*133 Decision will be entered for the respondent.
Petitioner was engaged in the factoring business, which consisted in purchasing accounts receivable and making loans on inventories to firms engaged in the textile industry. Petitioner had adopted the reserve method of treating bad debts. Upon the evidence, the amount of a reasonable addition to the petitioner's reserve for bad debts is determined.
*1366 Respondent determined a deficiency in petitioner's income tax for the calendar year 1942 in the amount of $ 5,030.61 and an overassessment of petitioner's excess profits tax liability in the amount of *1367 $ 14,128.24. Petitioner claims that there is an overpayment of $ 25,614.73 in income tax for 1942.
Petitioner in its petition assigns error as follows:
The respondent erred in allowing as a deduction for the year 1942 as a reasonable addition to the reserve for bad debts only the amount of $ 21,573.17, whereas a reasonable addition to the reserve for bad debts for 1942 to which the petitioner was entitled as a deduction*134 for the year 1942 was $ 164,475.34.
The only question therefore is the amount to which petitioner is entitled as a reasonable addition to its reserve for bad debts for the year 1942.
FINDINGS OF FACT.
The facts which were stipulated are so found.
Petitioner is a corporation, organized in 1919 under the laws of the State of Delaware and having its principal office in New York City.
Petitioner filed its Federal income tax return for the calendar year 1942 with the collector of internal revenue for the third district of New York.
Petitioner in 1942 and at all times prior thereto was engaged in the factoring business. The business consisted of purchasing and paying for accounts receivable from mills, converters, and merchants, without recourse against the assignor in the event of insolvency of the debtor and of making secured and unsecured loans. Petitioner dealt almost exclusively with the textile industry. Its activities were of two principal types. It made loans secured on running inventories and it purchased accounts receivable without recourse against the assignor. The losses from these two types of activity were about equal, although the purchases of accounts receivable exceeded*135 in volume the inventory loans.
The petitioner's loans to a mill, converter, or merchant, advanced against inventory, were limited by an amount approximately equal to 66 2/3 per cent of the running value of the borrower's inventory from time to time. These arrangements ran for an indeterminate period and could be canceled at the end of any given year by either party. These merchandise loans were paid off by the proceeds of the sale of the inventory against which the loan was made. So far as a client who borrowed against merchandise is concerned, he would make this type of loan solely from the petitioner. In the second type of credit transaction the petitioner purchased the accounts receivable created by the sales made by a textile mill, converter, or merchant. It immediately credited to the client the face amount of the account receivable at the time of the purchase. The petitioner would advance up to 90 per cent of the credit at the time of purchase of the account and the balance at maturity. In 1942 the petitioner had this arrangement *1368 with about 125 to 150 mills. As a result of these purchases of accounts receivable, petitioner had about 12,000 debtors in 1942. *136 In 95 per cent of the cases the petitioner would purchase all of the accounts receivable of its clients.
As a result of these continued operations the petitioner's various clients from time to time had credit or debit balances on the petitioner's books. Interest was paid on these balances at the rate of 6 per cent per annum. This arrangement worked both ways. If the client had a debit balance the client paid interest to the petitioner. If the client had a credit balance the petitioner paid interest to the client. The same individuals or concerns would be indebted to petitioner right along, even though the particular items might turn over and change.
The petitioner in effect acted as a credit department for its clients. It passed on the credit responsibility of the purchasers to whom its clients sold. In addition, the petitioner maintained a collection department. In return for these services the petitioner received a commission which was a percentage of the total volume of the credit risk taken by the petitioner in connection with the individual clients.
Petitioner in 1942 and in prior years maintained in its accounts a reserve for bad debts, to which it charged bad debt *137 losses as they occurred, and from time to time it credited additions to the reserve. Amounts collected on debts previously charged to the reserve were likewise credited to the reserve. Petitioner was required, for 1942 income tax purposes, to use the reserve method for treating bad debts and was entitled to deduct from gross income a reasonable addition to its reserve for bad debts.
The petitioner in connection with its business had substantial bad debts. These were very sporadic and fluctuated according to the condition of the textile trade. During the period 1920 to 1942 the annual net bad debt losses averaged .43 per cent of gross credit sales and 2.10 per cent of receivables outstanding at the close of the year. Losses were heavy during the years 1922 to 1924 because of the depression which followed the first World War. From 1924 to 1929 they were moderate, averaging less than $ 75,000 a year. From 1930 to 1932, because of the depression, losses averaged in excess of $ 250,000 a year as against an average of $ 75,000 a year or less during the previous seven years. From 1933 through 1937 the losses averaged less than $ 40,000 a year, but in 1938 and 1939 they averaged $ *138 135,000 a year. The net bad debts charged off, viz., the debts charged against the reserve for excess of recoveries credited to the reserve, the gross credit sales, and the receivables outstanding at December 31 of each year were as follows: *1369
| Percentage of | |||
| Gross credit | net charge-offs | ||
| Year | Net bad debts | sales | to gross credit |
| sales | |||
| Per cent | |||
| 1920 | $ 99,573.19 | $ 10,528,600 | .94 |
| 1921 | 37,304.00 | 11,138,100 | .33 |
| 1922 | 119,351.87 | 11,508,300 | 1.03 |
| 1923 | 51,736.56 | 11,457,600 | .45 |
| 1924 | 189,312.84 | 12,144,500 | 1.55 |
| 1925 | 94,441.49 | 15,774,300 | .59 |
| 1926 | 64,667.42 | 17,375.800 | .37 |
| 1927 | 69,783.65 | 16,686,800 | .41 |
| 1928 | 75,667.78 | 20,020,800 | .37 |
| 1929 | 80,050.88 | 23,538,200 | .34 |
| 1930 | 214,608.86 | 23,506,200 | .91 |
| 1931 | 144,526.43 | 22,513,700 | .64 |
| 1932 | 410,382.59 | 15,259,400 | 2.68 |
| 1933 | 32,437.02 | 16,875,000 | .19 |
| 1934 | 28,344.23 | 22,904,100 | .12 |
| 1935 | 49,420.11 | 24,705,000 | .20 |
| 1936 | 38,463.05 | 30,359,000 | .12 |
| 1937 | 53,423.13 | 29,291,600 | .18 |
| 1938 | 169,152.76 | 25,960,100 | .65 |
| 1939 | 101,138.43 | 33,163,900 | .30 |
| 1940 | 76,695.27 | 30,639,900 | .25 |
| 1941 | 82,522.87 | 48,546,200 | .17 |
| 1942 | 21,573.17 | 54,755,100 | .04 |
| Total | 2,304,577.60 | 528,852,200 | .43 |
| Percentage of | ||
| net charge-offs | ||
| Receivables | to receivables | |
| Year | outstanding at | outstanding at |
| close of year | close of year | |
| Per cent | ||
| 1920 | $ 2,184,100 | 4.55 |
| 1921 | 2,499,700 | 1.49 |
| 1922 | 2,929,800 | 4.07 |
| 1923 | 3,088,400 | 1.67 |
| 1924 | 2,871,300 | 6.59 |
| 1925 | 4,414,000 | 2.04 |
| 1926 | 4,670,300 | 1.38 |
| 1927 | 4,189,600 | 1.66 |
| 1928 | 5,457,100 | 1.38 |
| 1929 | 6,097,600 | 1.31 |
| 1930 | 5,529,300 | 3.88 |
| 1931 | 4,112,000 | 3.51 |
| 1932 | 1,693,100 | 24.23 |
| 1933 | 3,055,900 | 1.06 |
| 1934 | 3,897,000 | .72 |
| 1935 | 4,521,500 | 1.09 |
| 1936 | 6,939,200 | .55 |
| 1937 | 5,328,200 | 1.00 |
| 1938 | 5,232,800 | 3.23 |
| 1939 | 7,488,800 | 1.35 |
| 1940 | 6,865,900 | 1.11 |
| 1941 | 8,878,300 | .92 |
| 1942 | 7,863,200 | .27 |
| Total | 109,807,100 | 2.10 |
The bad debt reserve of petitioner, its gross credit sales, and the receivables as set out in its books for the years 1943 to 1948 were as follows:
| Charged | Net charges | ||
| Year | against | Recoveries | for accounts |
| earnings | written off | ||
| 1943 | $ 11,139.33 | 3,927.44 | 7,017.69 |
| 1944 | 11,705.08 | 3,453.10 | 8,251.98 |
| 1945 | 729.42 | 7,760.26 | (7,030.84) |
| 1946 | 1,076.20 | 3,782.88 | (2,706.68) |
| 1947 | 98,285.97 | 307.44 | 97,978.53 |
| 1948 | 206,617.68 | 4,382.57 | 201,635.11 |
| Reserve | |||
| balance | Receivables | ||
| Year | at end | Sales volume | end of year |
| of year | |||
| 1943 | 250,000 | 56,596,268.08 | 5,867,890.31 |
| 1944 | 250,000 | 54,563,337.26 | 5,645,167.47 |
| 1945 | 250,000 | 53,878,937.70 | 6,114,099.49 |
| 1946 | 350,000 | 95,309,109.30 | 10,157,093.76 |
| 1947 | 350,000 | 88,710,629.16 | 10,802,569.02 |
| 1948 | 350,000 | 95,336,741.88 | 12,061,250.03 |
*140 In connection with the audit of the company's accounts for 1941 its auditors suggested that the reserve for bad debts at the end of 1941 should be increased to $ 500,000 and it was subsequently agreed by the executive officers and its auditors that petitioner's reserve for bad debts at December 31, 1941, should be $ 250,000. A summary of petitioner's reserve for bad debts account for the year 1941 as entered on its books is as follows:
| Dr. | Cr. | |
| Balance Dec. 31, 1941 | $ 135,000.00 | |
| Net charges for accounts written off | $ 82,522.87 | |
| Addition to reserve for bad debts | 197,522.87 | |
| Balance Dec. 31, 1941 | 250,000.00 | |
| Total | 332,522.87 | 332,522.87 |
The petitioner, in its Federal income and excess profits tax returns for the calendar year 1941, deducted $ 197,522.87 as a reasonable addition to the reserve for bad debts for 1941.
*1370 At the end of 1942 the question of the reserve for bad debts was again considered and petitioner's officers and the auditors were of the opinion that the reserve should be maintained at $ 250,000 at December 31, 1942, notwithstanding the reduction in accounts receivable and the favorable bad debt experience for 1942. A summary of petitioner's*141 reserve and bad debts account for the year 1942 as entered on its books is as follows:
| Dr. | Cr. | |
| Balance, Dec. 31, 1942 | $ 250,000.00 | |
| Credits for collections on accounts previously | ||
| written off | 7,776.82 | |
| Charges to reserve: | ||
| For ordinary accounts | $ 26,228.48 | |
| For advances to salesmen | 3,121.51 | |
| Addition to reserve for bad debts | 21,573.17 | |
| Balance, Dec. 31, 1942 | 250,000.00 | |
| Total | 279,349.99 | 279,349.99 |
The petitioner, in its original Federal income and excess profits tax returns for the calendar year 1942, deducted $ 21,573.17 as a reasonable addition to the reserve for bad debts for 1942, which the respondent allowed.
The petitioner's officers regarded the war years as abnormal and they feared that the end of the war would cause a drop in prices and lack of demand which would cause enterprises to go out of business or require them to find other outlets.
Petitioner's income and excess profits tax return for the calendar year 1941 was audited by the respondent. The result of the audit was reflected in the revenue agent's report dated May 31, 1943, which determined the deficiency of $ 11,904 in 1941 income tax. The principal adjustment which resulted*142 in this deficiency was the disallowance of $ 37,500 of the deduction claimed as a reasonable addition to the reserve for bad debts. In a statement attached to the deficiency notice the respondent explained this adjustment as follows:
| (a) Reserve for bad debts | $ 37,500.00 | |
| Taxpayer was allowed as at Dec. 31, 1941 | $ 212,500.00 | |
| Instead of | 250,000.00 | |
| A decrease of | 37,500.00 |
The amount of $ 212,500.00 allowed as a reasonable reserve as at Dec. 31, 1941 was a little less than the amount arrived at on a percentage basis, which amount is $ 213,967.03 as shown below:
| 1922 to 1941 Accounts Receivable | $ 88,703,000.00 |
| 1922 to 1941 Actual Bad Debts | 2,139,300.00 |
| Percent | 2.41 |
| 2.41 percent of $ 8,878,300.00 (Dec. 31, 1941) | $ 213,967.03 |
* * * *
The petitioner did not protest this adjustment for 1941 and paid the resulting deficiency.
*1371 After receipt of the audit for 1941 the petitioner on or about July 10, 1943, filed amended income and excess profits tax returns for 1942, claiming additional deduction of $ 37,500 for the addition to the reserve for bad debts for 1942 because of the disallowance of that portion of the deduction claimed for 1941. *143 Subsequently, in connection with the audit of the petitioner's tax return for 1942, the petitioner was requested to prepare an analysis of its reserve for bad debts over its entire history. This analysis disclosed that certain disallowances had been made in the claimed addition to the bad debt reserve in 1920, 1927, and 1931 which had not been reflected in the petitioner's books. These disallowances were as follows:
| Year | Addition disallowance |
| 1920 | $ 40,000.00 |
| 1927 | 402.17 |
| 1931 | 70,000.00 |
| Total | 110,402.17 |
This amount of $ 110,402.17 plus the $ 37,500 disallowed for 1941, a total of $ 147,902.17, less $ 5,000 which had been transferred from the bad debt reserve to surplus in 1926, or $ 142,902.17, was allowed by the respondent in the notice of deficiency as a part of invested capital for the taxable year 1942.
The above disallowances resulted in the petitioner having a bad debt reserve as allowed for income tax purposes in the amount of $ 107,097.83 at January 1, 1942, viz., the reserve as set up on the books of $ 250,000, less the amount of $ 142,902.17 found by the respondent to be includible in 1942 invested capital as "surplus reserve for bad debts." As pointed*144 out above, the respondent allowed the amount of $ 21,573.17 as a deduction from gross income for the addition to the reserve for bad debts for the year 1942. The amount of $ 21,573.17 included a charge of $ 3,121.51 for advances to salesmen which respondent allowed as a direct charge to profit and loss. Hence, petitioner's reserve for bad debts at December 31, 1942, as determined by respondent was $ 110,219.34.
The petitioner had approximately $ 165,000 of overdue accounts at the end of 1941. At the end of 1942, the petitioner had approximately $ 337,000 of overdue accounts. The amounts overdue, broken down into different periods of delinquency at the end of each year, were as follows:
| 1941 | 1942 | |
| Overdue 1 to 30 days | $ 125,000 | $ 246,000 |
| Overdue 31 to 60 days | 27,000 | 42,000 |
| Overdue 61 to 90 days | 7,000 | 14,000 |
| Overdue in excess of 90 days | 6,000 | 35,000 |
| Total | 165,000 | 337,000 |
*1372 A reasonable addition to the petitioner's reserve for bad debts for the year 1942 is $ 21,573.17.
The deficiency in income tax in the instant case does not arise from any disallowance of deductions claimed by petitioner on its original return as an addition to its reserve for*145 bad debts, but arises from an automatic adjustment which follows a decrease in its excess profits tax as the result of respondent's increasing its excess profits tax credit to allow for the surplus reserve of bad debts.
OPINION.
The issue herein is whether petitioner is entitled to a deduction from gross income for the year 1942 in the amount of $ 161,353.83 as an addition to its reserve for bad debts. Petitioner's assignment of error claimed that the deduction should be $ 164,475.34, but now claims that it should be $ 161,353.83. Section 23 (k) (1) of the Internal Revenue Code1 permits a taxpayer, at the Commissioner's discretion, to make a reasonable addition to its reserve for bad debts in lieu of deducting debts which become worthless within the taxable year. What is a reasonable addition to reserve depends upon the nature of the business, general business conditions, past experience in collecting accounts and bad debts, the amount of the existing reserve, and all other material factors. Cf. Black Motor Co., 41 B. T. A. 300; affd., 125 Fed. (2d) 977.
*146 The facts herein disclose that petitioner's reserve for bad debts at January 1, 1942, was $ 107,097.83. The net charges against this reserve for 1942 (other than the charge of $ 3,121.51 for advances to salesmen which respondent has allowed as a deduction from profit and loss) amount to $ 18,451.66, leaving a bad debt reserve before any addition of $ 88,646.17. Petitioner, in its income tax return for the year 1942, deducted the amount of $ 21,573.17 from gross income for the addition to the reserve for bad debts which respondent allowed. This brought petitioner's reserve at December 31, 1942, to $ 110,219.34. Petitioner claims that a reasonable reserve for bad debts at December 31, 1942, was $ 250,000 and that an addition of $ 161,353.83 necessary to produce this reserve was a normal annual deduction to be made in 1942 in the light of its past experience and all the surrounding circumstances. Respondent denies that petitioner is entitled to the deduction of $ 161,353.83 as an addition to its bad debt reserve for 1942.
The fact that petitioner claimed on its return an addition to its *1373 reserve for bad debts of but $ 21,573.17 does not prejudice its right to deduct a *147 larger amount if that is found to be a reasonable addition to the reserve. The amount of the deduction to which petitioner is entitled as a reasonable addition to a reserve for bad debts is not to be determined on merely technical grounds, but, as pointed out above, depends on all the facts and circumstances of the petitioner's business. Houston Chronicle Publishing Co., 3 T. C. 1233, 1242; Rhode Island Hospital Trust Co. v. Commissioner, 29 Fed. (2d) 339; Athol Manufacturing Co., 22 B. T. A. 105; affd., 54 Fed. (2d) 230.
The evidence herein shows that the petitioner was engaged in the factoring business. It made loans to clients on the security of running inventories of merchandise up to two-thirds of the value of such inventories and it purchased accounts receivable from clients without recourse therein, taking the entire credit risk with respect to such amounts. This involved the dealing with some 125 to 150 clients and extending credit to some 12,000 customers of the clients. Petitioner dealt primarily with the textile industry, and it operated on a small*148 margin of profit.
Petitioner argues that the deduction of $ 161,353.83 claimed by it is fully justified by its actual past experience for the years 1920 to 1942, which was substantially the entire period of its existence. It points out that over this period petitioner's net bad debt losses amounted to $ 2,304,577.60 and averaged 2.10 per cent of the accounts receivable outstanding at the close of the years. Applying the ratio of 2.10 per cent to the amount of the accounts receivable of $ 7,863,200 outstanding at December 31, 1942, it arrives at a figure of $ 165,127. It further points out that over the same years petitioner's actual net bad debts were .43 per cent of its gross credit sales, and, applying the ratio of .43 per cent to the amount of $ 54,755,100, the gross credit sales for 1942 are $ 235,446. Thus petitioner claims that the deduction of $ 161,353.83 claimed by it as a deduction for 1942 is justified by its past experience. On the other hand, petitioner points out that the amount of $ 21,573.17 originally deducted by it and allowed by respondent is less than its actual bad debts for any of the years 1920 to 1941, inclusive, and is but .27 per cent of the receivables*149 outstanding at the close of 1942, as compared with an actual 23-year experience of 2.10 per cent. Also, that the amount of $ 21,573.17 is but .04 per cent of the gross credit sales as compared with an actual 23-year experience of .43 per cent.
A taxpayer's past experience as to the collection of accounts and bad debts is an important factor in determining a reasonable addition to its bad debt reserve. However, as pointed out in Black Motor Co., supra, "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."
*1374 As set out in our findings herein, petitioner's reserve for bad debts at the beginning of 1942 was $ 107,097.83 and at the end of 1942, with the addition of $ 21,573.17 to the reserve, which respondent has allowed, its bad debt reserve amounted to $ 110,219.34. The ratio of this reserve to the receivables in 1942 of $ 7,863,200 is approximately 1.40 per cent. The petitioner's experience during the previous seven years; that is, 1935 to 1941, shows that the ratio of bad debts to receivables was approximately*150 1.26 per cent. The application of that percentage to the receivables for the taxable year 1942 would indicate a bad debt expectancy of but $ 99,076.32.
Petitioner's officers testified that the principal consideration in determining to maintain a reserve of $ 250,000 was the economic situation, namely, the war conditions, giving rise to an abnormal prosperity which in their judgment would result in substantial losses when the war ended, their judgment being based on their experience after the first world war. We have given this testimony the careful consideration and weight which it deserves. Cf. Rhode Island Hospital Trust Co. v. Commissioner, supra.However, they did not show that they had good reason to believe that more than $ 110,219.34 would be lost in collecting on the receivables then due in 1942 in the amount of $ 7,863.200. A bad debt reserve is an estimate of the future losses which it is assumed will result from current business debts. The estimate of the bad debt reserve required for any year must be measured by the conditions as they appear at the time the estimate is made. C. P. Ford & Co., 28 B. T. A. 156.*151 The reserve of $ 110,219.34 appears to have been ample to take care of all losses on these accounts reasonably foreseeable in 1942. It was far in excess of what had proved to be necessary during the preceding seven years, with the exception of 1938, when its net bad debts amounted to $ 169,152.76. However, the evidence showed that this was abnormal and was due, at least in part, to inflation which existed in the years 1936 and 1937 and which had its break in the first part of 1938. Certainly the fact that the country was at war in 1942 made it likely that textiles would continue to be in demand and the risk of losses through nonpayment of accounts would be diminished. Furthermore, the evidence shows that, while petitioner's gross sales increased in 1942 over 1941 in the amount of $ 6,208,900, its receivables in 1942 decreased below 1941 in the amount of $ 1,015,100, and that the rate of collections on the receivables in 1942 was greater than the rate of collections in 1941.
Moreover, an analysis of the bad debt reserve of the petitioner for the years 1943 to 1946, inclusive, discloses that for the years 1943 and 1944 there were net charges for accounts written off in the respective*152 amounts of $ 7,017.69 and $ 8,251.98. For the years 1945 and 1946 the recoveries of bad debts previously written off exceeded the *1375 charge against the earnings for those years by the respective amounts of $ 7,030.84 and $ 2,706.68. Therefore, petitioner's actual experience for the four-year period following the taxable year indicates that the amount of the reserve of $ 110,219.34 on December 31, 1942, was more than adequate to meet petitioner's needs. In Farmville Oil & Fertilizer Co. v. Commissioner, 78 Fed. (2d) 83, the court said that "under proper circumstances the correctness of the taxpayer's estimate in fixing the amount to be added to the reserve in any year may be supported by reference to the losses actually incurred in subsequent years * * *."
The evidence does not convince us that petitioner could reasonably expect probable losses which would justify any addition to its reserve at January 1, 1942, over and above the amount of $ 21,573.71 deducted by the petitioner on its original return and allowed by the respondent. Cf. C. P. Ford & Co., supra,Maverick-Clarke Litho Co., 11 T. C. 1087,*153 Morris Plan Ind. Bank v. Commissioner, 151 Fed. (2d) 976. Based on all the evidence, our conclusion is that no further addition to petitioner's reserve for bad debts was reasonably required in 1942 than that which respondent has allowed, and we have found as a fact that a reasonable addition to the petitioner's reserve for bad debts for the year 1942 is $ 21,573.17.
Decision will be entered for the respondent.
Footnotes
1. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
* * * *
(k) Bad Debts. --
(1) General rule. -- Debts which become worthless within the taxable year; or (in the discretion of the Commissioner) a reasonable addition to a reserve for bad debts; * * * *↩