*4028 1. The valuation of merchandise inventory by petitioner is approved with relation to cash discounts deducted.
2. The amount of deductible bad debts determined.
3. Improvements of assets having useful lives longer than the taxable year are not deductible from gross income as current repairs.
4. The amount of deductible depreciation of automobile trucks determined.
*825 This proceeding results from the determination by respondent of a deficiency in profits and income taxes for the year 1918, amounting to $17,163.50.
Petitioner originally alleged error with respect to seven issues, but it withdrew three of them at the hearing and the remaining issues are as follows: (1) The closing inventory for 1918 has been increased by respondent by the amount of $6,500, on account of cash discount previously availed of and by anticipated returns and allowances. (2) Respondent disallowed as a deduction from gross income bad debts amounting to $5,373.40. (3) Respondent disallowed as a deduction from gross income repairs*4029 amounting to $670.43. (4) The disallowance by respondent of a deduction from gross income of depreciation amounting to $1,157.13.
FINDINGS OF FACT.
Petitioner is a Pennsylvania corporation incorporated in 1905 with principal office at Butler, and is engaged in the wholesale grocery business.
Purchases of the stock in trade of petitioner are made on various financial terms. Part of the merchandise is billed net. On some of the invoices for merchandise provision is made for the allowance to petitioner of a discount from the amount billed, in consideration of prompt payment. These "cash discounts" vary from practically nothing to as high as 10 per cent on certain classes of goods.
In 1910 employees of petitioner satisfied themselves by tests that an allowance of 2 per cent computed on the gross amount of inventory represented the average of all of the cash discounts which probably were taken in paying for the merchandise on hand. It has been the regular practice of petitioner since 1910 to reduce its inventory *826 by the 2 per cent allowance for cash discounts. The accounts kept by petitioner do not segregate the cash discounts. The books are kept and the returns*4030 are filed on the accrual basis.
Among other allowances and adjustments by petitioner not at issue here, the inventories at the beginning and at the end of 1918 were reduced in amount by deductions as follows:
| Inventory of Dec. 31, 1917. | In ventory of Dec. 31, 1918. | |
| Estimated reduction in value of merchandise due to cash discounts availed of: | ||
| 2 per cent of $242,272.40 | $4,845.45 | |
| 2 per cent of $316,362.69 | $6,327.25 | |
| Allowance for possible returns and allowances to customers | 154.55 | 172.75 |
| Total | 5,000.00 | 6,500.00 |
The inventory of December 31, 1918, was valued on a basis of cost or market, whichever was lower, and the 2 per cent discount was applied indiscriminately to cost and to market value.
In its return for 1918, petitioner deducted from gross income bad debts amounting to $9,072.47, which petitioner charged off to profit and loss on December 31, 1918, of which respondent has allowed $3,699.09, and has disallowed $5,373.40. The disallowed items were as follows:
| GROUP A. | |
| H. W. Cochran | $4.40 |
| W. E. Bonzo | 3.47 |
| C. W. Limbert | 8.99 |
| J. W. Parker | 5.36 |
The four above accounts were the aggregates of small balances left unpaid*4031 by the customers of petitioner for one reason or another, mainly for claims of shortages on shipments to them. The customers paid no attention to the claims and continued to deal with petitioner. Petitioner requested settlement of the items but did not sue the customers.
| J. H. Boyd | $7.32 |
This customer disposed of his store in October, 1918. Petitioner ascertained he was without assets on December 31, 1918, from which to recover payment.
| GROUP B. | |
| Baltimore and Ohio Railroad Company | $740.59 |
This is the aggregate of twelve claims which on December 31, 1918, had been on file with the Baltimore and Ohio Railroad Company for periods ranging from 5 1/2 to 14 1/2 months. During the year 1919, payments amounting to $702.60 were collected in satisfaction of these claims.
| P.H.B. & N.C. Railroad Company | $24.20 |
This is the aggregate of six claims which arose between February and May, 1918, on which payments amounting to $16.90 were collected during 1919 and 1920.
*827
| B. & L.E. Railroad | $8.36 |
This is the aggregate of six claims which arose between August, 1917, and May, 1918, on which $6.19 was collected*4032 during 1919.
| P.M. & B. Railway Company | $32.21 |
This is the aggregate of seven claims which arose between November, 1917, and July, 1918, on which $27.55 was collected during 1919 and 1920.
| B.R. & P. Railroad Company | $64.99 |
This is the aggregate of ten claims which arose between May and July, 1918, on which payments were collected during 1919.
| Pennsylvania Railroad Company | $238.75 |
This is the aggregate of sixteen claims which arose between February, 1917, and August, 1918, on which $211.07 was collected during 1919 and 1920.
| Erie Railroad Company | $1.75 |
One claim which has never been paid.
| Adams Express Company | $150.50 |
Two claims which have never been paid.
| GROUP C. | |
| Towle Maple Products Company | $13.35 |
| Elyria Canning Company | 2.02 |
| S.M. Bixby | 93.50 |
| Bay Port Fish Company | 1.90 |
| Dunbar Molasses and Syracuse Company | 1.85 |
| Phillips Packing Company | .38 |
| John Wildi | 4.12 |
The above seven items were charges to concerns from whom petitioner bought goods, entered to reflect a charge of the cost of goods which spoiled in the warehouse of petitioner after receipt of shipment. *4033 The firms were not liable for the damages but it was their occasional practice to make such losses good.
| GROUP D. | |
| Coriner Rice Company | $25.72 |
This item represented the cost of empty bags, the property of petitioner, in the hands of the rice company, bearing a printed trade name used by petitioner and intended for use as containers of rice. The practice of thus packing rice was discontinued in 1918. The practice of packing rice was resumed at Butler, Pennsylvania, in 1921 and the bags were then shipped to Butler and were used for that purpose.
| Carlo Carnasso | $116.72 |
This account was for flour substitutes shipped to Carnasso on an oral order from him for flour. It was necessary to ship the substitutes and not the flour under prevailing war regulations. Carnasso refused to accept the shipment and the merchandise was ultimately sold by the carrier for accumulated charges. Petitioner sued Carnasso and lost the suit, failing to recover any part of the claim.
*828
| C. George | $311.03 |
This customer was a baker located at Kittanning, Pennsylvania, who had ordered flour to be shipped him. Flour and flour substitutes*4034 amounting in sales value to $311.03 were shipped to him by petitioner on October 30, 1918. He refused to accept the shipment and the goods were placed in storage by the railroad company and finally sold to realize the accumulated charges for freight, etc. Governmental war-time regulations required the use of the substitutes in 1918. Suit was entered and petitioner recovered $201.03 in October, 1919, as a result of the judgment rendered in September, 1919.
| M. N. Heinzer | $500.00 |
The amount of a note due from Heinzer charged off in error. Heinzer was solvent and the debt was collectible.
| Krelandis and Johnson | $128.10 |
Sales were made to this firm during the period from March 28, 1917, to September 6, 1917. On the latter date $143.90 was owing and on September 12, 1917, petitioner received a payment of $73.90, and there then remained an unpaid balance of $70. In July, 1918, suit was brought by petitioner. The only asset of the firm, a lot in an undeveloped area, was put up at a sheriff's sale and bought in by petitioner for a nominal consideration not in excess of $5. The lot was sold in a subsequent year for $150 and petitioner recorded the*4035 entire proceeds of the sale on its books and in its return, as income.
| W. F & C. H. Marshall | $780.00 |
Three notes were given petitioner by this firm in 1917, amounting in the aggregate to $880. The earliest note was due on October 1, 1917, and the latest was due March 15, 1918. Prior to December 31, 1918, payments amounting to $100 had been made on the indebtedness. In July, 1918, petitioner charged off the balance due. This firm owed petitioner on open account a balance amounting to $200.41, on December 31, 1918, and credit on open account was continued thereafter. Payments of the balance due on the notes were made to petitioner as follows: On January 27, 1919, $400, on January 2, 1920, $380.
| Mercer County Light & Heat Company | $140.50 |
This item is the amount paid by petitioner to the light and heat company to defray the cost of furnishing and installing a transformer on a pole outside of the building of petitioner at Greenville, Pennsylvania, for the purpose of serving electric light and power to petitioner's warehouse. Title to the transformer was retained by the light and heat company. The cost was entered on the books of petitioner*4036 as an account receivable due from the light and heat company. In accordance with agreement the light and heat company is obligated to make an allowance of $1 per month on the bill of petitioner for electricity until the amount of the payment for the installation of the transformer is returned. Petitioner charged off to profit and loss in 1918 the entire cost of $140.50. Its method of accounting is to report the gross amount of the bill for electricity as expense and the $1 allowance every month as income.
| M. J. Moore | $503.71 |
On December 31, 1918, the indebtedness to petitioner of this party consisted of an open account amounting to $1,304.07 and a note given October 16, 1916, payable sixty days thereafter, for $503.71. Petitioner corresponded with Moore and his store was visited on a number of occasions by a representative of *829 petitioner. Moore stated he could not make payment and went over his financial condition with the representative of petitioner. Moore was the owner of a store worth approximately $1,500 and land worth approximately $5,000; the latter was mortgaged for nearly the amount of its value. Moore was indebted to other wholesalers*4037 and his liabilities exceeded his assets. Moore went into bankruptcy in 1923 and petitioner received two distributions from the trustee amounting to $35 and $87.51. There were payments to petitioner prior to 1923, and they were applied on the books in part to the indebtedness on the note.
| H. W. Tebay | $200.00 |
On August 8, 1916, Tebay gave petitioner a note for $400 due in 4 months upon which was paid in 1917, $200. The indebtedness of Tebay to petitioner on December 31, 1918, consisted of an open account amounting to $887.17, and the balance of $200 due on the note. Tebay owned no real estate and his liabilities exceeded the invoice value of his entire stock. The balance due on the note was paid in January, 1919.
| Charles Wacher & Company | $459.06 |
This item resulted from a debit on the books of petitioner setting up a claim amounting to $660 for breach of contract in failing to make delivery of a quantity of canned tomatoes. Petitioner found it necessary to purchase the tomatoes elsewhere at a price higher than agreed on with Wacher. The amount of the claim recorded on the books was the excess of the market price actually paid over the contract*4038 price. Subsequent to the transaction, Wacher went into bankruptcy in 1916. In June, 1918, petitioner received a final distribution from the trustee amounting to $225.94, of which $25 was applied to fees paid and the remainder was credited to the account leaving unpaid a balance of $459.06.
| Mrs. F. Watson | $477.61 |
Mrs. Watson gave petitioner a demand note dated September 4, 1917, amounting to $1,243.87. Demand for payment was made prior to December 31, 1918, and there remained due and unpaid on this note a balance of $477.61. In addition Mrs. Watson owed petitioner an open account amounting to $722.32. Mrs. Watson was unable to pay the note and was possessed of no assets save a small stock in trade. Petitioner charged off the balance due on the note to profit and loss on December 31, 1918. In January, 1919, Mrs. Watson sold her business to a competitor for a consideration of $1,000, and in lieu of payment therefor in cash, she received credit on the books of petitioner for $1,000, and the purchaser was charged the same amount. Subsequently she opened a new store and dealt with petitioner on a cash basis.
| E. T. Weister | $242.00 |
Weister gave*4039 petitioner his note on October 14, 1911, for $836.12. Payments were received on account of this note in 1913, 1914, 1916 and 1918, leaving a balance unpaid of $242. Weister also was indebted to petitioner for an open account and dealt with petitioner on a credit basis subsequent to December 31, 1918. The balance due on the note was paid as follows: in 1919, $50; in 1920, $192.
*830
| GROUP E. | |
| Petitioner charged off to profit and loss in 1918, and deducted the same from gross income in its 1918 return, the following accounts: | |
| C. L. Carnahan | $54.43 |
| J. E. Kirkpatrick | 13.12 |
| George Hamil | 13.39 |
| Total, $5,373.40. |
In 1918 petitioner expended $670.43 for labor and materials to do the following:
Item 1. - Remove the safety device which was not worn out on an open shaft freight elevator and install another safety device. The change of devices was by direction of either the Pennsylvania State Department of Labor or of the insurance companies. The safety device is still in use.
Item 2. - Take off old doors and put on new ones on passageway from the warehouse to the loading shops; removing the glass transoms above the doors and replacing them*4040 with a brick wall. These changes were made for purposes of protection from burglary and fire.
Item 3. - In connection with the office, a case designed for the display of samples was remodeled so as to afford space for storing stationery and labels, and a locker in which to hang coats and hats. The glass sliding doors were removed and solid wooden paneled doors were installed. The remodeled case is still in use. A glazed tile, wooden framed mantel with coal grate was removed and in its place a large size tile mantel and gas heater was installed and is still in use. The interior of the office was painted.
The cost of the labor and materials was as follows:
| Items 1 and 2 | $429.68 | |
| Item 3: | ||
| Painting office | $60.00 | |
| Remodelling | 180.75 | |
| 240.75 | ||
| Total | 670.43 |
Petitioner owns gasoline motor trucks which are operated daily throughout the year. The trucks are used under heavy loading, for hauling shipments to and from the warehouse of petitioner and for making deliveries of merchandise to customers. The town of Butler, Pennsylvania, is subject to heavy snowfalls and is very hilly. The warehouse of petitioner is located at a low point in the town*4041 and the trucks continually ascend and descend long steep grades.
During the period from 1916 to the present, five of the trucks acquired by the petitioner have been traded in in part payment for new ones, and one truck was retained for seven years, being utilized in the latter three years for occasional emergency service, and was then scrapped. In the experience of petitioner the trucks averaged three years of active use, whereupon the recurring repairs became excessive and the trucks were either traded in or retained for emergencies.
*831 In 1918 petitioner owned and used two 3 1/2-ton Federal trucks; one was purchased in April or May, 1916, the other was purchased in April or May, 1918. The cost of the two trucks totaled $5,775. One of these trucks cost $2,910, and it was traded in as part payment for a new truck in 1921. The price of the new truck was $5,711.16, and the exchange value allowed for the old truck was $1,170. The trucks in use in 1918 were driven by former drivers of horse teams.
OPINION.
TRUSSELL: The first issue relates to the valuation of the inventory of December 31, 1918. In computing gross income, respondent increased the amount of this*4042 inventory by the disallowance of a deduction taken by petitioner amounting to $6,500, which was the sum of two items; a reduction of $6,327.25 for cash discounts and an allowance of $172.75 for expected returns and allowances. At the hearing petitioner admitted error with reference to the returns and allowances, but it contends that the deduction of the amount of $6,327.25 is properly allowable. Purchases of merchandise by petitioner are made on various financial terms. In some instances invoices are priced at a net amount which petitioner is expected to pay. On other purchases discounts from the amount of the invoices are offered as inducements to make early payment. These discounts are customarily referred to as "cash discounts," and they range from extremely low rates to discounts as high as 10 per cent. Petitioner priced its inventory of December 31, 1918, on a basis of cost or market, whichever was lower, and it reduced the value thus arrived at by the allowance of 2 per cent for cash discounts. It is not denied by respondent that these discounts are properly allowable as reductions of the cost prices for inventory purposes under article 1583 of Regulations 45. The disallowance*4043 of the deduction is based upon the opinion that the amount is a mere approximation and the true amount of the discounts should be ascertained. Petitioner has overcome the presumption of material error, for it is in evidence that the rate of 2 per cent which was used in computing the amount of the reduction was arrived at by employees of petitioner who made tests which satisfied them of its practical accuracy. We are satisfied from the record that the summary disallowance by respondent of the entire deduction is erroneous and we believe that the deduction claimed by petitioner considered retrospectively is reasonably accurate. In addition to its accuracy, the method used has been the consistent practice of petitioner since 1910, and there is no basis before us for a conclusion that the method has resulted in a distortion of income. We have had occasion before to consider a similar issue in , wherein we decided *832 that the practice of allowing for cash discounts should be approved provided it is consistently adhered to.
The reduction of 2 per cent was also made by petitioner to its inventory at the beginning*4044 of the year 1918, and this deduction has also been disallowed by respondent. Petitioner did not appeal from this adjustment, but to allow it to stand and to restore the reduction to the closing inventory would depart from the consistency so vital to the approval of any method of inventory valuation. See ; and . It follows that the disallowances by respondent of the deductions of $4,845.45 from the opening inventory and $6,327.25 from the closing inventory were in error and they are reversed.
The second issue relates to deductions from gross income classified in the return as had debts. Included are an inventory item; trivial allowances to solvent customers; claims of various sorts; an item in the nature of a capital investment and numerous items partially charged off. It is necessary to consider in detail the various questions involved. For convenience of reference the items have been grouped in the findings of fact.
We think the small balances of Cochran, Bonzo, Limbert and Parker in Group "A" are in the nature of allowances which are unavoidably incident to a business such as*4045 that of petitioner. Disregard of them results in an overstatement of gross income and they should be allowed. The Boyd account was closely allied to these and in addition it is shown that it was uncollectible. This item also should be allowed. Respondent is reversed on the five items in Group "A."
The accounts in Group "B" are all claims entered on the books against transportation companies. There are a relatively great number of them and many are trifling in amount. The method of accounting followed by petitioner was to enter the claims on the books as accounts receivable and to charge them off to profit and loss, after a brief interval, if correspondence failed to result in assurance of the attention of the transportation companies. The conclusion is inescapable that the very short interval allowed was more convenient than justified, for the experiences detailed in the findings of fact show that in a majority of instances settlement was subsequently made and the amount finally settled upon was collected in the year following entry. However, there are two items: Erie Railroad Co., $1.75, and Adams Express Co., $150.50, which were never paid and we see no reason for reversing*4046 the conclusion which the petitioner arrived at in 1918, that these accounts were worthless in the sense that further proceedings would not result in the collection of any portion of them. In our opinion the deduction of $152.25 is allowable *833 in this group and the remainder was properly disallowed. Cf. .
Group "C" includes seven accounts reflecting charges set up on the books of claims for spoilage in the warehouses of petitioner of goods the property of petitioner. It is admitted by petitioner that the parties charged were not liable in any way for the losses. It is obvious that the accounts were not bad debts. But on the other hand they were most certainly losses and we are satisfied that they are properly allowable as deductions from gross income. Disallowance of them results in restoring to the balance sheet accounts which measure losses and are not assets, resulting in an overstatement of net income.
Group "D." It is necessary to discuss separately the items under this group.
The account of Corimer Rice Company was not a debt. It represents the cost of empty bags, the property of petitioner. The*4047 bags were charged off in 1918, for it was the opinion of petitioner that they would not be used for packing rice. They were retained, however, and eventually used, and we are not satisfied that they were definitely abandoned and entirely useless at the end of 1918.
The accounts of Carnasso and George are similar save in their ultimate outcome. Both customers had ordered flour, but, due to the war-time regulations then in force, mixtures of flour and substitutes were shipped. The customers were disappointed and refused to accept the shipments, denying liability. The shipments were finally sold by the transportation companies for the charges. Petitioner entered suit against these customers, losing to Carnasso and winning from George in part. These accounts receivable were entered on the books of petitioner in the manner usual to its system of accrual accounting and we see no reason for singling them out for differentiation. In a subsequent year, as the outcome of litigation, one account was determined wholly bad and the other partly so; the bad debts are properly deductible in the subsequent year.
The item of Heinzer is admitted by petitioner to have been charged off and*4048 deducted in error.
The debtors, Krelandis and Johnson, owned real estate in the form of an unimproved lot which was not highly valued by petitioner; nevertheless petitioner acquired title to the lot through the medium of a sheriff's sale at a nominal consideration. Petitioner charged off the entire account of Krelandis and Johnson in 1918 as a bad debt. The lot was subsequently sold for $150 and the entire proceeds were reported as income. From the meager facts before us, we are of the opinion that petitioner erred for there was no determinable loss in *834 1918. The amount of the debt was a part of the cost to petitioner of the lot, under the circumstances, and it was not a loss or bad debt in 1918.
The account charged on the books against the Mercer County Light & Heat Co. was the cost of a transformer of electric current. The expenditure did not result in the acquisition by petitioner of title to tangible property. Its cost, however, was in our opinion not merely an expense of the year 1918, for the Light & Heat Co. had agreed to allow $1 per month as a reduction of the bills of petitioner until the aggregate cost of the transformer was returned to petitioner. *4049 And, furthermore, the benefit to petitioner of the investment extended over a number of years. Subsequently petitioner treated the allowance of $1 per month as income, but we are unable to agree with this, for the credits were reimbursements of the money advanced by petitioner. We think the expenditure should have been capitalized as a deposit with the light and heat company and credited monthly with the $1 allowances until extinguished. The gross amount of the bills for electricity were properly deductible as expense in the year in which incurred.
The bad debts of Marshall, Moore, Tebay, Watson, and Weister are alike and may be considered together. They are for the unpaid amount of promissory notes due from the parties who were all also indebted to petitioner on open accounts at the close of 1918. The amounts of the open accounts are not claimed to be bad debts. In our opinion, petitioner has failed to establish any definite determination of bad debts, and, furthermore, partial losses are not deductible under the Revenue Act of 1918. See *4050 , and .
The claim of Wacher was recognized by the trustee in bankruptcy as an obligation of the bankrupt, and in 1918 a final distribution was received from him, leaving uncollectible and a loss the amount of $459.06. The deduction is allowed. Respondent reversed.
In Group "E" are three small accounts claimed as bad debts and disallowed as deductions by respondent. The record is utterly devoid of facts relative to these accounts and the respondent is sustained.
The third issue is relative to expenditures classified by the petitioner as repairs, but disallowed as deductions by respondent. The expenditures were almost entirely for remodeling fully detailed in the findings of fact and in our opinion having a useful life longer than the taxable year. It is well settled that improvements having a life longer than the taxable year should be capitalized and exhausted ratably over their useful lives. See , and *4051 . In connection with the work for the office, the expenditures *835 included the cost of $60 for painting the office, and this we think is allowable as a deduction in full in 1918. Respondent is sustained for $610.43 and is reversed for $60.
The fourth issue concerns amount of depreciation of motor trucks which is allowable as a deduction from gross income. The cost of the trucks is not in controversy. The parties are not in agreement as to the probable duration of the useful lives of the trucks. Taking into consideration an active, useful life of three years of the trucks, followed by a period of occasional emergency use, and in view of the severe conditions under which the trucks were operated, all in accordance with the evidence adduced, we are of the opinion that a life of four years affords a satisfactory basis upon which to compute an allowance for wear and tear of these trucks, and we so find. Respondent reversed in part.
Judgment will be entered upon 15 days' notice, under Rule 50.