*1831 1. Since the record does not disclose that there were dificiencies for the taxable years 1923 and 1924, the proceeding will be dismissed as to those years.
2. In its returns for 1921 and 1922 the petitioner took deductions for specific bad debts actually charged off. It also took as deductions for bad debts certain additional amounts representing additions made to a reserve. For the year 1921 the amount of the addition to the reserve represented the amount of the deficit or the excess of liabilities over assets disclosed by the balance sheet of a deferred creditor of the petitioner. The amount of the addition to the reserve for 1922 represented the increase in the deficit of the deferred creditor. Held that the petitioner has not established that the amounts added to the reserve represented worthless portions of indebtedness owing to it by the debtor.
*577 For the fiscal years ended February 28, 1921, and February 28, 1922, the respondent has determined against the petitioner deficiencies in income and profits taxes of $34,517.86*1832 and $4,109.66, respectively, and for the fiscal years ended February 28, 1923, and February 28, 1924, overassessments of $6,750.64 and $5,370.30, respectively. In appealing from the determination the petitioner alleges that the respondent erred as follows: (1) Failed to allow as deductions for the fiscal years ended February 28, 1921, February 28, 1922, and February 28, 1923, the amounts of $33,441.25, $40,561.96, and $8,369.30 respectively, for parts of debts ascertained to be worthless and charged off during the respective years; (2) failed to allow as a deduction for the fiscal year ended February 28, 1922, the amount of $42,015.43 expended for repairs; (3) failed to allow as a deduction for the fiscal year ended February 28, 1922, the amount of $42,015.43 representing the undepreciated value of property demolished and replaced; and (4) failed to allow as credits the amounts of $8,467.09, $7,285.02, $4,718.41, and $1,081.39 representing taxes overpaid for the fiscal years ended February 28, 1919, February 29, 1920, February 28, 1921, and February 28, 1922, respectively. At the hearing, the parties agreed that the issues presented by the allegations in No. 2 and No. 3 should be*1833 disposed of on the ground that $11,860.18 of the $42,015.43 contended for by the petitioner constituted an allowable deduction in 1922 for repairs and that the remaining $30,155.25 constituted a capital expenditure by way of additions *578 to real estate within 1922 and is to be depreciated at the rate of 3 per cent per annum. The issue raised by allegation No. 4 was waived by the petitioner at the hearing. There remains for our consideration only the question raised by No. 1.
FINDINGS OF FACT.
The petitioner is a New York corporation which began business about 1860 and has its principal office in New York City. In 1909 the petitioner entered into an arrangement with Anderson & Brothers, a partnership carrying on business in Chicago and composed of A. Anderson and P. R. Brothers, whereby the petitioner was to ship merchandise to the partnership, but was not to receive payment therefor until all other accounts of the partnership had been paid. The petitioner shipped between $200,000 and $300,000 worth of merchandise to the partnership each year. With the probable exception of some small accounts at the end of each year, the petitioner was the only unpaid creditor of*1834 the partnership. The original capital of the partnership at the time of its formation in 1909 was approximately $2,000.
About 1912 or 1913 the partnership began to sustain a series of losses, with the result that commencing about 1917 the petitioner adopted a general practice with respect to the account of the partnership. Under this arrangement the partnership was required to make certain changes in its accounting system, particularly with respect to the taking of inventories and the recording of sales. Monthly statements of operations were also required to be furnished in more detail than theretofore. The practice of the partnership in paying its other creditors before paying the petitioner was continued, the petitioner agreeing to advance such funds as would be necessary to carry out this arrangement. The merchandise shipped by the petitioner to the partnership was billed at the same price as shipments to others, except that while the partnership did not pay its account in such a manner as to earn a discount it was given the discount or credit as though it had paid its bills promptly.
Net shipments of merchandise by the petitioner to the partnership for the years before*1835 us were as follows: year ending February 28, 1921, $322,530.13; year ending February 28, 1922, $190,385.83.
At the end of February of each year the partnership would take a physical inventory of its merchandise. It would then prepare and submit to the petitioner a balance sheet, in which, among other items, the inventory appeared. At the close of its fiscal year, which ended February 28, the petitioner would take the balance sheet as of that date furnished by the partnership, subtract from the total amount of assets shown thereon the liabilities owing by the partnership to *579 others than the petitioner, and from the result thus obtained subtract the amount owing by the partnership to petitioner, thereby arriving at the net worth or the deficit of the partnership as the case might be. At the end of 1921 and 1922 the partnership had deficits. After ascertaining the amount of the partnership deficit at the end of the year the petitioner would compare that amount with the net worth or deficit at the beginning of the year and determine the amount of the increase in the deficit. An entry was then made on the petitioner's books charging profit and loss with the amount of*1836 the increase in the deficit thus determined and crediting an account designated "Reserve Anderson & Brothers" with the same amount. In years when the business of the partnership was profitable and its balance sheet showed a reduction in the amount of the deficit existing at the end of the preceding year, the petitioner would charge the account "Reserve Anderson & Brothers" with the amount of such reduction and credit profit and loss with the same amount.
The amounts owing to the petitioner by the partnership and the net worth of the partnership after taking into consideration such amounts were as follows on the dates indicated:
| Date | Amount | Net worth |
| owing by | of the | |
| partnership | partnership | |
| to petition- | ||
| er | ||
| Feb. 28, 1920 | $224,801.40 | $19,575.11 |
| Feb. 28, 1921 | 306,008.19 | 1 33,441.25 |
| Feb. 28, 1922 | 285,979.85 | 1 74,003.21 |
The petitioner carried on its books as an account receivable an account with the petitioner showing the amount due petitioner for merchandise shipped by it to the partnership. At all times this was carried as an open running account. The books of the partnership showed as an account payable the amount*1837 due from the partnership to the petitioner. While the petitioner set up a reserve in connection with the debt owing to it by the partnership, the same procedure was not followed with respect to the accounts receivable owing to it by other customers. No reserve was set up for bad debts arising from such accounts, but the determination of worthlessness of any of them was followed by a direct charge-off of the account.
The firm of Anderson & Brothers is still carrying on business in Chicago and the method of handling the account is being continued by the petitioner. The partnership filed returns of income for the years here involved.
In determining the deficiencies for the fiscal years ended February 28, 1921 and 1922, the respondent disallowed as deductions the *580 amounts of $33,441.25 and $40,561.96 taken by the petitioner as bad debts and representing respectively the amount of the deficit of Anderson & Brothers at February 28, 1921, and the increase in the amount of the deficit at February 28, 1922.
OPINION.
TRAMMELL: For the fiscal years ended February 28, 1923, and February 28, 1924, the respondent has determined overassessments. It not appearing that there*1838 were deficiencies for the years, the appeal will be dismissed with respect thereto. .
The petitioner contends that for the fiscal years ended February 28, 1921, and February 28, 1922, it is entitled to deductions of $33,441.25 and $40,561.96 respectively, representing the portions of the indebtedness of Anderson & Brothers ascertained to be worthless and charged off within the respective taxable years. The respondent denies that the amounts contended for as deductions within the respective years were ascertained to be worthless or that they were charged off.
The petitioner did not use the reserve method for the purpose of taking deductions for bad debts except in the particular case of Anderson & Brothers. All other accounts were treated differently. When an account was ascertained to be worthless and charged off it was deducted, but in the case of this particular account, the petitioner set up a reserve at the end of the year in accordance with the amount of deficit which Anderson & Brothers had on its books at the end of the year. The balance sheet of Anderson & Brothers of February 28, 1920, shows an excess of assets*1839 over liabilities of $19,575.11. On February 28, 1921, there was an excess of liabilities over assets in the amount of $33,441.25. On February 28, 1922, there was an excess of liabilities over assets of $74,003.21, or an increase in the deficit of $40,561.96. In 1921 a reserve was set up equal to the amount of the deficit for that year and in 1922 a reserve was set up in an amount equal to the increase in the deficit for that year.
The petitioner had been doing business with Anderson & Brothers in the same way for many years prior to the taxable year and has continued to do so up to the time of the hearing. It has continued through all the years to sell goods to them and it has treated the accounts in the same way. There is no evidence that the petitioner has ever lost anything as the result of its trading with Anderson & Brothers in any of the years. While the petitioner set up a reserve on its books for the deficits of Anderson & Brothers in the respective years, it now contends that it ascertained the amounts to be worthless and charged them off.
*581 The petitioner is not entitled to both the reserve method and the charge-off method. It could not use the charge-off*1840 method for certain accounts and the reserve method for certain other accounts.
We do not think that the contention of the petitioner that it ascertained the debt to be worthless in part and charged off is sustained by the evidence. The fact that the debtor had a deficit for certain years is not in itself sufficient, especially in view of the long course of dealings of the petitioner with the debtor. The continuation of the petitioner to sell goods to the debtor on the same terms and conditions as at all times before the subsequent was sufficient to indicate that the petitioner had absolute confidence in the integrity of the debtor and its ability to eventually pay, and this confidence seems to have been warranted by the course of dealings with the debtor from 1917 up until 1930, during which time no claim was made that any money was ever lost as a result of dealings with the debtor.
The method of treating the accounts used by the petitioner, that is, charging off the account or setting up a reserve in proportion to the deficit of the debtor, and as the deficit was reduced or as income increased to include such amount as income, is not recognized by the statute.
A witness*1841 for the petitioner testified that "If they (the partnership) should happen to earn enough money at any one time to wipe it (the debt) out we would increase the income, we would consider the account worth one hundred cents on the dollar."
The evidence is also silent as to the financial responsibiality of the members of the partnership aside from their interest in the partnership. So far as the record discloses they as individuals might have been well able to have paid the accounts at any time. In any event, the confidence of the petitioner in the debtors as shown by their continuation of the arrangement over the years indicates that it did not ascertain during the taxable years that their debts were worthless. This may have been the motive of the petitioner in not charging off the debts as bad during the taxable years as it did in the case of other debtors, and the reason as reserve was set up with respect to this particular account.
For the foregoing reasons we are of the opinion that the evidence does not show that the debts were ascertained to be worthless in part and charged off during the taxable years.
An order will be entered dismissing the petition with respect*1842 to the fiscal years ended February 28, 1923, and February 28, 1924. With respect to the fiscal years ended February 28, 1921, and February 28, 1922, judgment will be entered under Rule 50.
Footnotes
1. Deficit. ↩