1956 U.S. Tax Ct. LEXIS 162">*162 Decision will be entered for the respondent.
Petitioner is a national banking corporation which has been in existence for more than 20 years. For the years 1949, 1950, and 1951, the Commissioner determined that petitioner's accumulated reserve for bad debts at the end of 1948 was an amount which constituted its ceiling and he disallowed deductions in each of the taxable years for annual additions to the reserve which petitioner had computed under its own particular formula. Petitioner used in its computation of its annual addition to its reserve for bad debts a loss ratio determined by another bank. Petitioner challenges the determination of the respondent as arbitrary and unreasonable. Held, on the facts, that petitioner has failed to show that the respondent's determination was either an arbitrary or an unreasonable exercise of his discretion.
26 T.C. 537">*537 The Commissioner determined deficiencies in income tax for the years 1949, 1950, and 1951, in the amounts of $ 8,026.83, $ 2,620.72, and $ 807.27, respectively. The question presented is whether petitioner, 1956 U.S. Tax Ct. LEXIS 162">*163 a national banking corporation, is entitled to additions to its reserves for bad debts in the taxable years, and deduction therefor in each year. The Commissioner disallowed deduction in each year of all of the annual addition to its reserve for bad debts on the ground that at the end of 1948 the total amount of the petitioner's reserve for bad debts exceeded the ceiling to which petitioner was entitled under the Commissioner's regulations, and, therefore, petitioner was not entitled to a further addition to its reserve in any of the 3 years 1949-1951, inclusive.
FINDINGS OF FACT.
Petitioner is a national banking corporation organized in the year 1904. It is engaged in the general banking business and has its office in Elgin, Illinois.
The petitioner filed its returns with the collector of internal revenue for the first district of Illinois.
Prior to the year 1939, the petitioner's president and principal stockholder was Alexander Metzel. He was the founder of the bank, its cashier, and lending officer. Metzel managed the loan department under a conservative policy of banking and the making of loans was greatly dependent upon the management's knowledge about the borrower and his1956 U.S. Tax Ct. LEXIS 162">*164 background. The bank had no personal loans outstanding prior to 1939.
26 T.C. 537">*538 During the year 1939, Robert C. Kewley purchased Metzel's stock, became president of the bank, and initiated several changes in policy among which was a more liberal loan policy. There was a new slate of officers. A personal loan department was established. A loan committee was created which was authorized to get new loans and new business. Under Kewley's management, the volume of loans increased, the character of loans changed, and loans were made which involved more risk.
In 1942, petitioner obtained permission from the Commissioner to use the reserve for bad debt method in lieu of the specific charge-off method of deducting uncollectible accounts. Since 1942, petitioner has used the reserve for bad debt method.
Beginning in 1942 and continuing through 1947, petitioner's annual addition to its bad debt reserve was an amount equal to one-sixth of the interest collected by the bank on its outstanding loans and discounts with a ceiling of 5 per cent of the outstanding loans and discounts. The one-sixth-of-interest-collected formula was based upon the findings made by the Federal Deposit Insurance1956 U.S. Tax Ct. LEXIS 162">*165 Corporation as a result of a survey which it made which showed that the annual write-off for bad debts of banks covered by the survey equalled approximately one-sixth of interest collected by a bank.
On December 8, 1947, the Treasury approved a ruling of the Commissioner of Internal Revenue, Mim. 6209, published in 1947-2 C. B. 26, which dealt with the "reserve method of accounting for bad debts in the case of banks," and which established, inter alia, for years beginning after December 31, 1946, a ceiling for bad debt reserves, which ceiling was to be determined in the following way: The accumulated total at the close of any taxable year of a bank's reserve for bad debts was not to exceed three times the moving average ratio of net bad debt losses to loans and discounts (less fully insured loans) for a period of 20 years. In connection with the preparation of its returns for the taxable years 1949, 1950, and 1951, petitioner knew that Mim. 6209, for years beginning after December 31, 1946, established a ceiling for a taxpayer's reserve for bad debts as set forth above. However, in computing its 20-year moving average for each of the years 1949, 1950, 1956 U.S. Tax Ct. LEXIS 162">*166 and 1951, petitioner did not use its own experience for the years prior to 1940. Instead, petitioner used as a substitute for its own experience a "ratio as determined by the Research Department, Federal Reserve Bank of Chicago." The Commissioner has never consented to the petitioner's using a substituted bad debt experience.
As of December 31, 1948, petitioner's accumulated reserve for bad debts amounted to $ 52,737.60.
In its returns for the taxable years 1949 through 1951, the amounts added to petitioner's reserve for bad debts and the deductions taken for such additions to its reserve were as follows: 26 T.C. 537">*539
| Reserve for bad | |
| Year | debts deduction |
| 1949 | $ 15,434.11 |
| 1950 | 6,361.06 |
| 1951 | 1,590.67 |
The Commissioner disallowed entirely the bad debts reserve deductions set forth above.
The following schedule shows how the petitioner computed its addition to its bad debt reserve and its bad debt reserve deduction for 1949:
| Computation of Moving Average Ratio for Determination of Bad Debt Ceiling | ||
| at December 31, 1949: | ||
| Per cent of | ||
| net losses or | ||
| recoveries to | ||
| loans and | ||
| Year | Basis of percentage | discounts |
| 1930-1939 | For the ten year period 1930 to 1939, taxpayer has | |
| used the ratio as determined by the Research | ||
| Department, Federal Reserve Bank of Chicago | 16.79370 | |
| 1940-1949 | Taxpayer's total of individual ratios of bad debts | |
| to loans and discounts for the ten years | ||
| 1940 to 1949 | .14217 | |
| Total 20 years, 1930-1949 | 16.93587 | |
| Average of percentages (16.93587/20) | .84679% | |
| Determination of bad debt ceiling at December 31, 1948: | ||
| (1) Total all loans and discounts at 12/13/48 | $ 2,787,111.06 | |
| (2) Less: Fully insured loans (F. H. A.-Title II) | 245,814.02 | |
| (3) Net loans and discounts not fully insured | $ 2,541,297.04 | |
| (4) 20-year moving average as above | .84679 | |
| (5) Provision on basis of using moving average (3X4) | $ 21,519.45 | |
| Bad debt reserve ceiling at 12/31/49 (3X$ 21,519.45) | $ 64,588.35 | |
| Allowable deduction for year 1949 for addition to reserve: | ||
| Bad debt reserve ceiling as above | $ 64,558.35 | |
| Amount in reserve at 12/31/49 before any provision | 49,124.24 | |
| Permissible addition | $ 15,434.11 | |
| Actual amount added to reserve at 12/31/49 and taken as | ||
| a deduction | $ 15,431.11 |
1956 U.S. Tax Ct. LEXIS 162">*167 The petitioner computed its addition to the bad debt reserve for the year 1950 in the following manner:
| Computation of Moving Average Ratio for Determination of Bad Debt | ||
| Ceiling at December 31, 1950: | ||
| Per cent of | ||
| net losses or | ||
| recoveries to | ||
| loans and | ||
| Year | Basis of percentage | discounts |
| 1931-1939 | For the nine year period 1931 to 1939, taxpayer has | |
| used the ratio as determined by the Research | ||
| Department, Federal Reserve Bank of Chicago | 16.23054 | |
| 1940-1950 | Taxpayer's total of individual ratios of bad debts to | |
| loans and discounts for the eleven years 1940 to | ||
| 1950 | 0.31026 | |
| Total 20 years, 1931 to 1950 | 16.54080 | |
| Average of percentages (16.54080/20) (per cent) | .82704 | |
| Determination of bad debt ceiling at December 31, 1950: | ||
| (1) Total all loans and discounts at 12/31/50 | $ 3,198,522.03 | |
| (2) Less: Fully insured loans (F. H. A.-Title II) | 299,733.56 | |
| (3) Net loans and discounts not fully insured | $ 2,898,788.47 | |
| (4) 20-year moving average as above | .82704 | |
| (5) Provision on basis of using moving average (3 X 4) | $ 23,974.14 | |
| Bad debt reserve ceiling at 12/31/50 (3X$ 23,974.14) | $ 71,922.41 | |
| Allowable deduction for year 1950 for addition to reserve: | ||
| Bad debt reserve ceiling as above | $ 71,922.41 | |
| Amount in reserve at 12/31/50 before any provision | 65,561.35 | |
| Permissible addition | 6,361.06 | |
| Actual amount added to reserve at 12/31/50 and taken as a | ||
| deduction | $ 6,361.06 |
1956 U.S. Tax Ct. LEXIS 162">*168 26 T.C. 537">*540 The petitioner computed its addition to the bad debt reserve for the year 1951 in the following manner:
| Computation of Moving Average Ratio for Determination of Bad Debt | ||
| Ceiling at December 31, 1951: | ||
| Per cent of | ||
| net losses | ||
| to loans | ||
| Year | Basis of percentage | and discounts |
| 1932-1939 | For the eight year period 1932 to 1939, taxpayer has | |
| used the ratio as determined by the Research | ||
| Department, Federal Reserve Bank of Chicago | 14.92493 | |
| 1940-1951 | Taxpayer's total of individual ratios of bad debts to | |
| loans and discounts for the eleven years 1940 to | ||
| 1951 | .31012 | |
| Total 20 years, 1932-1951 | 15.23505 | |
| Average of percentages (15.23505/20) (per cent) | .76175 | |
| Determination of bad debt ceiling at December 31, 1951: | ||
| (1) Total all loans and discounts at 12/31/51 | $ 3,587,791.85 | |
| (2) Less: Fully insured loans (F. H. A.-Title II) | 351,419.19 | |
| (3) Net loans and discounts not fully insured | $ 3,236,372.66 | |
| (4) 20-year moving average as above | .76175 | |
| (5) Provision on basis of using moving average (3X4) | $ 24,653.07 | |
| Bad debt reserve ceiling at 12/31/51 (3X$ 24,653.07) | $ 73,959.18 | |
| Allowable deduction for year 1951 for addition to reserve: | ||
| Bad debt reserve ceiling as above | $ 73,959.18 | |
| Amount in reserve at 12/31/51 before any provision | 72,368.51 | |
| Permissible addition | $ 1,590.67 | |
| Actual amount added to reserve at 12/31/51 and taken as | ||
| a deduction | $ 1,590.67 |
1956 U.S. Tax Ct. LEXIS 162">*169 26 T.C. 537">*541 The total net amounts of petitioner's outstanding loans and discounts, after fully guaranteed loans, from 1928 through 1951, the amounts of its reserve for bad debts at the end of each of the years 1942 through 1951, the amounts of its net bad debts at the end of the years 1942 through 1951, are set forth in joint Exhibit 1-A. That joint exhibit is incorporated herein by this reference.
The total net amounts of petitioner's outstanding loans and discounts, after fully guaranteed loans, at the end of each of the years 1948 through 1951, were as follows:
| 1948 | $ 2,434,419.89 |
| 1949 | 2,541,297.04 |
| 1950 | 2,898,788.47 |
| 1951 | 3,236,372.66 |
During 1949 through 1951, the classes of petitioner's outstanding loans were personal loans, commercial loans, real estate mortgages, and F. H. A.-Title I loans.
For the 20-year period ended December 31, 1949, the amount of outstanding loans, less fully guaranteed loans, on petitioner's books as of the close of each calendar year was the total sum of $ 16,433,689.63. During the same period the petitioner's actual net loss from bad debts (losses minus recoveries) was the total sum of $ 19,235.65, and the percentage of actual loss experienced1956 U.S. Tax Ct. LEXIS 162">*170 was .117. The net loans and discounts (outstanding loans and discounts less fully guaranteed loans) at the close of the calendar year 1949 was $ 2,541,297.04. An accumulation in the reserve for bad debts of an amount equal to three times the 20-year moving average loss rate applied to the net outstanding loans and discounts would be $ 27,224.92 as at December 31, 1949
The reserve for bad debts on the petitioner's books as at December 31, 1949, was $ 49,124.24 before any additions to said reserve for bad debts was made for that year.
During 1949, the petitioner's actual bad debt experience was that its bad debts exceeded recoveries by the amount of $ 3,616.36.
26 T.C. 537">*542 For the 20-year period ended December 31, 1950, the amount of outstanding loans, less fully guaranteed loans on the petitioner's books as of the close of each calendar year, was the total sum of $ 19,041,129.48. During the same period the petitioner's actual net loss from bad debts (losses minus recoveries) was the total sum of $ 17,296.81, and the percentage of actual loss experienced was .091. The net loans and discounts (outstanding loans and discounts less fully guaranteed loans) for the calendar year 1950 was1956 U.S. Tax Ct. LEXIS 162">*171 $ 2,898,788.47. An accumulation in the reserve for bad debts of an amount equal to three times the 20-year moving average loss rate applied to the net outstanding loans and discounts would be $ 29,567.64 as at December 31, 1950.
The reserve for bad debts on the petitioner's books as at December 31, 1950, was $ 65,561.35 before any additions to said reserve for bad debts was made for that year.
During the year 1950, the petitioner's actual bad debt experience was that it had a net recovery of bad debts in the amount of $ 1,003.
For the 20-year period ended December 31, 1951, the amount of outstanding loans, less fully guaranteed loans, on petitioner's books as of the close of each calendar year was the total sum of $ 21,872,510.37. During the same period the petitioner's total net loss from bad debts (losses minus recoveries) was the total sum of $ 16,118.37, and the percentage of actual loss experienced was .074. The net loans and discounts at the close of the calendar year 1951 (outstanding loans and discounts less fully guaranteed loans) was $ 3,236,372.66. An accumulation in the reserve for bad debts of an amount equal to three times the 20-year moving average loss rate applied1956 U.S. Tax Ct. LEXIS 162">*172 to the net outstanding loans and discounts would be $ 32,040.09 as at December 31, 1951.
The reserve for bad debts on the petitioner's books as at December 31, 1951, was $ 72,368.51 before any additions to and reserve for bad debts was made for that year.
During the year 1951, the petitioner's actual bad debt experience was that it had a net recovery of bad debts in the amount of $ 456.10.
During the year 1952, the petitioner's actual bad debt experience was that it had a net loss of bad debts in the amount of $ 1,845.03.
During the year 1953, the petitioner's actual bad debt experience was that it had a net recovery of bad debts in the amount of $ 450.61.
The ceiling for the years 1949, 1950, and 1951, based upon the actual experience of the bank, would be in the respective amounts of $ 27,224.92, $ 29,567.64, and $ 32,040.09.
OPINION.
It is provided in section 23 (k) (1) of the 1939 Code that deduction may be taken for debts which become worthless within a taxable year, "or (within the discretion of the Commissioner) 26 T.C. 537">*543 a reasonable addition to a reserve for bad debts." The petitioner, with permission of the Commissioner, changed from the specific charge-off method of treating1956 U.S. Tax Ct. LEXIS 162">*173 its bad debts for income tax purposes to the reserve for bad debt method in 1942. In C. P. Ford & Co., Inc., 28 B. T. A. 156, 158, 159, this Court pointed out that if a taxpayer chooses to use the reserve for bad debt method of dealing with its bad debts, he subjects himself to the reasonable discretion of the Commissioner. We pointed out, further, that the statutory provision, referring to the discretion of the Commissioner, seems to have placed strong emphasis upon the presumption that the Commissioner's exercise of his discretion in allowing or disallowing an addition to a bad debt reserve is reasonable. Ordinarily, at any rate, the Commissioner's determination is prima facie correct and the taxpayer has the burden of proving error in the Commissioner's determination.
In this case, for the years 1949, 1950, and 1951, the Commissioner has applied the provisions of his ruling, Mim. 6209, 1947-2 C. B. 26, to petitioner. That ruling is declaratory of the Commissioner's position with respect to reasonable annual additions to reserves for bad debts by banks in general. The provisions of Mim. 6209 are lengthy and to avoid 1956 U.S. Tax Ct. LEXIS 162">*174 the task of reproducing it in full here we make reference to it in its entirety. However, paragraphs 2 and 3 thereof are particularly in point in considering the issue presented here and we therefore quote the pertinent parts of those two paragraphs which are as follows:
2. In determining a reasonable annual addition to a reserve for bad debts by a bank it is believed to be fair and sufficiently accurate to resort to the average annual bad-debt loss of the bank over a period of 20 years, to include the taxable year, as constituting a representative period in the bank's history and to accept the equivalent percentage of presently outstanding loans as indicative of the probable annual accruing loss. * * * However, such reserve can not be permitted to accumulate indefinitely simply because of the possibility that at some future date large losses may be concentrated within a relatively short period of time and operate to absorb the greatest probable reserve. To permit this would sanction the deduction of a mere contingency reserve for losses, which is not an allowable deduction for income or excess profits tax purposes. This latter rule makes imperative the imposition of some reasonable1956 U.S. Tax Ct. LEXIS 162">*175 ceiling on the accumulation of the reserve other than such indefinite limitation as might eventually prevail under a moving average method.
3. The Bureau has accordingly approved the use by banks of a moving average experience factor for the determination of the ratio of losses to outstanding loans for taxable years beginning after December 31, 1946. Such a moving average is to be determined on a basis of 20 years, including the taxable year, as representing a sufficiently long period of a bank's experience to constitute a reasonable cycle of good and bad years. The percentage so obtained, applied to loans outstanding at the close of the taxable year, determines the amount of permissible reserve in the case of a bank changing to the reserve method in such year * * * and the minimum reserve which the taxpayer will be entitled to maintain in future years * * *. A bank, following a change to the reserve 26 T.C. 537">*544 method of accounting for bad debts, may continue to take deductions from taxable income equal to the current moving average percentage of actual bad debts times the outstanding loans at the close of the year, or an amount sufficient to bring the reserve at the close of the1956 U.S. Tax Ct. LEXIS 162">*176 year to the minimum mentioned above, whichever is greater. Such continued deductions will be allowed only in such amounts as will bring the accumulated total at the close of any taxable year to a total not exceeding three times the moving average loss rate applied to outstanding loans.
It is clear that under the Commissioner's ruling, Mim. 6209, supra, a bank is required to use its own experience in determining its 20-year moving average loss rate, unless it does not have a 20-year experience of its own. First National Bank of La Feria, 24 T.C. 429, 432. Petitioner is not a new bank. Petitioner has a 20-year experience of its own. Petitioner has never received the Commissioner's consent to use a substituted bad debt experience of another bank or of other banks. In making his determinations, which have given rise to the deficiencies, the Commissioner has used petitioner's own 20-year experience in applying the provisions of Mim. 6209.
The questions are: First, whether petitioner must use its own experience in determining additions to its reserve for bad debts rather than the experience of other banks represented by the ratio determined by the1956 U.S. Tax Ct. LEXIS 162">*177 Federal Reserve Bank of Chicago. If the respondent is sustained on the first question, the second question is whether the petitioner is entitled to a deduction in any amount in each of the years 1949-1951, inclusive, for addition to its bad debt reserve.
The only reason advanced by petitioner for its contention that it should be allowed to substitute for its own experience what it calls "the ratio as determined by the Research Department, Federal Reserve Bank of Chicago" is that the new management of the bank under Kewley, who acquired the stock of the bank in 1939, instituted a new policy of liberality in making loans. There is a strong suggestion in the testimony of a witness for the petitioner, an accountant in the accounting firm which prepared petitioner's returns for the taxable years, that because of the change in the management of petitioner in 1939, petitioner is entitled to receive the status of a newly organized bank. Assuming this to be all or part of petitioner's theory, petitioner has failed to establish facts which support such theory and we therefore conclude that it is without merit. For example, there is no evidence in this case that petitioner expected large1956 U.S. Tax Ct. LEXIS 162">*178 losses; there is no evidence about the loss experience of any neighboring bank as compared with petitioner's experience. This Court rejected a similar argument in First National Bank of La Feria, supra.
The evidence shows that for the year 1949, the net bad debt loss of petitioner was $ 3,616.36; that for the year 1950, petitioner's experience showed a net recovery of bad debts in the amount of $ 1,003; and that 26 T.C. 537">*545 for the year 1951, petitioner's net recovery of bad debts amounted to $ 456.10. Petitioner has failed to prove that it is entitled to compute its bad debt reserve by use of a substituted bad debt experience of another bank or other banks.
This brings us to the second question, whether petitioner is entitled to any deduction in each of the taxable years for addition to its bad debt reserve; and whether the Commissioner's determinations are unreasonable, arbitrary, and an abuse of discretion.
On the basis of petitioner's actual 20-year experience, and under the method set forth in Mim. 6209, supra, petitioner's ceiling for the years 1949, 1950, and 1951, would be in the amounts of $ 27,224.92, $ 29,567.64, and $ 32,040.09, respectively. 1956 U.S. Tax Ct. LEXIS 162">*179 However, petitioner had accumulated a reserve for bad debts as of December 31, 1948, in the amount of $ 52,737.60. Petitioner's accumulated reserve at the end of 1948 was so greatly in excess of the permissive ceilings for 1949, 1950, and 1951, under Mim. 6209, supra, that it cannot be concluded that respondent's disallowance of any addition to the reserve for each of the taxable years was unreasonable or an abuse of his discretion. The petitioner has failed to establish that it is entitled to any deduction in each of the taxable years for addition to its reserve for bad debts.
The facts here are such as to bring petitioner squarely within the scope and purpose of the Commissioner's ruling, Mim. 6209. The ruling imposes a limitation upon the amount of the accumulation of the bad debt reserve. Petitioner's accumulated reserve at the end of 1948 already exceeded petitioner's ceiling. The Commissioner's determinations are sustained.
Decision will be entered for the respondent.