Rev. Rul. 79-88

ISSUE

Is a taxpayer who uses the reserve method of accounting for bad debts under section 166(c) of the Internal Revenue Code of 1954 entitled, by making a lesser addition to its reserve for the current taxable year than the amount determined under its normal and proper method of computing its addition for such year, to increase its deduction for additions to its bad debt reserve in a subsequent year?

FACTS

The taxpayer, a domestic manufacturing corporation, keeps its books on the accrual method of accounting and reports its income on a calendar year basis. The taxpayer accounts for its bad debt losses on the reserve method of accounting under section 166(c) of the Code. The taxpayer has consistently used for federal income tax purposes the formula described in Black Motor Company, Inc., 41 B.T.A. 300 (1940), acq., 1940-1 C.B. 1, aff'd, 125 F.2d 977 (6th Cir. 1942), which provides, in part, that a reasonable addition to the reserve for bad debts is the amount required to bring the reserve as adjusted at the end of the year up to a percentage of receivables, based on the average annual losses for the 6-year period ended with the close of the current taxable year.

The taxpayer's records reflected the following information:

                 Notes and

1. Average net bad debts for 6-year period = $720 ($790 - $70).

2. Percentage of receivables = 4 percent ($720 / $18,000).

3. Needed reserve requirement at close of taxable year 1974 = $760 (4 percent of $19,000).

4. Balance in reserve at close of taxable year 1974 prior to reserve addition = $500.

5. Reasonable addition to reserve = $260 ($760 - $500).

To bring the reserve up to the proper total reserve requirement called for under taxpayer's computation ($760), the taxpayer's reasonable addition to its reserve should have been $260, which amount would have been allowable as a bad debt deduction for federal income tax purposes. In order to avoid losing a net operating loss carryover from prior years that could not be carried past taxable year 1974, however, the taxpayer made an addition to its reserve of only $150 and deducted that amount on its federal income tax return. Thus, the opening balance of the bad debt reserve as of January 1, 1975, reflected a balance of $650 instead of $760. During the taxable year 1975, the taxpayer had bad debt losses of $795 and bad debt recoveries of $75. To bring the reserve up to the total reserve requirement called for at the end of 1975 ($720), the taxpayer made an addition to its reserve in the amount of $790. If the taxpayer had made an addition in 1974 of $260, the amount called for under its method of computing reasonable additions to its reserve, the reserve balance as of January 1, 1975 would have been $760, and the taxpayer's addition for 1975 would have been only $680.

LAW AND ANALYSIS

The applicable section of the Code and Income Tax Regulations are 166 and 1.166-4(b)(2) involving deductions for bad debts, 1.446-1(c)(2)(ii) relating to requirements for the accrual method of accounting, and 461 and 1.461-1(a)(3) involving taxable year of deduction.

Section 166(a) of the Code provides for the deduction of any debt that becomes worthless within the taxable year. Section 166(c) provides that in lieu of any deduction under section 166(a), there shall be allowed in the discretion of the Secretary a deduction for a reasonable addition to a reserve for bad debts.

Section 1.166-4(b)(2) of the regulations provides that in the event subsequent realizations upon outstanding debts prove to be more or less than estimated at the time of the creation of the existing reserve, the amount of the excess or inadequacy in the existing reserve shall be reflected in the determination of the reasonable addition necessary in the current taxable year.

Section 1.446-1(c)(2)(ii) of the regulations provides that no method of accounting will be regarded as clearly reflecting income unless all items of profit and deductions are treated with consistency from year to year.

Section 461 of the Code provides that any deduction allowed under subtitle A shall be taken for the taxable year that is the proper taxable year under the method of accounting used in computing taxable income.

Section 1.461-1(a)(3) of the regulations provides that the expenses, liabilities, or losses of one year cannot be used to reduce the income of a subsequent year. A taxpayer may not take advantage in a subsequent taxable year of the failure to claim deductions in a prior taxable year in which such deductions should have been properly taken under the taxpayer's method of accounting.

The courts have construed the "addition to the reserve for bad debts" as an amount necessary to adequately bring the balance in the reserve to an amount that can be reasonably expected to cover anticipated losses with respect to debts outstanding. See Dixie Furniture Company v. Commissioner, 390 F.2d 139 (8th Cir. 1968).

In the instant situation the taxpayer determined through the use of the 6-year moving average that $260 was the reasonable addition in 1974. However, in order to take advantage of a net operating loss carryover, the taxpayer increased the reserve by only $150. The addition to its reserve of only $150 in 1974 failed to increase the bad debt reserve in that year to an amount that reasonably could be expected to cover anticipated losses with respect to debts outstanding.

For the taxable year 1975, the taxpayer made an excessive addition to the reserve in the amount of $110 to make up for the inadequacy of the reserve at the beginning of the year resulting from its failure to increase the bad debt reserve in 1974 in the amount called for under the method it normally used.

The taxpayer's actions contravene the mandates of sections 1.446-1(c)(2)(ii) and 1.461-1(a)(3) of the regulations, which require that a taxpayer not ignore the consistent application of the reserve method of accounting for bad debts by manipulating deductions from year to year, and require that the losses of one year not be used to reduce the income of a subsequent year. Since additions to a bad debt reserve under section 166(c) are in lieu of deductions for specific bad debt losses under section 166(a), the taxpayer may not deduct a portion of its otherwise allowable deduction under section 166(c) because such action violates the "consistency" requirement of the regulations. Further, the taxpayer distorted the income for the taxable years 1974 and 1975 by making an inadequate addition to the reserve in 1974 and an excessive addition in 1975.

Moreover, because the reserve did not reflect the amount determined by the taxpayer to be a reasonable addition at the end of the taxable year 1974, the inadequacy in the reserve for the taxable year 1975 was not the result of a subsequent realization within the meaning of section 1.166-4(b)(2) of the regulations. Thus, section 1.166-4(b)(2) is not applicable to the facts of this Revenue Ruling. Therefore, the inadequacy in the reserve will not be reflected in the determination of the reasonable addition necessary in 1975.

HOLDING

The addition to the reserve in 1974 of only $150 instead of $260, the amount called for under the taxpayer's normal method of computation, may not serve as the basis for a larger addition in 1975. The amount of the reserve inadequacy in 1974, $110, is deemed to be added to the reserve in 1974 to restore the reserve balance to an amount that could reasonably be expected to cover anticipated losses with respect to debts outstanding, and the taxpayer is allowed to increase its reserve by only $680 in 1975.

PROSPECTIVE APPLICATION

Pursuant to the authority contained in section 7805(b) of the Code, this Revenue Ruling will not be applied to taxable years ending prior to the date of publication in the Internal Revenue Bulletin.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 59-83, 1959-1 C.B. 52, Rev. Rul. 65-92, 1965-1 C.B. 112, Rev. Rul. 66-26, 1966-1 C.B. 41, and Rev. Rul. 70-124, 1970-1 C.B. 38 are modified to the extent that they suggest that a taxpayer may make an addition to the reserve that is less than a reasonable addition.