*1733 1. A taxpayer, keeping its accounts on an accrual basis, may not refuse to return, as uncollectible, all interest due it on average daily balances, where such interest was included in a running account to which credits and debits were constantly being made.
2. A taxpayer has made no election to take as deductions individual bad debts or reasonable additions to a reserve for bad debts until it has had occasion to take a deduction of one or the other.
3. Reasonable additions to a reserve for bad debts determined.
*1297 The above proceedings were consolidated. The Commissioner determined deficiencies in income tax as follows:
| Year | Docket No. | Deficiency |
| 1924 | 37162 | $6,935.87 |
| 1925 | 37162 | 18,236.25 |
| 1926 | 41600 | 23,056.48 |
| 1927 | 44828 | 18,232.45 |
With respect to the years 1924 and 1925, it is alleged that the respondent erred in refusing to allow as deductions debts ascertained to be recoverable only in part and charged off to the extent of $55,550.73 during the year 1924 and $100,000 during*1734 the year 1925, and, further, that the respondent has included in its gross income the amounts of $55,550.73 for the year 1924 and $69,688.83 for the year 1925 which were accrued upon its books as interest, but which were not collectible. With respect to the year 1926, it is alleged that the respondent erred in refusing to allow as a deduction the amount of $200,000 as an addition to the petitioner's reserve for bad debts and, further, that he has illegally included in the petitioner's gross income the amount of $105,589.60 representing interest which, although accrued upon its books, was and is uncollectible. For the year 1927 it is alleged that the respondent erred in refusing to allow as a deduction a net operating loss incurred in 1926 and further erred in including in the petitioner's gross income the amount of $105,033.56 as accrued interest an open account when such interest was uncollectible.
FINDINGS OF FACT.
The petitioner is a corporation, organized in 1914 under the laws of the State of Maine, and has its principal office at New York City, *1298 N.Y. Its business is that of cotton factor, financing cotton mills and selling their products. Its income is derived*1735 from dividends, commissions on sales, and interest on balances owed it by the mills. It kept its books of account on an accrual basis.
During the years in question it sold, inter alia, all the output of the Langley Mills, the Aiken Mills and the Seminole Mills, all South Carolina corporations. It owned approximately 60 per cent of the stock of the Langley Mills and approximately 75 per cent of the stock of the other two. These mills were run under the direction of the petitioner and it financed them during all the years in question.
The Langley Mills passed through a receivership in 1914 or 1915. The petitioner, having made advancements to it, received stock for its debts. After the receivership the petitioner made advancements to this mill for the purchase of cotton and for other operating expenses. Interest was charged on these advances and this item, its commissions and the money produced by the sales were handled on the petitioner's books in the following manner: The mill was charged with the advances, commissions and interest, and credited with the net amounts received from sales after deducting commissions and interest. Monthly statements of this account were*1736 rendered to the mill. The petitioner was credited with interest on balances owed by the mill and the mill was credited with interest on amounts collected from sales made prior to the end of the month. The rate of interest in all cases was 6 per cent. Interest was computed quarterly on average daily balances.
On the following dates the debit balances in the current account of the Langley Mills on the petitioner's books were:
| January 1, 1924 | $571,388.82 |
| December 31, 1924 | 905,694.85 |
| December 31, 1925 | 690,308.06 |
| December 31, 1926 | 709,947.24 |
| December 31, 1927 | 688,110.37 |
After 1923 the only credits to the above current account were from sales of the mill's product made by the petitioner.
The following amounts were entered as interest on the books of the petitioner and reported as income in connection with the account current of the Langley Mills:
| 1924 | $55,550.73 |
| 1925 | 69,708.70 |
| 1926 | 60,603.70 |
| 1927 | 58,766.72 |
The balance sheet of Langley Mills at December 31, 1924, showed assets of $2,513,936.80. Among the liabilities were capital stock $996,300 and bonded indebtedness of $600,000. These liabilities remained *1299 the same*1737 through the years 1925 to 1928, inclusive. The balance sheets for these years showed the following deficits:
| December 31, 1924 | $208,003.36 |
| December 31, 1925 | 289,402.98 |
| December 31, 1926 | 295,496.99 |
| December 31, 1927 | 333,679.16 |
| December 31, 1928 | 335,473.56 |
The gross sales of and the losses suffered by the Langley Mills as shown by its books were:
| Year | Sales | Losses |
| 1924 | $1,232,507.35 | 1 $294,940.47 |
| 1925 | 2,260,621.27 | 1 79,434.59 |
| 1926 | 2,229,654.60 | 1 6,720.37 |
| 1927 | 2,267,819.67 | 2 55,967.83 |
| 1928 | 2,407,060.53 | 2 1,029.40 |
The petitioner advanced money to the Aiken Mills for the same purposes as to the Langley Mills, sold all its product, and on its books entered charges and credits in the same manner as in its account with the Langley Mills. The debit balances of the current account of the Aiken Mills on the petitioner's books were as follows on the dates shown:
| December 31, 1924 | $75,315.00 |
| December 31, 1925 | 284,058.08 |
| December 31, 1926 | 501,489.85 |
| December 31, 1927 | 451,556.39 |
| December 31, 1928 | 624,586.48 |
The interest*1738 entered on the books of the petitioner as owed by the Aiken Mills was as follows for the following years:
| 1926 | $29,157.42 |
| 1927 | 30,856.27 |
The gross sales of and losses suffered by the Aiken Mills as shown by its books were:
| Year | Sales | Losses |
| 1924 | $634,111.67 | 1 $83,109.93 |
| 1925 | 687,918.71 | 1 99,720.21 |
| 1926 | 836,848.27 | 1 151,709.00 |
| 1928 | 1,091,222.10 | 1 3,863.68 |
In the year 1927 gross sales of this company amounted to $1,068,384.17 and the company made a net profit before providing for depreciation of $41,050.15.
*1300 The balance sheet of the Aiken Mills at December 31, 1924, showed assets of $1,171,154.45. Among the liabilities were capital stock of $304,200, which remained the same through the years 1925 to 1928, inclusive, and mortgage indebtedness of $400,000, which after March 1, 1925, was reduced at the rate of $20,000 each year until its amount on December 31, 1928, was $320,000. The balance sheets for these years showed surpluses as follows:
| December 31, 1924 | $267,166.48 |
| December 31, 1925 | 158,994.27 |
| December 31, 1926 | 3,115.83 |
| December 31, 1927 | 44,166.16 |
| December 31, 1928 | 40,382.48 |
*1739 In April, 1929, the petitioner sold all of its stock in and all of the indebtedness due it from the Langley Mills, the Aiken Mills and the Seminole Mills. The purchase price was determined by the net worth of the property of the mills. On this sale the petitioner recovered nothing on its stock in the Langley and Aiken Mills; it lost on its current balance against the Langley Mills a little over $413,000; it lost on its current balance against the Aiken Mills a little over $216,000; and it received all of its debt against the Seminole Mills and a profit on its stock.
On December 3, 1924, the petitioner's board of directors adopted the following resolution:
RESOLVED, that in view of the heavy debt of The Langley Mills to this Company (now in the neighborhood of $950,000.) and in view of the present condition of trade and the apparent impossibility of obtaining any payment on account of this debt, it is further
RESOLVED, that the amount of interest accrued and accumulated on this debt during the calendar year 1924 and amounting to $55,550.73 be set aside in the account "Reserve for Bad Debts and Contingencies."
On January 29, 1926, the petitioner's board of directors adopted*1740 the following resolution:
RESOLVED, that in view of the heavy debt of The Langley Mills to this Company (now in the neighborhood of $700,000) and in view of present demoralized condition of trade and the apparent impossibility of obtaining any permanent reduction on account of this debt, it is further
RESOLVED that the sum of $100,000 be set aside in the account "Reserve for Bad Debts and Contingencies."
On March 31, 1927, the petitioner's board of directors adopted the following resolution:
RESOLVED, that the action of the officers in setting up a special reserve for contingencies, etc. of $200,000, taken in connection with the debt of The Aiken Mills to W. H. Langley & Co. is hereby ratified and confirmed. Also in view of prevailing uncertain conditions in the trade, it is the judgment of the directors that this Company set aside at all times a reserve at least equal to the debt on the plant of the Mills.
*1301 There was on the petitioner's ledger on December 31, 1919, an account entitled "Reserve for Bad Debts." To this account certain credits and debits were made. Two items of $6,000 each were credited in 1923 and an item of $55,550.73 (the amount mentioned*1741 in the resolution of December 3, 1924) was credited in 1924. Although additions were made to this reserve in 1921 and 1922, no deductions were taken by the petitioner in its income-tax returns for these years, either for additions to its reserve or for specific bad debts. In its return for 1923 it took as a deduction under the heading bad debts, the sum of $12,000 which it had added to its reserve in that year and in its return for 1924 it took as a deduction the sum of $55,550.73 the amount above set forth. The latter deduction the respondent disallowed. On June 30, 1925, the total credits to this reserve amounted to $124,373.02, and to this was added during the remaining part of that year the sum of $6,000. In March and June, 1926, two credits of $3,000 each were added, so that the total credits on June 30, 1926, amounted to $136,373.02. About this time the title of this account was changed to "Reserve for Bad Debts and Contingencies" and from that time that account appears as follows:
| Date | Folio | Debits | Date | Folio | Credits |
| 1926 | 1926 | ||||
| Dec. 31 | 79 | $12,072.36 | June 30 | 26 | $136,373.02 |
| Sept. 30 | 72 | 3,000.00 | |||
| Dec. 31 | 77 | 3,000.00 | |||
| Do | 79 | 12,072.36 | |||
| Mar. 31 | 82 | 3,000.00 | |||
| June 30 | 89 | 3,000.00 |
*1742 On December 31, 1925, there was opened an account entitled "Special Reserve for Bad Debts & Contingencies." To this was credited on that date the amount of $100,000 and on December 31, 1926, there was credited the further sum of $200,000, these being the only credits to this account. In its return for 1925 it took a deduction of $100,000. In its return for 1926 it took a deduction of $200,000. The respondent disallowed these deductions and added them to income.
In its return for 1927 it did not report interest which it had accrued on its books against Langley Mills, Seminole Mills and Aiken Mills in the total amount of $105,033.56, but attached to its return a statement that it had accrued such interest but did not return it for the reason that such interest was uncollectible.
In its income-tax return for 1926 the petitioner reported a net loss of $30,151.29. To this the respondent added:
| Reserve for contingencies | $200,000.00 |
| Taxes applicable to prior years | 637.51 |
| Refund from Aiken County | 432.22 |
| Total additions | 201,069.73 |
*1302 From this total he deducted depreciation in the amount of $129.70, leaving adjusted net income in the amount of*1743 $170,788.74, upon which he determined the deficiency as above set forth.
For the year 1927 the petitioner reported net income in the amount of $36,546.76. To this the respondent added "Net Loss," $30,151.29, and "Interest," $105,033.56, and granted a deduction for depreciation of $129.70, thus determining net taxable income of $171,601.91, on which he determined the deficiency above set forth.
The following amounts are reasonable additions to a reserve for bad debts for the years shown:
| 1924 | $25,000 |
| 1925 | 50,000 |
| 1926 | 75,000 |
| 1927 | 50,000 |
OPINION.
MURDOCK: The petitioner makes two alternative contentions in regard to the years 1924 and 1925. One, that certain interest was not income, because uncollectible; and the other, that, if the interest is to be included in gross income, then certain amounts, representing parts of debts ascertained to be recoverable only in part and charged off to that extent, should be allowed as deductions. The first contention is also made for the years 1926 and 1927, and for 1926 the alternative is that a $200,000 addition to a reserve for bad debts should be allowed as a deduction.
*1744 In support of its first contention the petitioner relies upon a principle announced by this Board, that a taxpayer, even though it accrues an item on its books as income, need not report the item for income-tax purposes, if, at the end of the year, there is no reasonable expectation of its ultimate receipt. ; ; . See also . But, obviously, this rule has no application where the taxpayer has not only accrued, but has actually received, the item, even though advances by the taxpayer to the debtor made the receipt possible. . Here, the petitioner must have received a part and may have received all of the interest items in question. The evidence is not very clear on this point, but apparently the interest items were charged against the mills in continuing accounts. Other items were also charged to these accounts; as goods were sold for the mills, the proceeds of the sales were credited*1745 to the account; and the accounts showed certain debit balances at the end of the years in controversy. The general rule is that payments should be applied to *1303 interest rather than principal. But in any event, the evidence does not show that the interest items in controversy were uncollectible at the end of the appropriate years. The first contention does not present the proper solution of the problem.
The petitioner's right to a deduction in any of these years depends upon whether or not the proven facts are sufficient to apply sections 234(a)(5) of the Revenue Acts of 1924 and 1926, which allow as deductions:
Debts ascertained to be worthless and charged off within the taxable year (or in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts); and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt to be charged off in part.
The Commissioner's Regulations 64 and 69, articles 561 and 151, relating to the above provisions, require that a taxpayer must elect in 1921 or in the first year thereafter for which it files a return which method (specific debts or reserve) it will follow, and follow*1746 that method until it secures the Commissioner's permission to change to the other. The Board has held that these requirements of the regulations are proper. . The petitioner claimed no deduction for bad debts in 1921 or in 1922. But in 1923 it made its election by claiming a deduction for an addition to a reserve for bad debts. Cf. . So far as we have been informed it has never requested or received permission to change. Therefore, an addition to a reserve is the only method available to the petitioner. Yet, in 1924 and 1925 it claimed the right to deduct certain amounts, $55,550.73 and $100,000, respectively, representing in each case an alleged partial charge-off of a specific debt which it claims it ascertained was recoverable only in part. It does not claim, by any issue raised in the pleadings, to be entitled to deduct in these years any amount as a reasonable addition to a reserve. Only for 1926 does it claim the right to deduct a certain amount as a reasonable addition to a reserve for bad debts.
The facts in regard to the various charge-offs and reserves add to*1747 the confusion on this point as it is presented to the Board. The petitioner has had on its books since 1919 an account entitled "Reserve for Bad Debts"; the name of the account was changed at some time; additions were made as before; but never, except in 1923, was a deduction claimed on its return representing additions to this reserve. In 1924 an item of $55,550.73 was credited to this account. On December 31, 1926, a new concurrent account was opened, entitled "Special Reserve for Bad Debts and Contingencies," with an opening credit of $100,000. On December 31, 1926, there was credited to this account the additional amount of $200,000. No addition was made in or for 1927. We have laboriously discovered the above facts *1304 from certain ledger accounts offered in evidence without explanation. Obviously, from the present viewpoint these reserve accounts appear to have been inartificially designed.
Can we, perhaps in spite of what has been done and claimed on the part of the petitioner, give any relief by way of a deduction representing a reasonable addition to a reserve for bad debts? The evidence indicates that some additions to a reserve for bad debts would be proper, *1748 but on the question of a reasonable amount it is extremely weak. The $55,550.73 amount was used merely because that was the amount of interest due from the Langley Mills for 1924. No other justification for the use of this particular amount has been suggested. The $100,000 and $200,000 additions for 1925 and 1926 are, so far as the record discloses, merely arbitrary amounts decided upon by the officers of the petitioners. Had they been multiplied or divided by two there would be as much but no more basis in the record for their use. We do not know why these figures were selected, or why they might or might not be reasonable in amount for the purpose of the case. The two mills were losing money. The use for the products of the Langley Mills was becoming less and the petitioner was having difficulty in finding purchasers. The petitioner's officers believed that certain assets of the mills were overvalued on the books and that the debit balances owed the petitioner would never be collected in full. The petitioner continued to make advances for various purposes, including the purchase of new machinery, but this is not so puzzling in view of the facts that the petitioner owned*1749 stock in the mills, depended upon them for products, and had already large amounts due from them. An addition must be reasonable in the light of what was known in the taxable years. Thus, the loss from the sale in 1929, unless foreseen, is not a proper measure of reasonableness. We have determined what in our opinion were reasonable additions to the reserve in the light of all of the circumstances and urged by the desirability, if not the necessity, of fixing upon some certain amounts. Despite the pleadings, these additions may be taken as deductions for the respective years.
Judgment will be entered under Rule 50.