Rev. Rul. 74-594

Advice has been requested regarding the computation of the bad debt reserve of a new bank under the circumstances described below.

On March 31, 1969, X and Y, two commercial banking corporations, consolidated to form a new corporation Z. The consolidation qualified as a reorganization within the meaning of section 368(a)(1)(A) of the Internal Revenue Code of 1954. Prior to the consolidation, X and Y reported income on a calendar year basis and used the reserve method of computing bad debts. As of December 31, 1964, X's bad debt reserve exceeded 2.4 percent of its outstanding loans and, therefore, the reserve additions for the years 1965 to 1968, inclusive, were computed under section 5 of Rev. Rul. 65-92, 1965-1 C.B. 112. Y's bad debt reserve as of December 31, 1964, was less than 2.4 percent of its outstanding loans and, therefore, the reserve additions for the years 1965 to 1968, inclusive, were computed under section 4 of Rev. Rul. 65-92. Z also reported its income on the calendar year basis. The combined bad debt reserve balances of X and Y as of December 31, 1964, exceeded 2.4 percent of their combined outstanding loans. In computing the addition to the reserve for bad debts at December 31, 1969, Z added the bad debt reserve of X at December 31, 1964, to the bad debt reserve of Y at March 31, 1969, in determining the maximum amount of reserve that could be maintained.

Rev. Rul. 65-92, effective for taxable years ending after December 31, 1964, sets forth a uniform reserve ratio for computing annual additions to reserves for bad debts by banks. In general, a bank is allowed deductions for such additions until the reserve equals 2.4 percent of loans outstanding at the close of the taxable year, subject to limitations contained in sections 4, 5, and 6 of that Revenue Ruling.

Section 4 of Rev. Rul. 65-92 provides, in part, that if the dollar balance of a bank's bad debt reserve, as of the close of its taxable year ending in 1964, is less than 2.4 percent of loans outstanding at such time, the addition to the reserve shall be comprised of one-tenth of such difference plus the net bad debts charged off during the year, plus 2.4 percent of the increase in outstanding loans.

Section 5 of Rev. Rul. 65-92 provides, in part, that if the dollar balance of a bank's bad debt reserve, as of the close of its taxable year ending in 1964, exceeds 2.4 percent of loans outstanding at such time, the addition to the reserve in any taxable year shall not increase the reserve above the greater of (i) such dollar balance, or (ii) 2.4 percent of loans outstanding at the close of the taxable year.

Specifically, the question presented is whether Z, formed as a result of the consolidation of X and Y, may maintain a reserve for bad debts computed by combining the reserve of X at December 31, 1964, with the reserve of Y at date of consolidation.

The purpose of Rev. Rul. 65-92, with its specific guidelines and limitations, is to provide uniformity among banks in determining annual additions to the reserve for bad debts. In situations where two banks consolidate and the dollar balance of one bank's reserve at December 31, 1964, exceeded 2.4 percent of eligible loans and the dollar balance of the other bank's reserve at December 31, 1964, was less than 2.4 percent of eligible loans, uniformity can only be achieved by combining the reserve balances and the outstanding loan balances of the two banks at December 31, 1964, to determine whether section 4 or section 5 applies for taxable years ending after the consolidation.

Since, in the instant case, the combined December 31, 1964 bad debt reserve balances of X and Y exceeded 2.4 percent of the combined outstanding loans, section 5 of Rev. Rul. 65-92 is applicable.

Accordingly, in the instant case, for the taxable year ending December 31, 1969, Z must use the combined balances at December 31, 1964, of X and Y's bad debt reserves in determining the dollar balance limitation prescribed in section 5 of Rev. Rul. 65-92 that is applicable in computing the current addition to the bad debt reserve balance. For subsequent taxable years, section 585 of the Code, as added by section 431(a) of the Tax Reform Act of 1969, is applicable to the computation of Z's bad debt reserve.

Rev. Rul. 65-92, as supplemented by Rev. Rul. 66-26, 1966-1 C.B. 41, Rev. Rul. 68-630, 1968-2 C.B. 84, and Rev. Rul. 70-495, 1970-2 C.B. 53, and as modified by Rev. Rul. 68-524, 1968-2 C.B. 83, and Rev. Rul. 74-593, page 62, this Bulletin, is hereby further modified.