1928 BTA LEXIS 3685">*3685 Reserves for bad debts disallowed.
11 B.T.A. 910">*910 These are proceedings for the redetermination of definciencies in income tax for 1919 and 1921. With respect to J. Gordon Hill, the deficiency for 1921 is $101.24. With respect to Frank A. MacHugh, the deficiency for 1919 is $204.59, and for 1921, $407.53.
The two proceedings were consolidated for the purpose of hearing and decision.
The issue involved in the proceeding of Frank A. MacHugh for 1919 was withdrawn at the hearing. The only issue involved is whether the amount claimed by the partnership of MacHugh, Hill & Co. as a deduction on account of a reserve for bad debts for 1921 should be allowed. The two petitioners were members of the partnership.
FINDINGS OF FACT.
Both petitioners were, during 1921, members of the partnership of MacHugh, Hill & Co., accountants and auditors, San Francisco, Calif. In determining the net income of the partnership the distributable shares of which were taxable to the petitioners, a deduction was claimed on account of a reserve for bad debts.
The partnership, 1928 BTA LEXIS 3685">*3686 during the taxable year as well as before and subsequently, set up a reserve on its books for bad debts. During 1921 there was credited to the reserve account $6,615. On January 1, 1921, there was a balance in the reserve account of $1,993.50, making a total of $8,608.50. During the year 1921 there was charged against the reserve account a total of $2,414.93, which results in a credit balance at the end of 1921 of $6,193.57.
The reserves were set up each month with respect to particular debts which were examined and at the end of the year the reserves appearing on the books were further examined and adjusting entries were made.
The reserves for bad debts included amounts set up on the books of the partnership as debts but which were denied by the so-called 11 B.T.A. 910">*911 debtors. There appeared on the partnership books an account against the American Coin Register Co. in the amount of $110. A reserve was set up for this amount on the books. The so-called debtor denied liability entirely.
There appeared on the books an account against F. Chevalier & Co. in the amount of $240, which account was disputed, and a reserve was set up for the amount.
There appeared on the books1928 BTA LEXIS 3685">*3687 an account against Gross & Miller in the amount of $4,410.34. The debtors claimed that the bill was too high and that a substantial reduction was expected. The amount of $882.07 was set up as a reserve on this account.
There was another account on the books in the amount of $585 against de Roos. A reserve was set up against this account in the amount of $441.09 in order "to bring the reserve into agreement with the books."
A reserve in the amount of $1,000 was set up against the account of Marchmont Calculating Machine Co. because the partnership thought that it would have to make an adjustment in collecting the account in view of the fact that the debtor considered the total account of $5,000 excessive. This was taken into income account subject to the reserve of $1,000 by which it was thought it would have to be reduced. Other accounts were put in the reserve account because of the fact that the accounts were disputed.
The reserve also included accounts which the partnership considered bad and had abandoned and also accounts which were considered bad but efforts to collect which had not been abandoned.
The partnership was engaged in the business of accounting and1928 BTA LEXIS 3685">*3688 auditing and had a comparatively small number of accounts on its books. Because of the character of the firm's clients and their small number, the partnership adopted the practice of inspecting the accounts and including in the reserves all or any portion of an account which it was thought might not be collected for any reason. The reserve included accounts ascertained to be worthless as well as accounts which might become worthless in the future or could not be collected in full. When an account was ascertained to be worthless during the taxable year, it was charged off the books against the reserve. However, the partnership did not exercise a great degree of care in actually charging off debts ascertained to be worthless during the year for the reason that the reserve had already been set up which was sufficient to cover such debts.
OPINION.
TRAMMELL: The question here involved is the deductibility, in determining net income, of the reserves set up for bad debts. The 11 B.T.A. 910">*912 Revenue Act of 1921, section 214(a), provides that in computing net income there shall be allowed as deductions:
(7) Debts ascertained to be worthless and charged off within the taxable year1928 BTA LEXIS 3685">*3689 (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 to be charged off in part.
The statute provides for a deduction in the discretion of the Commissioner of a reasonable addition to a reserve for bad debts and not the reserve itself. The reserve which existed at the beginning of 1921 is not deductible as an "addition" to the reserve made during the year. The petitioner, however, added the reserve as it existed at the beginning of 1919 in the amount of $1,993.50. This is in no proper sense an addition to the reserve.
The petitioner also, in the case of the indebtedness of the Marchmont Calculating Machine Co., included in income the bill rendered in the amount of $5,000 less the amount of $1,000 which was the amount of reserve set up with respect thereto, that being the amount by which it was expected that the bill would have to be reduced in order to satisfy the client.
The reserve also included other accounts in which there was a dispute over the correctness of the book charges and credits. Deductions on account of bad debts are not1928 BTA LEXIS 3685">*3690 allowable unless the debts themselves are first established.
We held in , that any loss resulting from a dispute over the correctness of book charges and credits in connection with business transactions is deductible in the year in which settled by compromise or otherwise. A deduction of an addition to a reserve on account of such disputes and subsequent settlements is not allowable.
The reserve included both bad accounts and those which were thought would probably be uncollectible, either by reason of disputes as to the correctness of the amounts charged and credits, or on account of the financial condition of the debtors, and the bad accounts could not be distinguished from those not ascertained to be bad in the reserve.
We do not think that the reserve set up by the petitioner and deducted in determining the net income was determined in the manner contemplated by the statute.
Judgment will be entered on 15 days' notice, under Rule 50.