Decisions will be entered under Rule 50.
1. Income -- Bad Debt Reserve -- Restoring Unneeded Balance to Income. -- A balance in a reserve for bad debts, built up by additions which offset taxable income, is properly to be restored to income of the year in which the need for maintaining the reserve ceases, a year prior to the year here in question.
2. Excess Profits -- Abnormal Income -- Attributable to Other Years. -- Regardless of whether certain income formed a class within the meaning of
*96 The Commissioner determined the following deficiencies for the calendar year 1940:
| Declared | Excess profits | ||||
| Docket | Income tax | value excess | tax | Penalty | |
| No. | profits tax | ||||
| Geyer, Cornell & | |||||
| Newell, Inc | 1019 | $ 11,933.00 | $ 37,586.62 | ||
| The Geyer Co | 1188 | 12,229.72 | $ 2,619.18 | 927.75 | $ 231.94 |
He also determined that Mary A. Geyer (Docket No. 1185), Mercedes G. Geyer (Docket No. 1186), and Bertram B. Geyer (Docket No. 1187), were liable as transferees of the Geyer *312 Co. (hereinafter referred to as Geyer) for amounts due from it. The liability of these three petitioners for any amounts due from Geyer has been stipulated. *97 Both corporations assign as error the action of the Commissioner in adding to income $ 48,942.88 representing a reserve for bad debts. Geyer, Cornell & Newell, Inc. (hereinafter referred to as G. C. N.) also contends that it received a "class" of income from advertising Nash automobiles, this income was abnormal, and a part was attributable to other years under
FINDINGS OF FACT.
Geyer is an Ohio corporation, organized in 1912. It conducted an advertising agency business until June 30, 1935. G. C. N. is a New York corporation, organized in 1926. It has conducted an advertising agency business from the date of its incorporation until the present time. Geyer or its stockholders owned all of the outstanding voting stock of G. C. N. Both corporations have *313 kept their books and filed their tax returns for calendar years upon an accrual method of accounting.
Geyer filed its return for the calendar year 1940 with the collector of internal revenue for the first district of Ohio. G. C. N. filed its return for 1940 with the collector of internal revenue for the third district of New York.
Geyer sold its business to G. C. N. for cash on July 1, 1935, but retained some assets including securities, cash, notes, and accounts receivable. Geyer did not operate as an advertising agency after July 1, 1935.
Geyer contracted with publishers for advertising space in advance of the date of publication. Amounts involved were large and the space was not transferable. Payment for this advertising was due from Geyer on a fixed date. Geyer sent a bill to its client, which bill was due prior to the date upon which Geyer had to pay the publisher. The bill which Geyer sent to its client was for an amount equal to the gross charge of the publisher for the advertising space. Geyer, however, paid the publisher a lesser amount after deducting a discount of 15 percent, and this discount represented Geyer's profit. Delinquency or default occurred on the part of a *314 few clients. G. C. N. used the same method.
Geyer adopted a reserve method of treating bad debts of clients on its books and its income tax returns. Additions to this reserve were claimed as deductions on its income tax returns for years prior to 1934. These additions represented a small percentage of sales to or of amounts due from clients. They bore no relation to other receivables, *98 if any. Deductions of additions to the reserve were allowed by the Commissioner. They offset income otherwise taxable. The reserve amounted to $ 49,093.52 at the close of 1933. No further additions to the reserve were made and deducted thereafter. Accounts then due from clients amounted to $ 52,819.75. Small amounts were charged to the reserve up to the end of June 1935, at which time the balance amounted to $ 48,961.64. All accounts receivable from clients had been paid by the close of 1935 except for an account in the amount of $ 61.58. This latter account was closed on December 19, 1938, by the receipt of $ 11.49 in cash, cancellation of a claim of a publisher in the amount of $ 31.33, and a charge against the reserve of the balance of $ 18.76. This reduced the balance in the account to *315 $ 48,942.88 at which it remained until December 1940, when Geyer transferred all of its assets to G. C. N. and dissolved.
G. C. N., after acquiring all of the advertising agency business on July 1, 1935, had insufficient assets to provide the necessary credit with publishers and Geyer therefore guaranteed its accounts payable to publishers. Geyer also on at least two occasions advanced money to G. C. N.
Representatives of the Bureau of Internal Revenue were acquainted at all times material hereto with the true situation in regard to the various accounts of Geyer and its guarantee of certain accounts payable of G. C. N. Representatives of Geyer, in discussions with agents of the Bureau of Internal Revenue up to 1940, stated that Geyer needed the reserve of about $ 48,000 because it might be compelled to make payments on its guarantee of the obligations of G. C. N. to publishers.
Geyer and G. C. N. entered into an agreement on December 18, 1940, whereby Geyer agreed to transfer all of its assets to G. C. N. in exchange for 400 shares of the voting common stock of G. C. N. and the assumption by G. C. N. of all of the liabilities of Geyer. One of the purposes of this agreement was to provide *316 G. C. N. with sufficient capital of its own to carry on its business. This agreement was carried out and, pursuant to the plan, Geyer immediately distributed the 400 shares of G. C. N. stock pro rata to its stockholders in complete liquidation and in redemption of their shares of Geyer stock. Geyer was dissolved on December 23, 1940. Among the assets of Geyer at the time of the above transfer was an account receivable due from G. C. N. in the amount of $ 152,024.84. G. C. N., after the transfer, charged this amount to its account payable to Geyer, closing that account. The amount of the balance in Geyer's reserve account for bad debt due from clients, $ 48,942.88, was entered on the books of G. C. N. at the date of the transfer and has remained there without change material hereto. G. C. N. was not permitted to use, and did not use, a reserve method for bad debts, but used the direct charge-off method. The closing balances *99 of G. C. N.'s accounts receivable from clients for the years 1935 through 1940 ranged from about $ 57,000 to $ 264,000. Geyer never had to make good on its guarantee of the accounts of G. C. N. to publishers.
The Commissioner, in determining the deficiencies, *317 included the amount of $ 48,942.88 in the income of Geyer, upon the ground that the need for the reserve ceased in 1940, and also included it in the income of G. C. N. upon the ground that it was realized in the extinguishment of G. C. N.'s debt to Geyer.
G. C. N., like most advertising agencies, accepted only one client for each type of product to be advertised. It had about 15 clients during 1940. Nash-Kelvinator Corporation (hereafter called Nash), was one of its principal clients in 1940. It has furnished advertising for Kelvinator refrigerators since 1935 and for Nash automobiles since 1937. It keeps a separate account for each client and, in the case of Nash and another client, a separate account for each of the two products advertised. Advertising different products for different clients requires the use of different skills and experience to solve the different problems presented. Specialists in advertising a particular product or group of products are employed. A group doing certain parts of the work on Nash automobile advertising was separate from groups doing similar special work on other products. G. C. N. had never advertised automobiles before it obtained the Nash *318 automobile account and it had to bring in some new employees experienced in advertising automobiles.
Nash employed a fiscal year ending September 30, and shortly after that date brought out the new model automobiles for the next year For example, the 1941 models were brought out in the fall of 1940. The advertising work for each new model was performed during a twelve-month period beginning on April 1 preceding the date on which the new model appeared. Income from advertising this model was realized in the twelve months beginning in October, about the time that the new model appeared.
The following table shows the income and expense of the Nash automobile account for certain twelve-month periods:
| Income | Expense | |||
| Year | ||||
| Calendar year | Year ended | Year ended | ||
| Sept. 30 | Calendar year | Mar. 31 | ||
| 1936 | None | |||
| 1937 | $ 128,496.00 | |||
| 1938 | 212,754.73 | |||
| 1939 | 294,239.19 | |||
| 1940 | 324,283.60 | 1 $ 283,334.36 | $ 154,670.86 | 3 $ 123,370.98 |
| 1941 | 295,520.19 | 2 351,654.96 | 158,127.19 | 4 153,746.05 |
*100 G. C. N. has paid excess profits *319 tax for 1940 and has filed a timely claim for refund of $ 7,644.48 thereof.
The Commissioner, in determining the deficiency against G. C. N., allowed no deduction for abnormal income attributable to other years.
The stipulation of facts is incorporated herein by this reference.
OPINION.
The only issue for decision in the case of Geyer is whether it realized income in 1940 of $ 48,942.88, an amount which appeared on its books as a reserve for bad debts. The Commissioner has held and contends that this amount, having been deducted from income in prior years, must be restored to income for 1940 because the need for the reserve ceased in that year. The amount in question was built up through additions to the reserve which were deducted from income in years prior to 1934. A reserve consists of entries upon books of account. It is neither an asset nor a liability. It has no existence except upon the books, and, unlike an asset or a liability, it can not be transferred to any other entity. Reserves are set up for various business purposes. They offset assets, either specifically or generally. Not all reserves are recognized for income tax purposes. The only one mentioned in
The Commissioner argues that the need for this reserve *321 ceased in 1940, while the petitioners contend that it ceased prior to that year. The evidence shows that the petitioners are right. The reserve was set up prior to 1934 solely for the purpose of covering accounts receivable due from the clients of Geyer while it was engaged in the advertising business. Geyer, in 1935, permanently discontinued its *101 advertising business and collected all of its accounts receivable from clients except for $ 61.58. The account for $ 61.58 was closed in 1938. Thus, the balance in the reserve should have been restored to income long prior to 1940.
The president of Geyer and G. C. N. were debtors of Geyer after 1935. The respondent concedes that the amount owed by its president can not be regarded as justification for continuing the reserve, but he seems to think that the amount due from G. C. N. might justify the reserve after 1935. The reserve was almost as large as this debt in 1935. The evidence is clear that the reserve never related to any amount due from G. C. N. and can not be supported upon that basis any more than on the basis of the loan to the president. Neither could its restoration to income be deferred upon the theory that it was a *322 reserve for Geyer's contingent liability upon its guarantee of the liability of G. C. N. to publishers in connection with the advertising business conducted by G. C. N. Such a reserve, no matter how prudent, is not recognized for Federal income tax purposes and does not prevent immediate restoration of a reserve to income.
The Commissioner argues briefly *323 that, if the amount is not income in 1940 to Geyer, it was income of G. C. N. for that same year. This argument seems to be that income of G. C. N. resulted from the fact that one of the assets of Geyer transferred in 1940 to G. C. N. was a debt due to Geyer from G. C. N. offset by this reserve. He frankly states that he does not think the argument is sound, and we agree. The reserve was not related to the G. C. N. debt and did not affect it in the transfer. It did not benefit G. C. N. in any way. The Commissioner erred as to this item.
The principal question in the case of G. C. N. is whether it is entitled to a deduction of $ 65,742.57, representing abnormal income of 1940 attributable to other years, in computing its excess profits tax. It contends that its income from advertising Nash automobiles is a "class" *102 of income within the meaning and intendment of the definition of abnormal income in
Abnormal income is defined in
The following excerpts are from Committee on Ways and Means Report No. 146, 77th Congress, 1st session, pp. 1-3, on the Excess Profits Tax Amendments of 1941:
* * * These purposes [of the excess profits tax provisions of the Second Revenue Act of 1940] were, first, to *325 provide additional revenue urgently needed to help meet the costs of the national-defense program, and second, to prevent the rearmament program from furnishing an opportunity for the creation of new war millionaires or the further substantial enrichment of already wealthy persons.
In view of these compelling motives, the provisions of that act lay a tax upon that portion of the earnings of corporations determined to be excess profits. The tax rates provided, or even higher rates, are thoroughly justified if the income subject thereto is clearly of the type intended to be reached. At the same time, equitable considerations demand that every reasonable precaution be taken to prevent unfair application of the tax in abnormal cases. The weight of the burden imposed carries with it a commensurate need for restricting its application to the cases for which it was designed.
* * * *
Experience with excess-profits taxes, both in the United States and abroad, has demonstrated conclusively that relief in abnormal cases cannot be predicated on specific instances foreseeable at any time. The unusual cases that are certain to arise are so diverse in character and unpredictable that relief provisions *326 couched in other than general and flexible terms are certain to prove inadequate.
For these reasons, the present legislation attempts to provide, both by specific terms and in carefully guarded general terms, a set of flexible rules which should alleviate at least the bulk of the severe hardship cases which may arise. The success or failure of legislation of this type depends, to a considerable degree, upon its intelligent and sympathetic administration. Through its confidence in the experience and ability of the officials of the Treasury Department and the Bureau *103 of Internal Revenue, your committee recommend the present flexible and broad legislation as the most satisfactory method of meeting the contingencies that will arise.
The evidence shows that the services furnished by the petitioner in advertising one commodity were different from those which it furnished in advertising another. E. R. Squibb & Son, for which G. C. N. advertised drugs, obtained from G. C. N. services which differed from those obtained by Nash for its automobiles. The Nash-Kelvinator advertising differed from the Nash motors advertising. Perhaps separate classification of the income from every one of the *327 separate accounts of G. C. N. is proper for the purpose of
The gross income of this class for 1940 was in excess of 125 per centum of the average of this class of income for the four preceding years. This results principally from the fact that 1940 was the best year for this account, and, since the account was not obtained until some time in 1937, there was no 1936 income of this class to support the average. Thus, it appears from the mathematics prescribed in the law, that the petitioner had "abnormal income" from this source and the "net abnormal income" amounted to $ 65,742.26. This necessarily follows, once the automobile income is recognized as a separate class. We can not learn from the legislative history of the law nor can we imagine any reason why Congress would want *328 to relieve this income of this petitioner from the excess profits tax. It was not abnormal in any ordinary sense of that word. It was just the result of a good year in a relatively new account. Nevertheless, Congress has given a rigid definition of abnormal income and this comes within it, once the classifications is accepted.
However, the taxpayer gets no deduction unless the net abnormal income or some part of it is properly attributable to other years under
The petitioner suggests that guidance can be obtained from section 30.721-8 of the regulations, which provides that income within
It should be remembered, however, that the "net abnormal income" in question does not relate to the income from advertising the 1940 model, but relates to the income of the calendar year 1940 which includes a part of the income from advertising the 1940 model and also a part of the income from advertising the 1941 model. The petitioner also suggests that it might be entitled to a similar shift of income under sections 42 and 43 in order to reflect income clearly. This latter suggestion serves to draw greater attention *331 to the obvious fallacy in the petitioner's entire theory of allocation. If some income of 1940 should be shifted to 1939 because some of the expenses of earning that income were incurred in 1939, then a similar shift of 1941 income to 1940 would have to be made for exactly the same reason in order to avoid a distortion of income for 1939. A distortion would always result in such a case if parallel treatment were not adopted as to both ends of each year. The reasons for making the one shift would apply equally to the other. *105 The above principles also apply for excess profits tax purposes. The petitioner's excess profits tax net income for 1940, which includes some income from the 1940 model and also some income from the 1941 model, is determined after deducting all expenses incurred in 1940. Those expenses include a large percentage of the total expenses incident to the 1941 model.
The administration of
Decisions will be entered under Rule 50.
Footnotes
1. Proceedings of the following petitioners are embraced in this report: Mary A. Geyer, Mercedes G. Geyer, Bertram B. Geyer, and The Geyer Company.↩
1. $ 105,708.27 was accrued in 1939 and the balance in 1940.↩
3. $ 91,833.19 was accrued in 1939 and the balance in 1940.↩
2. $ 146,657.51 was accrued in 1940 and the balance in 1941.↩
4. $ 123,133.07 was accrued in 1940 and the balance in 1941.↩