39 T.C. 999">*999 The respondent determined deficiencies in the petitioners' income taxes for the fiscal year ended February 28, 1955, in the following amounts:

1963 U.S. Tax Ct. LEXIS 170">*172 Both dockets involved the issue whether the balance of a bad debt reserve should be added to income in the taxable year at issue.

Docket No. 79184 involves the following additional issues:

(1) What was the amount of United's reserve for bad debts at the beginning of the year in issue?

(2) Is a $ 250,000 loss on the sale of loans a capital loss or an ordinary loss?

39 T.C. 999">*1000 (3) Is an amount of approximately $ 179,000 claimed as a loss deduction properly deductible?

(4) Is gain from sales of certain lots capital gain or ordinary income?

(5) Is the addition to tax for negligence under section 6653 of the Internal Revenue Code of 1954 properly asserted by the respondent?

The petitioner in Docket No. 79184 has failed to urge on brief certain other issues raised by the petition; therefore, we deem these issues to be abandoned.

FINDINGS OF FACT.

Some of the facts are stipulated and are found as stipulated.

Petitioner Burbank Liquidating Corp., hereinafter referred to as Burbank, is a California corporation organized in 1921 as Burbank Building-Loan Association. In 1950 its name was changed to Burbank Savings and Loan Association, and in 1954 its name was changed to Burbank Liquidating1963 U.S. Tax Ct. LEXIS 170">*173 Corp. Burbank filed its U.S. corporation income tax return for the fiscal year ended February 28, 1955, with the district director of internal revenue at Los Angeles, Calif.

Petitioner United Associates, Inc., hereinafter referred to as United, is a California corporation organized in 1945 as United Savings and Loan Association. On October 27, 1954, its name was officially changed to United Associates, Inc. United filed its U.S. corporation income tax return for the fiscal year ended February 28, 1955, with the district director of internal revenue at Los Angeles, Calif.

Both Burbank and United operated as domestic savings and loan associations until March 1, 1954. On that date both corporations transferred most of their assets and liabilities to Home Savings and Loan Association, hereinafter referred to as Home. Among the assets transferred by Burbank were loans receivable, most of which were secured by real estate mortgages, in the amount of $ 8,689,160.31. United transferred similar loans in the amount of $ 35,119,356.64. Burbank and United guaranteed Home against any default on these loans within 18 months after the transfer. This guarantee was set forth in article VII1963 U.S. Tax Ct. LEXIS 170">*174 of Burbank's agreement with Home and in article IX of United's agreement with Home as follows:

As a condition of this sales, Burbank [or United] guarantees all loans herein transferred as to payment of both principal and interest for a period of eighteen (18) months from the effective date of this agreement, and, in addition, guarantees the completion of all houses, buildings and structures under construction covered by loans transferred herein during said period. In the event a default 39 T.C. 999">*1001 occurs in any loan transferred hereby within eighteen (18) months, upon receipt of written notice within said eighteen (18) month period, Burbank [or United] agrees to repurchase said loan for the amount of the remaining unpaid principal plus accrued interest.

Immediately prior to the transfer Burbank had on its books certain accounts constituting a reserve for bad debts. The balance of these accounts after certain adjustments not contested by Burbank was $ 511,077.21. Of this amount $ 499,319.71 had been added to the reserve and deducted for Federal income tax purposes between January 1, 1952, and March 1, 1954, the date of the transfer to Home.

United also maintained several accounts1963 U.S. Tax Ct. LEXIS 170">*175 which performed the function of a reserve for bad debts. It made additions to these accounts and claimed deductions for periods after January 1, 1952, as follows:

The total of the above sums less certain adjustments made in the deficiency notice and not contested by United on brief is $ 1,208,949.63.

United submitted the following comparative balance sheet with its return for the taxable year ended February 28, 1955:

1963 U.S. Tax Ct. LEXIS 170">*176 39 T.C. 999">*1002 A pro forma balance sheet of United, prepared as of February 28, 1954, in connection with the transfer of assets and liabilities to Home showed that United owned real estate valued at $ 1,806,200 after the transfer. This amount was not separately stated on the balance sheet submitted with United's return.

The contract between United and Home includes the following paragraphs:

Article I. * * *

It is specifically understood and agreed that the loans insured under the Servicemen's Readjustment Act of 1944, as amended, are to be transferred hereunder at par less the aggregate sum of Two Hundred Fifty Thousand Dollars ($ 250,000.00). In other words, said loans are to be purchased at an aggregate discount of Two Hundred Fifty Thousand Dollars ($ 250,000.00).

* * * *

Article VI.

Certain construction loans made by United and described as The Grayson Investment Corp., Michael Grayson and Co., and Southern California Builders loans are presently in default. It is estimated that United will suffer a loss of $ 150,000.00 (One Hundred Fifty Thousand Dollars) more or less, in the ultimate work out of this transaction. The value of the assets assigned under this agreement is 1963 U.S. Tax Ct. LEXIS 170">*177 to be reduced by said One Hundred Fifty Thousand Dollars ($ 150,000.00) and any additional loss on this transaction will be immediately due and payable from United. If the loss caused by this transaction after all the buildings involved are completed and sold and all expenses paid indirectly or directly attendant thereto, and all recoveries taken into consideration, including without limitation interest adjustments claimed against Title Insurance and Trust Company and any and all other persons, shall be less than One Hundred Fifty Thousand Dollars ($ 150,000.00) Home will refund the difference to United. It is understood that among assets to be transferred hereunder all rights of United to recover funds from any and all parties in regard to this transaction are hereby assigned to Home.

39 T.C. 999">*1003 Neither Burbank nor United included any part of their reserves for bad debts in income for the year in which they transferred certain of their assets and liabilities to Home. The respondent determined that the balance of these reserve accounts, less the amounts accumulated prior to January 1, 1952, should be included in income for the year of the transfer. In the case of United, the respondent1963 U.S. Tax Ct. LEXIS 170">*178 determined that this amount was $ 1,208,949.63.

In 1951 section 6705 of the California Financial Code was enacted authorizing savings and loan associations to purchase and hold land. This section provided as follows:

Sec. 6705. Investment in real property: Acquisition and disposition: Limit to aggregate of investments. An association may invest in real property and such investment may include subdividing and developing real property and building homes and other buildings principally for residential use by veterans on such property. An association may own, rent, manage, operate for income, or sell such property. No association shall have investments, under this section aggregating at any one time more than whichever of the following is the lesser:

(a) Five percent of its total assets.

(b) An amount equal to the sum of its capital, surplus, undivided profits, loan reserve, federal insurance reserve, and such other reserves as the commissioner may prescribe.

Pursuant to this authorization United made the following purchases of subdivided real estate:

Additional real estate acquired by United on October 5, 1953 -- $ 485,150.

This land was purchased for residential housing development for veterans. On October 6, 1953, United's board of directors adopted the following resolution with respect to this land:

39 T.C. 999">*1004 Resolved, That the Executive Committee be given full authority to sell all or part of any lots in Tracts 18976, Los Angeles County, 15930, Los Angeles County, 3931, San Bernardino County, 3974, San Bernardino County, owned by the Association, and that the Loan Committee grant loans to the buyers of said lots should they be desired.

On October 6, 1953, United sold 72 lots of tract 18976 to Burbank for $ 180,000, which was United's cost. United made other sales of its real estate during 1953; it sold property with a cost basis of $ 485,150 and realized a gain of $ 42,361.70. After these sales United held real property (other than their office building) with a cost basis of $ 1,806,200. This property1963 U.S. Tax Ct. LEXIS 170">*180 was not transferred to Home but was retained by United. During the taxable year in issue United made numerous sales of these lots as follows:

The ledger accounts of United do not reflect any expenditures for improvement of this land nor do they reflect any expenditures1963 U.S. Tax Ct. LEXIS 170">*183 for advertising or brokerage fees with respect to it. They do, however, show a selling expense of $ 4,484.50 which is not further explained.

United reported the gain from the sale of these lots as capital gain. The respondent determined that this gain was ordinary income.

The respondent also asserted the addition to tax for negligence against United. On or about March 8, 1954, United redeemed 176 shares of its own stock for $ 492,000. On or about September 30, 1954, United redeemed 544 of its shares as follows:

The total of the amounts paid for the redeemed stock was $ 2,015,700. On its books, United set this sum off first against the accounts that it maintained as loan reserves and then against earned surplus. The result of these entries was that the reserve accounts were eliminated completely from United's books and the balance of the earned surplus was reduced to $ 437,709.62. The entries making these changes appeared on the books of United, but the real nature of these transactions was not revealed on the income tax return for the year in issue. 1963 U.S. Tax Ct. LEXIS 170">*184 The only indication of these transactions on the return was the balance of the accounts as shown on and eliminated from the balance sheet submitted with it.

In reporting a loss on the sale of its loans receivable, United reported the correct amount of the loss on its return for the year in issue; however, on the supporting statement submitted with the return certain figures relating to these assets were omitted so that the supporting statement did not show the correct figures. No part of the 39 T.C. 999">*1006 deficiency was due to this omission. A note payable had been recorded on United's books at a figure $ 20,500 less than the amount actually due on it. As a result the balance sheet submitted with the return for the year in issue was in error in that it understated notes payable and overstated earned surplus. No part of the deficiency was due to this error.

OPINION.

The respondent contends that the petitioners were required to include the balance of their reserve for bad debt accounts, insofar as they represent amounts deducted after December 31, 1951, in income for the year in which they transferred the debts to which the reserves were applicable. The petitioners, however, contend1963 U.S. Tax Ct. LEXIS 170">*185 that they were entitled to maintain these reserve accounts throughout the year in issue.

In Arcadia Savings & Loan Association, 34 T.C. 679">34 T.C. 679 (1960), affd. 300 F.2d 247 (C.A. 9, 1962), this Court held that a savings and loan association was required to include in income in the year in which a reserve for bad debts became unnecessary the amount deducted as an offset to taxable income as an addition to the reserve. That case is similar to the instant case in that (1) a savings and loan business was sold by the taxpayer and (2) any loan that was transferred was to be repurchased if within 18 months of the transfer a default occurred. In the Arcadia case the Commissioner included a portion of the amount of the questioned reserve in income in the first year following the year of sale and the balance of it in the second year. The correctness of this allocation by the Commissioner was stipulated to by the parties and was not in issue in that case. The sole issue in that case was whether a reserve for bad debts created by additions which offset taxable income must be restored to income in the year in which the need for the reserve1963 U.S. Tax Ct. LEXIS 170">*186 ceased. This was decided in the affirmative.

In the instant case the petitioners have raised the issue of the proper year for the inclusion of the reserves in income. The petitioners contend that they are entitled to maintain the reserves which they set up prior to the sale to Home for the 18-month period during which they were responsible for the loans they transferred. Both petitioners in transferring their loans receivable effective March 1, 1954, agreed to repurchase any loan on which there was a default during the 18 months following the transfer. Thus, the petitioners argue that they remained in a position to suffer a loss with respect to these loans.

The bad debt reserves of the petitioners were built up by large special deductions allowed to savings and loan companies by section 23(k) of the Internal Revenue Code of 1939. Implicit in the position 39 T.C. 999">*1007 of the petitioners is the contention that they are entitled to maintain the unusually large reserve accounts built up by special deductions while they were in the savings and loan business in spite of the fact that they ceased to engage in that business. When the petitioners ceased to be savings and loan institutions1963 U.S. Tax Ct. LEXIS 170">*187 they ceased to have the need of that type of institution for a large reserve for bad debts. As was stated by the Court of Appeals for the Ninth Circuit in Arcadia Savings & Loan Association v. Commissioner, supra at 251:

To us, the significant facts are that Arcadia received a tax benefit when its 1952 net income escaped taxation upon being added to its reserves for bad debts and and that the need for such reserves ceased following the sale of its business and real estate loans. [Emphasis added.]

Indeed, the need for such large reserves would be difficult, if not impossible, to demonstrate in view of the fact that many of the loans transferred by the petitioners were Government insured. Consequently, it is not at all clear under which circumstances, if any, the petitioners would be entitled to carry these large reserves on their books. We need not, however, decide this question as we may dispose of this issue on other grounds.

After the transfer to Home, any loss to the petitioners with respect to loans that had been made by them would not relate to a debt owing to the petitioners but would relate to a debt owing to their transferee, Home. The possibility of loss1963 U.S. Tax Ct. LEXIS 170">*188 to the petitioners arose only from their contingent liability to repurchase any loan that might be defaulted within the 18 months following the transfer of the loans to Home. This Court has held that a taxpayer is not entitled to maintain a reserve for bad debts as a provision for contingent liabilities. Hoover Grain Co., 14 B.T.A. 781">14 B.T.A. 781 (1928); Farmville Oil & Fertilizer Co., 30 B.T.A. 1048">30 B.T.A. 1048 (1934), affd. 78 F.2d 83 (C.A. 4, 1935); William M. Davey, 30 B.T.A. 837">30 B.T.A. 837 (1934). Thus, we must hold that the petitioners were, after the transfer of their loans, no longer entitled to maintain reserves for bad debts. It follows, then, that the amounts accumulated in these reserves after December 31, 1951, must be taken into income in the year in which the petitioners transferred their accounts, in accordance with our decision in 34 T.C. 679">Arcadia Savings & Loan Association, supra.

In connection with the contentions of the petitioners, we have considered the case of Wilkins Pontiac v. Commissioner, 298 F.2d 893 (C.A. 9, 1963 U.S. Tax Ct. LEXIS 170">*189 1961), reversing 34 T.C. 1065">34 T.C. 1065 (1960). See also Foster Frosty Foods, Inc., 39 T.C. 772">39 T.C. 772 (1963). We believe Wilkins Pontiac is distinguishable from the present situation. In Wilkins Pontiac the taxpayer, an automobile dealer, took notes in payment for goods sold and discounted them regularly with recourse to a finance company. The taxpayer there sought a deduction for an addition to a 39 T.C. 999">*1008 reserve for bad debts based on the notes taken and discounted. In the present case the facts are very different. The petitioners, former savings and loan companies, sold all of their loans with an agreement to purchase those defaulted within 18 months and ceased to engage in the savings and loan business. These factual differences include a number of significant distinctions. Among these the following two seem especially significant. In Wilkins Pontiac the taxpayer transferred the notes he received with full recourse. In the instant case the petitioner's responsibility for the loans they transferred (presumably long-term mortgage notes) was to continue only for a period of 18 months and applied only to notes that were1963 U.S. Tax Ct. LEXIS 170">*190 defaulted during that period. In Wilkins Pontiac the taxpayer was apparently continuing in business and receiving and discounting notes on a regular basis. In the present case, however, the petitioners ceased to conduct the savings and loan businesses and therefore ceased to have any need for the unusually large reserve accounts allowed to savings and loan companies.

United also contends that after the transfer of its loans to Home, it retained sufficient loans to justify the retention of the reserve for bad debts. In support of this contention, counsel for the petitioners has pointed to the fact that the comparative balance sheet submitted with United's return for the year in issue showed after the asset title "Notes and accounts receivable" (net of bad debt reserves) a figure of $ 36,959,762.54 for the end of the prior taxable period and a figure of $ 1,806,200 for the end of the taxable year in issue. However, this balance sheet does not reflect substantial land holdings which the stipulation shows United owned at the beginning of the taxable year in issue. Moreover, the amount shown under "Notes and accounts receivable" for the end of the taxable period is the exact book1963 U.S. Tax Ct. LEXIS 170">*191 figure revealed for land held at the beginning of the period. Thus, it appears that the figure under "Notes and accounts receivable" at the beginning of the period may have included the land, and the figure shown for the end of the period may represent land holding or debt acquired from the sale of land during the year in issue. However this may be, United has failed to show by a preponderance of the evidence that it retained any loans for which it would be entitled to maintain a bad debt reserve.

On behalf of United, it is also contended that the figure shown in the deficiency notice as the amount contained in the accounts representing the reserve for bad debts is substantially larger than it should be. In support of this contention, United presented the testimony of an accountant who stated that he examined the available books of United and that his examination revealed that the total of the amounts in accounts constituting the reserve for bad debts was substantially 39 T.C. 999">*1009 less than the figure for this total used in the deficiency notice. However, this witness testified that he had made his examination shortly before the trial, that he had not made a complete audit, that1963 U.S. Tax Ct. LEXIS 170">*192 he did not believe he had all of United's books available, and that he was unable to reconcile the figures found in the bad debt reserve accounts with the figures relating to them which appeared on prior tax returns submitted by United. On the other hand, the figures used in the deficiency notice appear to have been taken from tax returns submitted by United which are in evidence in this case. These figures are consistent with the returns. With the evidence in this posture, we must hold that United has failed to establish by a preponderance of the evidence that respondent was in error in the figures used in the deficiency notice.

The accountant who testified for United did point to certain losses (a discount of $ 250,000 on the sale of loans, a loss of $ 150,000 more or less on loans to Grayson Investment Corp., and others) as possible sources for the reduction of the amounts that should be shown in the bad debt accounts. However, the deductibility of these items will be discussed separately and therefore need not be treated as an aspect of this question.

United contends that it is entitled to an ordinary loss deduction as a result of the discount of $ 250,000 provided for in 1963 U.S. Tax Ct. LEXIS 170">*193 article I of the agreement covering sale of its loans to Home. The fact that this loss occurred is evidenced by article I of the agreement under which United transferred most of its assets and liabilities to Home and is not disputed by the respondent. However, the respondent contends that this loss is capital rather than ordinary.

Section 1221(4) of the Internal Revenue Code of 1954 excludes from capital assets:

(4) accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in paragraph (1); * * * ¹

The respondent contends that United's mortgage loans are not included within this language. There appear to be no decided cases on the issue in question. ² However, we believe that the mortgage loans made in the ordinary course of its business are "notes receivable acquired * * * for services rendered" and, thus, 1963 U.S. Tax Ct. LEXIS 170">*194 are ordinary rather than capital assets. Certainly, the business of a savings and loan 39 T.C. 999">*1010 company could properly be described as "rendering the service" of making loans. Therefore, we hold that United's loss on the sale of its loans is deductible as an ordinary loss.

United also contends that it is entitled to a deduction for a loss incurred resulting from loans to the Grayson Investment1963 U.S. Tax Ct. LEXIS 170">*195 Corp., Michael Grayson and Co., and Southern California Builders, which were referred to in article VI of United's agreement with Home. There is ample evidence that both parties to the agreement expected a loss to result from this transaction. However, the only evidence that such a loss occurred and of its amount is the difference between the balances found in the accounts serving as a reserve for bad debts as found by United's witness and the amounts originally transferred to those accounts as shown by United's tax return. This difference is a figure of approximately $ 429,000. If the loss of $ 250,000 on the sale of United's loans is deducted there is left an amount of approximately $ 179,000. The accountant who testified on behalf of United stated that he thought this sum might refer to the "loss of $ 150,000, more or less" mentioned in article VI of the agreement with Home as expected to result from the loans in question. United there agreed to bear whatever loss resulted. However, the pro forma balance sheet as of February 28, 1954, which was submitted in evidence, shows that United included in its reserve accounts an amount of $ 179,886.01 as a reserve for the payment1963 U.S. Tax Ct. LEXIS 170">*196 of accrued dividends on share accounts. Thus, the difference in question might refer at least as easily to the reserve for accrued dividends as to a loss on these loans. Therefore, United has failed to establish by a preponderance of the evidence that it is entitled to any loss deduction with respect to the loans in question.

United contends that it is entitled to capital gains treatment on the gain from the sale of the lots retained by it after the transfer to Home.

The facts as found by us convince us that this property was originally acquired by United for sale to customers in the ordinary course of its business. There is nothing in evidence to show us that this intent was altered prior to the sale of the property. Therefore, we hold that the sale of the property resulted in ordinary income rather than capital gain. Cohn v. Commissioner, 226 F.2d 22 (C.A. 9, 1955), affirming 21 T.C. 90">21 T.C. 90 (1953).

The respondent seeks to impose upon United the addition to tax for negligence provided in section 6653(a) of the Internal Revenue Code of 1954. This section provides:

SEC. 6653. FAILURE TO PAY TAX.

(a) Negligence or Intentional1963 U.S. Tax Ct. LEXIS 170">*197 Disregard of Rules and Regulations With Respect to Income or Gift Taxes. -- If any part of any underpayment ³ * * * 39 T.C. 999">*1011 is due to negligence or intentional disregard of rules and regulations (but without intent to defraud), there shall be added to the tax an amount equal to 5 percent of the underpayment.

The respondent's first contention in this regard is that the failure of United to disclose on its tax return that it eliminated a part of its bad debt reserve accounts in recording the redemption of stock renders it liable for the addition to tax. Mere nondisclosure in itself is not a ground for the imposition of the addition to tax. A number of cases have held that disclosure of facts has1963 U.S. Tax Ct. LEXIS 170">*198 made the addition to tax inapplicable in a case in which it might otherwise have been imposed. No case, however, has imposed the addition to tax for nondisclosure of an item of income where the taxpayer was not negligent in failing to include the item in income and did not intentionally disregard rules and regulations in failing to do so. The respondent urges, however, that United in failing to show this transaction in proper accounting form on its return showed "intentional disregard of rules and regulations." However this may be, no deficiency was due to the failure to provide information on the return as required by regulations. The deficiency resulted from failure to include in income the accounts constituting the reserve for bad debts questioned by the Commissioner. Section 6653 of the 1954 Code requires that a deficiency be due to the negligence or other stated conduct before the addition to tax may be imposed. Thus, the question becomes: Was United negligent in failing to include in income the appropriate portion of its reserve for bad debts? Savings and loan associations were tax exempt until January 1, 1952, and the language, which is now included in section 593 of 1963 U.S. Tax Ct. LEXIS 170">*199 the Internal Revenue Code of 1954, allowing them to maintain large reserves for bad debts was new at that time. Savings and loan companies were contesting the legal status of these reserves in litigation that was not concluded until 1962 in 34 T.C. 679">Arcadia Savings & Loan Association v. Commissioner, supra. In view of these facts we believe that United had reasonable grounds to differ with the Commissioner and, therefore, the addition to tax should not be imposed. Herman Senner, 22 B.T.A. 655">22 B.T.A. 655 (1931).

The respondent also contends that the inaccuracies in the schedule supporting United's report of the sale of its assets on its return and the improper balance sheet entries resulting from the erroneous recording of a note payable constitute negligence. Neither of these items resulted in any deficiency. They, therefore, may not be made the basis of an addition to tax for negligence.

Decision will be entered for the respondent in Docket 79044.

Decision will be entered under Rule 50 in Docket 79184.