NASH v. UNITED STATES

Citation Codes

Equivalent Citations

citation codes

Docket Number

Nos. 26928-26930.

Advocates

Macon L. Weaver, U.S. Atty., Birmingham, Ala., Johnnie M. Walters, Asst. Atty. Gen., Lee A. Jackson, Jonathan S. Cohen, Martin T. Goldblum, Attys., Tax Division, Dept. of Justice, Mitchell Rogovin, Asst. Atty. Gen., Washington, D.C., for appellant; E. Ray Acton, Asst. U.S. Atty., of counsel. E.M. Friend, Jr., Sirote, Permutt, Friend Friedman, Harold I. Apolinsky, Joseph S. Bluestein, Birmingham, Ala., for appellees.

Judges

Fred James Cassibry

See more information ...

Smart Summary

Factual and Procedural Background

This consolidated appeal concerns the taxability of a reserve for bad debts established by individual taxpayers upon transferring accounts receivable to controlled corporations under § 351 of the 1954 Internal Revenue Code. James G. Nash and Cecelia Nash, along with Birmingham Trust National Bank as trustee under two trusts, operated various finance institutions using the accrual and reserve methods of accounting for bad debts.

On June 1, 1960, the partnership incorporated eight finance businesses pursuant to § 351, transferring accounts receivable totaling $486,853.69 at face value. The partnership books reflected a reserve for bad debts of $73,028.05 against these receivables. In the new corporations' books, the accounts receivable were recorded at face value less the proportionate reserve, which taxpayers claimed represented the net value.

The Commissioner of Internal Revenue determined that the partnership should have included the full amount of the bad debt reserve ($73,028.05) in income for its final fiscal year ending January 31, 1961, as the reserve had not been used by specific charge-offs at the time of transfer.

Legal Issues Presented

Whether the reserve for bad debts established by individual taxpayers is taxable income upon the transfer of accounts receivable to controlled corporations under § 351 of the Internal Revenue Code.
Whether the transferors can treat the accounts receivable net of the bad debt reserve as the basis for the transferee corporations without recognizing income.

Arguments of the Parties

Government's Arguments

The reserve for bad debts should be included in income upon transfer because the transferors no longer need the reserve once the accounts receivable are transferred to corporations that hold them at face value.
Allowing the reserve to transfer without recognition would amount to a loss being recognized by the transferors, contrary to the purpose of § 351.
The tax benefit from the reserve deductions occurred at individual rates, but any subsequent tax on the reserve reversal would be at corporate rates, changing the identity of the taxpayer and not merely postponing tax incidence.

Taxpayers' Arguments

The accounts receivable were transferred at their net value, i.e., face value less the reserve for bad debts, reflecting the true economic value.
Section 351 allows transfers to a controlled corporation without recognition of gain or loss, and thus the reserve should transfer without immediate tax consequences.

Table of Precedents Cited

Precedent	Rule or Principle Cited For	Application by the Court
Estate of Schmidt v. Commissioner of Internal Revenue, 355 F.2d 111 (9th Cir. 1968)	Tax Court's acceptance of the Commissioner's position on bad debt reserves reversed; Ninth Circuit held reserve need not be included in income upon transfer.	The court respectfully disagreed with this decision and declined to follow the Ninth Circuit's reversal, siding with the Commissioner's position.
Arcadia Savings Loan Assn. v. Commissioner, 300 F.2d 247 (9th Cir.)	Prior Ninth Circuit decisions related to treatment of bad debt reserves.	Distinguished by the Ninth Circuit in Estate of Schmidt; mentioned but not adopted by this court.
West Seattle Natl. Bank v. Commissioner, 288 F.2d 47 (9th Cir.)	Prior Ninth Circuit decisions related to bad debt reserves.	Distinguished by the Ninth Circuit in Estate of Schmidt; not followed by this court.
Schuster v. Commissioner, 50 T.C. 98	Tax Court opinion supporting Commissioner's position on inclusion of bad debt reserves in income upon cessation of need.	Adopted by this court as correctly stating the law.
42 T.C. 1130 (Tax Court opinion in Schmidt case)	Tax Court analysis endorsing Commissioner's position before reversal by Ninth Circuit.	Considered and relied upon by this court in reaching its decision.
S. Rossin Sons., Inc. v. Commissioner, 113 F.2d 652 (2d Cir. 1940)	Recognition of bad debt reserve as income when reason for maintaining reserve ceases.	Cited in Mertens treatise to support the court's position on reserve inclusion.
Peabody Coal Co., 18 B.T.A. 1081, aff'd 55 F.2d 7 (7th Cir. 1931)	Same principle regarding bad debt reserves becoming income upon cessation of need.	Referenced by the court via secondary source to support its reasoning.

Court's Reasoning and Analysis

The court began by recognizing that the setting up of a bad debt reserve is an accepted accounting practice allowing taxpayers to estimate uncollectible accounts and reduce taxable income accordingly. It is also agreed that when the need for such a reserve ceases, the reserve must be included in income, typically upon liquidation or sale of assets at face value.

The government argued that upon transfer of the accounts receivable under § 351, the transferors no longer needed the reserve and thus the reserve amount should be recognized as income. The taxpayers contended the accounts were transferred at net value (face minus reserve) and thus no income recognition should occur.

The court analyzed § 351's purpose, which generally permits tax-free transfers when economic interests remain with the transferors, postponing gain or loss realization until actual disposition. Allowing the reserve to transfer without recognition would effectively recognize a loss by the transferors, contrary to § 351's intent.

Further, the court noted the tax benefit of the reserve deductions was realized at individual tax rates, but any later tax on the reversal of the reserve would be at corporate rates, changing the identity of the taxpayer and not merely postponing tax incidence.

After reviewing the Tax Court's reasoning in Schuster and Schmidt (prior to reversal by the Ninth Circuit), the court found the Commissioner's position sound and adopted it, respectfully disagreeing with the Ninth Circuit's contrary ruling in Estate of Schmidt.

Holding and Implications

The judgment of the Court of Appeals is reversed, and judgment is entered in favor of the United States.

This holding means that the reserve for bad debts, although established by individual taxpayers and associated with accounts receivable transferred to controlled corporations under § 351, must be included in income at the time of transfer. The transferors cannot treat the accounts receivable net of the reserve as the basis without recognizing income. The decision directly affects the parties by requiring inclusion of the reserve amount in income but does not establish a new precedent beyond affirming the Commissioner's position and the Tax Court's analysis in Schuster.

Show full summary ...

James G. NASH and Cecelia Nash, Plaintiffs-Appellees, v. UNITED STATES of America, Defendant-Appellant. BIRMINGHAM TRUST NATIONAL BANK, as Trustee of the Margaret Nash Trust, Plaintiff-Appellee,

TUTTLE, Circuit Judge:

This appeal presents the issue as to the taxability of a reserve for bad debts, set up by individual taxpayers, upon their transfer of the accounts receivable owned by the taxpayers, to controlled corporations, under § 351 of the 1954 Internal Revenue Code.

(26 U.S.C. 1964 ed., Sec. 166.)

SEC. 351. TRANSFER TO CORPORATION CONTROLLED BY TRANSFEROR.

(a) [as amended by Sec. 203(a), Act of Nov. 13, 1966, P.L. 89-809, 80 Stat. 1539]

General Rule. — No gain or loss shall be recognized if property is transferred to a corporation (including, in the case of transfers made on or before June 30, 1967, an investment company) by one or more persons solely in exchange for stock or securities in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation. For purposes of this section, stock or securities issued for services shall not be considered as issued in return for property.

These consolidated suits were brought to recover federal income taxes for the year 1961. The taxes had been paid by the taxpayers, James G. Nash and his wife by joint return and Birmingham Trust National Bank as trustee under the James G. Nash, Jr. Trust and under the Margaret Nash Trust. These persons were partners operating various finance institutions. In their operation they used the accrual method of accounting and the reserve method of accounting for bad debts.

On June 1, 1960, the partnership separately incorporaated eight of its finance businesses in accordance with § 351, supra. Among the partnership assets transferred to the controlled corporations were accounts receivable in the total amount of $486,853.69. This represented the face amount of the accounts receivable. However, the partnership books at that time reflected a reserve for bad debts applicable to the accounts receivable in the amount of $73,028.05. In setting up the books of account for the new corporation, the accounts receivable were shown at face value and then an item representing the proportionate part of the reserve for bad debts applicable to that particular account was deducted, purportedly then showing the net amount, which taxpayers contend represents the true or net value of the accounts.

The Commissioner determined that the partnership should have included for its final fiscal year ending January 31, 1961 the amount of the bad debt reserve, $73,028.05, which the partnership had built up during its operation and which at the time of transfer to the corporations had not been used by specific charge-offs.

This case appears to be in all respects similar to the case of Estate of Schmidt v. Commissioner of Internal Revenue (9th Cir., 1968) 355 F.2d 111, in which the Court of Appeals for the Ninth Circuit reversed a decision of the Tax Court which had accepted the Commissioner's position as here urged upon us. In reversing the Tax Court, the Court of Appeals for the Ninth Circuit distinguished prior decisions of its own. Arcadia Savings Loan Assn. v. Commissioner of Internal Revenue (9th Cir.) 300 F.2d 247 and West Seattle Natl. Bank of Seattle v. Commissioner of Internal Revenue (9th Cir.) 288 F.2d 47.

After carefully considering the analysis made by the Tax Court in its opinion in the Schmidt case (before reversal by the Ninth Circuit) found in 42 T.C. 1130 and its subsequent opinion in Schuster v. Commissioner of Internal Revenue, 50 T.C. 98, we have concluded that with deference, the Commissioner's position as supported by the Tax Court is sound and should be adopted. We, therefore, respectfully disagree with the judgment and decision of the Court of Appeals announced in Estate of Schmidt v. Commissioner of Internal Revenue, supra.

Mertens seems to agree with this treatment. See Mertens Law of Federal Income Taxation, Vol. 3, § 20. 45 at page 127. See also Mertens § 30.69 at page 132 where the text states: "The taxpayer should bear in mind that when all reason for maintaining a bad debt reserve ceases, the reserve then becomes an item of gross income, citing S. Rossin Sons., Inc. v. Commissioner of Internal Revenue, 113 F.2d 652 (2 Cir., 1940) reversing 40 B.T.A. 1274; Peabody Coal Co., 18 B.T.A. 1081 aff'd 55 F.2d 7 (7th Cir., 1931) [cert. den., 287 U.S. 605, 53 S.Ct. 9, 77 L.Ed. 526]. The subject is fully discussed on the following page in which at footnote 97(b) reference is made as to the Ninth Circuit decision in the Schmidt case.

The parties agree substantially to the proposition that the setting up of a bad debt reserve by a taxpayer is an accounting practice which permits him to estimate in advance what proportion or percentage of his accounts receivable will not be collected. This system of accounting is recognized by regulations and, so long as the amounts deducted from income are deemed reasonable, they are allowed as a reduction in taxable income. The parties also agree substantially that whenever the need for maintaining such reserve is no longer present, the amount carried as reserve must be covered back into income, because the taxpayer has reduced his tax during the period of accumulation of the reserve and it is only just and proper under the taxing system that it be reported as income when it has fully served its purpose. Of course, generally, this occurs only upon final liquidation or upon sale of assets in a manner that demonstrates that they are worth face value.

The government contends that this rule should be applied with its full vigor here, since it says that when the individuals transferred the accounts receivable to the eight corporations, they, the transferors, could never need such a reserve because the accounts could never become worth less than face value in their hands. The taxpayers counter with the argument that the accounts were really transferred to the newly organized corporation at the net value which was represented by the face of the accounts less the reserve for bad debt.

Taxpayers lay great stress upon the purpose of § 351, the section that permits the transfer of property to a corporation in return for a controlling stock ownership in the corporation without a recognition of either gain or loss in the hands of the transferor. It seems to us, however, that the government's position is at least technically correct. Without attempting to be too precise about expressing our views as to the main justification of such a tax free exchange or transfer, § 351 is generally thought to permit a transfer in which the economic interests are still such after the transfer as that this is merely a postponement of either gain or loss to the transferors, until such gain or loss is actually realized by them. Here, where the accounts are received by the new corporations at the basis which they had in the hands of the transferors, it would really amount to a recognition of a loss in the hands of the transferors if they were permitted to "transfer" the reserve for bad debts to the transferee corporations.

Moreover, although the actual amount of tax difference might not be large, the correctness of the government's positions seems to be strengthened by the following analysis: the deductions from income by the individual transferors as they annually set aside additions to the reserve resulted in lessening of the tax at individual rates, whereas the ultimate tax paid on any part of the reserve later determined not to be needed by the corporation or upon its decision to abandon the reserve method of accounting will be taxed at corporate rates. This would not be a mere postponement of the incidence of the tax; there would also be a change of the identity of the taxpayer.

Being unable to add to the reasoning of the opinion of the Tax Court in the Schuster case, we conclude that it correctly states the law and upon the basis of the opinion in that case we conclude that the judgment in this court must be reversed for the entry of judgment in favor of the United States.