Rev. Rul. 78-278

Advice has been requested regarding the effect of the decision of the Supreme Court of the United States in Nash v. United States, 398 U.S. 1 (1970), 1970-1 C.B. 72, in the situations described below.

In each situation, (i) the subsidiary (transferor) corporation is completely liquidated in a transaction in which the subsidiary recognizes no gain or loss under section 336 of the Internal Revenue Code of 1954 and the distributee (transferee) corporation recognizes no gain or loss under section 332(a); (ii) the basis of the assets in the hands of the transferee is determined under section 334(b)(2) and the Income Tax Regulations thereunder; (iii) the property transferred in the liquidation includes accounts receivable; (iv) prior to the transfer, the transferor used the accrual method of accounting under section 446(c) and the reserve method of treating bad debts under section 166(c); (v) all additions to the reserve for bad debts in prior years resulted in tax benefits; and (vi) the adjusted basis of the stock allocated to the accounts receivable pursuant to section 334(b)(2) and the regulations thereunder is equal to their fair market value of 95x dollars.

Situation 1. The transferor had accounts receivable with a face amount of 100x dollars and a reserve for bad debts of 5x dollars.

Situation 2. The transferor had accounts receivable with a face amount of 100x dollars and a reserve for bad debts of 7x dollars.

The question in each situation is the extent to which the balance in the transferor's reserve for bad debts is includible in the transferor's gross income.

Section 336 of the Code provides that, in general, no gain or loss shall be recognized to a corporation on the distribution of property in partial or complete liquidation.

Rev. Rul. 65-258, 1965-2 C.B. 94, points out that the carryover provisions of section 381 of the Code, including those relating to the carryover of the use of an accounting method, do not apply in section 332 liquidation in which the basis of the assets distributed is determined under section 334(b)(2). It therefore held that since the bad debt reserve of the liquidated corporation does not carry over, there is no longer a necessity for such reserve and the full amount of such reserve must be included in the taxable income of the liquidated corporation to the extent that tax benefits were derived therefrom.

However, as Rev. Rul. 78-280, page 139, this Bulletin, notes, the decision in Nash holds that, where the consideration received in exchange for the transfer of accounts receivable by a taxpayer using the accrual method of accounting is equal to the net value of the accounts receivable (the face amount of the receivables previously included in income less the amount of the reserve for bad debts), there is no recovery within the meaning of the tax benefit cases. See Estate of Schmidt v. Commissioner, 355 F.2d 111 (9th Cir. 1966), Estate of Block v. Commissioner, 39 B.T.A. 338 (1939), aff'd sub nom. Union Trust Co. of Indianapolis v. Commissioner, 111 F.2d 60 (7th Cir. 1940), cert. denied, 311 U.S. 658 (1940), and the cases cited therein; and Tennessee Carolina Transportation, Inc. v. Commissioner, 65 T.C. 440 (1975), 582 F.2d 378 (6th Cir., 1978).

Rev. Rul. 74-396, 1974-2 C.B. 106, applies the "tax benefit rule" to a transaction that was nontaxable under section 332, 334(b)(2), and 336 of the Code.

Accordingly, in the situations described above, the results are as follows:

Situation 1. The transferor has no recovery within the meaning of the tax benefit rule.

Situation 2. The transferor has a recovery of 2x dollars includible in its gross income.

It is presumed that the entire bad debt reserve is recovered through the transfer of the accounts receivable at their face amount. The burden is on the taxpayer to show that the amount received in excess of the net value of the accounts receivable is not a recovery of a tax benefit but rather attributable to economic factors such as appreciation in value of interest bearing accounts receivable resulting from changes in prevailing interest rates.

Rev. Rul. 65-258 is revoked.