*317 Decision will be entered under Rule 50.
1. Respondent's disallowance of deductions for additions to a reserve for bad debts for the years 1942 and 1944, approved.
2. Corporation, engaged primarily in manufacture and sale of chocolate syrup, entered into agreements with some of its customers wherein it agreed to furnish designated advertising material and services, and customers agreed to pay therefor a price per gallon for a specified number of gallons of syrup in excess of the base price paid by those not entering into such agreements. Advertising accounts carried in the names of participating customers were credited with amounts received and charged for advertising material and services rendered and for any refunds made. Held, excess of credits over charges to these accounts during each of the years 1942, 1943, and 1944 is includible in taxable income of corporation.
*31 This proceeding involves petitioner's liability as transferee of the assets of its predecessor, the Krim-Ko Company, for the following deficiencies *318 in tax:
| Declared value | Excess profits | ||
| Year | Income tax | excess-profits tax | tax |
| 1942 | $ 27,039.93 | ||
| 1943 | $ 955.69 | $ 692.53 | 9,057.83 |
| 1944 | 1,359.27 | 15,504.37 |
The petitioner concedes its liability, as transferee, if this Court decides that deficiencies in taxes were due from the Krim-Ko Company for the taxable years 1942, 1943, and 1944.
The issues are:
(1) Whether respondent properly disallowed as unreasonable the addition of $ 4,400 to the Krim-Ko Company's reserve for bad debts for 1942 and $ 3,000 for 1944.
(2) Whether respondent properly included in the gross income of the Krim-Ko Company for the taxable years the following amounts *32 reflected in the credit balances in accounts carried on its books in the names of customers who entered into "Cooperative Marketing and Sales Promotion Agreements":
| 1942 | $ 16,536.18 |
| 1943 | 13,072.65 |
| 1944 | 9,548.63 |
The facts in this proceeding were developed through a written stipulation of facts, exhibits and oral testimony.
FINDINGS OF FACT.
The stipulated facts are hereby found accordingly.
The petitioner is a corporation organized under the laws of the State of Illinois on October 17, 1929, as the Chocolate*319 Corporation of America. It owned a majority of the shares of stock of the Krim-Ko Company, a corporation which was organized under the laws of the State of Illinois on January 14, 1926, under the name of Creamko Corporation, which was changed in 1935 to the Krim-Ko Company. Prior to August 1, 1945, the Krim-Ko Company (hereinafter referred to as Krim-Ko) was engaged in the business of manufacturing and selling chocolate-flavored syrup and powder and the processing of moss as a stabilizer for its products. This syrup and powder were sold to dairies and creameries throughout the country for use in making so-called "chocolate milk."
On August 1, 1945, Krim-Ko was merged in accordance with the laws of the State of Illinois with the Chocolate Corporation of America. All of its assets were transferred to the latter on that date, and it thereupon ceased to exist. Thereafter the business previously carried on by Krim-Ko was conducted by petitioner, the Chocolate Corporation of America. Petitioner's name at the time of the merger was changed to Krim-Ko Corporation.
For the taxable years 1942, 1943, and 1944, Krim-Ko had its principal place of business at 4830 S. Christiana Avenue, Chicago, *320 Illinois, and filed its income and declared value excess-profits tax returns and its excess profits tax returns with the collector of internal revenue at Chicago, Illinois. Krim-Ko maintained its books and filed its returns on the accrual method of accounting.
Krim-Ko maintained a reserve for bad debts and made provision for its bad debts by making additions to such reserve. When debts became worthless or uncollectible, the amounts of such debts were charged to the reserve. In addition, there were also added to the reserve amounts representing the recovery of sums previously charged to the account as bad debts. For the years 1941 to 1945, inclusive, the additions to the reserve, the charges for bad debts and the additions *33 for the recovery of debts previously charged off, together with the balance in the reserve at the end of such years, were as follows:
| Balance | ||||
| Year | Additions | Charges | Recoveries | 12/31 |
| 1941 | $ 7,566.45 | $ 6,198.21 | $ 125.44 | $ 13,973.71 |
| 1942 | 4,400.00 | 5,316.07 | 119.60 | 13,177.24 |
| 1943 | 343.23 | 812.02 | 233.94 | 12,942.39 |
| 1944 | 3,000.00 | 1,947.21 | 12.80 | 14,007.98 |
| 1945 | 400.00 | 587.62 | None | 13,820.36 |
The bad debt charges to the reserve*321 were made only after Krim-Ko and a commercial collection agency had made exhaustive and unsuccessful efforts to collect, with resort to suit if feasible, and officials of the taxpayer were "positive from all sources" that collection was not possible. All recoveries of debts previously charged off were credited to the reserve.
For the years 1941 to 1944 Krim-Ko had the following amount of sales and at the end of each of said years had the following amount of accounts receivable attributable to sales:
| Year | Sales | Accounts receivable |
| 1941 | $ 1,043,376.65 | $ 102,056.89 |
| 1942 | 1,155,867.07 | 69,456.85 |
| 1943 | 1,343,974.64 | 85,068.64 |
| 1944 | 1,516,027.12 | 76,525.81 |
Krim-Ko's reserve for bad debts in the years 1942 and 1944 was adequate, apart from the amounts of $ 4,400 and $ 3,000 which it added at the end of those years, respectively, and the Commissioner's refusal to treat those amounts as reasonable additions to the reserve was not arbitrary. They did not constitute reasonable additions to the reserve.
During the taxable years 1942, 1943, and 1944, Krim-Ko sold chocolate-flavored syrup to its customers and agreed to furnish advertising and sales promotion service for them under*322 so-called "cooperative advertising and sales promotion agreements." These agreements were sometimes in writing on a form printed for that purpose, while other agreements were oral. The agreements, when made on the printed form, were usually for a period of 1 year. In a number of instances, after the period of the agreement had expired, the same arrangement continued even though the contract was not renewed in writing.
About one-half of the customers of Krim-Ko entered into the cooperative advertising and sales promotion agreements, although neither Krim-Ko nor the customer was compelled to do so. In addition to the Krim-Ko advertising provided for in these agreements, Krim-Ko also engaged in other advertising activities of a more general nature.
*34 The terms of the agreements varied, depending largely upon the desires and needs of the individual customers. The special advertising could be of any type the customer specified. Among other things, it consisted of supplying "Krim-Ko Komics"; signs and show cards; store clerks' aprons; pencils; uniforms for baseball, softball and bowling teams, and special newspaper advertisements. In addition, it furnished newspaper sampling*323 advertisements and redeemed sampling coupons; arranged driver salesmen's contests, and made available the sales promotion services of a salesman of Krim-Ko. While the charge for the advertising and sales promotion services varied under the terms of oral or written contracts, it was usually 40 cents per gallon of syrup sold.
The petitioner used two different printed forms in drawing up the contracts with its customers. Each form contained the statement that "This agreement covers advertising features and sales promotion services incident thereto to be furnished by Krim-Ko upon the following terms:"; each contained a list of the advertising material and services to be furnished, and in each the customer agreed that during the period covered by the contract it would buy its full requirements of Chocolate Drink flavoring in the form of Krim-Ko chocolate-flavored drink base (syrup) at a price of $ 1.60 per gallon for a specified number of gallons, and $ 1.20 per gallon thereafter. The principal difference between the two printed forms was the method used in arriving at the number of gallons, or "gallonage quota," to which the $ 1.60 price would apply. In one this was determined by *324 multiplying the number of dairy routes by 150 gallons. In the other the "gallonage quota" was determined by inserting after each item of advertising or service to be furnished an amount designated "Local Cost," and dividing the aggregate of these inserted amounts, designated as "Total Local Cost" by "40 cents per gallon." If the "gallonage quota" thus determined were 5,000 gallons, the customer agreed to pay $ 1.60 per gallon for the first 5,000 gallons purchased and $ 1.20 per gallon thereafter, but, in the event it purchased less than 5,000 gallons, it agreed to pay Krim-Ko at the end of the period covered by the contract an amount equal to 40 cents on each gallon under the quota.
On the books of Krim-Ko when syrup was sold, the total charge for the syrup, including the amount for advertising, was debited to accounts receivable and credited to sales. At the end of the month a debit to advertising expense in the amount of the advertising charge was made, and a credit in the same amount to the account designated "reserve for advertising." The entry at the end of the month was a summary of all of the advertising charges for that month. The syrup was billed to Krim-Ko's customers *325 at a total price per gallon which included the amount for advertising. The receipts from sales, including *35 the amount for advertising, were deposited in Krim-Ko's bank account, and the money representing the 40 cents per gallon for advertising was not physically separated or segregated from the general funds of the business.
For each customer who had entered into an advertising and promotion contract Krim-Ko set up two records on its books, one an account receivable representing the customer's merchandise purchases, including the advertising charges, and the other reflecting advertising reserve attributable to the particular customer. In this latter account there was entered under the heading "credits" the portion of the amount billed each customer for purchases which was allocable to advertising and sales promotion services to be furnished by Krim-Ko, under the heading "charges" amounts representing charges for advertising and sales promotion actually furnished, and the balance remaining after each credit or charge. When an invoice was issued to a customer, a rubber stamp was placed upon the back of the retained copy and the accounting distribution was shown thereon.
The*326 entries on the reverse of the invoice were next set up on the company's monthly sales register which also showed the accounting distribution, and posted to the two accounts set up for the individual customer.
The books of Krim-Ko were closed each month, and the monthly sales register sheets were compiled by months into the general ledger which reflected the totals for the 12 months. In the balance sheet at the end of the year the credit balances in the advertising accounts were recorded as a liability.
The advertising account for each customer showed currently the unappropriated balance therein. Krim-Ko did not send statements to customers having advertising contracts showing balances in the advertising accounts. These balances were discussed at meetings of salesmen, and when a contract expired, the salesman serving the territory in which the customer was located was advised of the balance in the advertising account of the customer. Any customer who inquired about the amount of the credit balance in the advertising account carried in his name was given this information.
In a number of instances where customers, upon the expirations of their contracts, requested that the credit*327 balances then shown on the books be refunded to them, they received refunds from Krim-Ko. For the years 1938 through 1941 it refunded to customers having credit balances in their accounts a total of $ 2,520.19. In 1942 it refunded $ 3,236.19; in 1943, $ 3,210.44, and in 1944, $ 4,240.36. In some years unspecified amounts were transferred from customers' advertising accounts to their merchandise accounts. There was no provision in the contracts requiring such refunds or credits.
*36 During the taxable years here involved the amounts credited to the reserve for advertising account on Krim-Ko's records, the charges to that account, and the balance remaining therein at the end of those years, as well as the years 1941 and 1945, were as follows:
| Year | Credits | Charges | Balance at 12/31 |
| 1941 | $ 8,983.36 | ||
| 1942 | $ 27,614.74 | $ 20,061.92 | 16,536.18 |
| 1943 | 30,963.07 | 17,890.42 | 29,608.83 |
| 1944 | 25,811.67 | 16,263.04 | 39,157.46 |
| 1945 | 50,258.60 |
The balance in the reserve for advertising account at December 31, 1946, was $ 57,988.34 and at December 31, 1947, was $ 56,827.26.
The advertising furnished by Krim-Ko was frequently furnished from an inventory of such advertising*328 material maintained for that purpose. All of the material and services furnished were for the advertisement of the name Krim-Ko and Krim-Ko chocolate milk. None of the material was for the advertisement of the name or products of the customer except its chocolate milk which was sold under the trade name Krim-Ko. The purpose of the advertising contracts was to get customers to buy Krim-Ko syrup in large quantities.
Among the principal ingredients in the chocolate syrup were cocoa, chocolate and sugar, which, due to war conditions, were in very short supply during the taxable years. As a result the demand for the product was greater than the supply and Krim-Ko's customers were very anxious to get it. This demand was heightened because cream and whole milk were also in short supply and the syrup was normally mixed with skim milk.
The amounts credited by Krim-Ko to the advertising accounts carried in the names of its customers were included in gross sales in its income tax returns for the taxable years, but these amounts were deducted from gross sales in arriving at the amount of net sales. The respondent determined that the full amount of the credit balance in these accounts at*329 the end of 1942 ($ 16,536.18) constituted gross income of Krim-Ko for that year, and that the net amounts by which the credit balance was increased at the end of 1943 and 1944, i. e., $ 13,072.65 and $ 9,548.63, constituted gross income of Krim-Ko for each of those years, respectively.
Petitioner is liable as transferee of the assets of Krim-Ko to the extent that deficiencies are due from Krim-Ko for the taxable years 1942, 1943, and 1944.
OPINION.
1. Respondent disallowed deductions in the amounts of $ 4,400 for 1942 and $ 3,000 for 1944 taken by Krim-Ko as additions *37 to its reserve for bad debts. Ordinarily, deductions based upon reserves are not allowed under the revenue laws (cf. Brown v. Helvering, 291 U.S. 193">291 U.S. 193), and this was true originally as to bad debts. Section 23(k)(1) of the Internal Revenue Code represents an exception to the general rule; it allows as a deduction "(in the discretion of the Commissioner) a reasonable addition to a reserve for bad debts * * *." 1 However, Congress was unwilling to give the taxpayer an absolute right to such deduction and explicitly made it contingent upon the Commissioner's discretion. The*330 question for decision here is whether there has been an abuse of that discretion. As was stated in C. P. Ford & Co., 28 B. T. A. 156, 158-159:
A taxpayer has an absolute right to choose to deduct his worthless debts when they are ascertained to be worthless and charged off, but if instead he chooses to deduct additions to a reserve, he subjects himself to the reasonable discretion of the Commissioner. Reserves of any sort are not ordinarily deductible, * * * and when Congress so far departs from the customary practice as to permit such a deduction as to a bad debt reserve, the condition is as important as the permission. Such a deduction presents substantial problems of administration, and it can not be assumed that Congress intended either that the taxpayer's unrestrained judgment as to the propriety or wisdom of his method or that the Board's judgment in a particular case when not supported by broad administrative considerations as well as the taxpayer's individual premises should override the Commissioner's sound discretion. * * *
See also Walter H. Goodrich & Co., 40 B. T. A. 960, 961-962.
*331 Petitioner stresses the fact that the effect of the Commissioner's disallowance of the addition to the reserve for 1942 and 1944 is to permit for the 3 years, 1942-1944, inclusive, an addition to the reserve of only $ 343.23, the amount by which the reserve was increased in 1943. It suggests that such amount is wholly insufficient, based upon its experience. But the crux of the matter is not whether the additions to the reserve are sufficient to absorb the bad debts that might arise during the years involved. Rather, the question is whether the reserve itself was sufficient for that purpose. And if the Commissioner was justified in concluding, in the light of prevailing conditions, that the reserve already on the taxpayer's books was adequate, we cannot overturn his exercise of discretion to disallow further additions to the reserve.
The evidence does not convince us that respondent's action in disallowing the contested deductions was either arbitrary or an abuse of the discretion vested in him by Congress. At the beginning of the year 1941, the balance in Krim-Ko's reserve for bad debts was $ 12,480.03. Its actual bad debts charged to the reserve during that *38 year exceeded*332 recoveries by $ 6,072.77, and $ 7,566.45 was added to the reserve. The balance in the reserve at the end of 1941 was $ 13,973.71. In 1942, although its sales increased by approximately $ 100,000 over 1941, there was a decrease in its accounts receivable of approximately $ 30,000 and a decrease in the amount of its actual bad debts over recoveries of $ 876.30 ($ 6,072.77 minus $ 5,196.47). Respondent's disallowance of any addition to Krim-Ko's reserve at the end of 1942 left it with a reserve of $ 8,777.24. This amount is some $ 2,700 in excess of the net charges to the reserve in 1941 and some $ 3,500 in excess of the net charges made thereto in 1942. This fact, and the absence of any evidence to indicate that Krim-Ko could reasonably anticipate a substantial increase in the amount of bad debts during the year 1943, seems to us to sustain respondent's determination that Krim-Ko was not entitled to any increase in the amount of its reserve for bad debts at the end of 1942.
The justification for respondent's disallowance of the $ 3,000 addition to Krim-Ko's reserve at the end of the year 1944 is even more clearly apparent. Without any addition, the reserve at that time was $ 6,607.98, *333 whereas net charges to the reserve amounted to only $ 1,934.41 in 1944 and $ 578.08 in 1943. The war years which brought Krim-Ko increased sales also brought a sharp decline in bad debts. These were facts which the Commissioner was certainly entitled to take into account, and, in the circumstances, he did not abuse his discretion in concluding that the reserve as it then stood did not require augmentation at that time.
2. The remaining issue relates to the correctness of the respondent's determination that amounts reflected in credit balances in the advertising accounts, carried on the books of Krim-Ko in the names of its customers at the end of the years 1942, 1943, and 1944, should have been included in the taxable income of Krim-Ko for those years. Apart from the year 1942, which will be discussed separately, the Commissioner treated as income of Krim-Ko the net amounts by which the credit balances were increased in each of the taxable years. For each year that amount was the excess of credits to the accounts over charges against them. Thus, the amount in controversy for the year 1943 is $ 13,072.65, which is equal to the excess of $ 30,963.07 in credits over $ 17,890.42 in*334 charges made during that year. Stated otherwise, although Krim-Ko received $ 30,963.07 from its customers during 1943 for advertising material and services, it expended at most only $ 17,890.42 2 for that purpose, and the Commissioner contends that the difference, $ 13,072.65, constitutes income to Krim-Ko.
*39 Petitioner, on the other hand, argues that the advertising account was a trust fund, "a fund belonging to [Krim-Ko's] customers"; that Krim-Ko itself "acted only as a conduit through which payment for advertising and promotional services was made"; and that none of the payments made by its customers for advertising could be included in the gross income. We disagree. The receipts on account of the so-called advertising charges did not constitute a trust fund for customers, nor were they set aside in any *335 other way as the property of the customers.
Petitioner's contentions find no support in the provisions of the agreements between Krim-Ko and its customers which were introduced in evidence. Therein Krim-Ko agreed to furnish certain designated advertising material and sales promotion services and its customers agreed to pay therefor a price per gallon for a specified number of gallons of syrup in excess of the base price charged in instances where such material and services were not furnished. The agreements placed no restriction upon Krim-Ko's use or disposition of any amounts received by it for advertising material and services and did not indicate that it was to act as a depository, conduit, trustee, or agent with respect to them.
At most, Krim-Ko, as an adjunct to its principal business, had undertaken to sell special advertising material and services to its customers. The amounts which it received for that purpose must be reflected in gross income, which may be reduced by the amount of expenditures which it made in connection therewith.
In support of its position that the credit balances belonged to the customers, petitioner points out that in some instances Krim-Ko refunded*336 such credit balances to its customers or credited them to the customers' trading accounts. But there was no provision in the agreements requiring such refunds or credits, and the fact is that the amount of the credit balances increased steadily from $ 8,983.36 at the end of 1941 to some $ 57,000 at the end of 1946. Moreover, correspondence placed in evidence by petitioner, relating to several instances where either the amount of a credit balance was refunded or credited to a customer's trading account, indicates that, in making such refunds or credits, Krim-Ko was probably motivated by a desire to help customers who were delinquent in their payments for syrup purchased or who were short of funds rather than by any recognition of a legal obligation to repay or refund unexpended balances.
Under our revenue laws income is determined on an annual basis. During each of the taxable years Krim-Ko received under the agreements with its customers substantial amounts for advertising material and services in excess of expenditures. We are not convinced on the record in this case that, as of the end of each of these years, there *40 was any reasonable assurance that the excess amounts*337 would ever be expended for the customers, in full or in substantial part. As noted above, the amounts did not constitute a trust fund. They were paid in consideration for Krim-Ko's promise to furnish designated advertising material and services. They belonged to Krim-Ko and it treated them as its property by commingling them with its other assets. Having been received under claim of right and without restriction as to disposition, they constitute income in the year of receipt or accrual notwithstanding that Krim-Ko or its successor might in later years make refunds or expenditures with respect to them. Cf. Brown v. Helvering, 291 U.S. 193">291 U.S. 193; Capital Warehouse Co., 9 T. C. 966, affd. (C. A. 8), 171 Fed. (2d) 395; Clay Sewer Pipe Assn., 1 T. C. 529, affd. (C. A. 3), 139 Fed. (2d) 130; Your Health Club, Inc., 4 T. C. 385; E. B. Elliott Co., 45 B. T. A. 82; South Tacoma Motor Co., 3 T.C. 411">3 T. C. 411. To the extent that refunds or expenditures are made*338 in later years in carrying out the agreements, the taxpayer will receive the benefit of them tax-wise in such years. Meanwhile, the amounts received by Krim-Ko must be reflected in gross income in accord with the principles applied in the foregoing decisions. This case is governed by those principles, and is to be distinguished from Seven-Up Co., 14 T. C. 965, where, under the special facts there presented, the taxpayer was thought to be a mere conduit in passing funds from its customers to an advertising agency.
We therefore approve respondent's action in including in the taxable income of Krim-Ko the amounts by which the credit balances in the advertising accounts were increased during the years 1943 and 1944. However, we do not approve his determination with respect to the year 1942. Respondent included in gross income the entire credit balance of $ 16,536.18 as of the end of 1942. But the credit balance as of the end of 1941 was $ 8,983.36, and the increase in 1942 was merely the difference between those two figures, namely, $ 7,552.82. It is only the latter amount which may be included in gross income for 1942. During 1942, Krim-Ko's total*339 receipts with respect to advertising were $ 27,614.74, and its expenditures for that purpose were listed as aggregating $ 20,061.92. The difference between these two figures -- $ 7,552.82 -- is the same as the increase in the credit balance during 1942, and represents the income chargeable to it in 1942. Respondent's determination would result in a distortion of income, since it in effect would attribute to the year 1942 receipts already reflected in the credit balance prior to 1942. Respondent erred in including more than $ 7,552.82 in Krim-Ko's income for 1942 in connection with this issue.
Decision will be entered under Rule 50.
Footnotes
1. The pertinent statutory language first appeared in section 234 (a) (5) of the Revenue Act of 1921. Prior thereto, the deduction for bad debts was allowed only if the debts were ascertained to be worthless and charged off within the taxable year. See, e. g., section 234 (a) (5) of the Revenue Act of 1918.↩
2. The record does not show that Krim-Ko actually expended that amount in full. Conceivably, the cost of the advertising to it may have been less. However, no issue has been raised as to this point.↩