*58 Decision will be entered for the respondent.
1. In 1936 taxpayer's predecessor deducted $ 79,421.15 as officers' compensation. The amount included $ 41,000 authorized in November 1936 as an additional bonus, but which was in fact a distribution of cash in anticipation of a sale of all of such corporation's stock, all of which except 10 shares of preferred, was owned by the officers. In 1939 such corporation deducted $ 29,896.38 as bad debts. This included $ 13,247.84 which was written off its best customer's account, but did not constitute a bad debt. The deduction included also $ 15,000 written off on account of a note of another customer, which note may have become worthless prior to 1939. Held, taxpayer is not entitled to adjustment of such "deductions" under section 711 (b) (1) (J) and (K), I. R. C., for failure of proof required thereunder.
2. As of December 30, 1939, taxpayer issued 150,000 shares of its common stock and 10,000 shares of its preferred stock to its predecessor corporation in exchange for all its assets, subject to its liabilities except two certain notes payable of $ 100,000. On the same date taxpayer's predecessor transferred some of the stock *59 received from taxpayer to the holder of the notes in full payment thereof. Held, under the circumstances, taxpayer is not entitled to a capital addition for the $ 100,000 under section 713 (g), I. R. C.
*609 The Commissioner determined a deficiency of $ 11,708.50 in the petitioner's excess profits tax liability for the year 1941. He disallowed a claim for refund of such tax in the amount of $ 6,766.06, with interest thereon of $ 137.17. The petition was filed under section 732 (a) of the*60 Internal Revenue Code.
The questions to be determined are:
(1) Whether, in computing the average base period net income of its component corporation, petitioner is entitled, under section 711 (b) (1) (K) (ii) of the Internal Revenue Code, to a disallowance of a portion of such corporation's (a) 1936 deduction for officers' salaries and (b) 1939 deduction for bad debts; and
(2) Whether petitioner is entitled to a capital addition, under section 713 (g) of the Internal Revenue Code, by reason of the exchange in 1940 of petitioner's capital stock for outstanding notes executed by its predecessor corporation.
FINDINGS OF FACT.
Certain facts were stipulated. The portions thereof pertinent to the issues are as follows:
The petitioner is a Rhode Island corporation, with its principal office in Providence, Rhode Island. Its return for the taxable year was filed with the collector of internal revenue for the district of Rhode Island. The petitioner was incorporated on December 20, 1939.
The net sales, gross profit from sales, salaries, and bonuses paid by the petitioner and its predecessor, Universal Optical Corporation, hereinafter called old Universal, during 1932 to 1941, inclusive, *61 were as follows: *610
| Deducted in item 15 | ||||
| Gross | ||||
| Year | Net sales | profit from | ||
| sales | ||||
| Salaries | Bonuses | |||
| 1932 | $ 334,928,58 | $ 94,011,43 | $ 5,200.00 | $ 10,000.00 |
| 1933 | 453,587.63 | 135,214.06 | 5,200.00 | 10,000.00 |
| 1934 | 470,344.41 | 118,313.01 | 5,200.00 | 10,000.00 |
| 1935 | 469,192.03 | 166,435.54 | 20,726.00 | 18,609.58 |
| 1936 | 554,084.59 | 188,569.78 | 29,421.15 | 50,000.00 |
| 1937 | 521,488.03 | 117,054.98 | 30,585.71 | |
| 1938 | 306,676.75 | 31,696.21 | 24,500.00 | |
| 1939 | 541,043.34 | 139,448.45 | 24,040.71 | |
| 1940 | 433,389.04 | 122,118.39 | 16,620.00 | |
| 1941 | 617,492.07 | 177,357.47 | 24,764.00 |
| Deducted in manufacturing | |||
| costs | |||
| Total | |||
| Salaries | Bonuses | ||
| 1932 | $ 17,160 | $ 32,360.00 | |
| 1933 | 15,526 | $ 6,914.88 | 37,640.88 |
| 1934 | 15,526 | 15,156.00 | 45,882.00 |
| 1935 | 39,335.58 | ||
| 1936 | 79,421.15 | ||
| 1937 | 30,585.71 | ||
| 1938 | 24,500.00 | ||
| 1939 | 24,040.71 | ||
| 1940 | 2,912 | 19,532.00 | |
| 1941 | 4,004 | 28,768.00 |
The gross income of the petitioner and its predecessor, old Universal, for the years 1932 to 1939, inclusive, was as follows:
| * Gross | |
| Year | income |
| 1932 | $ 102,870.57 |
| 1933 | 139,165.05 |
| 1934 | 124,687.72 |
| 1935 | 172,481.55 |
| 1936 | 196,557.46 |
| 1937 | 121,669.14 |
| 1938 | 38,650.01 |
| 1939 | 142,546.24 |
The officers receiving the above salaries and bonuses and the total amounts thereof for 1932 to 1936, inclusive, were as follows:
| 1932 | 1933 | 1934 | |
| E. J. R. Beattey, treasurer and general | |||
| manager | $ 15,200 | $ 15,200.00 | $ 15,200 |
| James A. Sweeney, president | 5,680 | 7,388.70 | 9,804 |
| Wayne S. Searles, vice president | 5,280 | 7,093.30 | 9,790 |
| Harry G. Smith, assistant treasurer | 3,540 | 4,809.34 | 6,697 |
| John I. Twombly, secretary | 2,660 | 3,149.54 | 4,391 |
| Total | 32,360 | 37,640.88 | 45,882 |
| 1935 | 1936 | |
| E. J. R. Beattey, treasurer and general | ||
| manager | $ 15,200.00 | $ 26,700.00 |
| James A. Sweeney, president | 7,786.18 | 16,907.23 |
| Wayne S. Searles, vice president | 7,590.15 | 16,907.23 |
| Harry G. Smith, assistant treasurer | 5,157.05 | 11,314.51 |
| John I. Twombly, secretary | 3,602.20 | 7,592.18 |
| Total | 39,335.58 | 79,421.15 |
For the year 1936 the officers and the amounts of their stockholdings, salaries, and bonuses were as follows:
| Shares held | ||||
| Officer | Salaries | Bonuses | ||
| Common | Preferred | |||
| Earl J. R. Beattey, treasurer | 436 | 200 | $ 5,200.00 | $ 21,500.00 |
| James A. Sweeney, president | 23 | 15 | 7,713.24 | 9,193.99 |
| Wayne S. Searles, vice president | 23 | 15 | 7,713.24 | 9,193.99 |
| Harry G. Smith, assistant treasurer | 11 | 7 | 4,879.21 | 6,435.30 |
| John I. Twombly, secretary | 5 | 3 | 3,915.46 | 3,676.72 |
| Total | 498 | 240 | 29,421.15 | 50,000.00 |
| Total shares outstanding | 500 | 250 |
*63 *611 The following is a schedule of the bonuses and salaries voted to be paid to the officers by old Universal in the years 1936 and 1937:
| E. J. R. | James A. | W. S. | H. G. | John I. | |
| Date voted | Beattey | Sweeney | Searles | Smith | Twombly |
| May 20, 1936 | $ 2,500 | $ 806.44 | $ 806.44 | $ 564.48 | $ 322.64 |
| Sept. 26, 1936 | 2,000 | 645.15 | 645.15 | 451.62 | 258.08 |
| Nov. 17, 1936 | 5,500 | 1,774.30 | 1,774.30 | 1,241.90 | 709.50 |
| Nov. 28, 1936 (payable) | |||||
| Dec. 5, 1936 | 3,226.00 | 3,226.00 | 2,258.00 | 1,290.00 | |
| Dec. 24, 1936 | 2,500 | 806.50 | 806.50 | 564.50 | 322.50 |
| Mar. 15, 1937 | 9,000 | 1,935.60 | 1,935.60 | 1,354.80 | 774.00 |
| Total bonus | 21,500 | 9,193.99 | 9,193.99 | 6,435.30 | 3,676.72 |
| Other compensation | 5,200 | 7,713.24 | 7,713.24 | 4,879.21 | 3,915.46 |
| Total compensation | 26,700 | 16,907.23 | 16,907.23 | 11,314.51 | 7,592.18 |
| Apr. 10, 1937 | 2,500 | 806.50 | 806.50 | 564.48 | 322.64 |
At a meeting of the board of directors of old Universal, held on December 26, 1933, a motion was made to pay certain bonuses to the executives, reciting, "By virtue of the successful and skillful management used by the executives of this Company, during the difficult and trying year, 1933, I move that a bonus **64 * *." The motion was adopted. At the same meeting, an additional bonus of $ 6,000 was authorized to be paid to Beattey. On April 5 and July 6, 1934, the board of directors of old Universal authorized bonuses to be paid to the executives "in recognition of the highly successful and skillful management displayed by them * * *." On December 31, 1934, additional bonuses were authorized to be paid to Beattey. On May 10 and September 17, 1935, bonuses were voted to the executives, with a recital similar to that contained in the motion of April 5, 1934.
The motions of the board of directors authorizing the payment of the bonuses to the executives in 1936, as above set forth, all contained the phrase "in recognition of the successful and skillful management displayed by them * * *."
The following are correct transcripts of the accounts "Max Zadek -- Account Receivable" and "Max Zadek -- Notes Receivable" for 1936 to 1941, inclusive:
| ACCOUNT RECEIVABLE | ||||
| Payments | ||||
| Year | Balance at | Sales | ||
| first of year | ||||
| Cash | Notes | |||
| 1936 | $ 537.92 | $ 30,285.90 | $ 0.00 | $ 28,121.97 |
| 1937 | 2,701.85 | 12,353.58 | 5,652.28 | 3,986.49 |
| 1938 | 5,416.66 | 20,788.39 | 8,069.69 | 5,494.13 |
| 1939 | 12,641.23 | 15,180.01 | 2,975.00 | 5,049.94 |
| 1940 | 19,796.30 | 10,131.03 | 5,640.79 | 8,700.73 |
| 1941 | 15,585.81 | 6,121.46 | 5,844.28 | (A)(1,063.48) |
| $ 94,860.37 | $ 28,182.04 | (B)$ 50,289.78 | ||
| 1942 | $ 16,926.47 |
| NOTES RECEIVABLE | ||||
| Balance at | Notes received | Cash payments | Write-offs | |
| Year | first of year | |||
| 1936 | $ 7,032.05 | $ 27,559.54 | $ 19,681.15 | |
| 1937 | 14,910.44 | 3,907.57 | 9,312.14 | |
| 1938 | 9,505.87 | 5,494.13 | ||
| 1939 | 15,000.00 | 5,049.94 | 1,749.94 | $ 15,000.00 |
| 1940 | 3,300.00 | 8,700.73 | 5,700.73 | |
| 1941 | 6,300.00 | (A)(1,063.48) | 4,400.00 | |
| (B)$ 49,648.43 | $ 40,843.96 | $ 15,000.00 | ||
| 1942 | $ 836.52 |
Notes: (A): Represents notes which were not paid when due and were added back to account receivable.
(B): Difference of $ 641.35 between note credits to accounts receivable and note debits to Notes Receivable, represents 2% discount allowed on 1936 and 1937 note payments.
During 1932 to 1941, inclusive, the petitioner and its predecessor, old Universal, charged off actual bad debts. Bad debt recoveries were deducted from the amounts otherwise to be charged off. There were bad debt recoveries during some or all of these years. During these years, the gross bad debt deductions, the recoveries, and the net bad debt deductions were as follows:
| Year | Bad debts | Recoveries | Net |
| 1932 | $ 18,736.36 | $ 3,850.42 | $ 14,885.94 |
| 1933 | 6,714.33 | 2,906.33 | 3,808.00 |
| 1934 | 9,279.86 | 3,205.01 | 6,074.85 |
| 1935 | 2,843.50 | 917.45 | 1,926.05 |
| 1936 | 2,433.97 | 940.68 | 1,493.29 |
| 1937 | 6,116.07 | 1,216.22 | 4,899.85 |
| 1938 | 910.87 | 5,637.06 | * (4,726.19) |
| 1939 | 29,896.38 | 75.00 | 29,821.38 |
| 1940 | 664.07 | 4,237.67 | * (3,573.60) |
| 1941 | 2,326.27 | 1,282.18 | 1,044.09 |
The following is a correct transcript of the "B. Robinson -- Account Receivable" for 1936 to 1941, inclusive:
| Year | Balance at | Sales | Cash | Write-off |
| first of year | payment | |||
| 1936 | $ 22,611.58 | $ 84,538.47 | $ 61,580.00 | |
| 1937 | 45,570.05 | 89,214.10 | 87,286.75 | |
| 1938 | 47,497.40 | 65,322.23 | 73,039.16 | |
| 1939 | 39,780.47 | 98,120.59 | 83,285.35 | $ 13,247.84 |
| 1940 | 41,367.87 | 80,676.56 | 72,250.00 | |
| 1941 | 49,794.43 | 100,896.88 | 101,017.47 | |
| $ 518,768.83 | $ 478,458.73 | $ 13,247.84 | ||
| 1942 | $ 49,673.84 |
At all times during 1939, Benjamin Robinson, heretofore referred to as "B. Robinson," was financially able to pay all his debts and obligations in full, including his open account with old Universal.
*613 The respondent admits that during 1939 Max Zadek, Inc., was financially unable to pay its debts and obligations, including its notes and open account with old Universal.
The petitioner experienced a capital reduction, within the meaning of section 713 (g) of the Internal Revenue Code, in the amount of $ 200,000 on October 1, 1940. In the event the petitioner's excess profits credit is computed on the income method, effect shall be given therein to such capital*67 reduction.
On August 31, 1943, and March 15, 1945, the petitioner filed claims for refund in the amounts of $ 3,414.69 and $ 6,903.23 ($ 6,766.06 tax and $ 137.17 interest), respectively. At various times it paid sums aggregating $ 23,292.87 covering its income and excess profits tax liability, including $ 137.17 interest for the year 1941.
The record discloses the following additional facts:
Old Universal manufactured frames for spectacles and eyeglasses. It made the "Ful-Vue" frame and the Ful-Vue rimless spectacle. Patents on both articles were owned by the Ful-Vue Sales Co., a partnership composed of George F. Kimmel and men named Emmons, Tuvin, and Hilliard.
In about 1930 old Universal constructed a sample Ful-Vue frame and submitted it to three of its customers, one of whom gave it to the American Optical Co., hereinafter called American, old Universal's largest competitor (except Bausch & Lomb, a manufacturer of about equal size). American forwarded the sample to Kimmel. Kimmel then consulted with James Sweeney, the petitioner's president and the vice president of old Universal, suggesting that old Universal secure a license from him. Although he challenged the validity*68 of the Kimmel patent, Sweeney agreed to take the license if he were allowed a differential under the price set for American. However, subsequently Kimmel and his associates granted an exclusive license to American, with the right to issue sublicenses. Thereafter old Universal and American entered into a written license agreement, but with an oral understanding that old Universal should have a price advantage and should manufacture the product under a different name, "Hi-Bo."
After about six months, American began to manufacture its own product under the name "Hi-Bo" and sold it at the same price as old Universal's product. There then ensued a controversy between American and old Universal, lasting several years. Because it felt American had violated its oral agreement, old Universal, in order to evade payment of royalty to American, cut prices and resorted to various practices, such as selling under different catalogue numbers, giving "free merchandise," marketing a similar frame under another name, *614 and other like devices, so as to conceal sales normally subject to the license agreement.
American brought suit against old Universal in August 1936 for violation of the *69 license agreement. Thereupon, old Universal canceled that agreement. In October 1936 Sweeney called upon old Universal's customers throughout the country and induced them to burn their records of "free merchandise" shipments and of other devices employed to evade payment of royalties to American. During the trip Kimmel talked with Sweeney on the telephone for the purpose of finding some way to settle the differences between American, Ful-Vue Sales Co., and old Universal and proposed that he, Kimmel, acquire the stock of old Universal. At that time, the stock was held as follows:
| Shares held | ||
| Stockholder | ||
| Preferred | Common | |
| Earle J. R. Beattey | 200 | 436.172 |
| James A. Sweeney | 15 | 23.404 |
| Wayne S. Searles | 15 | 23.404 |
| Harry G. Smith | 7 | 11.702 |
| John I. Twombly | 3 | 5.318 |
| John Nelson | 10 | |
| Total | 250 | 500. |
At a meeting of Kimmel and Sweeney in New York City on October 31, 1936, a purchase price of $ 500,000 for all the outstanding stock of old Universal was tentatively agreed upon. Sweeney thereafter discussed the proposition with the other stockholders, including Beattey, who agreed to the sale on the suggested basis. However, at a meeting held just before the close*70 of the year, when counsel for Kimmel came to Providence with a certified check to close the deal, Beattey objected to the suggested price, claiming that the business, upon audit and appraisal, would prove to be worth $ 700,000 or $ 750,000. No agreement was reached at that time. Finally, on July 7, 1937, Sweeney, Searles, Smith, and Twombly entered into an agreement to sell their shares to Kimmel or Keth Products Corporation, a corporation of Kimmel, Emmons, Tuvin, and Hilliard, as follows: 40 shares preferred for $ 4,000 and 63.828 shares of common for $ 60,000, of which $ 15,000 was payable at the time of the execution of the agreement; $ 20,000 on or before 30 days after October 1, 1937, and $ 29,000 on or before 30 days after January 1, 1938. The stock was deposited in escrow in the name of Keth Products Corporation. The agreement recited that Kimmel had entered into an agreement for the sale by Beattey to Kimmel of his common and preferred shares of old Universal. Under the agreement, the price to be paid to Beattey was to be determined upon audit and appraisal, but Beattey died before consummation of the sale. Due *615 to the fact that no agreement was reached with*71 respect to the price to be paid for Beattey's shares, the last payment due under the agreement of July 7, 1937, was not made to the minority stockholders, who thereupon recovered their stock.
Petitioner was organized with an authorized capital stock of 10,000 shares of preferred stock of the par value of $ 20 a share and 200,000 shares of common stock of the par value of $ 1 a share. Under date of December 30, 1939, all of the assets of old Universal, subject to all its liabilities except notes of the principal amount of $ 100,000 due to Bodell & Co., were transferred to petitioner in exchange for 150,000 shares of common stock of the par value of $ 150,000 and 10,000 shares of preferred stock of the par value of $ 200,000, which constituted all of the issued and outstanding stock of petitioner as of that date and as of January 1, 1940. Such transfer constituted the petitioner an acquiring corporation and old Universal a component corporation, as defined in section 740 of the Internal Revenue Code. The petitioner did not assume the liability of old Universal on the $ 100,000 notes due to Bodell & Co. In payment thereof old Universal, as of December 30, 1939, transferred and caused*72 to be issued to Bodell & Co. some of the shares received by it from petitioner.
Bonuses had been paid to its executives regularly by old Universal since 1928. In 1941 bonuses were paid to four officers, the president, the vice president, the assistant treasurer, and the assistant secretary. The treasurer and secretary were not active in the business. After his shares were sold, Searles resigned and his duties were performed in 1941 by two employees who were not officers. Services which were performed by additional officers in 1936 were performed by Sweeney in 1941. The amounts of the bonuses were deducted by old Universal in its income tax returns for 1936 as payment for services rendered by its executives in that year.
In 1936 Benjamin Robinson was old Universal's largest customer. He still enjoys that status with the petitioner. Old Universal started him in business and sold its product to him on the "free goods" basis, that is, it shipped to him more goods than were covered by the invoices. He carried an open running account with old Universal. Neither his books nor the books of old Universal reflected the shipment of free goods.
Early in 1936 Robinson suffered a robbery*73 in his store in Brooklyn. Robinson asserted a claim with his insurance company for the entire loss. The matter was litigated and by the verdict of a jury he recovered only about a third of the amount of his claim because his books were not adequately kept as required under the terms of the insurance policy.
Robinson took the position that old Universal was responsible for his failure to keep his own books correctly as provided by his insurance *616 policy, due to its practice of shipping to him free merchandise, and that old Universal should reimburse him for his entire loss. After many discussions, a compromise was arrived at, pursuant to which the amount of $ 13,247.84 was written off against Robinson's account. This sum represented about one-third of Robinson's claim against the insurance company.
Max Zadek, Inc., had been a good customer of old Universal for many years. In 1938 a dissension arose between Max Zadek and minority stockholders of his company. Those stockholders withdrew from the company and formed a new enterprise, called "The North Star Optical Company."
Max Zadek, Inc., did not purchase on open account from old Universal, but operated on a 3-month note*74 basis. The notes were regularly paid up to the time its minority stockholders withdrew. Thereafter, Max Zadek, Inc., was unable to pay its obligations. Old Universal had the choice of refunding its debtor's indebtedness or of throwing it into bankruptcy. The latter course might disclose to the trade the fact that there was some connection between old Universal, the Ful-Vue Sales Co., and American -- a situation which would be disastrous to old Universal's business. Consequently, old Universal refunded prior short term notes of the debtor by taking its note dated May 27, 1938, for $ 15,000 payable in five years, together with all of the debtor's shares as collateral, subject to a collateral agreement to make monthly payments on the note. The debtor defaulted immediately on his monthly payments and under the collateral agreement the note became due after a 60-day default. However, old Universal "nursed Zadek along" because it did not want to take drastic action against the debtor. It did not attempt to realize on the collateral held by it. To help the debtor, Sweeney personally guaranteed its accounts with other manufacturers.
In his notice of disallowance of claim for refund, *75 the respondent disallowed the petitioner's claims for refund, with the following comment:
In the computation of your average base period net income, no portion of the deductions taken for salaries of officers in the year 1936 and bad debts in the year 1939 may be disallowed as abnormal deductions under the provisions of section 711 (b) (1) (J) (ii) of the Internal Revenue Code, since it has not been shown that the deduction for the salaries of officers in the year 1936 is of the same class as the deduction for salaries of officers in the year 1941, or, as required by section 711 (b) (1) (K) (ii) of the Internal Revenue Code, that such deductions are not the consequence of an increase in gross income in the base period or a decrease in the amount of some other deduction in the base period and are not a consequence of change at any time in the type, manner of operation, or the size or condition of the business.
The excess profits credit of $ 18,024.11 allowed by the Commissioner was based on invested capital.
*617 OPINION.
In 1936 old Universal paid, and it deducted in its 1936 income tax return, salaries and bonuses paid to its five officers aggregating $ 79,421.15. The petitioner*76 claims that part of such amount should be disallowed in 1936 as abnormal under section 711 (b) (1) (J) (ii) of the Internal Revenue Code in computing the average base period net income for the purpose of determining its excess profits credit based on income under section 713 of the Internal Revenue Code.
From the evidence adduced, it is apparent that the class of deductions, i. e., officers' salaries and bonuses, was normal for the taxpayer and that the deduction of that class in 1936 was in excess of 125 per centum of the average amount of the deductions of such class for the four previous taxable years. Thus the excess of $ 30,915.33, under the mathematical formula provided in section 711 (b) (1) (J) (ii), is disallowable.
However, the respondent contends that petitioner has not established, as required by section 711 (b) (1) (K) (ii) of the Internal Revenue Code, that the 1936 deduction for salaries and bonuses was not a consequence of an increase in gross income for 1936, a base period year, or of a change in the manner of operation of the business engaged in by petitioner's component corporation, old Universal.
Section 711 (b), in so far as pertinent, is set forth in the margin. *77 1
*78 *618 It is argued by petitioner that, because of the practices indulged in by old Universal to evade payment of royalty to American, it, old Universal, was a "distinct thorn in the side of" American and Ful-Vue Sales Co.; that, when Kimmel of the latter company proposed to purchase the stock of old Universal as a means of settling the difficulties, the officers of old Universal were justified in concluding that their stock had a substantial nuisance value for which Kimmel and his associates would be willing to pay without reference to the true value of the stock or the assets of old Universal; and that the reason which prompted the payment of the bonuses of $ 41,000 voted in November 1936 was "the conviction of the management that cash could be distributed without adversely affecting the price of the stock."
It is true that the record indicates a regular and continuous practice of paying bonuses in "recognition of successful and skillful management," as argued by respondent, and that the amounts voted and paid as salary and bonuses in 1936 were deducted as such in the 1936 return of old Universal. However, Sweeney, the then president of old Universal and now of petitioner, testified*79 that the salary and bonuses authorized in the early part of 1936 were for services rendered, "but those November bonuses were obviously a distribution of cash," and, again, that "the bonus distribution at that time was a distribution of cash in anticipation of selling the business at a price, regardless of the equity behind the price" and "regardless of what the minutes say, the minutes were a formula." Thus it appears that the portion of the 1936 deduction to the extent of $ 41,000 was not compensation paid in recognition of services rendered, but a disposition of cash or profits to the officers, all of whom were stockholders of old Universal. With the elimination of such distribution from the 1936 deduction, there is no abnormality in amount.
The respondent states on brief that he has not assumed and does not now assume the payments to have been other than for salaries, as stated in the minutes. He argues that the increased salaries were inextricably involved with the increased gross income and that there was some connection between the increased earnings and increased compensation. The facts show otherwise, as illustrated by the following schedule:
| Per cent of | Per cent of | |||
| Officers' | change in | change in | ||
| Year | Gross income | compensation | gross income | officers' compensation |
| from prior | from prior | |||
| year | year | |||
| 1932 | $ 102,870.57 | $ 32,360.00 | ||
| 1933 | 139,165.05 | 37,640.88 | +35 | +16 |
| 1934 | 124,687.72 | 45,882.00 | -10 | +22 |
| 1935 | 172,481.55 | 39,335.58 | +38 | -14 |
| 1936 | 196,557.46 | 79,421.15 | +14 | +102 |
| 1937 | 121,669.14 | 30,585.71 | -38 | -61 |
| 1938 | 38,650.01 | 24,500.00 | -68 | -20 |
| 1939 | 142,546.24 | 24,040.71 | +269 | -2 |
*80 *619 Thus, although there was a decrease in gross income in 1934 of about 10 per cent, there was an increase in officers' compensation of about 22 per cent. In 1935, although there was an increase in gross income of about 38 per cent, there was a decrease in officers' compensation of about 14 per cent; and in 1936, although the increase in gross income was only about 14 per cent, the increase in officers' compensation was about 102 per cent.
In our opinion, the above schedule discloses no pattern of relationship between gross income and officers' compensation. The fact that there was an increase in gross income in 1936 is not sufficient by itself to establish that the deduction for officers' compensation was due to such increase. See Frank Shepard Co., 913">9 T. C. 913, 926, and O. Hommel Co., 8 T. C. 383, 387. American Paper Specialty Mfg. Co., 9 T. C. 166, cited by respondent, is distinguishable on the facts. Therein it was shown that it was understood that, if the company there involved would earn any substantial profits, suitable adjustment of the salary of the vice president and plant*81 superintendent would be made, and this was done in the year of the alleged abnormal deduction.
The petitioner, however, has not established that the payment of the additional bonuses authorized in November 1936 was not a consequence of a change in the manner of operation of the business engaged in by old Universal as required by section 711 (b) (1) (K) (ii). Prior to August 1936 old Universal was operating under a license agreement entered into with American covering patents owned by Ful-Vue Sales Co. After American instituted suit against old Universal for breach of the agreement, old Universal canceled the license agreement, which, as testified by Sweeney, "left us freedom to go out and combat them vigorously, realizing the weakness of their position from the standpoint of the validity of the patents." Shortly thereafter Kimmel, a member of the partnership of Ful-Vue Sales Co., contacted Sweeney in an attempt to purchase the stock of old Universal. This led to the decision of the officers, as testified by Sweeney, to "distribute some of the cash so long as the diminishing of the equities had no bearing on the purchase price." Thus there was a relationship of cause and consequence*82 between the change in the manner of operation of the business and the authorization in November of the additional bonuses of $ 41,000. Even if the additional bonuses be regarded as, in fact, officers' compensation for services rendered by them, the excess of the 1936 deduction as computed under section 711 (b) (1) (J) (ii) may not be disallowed because of petitioner's failure to establish the negative, as required by section 711 (b) (1) (K) (ii); i. e., that the excess is not a consequence of a change at any time in the manner of operation of the business engaged in by the taxpayer.
The petitioner, therefore, is not entitled to the disallowance claimed.
*620 In view of our conclusion, it is not necessary to consider respondent's further contention that petitioner has failed to prove essential facts with respect to the limitation on abnormality contained in section 711 (b) (1) (K) (iii).
The bad debts in 1939 of $ 29,896.38 included a write-off on the account of B. Robinson of $ 13,247.84 and a write-off on the notes receivable account of Max Zadek, Inc., of $ 15,000.
The account of Robinson was the largest account of old Universal. In 1939 a robbery occurred in Robinson's place*83 of business. Robinson had cooperated with old Universal in some of the devices and practices resorted to by old Universal to evade payment of royalty to American, as a consequence of which his books did not reflect the correct amount of merchandise on hand prior to the robbery. As a result, Robinson was unable to recover on his insurance his entire loss sustained by the robbery. He took the position that his method of bookkeeping was due to the practices of old Universal and that it was responsible for his failure to recover his loss from the insurance company. Apparently, to placate its best customer, to obtain payment of the account, in part, at least, and to obtain future business, a compromise settlement was reached, which resulted in the write-off in 1939 on Robinson's account of $ 13,247.84. It was stipulated that Robinson at all times during 1939 was financially able to pay all his debts and obligations in full, including his account with old Universal.
Obviously, the credit to Robinson's account of $ 13,247.84, under the circumstances, was improperly classified as a bad debt.
It is conceded on brief by petitioner that the item was not a bad debt in the usual sense of *84 an account which becomes worthless by reason of the inability of the debtor to pay. It contends, however, that it was an expense of operation of the business and that, if taken out of normal bad debts, it should be classified as a deduction of a class abnormal for the taxpayer under section 711 (b) (1) (J) (i), or as an abnormal deduction attributable to a claim within section 711 (b) (1) (H).
Such classification under either subsection is not permissible unless evidence is adduced showing that the deduction was of a class abnormal to the taxpayer; i. e., that there were no deductions of that class in the four previous taxable years. The burden to show this was upon petitioner, and it has failed to sustain such burden. Cf. R. C. Harvey Co., 5 T. C. 431, 441.
The respondent argues that the write-off was obviously either an adjustment of selling price or a trade allowance, which adjustments are not "deductions" within the meaning of the statute, and, therefore, petitioner is not entitled to relief.
*621 It is argued by petitioner that, whether the item is a deduction or part of the cost of sales, it goes to reduce the net taxable income of the taxpayer, *85 and if it goes to reduce the net taxable income of the taxpayer and if it is abnormal under the provisions of section 711 (b) (1) (J) and (K), the taxpayer is entitled to relief.
Petitioner has failed, however, to show that the item regarded as a part of cost of sales was abnormal within the meaning of the statute. Green Bay Lumber Co., 3 T. C. 824, does not support petitioner's position that it is immaterial under section 711 (b) (1) (J) whether or not the item involved is a statutory deduction. While it is stated therein that "Congress did not intend to limit classification of deductions for the purposes of subsection (J) to the 'statutory deduction categories' of section 23," it is also stated immediately following:
* * * This is not to say we disapprove or find to be unsound the requirement of the regulation that "reference must be made to the deductions of the entire class rather than to any particular deductible items therein." We merely hold that bad debts do not all have to fall into a single class -- a view, incidentally, specifically recognized by section 23 (k), I. R. C., which classifies bad debts into those coming within the "general rule," *86 securities becoming worthless, nonbusiness debts, and securities of affiliated corporations. * * *
The question therein involved was whether "two different kinds of bad debts may be put into separate classes." The item involved constituted an allowable bad debt deduction under section 23. Herein the evidence shows that the Robinson write-off did not constitute a bad debt in 1939 as defined in section 23 (k) (1). Clearly, section 711 (b) (1) (J) permits adjustment only of "deductions," abnormal, or normal, if abnormal in amount. The meaning of the statutory term "deductions" is well established. Without express enlargement of its usual meaning to include other items than those specified as deductions under the Internal Revenue Code, no item which is not shown to have been a statutory deduction may be adjusted under section 711 (b) (1) (J).
With respect to the write-off of $ 15,000 on the Zadek notes receivable account, petitioner contends that the write-off was a bad debt of a class normal for old Universal and out of the ordinary only in that it was excessive in amount.
The $ 15,000 written off represented the principal amount of a collateralized note dated May 27, 1938, payable*87 in five years, with an agreement for monthly payments. The purpose of the execution of the note was to refund, as testified in effect by Sweeney, the balance in the notes receivable account as of January 1, 1938, of $ 9,505.87 and the amount of notes received thereafter but prior to May 27, 1938, of $ 5,494.13, or a total of $ 15,000. Sweeney testified that Zadek defaulted *622 on the note "almost off the bat, immediately." It was stipulated that Zadek was unable to pay its debts during 1939. The note may have been worthless prior to 1939 and hence was not properly includible in bad debts for the year 1939. The evidence indicates that it should have been deducted in 1938. Under subsection (K) (ii) of section 711, the taxpayer is required to establish that the excess is not a consequence of "a decrease in the amount of some other deduction in its base period." The write-off made in 1939 may have been a reduction in the bad debt deduction in 1938. At least, petitioner has not established that it was not. As stated in William Leveen Corporation, 3 T.C. 593">3 T. C. 593:
* * * difficult as the proof of the negative may be, it is what the statute requires; *88 and, since it is required in clear and express terms, its rigors may not be abated by softening construction.
Furthermore, it is alleged in the petition that before petitioner assumed the business of old Universal it engaged an accountant to examine the financial structure of old Universal; that such accountant reviewed the account of Max Zadek, Inc., and concluded that, in view of the financial condition of that company, the $ 15,000 note should be charged to profit and loss as a bad debt because he did not want to have any questionable assets on the balance sheet of the new company; and that the note was accordingly charged off and deducted on the 1939 return of old Universal. This indicates that the charge-off may have been a consequence of a change in the manner of operation of the business engaged in by the taxpayer. Petitioner has not established the contrary, as it is required to do under subsection (K) (ii) of section 711.
Upon the record made, petitioner is not entitled to adjustment of its bad debt deduction for 1939 as claimed.
The next question to be considered is whether the petitioner is entitled to a capital addition under section 713 (g) of the Internal Revenue Code.
*89 Section 713 (g) (3) defines "daily capital addition for any day of the taxable year" as the "aggregate of the amounts of money and property paid in for stock * * * after the beginning of the taxpayer's first taxable year under this subchapter and prior to such day." The beginning of taxpayer's first taxable year was January 1, 1940.
Under date of December 30, 1939, all of the assets of old Universal, subject to all its liabilities except notes of the principal amount of $ 100,000 due to Bodell & Co., were transferred to petitioner in exchange for 150,000 shares of common stock and 10,000 shares of preferred stock of petitioner. This constituted all of the issued and outstanding stock of petitioner as of that date and as of January 1, 1940.
*623 There is no evidence that any additional money or property, other than the assets of old Universal, was paid in to petitioner on or after January 1, 1940, for its stock.
The argument of petitioner that it should not lose the benefits of a capital addition because it could have adopted another form in the exchange of its stock for the assets of old Universal, under which petitioner would have assumed the liability of old Universal on the*90 Bodell notes and issued its stock in payment of same, issuing less stock to old Universal, is without merit.
Petitioner issued all its outstanding stock to old Universal for all its assets, subject to its liabilities except the notes of Bodell & Co. This was a completed transaction. Old Universal then transferred and caused to be issued to Bodell & Co. some of the stock which it had received in payment of such notes. In connection with such transfer and issuance of a new certificate to Bodell & Co. for the stock transferred to it by old Universal, no money or property was paid in to petitioner. Petitioner merely canceled the certificates originally issued to old Universal and issued new certificates in their stead to the persons designated by old Universal, including Bodell & Co. This had no effect upon the amount of its outstanding capital stock or its assets.
Upon the evidence, petitioner is not entitled to a capital addition of $ 100,000 under section 713 (g).
Decision will be entered for the respondent.
Footnotes
*. These figures include income from sources other than sales.↩
*. Net recovery.↩
1. SEC. 711. EXCESS PROFITS NET INCOME.
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(b) Taxable Years in Base Period. --
(1) General rule and adjustments. -- The excess profits net income for any taxable year subject to the Revenue Act of 1936 shall be the normal-tax net income, as defined in section 13 (a) of such Act; and for any other taxable year beginning after December 31, 1937, and before January 1, 1940, shall be the special-class net income, as defined in section 14 (a) of the applicable revenue law. In either case the following adjustments shall be made (for additional adjustments in case of certain reorganizations, see section 742 (e)):
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(J) Abnormal Deductions. -- Under regulations prescribed by the Commissioner, with the approval of the Secretary, for the determination, for the purposes of this subparagraph, of the classification of deductions --
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(ii) If the class of deductions was normal for the taxpayer, but the deductions of such class were in excess of 125 per centum of the average amount of deductions of such class for the four previous taxable years, they shall be disallowed in an amount equal to such excess.
(K) Rules for Application of Subparagraphs (H), (I), and (J). -- For the purposes of subparagraphs (H), (I), and (J) --
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(ii) Deductions shall not be disallowed under such subparagraphs unless the taxpayer establishes that the abnormality or excess is not a consequence of an increase in the gross income of the taxpayer in its base period or a decrease in the amount of some other deduction in its base period, and is not a consequence of a change at any time in the type, manner of operation, size, or condition of the business engaged in by the taxpayer.
(iii) The amount of deductions of any class to be disallowed under such subparagraphs with respect to any taxable year shall not exceed the amount by which the deductions of such class for such taxable year exceed the deductions of such class for the taxable year for which the tax under this subchapter is being computed.↩