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Bankruptcy does not shift burden of proving losses.

Landbank Equity Corp. was in the business of making second mortgage loans, which it then sold. Landbank falsified loan histories to make loans more attractive to buyers. To avoid being caught defrauding buyers, Landbank bought back or serviced loans that went bad. It did not maintain accurate records of such loans, nor did it claim bad debt losses on its tax returns.

In 1985, Landbank filed a bankruptcy petition. The company's fraudulent practices came to light and the owners, husband and wife, were convicted of criminal fraud.

The IRS submitted a claim against the bankruptcy estate for $879,000 in back taxes, interest and penalties for 1982 to 1985. In its audit of Landbank, the IRS allowed $6.4 million for reasonable addi* tions to bad debt reserves during those years. The IRS used the reserve method because the amount of the company's bad debts could not be determined due to Landbank's lack of financial records.

Note: The reserve method of accounting for bad debts (former IRC section 166(c)) was repealed, ex* cept for certain financial institutions, by the Tax Reform Act of 1986. Under the law in effect before the repeal, a taxpayer could either (1) deduct a reasonable addition to a bad debt reserve under section 166(c) or (2) deduct a debt that it can prove actually became worthless during the year (under section 166(a)).

In his objection to the IRS's claim, the bankruptcy trustee argued Landbank owed no taxes for 1982 to 1985. He claimed Landbank's bad debts, which he said totaled $9.2 million, not $6.4 million, should be reallocated over 1982 to 1985 in proportion to the income reported. The trustee's "actual debt" method of reallocation resulted in Landbank owing no taxes during 1982 to 1985.

The Bankruptcy Court and the district court both held in Landbank's favor. The district court held a bankruptcy rule of procedure shifted the burden of proof, which normally is on the taxpayer, to the IRS. It also said the IRS had not met its burden of proving the trustee's allocation method wrong. Further, it pointed to the fact the IRS had not objected to Landbank's 1986 return, on which the trustee had raised the reserve from $6.4 million to $9.2 million.

Result: For the IRS. In bankruptcy proceedings, just as in nonbankruptcy proceedings, the burden of proving a deduction for bad debts is on the taxpayer. No implicit amendment of the tax law on bad debt deductions was intended. Thus, since Landbank cannot prove it incurred the claimed losses during the years in question, it is not entitled to them. The trustee cannot use the actual debt method of accounting for bad debts without providing proof of worthlessness. Further, equity considerations do not provide a reason to disallow the IRS's claim.

* Levy (In Re Landbank Equity Corp.) (4th Cir., 1992).
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Publication:Journal of Accountancy
Date:Nov 1, 1992
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