1928 BTA LEXIS 4012">*4012 The right to deduct an addition to a reserve for bad debts denied, where the evidence fails to show that he reserve was to anticipate a loss rather than to insure future profits.
10 B.T.A. 911">*911 The Commissioner determined a deficiency in income taxes for the fiscal year ended January 31, 1922, in the amount of $7,685.77. The error alleged is that the Commissioner added to income an amount of $35,000, which the petitioner had set up on his books of account as a reserve for bad debts against losses on leasehold accounts receivable.
FINDINGS OF FACT.
The petitioner is an individual residing at Zion, Ill. Under the title of "Zion Estate" he engaged in a number of different businesses and among others the real estate business. About ten years before the taxable year in question he became general overseer and recognized leader of the religious organization known as the Christian Catholic Apostolic Church of Zion. He then purchased land in and about Zion. Some of this land was vacant farm land, some of it was vacant city lots, and some of it was improved city1928 BTA LEXIS 4012">*4013 lots. The petitioner was at all times trying to dispose of this land to the church members, and in July, 1921, while many of them were assembled in Zion from all parts of the world for church purposes, the petitioner started a drive among them to dispose of as many of his lots as was possible. The drive continued until December 31, 1921, during which time more than 1,000 pieces of land were "sold."
In these "sales" a small cash payment was required and the payment of the balance of the total consideration was extended over a period of seven years, payments to be made monthly, deferred payments to carry 6 per cent interest. While the transactions were referred to as "sales" the parties in reality entered into articles of agreement for so-called Zion leases for the period beginning when the consideration was fully paid and extending to January 1, A.D. 3000, subject to certain restrictions immaterial hereto. The person who entered into the agreement with the petitioner for the acquisition of these pieces of land contracted to pay all taxes, both general and special, interest on the special taxes, and an annual leasehold fee of $1 for leases when issued, and to improve the properties1928 BTA LEXIS 4012">*4014 and keep them in a proper state of repair. Quite a number of lots were 10 B.T.A. 911">*912 "sold" for $100, on cash payments as low as $2 or $3 or $4 and the balance in small monthly payments extending over seven years.
The number of "sales" during the fiscal year before us was abnormally large as compared to the number of "sales" of the previous years and the succeeding years. After a time it was found that many of those who had contracted for lots were not making their payments and were not complying with their contracts in other ways. Many of them made no more than their initial payment. The petitioner's chief accountant, before the end of the fiscal year in question, went through the petitioner's books relating to the "sales" of these pieces of property, noted the contracts as to the payment of which he had any doubt, and called them to the attention of his superiors, the petitioner, the petitioner's general manager, his assistant general manager, and his credit department head, and all those individuals conferred in regard to these accounts. They decided to set up a reserve amounting to from 5 to 10 per cent of the total due on the contracts. To cover losses which might result1928 BTA LEXIS 4012">*4015 from the cancellations on contracts entered into during this drive and also some entered into at prior dates, a reserve of $35,000 was set up on the books of the petitioner. Contracts entered into during the 1921 drive but thereafter and up to January 1, 1925, canceled, represented a total consideration of $121,377.09. For the fiscal year ended January 31, 1922, the total consideration on contracts made for leaseholds amounted to $433,258.12, for the preceding fiscal year it amounted to $219,036.66, and for the succeeding fiscal year it amounted to $116,138.20.
On the petitioner's income-tax return for the fiscal year in question, there was reported total gross income in the amount of $3,026,816.21. Expenditures of $2,834,603.67 were claimed as deductions. Included, inter alia, in the gross income reported were:
| Farm land sales - gross profit | $13,208.59 |
| Buildings with land sales - gross profit | 6,195.00 |
| Subdivided land lots - gross profit | 207,120.63 |
| Sundry property purchased - gross profit | 23,730.47 |
| Total | 250,254.69 |
Under expenditures there was deducted as a reserve for bad and doubtful accounts, $55,000. This item included the $35,000 set up as1928 BTA LEXIS 4012">*4016 a reserve to cover contract cancellations now in question. This $35,000 reserve was disallowed as a deduction by the Commissioner.
It was stipulated by the parties to this proceeding that -
For the year in question the taxpayer in computing his income included in gross income the entire contract price, but deducted therefrom in arriving at that income the amount representing the unearned portion of these leaseholds at the end of the year and that in determining the reserve claims the Commissioner has not added to income the amount of those unearned profits.
10 B.T.A. 911">*913 OPINION.
MURDOCK: The petitioner claims that under section 214(a)(7) of the Revenue Act of 1921, he is entitled to deduct the $35,000 in question as a reasonable addition to a reserve for bad debts. The Commissioner disallowed this deduction and in his deficiency notice gave the following explanation of his action:
With reference to the item of reserve for collections, etc., of leaseholds receivable of $35,000, you are advised that inasmuch as the sale of leaseholds are reported on the installment sale basis there appears to be no valid reason to allow the reserve.
In the answer to the petition the1928 BTA LEXIS 4012">*4017 following is stated as a proposition of law:
In determining the taxable income from a particular trade or business where the accounts are kept and returns for tax purposes rendered on either cash receipts and disbursements basis or upon an installment basis, no deduction may be allowed for "a reasonable addition to a reserve for bad debts." (Section 214(a)(7), Revenue Act of 1921.)
Thus, the petitioner was sufficiently notified that in the opinion of the Commissioner, at least, the petitioner's method of reporting income was material to the determination of the deficiency and that the deduction of this reserve was inconsistent with the petitioner's method of reporting his income from the contracts in question. Yet evidence was not introduced from which we can determine what basis the petitioner used in computing his gain or what method he used in reporting his income from these transactions. This omission may have been intentional for the argument is made in the petitioner's brief,
That any part of a debt which is not fully recoverable, may be deducted regardless of the method of reporting earnings; that as to method of reporting the law makes no distinction.
1928 BTA LEXIS 4012">*4018 But in a considerable number of cases, beginning with , we have pointed out certain fallacies in such an argument and we are convinced that proof of the method of reporting income is material to the determination of the question now before us.
The computation referred to in the stipulation was not set out on the return. The latter merely shows a "gross profit." We neither know how this "gross profit" was computed, nor do we know the total amounts received by the petitioner on these contracts during the year. Assuming that the "gross profit" set out in the return was the result of the computation described in the stipulation, we still are unable to understand what this "gross profit" 10 B.T.A. 911">*914 represents. Perhaps the difficulty with the stipulation is that it contains words such as "unearned portion of these leaseholds" and "unearned profits," which when so used, in the light of the other evidence, convey to us no meaning.
The petitioner had, for example, a vacant lot which cost him an undisclosed amount. In the year before us, he entered into an agreement with a church member whereby the latter agreed to pay $4 at1928 BTA LEXIS 4012">*4019 once and $24 a year for four years, with the understanding that at the end of that time the petitioner would give him a lease on the property for a long time at a rent of $1 a year. If we do not know whether the petitioner reported as income any more than $4, or any more than that part of $4 which represented a profit to him, why should anything be deducted as a reserve from the amount returned? Suppose the man never pays any more money to the petitioner, can we say that the petitioner has lost anything more than a chance to make a profit? A reserve for bad debts is to anticipate a loss, not to insure future profits.
If the "gross profit" reported was computed by the cash receipts and disbursements method the petitioner would not be entitled to deduct therefrom a reserve for bad and doubtful accounts representing payments which were due him under the lease, but which had not been paid at the end of the fiscal year and which he might never collect.
If the "gross profit" reported on the return was computed on the basis of an installment sale, so that it represented or should have represented that proportion of the installment payments actually received in that year which the1928 BTA LEXIS 4012">*4020 total profit realized or to be realized when the payment was completed bore to the total contract price, then since, so far as we know, the total contract price was all profit and each payment therefore all profit, we hold that the reserve was not a proper deduction. It is not necessary in this case to decide and we do not decide whether in general an addition to a reserve may ever or never be deducted from income reported on the basis of installment sales. Neither is it necessary to discuss the question of the reasonableness of the amount of the reserve set up, or whether the transaction in fact amounted to a sale.
Whatever the petitioner's method of reporting his income was in fact, and regardless of what he might be entitled to deduct if his method had been sufficiently proven nevertheless, under the evidence, we are unable to say that the action of the Commissioner was erroneous and the weight of the evidence, which is free from obscurity, tends to support the action of the Commissioner.
Judgment will be entered for the respondent.