Morris Plan Industrial Bank v. Commissioner

Full title: MORRIS PLAN INDUSTRIAL BANK OF NEW YORK v. COMMISSIONER OF INTERNAL REVENUE

Court: Circuit Court of Appeals, Second Circuit

Date published: Nov 5, 1945

151 F.2d 976 (2d Cir. 1945)

Opinion

No. 14.

November 5, 1945.

Petition to Review a Decision of the Tax Court of the United States.

Petition by the Morris Plan Industrial Bank of New York against the Commissioner of Internal Revenue to review a decision of the Tax Court of the United States sustaining a determination by the Commissioner of Internal Revenue as to income tax liability for the years 1938, 1939 and 1940.

Affirmed.

This appeal by taxpayer relates to its income tax liability for the years 1938, 1939 and 1940. The pertinent statutory provisions and Treasury Regulations are as follows:

Revenue Act of 1938, Sec. 23, 26 U.S.C.A. Int.Rev.Acts, pages 1011, 1013. "Deductions from gross income. In computing net income there shall he allowed as deductions: * * * (k) Bad debts. (1) General rule. — 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); * * *."

Internal Revenue Code, 26 U.S.C.A. § 23. "Deductions from gross income. In computing net income there shall be allowed as deductions: * * * (k) [as amended by Section 124 of the Revenue Act of 1942, 56 Stat. 798, 812] Bad debts. (1) General rule. Debts which become worthless within the taxable year; or (in the discretion of the Commissioner) a reasonable addition to a reserve for bad debts; * * *."

Treasury Regulations 101, promulgated under the Revenue Act of 1938:

"Art. 23(k)-1. Bad debts. Bad debts may be treated in either of two ways: (1) By a deduction from income in respect of debts ascertained to be worthless in whole or in part, or (2) By a deduction from income of an addition to a reserve for bad debts.

"Taxpayers were given an option for 1921 to select either of the methods mentioned for treating such debts. (See article 151, Regulations 52.) The method used in the return for 1921 must be used in returns for subsequent years and in returns under the Revenue Act of 1938 unless permission is granted by the Commissioner to change to the other method. A taxpayer filing a first return of income may select either of the two methods subject to approval by the Commissioner upon examination of the return. If the method selected is approved, it must be followed in returns for subsequent years, except as permission may be granted by the Commissioner to change to another method. Application for permission to change the method of treating bad debts shall be made at least 30 days prior to the close of the taxable year for which the change is to be effective. (See also article 23(k)-5.)

"Art. 23(k)-3. Uncollectible deficiency upon sale of mortgaged or pledged property. If mortgaged or pledged property is lawfully sold (whether to the creditor or another purchaser) for less than the amount of the debt, and the mortgagee or pledgee ascertains that the portion of the indebtness remaining unsatisfied after such sale is wholly or partially uncollectible, and charges it off, he may deduct such amount (to the extent that it constitutes capital or represents an item the income from which has been returned by him) as a bad debt for the taxable year in which it is ascertained to be wholly or partially worthless and charged off * * *

"Art. 23(k)-5. Reserve for bad debts. Taxpayers who have established the reserve method of treating bad debts and maintained proper reserve accounts for bad debts, or who, in accordance with article 23(k)-1 adopt the reserve method of treating bad debts, may deduct from gross income a reasonable addition to a reserve for bad debts in lieu of a deduction for specific bad debt items.

"What constitutes a reasonable addition to a reserve for bad debts must be determined in the light of the facts, and will vary as between classes of business and with conditions of business prosperity. It will depend primarily upon the total amount of debt outstanding as of the close of the taxable year, those arising currently as well as those arising in prior taxable years, and the total amount of the existing reserve. In case subsequent realizations upon outstanding debts prove to be more or less than estimated at the time of the creation of the existing reserve, the amount of the excess or inadequacy in the existing reserve should be reflected in the determination of the reasonable addition necessary in the taxable year. A taxpayer using the reserve method should make a statement in his return showing the volume of his charge sales or other business transactions for the year and the percentage of the reserve to such amount the total amount of notes and accounts receivable at the beginning and close of the taxable year, and the amount of the debts which have been ascertained to be wholly or partially worthless and charged against the reserve account during the taxable year."

The corresponding provisions of Treasury Regulations 103 under the Internal Revenue Code are the same except that Section 19.23(k)-1 of Regulations 103 was amended to read as follows:

"Sec. 23(k)-1 [as amended by T.D. 5234, 1943 Cum.Bull. 119, and T.D. 5376, 1944 Cum.Bull. 119] Bad debts. — (a) Bad debts may be treated in either of two ways: (1) By a deduction from income in respect of debts which become worthless in whole or in part, or (2) By a deduction from income of an addition to a reserve for bad debts.

"Taxpayers were given a similar option for 1921 to select either of the methods mentioned for treating such debts. (See article 151, Regulations 62.) While ascertainment of worthless and charge-off during the taxable year (which were prerequisite to deductions of a bad debt under the law at that time) are no longer required for the allowance of a debt which becomes wholly worthless, the method used in the return for 1921 must be used in returns for all subsequent years unless permission is granted by the Commissioner to change to the other method. A taxpayer filing a first return of income may select either of the two methods subject to approval by the Commissioner upon examination of the return. If the method selected is approved, it must be followed in returns for subsequent years, except as permission may be granted by the Commissioner to change to another method. Application for permission to change the method of treating bad debts shall be made at least 30 days prior to the close of the taxable year for which the change is to be effective."

The facts as found by the Tax Court may be summarized as follows:

Taxpayer is a corporation organized under the banking laws of the State of New York and engaged in the business of making both commercial and industrial loans. In its income tax return for the year 1921 it claimed a deduction for bad debts on loans made prior to 1921, and in addition claimed a deduction of $26,435.04, reppresenting a "Reasonable reserve of ¼ of 1% on loans made during 1921, and so set up on the records." In Schedule A-17, attached to that return, it set up its reserve for bad debts as follows:

"Statement of reserve for losses account

Balance Dec. 31, 1920 per balance sheet .. $102,466.16 Plus Reserve For 1921 as above ........... 26,435.04 Collections of Accounts Previously Charged off ............................ 2,809.26 ___________ $131,710.46 Less charge-offs as above ............ 81,146.21 ___________ Balance December 31, 1921 per balance sheet ................... 50,564.25"

On October 22, 1925, in a protest filed in connection with its 1921-1922 tax liability, taxpayer stated in part as follows:

"* * * In 1921 the taxpayer, in accordance with its prior practice, charged off accounts ascertained to be worthless in that year and the amounts so charged off were claimed as deductions in the Income and Profits Tax return for 1921. The taxpayer also deducted in the return for 1921 the addition made to the reserve for bad debts, such deductions being made in accordance with provisions of Revenue Act of 1921 and being allowed for the first time in connection with the return for the year of 1921.

"In ascertaining the accounts to be charged off as bad debts in 1921, the taxpayer for the first time adopted the practice of charging off all loans which had been outstanding for at least one year after maturity. The adoption of this rule was the result of much consideration and discussion with other bankers and has been consistently followed since that time. In connection with Income Tax returns, however, the taxpayer since 1921 consistently followed the practise of deducting the net addition to the reserve each year in accordance with the provisions of Revenue Act of 1921."

In its 1921 return taxpayer deducted the above amount of $26,435.04, representing anticipated future losses on loans made during that year. It has followed that method in all its subsequent returns, and the Commissioner has not questioned that method. Taxpayer has never claimed in any of its returns the amount of bad debts ascertained to be worthless or that became worthless during such year. Since 1921 it has never requested permission to change its method of treating bad debt deductions.

During each of the years 1921 to 1937, taxpayer set up on its books an estimated amount against future losses. During that period it did not claim as a deduction any amounts representing specific bad debts ascertained to be worthless during such years. The deductions claimed were amounts computed with respect to an estimated reserve set up and adjusted under the taxpayer's system.

In its returns for the years 1921 to 1937, inclusive, taxpayer claimed a total deduction of $2,073,759.57 with respect to bad debts, computed as follows:

Reserve Set Up ................. $1,507,285.62 Charge Off ..................... 2,823,658.00 $4,330,943.62 _____________ Less: Reserve 2 Yrs. Prior Collections on Accts. ...... 1,196,959.64 Charged Off .................. 1,316,791.35 _____________ 2,513,750.99 Nontaxable Coll. ............... 256,566.94 2,257,184.05 _____________ _____________ Bad Debt Deduction In Return, as Adjusted ..... $2,073,759.57

Included in the total deductions of $2,073,759.57 is the estimated reserve set up for 1936 in the sum of $141,057.99 and the estimated reserve for 1937 in the sum of $169, 267.99, or an aggregate of $310,325.98 claimed by taxpayer and allowed by the Commissioner. This amount ($310,325.98) constituted the balance in taxpayer's reserve as of the end of 1937; moreover this balance does not include the sum of $256,566.94 received in the years 1935, 1936 and 1937 as recoveries on debts previously charged off.

The uncollected balance on industrial loans at the end of each of the taxable years was as follows:

1938 ...................... $19,178,000.00 1939 ...................... 20,371,000.00 1940 ...................... 21,855,000.00

For the period 1933 to 1940, inclusive, taxpayer's volume of loans totaled $242,518,182. Its charge-offs totaled $1,073,827.73 and its total recoveries were $863,848.11 or a net charge-off of $209,979.62. The percentage of net charge-offs to total loans is .000865 or approximately 1/12 of one per cent.

In its income tax returns for the years 1938, 1939 and 1940, taxpayer claimed deductions with respect to bad debts in the amounts of $96,110.92, $107,750.87 and $90,842.88, respectively, which amounts were computed in the returns as follows:

1938

Reserve Set Up during 1938 ........ $192,242.93 Losses on Bonds and Mortgages Charged Off ..................... 20,900.00 $213,142.93 ___________

Less: Reserve Set Up during 1936 ... $139,992.76 Less: 1936 Balances Charged Off in 1938 ...... 74,385.36 65,607.40 ___________

Collections on Accts. Charged Off ........ 103,239.47 Less: Non-Taxable Collections ........ 51,814.86 51,424.61 117,032.01 ___________ ___________ ___________ 96,110.92

1939

Reserve Set Up during 1939 ........ $208,061.49 Losses on Bonds and Mortgages Charged Off ..................... 24,219.36 $232,280.85 ___________ Less: Reserve Set Up during 1937 ..... $168,334.95 Less: 1937 Balance Charged Off ........ 100,222.12 ___________ 68,112.83 Collections on Accts. Charged Off ........ 94,676.49 Less: Non-Taxable Collections ........ 38,259.34 ___________ 56,417.15 124,529.98 ___________ ___________ 107,750.87 1940

Reserve Set Up during 1940 ..................... 223,532.03 Losses on Bonds and Mortgages .................. 500.00 ___________ 224,032.03 Less: Reserve Set Up during 1938 ..... $192,242.93 Less: 1938 Balances Charged Off ........ 147,974.10 44,268.83 ___________

Less: Collections on Accounts Charged Off ...................... 88,920.32 133,189.15 ___________ ___________ 90,842.88

In its tax returns, the taxpayer treated differently its losses on loans on mortgages (called "commercial loans") and its losses on its other loans (called "industrial loans"). With respect to the former, its practice was, in its returns, to deduct debts actually ascertained to be worthless.

The Commissioner in his notice of deficiency disallowed the losses on mortgages sold and foreclosed as claimed in the returns for each of the respective taxable years, on the ground that such deductions represented an estimate of the losses on mortgage foreclosures, but allowed the actual losses resulting from uncollectible deficiencies on foreclosed mortgages. Taxpayer does not object to the Commissioner's treatment of these claimed deductions. The Commissioner disallowed the balance of the claimed deductions, in the amounts of $75,210.92, $83,531.51 and $90,342.88 for the respective taxable years. With respect to the year 1938 the Commissioner gave the following explanation: "The balance of the deduction in the amount of $75,210.92, being an addition to the reserve for bad debts you had established and maintained under the method authorized by Article 23(k)-1(a)(2) and Article 23(k)-5 of Regulations 101, is disallowed. The balance in this reserve at the beginning of the year amounted to $308,327.71. This balance, increased by the addition thereto of recoveries on debts previously written off and reduced by debts ascertained to be worthless during the taxable year, results in increasing the reserve as of the end of the year to $365,562.10. This balance is deemed adequate to provide for future bad debts arising out of business transacted prior to the close of the taxable year. Therefore the entire addition thereto is disallowed."

Similar explanations were given for the disallowances in 1939 and 1940, with the appropriate changes to reflect the different amounts involved.

Taxpayer carried on its general ledger a reserve for bad debts as of January 1, 1938 of $308,327.71, which figure has been stipulated to be $310,325.98. The Commissioner made the following adjustments for each of the taxable years to taxpayer's reserve for bad debts:

1938 1939 1940

Balance in Reserve beginning of year ... $308,327.71 365,562.10 394,229.70 Add recoveries in year on debts previously deducted ............ 90,332.90 73,262.43 55,949.38 ___________ __________ __________ 398,660.61 438,824.53 450,179.08

Less: Debts ascertained to be worthless ..... 33,098.51 44,594.83 68,810.36 ___________ __________ __________ Balance in Reserve at end of year ......... 365,562.10 394,229.70 381,368.72

Taxpayer's vice president testified as follows:

"Q. Now, as shown by exhibits 3, 4 an 5, you set up a reserve for the particular year in question, and then made certain ad-adjustments thereto, is that true? A. For income tax purposes, yes.

"Q. Now, take the year 1938 to illustrate it, exhibit 3 shows a net figure of $96,110.92, which you deducted in your return, did you not? A. Yes, sir.

"Q. Does that amount represent debts worthless in 1938? A. No, sir, it is an adjustment. It is an adjustment of the debts estimated as being worthless in 1938.

"Q. Did you have a reserve set up on your books with respect to these industrial losses? A. We had an amount set aside as the estimated losses, sir. * * *

"Q. Now Mr. Morris, you stated yesterday that the method of computing a deduction as reflected in your 1938, 1939 and 1940 returns, had been consistently used since the year 1921? A. That is correct.

"Q. As a matter of fact, has the petitioner ever claimed in any year the amounts of debts ascertained to be worthless and charged off during that year? A. That amount used in the calculation each year, yes, sir.

"Q. Was that amount ever claimed as a deduction, the amount of debts ascertained to be worthless and charged off during the year? A. Yes, sir, that is used in the calculation, it was claimed.

"Q. That is not my question, my question is have you ever claimed as a deduction in your Returns the amount of bad debts ascertained to be worthless during that taxable year? A. No, sir."

The Commissioner, purporting to exercise the discretion vested in him by Section 23(k) of the applicable Revenue Acts, determined that taxpayer's reserve existing at the close of the respective taxable years, after giving effect to debts ascertained to be worthless and recoveries on debts previously written off, was adequate to provide for future bad debts and disallowed taxpayer's claimed additions to the reserve for the respective taxable years.

When the Commissioner sent his deficiency notice, there was pending in the United States District Court a suit brought by the taxpayer against the Collector of Internal Revenue for refunds of taxes paid in the years in question; the Collector had entered his appearance in that suit. In its petition to the Tax Court, petitioner asserted that, because that suit was pending in the District Court, the Commissioner had no authority to issue a deficiency notice which, among other things, disallowed taxpayer's claim for refunds.

The Tax Court held this contention invalid. It agreed with the Commissioner's determination, and held that his disallowance of the claimed additions to the reserve was a sound and not an arbitrary exercise of his discretion. Accordingly it sustained his determination.

The Tax Court said in part:

"The petitioner was using the reserve method and not the specific bad debt charge-off method of treating its bad debt losses. * * * The reserve existing at the beginning of each of the taxable years was sufficient to take care of the petitioner's bad debt losses without any additions to the reserve for any of the respective years. * * * The principal issue involves the factual determination of the petitioner's tax accounting method with respect to its bad debt losses. The respondent has based his deficiencies on the theory that the petitioner was on the reserve method. The petitioner contends that it used the specific bad debt charge-off method of treating its bad debts. The answer is to be determined from what the petitioner actually did with respect to its bad debts as disclosed by the record. * * *

"It is apparent that the petitioner did not deduct its bad debts ascertained to be worthless and did not report in gross income recoveries on bad debts as it should have done if on the specific bad debt method. The amount claimed in its tax return had no relation to actual charge-offs. Recoveries were never included in gross income. Based on what the petitioner did it is clear that it did not follow the specific bad debt charge-off method. The petitioner concedes that its method was wrong, but argues that since it had never elected the reserve method, respondent has no authority to compel it to adopt that method. We think that although the method used by the petitioner was somewhat irregular, it was in substance the reserve method for treating bad debts and not the specific charge-off method. In 1921 and in all subsequent years it has set up an estimated amount in anticipation of future losses in respect of accounts receivable. In 1921 the petitioner claimed and was allowed a deduction to which it was not entitled if it had not adopted the reserve method. Since 1921 the deduction taken was generally in excess of its bad debts for such year, and it may have enjoyed the benefit of deductions larger than those to which it was properly entitled. The fact that the petitioner adopted the reserve method in its 1921 return, and has since followed that method, constitutes an election of such method. * * * Petitioner, in support of its contention that it was using the specific charge-off method points out that the respondent, in his deficiency notice, has allowed actual losses with respect to its commercial loans. From this the petitioner argues that respondent has used both the reserve method and the specific charge-off method, whereas the tax law permits the use of either method but not both simultaneously. We are not required to determine the correctness of the respondent's action with respect to commercial loans. The petitioner accepted the respondent's treatment of losses on its commercial loans and that issue is not before us. Since petitioner elected the reserve method it is required to maintain that method until it obtains the respondent's permission to change. The petitioner has never sought permission to change its system. * * * We are convinced that respondent's determination that the reserve at the end of the respective years was adequate to take care of the petitioner's future losses, and his denial of additions to the reserve was a sound and not an arbitrary exercise of the discretion vested in him. We find no merit in the petitioner's contention it is entitled to deduct an addition to its reserve to the extent of the debts becoming worthless in the taxable year regardless of the size of its reserve. * * * Petitioner claims overpayment in the respective taxable years. No claim is made of any erroneous inclusion of items in gross income. The basis of the respective claims is that the petitioner is entitled to greater debt deductions than were claimed on its returns. Since we have sustained the respondent's disallowance of any additions to the reserve for bad debts, the claims for overpayment necessarily fall."

Donald Horne, of New York City (Henry W. Parker, of New York City, of counsel), for petitioner.

Samuel O. Clark, Jr., Sewall Key, Robert N. Anderson, and Harry Baum, all of Washington, D.C., for respondent.

Before L. HAND, CHASE and FRANK, Circuit Judges.

FRANK, Circuit Judge.

1. We cannot agree that the pending suit in the district court deprived the Commissioner of his statutory authority to issue a deficiency notice or rendered that notice legally inefficacious. The suit was not what is commonly called "in rem" or "quasi in rem," and therefore could not operate to prevent him from exercising his statutory powers. Perhaps had there been a judgment in the district court, it would have been res judicata; but there has been no such judgment. Since the district court action was in personam, it could not, at least before entry of a judgment therein, affect the Commissioner's authority.¹

1 It is to be noted that the suit in the district court was not against the United States but against the Collector; consequently, there might perhaps be a question whether, even if a judgment had been entered therein it would have been res judicata against the Commissioner. See United States v. Nunnally Investment Co., 316 U.S. 258, 62 S.Ct. 1064, 86 L.Ed. 1455, 140 A.L.R. 792. As the suit was begun before June 15, 1942, the amendment in 1942 to § 3772(d), 26 U.S.C.A. Int.Rev. Code, would not have been applicable.

2. On the merits, we see nothing to taxpayer's contentions. It had, we think, plainly elected in 1921 to use the reserve method with respect to its so-called "industrial" loans.

Since 1921, the taxpayer had never in its tax returns, before the tax years here in question, claimed any deduction from its gross income for any actual specific "industrial" loans ascertained to be worthless. It had merely, in making its calculations of the additions to the reserve as reported in its returns — which additions it did in those returns deduct from gross income — taken into account such loans actually ascertained to be worthless. Thus, before 1938, taxpayer adhered to the reserve method. This conduct constituted an election. The applicable regulation provides, "The method used in the return for 1921 must be used in returns for all subsequent years unless permission is granted by the Commissioner to change to the other method". We think that provision valid. No such permission has ever been granted.

Taxpayer asserts that its own accounting methods used in computing its additions to its reserve before 1938 were erroneous, and that, therefore, taxpayer cannot be said to have made an election. But whether its accounting techniques were in some manner mistaken, we need not consider; for undoubtedly in its returns taxpayer utilized, with respect to "industrial" loans, the reserve alternative and is bound by it. The taxpayer itself segregated its "industrial" from its "commercial" loans, applying the method of specific actual bad debt deductions solely to the latter. It now maintains that the same method must be applied to all its loans, and that, as the Commissioner has allowed its specific deductions as to bad debt "commercial" loans, the Commissioner and the Tax Court erred in finding that taxpayer elected the reserve method as to its other loans. We do not agree. Perhaps the Commissioner erred in approving the segregation and in allowing the specific deductions in the case of the "commercial" loans; but, if so, he has not complained, and taxpayer cannot. Whether or not the segregation was proper, there can be no doubt of the election with respect to the "industrial" loans.

If there could be any doubt as to the fact of such election, it was resolved by the Tax Court's decision that it occurred. For that decision did not turn on a "clear-cut question of law" but on one of "mixed law and fact," and the decision did not involve "a rule of general applicability." Bingham's Trust v. Commissioner, 65 S.Ct. 1232, 1235.

3. The sole issue, then, is whether we should reverse the Commissioner's determination that the reserve, in each of the tax years here in question, was so ample that no addition to the reserve could reasonably be made. The statute confers on him discretion to make such a determination. We cannot reverse his action unless it appears that he abused that discretion. Even without the Tax Court's decision, we would be strongly inclined to sustain him, since taxpayer's actual loss experience indicates clearly that the reserve in each of those years was wholly sufficient without any additions. But we need not decide that issue. The Tax Court has found that the Commissioner acted reasonably. We think such a finding is the kind which we may not disturb if there is substantial evidence to support it. Bingham v. Commissioner, supra. Plainly there is here such substantial evidence, no matter how the reserve is analyzed.²

2 For that reason we need not consider the correctness of the precise methods of analysis used by the Commissioner and by the Tax Court in arriving at their respective conclusions.

Affirmed.