*1199 1. Respondent's determination disallowing a portion of the amount claimed by petitioner as an addition to its reserve for bad debts approved.
2. In 1928 petitioner's board of directors fixed the salary of its general manager, which action was not thereafter rescinded. In the taxable year the manager drew $1,500 less salary than that fixed. This amount was not accrued on petitioner's books and was not deducted in its 1936 return. In a subsequent year the back salary was paid by petitioner's wholly owned subsidiary, which it charged to petitioner on its books. Held, under the facts here petitioner is entitled to deduct the amount of the salary as fixed by its directors in 1928, notwithstanding petitioner's books do not show an accrual of the unpaid salary in the tax year, or reflect petitioner's liability therefor to its subsidiary.
3. On August 20, 1936, petitioner's board of directors declared a 10 percent dividend amounting to $7,500, to be paid in four installments at the rate of 2 1/2 percent monthly, the first October 15, 1936, and one on the 15th day of each month thereafter until fully paid. During 1936 petitioner's two principal stockholders received 100 percent*1200 of their pro rata share of the dividend, two stockholders received 25 percent of their pro rata share, and the remaining stockholders received 50 percent of their pro rata share. Held, as the distributions were not pro rata, equal in amount and without preference, under section 27(g), Revenue Act of 1936, petitioner is not entitled to a dividends paid credit.
*301 This proceeding involves a deficiency in income tax for 1936 of $3,758.29 and a deficiency in excess profits tax for 1936 of $1,073.31. The issues presented are (1) whether respondent erred in disallowing a $12,270.64 addition to petitioner's bad debt reserve; (2) whether petitioner is entitled to an additional deduction of $1,500 as salary which accrued to its manager; (3) whether respondent erred in failing to allow a dividends paid credit in computing surtax on undistributed profits; and (4) whether respondent erred in determining an excess profits tax, which is alleged to be invalid and unconstitutional. The other assignment of error was waived*1201 by the petitioner at the hearing.
By amendment petitioner alleges that the addition to its reserve for bad debts for 1936 should have been $94,680.87 instead of the $91,602.88 claimed on its return.
Upon these alleged errors petitioner asserts that it has overpaid its 1936 taxes.
FINDINGS OF FACT.
The petitioner is a Kentucky corporation, with its principal place of business at Harlan, Kentucky. It is engaged in selling automobiles at retail. Its income tax return for 1936 was filed with the collector for the district of Kentucky. It paid income taxes for 1936 of $765.82 in the following installments on or about the dates set forth:
| May 13, 1937 | $192.89 |
| June 15, 1937 | 190.98 |
| Sept. 11, 1937 | 190.98 |
| Dec. 13, 1937 | 190.97 |
| Total | 765.82 |
It paid no excess profits tax. It filed the petition herein on February 24, 1939.
The petitioner kept its books and rendered its income tax returns on the accrual basis.
The deficiency letter shows that respondent disallowed $12,270.64 of the deduction claimed by petitioner as an addition to its reserve *302 for bad debts. The respondent's explanation of his adjustment is stated in the deficiency notice*1202 as follows:
| EXPLANATION OF ADJUSTMENTS | |
| (a) Deduction for addition to reserve for bad debts per return | $91,602.88 |
| Deduction allowable | 79,332.24 |
| Difference, disallowed | 12,270.64 |
It is held that a reasonable addition to the reserve for the taxable year as provided in Section 23(k) of the Revenue Act of 1936 is the amount required to bring the reserve as adjusted at the end of the year up to 32.13% of your accounts and notes receivable, and deferred certificates, based on your average annual losses for the six year period ended with the close of the taxable year, per the following computation:
| Accounts and notes receivable December 31, 1936 | $124,619.80 | |
| Deferred certificates December 31, 1936 | 49,400.91 | |
| Total of receivables to which reserve is applicable | 174,020.71 | |
| Reserve December 31, 1936 as adjusted, 32.13% of $174,020.71 | 55,912.85 | |
| Add: Losses charged to reserve in the taxable year | $61,295.11 | |
| Less recoveries | 375.43 | |
| 60,919.68 | ||
| Total reserve for bad debts requirement | 116,832.53 | |
| Deduct: Reserve as adjusted December 31, 1935 | 37,500.29 | |
| Allowable addition to reserve for taxable year | 79,332.24 |
The per cent of*1203 losses from bad debts to the total of accounts and notes receivable and deferred certificates as shown by your experience in the six year period 1931 to 1936, inclusive, is shown by the following schedule:
| Year | Accts. & Notes Receivable & Deferred Certificates | Bad Debts, Net | Per Cent of Losses |
| 1931 | $105,082.04 | $24,801.08 | 23.60 |
| 1932 | 67,899.65 | 15,527.29 | 22.87 |
| 1933 | 56,040.23 | 21,132.75 | 37.71 |
| 1934 | 71,119.32 | 27,476.63 | 38.63 |
| 1935 | 98,957.88 | 34,333.43 | 34.69 |
| 1936 | 174,020.71 | 60,919.68 | 35.01 |
| Total | 573,119.83 | 184,190.86 | 32.13 |
| Six year average | 32.13 |
In 1928 petitioner's board of directors elected E. V. Albert as its manager, with a salary of $400 per month. This action by petitioner's board of directors has never been rescinded or changed by formal action in any way. On account of adverse business conditions E. V. Albert did not draw, prior to and during the taxable year, the full salary he was entitled to receive. In 1936 he was paid $3,300. No additional amount was accrued on petitioner's books respecting *303 Albert's salary, and only $3,300 was claimed as a deduction on its 1936 return. During the taxable year petitioner's*1204 bookkeeper was unaware of the amount of salary authorized by the board of directors to be paid to E. V. Albert.
Subsequent to 1936, Albert drew $3,000 from one of petitioner's wholly owned subsidiaries as back salary due him. The subsidiary charged this withdrawal to petitioner on its books, but no corresponding entries were made on petitioner's books to reflect its liability to its subsidiary up to the date of the hearing.
The minutes of the annual meeting of petitioner's board of directors on August 20, 1936, after reciting a discussion regarding the paying of a dividend, states that "* * * it was finally unanimously agreed that a 10% dividend be declared, same to be paid at the rate of 2 1/2% monthly, the first installment to commence October 15, 1936, and each month thereafter until fully paid."
Under date of August 28, 1936, petitioner issued a general journal voucher which set up the $7,500 dividend as a liability of the company, charging it against surplus and crediting dividends payable. The explanation appearing on the face of the voucher reads as follows: "To set up amount of dividend declared at Directors Meeting Aug. 20, 1936; 10% of outstanding Capital Stock, *1205 payable 2 1/2% monthly, beginning October 15, 1936."
During 1936 the petitioner paid $5,487.50 in dividends, of which its two principal stockholders received 100 percent of their pro rata share of the $7,500 dividend, E. V. Albert and one other stockholder received only 25 percent of their pro rata share of the dividend, and the remaining 16 stockholders of the petitioner received 50 percent of their pro rata share.
OPINION.
ARNOLD: The first issue is to be determined under section 23(k) of the Revenue Act of 1936, which authorizes the petitioner to deduct "Debts ascertained to be worthless and charged off within the taxable year (or, in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts); * * *"
In this proceeding the respondent, in the exercise of his sound discretion, determined that $79,332.24 represented a reasonable addition to petitioner's reserve for bad debts for the taxable year. The petitioner offers no proof to support its contention that $94,680.87 is the proper addition to its reserve for bad debts, other than a mathematical computation, whereby it fixes the percent of losses from bad debts, to be applied against its total*1206 accounts and notes receivable and deferred certificates of $174,020.71, at 40.95 percent in lieu of the 32.13 percent used by the respondent.
*304 The test, however, is whether the amount ultimately determined, regardless of formula, constitutes a reasonable addition to petitioner's reserve. What constitutes a reasonable addition will depend upon the facts and circumstances of the business engaged in with relation to general business conditions. A method or formula that produces a reasonable addition to a bad debt reserve in one year, or a series of years, may be entirely out of tune with the circumstances of the year involved. Such, in our opinion, is the situation here, and, in the absence of a showing that the allowance contended for by petitioner is more reasonable than the addition determined by the respondent, the latter amount is approved as a reasonable addition to petitioner's reserve for bad debts.
Our approval of respondent's determination could be fortified, if necessary, by the computation appearing in the deficiency notice relating to petitioner's tax liability for 1937. It appears therefrom that respondent permitted the deduction of $6,654.00 more than*1207 petitioner's bad debts actually totaled in the subsequent taxable year, which fact corroborates the reasonableness of respondent's determination.
The second issue involves the petitioner's right to deduct an additional $1,500 as salary owed its manager. No accrual was made on petitioner's books of this amount and no claim therefor was made in its tax return. The resolution under which this liability was created was adopted long prior to the taxable year, and said resolution had not been rescinded. The failure to accrue the $1,500 due the manager was reasonably explained, and, since the liability was fixed, the petitioner's taxable income should reflect the existence thereof. ; certiorari denied, . In our opinion petitioner is entitled to the additional deduction.
The next issue involves petitioner's dividends paid credit. The applicable statutory provisions respecting this credit provide:
SEC. 27. CORPORATION CREDIT FOR DIVIDENDS PAID.
(a) DIVIDENDS PAID CREDIT IN GENERAL. - For the purposes of this title, the dividends paid credit shall be the amount of dividends paid*1208 during the taxable year.
* * *
(g) PREFERENTIAL DIVIDENDS. - No dividends paid credit shall be allowed with respect to any distribution unless the distribution is pro rata, equal in amount, and with no preference to any share of stock as compared with other shares of the same class.
Section 27 grants corporations a credit against the surtax on undistributed profits imposed by section 14 of the 1936 Act. Standing alone, subsection (a) of section 27 would provide for a dividends paid credit in the amount of the dividends paid by the corporation during the taxable year. The broad provisions of subsection (a) are, however, expressly limited by the succeeding subsections, and particularly (g) *305 and (h). Subsection (g) specifically limits the credit to dividends that are distributed pro rata, equal in amounts, and without preference. Distribution means division among those entitled to share.
It appears from the deficiency notice that respondent disallowed the entire amount of the dividends paid credit claimed by petitioner upon the ground that the distributions made were not pro rata and without preference. Our findings show that the distributions were irregular*1209 in amount and were not without preference, since the two majority stockholders secured the full amount of their dividends and the other stockholders received only 50 or 25 percent of their dividends. Had the dividends been distributed pro rata in the manner provided for by the petitioner's directors, that is, 2 1/2 percent on the 15th of each month for four months, starting October 15, petitioner would have been entitled to a dividends paid credit of $5,625. Not only did petitioner fail to follow the minutes of its own directors' meeting, but it definitely preferred its principal to its minority stockholders in the distributions made. Such preference and inequality of distribution among stockholders in the same class destroys the right to the credit given in subsection (a), and respondent's determination is therefore approved. See article 27(a)-1 and article 27(g)-1, Regulations 94.
In arriving at this construction of section 27(a) and (g) we have considered petitioner's argument that the declaration created a liability to its stockholders and that such an obligation constituted a property right to each stockholder. But we can not carry this theory to the extent that petitioner*1210 contends, namely, that its stockholders were "paid" within the meaning of section 27 by the obligations created when the dividend was declared. Section 27 requires more than the creation of a liability to pay; it grants a credit only with respect to "dividends paid during the taxable year."
Petitioner contends in the alternative that it is entitled to a "dividends paid credit" of three-fourths of the dividend, or $5,625, the amount to be paid in cash in 1936; or three-fourths, plus the additional one-fourth of $972.50 which was paid to two of the stockholders in cash, total $6,597.50; or the total amount paid in cash in 1936 of $5,487.50; or the total amount of cash paid on the three installments payable in 1936 of $4,515; and that in no case should the Board allow less than $1,875, the amount of the first installment which was paid in 1936.
Petitioner's last alternative contention that it is entitled to a credit of $1,875, as each stockholder received at least 25 percent of his portion of the dividend in the taxable year, can not be sustained. The record does not show that the dividend payable Octover 15 was distributed pro rata among the stockholders. Petitioner's two*1211 principal stockholders, from the facts shown, may have received more than their pro rata share of that distribution, in fact, may have received the *306 entire distribution, in which event the distribution could not have been made to all the stockholders pro rata. This view likewise disposes of petitioner's other alternative contentions.
Petitioner's argument with respect to the excess profits tax issue is that if the Board sustains it on the other issues there will be no deficiency with respect thereto. The alleged unconstitutionality of the tax is not argued, possibly because of the weight of authority against this contention, , and cases cited. We have sustained petitioner on one of the issues presented and in view thereof the excess profits tax deficiency should be recomputed in accordance therewith.
Reviewed by the Board.
Decision will be entered under Rule 50.