*1000 Taxpayer changed from the direct charge-off method to the reserve method in accounting for losses from bad debts and used the latter method in its income tax return for 1932 without first seeking and obtaining the consent of the Commissioner as required by article 191 of Regulations 77. It was apparent from the return that under neither of such methods of accounting was there a tax liability. There was no field examination of taxpayer's accounts and no adjustment of the accounts as stated in the return. The audit of the return consisted only of verifyng the computations thereof. Held, under the circumstances, the Commissioner did not consent to such change and the taxpayer was not authorized to use the reserve method as to bad debts in the following taxable year.
*726 The Commissioner determined deficiencies in income and excess profits taxes for the year 1933 in the respective amounts of $2,175.28 and $297.57. Petitioner asks a redetermination thereof and alleges in its petition the following assignments of error:
1. The respondent erred*1001 in disallowing as a deduction the amount of $186.93 representing ordinary and necessary expenses incurred and paid by the petitioner for the year 1933.
2. Respondent erred in disallowing as a deduction $5,697.72 representing an addition to reserve for bad debts during the year 1933 within the meaning of Section 23(j) of the Revenue Act of 1932.
*727 3. Respondent erred in disallowing a deduction for bad debts ascertained to be worthless and charged off within the taxable year in the amount of $9,821.25 within the meaning of Section 23(j) of the Revenue Act of 1932.
At the hearing petitioner waived the first assignment of error.
The evidence consists of oral testimony and certain documentary exhibits, from which we make the following findings of fact.
FINDINGS OF FACT.
Petitioner is a Texas corporation, with its principal place of business at Houston, Texas, and during the taxable year in question and for some years prior and subsequent thereto was engaged in the manufacture of work clothing. Prior to the year 1932 petitioner used the specific ascertainment method of charging off bad debts on its books and in its income tax returns. In 1932 petitioner changed*1002 to the reserve method for bad debts and used this method in its tax returns for that year and for the year 1933. This change was made without seeking or obtaining permission of the Commissioner to do so. Petitioner's income tax return for 1932 shows a deduction of $39,993.02 as additions to reserve for bad debts and also shows the net amount of such reserve at the end of that year as $19,574.10. The 1932 return also shows net loss for that year of $40,339.81 and a net loss for the year 1931 applicable to any net income for 1932, of $76,293.88, or a total of losses deductible for 1932 of $116,633.69 in excess of income. No field investigation of the 1932 return was made. No tax liability was shown thereon and no adjustment thereof was made by the Commissioner. The Commissioner officially audited this return and stamped it: "Computation Proved * * * Closed * * * No Additional Tax * * * Date 5-22-34."
Petitioner accrued on its books in 1933 and deducted in its income tax return for that year additions to reserve for bad debts totaling $33,014.86, comprising the following items: $22,971.55, "Reserve for Bad Debts", which applied only to customers' accounts receivable; $9,821.25, *1003 "Reserve for Bad Debts Others", covering note of Cyrus W. Scott, and accounts of R. B. Mundine and D. E. Ouzts, stockholders of petitioner; and $222.06, "Reserve for Bad debts Union Industrial Company."
In 1933 petitioner charged to such reserves as bad debts a total of $27,317.14. Included in this amount was $9,821.25, made up of the following items:
| Note receivable - Cyrus W. Scott | $4,114.94 |
| Accrued interest on note of Cyrus W. Scott | 641.53 |
| Advances to Cyrus W. Scott | 4,500.00 |
| Due from stockholders | 564.78 |
| Total | 9,821.25 |
*728 Respondent denied petitioner the use of the reserve method for bad debts in its 1933 return for the assigned reason that permission had not been granted to change from the method of charging off specific bad debts to that of reserve for bad debts. Respondent disallowed the deduction of $33,014.86 as additions to reserve for bad debts and disallowed the deduction of $9,821.25, comprising the items above set forth, as specific bad debts charged to such reserve. Respondent allowed a deduction of $17,495.89 for other specific bad debts charged to such reserve and he added to petitioner's income the difference between $33,014.86*1004 and $17,495.89, to wit, $15,518.97.
Respondent's explanatory statement and computation in this regard, accompanying the notice of deficiency, is as follows:
| Provision for bad debts | $33,014.86 | |
| Bad debts charged to reserve | $27,317.14 | |
| Less bad debts charged to reserve not allowable | 9,821.25 | |
| Bad debts allowed | 17,495.89 | |
| Increase to taxable income | 15,518.97 |
This amount of $15,518.97 is the sum of $5,697.72 and $9,821.25 set forth, respectively, in petitioner's second and third assignments of error.
The petitioner was founded by Cyrus W. Scott, and prior to October 1931 he was its president and manager. An audit of the company's books in the year 1929 showed Scott to be indebted to petitioner. On April 11, 1930, other officers of the corporation required Scott to give it his promissory note, due April 11, 1931, in the amount of the indebtedness and to post all the stock he then owned in the corporation (109.8 shares of par value of $100 per share) as security for payment of the note. At that time Scott's financial affairs were in bad shape. Everything he owned, except the 109.8 shares of petitioner's stock, had been pledged or hypothecated to*1005 secure his indebtedness to other creditors. He was unable to borrow any money without collateral. An additional reason for taking the note as evidence of Scott's indebtedness to petitioner was to prevent the collection of the account from being barred by the statute of limitations. At December 31, 1933, there was due and unpaid on the principal of such note $15,094.94, together with $641.53 of accrued interest. Up to the latter part of 1931 petitioner had sustained tremendous losses which were attributed to mismanagement of the business by Scott and his subordinates. For this reason persons financially interested in petitioner sought the removal of Scott as president and manager thereof. Scott resigned as president and manager in October 1931, and one E. Edwards took over the presidency and management of petitioner in an effort to rehabilitate it. Scott had many personal friends and friends among *729 the trade, and the directors of petitioner concluded that so long as the company continued to bear his name his good will would be an asset and therefore it was decided to advance him $250 a month and retain him as chairman of the board of directors. On March 9, 1932, the*1006 board of directors authorized the advancement to Scott of $250 per month, commencing March 1, 1932, and continuing as long as in its opinion the best interests of petitioner were served thereby. These advancements were continued at $250 per month to March 1, 1933, and thereafter at $150 per month to March 1, 1934. In the resolution authorizing this action the payments were referred to as "advances" and it was provided that same should be charged to Scott's personal account and be protected by the 109.8 shares of stock which petitioner held as collateral for payment of the above mentioned note.
The payments were charged on the books as advances rather than salary to Scott because one of the stockholders, who had previously been discharged as an employee of the petitioner by Scott and was not on friendly terms with him, objected to his being paid any salary by petitioner. The amount of the so-called advances to Scott during the year 1932 was $2,500 and the amount of such advances during the year 1933 was $2,000. The so-called advances were continued at $150 per month during January and February 1934, notwithstanding the total amount of such payments from March 1, 1932, to and*1007 including December 1933, in the sum of $4,500, were charged to the addition to reserve for bad debts in December 1933. No time was fixed for the repayment of such advance and no interest thereon was specified or required. The so-called advances were in reality payments for salary and it was not intended by petitioner that they should be repaid. On December 31, 1933, petitioner determined that the Scott note in the principal amount of $15,094.94, together with accrued unpaid interest thereon of $641.53, was uncollectible, except to the extent of the value of 109.8 shares of stock held as collateral security therefor, and that such stock was worth only par, or $10,980. Acting upon its determination petitioner, at the end of 1933, wrote the note down on its books to $10,980 and charged the difference, $4,114.94, between this figure and the face of the note, together with interest of $641.53, to the addition to its reserve for bad debts in 1933. No actual appraisal of the value of the stock was made at the time the note was partially written off. The stock at that time had a book value of $150 to $175 per share.
Prior to the year 1933 petitioner sustained losses as follows:
| 1930 | $80,584.00 |
| 1931 | 156,877.94 |
| 1932 | 116,633.69 |
*1008 *730 Petitioner reported net income of $52,631.10 for the year 1933. The outlook at the end of 1933 was quite encouraging.
The evidence does not show that the note was partially worthless in 1933 either as to principal or interest. The note was canceled and the collateral applied against Scott's indebtedness some time in January 1936, at which time petitioner took title to the stock collateral and marked the note "paid."
On December 31, 1933, petitioner charged to the addition to the reserve for bad debts the amount of the so-called advances to Scott during the years 1932 and 1933 in the total sum of $4,500. On December 31, 1933, petitioner charged to addition to reserve for bad debts $564.78 representing an indebtedness from two of its stockholders, R. B. Mundine and D. E. Ouzts. No further fact is shown relative to this latter item. There is no evidence as to whether it was worthless or, if so, whether it became worthless in the taxable year.
OPINION.
HILL: The questions presented for determination are:
(1) Was the petitioner entitled to use the reserve method of handling bad debts in its income tax return for the year 1933?
(2) Was petitioner entitled*1009 to deduct either the addition to its reserve for bad debts for the taxable year, or the following items as bad debts specifically ascertained and charged off during the taxable year:
| Note of Cyrus W. Scott | $4,114.94 |
| Interest on above note | 641.53 |
| Cyrus W. Scott advances | 4,500.00 |
| Due from stockholders | 564.78 |
| Total | 9,821.25 |
Relative to the first question presented, petitioner concedes that prior to 1932 it used the specific ascertainment method of charging off bad debts and that it changed to the reserve method on its books of account and in its income tax return for 1932, without having first requested or secured permission from the Commissioner to do so. Petitioner contends, however, that the Commissioner acquiesced in such change and gave implied permission therefor by accepting and closing its 1932 return without adjustment and that it is therefore entitled to use the reserve method in its accounts and in its income tax return for 1933. Respondent, on the other hand, contends that under the circumstances here his acceptance and closing of the return for 1932 without adjustment did not amount to permission to change to the reserve method.
*731 *1010 The pertinent parts of the applicable statute 1 and regulations 2 are set forth in the margin:
Petitioner relies on an implied rather than direct permission of the Commissioner to change from the method of specific ascertainment of bad debts to reserve for bad debts and bases such implication upon the fact that the Commissioner accepted and closed without adjustment its 1932 return in which it used the reserve method and deducted the additions to reserve for bad debts in that year from gross income. Petitioner cites the following cases as supporting the claim that the Board and the courts have held that such action on the part of the Commissioner constitutes the granting of the permission required by the cited statute and regulations: ; ; ; ; ; ; *1011 .
*1012 The facts in the instant case distinguish it from the cases cited above in that in all of those cases a tax liability was shown, either on the return or in the adjustments made therein by the Commissioner, while in the instant case there was no tax liability shown by the return, no field examination of petitioner's accounts was made, *732 and the Commissioner made no adjustment of the accounts as stated in the return. Furthermore, in the present case, it was apparent from the return that no adjustment which the Commissioner might make would result in a tax liability.
Petitioner's income tax return for 1932 showed a total of deductible losses of $116,633.69 in excess of income. The addition to reserves for that year shown as a deduction in such return was $39,993.02 and the net amount of such reserve at the end of that year was $19,574.10. Had the Commissioner disallowed in toto the deduction of $39,993.02 as reserve for bad debts in petitioner's tax return for 1932, there would have still remained deductible losses of $76,640.67 in excess of income for that year. If the Commissioner had disallowed the deduction of only that part of the reserve represented by the net*1013 amount of such reserve at the end of the year 1932, there would have remained deductible losses of $97,057.59 in excess of income for that year. In neither event would the return have shown a tax liability of petitioner for 1932. It being apparent from the return as filed that no action which the Commissioner might take with reference to the deduction of reserve for bad debts would result in a tax liability against petitioner for that year, no field investigation was made of petitioner's accounts and the audit of the return consisted solely of proving the computation thereof. Since the return showed conclusively that petitioner had no income tax liability in 1932, regardless of whether it followed the specific ascertainment method of charging off bad debts or used the reserve method in that respect, it would have been a futile act for the Commissioner to disallow the deduction of the reserve for bad debts and his failure to disallow such deduction is without negligence. There was no affirmative action by the Commissioner in this case, such as characterized the cases cited above, upon which to base an implication of consent to a change in the accounting methods. Under such circumstances*1014 we think it was not incumbent upon the Commissioner, in order to avoid a waiver of compliance with the regulations, to deny the deduction in question and that his failure to do so did not amount to implied permission to change from the one method of accounting to the other. Cf. , wherein we said: "We are unable to see, in the circumstances in this case, that mere inaction by the Commissioner is evidence of the voluntary relinquishment of right which is essential to waiver, and plainly estoppel does not lie, there being no showing of detriment to petitioner."
Accordingly, we hold that petitioner was not entitled to the deduction of $33,014.86, claimed as additions to reserve for bad debts. Our holding on this point disposes of the assigned error based upon the disallowance by respondent of a deduction of $5,697.72 representing that part of the above claimed additions to reserve which is in excess *733 of $27,317.14, the amount of bad debts charged to such reserve by petitioner.
The next question for consideration is whether petitioner is entitled to deduct as debts ascertained to be worthless and charged off in*1015 the taxable year the items totaling $9,821.25 set forth in our findings of fact. Petitioner charged those items to the reserve for bad debts. The first of those items is $4,114.94 representing a charge-off for partial worthlessness of the principal of a note by Cyrus W. Scott to petitioner and the second of such items is $641.53, representing a charge-off for worthlessness of the total amount of accrued interest on such note. This note was for the principal sum of $15,094.94, with interest at 6 percent per annum, dated April 11, 1930, and due April 11, 1931. It was secured by 109.8 shares of stock of petitioner corporation, having a book value at the time of such charge-off of $150 to $175 per share, according to the testimony of L. R. Bryan, Jr., vice president of the Second National Bank of Houston, and a stockholder and director of petitioner. In view of this testimony, we can find no justification for the charge-off for partial worthlessness either as to the principal of the note or accrued interest thereon, and the deduction therefor is disallowed.
The third item included in the claimed deduction of $9,821.25 is $4,500, representing the total of moneys advanced monthly*1016 to Cyrus W. Scott in 1932 and 1933 after he had resigned as president and manager of petitioner, which petitioner claims was to be repaid to it. After his resignation as indicated Scott was elected chairman of the board of directors of petitioner in order that his name might continue to be connected with the corporation. The evidence is clear that this advance was made to Scott for the use of his name in connection with petitioner's business. The Cyrus W. Scott Manufacturing Co. was organized by Cyrus W. Scott and he had many personal friends and friends in trade circles, which fact was thought to be commercially valuable to petitioner. We are convinced that it was never intended that Scott should repay these advances, but that they were paid to him as salary for the use of his name and for acting in a nominal official capacity. This conclusion is further fortified by the fact that no time was fixed for the repayment of these advances and no interest thereon was charged or provided for. Also, petitioner continued to advance Scott $150 a month through January and February 1934, after charging off in December 1933 as a bad debt the $4,500 advanced to him in 1932 and 1933. The*1017 deduction of this item of $4,500 is disallowed for the reason that no part of it represented a debt owing by Scott to petitioner. However, $2,000 of the $4,500 was paid by petitioner to Scott in the taxable year as salary and petitioner is entitled to deduct that amount as a business expense. Respondent concedes petitioner's right to this deduction.
*734 The fourth and last item included in the claimed deduction of $9,821.25 is $564.78 owed to petitioner by two of its stockholders, R. B. Mundine and D. E. Ouzts. Beyond the fact that this item was charged as a bad debt to the reserve for bad debts in the taxable year, no evidence was offered as to its worthlessness or when, if at all, it became worthless. Petitioner is, therefore, not entitled to a deduction for this item.
Judgment will be entered under Rule 50.
Footnotes
1. Revenue Act of 1932. -
SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
* * *
(j) BAD DEBTS. - Debts ascertained to be worthless and charged off within the taxable year (or, in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts); and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction. ↩
2. Regulations 77. -
ART. 191. Bad debts. - Bad debts may be treated in either of two ways -
(1) By a deduction from income in respect of debts ascertained to be worthless in whole or in part, or
(2) By a deduction from income of an addition to a reserve for bad debts.
Taxpayers were given an option for 1921 to select either of the methods mentioned for treating such debts. (See article 151, Regulations 62.) The method used in the return for 1921 must be used in returns for subsequent years and in returns under the Revenue Act of 1932 unless permission is granted by the Commissioner to change to the other method. A taxpayer filing a first return of income may select either of the two methods subject to approval by the Commissioner upon examination of the return. If the method selected is approved, it must be followed in returns for subsequent years, except as permission may be granted by the Commissioner to change to another method. Application for permission to change the method of treating bad debts shall be made at least 30 days prior to the close of the taxable year for which the change is to be effective. (See also article 195.)
Where all the surrounding and attending circumstances indicate that a debt is worthless, either wholly or in part, the amount which is worthless and charged off or written down to a nominal amount on the books of the taxpayer shall be allowed as a deduction in computing net income. * * * In determining whether a debt is worthless in whole or in part the Commissioner will consider all pertinent evidence, including the value of the collateral, if any, securing the debt and the financial condition of the debtor. Partial deductions will be allowed with respect to specific debts only. ↩