Opinion
Docket No. 2599.
1946-08-26
THE HECHT COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
I. Herman Sher, Esq., and R. A. Bartlett, Esq., for the petitioner. Paul E. Waring, Esq., for the respondent.
Petitioner, having established its eligibility, elected under section 736(a) of the Internal Revenue Code to compute, for excess profits tax purposes, its income from installment sales on the accrual basis in lieu of the installment basis provided by section 44(a). During the taxable year ended January 31, 1941, certain installment accounts receivable arising out of sales made prior to February 1, 1940, became worthless and were charged off. In addition petitioner incurred collection expenses during the taxable year in connection with collections of installments arising out of pre-1940 sales. Held, respondent's regulation, in so far as it denies to installment basis taxpayers electing under section 726(a) any deductions (including deductions for bad debts) on account of pre-1940 sales, is invalid; held, further, petitioner is entitled to a bad debt deduction in the amount of its unrecovered cost of goods represented in the pre-1940 installment accounts receivable charged off in the taxable year, Mackin Corporation, 7 T.C. 648; and petitioner is also entitled to deduct the collection expenses incurred during the taxable year in connection with installment accounts receivable arising out of pre-1940 sales. I. Herman Sher, Esq., and R. A. Bartlett, Esq., for the petitioner. Paul E. Waring, Esq., for the respondent.
This proceeding involves petitioner's excess profits tax liability for the fiscal year ended January 31, 1941. Respondent originally determined a deficiency in the amount of $109,611.71. By amended answer he asked an additional deficiency in the amount of $163,162.33. All the issues raised with respect to the original deficiency have been settled by stipulation of the parties, and effect will be given thereto in a recomputation under Rule 50. The issues remaining for decision are whether, in the computation of excess profits net income under the provisions of section 736(a) of the Internal Revenue Code, deductions should be allowed the petitioner for (1) bad debts of $55,392.45 on uncollectible installment accounts receivable arising from installments sales made prior to February 1, 1940, and (2) the amount of $33,211.22 representing moneys expended in collecting installment accounts receivable arising from installment sales made prior to February 1, 1940.
Substantially all the facts have been stipulated and are accordingly adopted. Only those material to an understanding of the issues will be set out in our findings.
FINDINGS OF FACT.
Petitioner is a Maryland corporation. It operates on the basis of a fiscal year ending January 31. For the year ended January 31, 1941, its income and excess profits tax returns were filed with the collector of internal revenue at Baltimore. Said returns were prepared with income from installment sales computed upon the installment basis of accounting in accordance with the provisions of section 44(a) of the Internal Revenue Code.
At the close of its fiscal year ended January 31, 1943, petitioner became eligible to report its income from installment sales under section 736(a) of the code, since its average outstanding installment accounts receivable at the end of the four preceding years was more than 125 per cent of the amount of such accounts receivable at the end of that year. On June 12, 1943, it accordingly filed an amended excess profits tax return for the year ended January 31, 1941, electing therein to compute income from installment sales under section 736(a). In the amended return petitioner increased its excess profits net income by the amount of unrealized profits, $193,310.18, which had been deferred in the original return computed on the installment basis. A statement attached to its amended return explained the computation as follows:
+-----------------------------------------------------------------------------+ ¦Excess Profits Net Income computed under income credit method, ¦$1,768,292.00¦ ¦as per items 13 and 20, page 1 of Form 1121 as originally filed¦ ¦ +---------------------------------------------------------------+-------------¦ ¦Add Unrealized Profits on Installment Sales for year ended ¦ ¦ ¦January 31, 1941, which had been deferred when filing the ¦ ¦ ¦original return. This additional is to place year on accrual ¦ ¦ ¦basis in accordance with Sec. 736(a): ¦ ¦ +---------------------------------------------------------------+-------------¦ ¦Unrealized Profits End of Year ¦$1,379,867.46 ¦ ¦ +---------------------------------------------+-----------------+-------------¦ ¦Less Unrealized Profits Beginning of Year ¦1,186,557.28 ¦ ¦ +-----------------------------------------------------------------------------+
Additional Profits on Sales during Year which was deferred when filing the original return 193,310.18 193,310.18 Excess Profits Net Income, as amended for year ended January 31, 1941, after giving effect to Sec. 736 (a) 1,961,602.18
Entered as Item 20, Page 1 of amended return.
Petitioner's total gross sales during the taxable year on the accrual basis amounted to $32,889,490.91. After adjustments for unrealized profits on installment sales, in the net amount of $193,310.18, and for sales returns of $3,885,559.03, petitioner's net sales on the installment basis amounted to $28,810,621.70, which figure was reported in its income tax return.
Petitioner's net sales on the accrual basis amounted to $29,003,931.88. That figure does not include any unrealized profits attributable to accounts receivable arising from installment sales made prior to February 1, 1940.
Normal tax net income reported by petitioner in its income tax return amounted to $2,741,424.45. A small upward adjustment of that figure made by respondent as a result of the disallowance of a contingent reserve is not challenged by petitioner.
Respondent's minor downward adjustment of petitioner's excess profits credit based on income, resulting from the disallowance of restoration to base period income of certain small abandonment losses, is likewise now agreed to by petitioner.
In its income tax return petitioner, in computing its normal tax net income, took a bad debt deduction in the amount of $236,732.42, computed as
+--------------------------------------------------------------------------+ ¦Additions to Reserve-Regular Charge Accounts ¦$486,320.80¦ +--------------------------------------------------------------+-----------¦ ¦Actual Charge Offs-Installment Accounts (No Reserve Method for¦ ¦ +--------------------------------------------------------------+-----------¦ ¦Installment Accounts) ¦88,938.64 ¦ +--------------------------------------------------------------+-----------¦ ¦Actual Charge Offs-Purchase Ledger Accounts and Notes Receiv- ¦ ¦ +--------------------------------------------------------------+-----------¦ ¦able ¦1,128.77 ¦ +--------------------------------------------------------------+-----------¦ ¦ ¦576,388.21 ¦ +--------------------------------------------------------------+-----------¦ ¦Less: Bad Debts Recovered ¦339,655.79 ¦ +--------------------------------------------------------------+-----------¦ ¦Total Bad Debts ¦236,732.42 ¦ +--------------------------------------------------------------------------+
The amount of $236,732.42 so deducted included the net amount of $55,392.45 representing bad debts on uncollectible installment accounts receivable arising from installment sales made prior to February 1, 1940. Unrealized profits, aggregating $1,186,557.28, attributable to installment accounts receivable as of February 1, 1940, were included as part of the net sales of $28,810,621.70 reported in petitioner's income tax return. Unrealized profits on installment sales as of January 31,1941, aggregating $1,379,867.46, did not include any amount with respect to the $55,392.45 installment accounts receivable charged off by petitioner as worthless during the taxable year.
In its income tax return petitioner's total deductions (including bad debts) from its reported gross income of $11,984,029.85 amounted to $9,239,509.94. Of said total deductions, the amount of $33,211.22 represented the expense of collecting installment accounts receivable arising from installment sales made prior to February 1, 1940.
Respondent, in asking for the additional deficiency, claims that the amounts of $55,392.45 and $33,211.22, respectively representing bad debts and collection expenses attributable to installment sales made prior to February 1, 1940, are not proper deductions under section 736(a) of the code in computing petitioner's excess profits net income.
For the taxable year ended January 31, 1941, pursuant to its original and amended excess profits tax returns, petitioner paid to the collector of internal revenue for the district of Maryland excess profits tax of $139,386.09 on the dates and in the amounts as follows:
+--------------------------+ ¦April 12, 1941 ¦$14,250.00¦ +---------------+----------¦ ¦July 14, 1941 ¦14,120.68 ¦ +---------------+----------¦ ¦Oct. 9, 1941 ¦14,250.00 ¦ +---------------+----------¦ ¦Jan. 12, 1942 ¦14,120.66 ¦ +---------------+----------¦ ¦June 12, 1943 ¦82,644.75 ¦ +---------------+----------¦ ¦Total ¦139,386.09¦ +--------------------------+
In addition, petitioner, on July 31, 1943, paid interest in the amount of $10,696.72.
OPINION.
ARUNDELL, Judge:
Petitioner, after becoming eligible and electing under section 736(a) of the Internal Revenue Code,
adjusted its excess profits net income for the taxable year ended January 31, 1941, to conform to the accrual basis by adding to the figure reported in its original excess profits tax return the net amount ($193,310.18) of unrealized profits on installment sales which had been deferred under the installment method. Respondent's contention that the figure should be further increased by the amounts of $55,392.45 and $33,211.22, respectively representing bad debts and collection expenses in connection with installment sales made prior to February 1, 1940, is based on section 30.736(a)-3, Regulations 109, as amended by T.D. 5257, 1943 C.B. 856. The pertinent portion of the regulation reads as follows:
SEC. 736. RELIEF FOR INSTALLMENT BASIS TAXPAYERS AND TAXPAYERS WITH INCOME FROM LONG-TERM CONTRACTS.(a) ELECTION TO ACCRUE INCOME.— In the case of any taxpayer computing income from installment sales under the method provided by section 44(a), if such taxpayer establishes, in accordance with regulations prescribed by the Commissioner with the approval of the Secretary, that the average volume of credit extended to purchasers on the installment plan in the four taxable years preceding the first taxable year beginning after December 31, 1941, was more than 125 per centum of the volume of such credit extended to such purchasers in the taxable year, or the average of outstanding installment accounts receivable at the end of each of the four taxable years preceding the first taxable year beginning after December 31, 1941, was more than 125 per centum of the amount of such accounts receivable at the end of the taxable year, of if the taxpayer was not in existence for four previous taxable years, the taxable years during which the taxpayer was in existence, in either case including only such years for which the income was computed under the method provided in section 44(a), it may elect, in its return for the taxable year, for the purposes of the tax imposed by this subchapter, to compute, in accordance with regulations prescribed by the Commissioner with the approval of the Secretary, its income from installment sales on the basis of the taxable period for which such income is accrued, in lieu of the basis provided by section 44(a). Except as hereinafter provided, such election shall be irrevocable when once made and shall apply also to all subsequent taxable years, and the income from installment sales for each taxable year before the first year with respect to which the election is made but beginning after December 31, 1939, shall be adjusted for the purposes of this subchapter to conform to such election. In making such adjustments, no amount shall be included in computing excess profits net income for any excess profits tax taxable year on account of installment sales made in taxable years beginning before January 1, 1940. * * *
SEC. 30.736(a)-3. COMPUTATION OF INCOME ON STRAIGHT ACCRUAL BASIS.— If the taxpayer has elected under section 736(a) and section 30.736(a)-2 to compute for excess profits tax purposes its income from installment sales on the basis of the taxable year for which such income is accrued, in lieu of the basis provided by section 44(a), the gross income of the taxpayer from installment sales shall be computed upon such accrual basis. Likewise all deductions under section 23 allowable in computing net income and attributable to such sales, shall be computed upon the straight accrual basis. However, no income or deductions (including deductions for bad debts) shall be included in the computation of excess profits net income for any excess profits tax taxable year on account of installment sales made in taxable years beginning before January 1, 1940.
In Mackin Corporation, 7 T.C. 648, decided concurrently herewith, the same section of the code and the same portion of the regulations were involved in connection with a claim for bad debt deduction on account of pre-1940 installment sales. We have held in that case that the regulation, in denying to qualified installment basis taxpayers electing under section 736(a) any deduction for bad debts on account of pre-1940 sales, is invalid and in excess of the Commissioner's authority. Our reasons for so holding have been set out at length in our opinion therein and need not be repeated here. Suffice it to say that in view of our decision in that case the petitioner herein is entitled to a bad debt deduction, for excess profits tax purposes under section 736(a), to the extent of its unrecovered cost of goods represented in the $55,392.45 of pre-1940 installment accounts receivable charged off in the taxable year. The record in this case does not show what portion of said accounts represented unrecovered cost of goods and what portion represented unrealized profits, as did the record in the Mackin case. However, a recomputation under Rule 50 is necessary herein to give effect to the stipulations of the parties as to other issues originally raised. Inasmuch as substantially all the facts have been stipulated, doubtless the parties will have no difficult in ascertaining and agreeing upon the amount of unrecovered cost of goods involved in the accounts charged off, so as to take care of the matter in the recomputation.
There remains the issue whether petitioner is entitled to deduct its expenses of collecting installment accounts arising out of sales made prior to February 1, 1940. No such question was involved in the Mackin case. Nevertheless, from the reasoning of that case it follows that the regulation is as much invalid in denying deductions for those expenses as in denying any deduction for bad debts. As we there pointed out, section 736(a) of the code contains no provision whatever with respect to deductions and did not change the provisions of section 23 of the code allowing deductions or those of section 43 relating to the time for taking deductions. In so far as the regulation adopted under section 736(a) purports to deny all deductions for expenses, losses, etc., incurred or accrued during the taxable year, which relate to or arise out of pre-1940 sales, it is an unauthorized amendment of the statute and denies to qualified electing installment basis taxpayers the relief to which they are entitled under the statute. It follows that petitioner is entitled to deduct the amount of $33,221.22 collection expenses in computing its excess profits net income for the taxable year under section 736(a).
Decision will be entered under Rule 50.