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Increase to a Reserve Account Does Not Satisfy the Bad Debt Charge-Off Requirement.

(Parker Tax Publishing September 23, 2015)

Where a taxpayer's books indicated that the entry to record a partial bad debt was in the nature of a reserve for an anticipated future loss and not a sustained loss, no tax deduction was allowed. FAA 20153501F.

In FAA 20153501F, IRS Field Attorneys (IRS) were asked whether a taxpayer was entitled to a partial bad debt deduction. Under Code Sec. 166(a)(2) and Reg. Sec. 1.166-3(a)(2), a taxpayer can claim a bad debt deduction for a debt that is only partially recoverable. However, the amount deducted cannot exceed the amount charged off within the tax year. The taxpayer alleged that it charged off the claimed debt from its books and, thus, the deduction was proper.

The taxpayer relied on Brandtjen & Kluge, Inc. v. Comm'r, 34 T.C. 416 (1960), in which the taxpayer claimed partial bad debt deductions in two consecutive years in the amounts of $28,000 and $12,000. Those were amounts due from a subsidiary. On its books, the taxpayer increased its Reserve for Doubtful Notes and Accounts, which reduced its assets, and debited its Bad Debts account, which reduced its net income. The taxpayer in Brandtjen did not charge-off the $28,000 in its account receivable due from its subsidiary; instead, it made an adjusting journal entry of $28,000 in a new ledger account entitled "Reserve for Loss on B & K Canada" (i.e., the subsidiary). The explanation for the adjusting journal entry was "to charge bad debts with loss from Canadian operation."

In Brandtjen, the Tax Court held that the taxpayer was entitled to the partial bad debt deductions because the title of the new account (i.e., Reserve for Loss on B & K Canada), even though designated as a reserve, was in terms of a loss which had been incurred by reason of existing partial worthlessness, and not of an anticipated future loss.

In the instant situation, the IRS advised that the taxpayer was not entitled to partial bad debt deductions because the amounts were not charged off during the tax years in accordance with Code Sec. 166(a)(2) and Reg. Sec. 1.166-3(a)(2). Citing the decision in Findley v. Comm'r, 25 T.C. 311 (1955), aff'd, 236 F.2d 959 (3d Cir. 1956), the IRS noted that the purpose of the charge-off requirement is to perpetuate evidence of a taxpayer's election to abandon part of the debt as an asset. An increase in a general reserve account, the IRS said, does not constitute the required charge off.

The IRS also cited the decision in International Proprietaries, Inc. v. Comm'r, 18 T.C. 133 (1952), where the Tax Court held that a taxpayer's intent to abandon a charged-off portion of debt must be reflected in its books and records. An increase in a general reserve account does not constitute the required charge off. In International Proprietaries, Inc., the Tax Court concluded that the taxpayer's bookkeeping entries did not comply with the statutory requirement that there be a charge-off. The court rejected the notion that an increase to a reserve account satisfies the charge-off requirement. Rather, the court said, the taxpayer must eliminate the debt as an asset on its books in order to comply with the statutory requirements of charge-off.

According to the IRS, the situation in Brandtjen was not comparable to the taxpayer's situation. The reason that the Tax Court in Brandtjen held in favor of the taxpayer in that case was that the entries in the taxpayer's books were described in words indicating a sustained loss, and not an anticipated future loss. In contrast, the IRS said, the taxpayer's books indicate that the entries were in the nature of a reserve for an anticipated future loss, not a sustained loss.

For a discussion of the rules for deducting a partial bad debt, see Parker Tax ¶98,430. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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