*2295 1. Partnership held not entitled to both deductions for debts ascertained to be worthless and written off and also reserves for bad debts.
2. Increase of partnership income by reason of the disallowance of claimed reserves for bad debts does not, on the evidence, entitle it to additional deductions for distributions to employees who were to share in the firm's net profits.
*499 Proceedings for the redetermination of deficiencies in income taxes as follows:
| Docket No. | Petitioner | Year | Deficiency |
| 27826 | Harry Kahn | 1922 | $3,552.60 |
| 1923 | 4,273.94 | ||
| 27827 | Meyer Stern | 1922 | 4,214.33 |
| 1923 | 6,041.60 |
Petitioners allege that respondent erred in denying to the partnership the right to set up a reserve for bad debts and in disallowing deductions for entertaining and other expenses. By amendment to the petitioners it is alleged that respondent erred in distributing to the partners any income of the partnership in excess of the amounts reported, the basis for this assignment of error*2296 being that certain employees were under contract to share in partnership profits and that the additional partnership income determined by the respondent, if sustained by the Board, should be distributed to such employees before any distribution thereof is made to the partners.
No evidence was offered as to the claimed entertaining and other expenses and counsel for petitioners states in his brief that the claim in respect thereto is withdrawn.
FINDINGS OF FACT.
Petitioners are members of a partnership known as Jacob Bernheimer & Brothers, which is engaged in the business of converting cotton goods. Prior to June 14, 1923, the partnership consisted of *500 three members. On that date one of the partners died and his interest was purchased by the two surviving partners, the petitioners herein, who continued the operation of the business.
It has been the practice of the partnership since 1913 to carry on its ledger an account designated "Guarantee Account." Throughout these years monthly charges, purporting to represent 2.5 per cent of the monthly sales, were made against the profit and loss account, and at the end of the year the total of these charges was carried*2297 to the credit side of the guarantee account. The total amounts so charged to profit and loss account and credited to guarantee account, for each of the years 1918 to 1923, inclusive, were as follows:
| 1918 | $95,310.20 |
| 1919 | 111,315.63 |
| 1920 | 157,265.29 |
| 1921 | $84,674.84 |
| 1922 | 83,872.77 |
| 1923 | 98,215.95 |
There are also credited to the guarantee account collections made during each year on debts charged off in prior years. On the debit side of the account, itemized debts ascertained to be worthless were entered. The total debits to the account on account of worthless debts for each of the years 1918 to 1923, inclusive, were as follows:
| 1918 | $10,986.97 |
| 1919 | 22,788.49 |
| 1920 | 119,320.19 |
| 1921 | $211,999.44 |
| 1922 | 24,830.55 |
| 1923 | 37,894.72 |
In only one year, namely 1921, did the bad debts charged off exceed the credit to the guarantee account, and in that year the amount of the debit balance was charged to profit and loss. In all other years there was a credit balance in the guarantee account at the close of the year which was disposed of in various ways. In some years the credit balance remaining was carried over to the guarantee account for the*2298 following year, at times the balance was credited to profit and loss, and in other years it was distributed to the partners' capital accounts.
In 1921 the partnership did a very considerable export business. Most of the bad debts charged to the guarantee account in that year represented foreign accounts. A few of the 1921 foreign accounts were still carried on the books at the close of 1922, and at that time there was some question in the minds of the partners as to whether such accounts would ultimately be paid.
Gross sales of the partnership for 1922 and 1923 amounted to $3,802,204.32 and $4,409,777.72, respectively.
In 1922 the sums charged to profit and loss and credited to the guarantee account amounted to $83,872.77. Bad debts charged to the guarantee account amounted to $24,830.55, and the remainder, $59,042.22, was distributed at the close of the year to the capital accounts of the partners in the amount of $19,680.74 to each. On December 31, 1922, there was also charged to profit and loss account the sum *501 of $30,000 and the same amount was credited to a newly created reserve for bad debts for the purpose of taking care of bad debts for the following*2299 year. At December 31, 1923, the 1922 reserve for bad debts account was closed by a debit of $30,000 and a credit to profit and loss of like amount. Recoveries on bad debts in 1922 amounted to $28,310.57 which amount was credited to profit and loss. Deductions for bad debts claimed in the partnership return for 1922 amounted to $26,519.98.
In 1923 montly charges aggregating $98,215.98 were made to profit and loss and this sum was credited to the guarantee account on December 31, 1923. Bad debts totaling $37,894.72 were charged to the guarantee account and the balance $60,321.26 was credited to profit and loss. There was also a charge to profit and loss and a credit to reserve for bad debts of $70,000. Bad debt recoveries in
In 1923 monthly charges aggregating $98,215.98 were made to and loss for that year. Deductions for bad debts claimed in the partnership return for 1923 amounted to $60,280.09.
For the year 1922 respondent added to partnership income, as reported, the amount of $30,000, representing the amount set up as a reserve for bad debts. For the year 1923 the respondent added to partnership income the amount of $40,000, being the difference between the 1922*2300 reserve for bad debts carried forward to 1923 and the $70,000 carried as a reserve for bad debts in the latter year.
During the taxable years the partnership employed, under written contracts, Milton Levy, W. B. Milius, and Arthur A. Lansburgh. These contracts were in the form of letters from the employees to the firm differing only as to the percentage to be paid the employee, and, as far as material here, read as follows:
In consideration of the above services and in full payment thereof I am to receive from you as a compensation an amount equal to per cent of the net profits, if any, of the business of each calendar year, respectively or in proportion, if contract is terminated before the end of the calender year by notice as hereinafter provided for.
I also agree that in arriving at the amount of the net profits that same methods be used as you have used heretofore, that is, all expenses and interest on capital shall be deducted before any profit can be divided. You are to have the privilege of determining what the said net profits of the business are, at such time and in such manner as you may think fit, that is in appraising the stock and outstanding accounts. Your*2301 estimates shall be final and conclusive, also I shall have no interest in the prospective profit that may be realized by unfilled orders existing at the time this contract is terminated or liable for any losses realized by reason of such unfilled orders, and I hereby agree to accept same as a basis of calculating the amount of what the profits are, if any may be.
This agreement is to be considered as merely an agreement between employer and employee and nothing whatever in this agreement shall be considered to constitute me a partner in your business or to entitle me to any assets or *502 right to participate in the management thereof. A share of the profits if any, to which I may be entitled as herein stated, is compensation for services to be rendered.
Under the contracts Levy and Lansburgh were to receive 7 per cent of the net profits, and Milius $9,000 plus 4 per cent of the net profits.
OPINION.
ARUNDELL: In the return for 1922 the partnership deducted $26,519.98 for bad debts. The amount of the deduction is the sum of specific bad debts charged off within the year, amounting to $24,830.55, and the addition of $30,000 to the reserve for bad debts, less collections*2302 made during the year, amounting to $28,310.57, on accounts charged off as worthless in prior years. In the return for 1923 the partnership deducted $60,280.09 for bad debts. The amount of the deduction is the sum of specific bad debts charged off within the year, amounting to $37,894.72, and the addition of $40,000 to the reserve for bad debts, less collections made during the year, amounting to $17,614.63, on accounts charged off as worthless in prior years. The Commissioner disallowed so much of the deduction taken in each year as represented the addition to the reserve for bad debts, i.e., $30,000 for 1922, and $40,000 for 1923, and it is of this action which the petitioners complain.
The petitioners contend that the method of treating bad debts in the two years on appeal was consistent with the accounting practice uniformly followed since 1913, and, hence, involved no change which required the consent of the Commissioner; that the deductions claimed were reasonable in amount; and that the partnership is entitled, under the provisions of section 214(a)(7) of the Revenue Act of 1921, to deduct the amount added in each year to the reserve for bad debts. The Commissioner answers*2303 that the partnership is not entitled to deduct the amounts added in 1922 and 1923 to the reserve for bad debts, because (1) the partnership elected to deduct specific bad debt items in 1921, in lieu of a reasonable addition to the reserve, and such election is binding upon the partnership for all subsequent years unless the consent of the Commissioner is obtained to change the method of treating bad debts, as required by article 151 of Regulations 62, and such consent was not obtained by the partnership; and (2) the partnership is not entitled to deduct both specific bad
We may put aside the questions as to whether the method of treating
We may put aside the questions as to whether the method oftreating bad debts in 1922 and 1923 constituted a change in the partnership's accounting practice of previous years, or a departure from any election assumed to have been made in 1921, and as to the necessity of a taxpayer seeking to change its method of treating bad debts, *503 obtaining the consent of the Commissioner, as required by the regulations, as a requisite to making the change. Our disposition of the case requires no consideration of these questions.
*2304 Under the provisions of section 214(a)(7), a taxpayer may, for the purposes of the tax, treat its bad debts in one of two ways. It may 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)." The use of the word "or" clearly indicates that the deduction spoken of in the parenthetical clause is an alternative one. A taxpayer may either deduct specific bad debts, or, in lieu thereof, a reasonable addition to a reserve for bad debts. It may not deduct both specific bad debts and the addition to the reserve. ; .
However, while the partnership was technically wrong in deducting both specific bad debts and the additions to the reserve, the entire amount deducted in each year may be allowed, as pointed out by the Circuit Court of Appeals in the Rhode Island Hospital Trust Co., case, supra, if the partnership is entitled to treat its bad debts on a reserve basis and the total amount deducted meets*2305 the test of reasonableness. Assuming, without deciding, that the partnership was entitled to treat its bad debts on the reserve basis, there remained for the petitioners to prove the reasonableness of the deductions, but this they have failed to do.
There is set forth in the findings of fact the amount of bad debts charged off in each of the years 1918 to 1923, inclusive, but, without knowing what the sales in the years prior to 1922 amounted to, any prognostication as to probable losses on 1922 and 1923 accounts, based upon the ratio of bad debts to gross sales in prior years, is impossible. The auditor for the partnership testified that the amount credited to the guarantee account of each year from profit and loss was 2.5 per cent of the gross sales. Knowing the amounts credited to the guarantee account in each year, it might appear that the sales for the years prior to 1922 were possible of determination. However, when we analyze the figures for 1922 and 1923, we find that we can not rely upon the auditor's testimony in this respect. The total amounts set up in the guarantee account in 1922 and 1923 were $83,872.77 and $98,215.98, respectively. If these two sums are divided*2306 by 2.5 per cent, gross sales are indicated for those years in the respective amounts of $3,354,910 and $3,928,638. The same witness testified that the sales amounted to $3,802,204 for 1922 and $4,409,777 for 1923.
*504 Furthermore, we have no satisfactory evidence before us as to the condition of the accounts receivable outstanding at the close of 1922 and 1923, in respect of which the additions to the bad debt reserve were made, or as to the probability of losses on those accounts. The only evidence along that line is the statement of the auditor that following the depression in 1921, in which year the partnership carried on a large export business, it was found necessary to charge off a large number of foreign accounts, and that other foreign accounts still remained on the books at the close of 1922, as to which there was some question of ultimate collection in the minds of the partners. We do not know what the total of these accounts still outstanding in 1922 amounted to.
The evidence before us does not prove the reasonableness of the deductions claimed, or that the partnership is entitled to any greater deductions for bad debts than those allowed by the Commissioner.
*2307 The only other point in the case is whether, if we hold against the petitioners on the bad debts question, the resulting increase in partnership income should be reduced by distributions to employees before determining the distributive shares of the partners. The contracts in evidence disclose that three employees were each entitled to receive a specified percentage of the "net profits" the determination of which was hedged with very general limitations. Obviously the net profits of the firm as referred to in the contracts are not the same as net income under the taxing act, and so while our decision on the principal issue results in an increase of net income over the amount reported, it may or may not be that the employees are entitled to receive any additional sums from such increase.
Judgment will be entered for the respondent.