were claimed by petitioner in its 1936 and 1937 income tax returns, respectively, as dividends paid credits. Such credits were allowed by respondent.
On its books of account, kept on an accrual basis, the petitioner has an account entitled "Reserve for Contingencies and Expansion", to which all amounts representing service charges in excess of cost were credited. This reserve was established for the purpose of providing additional working capital. Pursuant to resolution of petitioner's board of directors, adopted October 29, 1929, no refunds of excess service charges were made to its customers during 1929 to 1935, inclusive. From time to time during that period funds from such account were expended for the purpose of expansion, including the establishment of new branch offices and the purchase of new equipment. In 1901 the petitioner had four branch offices and in 1937 it had 105 branch offices, located in thirteen central west states. From 1895 to 1937, inclusive, the petitioner charged the cost of all equipment purchased by it, including office devices and equipment, furniture and *724 fixtures, *1083 curtains, floor coverings and typewriters, to expense in the year of purchase. In 1936 and 1937 there were charged to expense on the books of the corporation $45,481.67 and $56,811.73, respectively, which amounts represent the cost of equipment purchased in such years. In its income tax returns for 1936 and 1937 such items, together with similar purchases made in previous years, were treated as capital assets and depreciation was deducted thereon in the amounts of $15,391.68 and $20,986.33, respectively. At a meeting of petitioner's board of directors held on December 22, 1936, the following resolution was adopted:
WHEREAS, in 1929, the corporation suspended patronage rebates until such time as the reserve for extension of business was sufficiently built up to carry on the business in a safe and convenient manner; and
WHEREAS, the sum of approximately $400,000.00 is deemed to be necessary for the purpose stated, therefore.
BE IT RESOLVED, That the Officers of the Corporation are authorized and directed to increase the Reserve for Extension of Business in the sum of approximately $47,000.00 and to rebate any amount of excess service charges for 1936 over and above said amount*1084 to all customers doing business during the year 1936 in the proportion which each customer's total charges bear to the total charges for the year.
BE IT FURTHER RESOLVED, That the Secretary and General Manager advise all patrons of the action of the Board in this regard, and to further advise such patrons that the reserve requirements of the Company have been met and therefore rebates or assessments will be made at the end of each succeeding calendar year to adjust the charges made currently during the year to the actual cost of the business to this company.
Rebates were made to the customers of petitioner in 1936 and 1937 on the basis of business contributed as follows:
| 1936 | 1937 | |
| Stockholders | $173,463.99 | $175,309.94 |
| Other companies | 31,826.96 | 33,660.83 |
| Total amount rebated | 205,290.95 | 208,970.77 |
In its income tax returns for 1936 and 1937, the amount rebated to customers was not included in reported gross receipts. These items or their exclusion from gross receipts is not in controversy. The balance remaining in the account "Reserve for Contingencies and Expansion" as of December 31, 1936, and 1937, respectively, was $347,728.84 and 348,791.36.
*1085 In its income tax returns for 1936 and 1937 the petitioner reported net income in the amounts of $35,494.68 and $37,930.21, respectively. In determining the deficiencies involved herein, the respondent made several adjustments, some of which are not in controversy, and determined that petitioner's net income in such years was $48,999.02 and *725 $41,520.25, respectively. In its 1936 return the petitioner computed a surtax on undistributed profits but did not claim a credit under section 26(c)(1) of the Revenue Act of 1936. It paid for 1936 a normal tax in the amount of $4,039.14 and a surtax on undistributed profits in the amount of $5,345.23. In its 1937 return the petitioner claimed a credit under section 26(c)(1) of the Revenue Act of 1936, leaving no taxable undistributed income. It paid for 1937 a normal tax of $4,350.42.
The petitioner employs approximately 515 adjusters and adjusts from 150,000 to 300,000 claims a year. An adjuster may have from 75 to 100 claims pending at a time. As each case is settled a report, together with a bill for expenses, is transmitted to the insurance company involved. Upon the payment of the bill the insurance company closes*1086 its file and thereafter refuses to reopen the same. Due to a defective system of bookkeeping in use prior to 1936, some items of expense incurred by petitioner over a period of time prior to 1936 in the adjustment of various claims were not included in bills rendered to insurance companies. In 1936 the petitioner's books of account disclosed such expense items in the aggregate amount of $10,587.05, which should have been charged to some unidentified insurance companies at some time prior to 1936. In 1936 the petitioner changed its method of handling such expense items and charged off the amount of $10,587.05 as a bad debt. The respondent disallowed the deduction.
The method of billing customers was discussed by the board of directors at its meeting held on December 22, 1936, which resulted in the adoption of the following resolution:
WHEREAS, charges are made to customers at cost for services rendered by the Corporation, and
WHEREAS, it is impossible to determine in advance the cost of doing business for the corporation in any year,
BE IT RESOLVED: That all billings to customers beginning January 1, 1937, shall have a notation thereon that the billing is a tentative or*1087 memorandum charge based upon an estimate cost, and that the same is subject to revision by way of assessment or refund at such time as the cost shall have been accurately determined.
BE IT FURTHER RESOLVED: That the Secretary and General Manager advise all patrons of the action of the Board of Directors in this regard prior to January 1, 1937, and that new customers be advised of this method of billing at the time they apply for service.
Thereafter the bills sent to customers contained the following statement:
The charge shown on this bill is based on estimated cost and is subject to adjustment at the end of the year when the actual cost is determined.
In 1937 the petitioner received rebates on purchases made in years prior to 1936 from the Uniform Printing & Supply Co. as follows:
| Rebates on purchase: | ||
| 1930 | $1,001.11 | |
| 1932 | 572.27 | |
| 1933 | 469.38 | |
| 1934 | 493.75 | |
| 1935 | 469.90 | |
| 3,006.41 | ||
| Rebates on sales tax: | ||
| 1933 | $93.80 | |
| 1934 | 197.35 | |
| 1935 | 187.60 | |
| 1936 | 271.64 | |
| 750.39 | ||
| Total amount received and credited to reserve for expansion | 3,756.80 |
*726 In its income tax return for 1937 the petitioner did not report the above amount*1088 of $3,756.80 as income. In recomputing petitioner's tax liability for 1937 the respondent included the above amount as additional income for 1937. The petitioner's income tax returns for 1933 and 1935 showed net losses in the amount of $17,667.63 and $74,062.45, respectively.
OPINION.
ARNOLD: The petitioner filed income tax returns for 1936 and 1937 showing taxable income for each year. It now contends that it had no taxable income in such years because it derived no income from the operation of its business for its separate use, benefit, or disposal in excess of $12 a share of its outstanding stock. It claims that all excess charges above $12 a share of its outstanding stock retained by it were contractually owing and refundable to its customers under article 14 of its bylaws in proportion to the volume of business transacted and by virtue of its written and printed representations to customers that it acted as a service organization not operated for profit and adjusted insurance losses at cost.
Article 14, in force and effect from 1895 to December 22, 1936, expressly refers to "surplus of this company arising from earnings other than interest earnings." This indicates*1089 that the petitioner expected to acquire a surplus consisting of earnings derived from its business in excess of $12 per share.
"Cost" and "profit" are terms of equivocal meaning. The petitioner from the time of its organization in 1885 to 1937, inclusive, used payments received from its customers for the purchase of furniture and fixtures and other equipment, which it charged to expense of operation in the year of purchase in determining profits. In 1936 and 1937 there were charged to expense approximately $45,000 and $56,000, respectively, which amounts represented the costs of equipment and *727 were treated as capital expenditures on its returns. The board of directors of petitioner determined what expenditures represented "cost." This directors determined that a reserve be established of approximately $400,000 for the purpose of providing funds for business expansion and contingencies and to carry on the business in a safe and convenient manner. It is indicated that this was regarded as a cost of operating the business. The charges in excess of cost retained for such purpose were credited to a reserve for contingencies and expansion, thus negativing the claim of*1090 liability to customers for charges in excess of actual operating cost. Excess charges retained by petitioner and not rebated were not divided in any year "in proportions which each customer's total charges bear to the total charges for the year" and credited to accounts of customers. Cf. . The board of directors retained control of such funds, and expended amounts therefrom from time to time for business purposes of the corporation. No objections were made by any customers, whether stockholders or nonstockholders. No claim was made by any customer for any rebate of such reserve or any other funds retained by the corporation or expended by it for furniture and equipment and establishment of branch offices. The equipment and branch offices and excess charges retained by petitioner were the property and a part of the business of petitioner. Obviously such excess charges were received and used by the petitioner for its "separate use, benefit or disposal" and hence were income as defined in *1091 . In , the Court stated as follows:
* * * If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent. * * *
See also ; certiorari denied, ; .
The petitioner claims that it is entitled to a credit under section 26(c)(1) of the Revenue Act of 1936. The petitioner's bylaw restricting payment of dividends to 6 percent per annum of the par value of its paid-in capital and paid-in surplus and representations made by petitioner in letters and booklets issued by it to customers to the effect that it rendered services at cost and was not operated for profit do not constitute a "written contract executed by the corporation" within*1092 the meaning of section 26(c)(1). A written contract under that section refers to "routine contracts dealing with ordinary debts." ; Crane-Johnson*728 . A corporate bylaw is not a "written contract executed by the corporation" within the meaning of the section. . Written and printed representations made by petitioner in the course of its business to its customers may be the basis of an implied contract, but do not constitute "a written contract executed by the corporation." That its customers may have, by virtue of petitioner's bylaw and its representation, an enforceable right to have the charges in excess of cost rebated to them is immaterial and not determinative of petitioner's right to the credit claimed. Such rights of petitioner's customers, if any, are founded upon an implied contract and not upon a written contract executed by petitioner. Substantive law or state statutory law is not applicable here. The provisions of a Federal revenue statute determine whether petitioner*1093 is entitled to the credit claimed. Section 26(c)(1) grants a credit under certain conditions. Such a tax law must be strictly construed. ; affd., . There being no written contract executed by the corporation as required by section 26(c)(1), the petitioner is not entitled in the taxable years involved to the credit granted thereunder.
The petitioner claims a bad debt deduction of $10,587.05. During a period of years prior to 1936, items of expense incurred in connection with adjusting losses were overlooked and not charged or billed to the customers. This was due to a faulty system of reporting expenses and bookkeeping. In 1936 the system of handling such items was changed. After being billed, the customer closed its file and considered the case closed and settled in full. There is no evidence to show that these items were ever charged to the customer for whom the expense was incurred. The items were not treated as debts owing to petitioner. Apparently no attempt was made to bill or collect the items. It is indicated that the items were carried in an account designated loss*1094 expense and the customers for whom the expenses were incurred were not identified. The item was not ascertained to be worthless. It was considered to be uncollectible because the cases in which the expenses were incurred were closed so far as the customers were concerned. Section 23(k) of the Revenue Act of 1936 allows the deduction of "debts ascertained to be worthless." No statutory provision is made for the deduction of expense items which are uncollectible due to failure of taxpayer to bill its customers therefor. This item represents an accumulation of expenses incurred by the petitioner in the course of its business. It is not allowable as a bad debt deduction in 1936.
In 1937 the petitioner received from the Uniform Printing & Supply Co. $3,756.80 representing rebates on account of supplies purchased *729 over a period of years from 1930 to 1936, inclusive. Of the amount of $3,756.80, $563.18 represents a rebate on account of purchases made in 1933 and $657.50 represents a rebate on account of purchases made in 1935. The petitioner concedes that the rebates received in 1937 applicable to purchases in other years are includable in income in 1937, but contends*1095 that the above amounts applicable to 1933 and 1935 are not includable in 1937 income for the reason that in 1933 and 1935 the petitioner sustained losses and gained no tax advantage by reason of the overaccrual of purchases in the above amounts.
In ; affd., , it was stated:
It is now well settled that where amounts previously deducted from income for losses, expenses, bad debts, taxes, etc., which effect an offset of taxable income, are recovered in subsequent years, such recoveries "should be reported as a part of gross income for the year in which * * * recovered." ; . The converse of this proposition is also true - that if such amounts so deducted did not effect an offset of taxable income for the year in which deducted, then recoveries in subsequent years should not be included in gross income in the years of recovery. *1096 . * * *
The evidence shows that the petitioner's income tax returns for 1933 and 1935 showed net losses in excess of approximately $17,000 and $74,000, respectively. It is apparent that the deductions in 1933 and 1935 of the amounts herein involved accomplished no reduction in tax liability of petitioner in such years. The amounts of $563.18 and $657.50, representing recoveries on purchases made in 1933 and 1935, respectively, do not constitute taxable income to petitioner in 1937.
The respondent concedes that the amount of $550.59 should be excluded from income in 1937. Effect will be given to this concession upon recomputation under Rule 50.
Decision will be entered under Rule 50.