The bad-debt reserve: opportunity for partial current deduction.

The Tax Reform Act of 1986 repealed the reserve method for claiming bad-debt deductions for most taxpayers. As a result, they often mechanically calculate taxable income by adjusting book income for any change in the "allowance for bad debts" account from the prior year. However, as is discussed below, case law suggests that the charge-off requirement of Sec. 166(a)(2) and Regs. Sec. 1.166-3(a)(2)(i) may be accomplished in ways other than by recording an entry (i.e., a write-off entry) that removes the debt from both the receivable and allowance accounts maintained on the taxpayer's books. By mechanically relying on the write-off performed for financial accounting, taxpayers may be forgoing the opportunity to deduct currently the portion of the allowance account that represents partially worthless business debts.

Deduction for Partially Worthless Business Debts

Sec. 166(a)(2) and Regs. Sec. 1.1663(a)(2)(i) provide that, when satisfied that a bona fide debt (as defined in Regs. Sec. 1.166-1(c)) is recoverable only in part, the IRS may allow the amount that has become worthless as a deduction only to the extent charged off during the tax year (specific charge-off method). Assuming there is sufficient evidence to prove that a bona fide debt is in part worthless (a facts-and-circumstances determination, according to Regs. Sec. 1.166-2(a)), a question arises: what constitutes a charge-off?

The Tax Court in Findley, 25 TC 311 (1955), stated that, in the case of a debt that has become partly worthless, the charge-off is an act "to perpetuate evidence of taxpayer's election to abandon part of the debt as an asset." While merely increasing a general reserve account without specifically identifying the debt(s) to which the reserve increase relates does not provide evidence sufficient to comply with the statute (see, e.g., International Proprietaries, Inc., 18 TC 133 (1952)), increasing a reserve account for specifically identified debt(s) that are partly worthless can constitute a charge-off for purposes of Sec. 166(a)(2) and Regs. Sec. 1.166-3(a)(2)(i).

Charge-Off Required

Regs. Sec. 1.166-3(a)(3)(iii) specifies that, in the case of significantly modified debt (within the meaning of Regs. Sec. 1.1001-1(a)), the amount of deemed charge-off "is the amount by which the tax basis of the debt exceeds the greater of the fair market value of the debt or the amount of the debt recorded on the taxpayer's books and records reduced as appropriate for a specific allowance for loan losses" (emphasis added). This language suggests that the term "charge-off" can encompass actions other than the act of recording for financial accounting purposes an entry that reduces both the receivable and allowance accounts by the bad-debt amount. Case law supports this position.

The court in Fairless, 67 F2d 475 (6th Cir. 1933), addressed the specific charge-off requirement and noted that Congressional intent was to allow a deduction for business bad debts in the year in which ascertained worthless, provided there was "some specific act of the taxpayer clearly indicating their abandonment as assets." In concluding that the taxpayer had failed to perform such act of abandonment within the tax year, the court acknowledged that "the charge-off of debts may take other forms than entries on the books of the taxpayer, may be effected in a variety of ways, and yet be sufficient for substantial compliance with the statute" (emphasis added).

In Brandtjen & Kluge, Inc., 34 TC 416 (1960), the court allowed a bad-debt deduction under the specific charge-off method when the taxpayer's book entries consisted of a credit to a new reserve account. Distinguishing its decision in International Proprietaries, Inc., the Tax Court concluded that the taxpayer's entries did not indicate an anticipated future loss but, rather, a sustained loss. In reaching its conclusion, it noted that there was no prescribed method for making a charge-off of a partially worthless debt and stated that an effective charge-off is generally made if the entries effectually eliminate from the taxpayer's book assets the part of the debt that is worthless.

Citing both International Proprietaries, Inc. and Brandtjen & Kluge, Inc., the court in Berlin, TC Memo 1961-194, denied the taxpayer's bad-debt deduction on the grounds that his recorded entries neither credited the receivable account nor had "the effect of removing any part of the balances of accounts receivable from the book assets." The inference is that, had the taxpayer specifically identified an allowance account (or portion thereof) as offsetting the bad debt in question--as in Brandtjen & Kluge, Inc.--the court would have concluded that the taxpayer had effectuated a charge-off within the tax year and sustained the bad-debt deduction.

Example: ABC, Inc., an accrual-basis taxpayer, has $60 million of trade accounts receivable and a $7 million bad-debt allowance at the end of its tax year. The current-year bad-debt reserve represents a $2 million increase from the prior year. Typically, absent an analysis of the allowance account, ABC would record a Schedule M-l, Reconciliation of Income (Loss) per Books With Income per Return, adjustment, adding back to book income the $2 million increase in the bad-debt reserve. However, ABC determines that, due to insolvency or other conditions arising during the year, a particular $1 million receivable from XYZ, Inc. is 80% uncollectible. ABC should establish in its books and records--via a credit to a new reserve account, for example, that $800,000 of the total $7 million bad-debt reserve represents a sustained loss equal to 80% of the $1 million receivable from XYZ. ABC would thereby satisfy the charge-off requirement of Regs. Sec. 1.166-3(a)(2)(i) and could claim an $800,000 partially worthless bad-debt deduction. In contrast, by mechanically adjusting book income for the $2 million increase in the allowance for bad debts account, ABC could not claim any portion of the $800,000 deduction until a write-off entry is recorded for financial accounting purposes.

Summary

Congress repealed the reserve method for chiming bad-debt deductions in the belief that allowing deductions for future losses was inconsistent with the treatment of other deductions under the all-events test, in that it permitted a deduction larger than the present value of the losses. However, counter to the way implemented by many taxpayers, the repeal of the reserve method does not require them to rely on the write-off entry recorded for financial accounting purposes; Congress intended to allow a deduction for partially worthless business bad debts in the year in which ascertained worthless, provided they are charged off by the taxpayer.

Case law suggests that the charge-off requirement of Sec. 166(a)(2) and Regs. Sec. 1.166-3(a)(2)(i) may be effected by acts other than the write-off entry, including identifying an allowance as pertaining to identifiable partially worthless business debts. Thus, taxpayers may accelerate the deduction for some portion of the bad-debt reserve if entries to the allowance account are accompanied by contemporaneous documentation indicating that the allowance is intended to reflect the partial worthlessness of specifically identifiable business bad debts occurring within the tax year. Because the deduction for partial worthlessness is elective (see, e.g., Richard Meinig Co., 9 TC 976 (1947)) and is specific to each debt, a request for a change in accounting method is not required.

FROM DAVID W. RANDOLPH, PH.D., CPA, UNIVERSITY OF DAYTON, DAYTON, OH (NOT AFFILIATED WITH CPAMERICA INTERNATIONAL)