Sauter, Dennis C.

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Volume 73 | Issue 1 Article 8February 1971Taxation--Reserve for Bad DebtDennis C. SauterWest Virginia University College of LawFollow this and additional works at: https://researchrepository.wvu.edu/wvlrPart of the Business Organizations Law Commons, and the Tax Law CommonsThis Case Comment is brought to you for free and open access by the WVU College of Law at The Research Repository @ WVU. It has been acceptedfor inclusion in West Virginia Law Review by an authorized editor of The Research Repository @ WVU. For more information, please contactian.harmon@mail.wvu.edu.Recommended CitationDennis C. Sauter, Taxation--Reserve for Bad Debt, 73 W. Va. L. Rev. (1971).Available at: https://researchrepository.wvu.edu/wvlr/vol73/iss1/8WEST VIRGINIA LAW REVIEWCASE COMMENTSTaxation-Reserve for Bad DebtTaxpayers were partners operating eight finance offices in Ala-bama. They used the accrual method of accounting to report incomeand the reserve method for bad debts as prescribed by section 166(c)of the 1954 Internal Revenue Code.' As of May 31, 1960, the part-nership books showed accounts receivable in the sum of $486,853.69and a reserve for bad debts in the amount of $73,028.05. On June 1,1960, the partners incorporated within the terms of section 3512of the Internal Revenue Code of 1954 and transferred all assets, in-cluding the face amount of accounts receivable, to the corporation inexchange for stock in the corporation. However, in setting up the cor-poration books, the reserve for bad debts was deducted, reflecting thenet amount of accounts receivable. The Commissioner determinedthat the reserve for bad debts should have been included as incomein the partnership's final fiscal year.' The district court,4 in a refund30 398 U.S. 333 (1970).3, "The two groups of registrants that obviously do fall within theseexclusions from the exemption (for conscientious objectors] are those whosebeliefs are not deeply held and those whose objection to war does not restat all upon moral, ethical, or religious principle but instead rests solely uponconsiderations of policy, pragmatism, or expediency." Id. at 343. But seeMacgill, Selective Conscientious Objection: Divine Will and Legislative Grace,54 VA. L. REv. 1355, 1376 (1968). "Application of these requirements [fora 'just war'] to any particular war necessarily involves the weighing ofpolitical facts which the state itself has already considered. Therefore, it isnot surprising that opposition to such a war derived from that applicationmight be regarded as political rather than religious in character, and a threatto good order."39 McFadden has also been filed for appeal with the Supreme Court,39 U.S.L.W. 3074 (U.S. Aug. 25, 1970), but it may be dismissed for lackof jurisdiction as was Sisson.INash v. United States, 398 U.S. 1 (1970); for a discussion of theFifth Circuit decision, Nash v. United States, 414 F.2d 627 (5th Cir. 1969),and an explanation of the accural method of accounting, reserve for baddebts, and accounts receivable see 72 W. VA. L. REv. 302 & n.1, 2, 4 (1970).2 § 351 (a) General RuleNo gain or loss shall be recognized if property is transferred toa corporation by one or more persons solely in exchange for stockor securities in such corporation and immediately after the exchangesuch person or persons are in control (as defined in section 368(c) ) of the corporation. For puiposes of this section, stock orsecurities issued for services shall not be considered as issued inreturn for property.I "Upon examination, the Commissioner determined that for the fiscalyear ending January 31, 1961, the partnership should include as taxable in-[Vol. 731Sauter: Taxation--Reserve for Bad DebtPublished by The Research Repository @ WVU, 1971CASE COMMENTSsuit, allowed taxpayer a recovery and the court of appeals5 reversed.The Supreme Court, reversing the decision of the Fifth Circuit6 andresolving a conflict between the Fifth Circuit and the Ninth Circuit,'held that the partnership, upon incorporating within the terms ofsection 351, was not required to include in income the amount of thebad debt reserve. Nash v. United States, 398 U.S. 1 (1970).Prior to Revenue Ruling 62-128,' there had apparently beenlittle dispute over the treatment of a bad debt reserve upon an incor-poration within the provisions of section 351. Yet a similar statutehad been on the books since the Revenue Act of 1921. 9 Since thecome Seventy-three Thousand Twenty-eight and 05/100 Dollars ($73,028.05),the bad debt reserve applicable to the accounts receivable transferred tothe corporation." Nash v. United States, 68-2 U.S. Tax Cas. [ 9513 (N.D.Ala. 1968).4 Nash v. United States, 398 U.S. 1 (1970), rev'g 414 F.2d 627 (5th Cir.1969), aff'g 68-2 U.S. Tax Cas. 9513 (N.D. Ala. 1968).5 Nash v. United States, 414 F.2d 627 (5th Cir. 1969), rev'g, 68-2 U.S.Tax Cas. f 9513 (N.D. Ala. 1968).6Nash v. United States, 398 U.S. 1 (1970), rev'g, 414 F.2d 627 (5thCir. 1969).7 In Estate of Schmidt v. Commissioner, 355 F.2d 111 (9th Cir. 1966),the Ninth Circuit had disagreed with the Commissioner's reasoning and heldthat the bad debt reserve when transferred under a section 351 exchangewas not to be taxed as income.8 A taxpayer, engaged in a business as a sole proprietor, transferredall of the assets of his business, subject to its liabilities, to a cor-poration controlled by the transferor in a nontaxable exchangeunder the provisions of section 351 of the Internal Revenue Codeof 1954. Prior to the transfer the business had, on its books ofaccount, a reserve for bad debts which had been accumulated byadditions for which the taxpayer had derived full tax benefits inprior taxable years. Held, under these circumstances the reserve forbad debts is not transferable to any other entity. Accordingly, thereserve for bad debts represents ordinary income to the taxpayerfor the taxable year during which the transfer of the accountsreceivable was made, since during such time his need for the reserveceased.Under similar circumstances, a partnership must likewise includesuch reserve for bad debts in its final return as ordinary income.However, to the extent that the additions to the reserve for bad debtsin prior years may not have resulted in tax benefits, they need notbe included in the transferor's gross income.1962-2 Cum BuLL. 139 [citations omitted].9 REvm'Eu Acr oF 1921, ch. 136, § 202(c) (3), 42 Stat 230. In Estateof Schmidt v. Commissioner, 355 F.2d 111, 112-13 (9th Cir. 1966), the courtobserved that, prior to Revenue Ruling 62-128, there had never been areported case in which the Commissioner had taken the position that a baddebt reserve should be restored to income upon incorporation.2West Virginia Law Review, Vol. 73, Iss. 1 [1971], Art. 8https://researchrepository.wvu.edu/wvlr/vol73/iss1/8WEST VIRGINIA LAW REVIEWissuance of the ruling, much litigation"° and confusion had precededthe Nash decision. The dispute in prior cases over the disposition ofthe reserve for bad debts seems to have stemmed from a differencein opinion as to what the reserve represents. The Internal RevenueService viewed the reserve as representing untaxed income, whilethe taxpayer saw it as an allowance for bad debts which representeda decrease in value recognized for tax purposes, a loss inherent in thetotal of the receivables."The tax benefit rule, 2 that is, a recovery of an item that hasproduced an income tax benefit in a prior year is to be added to in-come in the year of recovery, formed the basis of the Commissioner'scontention"3 that the reserve should be restored to income. The Com-missioner felt that the unused amount of the bad debt reserve had tobe restored when the "need" for the reserve ended with the termina-tion of the proprietorship or partnership. The concept that incomeshould be recognized when the "need" for maintaining the reserveceased was not novel. The Commissioner had often treated the endof "need" as a taxable event.' 4The Court in Nash stated that Congress, if it desired to make theend of "need" synonomous with "recovery", could make the taxbenefit rule read: "[A] bad debt reserve that has produced an incometax benefit in a prior year is to be added to income in the year whenit was recovered or when its need is ended."' 5 In that context the'0 See, e.g., Robert P. Hutton, 53 T.C. 37 (1969); Bird Management,Inc., 48 T.C. 586 (1967); J. E. Hawes Corp., 44 T.C. 705 (1965). For adetailed history of the litigation preceding the Supreme Court decision inNash see 72 W. VA. L. Re. 302, 304-06 (1970)."1 Stoffel, Treatment of Reserve Accounts on Incorporation and Liquida-tion, N.Y.U. 26Tm INST. ON FaD. TAx. 773, 773 (1968).12Cf. INT. REV. CODF OF 1954, § 111 (a): General Rule.-Gross income does not include income attributable to therecovery during the taxable year of a bad debt, prior tax, ordelinquency amount, to the extent of the amount of the recoveryexclusion with respect to such debt, tax, or amount.13 See, e.g., Max Schuster, 50 T.C. 98 (1968); West Seattle Nat'l Bankof Seattle v. Commissioner, 33 T.C. 341 (1959), af'd, 288 F.2d 47 (9thCir. 1961).14 See, e.g., Argus, Inc., 45 T.C. 63 (1965); Geyer, Cornell & Newell,Inc., 6 T.C. 96 (1946).,5 Nash v. United States, 398 U.S. 1, 4 (1970).[Vol. 733Sauter: Taxation--Reserve for Bad DebtPublished by The Research Repository @ WVU, 1971CASE COMMENTSCourt said the Commissioner's ruling would be honored, but itdid not feel free to state the tax benefit rule in those terms. 6 Rather,the Court turned to section 351 (a) of the Code, which states thatno gain or loss shall be recognized upon transfer of property to a cor-poration in exchange for stock if immediately after the exchangethe transferrors of property are in control of the corporation."7The Commissioner's position on the treatment of a bad debtreserve was an attempt to give a section 351 transfer an entirely neweffect, specifically from a tax free transaction into a semi-taxableevent. 8 Following the reasoning of the Ninth Circuit,19 the SupremeCourt felt the deduction of the reserve from receivables upon incor-poration conformed to the "reality of the transaction."2 Taxpayersreceived stock equal in value to the net worth of the accounts trans-ferred, that is, the face amount of receivables less the total of thebad debt reserve.2" Since it was conceded that the reserve was rea-sonable and the stock received was equal to the net value of receiv-ables, the Court felt there was no "recovery".22The Court reasoned that a tax benefit was received by the part-nership when the bad debt reserve was initially taken as a deductionand a double benefit would have occurred had the stock been issuedfor the gross amount of receivables, but stated: "We do not, however,understand how there can be a 'recovery' of the benefit of the baddebt reserve when the receivables are transferred less the reserve. 23Accordingly, the Court agreed with the position of the Ninth Cir-cuit 24 that although the "need" for the bad debt had ceased, it didnot mark a "recovery" within the meaning of the tax benefit rule.2"61id.17 INT. Rav. CODE OF 1954, § 351.8 Hickman, Incorporation and Capitalization, 40 TAXEs 974, 977 (1962).In the author's critical comment, he stated that the Commissioner's position"flies directly in the teeth of the purpose of that section [section 351] topromote incorporation."19 Estate of Schmidt v. Commissioner, 355 F.2d 111, 113 (9th Cir. 1966).The Ninth Circuit felt that the Tax Court's and the Commissioner's positiondisregarded the "economic realities" of the situation. Schmidt was alsofollowed in Rowe v. United States, 69-1 U.S. Tax Cas. If 9162 (W.D. Ky.1969), where the court, with a similar factual situation, stated the reasoningof the Ninth Circuit was "controlling".20 Nash v. United States, 398 U.S. 1, 4 (1970).21 Id.,221d.2 Id. at 5.2 4 Estate of Schmidt v. Commissioner, 355 F.2d 111 (9th Cir. 1966).25 Nash v. United States, 398 U.S. 1, 5 (1970).4West Virginia Law Review, Vol. 73, Iss. 1 [1971], Art. 8https://researchrepository.wvu.edu/wvlr/vol73/iss1/8WEST VIRGINIA LAW REVIEWThe Supreme Court decision in Nash hopefully resolves thecontroversy over disposition of a bad debt reserve upon the transferof assets in a section 351 exchange. However, the opinion does notgo so far as to say that a bad debt reserve may never be restored toincome in a section 351 transfer. The decision was based on an ex-change of assets for stock equal to the net value of accounts receiv-able. Therefore, where it can be determined that the value of stock is-sued to the transferor represents the face value of accounts receiv-able and disregards the bad debt reserve, there would be a "recov-ery" within the meaning of the tax benefit rule, and the recoverywould be considered a taxable event. Whether or not the Nash de-cision will be applied to a section 33726 liquidation with a similarfactual situation is left unanswered; however, in light of the economicrealities test applied in Schmidt and the apparent adoption of thatprinciple by the Supreme Court in Nash, it seems likely that a sec-tion 337 liquidation would not be considered a taxable event.Dennis C. SauterConstitutional Law-Freedom of Religion-Tax Exempt Status of Church PropertyThe plaintiff, an owner of real property, brought suit in theNew York courts seeking to enjoin the New York City TaxCommission from granting property tax exemptions to religiousorganizations on properties used solely for religious purposes. Theseexemptions were authorized by state constitutional' and statutory26 INT. REV. CODE OF 1954, § 337 (a) General Rule.- If-(1) a corporation adopts a plan of complete liquidation on orafter June 22, 1954, and (2) within the 12-month period beginningon the date of the adoption of such plan, all of the assets of thecorporation are distributed in complete liquidation, less assetsretained to meet claims, then no gain or loss shall be recognizedto such corporation from the sale or exchange by it of propertywithin such 12-month period.'N. Y. CONST. art. XVI, § 1:Exemptions from taxation may be granted only by generallaws. Exemptions may be altered or repealed except those exemptingreal or personal property used exclusively for religious, educationalor charitable purposes as defined by law and owned by any corpora-tion or association organized or conducted exclusively for one ormore of such purposes and not operating for profit.[Vol. 735Sauter: Taxation--Reserve for Bad DebtPublished by The Research Repository @ WVU, 1971

Taxation--Reserve for Bad Debt

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Taxation--Reserve for Bad Debt

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