8 T.C. 383">*383 Respondent determined petitioner's excess profits tax liability for the year 1941 to be $ 13,423.43. He has disallowed a claim for refund 8 T.C. 383">*384 of excess profits tax for 1941 in the amount of $ 2,517.13. The petition has been filed under the provisions of section 732 (a) of the Internal Revenue Code. The question arises under section 711 (b) (1) (J) (ii) of the code, as amended. The excess profits credit is computed under the income credit method. It is agreed that bad debt deductions which were allowed for the year 1938 in the total amount of $ 15,798.18 were abnormal in amount within the meaning of section 711 (b) (1) (J) (ii). The only question is whether an abnormality in amount of bad debt deductions for 1938 should be disallowed so as to make an adjustment upward in petitioner's base period income for 1938. This question turns upon whether the abnormality in amount was not a consequence of an increase in the gross income of the petitioner in its base period within the meaning of section 711 (b) (1) (K) (ii).

Petitioner filed its1947 U.S. Tax Ct. LEXIS 272">*274 return and claim for refund with the collector for the twenty-third district of Pennsylvania.

FINDINGS OF FACT.

Some of the facts have been stipulated and the stipulation is made part of the findings of fact and is incorporated herein by reference. The facts necessary to an understanding of the issue are as follows:

Petitioner is engaged in the business of manufacturing porcelain enamel frit and pottery frit, and ceramic colors, which it sells to manufacturers of cooking utensils, refrigerators, stoves, pottery, china, and such products. The manufacturers apply frit to their products.

The base period years of petitioner for purposes of the excess profits tax credit based on income are 1936, 1937, 1938, and 1939. Petitioner computed its excess profits tax credit on the income method.

Petitioner has never used the reserve for bad debts method for bad debt deduction purposes. It has always based its bad debt deductions in its income tax returns on the bad debts actually sustained.

In its income tax return for 1938 petitioner deducted $ 15,798.18 for debts ascertained to be worthless in 1938, and the deduction was allowed. Of the above total, the sum of $ 15,075.47 represented an1947 U.S. Tax Ct. LEXIS 272">*275 indebtedness owing to petitioner from one customer, Hayes-Custer Stove, Inc. The rest of the bad debt deduction, $ 722.71, represents small amounts of indebtedness of six other customers and is of no significance.

Hayes-Custer Stove, Inc., filed a 77-B petition in bankruptcy on May 26, 1937, and nothing remained for general creditors after a sale of its assets and the application of the proceeds to an R. F. C. mortgage. The last sale of petitioner to Hayes-Custer Stove, Inc., was made on May 7, 1937.

8 T.C. 383">*385 The following schedule shows the net sales and gross income of petitioner for the years 1934 and 1935, before its base period, and for the years 1936 through 1939, inclusive, the base period; the total annual sales to Hayes-Custer Stove, Inc., in each year; ¹ the amounts of the total accounts receivable from all customers at the end of each year; and the amounts of the accounts receivable at the end of each year from Hayes-Custer Stove, Inc.:

Petitioner's bad debt deductions for the years 1934 to 1941, inclusive, were as follows:

Total sales to Hayes-Custer Stove, Inc., during 1937 were $ 5,425.27 less than sales to that company in 1936, and, as stated above, the last sale to that company was made in May 1937.

The parties have stipulated that, under section 711 (b) (1) (J) (ii) of the code, the bad debt excess for the year 1940 was $ 8,224.18 and for the year 1941 was $ 5,374.69, both being the excess part of the 1938 bad debt deductions as computed under the foregoing section of the code, and section 711 (b) (1)1947 U.S. Tax Ct. LEXIS 272">*277 (K) (iii).

If petitioner establishes that the bad debt excess is not a consequence of an increase in the gross income in its base period, or a decrease in the amount of some other deduction in its base period, and is not a consequence of a change at any time in the type, manner of operation, size, or condition of its business, then the bad debt excess of $ 8,224.18 for the computation of the 1940 excess profits tax would result in an excess profits credit carry-over from 1940 for credit in 1941.

Petitioner filed its excess profits tax return for the year 1941 with the collector at Pittsburgh, Pennsylvania, on March 16, 1942. On May 11, 1943, petitioner filed amended excess profits tax returns for 8 T.C. 383">*386 the years 1940 and 1941, and also a claim for refund of excess profits tax for the year 1941 in the amount of $ 2,517.13. No tax was shown to be due under the return filed for 1940. The claim for refund was based upon the failure to restore to base period excess profits net income, by disallowing as a deduction under section 711 (b) (1) (K) (ii) an alleged excessive amount of bad debts in 1938. Respondent disallowed the claim by notice dated September 26, 1944, on the ground1947 U.S. Tax Ct. LEXIS 272">*278 that petitioner had failed to establish that the alleged excess in bad debts was not a consequence of one or more of the factors enumerated in section 711 (b) (1) (K) (ii).

There was no decrease in the amount of some other deduction in petitioner's base period, nor was there any change at any time in the type, manner of operation, size, or condition of petitioner's business which caused the excessive amount of bad debts in 1938.

OPINION.

The only question to be decided is whether petitioner has established that the abnormality in amount of its total bad debt deduction in 1938 was "not a consequence of an increase in the gross income" for its base period, as it is required to do by the terms of section 711 (b) (1) (K) (ii) of the Internal Revenue Code. The parties are agreed that a total bad debt deduction which was taken and allowed for the year 1938 in the amount of $ 15,798.18 was not abnormal in class, but was abnormal in amount; and that it was in excess of 125 per cent of the average amount of petitioner's bad debt deductions for the four taxable years prior to 1938. Sec. 711 (b) (1) (J) (ii).

The evidence shows that petitioner's business did not involve sizable losses from1947 U.S. Tax Ct. LEXIS 272">*279 bad debts in the base period years and two years before, and that there was not a correlation between the volume of its business, as represented by its net sales, and losses from bad debts. That is, bad debt losses bore no constant percentage relation to volume of business; they did not increase as the volume of business increased, nor vice versa. With reference to the 1938 bad debt deduction, it represented, for the most part, a loss from an account with one customer, Hayes-Custer Stove, Inc., which went bankrupt in 1937. The loss from the indebtedness of that company in 1938 was $ 15,075.47 out of total bad debts for the year of $ 15,798.18. It is this one bad debt loss in 1938 which gives rise to the issue presented and, accordingly, consideration of the question revolves about that one bad debt loss.

The gross income of petitioner in the base period years ranged around $ 200,000; it increased in 1936 and 1937, but decreased in 1938. 8 T.C. 383">*387 The average gross income received in 1936 and 1937 was $ 232,635, and the gross income in 1938, $ 208,454, was less than the average of the two preceding base period years. Losses from bad debts decreased in 1936, when gross income 1947 U.S. Tax Ct. LEXIS 272">*280 increased. Losses from bad debts increased in 1938, when gross income decreased. This comparison of the trends of gross income in 1936, 1937, and 1938 with the losses from bad debts in the same years shows that the increase in the 1938 loss from bad debts was not a consequence of an increase in gross income. Cf. William Leveen Corporation, 3 T.C. 593, 595. The abnormal or excess part of the 1938 loss from bad debts was $ 8,224.18. This was very much greater than the total bad debt deduction for the year 1936 and the year 1937, when gross income increased; and, as noted above, 1938 gross income decreased.

The sales to Hayes-Custer Stove, Inc., declined in 1936 and 1937, and none were made in 1938. The question presented relates to the loss on this account, deducted in 1938, and the deduction of $ 15,075.47 in 1938 resulted from sales made to Hayes-Custer in 1936 and 1937. About one-half of the bad debt loss resulted from sales made to Hayes-Custer in 1937, in which year sales to Hayes-Custer were almost half of what they had been in 1936. At the same time sales to other customers increased substantially in 1936 and 1937, reaching about $ 1,000,0001947 U.S. Tax Ct. LEXIS 272">*281 in 1937.

The situation here is clearly one in which the abnormality or excess amount is a single item of loss due to the failure of one of many customers. Under the facts, we can not hold that the abnormality or excess in 1938 was "a consequence of an increase in the gross income of the taxpayer in its base period." It is held that it was not such "a consequence," and that respondent erred in his determination. Petitioner is entitled to have the excess of the 1938 bad debt deduction disallowed as a deduction and restored to its base period excess profits net income in computing its excess profits credit for the years 1940 and 1941. The bad debt excess of $ 8,224.18 for the computation of the 1940 excess profits tax will result in an excess profits credit carry-over from 1940 for credit in 1941. The parties have so agreed.

Decision will be entered for under Rule 50.