Brief for the United States — Nash v. United States

Supreme Court brief1970

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Opinions below- ._-.=_---- $2 Swoosh e inurisdcsekssst «|

JurindictiGn « - sac cose i se oloawulblsdt ude Sciesh - |

é ‘Question presented... « .. 1.4... i¢2-e02 sin shee sce be SOB

: _ Statutes and regulations involved. .22222- ossk sau ou): 9

Rak, Saath) at

Argument: : : L barat

Introduction and summary--_. 4.2 -2--i-L-seusls. ASP

The Commissioner properly applied the tax’ benefit \

rule in requiring restoration to income of the

| Siysbe aren po he rr fat aseets)

ee af? trolled rations... 22S. Oak. 7

A. The tax Denefit rule applies when a bad debt.

e is no longer needed, whether or. not

A feta ) there has been a cash collection of accounts

a poothveable. << cccsscce cn sced HALL 7

B. Section 351 of the Code does not Rersagiollon’

tion of the tax benefit rule___.....-..-._. 15 .

C. The existing framework of the Code is .not

readily adaptable to either of petitioners’

proposed solutions to the double deduction

1. Carryover of resds've far bed deble:.\' Ps |

2. Reduction in basis of accounts —

D. Sines the Commissioner’s solution to the

double deduction problem is reasonable, it

mist be upheld even if he might have solved

the problem by other means...0.-)..-...-. . 80

Conclusion._.....- dann SB LniL SRS is binwallccibekt: $2»

Appendhticdl. 420 «ciisioxisunw'\.x..02.,derptcbS.coameitin? 33. Ct

w :

380-620—70——1 wid

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a! : ag

—

* RCS Se ; CITATIONS ,

Cases: ~ : fe

Arcadia Savings and Loan Assn. v. Commissioner, ‘Page

BOO Be Oe MO wa cecwbiwscuackacee weg atlirta ines —<e 10, 11

Benedum v..Granger, 180 F. 2d 564------.------- 2. 12

, Bird Management, Inc. v. Commissioner, 48 T.C. | RE | ae

» Burnet v. Aluminum Goods Co., 287 U.S. 5442.....----—*~ 6

Burnet v. Sanford & Brooks Co., 282 U.S. 3592.2... --. §

Bush Terminal Buildings Co. v. ommissioner, 7 TC.

“Calavo, Inc. v. Comsuiasioner, 804 F. 2d 650__-.. Sues 23, 24

- Candy Bros. ‘Mfg. Co. v. Commissioner, 17 T.C. 298,

affirmed, 198 F. 2d 330__..---.=----2--------22- ~

- Charleston & W. CO, Ry. Co. v. Burnet, 50 F.2d 342... ° 8

Chicago, R. I. & P. way Co. v..Commissioner, 47 F.

2d 990, certiorari enied, S04 US. 618ie.cc.5:2b2. ° 8

Citizens Federal S. & L. Ass’n of Clevelgdd v. United . .

“States, 200 F.9d 982__ 2 sebssil lene, 8

Commissioner v. Gordon,-391 WEB lice tcshunn -11, 25

Dearborn Gage Co. v. Commissioner, 48 T.C. 190_---- a;

Doylestown c& Easton Motor Coach Co. ¥. Commissioner, ee

9 T.C.846__--. ii svusvshbbhbdbinrteWadsriton va 6

Eljer Co. v. Demivinsiont, 134 F. he) REE rege ca ar 5

Ezo Products Co. v. Commissioner, 37 T.C. 3855___-_- 22-23

Freihofer Baking Co. v. Commissioner, 151 F. 2d 383-. . 8

Geyer, Cornell & Newell, Ine. v: Commissioner, -

6 T.C, 962..2.-- BRAS CHEAT TOO Pie -- 9,16

~ Gould Coupler Co., 6 B.T.A. Sa ae Pe cual 6

Handelman v. issioner, 36 T.C. 560__.--------- ee

-. Hawes, J. E., Corp. v. Commissioner, 44 T.C. 705---- 16 .

Helwvering v. Cement Investors, ‘Inc., 316 U.S. 627. _--- 27

Helvering vi Metro. Edison Co., 306 U.S: 522......__- of

Home Savinge and Loan Association v. United States,

296 B. Supp. 124. oso ches 2st ie -- 28,24 .

_. Hutton v. Commissioner, 53 T.C..37...2----zee-----* = 24

Ifeld Co. v. Hernandez, 292 U.S. 62.--.--2------2-- write

Katzinger, Edward, Co. v. Commissioner, 44 B.T.A. u

533, affirmed, 129 F. 2d 74._-------------------- 6

omy V. Commissioner, 46 B.T.A. 423, affirmed, 131. :

ee .

Cases—Continued

- Merchants Nat. Bank v. Cotbinitaetiohier, 190 F. Ba 6872: ;

__-— National Bank of Commerce of Seattle x v. Perera.

os 115 F.. 2d 876. Wu etcc corre evn cen etn tts:

‘Portland Oi Co. v. Commissioner, 109 Fr. od 479...

Reed v. Commissioner, 45 B.T.A. 1130, affirmed, 129

-* Rossin, S., & Sons v. Duties, 113 F. “operas

Schmidt, Estate of v. Commissioner, 355 F. 2d 111....@

9, 115 12, 13; 14,

Schuster v. Commissioner, 50 T.C. GB RK SL

Sullivan, Alice Phelan, Corp. v. United States, 381 F.

Union Trust Co. v. Commissioner,.111 F. 2d 60, cer-

. tiorari denied, 311 Si GER. wcce ch: cet.

United States v. Ludey, 274 US. 205_.-_------- -

- United States v. Skelly Oil Co., 394 U.S. 678-.-.2._-

Von Hoffman Corp. v. Commissioner, 253 F. 2d 828.__. _

West Seattle Netiopot Bank of Seattle v. Gewenicsioner, ;

ae 9609. PEPE Ra

Statutes: : .

Internal Revenue Code of 1954 (26 U. Ss. C):

_ 380

15»

12.

ig.

15, 20

24.25.

_ 6, 6, 7, 11, "15; 16, 17, 18, 19, 20, 21, 22, 23, 24, 25,

Ss " 26, 27, 28, 31, 33. ,

>» a

~ Statutee—Continued ~ pie catres

; Internal Revenue Code of 1954 26U8C.)—Con. |. Page

Seo, 364... .. 5-2 .c-+-2------ jekimssidens pou. 21, 26

Secs. 354-382_...--- gener enn c een n se eneee dalnivie 27

Sec. 398... Lisa s eos Bdicccdebsdcastnds 15, 28

: Set B68bc itis Act. jadbrebaw aa da su dass 22

Sec. 362.....----- gi 2 Ll gaa OO de 21, 24, 34

- ies BOBS Suk ccs es ccosees lwiietsditnds nota “21, 24, 26

Sec, 881. ..-----------2+------- 21, 22, 24, 25, 26, 31

ae I Si cian ec ecwhs ae

. Sec. 446. 2nd 2 Lacs pasns emails on bunk? 81

Ses, 4002 jie 2 esis -ncdsiisesl-nssces 31

Secs. 531-537 ..2- 2 22a nono o econo eneensee 27

Secs. 541-547.......---------------------- pore 27

Bet. CAB iss ole cc cca lesieb eedtbUsbebse sie 5

Seo. 1001... 855.525 OPE TA hebsoeuuek 15

Sess 1008) sivies lec cecke secre ale cae sacne 15, 16

BiB. ose bSccticc nccenceostenveenso5 29, 30, 31

§ Ben, 1966. Co SER escent bic cna ged 23

F. Bec. 1260_..----.-- Age LR ee Octo sds “% 23

® Sees, 1811-1815-------- Sd JovoubeoL swan Moco t: &

: yx? Be, 1841_.---- peeecenngacennnnnereeneaton 5

irae UG Secs. 1871-1878... -.--2------=- baie ST

; Oe | Pre re rr 30

Sec. 7862 Jel MSE ebsocaks aivareiisecses 5

Aaiatitie Handbook (4th ed. II) cc ctedd yiiwes 29

Finney and Miller, Principles of Accounting, Interme- ie

eed Hate Gs O8::19688) ic cccccnesnee sel ce cen--- 16

+ > EE Rep. No. 1447, 87th Cong,, 2d Sess....1----:---- 23

3 BL Rep. No. 749} 88th Cong., 1st Sess.....---------- 23

Karrenbrock and. Simons, Intermediate Accounting

(Ad od. 1088).in kav eeencene nee dsl. | 20

3% Paton, Advanced Accounting(1947 PMI A 16

-< ot & Rul..57—482, 1957-2.Cum. Bull. Ba odGiewecees 9

- Rul. 62-128, 1962-2 Cum. Bull 139__.. 6,9, 16, 17, 19

20, 30

. Rul. 67-286, 1967-2. Cum. Bull. 101 sd355~.: 23

Ss. Rep.. No. 1881, 87th Cong., 2d Sess pabaiad dite Sittin ie

ae p- No. re hae sp Ve aap ee ee 28

“y *

Misccliinsous—Onatlesiiil °

Treasury Regulations on Income Tax’ OF-E): Page

i YS eee ae OSA Ta pe 5

ae CUURMI A ooo iced pcwodbcowsoncsoscescesl 14

Sec. 1.161-1-.-..----- eee: PAIS a7 5 iy

PE Le asckceoensed Te. si. mavakenaccheaseamiente 22

et: Ri wnacewasnende aint maakieusette: 2,35 34

. San. LOUGH sb Fs Secs en cendqeet "22

ee? 3 AG. | nccntnnddabnwomiipamuintninade o

ek, MIG ccs ndinitcoracinhpiccemienwan .

iS it 2 cn dtcoctéubons nicha apiateeeleut wien 5 :

Sec. 1.1016-6_...-+---------------------- eee 5

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3 he Sgrme on of he ed Sates

| - Octosen ‘Tena, 1969 ait !

| No. 678

James G. NASH, -ET AL., PETITIONERS

, - uv. A ’ A y : 3

UNITED States OF AMERIOA

ON WRIT OF. OBRTIORARI TO THE UNITED STATES COURT oF

Aan FOR THE FIFTH OIROUIT

‘ BRIEF-FOR THE UNITED STATES

OPINIONS BELOW ll

The findings of fact and conclusions of law of the

' district court (R. 12-13)* are: not officially reported.

The opinion of the court of appeals (R. 16-19) is Te-.

ported at 414 ¥’. 2d 627. |

JURISDICTION |

The yf of the court of appeals were entered -

on July 2, 1969 (R. 20-22). The petition for a writ.

of certiorari was filed on September 30, 1969, and

certiorari was’ — on January 12, 1970 (R. 23).

The jurisdiction | lof. this os rests on 28 U.S.C.

1254(1). ) : |

TER? references m are to the record aa:

a) >

.. ie tax" benefit rule upon the transfer of the partner-

eS: under Section 351 of the Internal Revenue Code.

| QUESTION PRESENTED 9

Whether a partnership’s reserve for bad debts,

representing in 1e tax deductions allowed in prior

years, ghould restored to partnership income under

ship’s accounts receivable to controlled corporations

STATUTES AND REGULATIONS INVOLVED

. ~The pertinent provisions of Sections 166, 351 and

= 362 of the Internal Revenue | Code of 1954 and Section

1.1664 of the Treasury Regulations are set forth in

the Appendix, in]e, pp. 33-36.

STATEMENT

ule 1960, petitioners * were members of a sal

nership operating eight finance organidtions in Ala-’

bama and two-in South Carolina, The partnership

reported its income on the accrua method of account-

ing and used the reserve method of accounting for

bad debts permitted by Section 166(c), of the Internal

Revenue Code of 1954 and Treasury Regulations, Sec-

tion 1.166-4. (R. 7.) . }

. Under the reserve method ' of accounting for bad

debts, a taxpayer includes in his income the fuil face , |

_ amount of an account receivable jupon its creation. :

He also maintains a reserve account, the balance of © |

. which i is to.be adjusted at the end of each taxable year 4

') that it equals that portion of current accounts re- 7

In addition to James G. Nash, petitioners are. Cecelia Nash,

who is:a, party solely by reason of the filing ofa joint return; _

- Birmingham Trust National Bank, as Trustee of the Margaret.

Nash Trust; and Birmingham Trust National Bank, as ‘Trustee

under the James G. Nash, Jr. Trust (R. 15-16). .

“ee

.°

™

* forth in the stipulation of facts (R. 7-11).

_ eeivable which is \reé ably: cstnintiak to ‘becorhe

worthless in subsequent ears; Any ‘additions’ neces-

sary to increase the reserve to its required level ‘are

currently deductible. When specific accounts receivable —

3 actually become worthless during the ‘year, the Téserve |

account is decreased and no ‘addttiotial bree debt: ~

- duction is allowed. if be il

As of May 31, 1960, petitioners’ partnership hooks

‘reflected accounts receivable for the Alabi orga-

nizations of $486, 853.69 and a reserve fo a, .

of $73,028.05 (R. 7)?

On June 1, 1960, petitioners formied eight new cor-

porations: and traasferred the . assets '. of the ak

Alabama organizations, ineluding the -accoun

_ eeivable, to these’ corporations in exchange for the

latters’ stock. The transfer was within the terms ‘of —

Section 351 of the Internal Revenue Code, which pro-

vides that no gain or loss shall be recognized if prop-"

erty is transferred to a corporation in ékchange for

_ stock if, iminediately after the exchange, the trans-

- ferors possess at least: 80 ee ‘control of the cor-”

poration. (R. 7.) 2 : mt

Upon examination of the. partnership sito 1 filed

for the fiscal year ended January 31, 1961, the Com-

missioner: determined that the partnership should

have included in income the amount of the bad debt

reserve. ($73,028. 05) applicable to the. accounts re-

“eeivable transferred ‘to. the corporations on June 1,

1960, because the partnership no longer had heed of —

* The exact amounts of the accounts receivable. reserves

for bad debts of each of the.cight Alabama oganizati are et

880-620—70——-2

2 +

the reserve account. ‘This adjustment in the partner- |

ship income: led to an increase in the di ibutive-

shares of petitioners and resulting tax defi encies-

for the calendar year 1961. (R. 11.)* Petitioners paid |

- the deficiencies and brought suit in the district court

_after denial of their refund claims (R. 11). -

The district court held that the amount of the out. .

standing reserve. for bad debts did not lave to be

restored to petitioners’ income as of the end cae”

‘partnership’s fiscal year in. which the transfer oc-

curred (R. 12-13). On the *government’s appeal, the

. Fifth Cireuit reversed (R. 16-19).

To resolve a square conflict of decisjons between the

Fifth and Ninth Circuits on this Ssue, this Court -

granted the taxpayers’ petition for certiorari on Jan-

uary 12,@970 (R. 28)

: INTRODUCTION AND SUMMARY sis

Shidiie the reserve method of. accounting for bad

debts, a taxpayer is permitted to take a current deduc-

tion for the amount of tts accounts receivable which

it is. estimated will become worthless in subsequent

taxable years.” The problem preserited in this case is

*The deficiencies determined against petitioners were. as fol-

‘lows (R. 11): James G. Nash and Cecelia. Nash—$48,473.14 ;

. Birmingham Trust National Bank as Trustee for James G.

Nash, Jr. —$1,042.96; and Birmingham Trust National Bank, me:

Trustee for Margaret Nash—$1,041.52.

5The reserve method is to be contrasted with the specific:

charge off method. under: which a deduction for bad debts is.

allowed only as and when a specific account becomes worthless. |

The use of either method is authorized in: Section 166. of the

Internal Revenue Code...

‘

- e; ry. ‘ . atic «4 8,

te y : By

, ‘e.. es a :

the proper tax sank. clincedddiemmi a

partnership when it transfers all of its iassets to a. ~

corporation in exchange for the latter’s stock ina;

_ transaction. described in Section’ 351. of the Internal

* Revenue Code. Because a bad debt reserve represents

anticipated . future losses that have not. in. fact -been - *

sustained, the possibility exists, if: adjustment is not

‘made for the bad debt’ reserve, that the identical bad -

debt loss would be’ allowed twice—once to the partner- _

ship when it established the, reserve and a second time ~

to the corporation which will actually suffer the bad -

"> debt loss on the accounts receivable transferred. _

Petitioners recognize the necessity for avoidance of

a double deduction of the ‘same bad debt loss (Br. 5-6,

20-31). They. can do no less, for decisions of this

Court extending over a period of more ,than four

decades—the most recent, of which was ‘announced Aare

only last Term—make it clear that “the Code should —

not be interpreted to allow \* * * ‘the practical equiv-

alent of double deduction,’ * * * absent, a clear. dec-

peas of intent by. Congress. 2? United States. v.

kelly Oil. Co., 394 U.S. 678, 684. See United States se

Ludey, 274 U.S. 295, 301; Burnet v.. Aluminum. Goods

Co., 287 U.S. 544, 551; ifeld Co. v. Hernandez, 292°

US. 62, 68.° | 7 Wie

¢ The policy agin a alloiands of double deductions is

reflected. in- various provisions of the Internal Revenue Code

(Sections 164(e), 642(e), 642(g), 1811-1815, 1841(b) (3) and

7852(c)) and the Treasury Regulations. (Sections 1.62-1(b),

1.161-1, 1.691(b)-1(b), 1.901-1(b) (2) (h) and 1.1016-6(a)) and =

has been the basis of decision in numerous. lower court cases.

See, ¢.9., Candy Bros. Mfg..Co. v. Commissioner, 17 T. ©. 298,

304, affirmed, 198 F. 2d 330 (C.A. 8) ; Eljer Co. v./Commissioner,

‘

ates. “gemeae

‘The dispute between the-parties thus is.not so much

whether a Qouble deduction. is to be avoided, but: which

of several possible rules should be applied to avoid a

"double deduction. The Code does not speak’ explicitly -

to the point. The position of the Commissioner of In

ternal Revenue, which was approved by the court

below but’ rejected by the Ninth Circuit in Estate of ©

' Schmidt v. Commissioner, 355 F.2d 111, is set. out in

- Rev. Rul. 62-128, 1962-2.Cum. Bull. 139. That ruling

provides that since the Section 351 transfer makes it

clear that the transferor will not suffer the losses

represented by the earlier deductions, the balance of

the reserve‘should be restored to income pursuant to

the so-called “‘tax benefit’’ rule. Under this rule, the

recovery ofan item—in this case the bad debt re-

serve—which has produced an income’tax benefit in

a prior year is to be added to income in the year of

_ Tecovery. Consistently, the Commissioner would per-

‘mit the corporation to which the accounts receivable

_are transferred to take an appropriate bad debt de-

duction in respect of the receivables transfe

Petitioners contend, on the other hand, that the tax |

“ benefit rule does not apply here bécause the transferor

- did not:collect the full face amount of the eo specie

accounts receivable, and that, in any event/ its ‘appli-

eation is barred by Section 351 of the Code, which

provides that gain or ‘Joss shall not be recognized if

property is transferred by a _partiership (or sole

134 F. 194 F. 2d‘ 251, 254-255 (C.A. 3) ; Edward Katzinger Co. v. Com:

missioner, 44 B.T.A. 588, affirmed, 129 F. 2d 74 (C.A. 7); Doyles-

- town & Easton Motor Qoach Co., v. Commissioner, 9 TC. 846, 850;

Bush Terminal Buildings Co. v. Commissioner, 7 T.C. 798, 816-

817; Gould Coupler Co., 5 - T.A. 499, 518.

- proprietorship) to a ocutedlned corporation, "Petition-

ers would solve the double, deduction problem gither

“a “by requiring that the partnership's reserve be carried

over to the corporate transferee, or by. reducing the

: basis of the accounts receivablesby the amount of the *

reserve.

We will show Grst. that this is a proper ecasé in

which to apply the tax ‘penefit rule because, when: the - -

_ partnership terminated, there was no longer any need

for maintenance of the resérve. This, we submit, is a

sufficient recovery -to warrant application of the tax:

benefit rule. We will. then show that application of

the rule is in no way inconsistent with the proserip-

tion of Section 351 against recognition of gain gr loss.

With regard to petitioners’ proposed solutions) to the

double deduction problem, we ‘contend —

solution is prescribed in the Code. In the absénce of

a Code directive requiring sana sesdete or a. reduction )

in basis, the Commissioner’s solution\must be upheld,

because ‘it is reasonable and not inconsistent with the

statute. ‘<

HE COMMISSIONER PROPERLY APPLIED THE TAX BENEFIT

_ RULE IN REQUIRING RESTORATION TO INCOME. OF WHE

PARTNERSHIP’S BAD DEBT RESERVE UPON THE TRANSFER

‘OF ITS ASSETS TO CONTROLLED CORPORATIONS

A. THN TAX BENEPIT RULE APPLIES WHEN'A GAD DEBE RESERVE IS

NO LONGER NEEDED, WHETHER OR NOT THERE HAS BEEN A CASH

COLLECTION OF ACCOUNTS RECEIVABLE

-It is a fundamental. principle. of federal income

taxation that a recovery of’an item which has produced _

an income tax benefit in a prior year is to be added to

” income in the year of recovery. See, e.g., Alice Phelan

Sullivan Corp. v.. United States, 381 F. 3a 399, 401

(Ct. Cl); M erchants Nat. 7 ae v. Commissioner,

199 F. 24 657,659 (C.A. 5); Freihofer Baking Co. v.

. Commissioner, 151 F. 2d 388, 386 (C.A. 3); Union

| Trust Co. of Indianapolis v. Commissioner, 111 F.2d

60 (C.A. 7), certiorari denied, 311 U.S. 658; Chicago, ~

_ RI. & P. Railway Co. v. Commissioner, 47 F. 2d 990

(C.A. 7), certiorari denied, 284 U. S. 618; Charleston

& W.C. Ry. Co. VY. Burnet, 50 F. 39 342 (C.A.D.C.).

Although no provision of tS Tntarnel Revenue Code

articulates*the so-called tax benefit rule, it is engrained :

in the tax law and is recognized in Section 111, which»

prevents the restoration to income of “bad debts, prior

taxes and delinquency amounts” to the extent that ng

tax benefit therefor has been allowed in a prior tax-

able year.’ The rule rests.on the. notion ty a taxpayer

' should not.be permitted to retain the tax benefit of a

deduction when later events demonstrate that he no

longer is entitled to it. That the adjustment is made

in, a taxable year subsequent to the year in which the —

deduction is allowed is a consequence of the annual

accounting system.Ree Burnet v. Sanford & Suey

Co., 282 U.S. 359. ” .

Since a reserve for bad ttekts represents losses that _

are estimated will be sustained in subsequent taxable

- years, it is the accepted and longstariding general rule

that any unabsorbed dmounts in such a Reserve must

‘Section 111 would Er for example, to prevent applica-

. ‘tion of the tax benefit rule upon recovery of a bad debt allowed ,

as a -aget in a prior year, wheré the loss did ‘not result in

a f taxes because the taxpayer's other expenses ¢ com-.

. pletély of income.

be restored to inééme when the reserve is found to be

excessive or no longer neéessary—that is, when it be-

comes dlear that the taxpayer will not suffer some or’

.all of the estimated losses as a result of the uncollecti-

bility of accounts .receivable. Arcadia Savings .and

Loan Assn. v. Commissioner, 300 F. 2d 247: (C.A: 9);

| West Seattle National Bank of Seattle. v. Commis- /

sioner, 288 F.2d 47 (C.A. 9); S. ‘Rossin & Sons v. /

Commissioner, 113 F. 2d 652, 654 (C.A.'2).; Citizens

« Federal’ S, & L. Ass’n of Cleveland v. United States,290

, F. 2d 932, 936 (Ct. Cl.). Sed also Handelman v. Commis:

sioner; 36 T.C. 560; Geyér, Cornell & Newell, Ine. v.

Commissioner, 6 T.C. 96, 100; and C. Standlee Martin;

Ine. v. Riddell, 56-2 U.S.T.C., par. 9989 (S.D: Calif.).*

These cases formed the basis for the Commissioner’s ”

ruling in 1962 that a reserve for bad debts ‘must

be restored to the income of a sole proprietorship

or partnership upon the incorporation of its busi- °

‘ness, because, when the separate ownership of the

business terminates, the taxpayer’s need for a reserve

- also terminates. Rey. Rul. 62-128, 1962-2 Cum. Bull.

BORE Pe? Sitios pak Retr | :

In the first appellate‘decision to consider the ques-

tion here presented, the Court of Appeals for the

|. _ Ninth Circuit rejectéd the Commissioner’s ruling:

_ ss Estate of Schmidt v. Commissioner, 355 F. 2d 111.

| It did so despite its earlier recognition that it is a

* Published rulings of the Commissioner have also applied “

this rule. For example, Rev. Rul. 57-482, 1957-2 Cum. Bull. 49,

indicates that when a corporation sells its assets in a Section

337 liquidation (where gain or loss on the sale of property is

not recognized), it realizes ordinary income to the extent of

its reserve for bad debts. ; deal :

“well sedittiedick abate

for bad debts previously deducted in computing tax- -

able income must be included in taxable income when

and to the extent that the reserve is no longer neces- .

sary.” Arcadia Savings and Loan Assn. v. Commis-

stoner, supra, p. 250. In Arcadia, the court had held

that the tax benefit rule applied to require restoration -

of a bad debt reserve to income following a sale of

substantially all of a corporation’ s assets, even though

gain on the sale was not’ recognized under Section 337.

of the Code.

The Ninth Circuit’s rationale in «Schmidt, upon

which petitioners rely (Br. 31-34), was that although

it was trie that the taxpayer no longer needed the

reserve, it’ was not true in-an economic sense that he

had “recovered” its value. 355 F. 2d at 113. As that

court saw the matter, all that the taxpayer “recov-

ered” in relation to the receivables transferred to the

controlled corporation were stock certificates repre-

senting the net value (the face amount of the receiv-

able less the reserve), rather than the face value, of

the receivables (Ibid.) Therefore, the court concluded

'. that the tax benefit rule did not apply. It found

‘Arcadia and the other prior deci§ions distinguishable

on the ground that the value of the reserves in those ~

cases had been recovered through actual sales of

receivables. Id., p. 113, n. 7.

_. Apart from the fact that the Ninth Circuit was mis-

“taken in its reading of Arcadia—the amount of the re-

_ serve there was not actually collected’—we submit

*.°Nor can Arcadia bt explained away, as ‘the Ninth Circuit |

suggested (355 F. 2d. at. 113, n.’ 7), on the ground that it ih- -

WW}, .

that the court erred in holding that the tax kenefit rule

does not apply to 4 non-recognition transacfion under

- Section 35t, as well as to such a transacffon arising —

under Section 337. To lim}t application of the rule to

_ eases in which there has been an economic recovery

would frustrate its purpose, which is to insure that a

taxpayer not retain the benefit. of a deduction. to which

it is no longer entitled. Fulfillment of that purpose

_ requires application of the rule, whether the lack of

need for a\bad debt reserve arises from a sale or’

collection of agcounts receivable, or merely by reason

of the terminatjon of the 5 MB ve the owner of the

receivables. attee ost

In addition to failing to take account of the purpose

of the tax benefit rule, the Ninth Circuit, rested its de-

cision in Schmidt on three faulty premises.

First, the court stated (355 °F. 2d at 113, n. 6):

“Surely, if the taxpayer had sold the receivables, for

' volved “a change in accounting methods.” There is no indica-

tion in the Arcadia opinion that such a change was the basis

for the decisiof.

©The court of appeals’ cha¥acterization of the income rea-

lized in Schmidt as “fictitious income, never received by the

taxpayer in fact” (355 F.2d at 114), does not change the fact

that the taxpayer no longer needed the reserve thgt had been |

created. Nor does it justify the court’s refusal to restore the

reserve to income, since the bad debt deduction which gave rise

to the reserve could be characterized, under the court’s economic .

- analysis, as “fictitious expense, never sustained by the taxpayer

in fact.” This Court recently has cautjened against the resolu-

' tion of income tax problems on the basis f“economic” analysis

which assumes as its premise that what is sought to be taxed

is “fictitious” income. Commissioner v. Gordon, 391 U.S. 83, 90, -

n. 5. While that admonition was ashi 3 in a different context, tt

is equally well taken here.

880-620—70 —3

™ *

| MMe

cash, : for their net value, he would not have realized

income in the amount of the reserve. Yet, just as

surely, he. would no longer ‘néed’ the reserve. ”” This

observation, which’ the court presumably made to sup- _

| re its conclusion that the tax benefit rule may be

voked only where there is an economic recovery of \

a bad debt reserve, is, we submit, unfounded. When a

taxpayer on.the reserve method sells accounts receiv- .

-able for their net value, he must nevertheless restore

-the reserve to income. Restoration is required , be-

cause the loss he has sustained is’ not a bad debt ldss,

but rather a loss from the sale of property. Levy v.

: Commissioner, 46 B.T.A. 423, affirmed, 131 F. 2d 544 ©

(C.A. 2), certiorari denied, 318 U.S. 780; Benedum v.

Granger, 180 F. 2d 564 (C.A. 3) 5. Reed v. Commis-

stoner, 45 B.T.A. 1130, affirmed, 129 F. 2d 908 (C.A.

4); and Von Hoffman Corp. v. Commissioner, 253

F’, 2d 828 (C.A4. 8). The proper analysis of the trans-

action where accounts receivable are sold for theiz net

value by a reserve method taxpayer is to restore the

reserve to his income and accord him a loss on the

sale. of property.” That this loss (face value less

amount realized) equals the amount of the restoration

to income does not militate against the basic principle

hat the reserve must be restored to income when it is

no longer néeded, irrespective of whether there has

been an economic recovery.

- 4 The. court of appeals’ conclusion in Schmidt (355 F. 2d, at:

114) that “where accounts receivable are sold for cash for less

than facé value, the difference being the amount of the reserve,

the taxpayer does not then ‘realize’ .& loss,” seems dithapaed

incorrect.

A 13

Second, -there is no basis for the Ninth Cireuit’s —

assumption (355 F. 2d, at 113) that the tax benefit

rule has no application where a taxpayer receives

only ‘‘pieces of paper—stock certificates’’—in ex-

change for the accounts receivable transferred, If a

corporation liquidates and distributes its assets, in- —

cluding accounts. receivable, to its shareholdérs in .

kind, the rule requires restoration of the reserve to -

the corporation’s incdme, even though gain or loss is

not recognized on the liquidation pursuant to Section —

336 of the Code. This much petitioners concede (Br.

32) despite the fact that the corporation’s “recovery” :

consists only of the stock certificates which are > turned

in by its shareholders. _ .

Third, the court erred in. refusing to consider the

effect of its holding upon the corporate transferee i in

Schmidt. It stated (355 F. 2d at 114): “We do not

pass upon the right of the corporation, at the com-

mencement of its business, to set up the same reserve

as an offset to the receivables entered upon its books.

The only question before ‘us is the liability of the

individual taxpayer.” This refusal, although couched

in traditional ternmis of judicial restraint, cannot be

squared with this Court’s recent reaffirmance : of the

principle that “the Code should hot be interpreted to

allow * * * ‘the practical equivalent of double de-:

‘duction,’ * * *, absent a cleat declaration of intent

by ‘Congress. ”? United States v. Skelly Oil Co., 394 :

U.S, 678, 684. See pp. 5-6, supra. Whatever doubts may *

_ have existed as tothe viability of this principle when ©

: Schmidt was Coenen 3 in 1966. were resolved by saciid

Q.-

Oa in 1969: In approaching the question whether the

tax benefit rule should have been applied in Schmidt, the

court should have been mindful of the possibility that

its. decision could lead to the “practical opreetent of

‘double. deduction’ 6 2” |

There is, in sum, : nothingNin the Ninth Circuit’s

opinion that’ justifies its failure to invoke the tax

benefit rule. Petitioners advance only one. additional

argument, in support of that ¢gourt’s economie¢ analy- -

sis. They rely (Br. 34) on Treasury Regulations,

Section 1.111-1(a)(2), which provides: “Recoveries* ~

/result from the receipt of amounts ‘in respect of the --

previously , deducted or credited section 111 ite

such as from the collection, or sale of a bad actt, |

refund or credit of taxes paid, or cancellation of taxes -

. accrued. * * *’’ Petitioners contend that because wi

, earn includes examples of what the Ninth Ci

“—euit characterized as “economic? recoveries (355 F. 2d

at ‘T18), only such recoveries can come within the tax

benefit rule. This is not correct: The use of the words

~ “such as” in the Regulation makes it clear enough .

that what are referred to as examples of recoveries’

are.only examples. Moreover, as we have noted (p. 13, ©

supra), petitioners do not dis ute that a recovery .

occurs when a corporation ibutes its accounts

receivable in liquidation, even though it. receives only

. its. shareholders’ stock certificates in “return. The re-

covery here is no different than that of a liquidating

; corporation and is sufficient to warrant »pplication of *

the'tax benefit rule.” -s

12 Petitioners also contend (Br. 17) that the tax benefit’ rule

does not apply here because “the bapegets need (for the bad

yi A

—e .

B. SECTION 351 OF THE CODE DOES NOT BAR aegaresaes OF ‘THE

TAX BENEFIT RULE

3 Section 351(a) of the Code provides that ‘‘ [n]o gain -

or loss shall be recognized if property is transferred

to a corporation * * * by one ‘or more persons solely

in exchange for stock or securities in such corpora-

~ tion and immediately after the exchange such person

or persons are in control * * * of the corpora-

tion. * * *’? The non-recognition rule of Section 351 is

an exception tothe general rule of. Section 1002 that"

the entire amount of gain or loss. (determined under .

Section 1001) resulting from the sale or exchange of

property is to be recognized, with immediate tax con-

sequences. If a transfer qualifies under Section 351,

L the basis of the property given up by: the transferor

becomes the basis of the stock received in the ex-

change. Section 358. -Thus, the practical effect of Sec-

. tion 351 is to defer the recognition of gain or loss

_ until the ultimate sale or disposition of the corporate

stock by the transferor. Seé Portland Oil Co. v. Com-

missioner, 109 F. 2d 479, 488 (C.A. 1). |

Petitioners’ major contentior is that the non-recog-

nition rule of Section 351 precludes the application of

the, tax benefit rule in the circumstances of this case.

Pointing to the legislative history of Section 351 (Br.

7-12), petitioners maintain that the policy of the pro-

debt reserve] continues in a Section 351 trangfer. ” This was not

the rationale of the Ninth Circuit. That court agreed (355 F.

2d at 113) that the partnership’s need terminated at the time

of the: transfer. In all-events, petitioners’ contention turns on

the interpretation of Section 351 and whether the partnership’s .

reserve nity be carried over to the transferee corporations,

matters with which we deal. below, pp. 19-20, 26, n. 24, infra. —

7 ¢

35.3 ae cae bots

vision requires that the feet ’s bad debt re-

_ serve not be restorad to income, because a Section 351

transfer ixtyolves nothing more than a change in the

form of ownership of an existing business. 7 toe 2

The fallacy i in petitioners’ argument is that the lan-

guage of Section 351 does not read as petitioners

‘ would have it read. It provides that “[n]o gain or loss

“shall be recognized if property is t erred to a cor-

- poration .* * *» solely in exchange for stock or securi-

ties 08” But the Commissiqner is not here seeking

to tax “gain or loss.” “Gain or loss’ is a statutory

’ term of art and can aris y ‘‘on the sale or exchange

of property” as provided in Section 1002.-A reserve

for bad debts is not property, however. Nor is it capa-

ble of being sold or exchanged. ‘‘A reserve consists of 3

entries ypon books of account. It is neither an asset

nor a liability. It has no éxistence except upon the

books, and, unlike an asset or a liability, it can not be.

transferred to any other entity.” Geyer, Cornell &

Newell, Inc. v.. Commissioner, 6 T.C. 96, 100. See also

J. E. Hawes Corp. v. Commissioner, 44 'T.C. 705, 707- -

708; Bird Management, Ine. v. Commissioner, 48 T.C.

586, 594-597 pFinney and Miller, Principles of Account-

ing, Intermediate (4th ed. 1953), p. 534; Paton, Ad-

vanced Accounting (1947'ed.), p. 598. It follows—since

a bad debt reserve is not “prope if, and cannot be

transferred—that restoration of the.reserve to income

cannot result in “gain or loss.’’ Thus, Rev. Rul. 62-128, |

1962-2 Cum. Bull. 139, which requires restoration of the

reserve when accounts receivable are transferred in a

Section 351 enaneOny does not contravene the restric-

“tion of that prarision against redo of “gain or

loss. 99:18

Petitioners are in 1 substance aakind that the Court |

construe Section 351 as if it called for “non-recegnition

of gain, loss or income” (Br. 11), even though the —

statute provides only that ‘‘gain or loss” should. not

be recognized.“ The . legislative history up whieh

| petitioners rely (Br. 7-12) to support thei ent :

does not go beyond the language of the statute, how-.

ever.. That history shows only that Congress intended

to irisulate “gain or loss” from recognition in a Sec-,

‘tion 351 transfer. It is true that Congress could ,haye

legislated further and provided that income generally,

not merely ,“gain or loss,” should go unrecognized

under Section 351, or that reserves should go over to

the transferee of the assets, without immediate tax con-

sequenées. But Congress did not legislate further, and

the courts should not extend the-statute beyond its

plain terms. As this Court has observed, .‘ “Tf is our =

judicial function to apply statutes on the basis of, what

Congress has written, not what Congress might have

written.’’ United States V. Great N orthern Railway Co.,

348 US. BOO GIS: 26 oc ons ?

BSS * 38 Treasury. Regulations, Section ame-oty (2), which pro-

vides that gain or loss shall not be recognized-upon the transfer

of installment obligations in a Section 351 transaction is not

inconsistent with Rev. Rul. 62-128, swpra, 4s petitioners contend aes

(Br. 11-12). Unlike a reserve for ‘bad debts, installment obliga-

tions: are property “and are capable of being transferred, and.

a taxpayer, therefore, can realize gain or loss on their disposition.

4In apparent contradiction, petitioners recognize (Br. 21).

that “gain” -as it appears in the term “gain or loss” is eset

coextensive with the concept of income.’

a> ; é

‘5 .

t%\

None of petitioners’ remaining arguments in sup- ,

port « of their r interpretation of Section 351 have merit. «

Their contention (Br. 17-18), that ifswould be “‘para- _

_ doxical’’ to restore the reserve to income in an other-

wise tax-frée transaction under Section 351, suggests

t the reserve would not be so restored in a taxable

; transaction. As we have previously shown (pp. 11-12,

supra), however, restoration of the reserve would be

required in either event, for application of the tax

benefit rule does not turn-on. whether a transaction .

is taxable, but simply ‘on whether the need for the |

reserve has terminated. While petitioners are correct.

in pointing out that. a taxable sale of receivables .

would result in no nét income, that résult obtains not —

beeause the tax benefit rule ‘is inapplicable, but be-

cause the loss realized on the sale (the excess of the

face amount of the receivables over #4 value) would -

offset the amount restored to income. When petition-

ers’ partnership transferred its accounts receivable to

the controlled ¢orporations, petitioners realized a loss, .

just as they would have in a taxable transaction: Pe-

" titioners were barred from recognizing that loss, how-

ever, by the non-recognition rule of Section 351. There

is thus nothing “paradoxical” in applying the tax

benefit rule in an otherwise tax-free .situation.

. As the Fifth Circuit recognized below (R. 19), the.

“paradox would arise if the rule were not applied, since

petitioners would then in effect be recognizing the loss

on ‘transfer. ofthe receivables which Section 351 says

may not be recognized—along with any gains which

-_@#

‘inhered i in the ee transaction. In aa petitioners

are here seeking recognition of their losses, while their

gains go unrecognized, which is not what Congress —

provided. Section: 351 is sis ees applicable to gains

and losses. ;

The contentions. that;q¢—taxpayer’s need for a bad

debt reserve continues in a tion. 351 isaction _

(Br. 17) and that application af Rev. Rul. 128,

supra, would distort the income of both the transferor

and the’ transfered in the transaction (Br. 18-19) as-

sume the very point which is an issue. If, we con-—

— tend (pp. 16-17, supra), Congress did not legislate as

broad a non-recognition rule as it might have when it .

enacted Section 351, the trahsferor and transferee

cannot be considered the .same taxpaying entity with

- respect to those items which do- not constitute prop-

erty or are not capable of being transferred—includ-

~ a reserve for bad debts. This ‘being the’ cage, the

‘‘continuation of business’’ theory cannot apply -with

respect to such items. Absent this theory, there would

be no cortinuing need for the reserve, because, for -

purposes of determining the adequacy of the reserve,

the transferor would not be deemed a. continuing

entity.” There would likewise be no distortion of the

_ income of either the- transferor or the transferee, since . -

the former’s income would reflect all bad losses ac-

tually sustained up to the time of the transfer, and

. %Qnce this is recognized, it becomes aia

standing petitioners’ contentions to the contrary (Br. 12, 17)—

that the partnership’s reserve, determined on the’ assumption

that the parfpership would continue to exist, was reasonable.

the latter’s-would reflect all such losses activally sus-

_ tained thereafter."

That the Commissioner first ruled on the oritetion

here presented in 1962 (Rev. Rul. 62-128, supra) does

_ warrant the inference drawn by petitioners (Br.

13, 26) that prior to 1962 he agreed with their pro-

| ound interpretation of Section 351, Nor ean this in-

ference be drawn from the fact that the question was _

first litigated in 1966 in Estate of Schmidt v. Commis-

stoner, supra, as ‘petitioners suggest (Br. 15). We are

advised by the Internal Revenue Service that during

. the pre-ruling period the problem was handled on-an

- ad hoc basis by revenue agents in the field. The ruling,

which we believe to be completely consistent with. Sec-

tion 351, was designed to provide a uniform rule for

all taxpayers and one which would, in all events, effec-

“tively prevent a double deduction. In these circum-

stances,..there is no basis for interpreting the

Commissioner’s failure to rule before 1962 as indica- .

tive of his acquiescence in a rule contrary to that

‘which we urge here. 4

¢. THE EXISTING FRAMEWORK OF CODE IS. NOT READILY ADAPT-

ABLE TO EITHER OF PETITION % PROPOSED SOLUTIONS TO THE °

DOUBLE DEDUCTION PROBLEM

Recognizing that a double deduction iis result if

. the tax benefit rule does not apply (Br. , 29), peti-

tioners argue that this problem can b roided by

requiring that a partnership’s reserve for bad debts

be carried over to a cqrporate transferee, or by recog-

%° As noted above (p. 6, supra), the Commissioner would al-

low the transferee corporation to comet bad debt losses on the

: receivables transferred to it.

ig ec eas

ra | |

nizing that the reserve reduces the basis for the re- -

ceivables in the hands of the partnership. The first.

alternative would preclude a corporate transferee from

claiming the same bad debt deduction allowéd to the

‘partnership, since the reserve in respect of the trans-

ferred receivables would be reflagted on, the corpora- -

tion’s books without the allowance of any additional

deduction. The second alternative: ‘would acgomplish

_the same purpose, since the eepbrate ansferee

would take the partnership’ s basis for the’ receivables

pursuant to Section 362. While each proposed solution

thus would prevent both parties to a Section -351 —

transfer from claiming the same deduction, neither —

solution 1 is in line with prior judicial authority or with

the technical requirements of the Code.

1. Carryover of reserve for bad debts .

Section 381 of the Code is the basic statute dealing

; with the carryover of certain specified “items” (Sec-

tion 381(a)) from one taxpayer to another. By its

terms,.i¢ provides for carryovers ‘only in cases involv-

ing intercorporate transfers of preperty—certain liq-

uidations of corporate subsidiaries (Section 381(a)

(1)) and certain corporate réorganizations described

in Section 368 (Section 381(a) (2)).’” It does: not pro-

. vade for the carryover of “items” in a transaction de-

-scrihed)in Section 351. si: : “

17 These are-the reorganizations described in Section 368(a)

(1) (A), (C), (D) and (F). In the case of Section 368(a) (1)

(D) reorganizations, the carryover rules are applicable only if

the requirements -of Section 354(b) (1)(A) and ‘(B) are

. er

SPY ge

. = ¢ |

_.. Among the items which aré to be carried over by ait

‘acquiring corporation ‘subject to Section 381 are the

_ methods-of accounting of the transferor corporation,

‘including, where the transferor is using the reserve

method of accounting for bad debts, its reserve for

bad .debts. ‘See Section 381(¢) (4); Treasury Regula-

tions, Section 1.381(¢) (4)-1(a) (1) (ii). Petitioners”

maintain that the rule of Section 381(¢) (4) should

apply here despite ‘‘the lack of specific statutory di- _.

rection” (Br: 24). = 8 a : mn te

To support this contention, petitioners again con-

tend that the transfer from partnership to corpora- -

tion constitutes nothing more than a mere change in»

the form of ownership of a business. They point out

that this theory also. underlies Section’ 361, which

provides for nonrecognition of “gain or logs” upon

the transfer of property from one corporation to

another in a corporate reorganization; and conclude

from this that bad debt reserves should, be car-

- Tied in corporate organizations as well as corporate

reorganizations. Ve ;

(1) Petitioners’ conclusion ignores the well-settled

Tule that the transferee corporation in-a Section 351

exchange is a new taxpayer and is entitled to

adopt its own taxable year and its own ‘accounting

' methods, including, in this instance, the specific charge

. Off method forsreporting bad debts." See, ¢.g., Ezo -

38 Petitioners argue to the contrary (Br. 25) in reliance on

Treasury Regulations, Section 1.166-1(b) (1). While we do not

agree that the Commissioner could prevent @ corporate trans-

feree from using the specific charge off method merely because

the’ transferor used the reserve method, nothing in the cited

J 2 pak,

Fe 255 Tar

ib. Products” Co. v. Commissioner, 37. T.C. 385, 393-394;

D earpokn Gage Co. v.. Commissioner, 48 T.C. 190, 201,

and cases cited therein. Indeed, the transferee is con-

sidered to be a new taxpayer with respect to. depre-

ciable assets received by it in the exchange and is

therefore not entitled to use the accelerated methods -

of depreciation that are available only to: original

users of. property under Sections 167 (b) and (c).

Rev.. Rul. 67-286, 1967-2 Cum. Bull. 101... ;

Pies ‘Finally, to the extent that Congress has perthitted

. gertain’carryovers of tax attributes in Section 351

i transactions, it has’ carefully delineated the jee

? overs. See Sections 47(b)(3), '1245(b) (3),

3S 1250(d)(3):2° Except as to these specific provisions,

Congress has apparently seen fit to limit the carry-

_over of a bad debt-reserve to certain’ types of cor-

porate’ reorganizations and not the _ corporate

organization encompassed in Section 35F.*° For the

—

Regulation empowers the Commissioner to insist on a carry-

; over of* the transferor’s reserve in order to avoid a double

“~~. = deduction.

| . eileen to petitioners’ contention (Br. 30), the enact-

‘ ment of these provisions is not indicative of any Congres-

sional policy to treat Section 351 transfers and reorganizations

in a “similar * * * fashion.” The legislative history of these spe-

| _ + cific enactments dealing with the investment credit and the recap-

| ture of depreciation reveals no such purpose. See H. Rep. No.

1447, 87th Cong., 2d Sess. pp. A15-A16, A109-A110; S. Rep.

No. 1881, 87th Cong., 2d Sess., PP. 152, 282-983; H. ‘Rep. No. -

749, 88th Cong., 1st Sess. p. 105; S . Rep. No. 830, 88th Cong,, |

2d Sess., pp. 185-136.

2° Calawo, Inc. v. Cominiisenen, 304 F. 2d 650 (C.A. 9), and

©: 5 Home Savings and Loan Association v. United States, 293 F.'

. Supp. 184 (S.D. Calif.), relied upon by petitioners (Br. 22,

n. 22), are not: in point. Each of those cases involved transac-

"Ss

“——

]

only carryover bai ai of Section 351, as set forth in

that provision, is the requirement that. the controlled

corporation carry over the transferor’s basis in the

property transferred. Sections 351(d) (2) and $62,

Appendix, infra, pp. 34-35. ,

- Aecordingly, whatever abstract merit a carryover of

_ the bad debt reserve in the instant case might have,

\ it is plain, at the very least, that Congress has not

\ authorized such a carryover. Under these circum-. -

\ stanceé, the existing structure of the Code does not

\ deeioniaet the bad debt reserve carryover for which peti- —

- tioners’’ contend. As. Judge Raum explained in

Schuster v. Commissioner, 50 T.C. 98, 102, which ap-

proved the Commissioner’s Foes, as, applied in the

instant case "— -

The Code ‘is a highly ‘complex’ instrument, and.

it would be inappropriate, in order to reach a

seemingly equitable ‘result, to procéed upon

theories that .depart from an established course

of decision or that do violence to the statute.

In a field that is governed by so specific es

statutory scheme relating to nonrecognizable

' transfers, any logical departure therefrom must

be based jon specific legislative ‘Modifications.

The remedy is one that must be provided by —

_ Congress, rathey than through a judicial re-

, construction of a complex law. [Footnote

\ omitted.] .

tions—Calavo, a Section 332 liquidation, and Home Savings,

a Section 368(a)(1)(A) reorganization—to which.the carryover

. ules of Section/881 specifically apply.

The Tax Court has adhered to its position in Hutton v.

Commissioner, 53 T.C. 37.

ee ee

This Court simitarly obset'ved in Commissioner v.

“Gordon,*391 U.S. 83, 91-92,-in construing another

technical provision of Subchapter:C, that ‘The ‘re-

quireménts of the sections are detailed and specific,

and myst be applied with precision.’ Since the terms _

of the Code do: hot expressly require the carryover of

a bad debt reserve from_a partnership to a corpora-

tion; the Commissionef’s Tile requiring a restoration

of the reserve to income is more closely in harmony

‘ with the Code’s highly technical structure.” , .

(2) Given the existing framework of the Code,

petitioners’, contentiom that the Commissioner’s rule

yield to their carryover solution to the double deduc-

tion problem is unpersuasive. Not only do the highly

articulated provisions . of the Code point toward the

correctness of the Commissioner’s rule, but there is,

in addition, no theoretical justification for .broadly

22 Petitioners rely (Br. 26-28) on the reasoning of the dis-

- senting opinion in Schuster (50 T,C. at 103-104) to the effect

that the legislative history of Section 381 indicates that it w

not meant to be exclusive on the subject of carryovers of tax

attributes. However, it should be noted that the Committee

‘Report references deal only with carryovers from predecessor

to successor corporations and de’ not. ‘expressly refer to carry-

overs from partnerships to corporations:in a Section 351 ex-

change. While petitioners are correct (Br. Ww ) in observing that

prior to the enactment of Section 381, the courts, in certain .

nees, permitted -carryovers, those cases all involved. inter-

corporate transfers. Furthermore, the results were by no m

- uniform. Compare, Libson Shops, Inc. v. Koehler, 353 U.S.

with Helvering v. Metro. Edison Co., 306 US. 522. Si

cantly, petitioners do not advance any cogent a

returning tothe era of court-made lay in this highly

area, given the precise and detailed manner.in which

‘has established the ground ‘rules in Section 381.

ness amalgamations accomplished either by statutory .

26:

enabeiabs a Section 351 transfer to. a corporate

reorganization. — \

~All of: the corporate iedieieibiatleni to which the

carryover provisions of Section 381 apply involve bisi-

_Inerger or ‘consolidation (Section 368(a)(1)(A)) or

by a transfer of substantially all of the assets of the

transferor corporation (Section 368(a)(1)(C), (D), -

and (F)).” This is likewise true of the. corporate

liquidations to which the Section 381 rules apply. The

_ carryover rules can apply only in the case of com-

plete liquidations of subsidiaries under Section 332. A

Section 351 transaction, on the other hand, may in-

volve the transfer of a single asset. It-is thus entirely

reasonable for Congress not to have carried the con-.

tinuation of business theory as far in the corporate

organization area as it did in the area of corporate

reorganizations.™ ; 7

2° The Section 368(a) (1) (C) reorganization requires a trans- .

fer of “substantially all of the properties” of the transferor.

Similarly, the non-divisive Section 868(a)(1)(D) reorganiza-

' tion, by operation of Section 354(b) (1) (A), requires a transfer

of “substantially all of the assets” of the ‘transferor. And, the

Sectiqn 368(a)(1)(F) reorganization—“a mere change in iden-

: tity, form, or place of organization * * *”—presupposes the

transfer of an entire business organization.

*4 Petitio: ask rhetorically (Br. 20) how the nest for a

bad debt reserve can terminate in a Section, 351 transaction, so

as to justify invocation of the tax benefit rule, while the need

would not terminate in an otherwise comparable corporate re-

organization situation. The answer to this questign is that in

enacting Section 381, Congress determined that the need con-

tinues in the latter-situation. Its failure to include Section 351

transactions“within the coverage 6f Section 381 indicates that.

it made no such determination with — to corporate:

organizations.

hd =

wit 27

_ Further reason for the oi omipectiitt decision. may

be found in the fact’ that although corporate re-

organizations, lyylefinition, involve only corporations,

a-Section 351 transfer may- involve a non-corporate

party. The distinction between individual and cor-

porate taxpayers is manifest throughout the Code.

First, graduated tax rafes are imposed upon. in-'

dividuals by Section 1, while corporatiens are subject

to the normal tax and surtax under Section 112° In

- addition, the assumption of corporate form triggers

an entire body of detailed provisions (Sections 301-

318, 332-337, 354-382) and presents a variety of ben-

efits and elective options (¢.g., Sections 243-246, 421-

425 and 1371-1378) and potential liabilities - (Sections |

841, 531-537, 541-547), none of which apply to non-—

corporate taxpayers. All of this suggests that it would

be inappropriate to draw a broad analogy between -

the corporate organization, and a ataenne ee teen

. sions of the Code.” ~

(3) Moreover, although a carryover of a bad debt —

reserve would prevent the deduction of the same bad

*°The Fifth Circuit regarded this difference in ‘tax rates as -

significant (R.. 19) in upholding the Commissioner’s rule re

quiring restoration of the bad debt reserve to income. <

‘ %6Tt would likewise be inappropriate to draw such a broad .

analogy. on the basis of this Court’s decision in Helvering v.

- Cement Investors, Inc., 316 U.S. 527. The Court there noted (p.

534) the “close, relationship” between the organization and re-|

organization provisions, in holding that the. former, meng

_. than the latter, were applicable in the circumstances presented.

But the Court also. recognized the distinction- we have diseussed

above. It observed (p. 538) that “TwHhile: the ‘reorganization’

- provisions are restricted to- inter-corporate transactions § (851)

is not so co ee 2

28 |

‘ debt P by. the tranafosror and transferee. in a Sec-

* » tion 951 transaction, it would result in ‘a double bene-

- fit for the transferor. This double benefit arises by

_ reason of the operation of Section 358. Under that.

provision, the transferor in a Section 351 transaction

receives a tax basis in the corporate stock he acquires

equal-to the basis of the property he transfers, here

the face amount.of the accounts receivable.”” On the

other hand, the value of the stock he receives would —

be equal to the net value of the receivables (face

~ amount less reserve). Accordingly, the tax benefit

which . resulted when the reserve was established is

perpetuated in an inflated basis for the corporate stock

received. [nless the reserve is taken into income at

the time of the Section 351 transfer, the transféror

could ultimately diniinish his income twice: once when

he established the reserve and obtained a bad debt de-

ductién, and a second time when he disposes of the .

stock and is permitted to use its inflated basis in com-

Puting gain or loss. ’

2. Reduction in basis of accounts receivable

Presumably in recognition of the fact that their

| _ reserve carryover proposal solves one double deduc-

tion problem but creates another, petitioners contend

_ (Br. 30-31) that the basis of accounts receivable in

~ the hands of a taxpayer on the reserve method should

be reduced at the time the taxpayer takes a deduction

that increases the reserve, rather than atethe later

27 As we explaingt below (pp. 29-30, infra), there is no statutory

authority whereby the,basis of the receivables transferred can

be adjusted downward te reflect the bad debt reserve. _

reese |

time when the reserve-is decreased to reflect the worth-

lessness of a specifie account. But the Code no more

provides for-a basis reduction prior to the actual .

worthlessness of an. t than it does for a

carryover.

Under Section 1016 (a) (1), adjustments to basis

items, properly chargeable to. capital account * *-*,”

The deduction that increases the reserve.does not’ come

within any of the specified categories. It cannot be

considered a loss because, at any given time, the re-

serve reflects only losses. which it is estimated will be

sustained in ‘the future. Nor can it be considered an

“other item’’ chargeable to capital account, since it re-

flects a provisional estimate rather than a fixed and

final determination and, as a matter of | accounting

: technique’ i is not chargeable against accounts receiv- |

able.” Sée Accountants’ Handbook {4th ed. 1957),

See. 11.24; Karrenbrock and Simons, Intermediate

_ Accounting (2d ed. 1953), pp. 87, 184.

28 Petitioners poirit out that a taxpayer on the specific charge

off method may reduce his basis in accounts receivable at the

time he becomes entitled to a bad debt deduction—when a

- specific account mes worthless. They maintain that a re-

serve method taxpayer should be entitled to reduce basis at

the time he becomes entitled to a bad debt deduction—when he.

increases the reserve in advance of actual worthlessness—and :

' that not to allow a basis reductign at that time is discrimina-

tory. This argument ignores the language of Section 1016(a) (1)

_ and the rationale of the reserve method itself. There is no dis-

crimination between specific charge off and reserve method

taxpayersi Both are entitled to a. basis adjustment. when’ a loss

is in ~_ sustained.

Finally, we deal ‘with the argument that a reserve

for bad debts should be treated as reducing basis on

the theory that it is like'a reserve for depreciation |

which’ does reduce basis. The reduction in basis for a

depreciation reserve is not made under Section 1016

(a) (1), however, but is specifically provided for in Sec-

tion 1016(a) (2). See also West Seattle National Bank

of Seattle v. Commissioner, 288 F. 2d 47, 49 (C.A. 9) ;

National Bank of Commerce of Seattle v. Commis-

— stoner, 115 F. 2d 875, 877-878 (C.A. 9). No comparable

specific provision prescribes a basis adjustment for a

_ D. SINCE THE COMMISSIONER’S SOLUTION TO THE DOUBLE DEDUCTION

a veges denducannamgmee \drenbyassepelicookags ocategagtientlares lacacead

VE SOLVED THE PROBLEM BY OTHER MEANS

Under Section 7805 (a) of the. Code, the- Commis- °

_ sioner is empewered to ‘“‘prescribe all needful rules

‘and regulations for .the enforcement of — this

title * * *.” The OdiniinienioineNeravdaed: the discre-

i tion confided to him thereunder in Rev. Rul. 62-128

“supra. There he,prescribed a uniform rule for all tax-

‘payers and one which would ‘insure against the ‘pos-

sibility of a double deduction for the same bad debt

loss.

As we have din, the Corantanione’ s rule requir-

ing restoration of the reserve to income in the’ circum-

_, Btances of this case is fully consistent with all per-

be thé end of the matter. For even if the Commis-

. Sloner could properly have resolved ‘the double deduc-

tion problem by other means, it was not error for him

not to have done so. Petitioners maintain that the

een

—

eo Fee

; Commissioner could have. required a reserve carry-

over or a reduction in basis of accounts receivable

under Sections 351, 881 and 1016. In addition; peti-

.tioners suggest (Br. 29) that the Commissioner might

have acted under Section 446 (relating to methods of,

_aecounting) oy Section 482 (relating to allocation of

. Income and deductions among taxpayers): Whatever °

the merits of these alternative solutions, the Commis-

sioner has chosen to restore the reserve to income—

a result firmly grounded upon the well-settled tax

benefit rule. Under these circumstances, it is of no

significance that there may be alternative methods to

deal with the problem. As this Court observed in "5

| UnitedsStates v. Correll, 389 U.S. 299, 306-307

Alternatives to the Commissioner’s * * * rule

are of course available. Improvements might be

: imagined. But we do not sit as’a committee of

. revision to perfect the administration of the tax

laws. Congress has delegated to the Commis-

sioner, not to the courts, the task of préscribing

‘‘all needful rules and regulations for the en-

-forcement’’ of the Internal esis Code. 26

U.S.C. § T80G(8). ee ee

' $2 ah 4

comotustow .

For the reasons stated, it i is respectfully submitted

that the judgments of the court of appeals should be

- affirmed.

— N. Griswow, , :

Poker} Solicitor General.

: JOHNNIE M. WALTERS,

~~ * Assistant Attorney General.

' Marrnew J. Zu,

° Assistant to the Solicitor General.

‘GIEBERT F. ANDREWS,

Stuart A. Smiru,

; 7 Attorneys.

-Marcx 1970.

. A

{ ;

APPENDIX

rey _. Internal Revenue Code of 1954 (26 U. epee

| ' Suc. 166. Bap Dests: |. =f ‘

J , (a) General Rule.— .

| 7 (1) Wholly worthless debts —There shall be .

‘allowed as a deduction any debt which becomes

| worthless ‘within the taxable year. _ .

| “1 (2) Partially worthless debts—When satis-

| _ fied that a debt is recoverable only in part, the

j a _ Secretary or his delegate may allow such debt,

| ~. in an amount not in excess of the part charged |

off within. the taxable year, as a deduction.

_ -(b) Amount of Deduction.—For purposes of ‘.

_gubsection (a), the basis for determining the

amount: of the deduction for any bad debt shall

‘be the adjusted basis aided in section 1011

for determining the loss from the sale or other

disposition of property. —

(e) Reserve for Bad Debts.—In lieu of any -

fae deduction under subsection (a), there shali be

, | allowed (in the discretion of the,Secretary or

, his delegate) a deduction for a redésonable-dddi- -

4 tion to a reserve for bad debts: + 7

# * “UL isc! BGs

Sec. 351, TRANSFER TO CORPORATION CONTROLLED

BY TRANSFEROR. ~ ~.

(a) General Rule.—No gain or loss shall be —

recognized if property is transferred to a cor-

por, by one or more persons solely in ex-

| change for stock or securities in such corporation

and ediately after the exchange such person -

‘ or persons are in control (as-defined in, section -

_ 368(c)) of the corporation. For ptirposes of

i‘ section, stock or securities issued for serv- . -

ices shall not be considered as eee, 2 in return ~

for —

(38) *

_-(b) Receipt of Property.—it subsection’ (a)

_. would ‘apply to an exchange but for the fact

or securities permitted to be received under

subsection (a), other property or money, then—

= (1) gain (if-any) to such recipient shall be

recognized, but not in excess of— |

(A) the amount of money received, plus

-" (B) the fair market value of such other

nized. .* ) a7} ite

for purposes of this section, the fact that any

"the stock which it receives in the exchange to

pres - .°. its shareholders shall not be taken into account.

«= (d) Cross References.— , 3

‘' “the exehange assumes. a liability, or acquires

property subject to a liability, sé section 357.

(2) For the basis of stock, securities, or

‘ section applies, see sections 358 and 362.

(3) For special rule in the case,of an ex-

change described in this section but which re-

(4) For special rule in the case of an -€x-

, change described in this section but which has

ei ia the effect of the payment of compensation by

' the corporation or by a transferor, pee section

61(a)(1). - | 3 ae

‘Sec. 362.. Basis TO CORPORMTIONS. .

ee Property ‘Acquired by Issuance of Stoc

or as Paid-In Surplus—Ii property was ac-

“quired on or after June 22, 1954, by &

> alle 1) in connection with a transaction to which.

section 351 (relating to transfer of property to

that there is received, in addition to the stock .

(2): no loss to such recipient shall be Tecog- -

i ‘4 eorporate transferor distributes part or all of |

as _-- / (1) For special rule where another party to .

sults in a gift, see section 2501 and following. ~

CO. ration— . e

corporation controlled by transferor) applies,

(2) as paid-in surplus or as 3 contribution to

capi

43 then_the basis shall be the same as it would be

*° in the hands, of the transferor, increased in the

_ amount.of gain recognized to the transferor on

aati oneh: erveanis

* . * p*

Tenaaiy Regulations 2 eau (1964 Code)

(26 C.F.R.):’ he

) Sec. .1.166-4. RESERVE For Bab

} 4 (a) Allowance of ded —A taxpayer

who has established the régerve method of

treating bad debts and has mbintained proper

‘reserve accounts for bad. d or who, in ac-

cordance paragraph

adopts t serve. method of treating debts.

ma ct/from gress income a reasonable

rs ae specific sete eee debt items. |

Ro peiablowens of addition to reserve—

re | a) le my! faétors.—What constitutes a rea-

.° ‘wadftion to a reserve for bad debts shall .

be di fete rmiffed in the light of the facts existin

at the ‘close of the taxable year of the proposed:

addition. The reasonableness of the addition

| ' will vary as between classes of business and .

8B eect: with conaitions of business prosperity. It

| depend primarily upon the total amount” of

debts outstanding as of the close of the taxable

- year, including those arising currently as well

; as those arising in prior taxable years, and the.

as - total amount of the~existing reserve.

> ° (2) Correction of errors.in ‘prior estimates.

“Tn the event that 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

ingdequacy in the existing‘ reserve shall be re- S

flected in the determination of th

‘ ‘addition necessary in the current

nable

year.

§-

ee A. hl. j-

—_—_ is “ . PA

- 36

(e) Statement Fesotalt —A taxpayer using

the reserve method shall file with his return a

statement showing—

(1) The volume of his charge sales or other

business transactions for the taxable year and

the percentage of the reserve to such amount;

(2) The-total amount of notes and accounts

receivable at the ginning and close.of the

taxable year ;

(3) The amount of the: debts which have be-

come wholly’ or partially worthless and have

been charged agamst the reserve account; and.

- (4) The computation of the addition to the

reserve for bad debts.

(d) Special rules applicable to certain bank-

.ing organizations.—For special ‘Trules for the

- addition to the bad debt reserves of certain

- mutual savings banks, domestic building and

loan - associations, and cooperative banks, see

§§ 1.593-1 through 1. 593-11. M4

U.S. GOVERNMENT PRINTING OFFICE: 1970.

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This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.