Decision will be entered under Rule 50.
1. Held, on the record as a whole, petitioner allowed its earnings and profits to accumulate beyond the reasonable needs of its business during 1947 through 1950, and 1952, and was availed of during those years to prevent the imposition of surtax upon its shareholders.
2. Reasonable additions to petitioner's bad debt reserve determined for the years 1947 and 1949.
3. Where petitioner made an addition to its bad debt reserve on the basis of a specific doubtful account, and that account was subsequently collected, held, petitioner was not required to take into income that portion of its bad debt reserve attributable to that specific account.
*41 This proceeding involves deficiencies in income tax for the years and in the amounts as follows:
| Year | Deficiency |
| 1947 | $ 15,588.30 |
| 1948 | 5,890.72 |
| 1949 | 6,397.34 |
| 1950 | 3,341.65 |
| 1951 | 975.38 |
| 1952 | 11,887.51 |
The issues for decision are: (1) Whether petitioner was availed of during the years 1947 through 1950, and 1952, to prevent the imposition of surtax upon its shareholders; (2) whether the amounts of $ 5,222.43 *175 and $ 1,887.73 were reasonable additions to petitioner's bad debt reserve in 1947 and 1949, respectively; and if so (3) whether that reserve should be reduced, and petitioner's income proportionately increased, in 1951 and 1952 to reflect recovery of amounts previously charged to the reserve.
Some of the facts were stipulated.
FINDINGS OF FACT.
The stipulated facts are so found, and are incorporated herein by this reference.
R. Gsell & Co., Inc. (hereafter referred to as the petitioner), a New York corporation, filed its Federal income tax returns for the years 1947 through 1951, with the collector of internal revenue for the third district of New York. Its 1952 return was filed with the district director of internal revenue, Upper Manhattan District, New York.
Roland Gsell (hereafter referred to as Gsell) has always been petitioner's president, principal stockholder, and chairman of its board of directors. During the years in issue, he owned 9,998 of its 10,000 shares of common stock, and 862 of its 1,000 shares of class B stock. *42 His wife owned 1 share of the common, and, with other members of the Gsell family, owned 61 shares of the class B stock. The Mt. Vernon Watch Company, a corporation *176 controlled by the Gsell family, owned 44 shares of petitioner's class B stock.
Gsell was trained in the watch business as a young man. He always has taken an active part in the industry, and enjoys considerable standing in the trade. In 1922 he organized the petitioner. Since that time it has engaged in purchasing, importing, assembling, and selling Swiss watch movements and watches. Operationally, its activities are carried on in two departments; a merchandising department and a commission department.
In its merchandising operation, petitioner imported from Switzerland complete watches and watch movements. At its New York factory, the imported movements, along with American-made cases and watch bands, were assembled into finished watches. It then undertook the sale of this finished product to several hundred customers, including wholesalers, department stores, and other retail outlets. Ordinarily, assemblage of a watch took only a few days time, the work being done by a work force of three to five watchmakers. Sales were made throughout the country by four or five salesmen on a salary-plus-commission basis. Normally, there was a constant turnover in inventory, orders being filled *177 as rapidly as possible.
The Swiss concerns from which petitioner acquired its watch movements were organized in a rigidly controlled cartel or syndicate. These concerns neither would nor could contract for a definite delivery date or a fixed purchase price. Until notified by the Swiss manufacturer, petitioner did not know when an order would be delivered. During 1947 and 1948, deliveries were 11 to 24 months behind orders. By the date of this trial, this time lag had been reduced to 8 months. Outstanding orders were never shipped all at one time. Petitioner gauged its current orders by the sales anticipated in the following year.
United States Customs required all imported watch movements to bear the importer's customs symbol and his trademark. Because these were stamped on the watch plates at the outset of production, orders placed with a Swiss factory could not be canceled. An attempt to cancel would result in blacklisting by the industry.
Upon advice that an order was ready for shipment, petitioner had 8 days to pay the purchase price in order to avail itself of a 5 per cent discount. Thirty-day payments were afforded a discount of 4 per cent. Usually, petitioner paid the *178 amount due 2 or 3 days after notification of shipment. Immediately upon arrival of the merchandise in this country, petitioner was required to pay the customs duty due on the shipment. On its books, petitioner did not *43 carry as a liability the anticipated expense for the purchase price and duty due on outstanding Swiss orders.
During 1947 and 1948 delivery of watchcases, ordered from American manufacturers, ran approximately 2 years behind orders. To effect a rapid inventory turnover, petitioner attempted to dovetail the case and movement arrivals. Because its principal product was an assembled watch, the forward placing of orders for movements, cases, and other supplies was an essential part of petitioner's business.
During the war and post-war years, petitioner's commission business produced a substantial part of its annual income. In this segment of its business, petitioner, acting as agent for several Swiss watch manufacturers, arranged the sale of their watches to large outlets in this country. On each sale petitioner received a direct commission from the manufacturer. Its customers included the four major mail-order firms in this country: Montgomery Ward, Alden, Sears and *179 Roebuck, and Spiegel. Throughout the years, these were loyal customers. However, petitioner always feared a reduction in orders, or a personnel change which might result in these customers turning to some other source for their watches.
There was a relation between petitioner's commission and merchandising departments. Merchandising kept petitioner in touch with the market and the watch industry. Thus it was able to give its commission customers market and style advice. Merchandising inventory enabled petitioner to supply commission customers with finished watches at acceptable prices in the event these customers ran short. These were "accommodation sales," and produced little or no profit. They were made to gain, or hold, the goodwill of the commission customer.
At the annual meeting of petitioner's stockholders, the chairman of its board of directors reported on the business for the past year, and the outlook for the coming year. These reports, prepared by Gsell without assistance or advice from counsel or accountants, were included in the minutes of the annual meetings. Excerpts from these reports are set forth below:
March 25, 1946
We are particularly happy to enter a year *180 when there will be no gross profits tax to pay; a tax which has been extremely heavy on firms of our type. It has not permitted us to make the reserves and accumulation of profit which we should make during these troubled times.
May 19, 1947
The Chairman in his report indicated that business for 1946 has been satisfactory and although some distinct uncertainty loomed at the beginning of this year regarding the business for 1947, indications now are distinctly favorable.
The firm purchased $ 25,000 worth of certificates of indebtedness, and made a profit of $ 2,593.71 on its stock purchases. * * * These investments are considered *44 as having a temporary character, as it is fully realized that these monies will be needed in the business sooner or later.
March 29, 1948
The Chairman in his report indicated again that the year 1947 was very satisfactory, but, that the prospects for 1948 looked very doubtful. Like everybody else, our expenses are much higher and a drop in sales would soon have a distressing effect upon the whole situation. The customers have become much more choosy, while the Swiss suppliers are not shipping the way they should. We expect the situation to straighten out during *181 the latter part of the year.
The Chairman stated that the corporation has been considering paying back the Preferred stock, but, that it has been decided to wait, because, while finances are favorable, the future is too unclear. We have had so many years of difficulty in financing our business that it was decided, in view of the situation and the definite prospect of having to carry large stocks and extend longer credits to our customers, all of which will strain our finances, to wait another year or two to see what happens, before taking the step in question. For the same reason it was deemed not advisable to declare any dividends. The tax situation has improved somewhat and permits us to strengthen our liquid assets position, which should in turn permit us relatively soon to take some of the steps contemplated above.
March 28, 1949
The Chairman in his report stated that the trade situation has changed entirely. There are liquidations at cost and below cost all over the country and while we are in a position to take care of all the orders placed, we review with alarm the income account due to the drop in sales.
March 27, 1950
The Chairman reported that conditions in the trade had not *182 been favorable at all this year. The liquidation of distressed merchandise reported at the last annual meeting has kept up. In fact, they have increased greatly, with no sign of betterment. Sales below cost, over-stocks, etc. have disrupted the trade considerably and now seem to have actually created a great fear in the minds of the buyers and sales are becoming increasingly poor. * * *
On the other hand, the Chairman reported that the direct import department is working very well and it is due to this department that the net operation for the year can close with a profit.
March 27, 1951
The Chairman reported that conditions in the trade continued to be unfavorable during the entire year. Sales of merchandise at either slightly below or slightly above landed cost was the rule throughout the country, and they are very difficult to explain. These sales might be connected with illegal entry into this country. In the meantime, they have depressed the whole market for non-advertised watches. These circumstances have brought about a substantial loss in what we call our "merchandising department." The over-all more favorable figure is due to the excellent returns on what we call our "direct *183 import department." The total over-all profit, is far from being satisfactory.
March 26, 1952
The Chairman reported that the conditions in the trade mentioned at the last annual meeting have been exactly the same, if not worse during 1951. * * * Our sales have been worse than during the 1932 depression. * * * The conclusion is that a re-alignment of some type is long overdue. If it was not for the normal returns of the Direct Import department, the firm would be deeply in *45 the red and would have been forced to take drastic action long ago. It is very unbusinesslike for one department to maintain the other. * * * There was a time when one might and could have figured that this bad period was temporary and had to be expected and accepted with the good results of other years, but, these conditions have been going on now for several years and there is no expected improvement in sight so far.
Throughout its history, petitioner has considered its primary business to be merchandising. During and immediately after World War II, the watch industry experienced a strong sellers market. Customers were plentiful, and all sales were for cash. By the late 1940's and early 1950's, a noticeable *184 recession occurred within the industry. Sales dropped, and the cash customer was replaced by the credit customer. In 1952, petitioner began to look for other sources of revenue. While it always had dealt in the higher priced jewellever watches, at this time it arranged to sell a less expensive pinlever watch. First sales of this watch took place in 1953. Sales increased steadily through 1956.
On June 30, 1947, petitioner's outstanding orders for watch movements amounted to $ 244,855. Duty payable thereon was $ 96,021. Also, it had $ 56,767 worth of outstanding orders for cases and boxes.
Petitioner's gross sales, gross profit from sales, commissions, other income, expenses other than for cost of goods sold, pre-tax net income, and tax liability for the years 1947 through 1952, as set forth on its tax returns were:
| Gross sales | Gross profit | Commissions | Other | |
| income | ||||
| 1947 | $ 522,242.97 | $ 125,731.43 | $ 56,488.72 | $ 10,054.87 |
| 1948 | 352,374.82 | 65,505.74 | 59,420.50 | 11,967.49 |
| 1949 | 188,772.70 | 42,432.52 | 59,718.90 | 5,762.46 |
| 1950 | 141,960.36 | 28,715.05 | 68,613.90 | 2,852.01 |
| 1951 | 100,751.00 | 17,870.93 | 64,153.87 | 1,647.66 |
| 1952 | 200,039.95 | 19,021.11 | 82,771.35 | 4,237.22 |
| Expenses 1*185 | Pre-tax | Tax | |
| net income | liability | ||
| 1947 | $ 121,327.29 | $ 70,947.73 | $ 26,911.69 |
| 1948 | 107,842.61 | 29,051.12 | 7,728.15 |
| 1949 | 84,461.88 | 23,452.00 | 5,299.25 |
| 1950 | 85,516.51 | 14,664.45 | 3,372.82 |
| 1951 | 80,822.00 | 2,850.46 | 819.51 |
| 1952 | 82,316.86 | 23,712.82 | 6,881.80 |
Its selling and general expenses (as stipulated), pre-tax merchandising net profit (loss), and its net pre-tax profit and surplus for each of the years 1947 through 1952 were:
| Selling and | Merchandising | Net pre-tax | ||
| general | net profit | profit | Surplus | |
| expenses | (loss) | |||
| 1947 | $ 136,454 | $ 25,563 | $ 70,947 | $ 116,108 |
| 1948 | 123,433 | (32,179) | 27,720 | 136,139 |
| 1949 | 97,778 | (33,828) | 23,452 | 145,113 |
| 1950 | 94,854 | (49,878) | 14,719 | 157,812 |
| 1951 | 89,746 | (55,604) | 2,545 | 158,047 |
| 1952 | 88,202 | (56,523) | 23,821 | 168,157 |
Petitioner charged all overhead expenses of these years to its merchandising department.
At all times material hereto, petitioner's stated capital was $ 150,000.
*46 Petitioner's gross sales, selling and general expenses, net pre-tax profit, and surplus for each of the years 1922 through 1946 and the years 1953 through 1956 were:
| Year | Gross sales | Selling and general | Net pre-tax | Surplus |
| expenses 1 | profit (loss) | (deficit) | ||
| 1922 | $ 600,584 | $ 74,172 | $ 48,576 | |
| 1923 | 511,687 | (14,228) | 21,572 | |
| 1924 | 407,104 | 1,576 | 31,572 | |
| 1925 | 500,641 | (85) | 23,647 | |
| 1926 | 588,623 | 10,796 | 43,423 | |
| 1927 | 500,926 | 4,948 | 43,276 | |
| 1928 | 451,696 | 6,569 | 44,145 | |
| 1929 | 655,429 | 20,741 | 57,586 | |
| 1930 | 400,724 | (6,488) | 44,836 | |
| 1931 | 176,833 | (28,489) | 16,251 | |
| 1932 | 80,188 | (50,131) | (48,879) | |
| 1933 | 82,077 | (13,808) | (62,687) | |
| 1934 | 165,637 | (2,472) | (65,159) | |
| 1935 | 139,711 | (679) | (66,339) | |
| 1936 | 163,078 | 1,433 | (65,156) | |
| 1937 | 134,544 | 132 | (65,023) | |
| 1938 | 80,152 | (2,029) | (67,081) | |
| 1939 | 91,707 | (839) | (67,920) | |
| 1940 | 94,866 | 1,248 | (66,671) | |
| 1941 | 204,362 | $ 57,273 | 17,231 | (53,810) |
| 1942 | 454,109 | 99,918 | 42,538 | (33,224) |
| 1943 | 480,879 | 102,623 | 53,881 | (13,802) |
| 1944 | 338,806 | 99,802 | 45,359 | 7,676 |
| 1945 | 451,573 | 131,215 | 45,743 | 29,449 |
| 1946 | 469,621 | 123,232 | 68,954 | 71,128 |
| 1953 | 90,797 | 93,772 | 173,008 | |
| 1954 | 133,057 | 106,607 | 173,956 | |
| 1955 | 325,238 | 143,535 | 174,769 | |
| 1956 | 406,005 | 134,335 | 176,372 |
Petitioner's monthly cash expenditures for each of the years 1947, 1948, and 1949 were:
| 1947 | 1948 | 1949 | |
| January | $ 62,060.91 | $ 45,966.62 | $ 27,902.43 |
| February | 23,959.33 | 18,807.13 | 24,226.00 |
| March | 30,737.91 | 36,588.13 | 39,533.82 |
| April | 53,867.60 | 80,774.89 | 29,412.38 |
| May | 39,409.37 | 69,551.56 | 57,459.90 |
| June | 40,712.65 | 95,613.59 | 46,790.88 |
| July | 37,069.01 | 60,098.88 | 34,414.55 |
| August | 33,883.74 | 39,518.83 | 25,906.34 |
| September | 70,372.78 | 70,724.94 | 46,385.58 |
| October | 42,277.27 | 63,397.82 | 41,743.18 |
| November | 57,724.79 | 63,399.75 | 21,421.69 |
| December | 72,698.99 | 63,233.19 | 55,819.38 |
| 564,774.35 | 707,675.33 | 451,117.24 |
On its returns for each of the years 1947 through 1952, petitioner computed its cost of goods sold in the following manner:
| 1947 | 1948 | 1949 | |
| Opening inventory | $ 73,917.92 | $ 72,717.48 | $ 145,702.54 |
| Manufacturing expense | 5,094.55 | 3,393.45 | 1,379.93 |
| All purchases | 280,700.95 | 237,948.42 | 95,306.46 |
| Shop salaries | 10,236.41 | 10,866.97 | 8,197.80 |
| Duty | 99,279.19 | 107,645.30 | 58,663.57 |
| Total | 469,229.02 | 432,571.62 | 309,250.30 |
| Less closing inventory | 72,717.48 | 145,702.54 | 162,910.12 |
| Cost of goods sold | 396,511.54 | 286,869.08 | 146,340.18 |
| 1950 | 1951 | 1952 | |
| Opening inventory | $ 162,910.12 | $ 119,621.08 | $ 79,100.45 |
| Manufacturing expense | 1,407.01 | 892.54 | 564.12 |
| All purchases | 32,134.30 | 27,224.15 | 104,408.93 |
| Shop salaries | 7,716.00 | 7,364.50 | 5,229.76 |
| Duty | 28,698.96 | 6,878.25 | 38,972.86 |
| Total | 232,866.39 | 161,980.52 | 228,276.12 |
| Less closing inventory | 119,621.08 | 79,100.45 | 47,257.28 |
| Cost of goods sold | 113,245.31 | 82,880.07 | 181,018.84 |
*47 *187 Its inventory as of December 31, 1946 through 1952, was composed of the following items:
| 1946 | 1947 | 1948 | 1949 | |
| Complete watches | $ 13,325.39 | $ 32,019.60 | $ 48,947.05 | $ 41,325.15 |
| Watch cases | 12,606.76 | 11,142.83 | 14,605.49 | 14,188.30 |
| Movements | 43,721.37 | 26,064.68 | 70,802.68 | 99,949.63 |
| Material and dials | 719.40 | 1,103.00 | 2,572.78 | 1,831.82 |
| Attachments | 3,462.00 | 2,304.37 | 3,106.94 | 2,302.02 |
| Miscellaneous diamonds | ||||
| and watches | 83.00 | 83.00 | 5,667.60 | 3,313.20 |
| Total | 73,917.92 | 72,717.48 | 145,702.54 | 162,910.12 |
| 1950 | 1951 | 1952 | |
| Complete watches | $ 32,165.10 | $ 20,869.70 | $ 13,865.58 |
| Watch cases | 12,236.40 | 13,420.84 | 9,715.04 |
| Movements | 68,283.70 | 38,766.03 | 19,700.16 |
| Material and dials | 1,586.20 | 2,002.13 | 950.03 |
| Attachments | 2,492.92 | 2,488.35 | 1,929.42 |
| Miscellaneous diamonds | |||
| and watches | 2,856.76 | 1,553.40 | 1,097.05 |
| Total | 119,621.08 | 79,100.45 | 47,257.28 |
Since its organization, petitioner has made no loans or advances to either Gsell or members of his family, or any other stockholder, save a temporary advance of $ 9,000 made Gsell in 1945. This advance was repaid within the space of a few months.
Gsell and his wife owned stock in three Swiss watch companies. Beginning in 1940 and continuing through the years in issue, Gsell made repeated efforts to have the management of these companies increase *188 the dividends payable upon their shares. These efforts were successful, the Gsells receiving the following dividends on these stocks during the years 1942 through 1952:
| 1942 | $ 3,026 |
| 1943 | 2,842 |
| 1944 | 2,691 |
| 1945 | 2,080 |
| 1946 | 2,080 |
| 1947 | 2,664 |
| 1948 | $ 5,287 |
| 1949 | 2,968 |
| 1950 | 10,819 |
| 1951 | 13,641 |
| 1952 | 16,317 |
From its organization through 1930, petitioner paid dividends in only 3 years. No dividends were paid during the years 1931 through 1950. A dividend of $ 5,000 was paid in 1951, and one of $ 7,000 was paid in 1952.
On December 31, 1946 through 1952, in addition to its inventory, petitioner held the following receivables, cash balance, and investments:
| Dec. 31 -- | Receivables | Cash balance | Investments |
| 1946 | $ 190,912 | $ 21,828 | $ 30,035 |
| 1947 | 185,409 | 44,381 | 35,227 |
| 1948 | 102,018 | 52,161 | 33,275 |
| 1949 | 66,227 | 65,209 | 28,908 |
| 1950 | 67,205 | 129,548 | 25,156 |
| 1951 | 27,294 | 145,763 | 78,987 |
| 1952 | 21,780 | 115,714 | 170,339 |
Among the investments held in 1951 were $ 33,987 in bonds of American Telephone & Telegraph Co., and $ 45,000 in United States Treasury notes. In 1952 they included $ 40,574.48 in American Telephone & Telegraph bonds, 200 shares of American Telephone & Telegraph stock valued at $ 29,764.63, and $ 100,000 in United States*48 Treasury debentures. The American*189 Telephone & Telegraph stock was sold in 1956. The receivables included the following commissions due from Swiss firms as of December 31, 1947 through 1952:
| Unpaid | |
| Dec. 31 -- | commissions |
| 1947 | $ 33,133.39 |
| 1948 | 17,940.67 |
| 1949 | 14,963.60 |
| 1950 | $ 30,078.05 |
| 1951 | 13,578.16 |
| 1952 | 10,416.85 |
Commissions were ordinarily paid 2 to 4 months after they were earned. The balance of the receivables included merchandising accounts usually settled in 4 to 6 months' time.
On December 31, 1947 through 1952, petitioner's books and records revealed the following current assets and current liabilities, the latter being exclusive of outstanding commitments for purchases:
| Current | Current | |
| assets | liabilities | |
| 1947 | $ 347,988.19 | $ 62,006.28 |
| 1948 | 333,330.54 | 27,355.01 |
| 1949 | 323,430.31 | 16,485.87 |
| 1950 | $ 341,744.22 | $ 17,954.69 |
| 1951 | 331,297.03 | 6,988.02 |
| 1952 | 356,238.06 | 21,864.28 |
During the depression years, petitioner and its president experienced difficulty in obtaining bank financing. Loan requests were either refused, or, if granted, were severely restricted in amount and term. Creditors imposed rigid requirements as to petitioner's inventory and salary policy. Because of these difficulties, petitioner decided to forego the use of bank credit in its business. *190 It determined that thereafter it would use its own resources to finance operations. However, on occasions it borrowed funds from the Mt. Vernon Watch Company; borrowing the amount of $ 50,000 in 1945, $ 50,000 in 1946, and $ 10,000 to $ 27,000 in 1947.
Petitioner's officers and directors were paid the following salaries and commissions during the years 1947 through 1952:
| Roland Gsell | John Zwygart | Freya Gsell | ||
| Salary | Salary | |||
| Salary | Commission | |||
| 1947 | $ 11,800 | $ 8,255.42 | $ 8,580 | $ 600 |
| 1948 | 11,100 | 8,920.28 | 7,660 | 600 |
| 1949 | 7,300 | 7,112.98 | 6,250 | 200 |
| 1950 | 10,500 | 8,929.88 | 7,030 | 400 |
| 1951 | 10,500 | 8,214.24 | 7,030 | 400 |
| 1952 | 10,600 | 10,895.61 | 7,130 | 400 |
Roland Gsell filed an individual Federal income tax return for the taxable year 1947. He filed joint returns with his wife, Freya, for the taxable years 1948, 1949, 1950, and 1952. On these returns were reported adjusted gross income and tax liabilities in the following amounts: *49
| Year | Adjusted | Tax liability |
| gross income | ||
| 1947 | $ 34,410.39 | $ 11,363.69 |
| 1948 | 41,869.04 | 9,020.30 |
| 1949 | 40,194.56 | 8,769.44 |
| 1950 | 44,578.92 | 8,604.22 |
| 1952 | 52,589.79 | 12,164.54 |
In computing the deficiencies herein, respondent determined petitioner had the following undistributed section 102 net income:
| 1947 | $ 47,953.58 |
| 1948 | 20,250.23 |
| 1949 | 19,615.96 |
| 1950 | $ 11,703.78 |
| 1951 | none |
| 1952 | 17,287.56 |
Had *191 petitioner distributed its determined "undistributed section 102 net income" during each of the years in issue, Gsell's personal tax liability would have been increased in the following amounts:
| Year | Increase |
| 1947 | $ 33,446.59 |
| 1948 | 10,092.38 |
| 1949 | 9,543.97 |
| 1950 | $ 5,949.36 |
| 1952 | 11,937.48 |
The parties have stipulated that the distribution in each of the years in issue by petitioner of its determined "undistributed section 102 net income" would have produced the following effect on its financial position:
| Year | Net worth 1 | Inventory | Receivables | Cash and | Current |
| investments | liabilities 2 | ||||
| 1947 | $ 218,155 | $ 72,717 | $ 185,409 | $ 31,655 | $ 62,006 |
| 1948 | 217,936 | 145,702 | 102,018 | 17,233 | 27,355 |
| 1949 | 207,295 | 162,910 | 66,226 | 6,299 | 16,485 |
| 1950 | 208,291 | 119,621 | 67,206 | 55,183 | 17,954 |
| 1951 | 208,526 | 79,100 | 27,294 | 125,229 | 6,988 |
| 1952 | 201,349 | 47,257 | 21,780 | 169,245 | 21,864 |
| 1953 | 206,200 | 83,490 | 25,705 | 134,325 | 22,958 |
| 1954 | 207,148 | 129,097 | 35,301 | 77,158 | 19,191 |
| 1955 | 207,961 | 197,146 | 86,312 | (11,934) | 56,802 |
| 1956 | 209,564 | 89,895 | 118,732 | 14,051 | 13,986 |
At all times material hereto, petitioner used the reserve *192 method of bad debt accounting. For the years 1929 through 1946 its gross sales, losses on merchandising accounts, and bad debt reserve balance, as of December 31, were:
| Gross | Actual | Dec. 31 | |
| Year | sales | losses | reserve |
| balance | |||
| 1929 | $ 655,429 | $ 16,978.40 | $ 1,598.32 |
| 1930 | 400,724 | 3,281.83 | 2,323.74 |
| 1931 | 176,833 | 3,660.28 | 2,200.10 |
| 1932 | 80,188 | 5,863.19 | 1,745.45 |
| 1933 | 82,077 | 4,030.34 | 997.79 |
| 1934 | 165,637 | 1,454.70 | 1,162.45 |
| 1935 | 139,711 | 1,090.85 | 1,419.23 |
| 1936 | 163,078 | 1,190.13 | 995.66 |
| 1937 | 134,554 | 1,095.47 | 532.83 |
| 1938 | $ 80,152 | $ 582.73 | $ 329.86 |
| 1939 | 91,707 | 332.54 | 370.80 |
| 1940 | 94,866 | 606.42 | 737.50 |
| 1941 | 204,362 | 5,778.65 | |
| 1942 | 454,109 | 5,778.65 | |
| 1943 | 480,879 | 5,778.65 | |
| 1944 | 338,806 | 5,778.65 | |
| 1945 | 451,573 | 5,778.65 | |
| 1946 | 469,621 | 10,474.07 |
*50 Its gross sales, accounts receivable as of December 31, additions to its bad debt reserve, losses on its merchandising accounts, and reserve balance as of December 31, for each of the years 1947 through 1952, were:
| Dec. 31 | Additions to | Dec. 31 | |||
| Year | Gross sales | accounts | reserve | Actual losses | reserve |
| receivable | balance | ||||
| 1947 | $ 522,242 | $ 185,409 | $ 5,222.43 | $ 15,696.50 | |
| 1948 | 352,374 | 102,018 | 15,696.50 | ||
| 1949 | 188,772 | 66,227 | 1,887.73 | $ 5,273.74 | 12,310.49 |
| 1950 | 141,960 | 67,205 | 12,310.49 | ||
| 1951 | 100,751 | 27,294 | 1*193 3,952.74 | 16,263.23 | |
| 1952 | 200,039 | 21,780 | 1 1,321.00 | 17,584.23 |
Included in petitioner's 1947 accounts receivable was an account of the Beck Jewelry Enterprises which totaled $ 22,000. At the close of 1947 it was extremely doubtful whether this account would ever be satisfied. In 1949, $ 10,547.10 was still owed petitioner on the Beck account, and the account still appeared doubtful. One-half of this amount, $ 5,273.74, was considered uncollectible by petitioner, and was written off as a bad debt by a charge to its reserve in 1949. Further, petitioner made an addition to its bad debt reserve in 1949 of $ 1,887.73.
In 1950, Leon Beck guaranteed a note of Beck Enterprises in the face amount of $ 10,547.10 issued to petitioner. This note was payable in 24 monthly installments of $ 440.32. The sum of $ 3,952.74 was paid on this note in 1951, and $ 1,321 in 1952. Both these amounts, when received by petitioner, were added back to its bad debt reserve under an adjustment labeled "Recovery." This account was finally paid in full in 1952.
Among petitioner's receivables for 1947 and 1949 were commissions due from Swiss firms in the respective amounts of $ 33,133.39 and $ 14,963.60. These amounts were subject to possible loss due to devaluation *194 of the Swiss franc, restriction on exchange rates, or political occurrences. During an undisclosed period petitioner was forced by the Swiss Government to collect these commissions at the official rate of exchange of 23 cents, when the franc was worth 40 cents in the free market. Otherwise, it never lost any money on its foreign commission accounts.
On its returns for the years 1947 and 1949, petitioner deducted, as bad debts, the additions to its reserve of $ 5,222.43 and $ 1,887.73, which represented 1 per cent of its gross sales in each such year. Respondent determined these were unreasonable additions to its bad debt reserve, and accordingly disallowed the deductions. He further determined:
*51 In the event that the deductions as claimed are found reasonable, it is held, in the alternative, that the reserve for bad debts should be decreased and income increased in the amounts of $ 2,395.83 and $ 13,730.68 in the years 1951 and 1952, respectively, inasmuch as the accounts receivable against which these amounts had been set up had been collected, and for the further reason that the reserve is deemed excessive as indicated by the following schedule:
| Balance Per Return | December 31, 1951 | December 31, 1952 |
| Accounts Receivable | $ 13,867.40 | $ 12,510.02 |
| Reserve for Bad Debts | 16,263.23 | 17,584.23 |
On *195 November 13, 1956, respondent notified the petitioner of an intention "to issue a statutory notice of deficiency for the years 1947, 1948, 1949, 1950, and 1952 setting forth an amount with respect to section 102 of the Internal Revenue Code of 1939 relating to surtax upon corporations improperly accumulating surplus." On December 11, 1956, petitioner submitted a 24-page statement, pursuant to the provisions of section 534 of the Internal Revenue Code of 1954, setting forth the grounds, and supporting facts, upon which it relied to establish that its earnings and profits had not been permitted to accumulate beyond reasonable business needs. That statement is incorporated herein by this reference. On May 15, 1957, respondent mailed a statutory notice of deficiency to petitioner.
Petitioner's earnings or profits were permitted to accumulate beyond the reasonable needs of its business in each of the years 1947 through 1950, and in 1952.
OPINION.
Respondent determined petitioner was availed of in the years 1947 through 1950, and 1952, to prevent the imposition of surtax upon its shareholders, by accumulating, rather than dividing or distributing, its earnings and profits, all within the *196 meaning of section 102 of the Internal Revenue Code of 1939. 1
As provided by the statute, an accumulation of earnings or profits beyond reasonable business needs is indicative of a purpose to avoid the shareholder surtax, unless the contrary be established by a clear preponderance *197 of the evidence. In the final analysis however, reasonableness of the accumulation is merely a subsidiary consideration, the ultimate question being whether the taxpayer was availed of for *52 the purpose proscribed by the statute. Young Motor Co., 32 T.C. 1336 (1959), on appeal (C.A. 1). Thus, it may well be that a taxpayer was not availed of to avoid the surtax during a particular year, even though the accumulation in that year was clearly beyond reasonable business needs. Gus Blass Co., 9 T.C. 15 (1947).
Whether the accumulations challenged here were consonant with reasonable business needs is a question of fact, to be decided on the basis of sound business management, not in a theoretical vacuum. The measure of reasonableness is the business need which exists at the time of the accumulation. Proceeding on a year-by-year basis, we turn to the case at hand.
Petitioner's gross sales and net pre-tax profit for 1947 were at an alltime high. Unquestionably, it was riding the crest of a post-war business boom. It had just concluded its eighth successive year of net pre-tax profits and the fourth consecutive year wherein it could boast an unimpaired surplus. In March of 1948, its chairman *198 considered retiring its preferred stock, a clear indication of its economic prosperity. Apparently the only reason this step was not taken was the chairman's extremely conservative nature; a nature born of years of financial vicissitudes. Albeit petitioner's past had not been without hardship, as of December 31, 1947, its future was bright. In fact, it now would justify the 1947 accumulation on the grounds that it expected the boom to continue throughout 1948, thus generating a need for the funds; i.e., to finance the increase in inventory and receivables which would be occasioned by the additional business.
As of the close of 1947, undivided earnings and profits (not including those accumulated during the year) were at a 25-year peak of $ 71,128. Current assets exceeded current liabilities by a ratio of 5 to 1 ($ 347,988/$ 62,006). Its assets included cash of $ 44,381, short-term investments of $ 35,227, receivables of $ 185,409, and inventory of $ 72,717. Some $ 33,000 of those receivables represented commissions due from Swiss factories, amounts ordinarily paid within 4 months after they were earned. The balance of its receivables were accounts liquidated within a 6-month *199 period. Of its total yearend inventory, $ 32,000 represented completed watches. In light of these facts, and what appears to have been a steady turnover in inventory, petitioner's argument that its receivables and inventory should not be included among its current assets is untenable.
Petitioner further argues that the expenditures it was to make during 1948 on its purchases and customs duty represented yearend liabilities at the close of 1947, and should have been taken into account in judging its business needs as of that time. True, petitioner had very little advance notice of the delivery date of a shipment of Swiss merchandise. It is also evident that immediate payment *53 was required in order to obtain the highly desired discount. However, petitioner's argument assumes its entire outstanding orders would be delivered in a single shipment, an event which as a practical matter and based on past experience would never take place. As it was, orders were lagging far behind in shipment, a fact of great concern to the petitioner. Moreover, its average monthly expenditure during 1948 for the expenses of manufacturing, all purchases, shop salaries, and customs duty was only $ 30,000. *200 This fact, when coupled with its total monthly cash expenditures for all purchases during 1948 (which reached a high of $ 95,600 in June and a low of $ 18,800 in February), clearly indicates the gradual manner in which its orders were being shipped. Finally, it is significant to note that petitioner itself chose not to record these commitments on its books as liabilities. On the basis of these facts, we believe it was reasonable to assume, at the close of 1947, that these outstanding commitments would, in the normal course of events, be met out of current assets as well as anticipated 1948 business.
After a careful consideration of these and other facts of record, each of which has been affirmatively shown, we have concluded and have found as a fact that petitioner's accumulation of $ 47,953.58 in 1947 was beyond its reasonable business needs.
Much the same applies to the remaining years in issue. The ratio of petitioner's current assets to its current liabilities rose to 12 to 1 by the close of 1948; 20 to 1 by the end of both 1949 and 1950. As 1952 came to a close, that ratio stood at 17 to 1. Its cash and investments totaled $ 85,436 as of December 31, 1948, $ 94,117 at the *201 end of 1949, $ 154,704 at the close of 1950, and $ 286,053 at December 31, 1952. Throughout each of these years its undivided earnings and profits increased steadily, reaching $ 116,108 at December 31, 1947, $ 136,139 at December 31, 1948, $ 145,113 at December 31, 1949, and $ 158,047 at December 31, 1951. Though a noticeable decrease in gross sales occurred during 1948, 1949, and 1950, it was accompanied by a corresponding decrease in operating and merchandise expenses. Finally, the decrease in merchandising income was offset, in part, by an increase in commission income.
Thus, consistent with our reasoning as to the year 1947, we have concluded and have found as a fact that petitioner's 1948 accumulation of $ 20,250.23, its 1949 accumulation of $ 19,615.96, its 1950 accumulation of $ 11,703.78, and its 1952 accumulation of $ 17,287.56 were beyond its reasonable business needs.
In reaching this conclusion we have carefully examined petitioner's contention that the years 1948 through 1952 were beset by a recessed economy, bringing about uncertainty insofar as its future was concerned. Militating strongly against this argument is the fact that, *54 even in the midst of a recession, *202 it still managed to make a profit. Perhaps the explanation for this lies in the fact that it was able to curtail its costs in the face of declining sales. Whatever may have been the reason, petitioner consistently closed out each of the years under consideration with an overall profit. While its chairman may have viewed cautiously the decline in merchandising income, he continually expressed satisfaction in the improvement of the commission department. Whichever department contributed to its success, petitioner was able to accumulate earnings and profits. Thus, we cannot give much weight to its claim that "uncertain and adverse business conditions" prevailed during these years which caused its management to conclude that a distribution of earnings and profits beyond those made would be detrimental to the business.
The record indicates that sometime in 1952 petitioner began to look elsewhere for a source of revenue, a search which ultimately took it into the pin-lever watch field. However, the record further indicates that it was not until late in 1953, or early 1954, that petitioner became aware of the needs generated by this new line. Thus, any attempt to connect the accumulations *203 in issue with the entry into the pin-lever watch field would be unavailing.
Having concluded that the accumulations in issue exceeded reasonable business needs, we must also conclude that petitioner was availed of during each of the years under consideration to avoid the imposition of the surtax upon its shareholders, unless the contrary is shown by a clear preponderance of the evidence.
Petitioner points first to the fact that there was no "leakage" of earnings and profits to any shareholder in the guise of interest-free loans. While the existence of such "leakage" is a positive indication of the proscribed purpose, its absence does not necessarily mean petitioner was not so availed of. That earnings and profits were allowed to accumulate within the corporate shell merely indicates, to use a time-honored cliche, that petitioner was a "corporate pocketbook." Nor are we persuaded by Gsell's attempt to increase his foreign dividend income, that petitioner was not a means of avoiding the surtax on his domestic dividends. We are first impressed by the relatively small amount of foreign dividend income actually received. Further, we are not convinced that positive attempts to increase *204 the one, conclusively establishes that he was not attempting to reduce the other. As a foreign stockholder, it may well have been that his only chance to receive a return on his investment would be during those years when the Swiss concern realized a profit. Thus, it was to his benefit that he actively attempt to effect as early a distribution on his foreign investments as possible. On the other hand, so far as petitioner was concerned, if he did not so desire to distribute earnings *55 and profits in a current year, he could wait for a more propitious time.
Finally, the distribution in 1952 of a $ 7,000 dividend in no way establishes that the $ 17,000 in earnings and profits which remained undistributed were not retained to avoid the shareholder surtax. We have found the $ 17,000 accumulation exceeded reasonable business needs. Petitioner has not overcome the statutory presumption that it was retained for the proscribed purpose. Thus, the $ 7,000 distribution is immaterial.
Moreover, there exist affirmative indications that petitioner was availed of to avoid the shareholder surtax. First we note its meager dividend record over the period extending from 1922 through 1952. Despite *205 12 years of impaired surpluses, it could look back on some 19 years with an unimpaired surplus. Nevertheless, it chose to distribute earnings and profits in only 5 years. Second, as is usually the case in proceedings of this type, petitioner's stock was closely held. Third, the tax saving effected by the majority shareholder through forbearance, greatly exceeds the penalty now sought to be imposed upon the taxpayer corporation under section 102. Finally, so far as we are able to discern, no valid business reason has been advanced to justify why the challenged accumulations were made.
Therefore, we have concluded that petitioner was availed of during each of the years 1947 through 1950, and 1952, for the purpose of avoiding the imposition of surtax upon its shareholders. Respondent is sustained on this issue.
Throughout our discussion, we have assumed petitioner had shifted the burden of proof to respondent, insofar as its reasonable business needs were concerned, by virtue of the statement of grounds and facts which it filed pursuant to the provisions of section 534 of the 1954 Code. 2*207 We have reached our conclusions as to its reasonable *56 business needs on the basis of affirmative *206 facts of record. Thus, we need not consider the sufficiency of petitioner's section 534 statement.
The next issue is whether the additions of $ 5,222.43 and $ 1,887.73 made by petitioner to its bad debt reserve in 1947 and 1949, respectively, were reasonable.
Section 23(k)(1) of the 1939 Code permits a deduction from income, in the discretion of the Commissioner, of a reasonable addition to a reserve for bad debts. Great latitude is extended the Commissioner in exercising that discretion; and the burden of establishing an abuse of discretion falls heavily upon the taxpayer. Union National Bank & Trust Co. of Elgin, 26 T.C. 537">26 T.C. 537 (1956).
Essentially, a bad debt reserve constitutes an estimate of those losses which can reasonably be expected to result from current business debts. In every case, then, the ultimate question is not whether the proposed addition to the reserve is sufficient *208 to absorb the estimated losses, but rather whether the credit balance in the reserve is adequate for that purpose. Platt Trailer Co., 23 T.C. 1065">23 T.C. 1065 (1955). While the reasonableness of an addition to the reserve ordinarily will be judged in the light of the taxpayer's experience in collecting its accounts, no hard and fast standard should be adopted. A formula which may have produced a reasonable addition over a series of years might very well prove inadequate under the circumstances attendant upon the year involved. Black Motor Co., 41 B.T.A. 300">41 B.T.A. 300 (1940), affd. 125 F. 2d 977 (C.A. 6, 1942). In the final analysis, the estimate as to the reserve required for any given year will be measured in light of the conditions which exist at the time the estimate is made. Primarily, the reasonableness of any addition will depend on the total amount of debts outstanding at the close of the year, including current debts as well as those which arose in prior years, and the total amount of the existing reserve. Regs. 118, sec. 39.23(k)-5.
The record indicates that petitioner's experience, over the years 1929 through 1946, was that an amount equal to approximately 0.86 per cent of its gross sales *209 turned out to be bad debts. No relationship between accounts receivable and worthless accounts has been shown. The record further reveals that petitioner's 1947 gross sales totaled $ 522,243, and its yearend receivables $ 185,409. Included among those receivables was a $ 22,000 account of Beck Jewelry Enterprises, which we have found to have been extremely doubtful as of that time. Prior to any additions, petitioner's bad debt reserve balance at the close of 1947 was $ 10,474.07. In the light of these facts, and the principles set forth above, it is clear that petitioner's reserve at the close of 1947 was inadequate to provide for anticipated losses. It is likewise clear that the addition to the reserve in that year of $ 5,222.43 was reasonable, and we so hold.
*57 By the close of 1949, however, an entirely different situation prevailed. Gross sales during that year totaled $ 188,772, and yearend receivables $ 66,227. While $ 10,547.10 was still owed petitioner on the Beck account, one-half of that amount was determined to be totally worthless, and was written off during 1949 by a charge to the bad debt reserve. Thus at the close of that year only $ 5,273.36 of petitioner's receivables *210 represented the still doubtful Beck account. The credit balance in its bad debt reserve, prior to any addition and adjusted for the $ 5,273.74 chargeoff, was $ 10,422.76. Clearly this was adequate to meet any anticipated losses attributable to its current business debts. Thus, the addition to the reserve in 1949 of $ 1,887.73 was unreasonable, and properly disallowed by respondent.
But petitioner maintains that its 1949 yearend receivables included $ 14,963.60 of unpaid Swiss commissions which were "vulnerable to loss or deduction by devaluation, restrictions on currency exchange or political upheaval." There is no support for this contention in the record. Petitioner's experience was that these commissions had always been collected within 4 months after they were earned. Further, other than a nebulously identified instance when petitioner was required to collect these commissions on the basis of a lower rate of exchange than prevailed on the market, it never suffered any loss whatsoever on the accounts. Finally, in light of this record, the mere possibility that these accounts were subject to loss due to devaluation of the franc, restriction on exchange rates, or political occurrence, *211 appears entirely too remote to justify their classification as possible bad debts.
By way of an alternative, should either addition to the reserve be found reasonable, respondent contends that that portion thereof attributable to the Beck account must be taken into income in 1952, the year in which the account was finally collected in full. Originally he determined under this theory that petitioner should report as ordinary income the amounts of $ 2,395.83 and $ 13,730.68 in 1951 and 1952, respectively. He now concedes error as to that determination, and in light of our holdings above, would require only that $ 5,222.43 be added to petitioner's income in 1952. We do not agree. Respondent's own regulations 3 clearly provide that:
In case subsequent realizations upon outstanding debts prove to be more * * * than estimated at the time of the creation of the existing reserve, the amount of the excess * * * in the existing reserve should be reflected in the determination of the reasonable addition necessary in the taxable year.
Thus, the excess will be used to reduce what otherwise may have been a reasonable addition to the reserve in subsequent taxable years. We find nothing, either *212 in the law or cases, which would justify respondent's present position.
*58 Finally, we note that the case of Geyer, Cornell & Newell, Inc., 6 T.C. 96">6 T.C. 96 (1946), is no authority for respondent's present position. There we were confronted by the permanent discontinuation of that portion of the taxpayer's business which gave rise to a need for a bad debt reserve. Moreover, all its accounts receivable had been collected. After noting that the balance in the reserve no longer served any purpose, we held it should be treated as income "where it was built up by additions which were allowed as deductions from income of prior years." Here there was no discontinuation of credit sales. The reserve still served a useful function.
Decision will be entered under Rule 50.
Footnotes
1. Other than for cost of goods sold.
1. No figures available for the years 1922-1940.↩
1. As per petitioner's books without adjustments proposed by respondent other than with respect to section 102↩ income.
2. As per company's books without reflection of commitments to Swiss watch factories.↩
1. Recovery of amount charged off in 1949.
1. SEC. 102. SURTAX ON CORPORATIONS IMPROPERLY ACCUMULATING SURPLUS.
(a) Imposition of Tax. -- There shall be levied, collected, and paid for each taxable year (in addition to other taxes imposed by this chapter) upon the net income of every corporation * * * if such corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders or the shareholders of any other corporation, through the medium of permitting earnings or profits to accumulate instead of being divided or distributed, a surtax * * *
* * * *
(c) Evidence Determinative of Purpose. -- The fact that the earnings or profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid surtax upon shareholders unless the corporation by the clear preponderance of the evidence shall prove to the contrary.↩
2. SEC. 534. BURDEN OF PROOF.
(a) General Rule. -- In any proceeding before the Tax Court involving a notice of deficiency based in whole or in part on the allegation that all or any part of the earnings and profits have been permitted to accumulate beyond the reasonable needs of the business, the burden of proof with respect to such allegation shall --
(1) if notification has not been sent in accordance with subsection (b), be on the Secretary or his delegate, or
(2) if the taxpayer has submitted the statement described in subsection (c), be on the Secretary or his delegate with respect to the grounds set forth in such statement in accordance with the provisions of such subsection.
(b) Notification by Secretary. -- Before mailing the notice of deficiency referred to in subsection (a), the Secretary or his delegate may send by registered mail a notification informing the taxpayer that the proposed notice of deficiency includes an amount with respect to the accumulated earnings tax imposed by section 531. * * *
(c) Statement by Taxpayer. -- Within such time (but not less than 30 days) after the mailing of the notification described in subsection (b) as the Secretary or his delegate may prescribe by regulations, the taxpayer may submit a statement of the grounds (together with facts sufficient to show the basis thereof) on which the taxpayer relies to establish that all or any part of the earnings and profits have not been permitted to accumulate beyond the reasonable needs of the business.
3. Regs. 118, sec. 39.23(k)-5.↩