19 T.C. 229">*230 The Commissioner disallowed claims of the petitioner under section 711 (a) and (b) of the Internal Revenue Code for refund of excess profits taxes for 1940, 1942, and 1943. The issues for decision are whether or not (1) a deduction during the base year 1939 of an amount placed in a reserve for a possible loss on a surety contract should be disallowed because abnormal in class under 1952 U.S. Tax Ct. LEXIS 50">*51 section 711 (b) (1) (J) (i); (2), or, in the alternative, a part of the same deduction should be disallowed because abnormal in amount under section 711 (b) (1) (J) (ii); and (3) amounts received during the taxable years as partial reimbursements of losses for which the petitioner had taken deductions in prior years are excludible from excess profits net income as recoveries of bad debts within the meaning of section 711 (a) (1) (E).

FINDINGS OF FACT.

The petitioner, a New York corporation organized in 1926, filed its excess profits tax returns for the taxable years with the collector of internal revenue for the second district of New York.

The petitioner writes a number of different kinds of policies and bonds, including various types of insurance policies and surety bonds.

New York City advertised for bids in 1938 for the construction of a foundation for a new Criminal Courts building. The work was to include the construction of about 200 concrete columns reaching down to bedrock. The city had had some test borings made on the location, the result of which was known to the bidders, but it did not warrant that they adequately disclosed the nature and condition of the substrata. 1952 U.S. Tax Ct. LEXIS 50">*52 The bid of L. P. O'Connor, Inc., hereinafter called O'Connor, to do the work for $ 1,735,000 was accepted. O'Connor did not make its own test borings.

The city required O'Connor to furnish a surety bond. The petitioner and ten others joined in furnishing a bond for which they charged $ 17,350. The petitioner received one-tenth of that amount, or $ 1,735. The bond, dated October 4, 1938, was a specially typewritten bond in accordance with the requirements of the city. The bond provided that O'Connor was bound to the city in the penal sum of $ 1,735,000 and the sureties listed were bound jointly and severally 19 T.C. 229">*231 with the principal to the city in the sums set opposite their respective names. The amount set opposite the name of the petitioner was $ 173,500. The bond guaranteed performance by O'Connor of its contract with the city and payment by the contractor of its various obligations to materialmen, labor, and subcontractors in connection with the work.

O'Connor commenced work on the contract on October 15, 1938, but soon ran into an underground pond and large boulders which seriously interfered with the work. Those conditions had not been revealed by the test borings. 1952 U.S. Tax Ct. LEXIS 50">*53 O'Connor suggested the use of a different type of foundation but the city insisted upon compliance with the contract. The city declared O'Connor in default on February 29, 1939, at which time it had constructed approximately 60 of the columns, had earned approximately $ 330,000 of the contract price, and had spent approximately $ 1,300,000 on the work.

The petitioner set aside on its books in 1939 a reserve of $ 135,001 for impending loss growing out of the O'Connor bond. Litigation ensued between the city, O'Connor, the companies obligated on the bond, and various subcontractors and materialmen. The petitioner increased the reserve set aside against the threatened loss by $ 40,000 in 1940, $ 40,000 in 1942, and $ 10,400 in 1943, making a total reserve of $ 225,401. The Supreme Court of the State of New York handed down its decision in 1944 holding that the contractor was not liable to the city, and the petitioner in that year paid $ 26,621 by way of compromise of the litigation in consideration of which appeal from the decision of the court was abandoned. The petitioner, in 1944, restored $ 198,780 to income, being the difference between the total reserve set up and the payment1952 U.S. Tax Ct. LEXIS 50">*54 made to avoid further litigation.

Another contractor attempted to complete the foundation on a cost plus basis but was unable to sink proper concrete columns and, with the approval of the city, finished the work by the alternative method originally advocated by O'Connor.

A rating bureau, referred to herein as Towner, acted and was recognized by the Insurance Department of the State of New York as statistical agent of companies writing fidelity, surety, and forgery bonds in that State, at all times material hereto. Towner assembled and reported operating data required by State insurance departments from such companies. It also fixed and promulgated rates to be charged by those companies, with approval of the State Insurance Department, and prescribed codes (account classifications) to be used by them in periodic reports of premiums and losses. Similar codes and rates prescribed by other agencies were followed by the petitioner in connection with all the other different lines of business handled by it.

19 T.C. 229">*232 One of the numerous subdivisions of the Fidelity and Surety Code prior to 1936 was as follows:

G. Other Public and Private Contracts (Except Federal):

1952 U.S. Tax Ct. LEXIS 50">*55 A New York State Insurance Department examiner had reported in 1934 that Towner had not adopted sufficient codes to permit an adequate refinement of loss experience so Towner increased the number of codes as of January 1, 1936, and gave as one of the subdivisions the following:

Code No. 365 is for light construction. Code No. 366 is for heavy construction such as buildings.

The Towner codes included classifications1952 U.S. Tax Ct. LEXIS 50">*56 similar to the above for Federal contracts.

The $ 135,001 set aside by the petitioner in 1939 and additions thereto 19 T.C. 229">*233 in later years in connection with the O'Connor bond were classified in its accounts under Code No. 367. The following is a summary of the net amounts recorded for each year as premiums and losses for 1936 through 1945 in the accounts of the petitioner in respect of Code No. 367:

The petitioner, for its own purposes, maintained seven general accounts in which it recorded aggregate earned premiums and losses incurred in respect to various kinds of surety bonds issued by it. It included under one of those accounts, "Contract Bonds Other Than Federal," items falling into a number of different codes including No. 367.

The petitioner took a deduction of $ 5,356,021.05 on its return for 1939 for losses and loss expense incurred on insurance contracts and reported that the amount differed by $ 6,016 from the same 1952 U.S. Tax Ct. LEXIS 50">*57 item on its annual statement. Loss expense includes amounts paid attorneys and adjusters. The $ 135,001 entered as a reserve in 1939 in respect to the O'Connor bond was used in the computation of the above deduction.

The petitioner sustained two surety losses of about $ 300,000 each on construction contracts in about 1930. Thereafter, it had no individual surety losses in excess of about $ 25,000 per loss with the exception of the one here in question and one of about $ 37,000 on a highway contract. The losses from all sources accrued by the petitioner on its books for the years 1935 through 1943 averaged about $ 3,400,000 per year. The following table shows the net amounts accrued for each year by the petitioner on its books as losses from its surety business for the years 1935 through 1943:

The computations of average base period net income on the excess profits tax returns filed by the petitioner for the taxable years showed 19 T.C. 229">*234 no disallowances for abnormal deductions. The petitioner, in 1952 U.S. Tax Ct. LEXIS 50">*58 its claims for refund for the taxable years, made claim for disallowance of all or a part of the deduction taken in 1939 in connection with the O'Connor bond. The Commissioner, in denying the applications for relief and the claims for refund held that the petitioner was not entitled to any exclusion under section 711 (b) (1) (J) on account of that deduction.

No part of the deduction claimed for 1939 in connection with the O'Connor bond was a consequence of an increase in gross income or a decrease in the amount of some other deduction during the base period, or a change at any time in the type, manner of operation, size, or condition of the business engaged in by the petitioner.

The amount of $ 135,001 entered in the reserve in 1939 to anticipate a loss on the O'Connor bond is not a separate class of deduction for the purpose of section 711 (b) (1) (J) (i). Amounts accrued as losses by the petitioner under Code No. 367 are not a separate class of deduction for the purposes of section 711 (b) (1) (J) (ii). The deduction of $ 135,001 was not abnormal as a class within the meaning of section 711 (b) (1) (J) (i) and no part of it was abnormal in amount within the meaning of section 1952 U.S. Tax Ct. LEXIS 50">*59 711 (b) (1) (J) (ii).

The petitioner paid various sums during the years 1936 through 1939 in settlement of claims of those insured by it and effected collections during the years 1940 through 1943 on account of claims settled during those prior years. Amounts recovered in that way are called salvage. The following table shows the amount of salvage recovered during the years 1940 through 1943 on account of claims settled in the years 1936 through 1939:

The petitioner did not set up an account receivable from the principal when it paid a loss occasioned by the principal's default. It set up no account for salvage income until the salvage was actually received, except in a few instances in which it knew at the end of a given year the amount that it would be able to recover in a subsequent year. The record does not show that any amounts owed the petitioner by those principals from whom salvage was received during the taxable years were ever worthless debts.

The petitioner, in its claims for refund, claimed that an estimated amount of $ 10,000 should be excluded under section 7111952 U.S. Tax Ct. LEXIS 50">*60 (a) (1) (E) 19 T.C. 229">*235 on account of the salvage received during the taxable years. The Commissioner denied the claim.

The salvage recovered during the taxable year on account of claims settled during the years 1936 through 1939 does not represent recoveries of bad debts within the meaning of section 711 (a) (1) (E).

All facts and exhibits stipulated by the parties are incorporated herein by this reference.

OPINION.

Insurance companies, other than life or mutual, are taxed in accordance with the special provisions of section 204. One of the deductions allowed is for losses incurred as defined in subsection (b) (6). That subsection is as follows:

Losses Incurred. -- "Losses incurred" means losses incurred during the taxable year on insurance contracts, computed as follows:

To losses paid during the taxable year, add salvage and reinsurance recoverable outstanding at the end of the preceding taxable year, and deduct salvage and reinsurance recoverable outstanding at the end of the taxable year. To the result so obtained add all unpaid losses outstanding at the end of the taxable year and deduct unpaid losses outstanding at the end of the preceding taxable year;

The deduction for1952 U.S. Tax Ct. LEXIS 50">*61 losses incurred taken by this petitioner on its 1939 return, in the computation of which the $ 135,001 amount involved herein was used, was taken under those provisions of section 204. The record does not show just why the petitioner chose the amount of $ 135,001 in setting up the reserve in 1939 to cover the loss which it anticipated on the O'Connor surety bond. It contends that the deduction of that amount in 1939 was in a class by itself and was abnormal within the meaning of section 711 (b) (1) (J) (i). No one has attempted to state any general rule for classifying deductions for that purpose and no prior decision, close enough to be helpful here, has come to light. This issue must be considered and decided on the facts presented.

The combination of such a large deduction taken in the base year 1939 and an even larger offsetting restoration to income in the excess profits tax year 1944, in which the actual liability, if any, was settled by payment of $ 26,621, is an unfortunate one for the petitioner. However, this Court has no authority to grant relief except in cases coming within the statutory provision. Furthermore, the deduction and the inclusion were within the special1952 U.S. Tax Ct. LEXIS 50">*62 method of reporting permitted taxpayers like this one and it is not clear that the system as a whole worked any hardship upon the petitioner. Nevertheless, the petitioner is entitled to any relief for which it qualifies under section 711 (b) (1) (J).

19 T.C. 229">*236 It is proper to consider the circumstances which gave rise to the deduction. But unusual features of the bond or of the risk are not particularly significant except as they have some bearing upon the deduction itself and tend to make it abnormal. The petitioner discusses various allegedly unusual features of the bond and of the risk which do not appear to have led to the deduction or the loss and for that reason seem immaterial to the decision of this issue. The petitioner argues, for example, that mere size is some justification for separate classification of this deduction. That entire line of reasoning lacks persuasiveness in view of the fact that section 711 (b) (1) (J) (ii) is especially designed to give relief where a deduction is abnormal in amount. A Congressional intent to have the application of section 711 (b) (1) (J) (i) also depend upon size is not readily apparent. Cf. Tovrea Land & Cattle Co., 10 T.C. 90.1952 U.S. Tax Ct. LEXIS 50">*63 There is evidence that the petitioner made some effort to limit its risks to $ 50,000, but any such practice was not closely followed. The facts that a printed form was not used but, instead, the bond was especially drafted, that it covered performance and payment, and that the city was protected prior to those entitled to payment, do not justify separate classification of the 1939 deduction. It does not appear that any of those characteristics of this bond bears any close or significant relation to the deduction taken in 1939 which would lead to the separate classification of that amount as an abnormal deduction.

Likewise, the cause of the loss is a poor basis for separate classification of the 1939 deduction as an abnormal one. The business of this petitioner was to take risks for a fee in order to protect others. Its success depended upon knowing what risks it was taking. It tried to calculate its risks and charge accordingly so that the total charges would exceed the eventual losses. The purpose of this particular bond was to protect the city from loss or damage up to $ 1,735,000 suffered by reason of any failure of O'Connor to carry out its contract, and, secondly, to guarantee1952 U.S. Tax Ct. LEXIS 50">*64 that O'Connor would pay for materials and labor used in performing the work. O'Connor was to construct concrete columns down to bed rock upon which the building was to rest. An important factor to all concerned, including the petitioner, was the kind of substance which had to be penetrated in order to have the columns reach bed rock. O'Connor defaulted because that overburden was not what it expected. The possibility that that overburden might present difficulties was one of the risks inherent in the piece of business which the petitioner accepted by joining in the bond and accepting a fee for taking all such risks. Overlooking that possibility in construction work below ground or water level would be inexcusable in the case of a surety and the petitioner undoubtedly considered it. Borings were made to determine the character and condition 19 T.C. 229">*237 of the overburden, but for some reason not disclosed by the record those borings were inadequate. However, the presence of rocks and water in the overburden, which made the work so difficult and expensive, is not shown to be so unusual, unforeseeable, or unpredictable, had proper investigation been made, as to justify separate classification1952 U.S. Tax Ct. LEXIS 50">*65 of the 1939 deduction as abnormal within the meaning of section 711 (b) (1) (J) (i). The default of O'Connor caused the petitioner to set up a reserve and take a deduction in 1939, but the ultimate cause of the loss to the petitioner was its decision, along with the other sureties, to compromise, rather than risk a possible appeal from a court decision in their favor. Perhaps the most abnormal thing about the 1939 deduction of $ 135,001 may have been its excess over the ultimate loss, but section 711 (b) (1) (J) grants no relief for that kind of an abnormality.

Differences between the risks taken by the petitioner on different business are apparent, but every difference in risk, in cause of loss, or in some other circumstance to which the petitioner can point, does not justify a separate classification of a deduction for the purpose of section 711 (b) (1) (J) (i). The Commissioner would place all of the deductions of the petitioner based upon entries in its reserve accounts in but one class. That may be too narrow a view. Nevertheless, the record not only fails to show that all other deductions taken by the petitioner can be distinguished for present purposes from the 1939 deduction1952 U.S. Tax Ct. LEXIS 50">*66 of $ 135,001, but it shows, on the contrary, that the petitioner was entitled, or may have been entitled, to take other deductions, even some larger ones, which would seem to fall into the same class as this one. No sufficient reason, or combination of reasons, for classifying this deduction separately for the purpose of section 711 (b) (1) (J) (i) appears here despite careful study of the record and of the arguments of the petitioner. If this particular deduction is so different from all usual deductions in the history of the petitioner as to justify separate classification for the purpose of this Code provision, this Court is unable to describe that difference.

The petitioner contends, as a rather secondary alternative, that all deductions based upon surety bonds accounted for under the Towner Rating Bureau Code No. 367 should be classified separately for the purpose of section 711 (b) (1) (J) (ii). Accounting practice is of some significance under the Treasury Regulations pertaining to this section, cf. Tovrea Land & Cattle Co., supra, and undoubtedly the classification of accounts prescribed by Towner was important for some purposes. It enabled1952 U.S. Tax Ct. LEXIS 50">*67 studies to be made in fixing rates, it may have helped to show the petitioner the relation of charges to risks under bonds which differed in some particulars from each other, and it may have had other advantages. Still it does not appear that every 19 T.C. 229">*238 Towner Code number, or this one in particular, should be the basis for a separate classification of deductions for the purpose of section 711 (b) (1) (J) (ii). These code numbers have been increased by subdivision in the past and the process may continue for reasons sufficient to the bonding companies, Towner, and the state authorities. Yet it does not necessarily follow that those reasons have any relation to classifications for the purpose of section 711 (b) (1) (J) (ii). Cf. George J. Meyer Malt & Grain Corporation, 11 T.C. 383, in which at page 392 reference was made to "unwieldy number of classifications." The Court has been told only superficially, for example, how "Other Public and Private Contracts (Except Federal), Other Construction: All Others," which describes Towner Code No. 367 contracts, would differ from "Federal Contracts, Other Construction: All Others" or from contracts classified1952 U.S. Tax Ct. LEXIS 50">*68 under other code numbers as, for example, 357 through 362 and the corresponding code numbers for similar Federal contracts, and it does not know how the differences, whatever they are, would justify separate classification of deductions relating to those contracts for the purposes of section 711 (b) (1) (J) (ii). There is the possibility that underground rocks or water might be encountered in the course of construction in all contracts mentioned in those classifications, so the different classes could not be distinguished satisfactorily on that basis.

The petitioner makes no claim that any other classification would bring it relief and no other classification which would bring it relief is apparent from the record.

The remaining contention of the petitioner is that it is entitled to exclude certain amounts from excess profits net income for the years 1940 through 1943 under section 711 (a) (1) (E). The excess profits net income for those years is the normal-tax net income with adjustments, one of which is covered by (E), entitled "Recoveries of Bad Debts." It provides "There shall be excluded income attributable to the recovery of a bad debt if a deduction with reference to such1952 U.S. Tax Ct. LEXIS 50">*69 debt was allowable from gross income for any taxable year beginning prior to January 1, 1940." The parties have stipulated that the petitioner paid various sums during the years 1936 to 1939 inclusive in settlement of claims of those insured by it and effected collections, called "salvage," during the years 1940 through 1943 on account of those same claims in the total amount of $ 101,561.93. Those are the amounts which the petitioner seeks to exclude as "recoveries of bad debts for prior years."

The petitioner did not set up an account receivable from the principal when it was required to meet a loss insured by it and it set up no account to show income due from salvage until salvage was actually received, except in a few instances in which it definitely knew at the 19 T.C. 229">*239 end of a year that it would be able to recover some amount as salvage in a subsequent year. The record does not show that any amount due the petitioner which it collected as salvage during the taxable years was ever a part of a worthless debt. The petitioner never took any deductions for worthless debts in connection with these items and none was allowable. It took deductions for losses incurred on policy1952 U.S. Tax Ct. LEXIS 50">*70 contracts and the salvage represented recoveries of a part of those amounts deducted as losses. Thus, the amount which the petitioner seeks to exclude does not represent the recovery of a bad debt with reference to which a deduction was allowable from gross income for any year prior to January 1, 1940.

The petitioner did not know what amount, if any, might be collected from the principal at the time it claimed the deductions for anticipated losses against which it had insured. The deductions were allowable as amounts were entered in the reserve for anticipated losses without regard to or consideration of any possible recovery of salvage from the principal or otherwise in a later year. ¹ A proper investigation might have disclosed at the time the deduction was taken that these salvage recoveries would be made. Thus, the recoveries may have been of good debts rather than of bad debts. Furthermore, there is evidence that "salvage" is not limited to recoveries from defaulted principals and it is not clear that the amounts in question were all recoveries from principals. Although, as the petitioner claims, there may be some similarity between the "salvage" which it recovered as 1952 U.S. Tax Ct. LEXIS 50">*71 a normal incident of its business and the recovery of bad debts which Congress has excluded, nevertheless its salvage may not be excluded since it does not come within section 711 (a) (1) (E).

The petitioner quotes extensively from and places considerable reliance upon the case of Beneficial Industrial Loan Corporation, 7 T.C. 1019, but that case is distinguishable upon its facts. The petitioner filed a consolidated excess profits tax return for 1940 in which about 256 subsidiaries joined. The principal business of the group was the making of small loans from which innumerable "bad debts" developed. Two of the subsidiaries insured the loans for the lenders and paid the lender for any part of a loan which was not collected. The insurer thereafter sometimes made some recoveries on the unpaid debts. This Court held that those recoveries, although salvage 1952 U.S. Tax Ct. LEXIS 50">*72 on losses deducted by the two insurance companies, were excludible under section 711 (a) (1) (E) as recoveries of bad debts, considering the consolidated group as a business unit, engaged in the small loan business. The facts in the present case do not present such a situation.

Decision will be entered for the respondent.