*2944 1. During the taxable years, payments were received upon accounts which had been charged off the books in prior years and deducted in computing net income of such years. Such accounts were not worthless or ascertained to be worthless in prior years. Held, in the absence of fraud or misrepresentation in connection with such deductions for prior years, that petitioner is not required to include the amounts collected in the taxable years as income in those years. Held, further, that the amounts improperly charged off in such prior years are not to be excluded in computing invested capital.
2. Amounts expended in purchasing novelty banks to be distributed to now depositors held not to be deductible in the year of expenditure as an expense of that year. The action of the Commissioner in allowing such expenditure to be deducted rateably over a period of four years approved.
3. Under the Revenue Act of 1921, deductions for debts which are recoverable only in part may be allowed only when a proper charge-off has been made.
*1429 This proceeding is for a redetermination of deficiencies in income and profits taxes for 1920 and 1921, amounting to $4,034.94 and $1,715.18, respectively.
FINDING OF FACT.
Petitioner is a Kentucky corporation, with its principal offices at Market and Second Streets, Louisville.
During the years 1916, 1917, 1918, and 1919, petitioner charged off its books certain accounts which were recovered in whole or in part in the years 1920 and 1921. In computing the deficiency for 1920 the Commissioner included, as income to petitioner for that year, amounts collected by it on accounts due to it as follows:
| Knadler and Lucas | $2,100.00 |
| Louisville Brick Co | 2,120.00 |
| Louisville College of Dentistry | 212.20 |
| American Standard Asphalt Co | 4,160.00 |
| Highland Park Bank | 150.92 |
| Fred G. Jones Lumber Co | 7,500.00 |
In computing the deficiency for 1921 the Commissioner included, as income to petitioner for that year, amounts collected by it on accounts due to it as follows:
| Louisville Brick Co | $1,636.92 |
| Highland Park Bank | 30.19 |
Knadler and Lucas manufactured table condiments. They started operations before 1900 and were still operating*2946 in Louisville in April, 1928. They owned petitioner $2,100 in 1916. At a meeting of the creditors of this concern early in 1916, some of the small creditors sold their claims for 25 per cent of their full amount. Petitioner, with other creditors, did not sell or settle its claim, but granted an extension to this debtor. Petitioner charged off this account on its books on August 24, 1916, and deducted the amount in its income-tax return for 1916. At the time of charge-off, Knadler and Lucas had inventories valued at approximately $32,000 and *1430 owned a plant and equipment on leased ground. Interest on the full amount of the indebtedness was paid to petitioner quarterly up to at least February, 1918. The indebtedness was paid in full July 21, 1920.
Petitioner charged off the account of Louisville Brick Co., amounting to $7,500, on July 13, 1917, and deducted that amount in its income-tax return for 1917. It received $1,585,98 on the account upon the sale of the company's plant in July, 1917, to M. J. Bannon, the company's president. This $7,500 account was represented by the company's notes which were endorsed by Bannon. On August 15, 1917, Bannon made five new*2947 notes to petitioner for $1,585.98 each, due in one, two, three, four, and five years. These notes were substituted for the company's notes. They were secured by a first mortgage on seven lots on which the brick plant stood, together with the whole equipment thereon, and by a second mortgage on Bannon's home of 18.11 acres. The notes were paid off in weekly installments of $35. In 1920, $1,820 was paid, and $1,636.92 in 1921.
Petitioner charged off on October 15, 1918, and deducted from gross income in its income-tax returns for 1918, the following:
| Note of W. E. Grant, endorsed by Louisville College of Dentistry, due September 16, 1918 | $3,000.00 |
| Note of Louisville College of Dentistry, endorsed by W. E. Grant, due October 3, 1918 | 430.00 |
| Note of Louisville College of Dentistry, endorsed by W. E. Grant due October 20, 1918 | 5,900.00 |
| Note of Louisville College of Dentistry, endorsed by W. E. Grant, due August 25, 1918 | 2,900.00 |
| Demand note, Louisville College of Dentistry, endorsed by W. e. Grant and J. G. Sherrill, dated January 18, 1918 | 2,700.00 |
| Total | 14,930.00 |
W. E. Grant was president and practically sole owner of the Louisville College of Dentistry*2948 at the time these accounts were charged off. Grant had just made an assignment for the benefit of his creditors. His assets were:
(1) A lot 53 by 183 feet mortgaged for $28,000, on the northwest corner of Broadway and Brook Streets in the down-town business district of Louisville. This property sold for $60,000 in 1923.
(2) A lot 75 by 100 feet on the west side of Brook Street south of "V" Street in the residential section of Louisville.
(3) Lot No. 34 on the plot of University Place in the residential section of Louisville.
(4) Lot No. 39 in Block 12 as shown in plot of Beechmont in the residential section of Louisville.
(5) The equipment of the College of Dentistry which sold in 1919 for $16,000.
(6) An interest in the Winfield Candy Shop of $4,200.
*1431 Some of the creditors settled their claims in 1918 for 25 cents on the dollar. The petitioner did not sell its claims. Grant's liabilities were somewhat in excess of $50,000. Sherrill, an endorser of one of the notes held by the petitioner, was a practicing dentist who made payments on this note in 1920 totaling $202.20.
The petitioner held a mortgage in the sum of $4,900 against the indebtedness*2949 of the college. In the charge-off of the notes only $2,900 of the mortgage value was charged off, leaving $2,000 of the mortgage value remaining as an asset.
On or about December 1, 1919, petitioner cashed $301.81 in checks on the Highland Park Bank. The Highland Park Bank was closed by the State Bank Examiner on December 1, 1919, before such checks were paid. On December 9, 1919, petitioner charged the total of the checks off its books as bad debts and deducted $301.81 from gross income in its income-tax return for 1919. On December 24, 1919, petitioner was paid $75.45 on this account; $75.45 on March 9, 1920; $75.45 on July 2, 1920; and $30.19 on April 20, 1921.
Petitioner charged off the account of Fred G. Jones Lumber Co., amounting to $7,500, on August 18, 1919, and deducted that amount in its income-tax return for 1919. This account was represented by three notes of the lumber company, endorsed by Fred G. Jones, president and principal owner of the company. Jones died on July 18, 1919. The inventory of his estate showed net assets of $27,000. He owed petitioner $11,551.73 at the time of his death, which was in addition to his liability as endorser. On April 21, 1920, one-half*2950 of the amount of the note was paid to petitioner and the other half was paid on June 12, 1920.
The returns filed by petitioner for 1916, 1917, 1918, and 1919 were examined and audited by the Commissioner. The deductions from gross income, claimed as bad debts in said years in the said returns, were allowed by the Commissioner. Petitioner's business loss for 1919 was approximately $16,000.
The invested capital of the petitioner for 1920 was computed without including, in the determination of its earned surplus, any *1432 amount for the following debts owing to it which it had previously written off:
| Knadler & Lucas | $2,100.00 |
| Louisville Brick Co | 5,374.02 |
| Louisville College of Dentistry | 14,930.00 |
| American Standard Asphalt Co | 4,160.00 |
| Highland Park Bank | $226.38 |
| Fred G. Jones Lumber Co | 7,500.00 |
| International Traction Co | 3,000.00 |
| S. Lilienthal | 1,455.60 |
The invested capital of the petitioner for 1921 was computed without including, in the determination of its earned surplus, any amount for the following debts owing to it which it had previously written off:
| Louisville Brick Co | $3,254.08 |
| Louisville College of Dentistry | 14,717.80 |
| Highland Park Bank | 75.46 |
| S. Lilienthal | 1,455.60 |
*2951 Prior to the World War, petitioner's name was "The German Insurance Bank." Upon the advent of the War the name was changed to "Liberty Insurance Bank." During 1920 and 1921 petitioner paid $5,497.00 and $6,125.90, respectively, for a certain number of coin banks formed in the shape of the Liberty Bell. The banks were novelties. They cost petitioner about 75 cents each. They were used by petitioner in soliciting new savings accounts. They were given to every new depositor who deposited one dollar or more. Other banks in Louisville gave away various advertising novelties or toys in soliciting new accounts. Petitioner paid its solicitors approximately 80 cents for each new account obtained. The recipient of a bank was under no obligation to return it. Petitioner, however, kept the key to the banks. It was petitioner's practice to replace old, resty banks with new ones. Petitioner charged the cost of the banks to advertising as an expense. The Commissioner has refused to allow a deduction of the amount paid for such banks in 1920 and 1921, but has allowed the cost thereof to be depreciated at the rate of 25 per cent per year and allowed such depreciation as a deduction.
*2952 On January 1, 1921, petitioner maintained in its ledger an account entitled "Contingent Fund for Losses," and there was a credit to this account of $20,000. On July 30, 1921, the "Contingent Fund for Losses" account was increased by $30,000 by a charge to "Undivided Profits," and December 21, 1921, was increased by $45,000 by a similar charge. In petitioner's annual statement for 1921, the balance of $95,000 in said account was deducted from the item "Other Bonds and Securities." There had been an appreciation in petitioner's "Other Bonds and Securities" account during the year.
Petitioner deducted in its return for 1921 accounts ascertained to be totally worthless in the sum of about $35,000. It did not deduct the "Contingent Fund for Losses" account in its return for that year. The Commissioner has not allowed a deduction for any part of such account for 1921.
At the date when such entries were made in such account it was anticipated by the officer who ordered such charges to be made that substantial losses in excess of the amounts so charged would be sustained on the accounts of the Kentucky Wagon Manufacturing Co. and the Wolke Lead Batteries Co. The first of such companies*2953 was known to be in financial difficulties prior to July 30, 1921, and both *1433 of such companies were known to be in financial difficulties on December 31, 1921. On December 31, 1921, the Kentucky Wagon Manufacturing Co. was indebted to the petitioner in the total amount of $358,000, of which $50,000 was upon first mortgage bonds and $66,000 upon trade paper discounted and $242,000 upon other indebtedness. On December 31, 1921, the Wolke Lead Batteries Co. was indebted to the petitioner for approximately $125,000.
OPINION.
PHILLIPS: The first allegation of error is that the Commissioner included as taxable income for 1920 an amount of $9,362.36 which was, in fact, earned in previous years. The respondent concedes that such an error was made and that taxable income for 1920 was overstated by that amount.
A second group of errors assigned arises out of recoveries made in the taxable years from debts previously charged off. During 1920 the petitioner made recoveries on items previously charged off as follows:
| (1) Knadler & Lucas | $2,100.00 |
| (2) Louisville Brick Co | 2,120.00 |
| (3) Louisville College of Dentistry | 212.20 |
| (4) American Standard Asphalt Co | 4,160.00 |
| (5) Highland Park Bank | 150.92 |
| (6) Fred G. Jones Lumber Co | 7,500.00 |
*2954 In 1921 it made such recoveries as follows:
| Louisville Brick Co | 1,636.92 |
| Highland Park Bank | 30.19 |
The Commissioner included the amount of such recoveries as income for the respective years. The respondent conceded that the amount recovered from the American Standard Asphalt Co. in 1920 was not income, leaving for determination the question whether the balance of the recoveries should be included in computing income.
The evidence shows that petitioners vice president had charge of its loan department and that it was his practice to charge off all overdue accounts, as soon as they became past due. From the record it appears that the debts in question were not worthless when they were charged off, nor had there been any ascertainment of worthlessness. Prior to 1921 there was no provision for charging off a debt which was worthless in part. The statute is specific in the statement that debts are to be deducted in the year when ascertained to be worthless. No option is allowed to deduct them at any other time. In such circumstances no deduction could properly be claimed or allowed in these earlier years. *2955 ; ; ; .
*1434 This case does not fall within the regulation of the Commissioner that where debts have been ascertained to be worthless and charged off, any collection is to be included in income, and we are not called upon to discuss the soundness of that regulation. Here there was no ascertainment of worthlessness and consequently no proper deduction in the former year.
There is no charge and no evidence that there was any fraud or misrepresentation in connection with the deductions claimed in the earlier years. The mistakes made in claiming and allowing the deductions for prior years may not be corrected by including the amounts collected as income in the year of collection. The proper remedy is to adjust the tax for such prior years. It is suggested that the period within which any additional taxes for such prior years may be assessed has expired. With respect to the situation created by the expiration of the statutory period, we said in *2956 :
* * * We can not concede, however, that the filing of amended returns, showing correct computations of net income for prior years, can be made a condition to correct determination of a taxpayer's liability for income and profits taxes for subsequent years. The fact that a taxpayer has paid lower taxes for prior years than those which were rightfully due, because of erroneous computations of taxable income, and that the statute of limitations now bars the assessment and collection of any deficiency for those years, does not justify any erroneous computation of its tax liability for any subsequent year. Appeal of goodell-. Income and profits taxes are levied with respect to annual periods, and each annual period must necessarily stand by itself. .
We are of the opinion that the Commissioner was in error in adding to taxable income the amount received in 1920 and 1921 from the above mentioned accounts.
The petitioner further contended that its invested capital for 1920 has been improperly reduced by $33,746, being the amount of*2957 certain debts erroneously written off in prior years as follows:
| (1) Knadler & Lucas | $2,100.00 |
| (2) Louisville Brick Co. | 5,374.02 |
| (3) Louisville College of Dentistry | 14,930.00 |
| (4) American Standard Asphalt Co | 4,160.00 |
| (5) Highland Park Bank | 226.38 |
| (6) Fred G. Jones Lumber Co | 7,500.00 |
| (7) International Traction Co | 3,000.00 |
| (8) S. Lilienthal | 1,455.60 |
The respondent admits error in reducing invested capital by the items identified above as (4), (7), and (8). The remaining items are those which we have discussed above. They had not been ascertained to be worthless prior to the taxable year involved and were therefore improperly excluded from the computation of invested capital. For 1921 the Commissioner reduced invested capital by *1435 $19,502.88 on account of some of these same items. For the reasons given above such reduction was erroneous.
It is alleged that the Commissioner erred in refusing to allow as deductions expenditures of $5,497 and $6,125.96 in the years 1920 and 1921, respectively, for savings banks which were used as advertising novelties. These were in the form of miniatures of the Liberty Bell.
The evidence shows that*2958 the "Liberty Bell Banks" were distributed by petitioner for three purposes; to obtain new depositors, to advertise petitioner's business and name, and to stimulate and encourage thrift in the community. Solicitors were engaged to call from house to house and offer a bank to those who opened new accounts counts with petitioner. Advertisements depicting the banks and offering to give them to new depositors were displayed in newspapers. These banks could not be opened unless they were brought to petitioner's place of business or unless they were forcibly broken open. A supply of these banks was on hand at the close of each of the years involved and, as no record of their number was kept, it is not possible to determine the cost of those distributed. On this basis alone it might be necessary to approve the Commissioner, but we prefer to rest our decision on a broader ground. In several cases we have pointed out that expenditures for advertising and promotion may create or increase the value of an asset in the nature of a trade name or good will. We have pointed out that in such cases it would be proper to capitalize that portion of such expenditures that can properly be said to*2959 be directed toward such an object. ; ; affd. . The difficulty is a practical one in determining what portion represents a current expense of the business of the year and what portion is properly to be attributed to future years. We are satisfied that in the instant case the usefulness of these banks as an advertisement for the petitioner did not cease with the taxable year. The Commissioner has allowed 25 per cent of their cost to be written off each year until the whole is recovered. There is nothing which would lead us to believe that this is not a proper period over which to distribute the cost of these banks.
The remaining contention of petitioner is that debts of the Kentucky Wagon Manufacturing Co. and the Wolke Lead Batteries Co. were recoverable only in part in 1921 and that a deduction should be allowed. The Revenue Act of 1921 provided in section 234(a) that there should be allowed as deductions:
(5) Debts ascertained to be worthless and charged off during the taxable year (or in the discretion of the Commissioner a reasonable addition*2960 to a reserve for bad debts); and when satisfied that a debt is recoverable only in part the Commissioner may allow such debt to be charged off in part.
*1436 The revenue acts prior to that of 1921 had allowed as deductions only "debts ascertained to be worthless and charged off during the taxable year." Under such prior acts no deductions were allowed for reserves for debts which were worthless in part. It was only when the debts was ascertained to be wholly worthless that a deduction could be allowed. We must assume that Congress did not intend that a deduction should be allowed for a part of a debt, in the year in which it became worthless in part, and for the whole debt when it was ascertained to be wholly worthless and charged off. A literal construction of the statute might lead to that result. The proper interpretation would seem to be that the partial indebtedness must be ascertained and the amount charged off during the taxable year. In other words, the amount charged off is to be allowed as a deduction if, in fact, the charge-off is justified by an ascertainment that the debt is worthless to the extent written off. This is the interpretation placed upon the*2961 statute by regulations and in effect accepted by Congress by reenacting the section without change in subsequent acts. We are, therefore, of the opinion that it is incumbent upon the petitioner to establish not only that the debts were worthless in part, but that they were charged off.
The evidence shows that at the beginning of the taxable year petitioner had on its books an account known as "Contingent Fund for Losses" in which there was a credit of $20,000. On July 30, 1921, this was increased by $30,000 and on December 31, 1921, by $45,000, making a balance of $95,000 in this account at the close of 1921. These increased amounts were charged into the undivided profits account. The effect was to set aside a part of the undivided profits as a contingent fund to cover prospective losses. The testimony is that the official who directed these entries had in mind the anticipated loss on the two accounts in question. On the balance sheet of the petitioner, the amount of this account was deducted from its securities, although there had been no loss from this source. No deduction was claimed in preparing petitioner's income-tax return. The reserve so set up was available for*2962 the purpose of meeting any loss which might be sustained.
Furthermore, it appears that when the notes of the Kentucky Wagon Manufacturing Co. were later determined to be worthless they were charged directly into the undivided profits account, and not into this reserve fund, although this reserve was at the same time decreased in amount by charging a part of it back into undivided profits. All the circumstances considered, we are of the opinion that the debts in question were not charged off in part and that the deduction now claimed can not be allowed.
Reviewed by the Board.
Decision will be entered under Rule 50.
MARQUETTE did not participate.
*1437 SMITH, dissenting: Under a taxing statute the ascertainment of the worthlessness of a debt must be by the taxpayer. United Statesv. Frost, Federal Case 15172. If there has been an ascertainment of worthlessness by the taxpayer and that has been made in good faith the respondent may not disallow the deduction. In its income-tax returns in years prior to the taxable years the petitioner filed returns in which it deducted from gross income debts which it alleged had been ascertained*2963 by it to be worthless. In the audit of such returns the respondent allowed the deductions to stand. In my view of the case the taxpayer is now estopped to deny that the debts were ascertained to be worthless in the years for which they were claimed as deductions from gross income.
ARUNDELL, dissenting: I can not agree with the treatment in the prevailing opinion of the amounts charged off as bad debts and allowed as deductions in the years prior to 1920 and 1921 and on which there were recoveries in the taxable years. While, as stated in the Macmillan Company decision, "income and profits taxes are levied with respect to annual periods, and each annual period must necessarily stand by itself," it does not follow that in determining the tax liability of the current year that the course of conduct of a taxpayer during past years in his dealings with the United States should be entirely disregarded. The limitation on the making of additional assessments for the years 1916 to 1919, inclusive, has admittedly expired, but petitioner seeks to retain the benefit of its own acts and at the same time avoid the consequences thereof. The respondent under such circumstances invokes*2964 the doctrine of estoppel and it would seem that the necessary elements of an estoppel are here present. That this doctrine has been recognized in tax cases may be seen from an examination of the case of .
The petitioner herein had not ascertained the accounts to be worthless but represented to the respondent that it had. With respect to at least some of the items petitioner knew, or at any rate had abundant reason to believe, that they were not worthless. For instance, in the case of the Louisville Brick Co. item petitioner obtained within the year new notes given by the president of the company and secured by mortgages. As to the notes of W. E. Grant and the Louisville College of Dentistry, petitioner held a mortgage against the indebtedness of the college, and so it must have known that the college had some property to which it could look for payment.
The Commissioner is not chargeable with knowledge of the facts pertaining to the financial condition of petitioner's debtors and no duty is imposed upon him by law to acquaint himself with the *1438 facts. It is intention of the statute that returns shall*2965 be honestly made and if the Commissioner so desires he may rely on the statements made in them. If it were otherwise the Commissioner would be obliged to examine with suspicion every return filed and be required to make an independent investigation of every fact stated despite the oath of the taxpayer. It was stipulated by the parties that the "returns for 1916, 1917, 1918, and 1919 were examined and audited by the respondent," and petitioner quotes this in its argument against the working of an estoppel. How far the examination and audit went is not shown, but it is unbelievable that these deductions would have been allowed if the facts as now asserted by petitioner had been made known to the respondent.
It is to be remembered that the real party in interest is not the Commissioner of Internal Revenue but the United States, and that the petitioner by taking the deduction for bad debts was benefited by reductions of its taxes which it would not have received but for its erroneous claims, and the United States was correspondingly damaged. The petitioner argues that it was mathematically impossible for the United States to have suffered any pecuniary prejudice on account of the*2966 deductions taken for 1919 because in that year petitioner had a net loss of approximately of $16,000 and the bad debt deductions amounted to but $7,801.81. In making this argument petitioner fails to take into account the net loss provision of the statute under which a taxpayer obtains the benefit of a net loss as a deduction against income of another year. It is, therefore, my opinion that the position of the respondent is well taken and that petitioner is estopped to now say that he erred in taking the deductions claimed in 1916, 1917, 1918, and 1919. If I am correct in this view, it follows that invested capital can not now be increased because of the claim that the deductions were erroneously taken. In other words, the petitioner must abide by its acts, which acts were the cause of the reduction in invested capital.
Finally, as to the inclusion in income of the amounts recovered in 1920 and 1921. If my view of the application of the doctrine of estoppel is correct, the result is the same as if the deductions taken for bad debts were proper deductions, and consequently any recoveries in subsequent years constitute income. *2967 Nott-Atwater Co.v. Poe, Fed.(2d) (Dist. Ct., W. Dist. Wash., Oct. 10, 1928). Cf. .
TRUSSELL agrees with this dissent.