*2021 1. Amount of addition to reserve for bad debts determined.
2. Held that the respondent has not sustained the burden of proof with respect to his contention that a deficiency should be determined in excess of that shown in the notice of deficiency.
*850 This proceeding is for the redetermination of a deficiency in income tax of $1,572.25 for 1925. The only matter put in issue by the petition is the action of the respondent in disallowing as a deduction an amount of $10,000 taken by the petitioner as an addition to its reserve for bad debts. In his answer, and by way of affirmative defense, the respondent alleged that the petitioner had understated its income for 1925 by $11,485 as a result of having credited to surplus during that year certain real estate and inventories of materials and supplies which were acquired by petitioner in 1924, charged to expense and included in its closing inventory for 1924. He accordingly asked that the deficiency be redetermined in the amount of $3,065.30.
FINDINGS OF FACT.
The*2022 petitioner is a New York corporation, organized in 1916 and having its principal office at Rochester. The business carried on by it is that of building contractor. From its beginning until 1924 it was engaged mostly in residential work. In 1924 the petitioner, in addition to doing residential work, began to do store remodeling and also entered the masonry business. As no one else in Rochester had specialized in the new lines of business taken on by the petitioner, *851 a large field of new customers was open to it. The petitioner's business increased to such an extent that an increase in its capital stock was found necessary in October, 1924.
Some time during 1924 one Stewart, who had conducted the business carried on by the petitioner prior to its incorporation and who had been active in the affairs of the petitioner, suffered a breakdown and thereafter became inactive. This resulted in the entire burden of the general supervision of the business being placed on Vincent S. Bennett, the treasurer of the petitioner. Prior to Stewart's breakdown, Bennett's duties had been concerned with the collection of accounts, checking up of merchandise and the extension of credit*2023 to customers. With his added duties, Bennett was unable to give as much time to the collection of accounts and the extension of credit as formerly.
The petitioner's gross business increased from $524,321.06 in 1924 to $848,965.45 in 1925. In 1925 about 30 per cent of the total business was masonry work and about 65 per cent was store remodeling. This shifting of the business largely from residential work to remodeling and masonry work brought the petitioner into contact with a new class of customers the majority of whom were tenants and lessees of property. This resulted in the petitioner having more difficulty in collecting its accounts. When engaged largely on residential work, the petitioner's work was for property owners and the mechanic's-lien law could be used in collecting accounts from customers if necessary. This remedy, however, was not available in collecting accounts from customers who were tenants or lessees, nor was there the security back of such customers as was back of property owners.
The petitioner's customers generally were billed on a basis of net 30 days. However, contract work was billed on the basis that 90 per cent of the work performed was to*2024 be paid for within 10 days of the first of the following month and the balance within 30 days after the completion of the contract.
At the end of 1924 the petitioner had accounts receivable outstanding in the amount of $50,714.61, of which $1,228.73 represented accounts more than one year old; $8,649.24 represented accounts from six to twelve months old; and $5,482.45 represented accounts three to six months old.
At the beginning of 1925 the petitioner's reserve for bad debts account contained no balance due to the fact that all of the amounts set up as credits to the reserve had been offset by charges to it on account of bad debts written off.
*852 Shortly after the end of 1925 the accountant who was in charge of the audit of the petitioner's books made an analysis of its accounts receivable as of December 31, 1925, as follows:
| Accounts more than 1 year old | $4,647.25 |
| Accounts from 6 to 12 months old | 10,105.57 |
| Accounts from 3 to 6 months old | 25,256.73 |
| Accounts billed to customers during October and November, 1925 | 21,288.99 |
| Accounts billed to customers at the end of 1925 | 2,693.63 |
| Total | 63,992.17 |
With the exception of the amount billed to*2025 customers at the end of 1925, all of the above accounts were overdue at December 31, 1925.
From the accounts receivable outstanding at the end of 1925 the accountant prepared a list totaling something over $14,000 which he considered to be bad. This list was composed of accounts that were from six to twelve months old and of accounts that were more than a year old. After checking over the list with the accountant and taking into consideration what he knew about the particular debtors and whether they were owners or tenants as well as the kind of work done for them, and acting on his experience gained during 17 years in the general contracting business, Bennett selected accounts totaling $10,110.03 which he considered bad and decided that an addition of $10,000 should be made to the petitioner's reserve for bad debts as at the end of 1925.
An addition of $10,000 was made to the reserve for bad debts and a deduction of the same amount was accordingly taken for such purpose in the petitioner's 1925 income-tax return. Although the petitioner's method of reporting its income for tax purposes beginning with 1921 and continuing therefrom has been on the basis of an addition to a*2026 reserve for bad debts, the respondent in determining the deficiency here involved disallowed the deduction of $10,000 taken by the petitioner, on the ground that the petitioner had elected in 1921 to report income on the "actual bad debt method." However, the respondent allowed $732.47 representing the amount of bad debts charged by the petitioner to its reserve for 1925.
Of the accounts totaling $10,110.03 which Bennett determined to be bad at the end of 1925 and which he considered in determining the amount to be added to the petitioner's reserve for bad debts in 1925, $5,899.18 have never been paid, $3,443.86 were partially paid after litigation, and $766.99 were adjusted or compromised. Since December 31, 1925, and down to December 31, 1929, $4,630.92 of the accounts receivable outstanding at the end of 1925 have been determined to be worthless and charged off.
*853 The addition to the petitioner's reserve for bad debts, the charges to the reserve, and the amount of bad debts arising from the business of the respective years from 1925 to 1929, are as follows:
| Year | Addition to reserve for bad debts | Charges to reserve for bad debts | Bad debts arising from business of year |
| 1925 | $10,000.00 | $732.47 | $4,630.92 |
| 1926 | 3,000.00 | 1,970.44 | 8,644.97 |
| 1927 | 4,000.00 | 11,190.31 | 25,770.69 |
| 1928 | 2,000.00 | 2,231.48 | 197.62 |
| 1929 | 32,500.00 | 192.08 |
*2027 In 1925 about the time the petitioner started in the masonry business it bought certain real estate at a cost of $2,700 and shortly thereafter built some sheds on this and other property at a cost of $1,500. These amounts, totaling $4,200, instead of being treated as expenditures for capital assets, were charged to expense. However, at the end of the year they were treated as part of the petitioner's closing inventory, thereby eliminating them as expense for 1924. At the end of 1924 the petitioner had on hand and remaining from materials and supplies purchased during the year and charged to expense the following:
| Paint shop materials | $2,725 |
| Carpenter shop materials | 2,560 |
| Mason supplies and equipment | 2,000 |
| 7,285 |
These were also treated by the petitioner as a part of its closing inventory for 1924.
During the first part of 1925 the petitioner engaged a firm of accountants to audit its books. The accountants finding that the above mentioned items of real estate, sheds, materials and supplies had not been recorded on the petitioner's books, directed that entries be made setting up these items as assets and crediting surplus for the corresponding amounts.
*2028 In computing its taxable income for 1925, the petitioner used as a part of its opening inventory for that year the above mentioned materials and supplies totaling $7,285 which had constituted part of the closing inventory for 1924. Any unused portion of these items on hand at the end of 1925 formed a part of the closing inventory for 1925. The real estate and sheds not being proper inventory items, although having been included in the 1924 closing inventory, were not used as a part either of the opening or closing inventory for 1925. In determining the deficiency here involved, the respondent made no change in the petitioner's income because of the *854 materials and supplies totaling $7,285 having been included in the opening inventory, or because the real estate and sheds totaling $4,200 were not included in shch inventory, or because in bringing these items totaling $11,485 on the petitioner's books as assets, corresponding credits totaling $11,485 were made to surplus.
OPINION.
TRAMMELL: With respect to the disallowance by the respondent of the deduction of $10,000 taken by the petitioner as an addition to its reserve for bad debts, the petitioner contends that*2029 under the circumstances present in its case the amount constituted a reasonable addition to its reserve for bad debts.
The respondent although having disallowed the addition to the reserve in determining the deficiency, on the ground that the petitioner had elected in 1921 to report its income on the "actual bad debt method," admitted in his answer that beginning in 1921 and continuing therefrom the petitioner has reported its income on the reserve basis. In his brief he contends that his action should be sustained because the petitioner has not shown that the addition made by it was reasonable.
In view of the admission in the respondent's answer there is no controversy between the parties as to the petitioner's right to use the reserve for bad debts method in reporting its taxable income. The only question is as to the reasonableness of the addition of $10,000 to the reserve.
The petitioner's 1924 return shows that for the five-year period from 1919 through 1923 the petitioner's gross business amounted to $1,264,264.75 and the bad debts for the same period amounted to $3,120.25. During this period the petitioner's business was mostly residential work and the class of customers*2030 was different from what it was when the petitioner went into the store-remodeling and masonry business. The mechanic's-lien law could also be invoked as an aid to collection. The 1924 return also shows that the deduction taken for that year as an addition to the reserve for bad debts was only $88.33. During 1925 the petitioner's business increased very materially. In that year about 95 per cent of its business was other than residential work and the detailed supervision was not given to the granting of credit that had been given to it prior to the breakdown of one of the petitioner's officers in 1924. Nor was there available to the petitioner the same remedy for collection as when it was doing residential work which was largely for owners.
In view of the change in the kind of business and the changed circumstances under which the petitioner was doing business in 1925, we do not think that it would be proper to base a determination of *855 the amount to be added to the reserve for bad debts in 1925 upon the amount of bad debts for prior years. The determination is to be based on conditions existing during 1925. See *2031 .
While it is apparent that the petitioner was faced with a new situation when it came to determining the amount to be added to its reserve for bad debts, we do not think that this in and of itself should serve as a justification for an unreasonable or excessive addition to such reserve. The basis on which the amount of the addition of $10,000 was computed by the petitioner is set forth in our findings of fact. While Bennett, the accountant who made an analysis of the petitioner's accounts receivable and a member of the accounting firm which audited the petitioner's books, testified as to the $10,000 being in their opinion a reasonable addition to the reserve, we are not bound in our decision by their opinions alone, but must also consider the facts presented in the case, as well as the basis for their opinions. See .
In the light of the facts before us, considering the amount of debts at the end of 1925 which were subsequently ascertained to be worthless and never collected, we think that the petitioner is entitled to deduct as an addition*2032 to its reserve for bad debts the amount of $7,000. In determining this amount we have given due consideration to the testimony of the witnesses, the experience of the company in the past and also subsequent to 1925. We think the actual facts are inconsistent with a higher amount, indicate that the witnesses' opinions as to a $10,000 reserve as being a reasonable amount were not well founded, and fully bear out and support the amount determined by us to be a reasonable addition to the reserve. As the respondent has allowed $732.47 as a deduction in determining the deficiency, the petitioner is entitled to have the deduction increased by the amount of $6,267.53.
The remaining issue arises from the allegation in the respondent's answer that the petitioner's income for 1925 had been understated by $11,485 as a result of the petitioner having credited to surplus during that year certain real estate, sheds and inventories of supplies and that the deficiency should accordingly be increased. The burden of sustaining this allegation is upon the respondent. We have set out in detail in our findings of fact the manner in which the items complained of by the respondent were handled by*2033 the petitioner in computing its taxable income. From the facts we are of the opinion that the respondent has not sustained the burden of showing that the petitioner's income was understated in 1925 as a result of the manner in which the items were handled by it in computing its taxable income. In 1924 the petitioner erroneously *856 charged the land and sheds to expense. It also charged to expense certain materials and supplies. At the end of 1924, however, the land, sheds, material and supplies were included as a part of the closing inventory for 1924. While as to the land and sheds this was clearly erroneous, the effect as to all these items was to offset the previous charge to expense. In any event there was no taxable income in 1925 as the result of these transactions.
Counsel for the respondent conceded that as the result of the entries made in 1924 the income for that year was properly stated in the deficiency letter, but contends that for 1925 the credits to surplus of the items previously charged to expense and the inclusion thereof in closing inventory for 1924 and the opening inventory for 1925 resulted in taxable income for 1925.
The respondent is in error*2034 in stating that the 1925 opening inventory was the same as the closing inventory for 1924. The petitioner did not include in its opening inventory for 1925 the land and sheds, although it did include in the 1925 opening inventory the materials and supplies at the same figures at which they were included in the 1924 closing inventory. As to the buildings and sheds, and materials and supplies, the petitioner in 1925 placed them on its books as assets, crediting the amounts thereof to surplus. The materials and supplies, however, were included in the opening inventory for that year, the effect of which was to charge to expense of operations for 1925 the materials and supplies actually used during the year. We see no reason why the taxable income determined by this method should be increased as proposed by the respondent. The fact that these items including the sheds and land were put on the books as assets with a corresponding entry crediting surplus for the first time in 1925 does not increase the income for that year. Mere bookkeeping entries alone do not give rise to taxable income. We must consider the actual facts and transactions.
Judgment will be entered under Rule*2035 50.