Thompson v. C.I.R.

• Decision Date: 29 April 1985
• Docket Number: Nos. 83-1393,s. 83-1393
• Citation: 761 F.2d 259
• Parties: -1439, 85-1 USTC P 9355 DeWitt C. THOMPSON, III, and Diana R. Thompson (83-1393, 83-1396), Thompson & Green Machinery Company, Inc. (83-1394, 83-1395, 83-1397), Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. to 83-1397.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 259

761 F.2d 259

55 A.F.T.R.2d 85-1439, 85-1 USTC P 9355

DeWitt C. THOMPSON, III, and Diana R. Thompson (83-1393 83-1396), Thompson & Green Machinery Company, Inc (83-1394, 83-1395, 83-1397) Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Nos. 83-1393 to 83-1397.

United States Court of Appeals Sixth Circuit.

Argued June 13, 1984.

Decided April 29, 1985.

Mark H. Westlake (argued), Tune, Entrekin and White, Nashville, Tenn., for petitioners-appellants.

Kenneth W. Gideon, Chief Counsel, I.R.S., Glenn L. Archer, Jr., (Lead Counsel), Michael L. Paup, Tax Div., Dept. of Justice, Jonathan S. Cohen, Joan I. Oppenheimer (argued), Washington, D.C., for respondent-appellee.

Before MERRITT, MARTIN and JONES, Circuit Judges.

BOYCE F. MARTIN, Jr., Circuit Judge.

This is an appeal from a decision of the Tax Court, T.C.M. (P-H) p 83,081 (1983), holding that certain bad debt expenses taken by a Tennessee heavy equipment dealer were improperly taken under the reserve for bad debts section, 166(c), of the Internal Revenue Code. We affirm in part and reverse in part.

The taxpayers in this case are Thompson & Green Machinery Company, Inc., a Nashville, Tennessee, dealer in heavy construction equipment; DeWitt C. Thompson, III, its principal shareholder; and Diana R. Thompson, his wife. The case turns entirely on the propriety of certain bad debt reserve deductions made by Thompson & Green in 1971 and 1976. The Thompsons are affected only by Mr. Thompson's interest in Thompson & Green.

Introduction

Bad debts are deductible from income tax under section 166 of the Internal Revenue Code, which reads in relevant part:

Sec. 166. Bad debts

(a) General Rule.--

(1) Wholly worthless debts.--There shall be allowed as a deduction any debt which becomes worthless within the taxable year.

(2) Partially worthless debts.--When satisfied that a debt is recoverable only in part, the Secretary may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction.

....

(c) Reserve for bad debts.--In lieu of any deduction under subsection (a), there shall be allowed (in the discretion of the Secretary) a deduction for a reasonable addition to a reserve for bad debts.

A taxpayer with substantial accounts receivable can reasonably anticipate that some part of these accounts will not actually be received. Because the money is out of his hands and will never come back, Congress deemed it appropriate for the taxpayer to take an immediate deduction.

The taxpayer holds the amount of this deduction in a running reserve account for bad debts. When debts actually become worthless in whole or in part, the reserve account is reduced; if debts written off as worthless are subsequently recovered, the reserve account is increased. At the end of each taxable year, the taxpayer is allowed to increase the reserve account to a level adequate to cover losses properly anticipated on current accounts receivable. If the reserve account has dropped to a negative level in the course of the year, the increase in the reserve will be that much greater than the reserve account at year end. It is this increase in the reserve account that is the actual deduction under section 166(c). See generally Roth Steel Tube Co. v. Commissioner, 620 F.2d 1176, 1178-79 (6th Cir.1980).

It is a radical departure from the general policy of the tax laws to allow a deduction for a loss before its very existence has been ascertained. Any deduction allowed under section 166(c) is a tax preference in the sense that taxpayers not using a bad debt reserve are required to wait until the debt actually has become worthless before taking a deduction under section 166(a). For this reason, the taxpayer bears a heavy burden in showing that the Commissioner abused his statutory discretion. "He must show not only that his own computation is reasonable but also that the Commissioner's computation is unreasonable and arbitrary." Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 548, 99 S.Ct. 773, 789, 58 L.Ed.2d 785 (1979) (footnote omitted).

The regulations, set out in relevant part as a footnote, ¹ are of limited aid to the taxpayer in computing the proper amount of the reserve in specific cases. However, since 1940 courts have frequently looked to the standard used in Black Motor Co. v. Commissioner, 41 B.T.A. 300 (1940), aff'd on other grounds, 125 F.2d 977 (6th Cir.1942). The Commissioner there argued that an allowable addition to the reserve is the amount required to bring the year-end reserve as a percentage of total receivables up to the percentage of average annual losses on bad debts for the six years just ended. The Commissioner's computation is set out in 41 B.T.A. at 302. The taxpayer had no proof to support its use of a higher anticipated percentage loss on bad debts. The Board of Tax Appeals approved the use of the formula on the facts in that case.

The test, however, is whether the amount ultimately determined, regardless of formula, constitutes a reasonable addition to petitioner's reserve. What constitutes a reasonable addition will depend upon the facts and circumstances of the business engaged in with relation to general business conditions. A method or formula that produces a reasonable addition to a bad debt reserve in one year, or a series of years, may be entirely out of tune with the circumstances of the year involved. Such, in our opinion, is the situation here, and, in the absence of a showing that the allowance contended for by petitioner is more reasonable than the addition determined by the respondent, the latter amount is approved as a reasonable addition to petitioner's reserve for bad debts.

Id. at 304.

Despite this rather grudging initial use, the Black Motor formula subsequently has been treated as the presumptively correct method of calculating the bad debt reserve for an established business. The formula has been challenged in the literature as "demonstrably unsound," primarily because of its exclusively retroactive view. Whitman, Gilbert & Picotte, The Black Motor Bad Debt Formula: Why it Doesn't Work and How to Adjust It, 35 J. Tax'n 366, 366 (1971). These arguments were made to the Supreme Court in Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 547 n. 24, 548-49, 99 S.Ct. 773, 788 n. 24, 789-90, 58 L.Ed.2d 785 (1979). The Court refused to declare the formula invalid, noting that it "possesses the not unconsiderable advantage of enhancing certainty and predictability in an area peculiarly susceptible of taxpayer abuse. In any event, after its 40 years of near-universal acceptance, we are not inclined to disturb the Black Motor formula now." Id. at 549, 99 S.Ct. at 789. The Court thus ratified rather than altered existing law, which gave the taxpayer a chance to show that the Commissioner abused his discretion in invoking the formula in a given case. See id.

The Gregory Debt

The first issue stems from certain leases of equipment to James T. Gregory, Inc., a highway contractor. Pursuant to state statute, Tenn.Code Ann. Sec. 54-519 (1968) (current version at Tenn.Code Ann. Sec. 54-5-119 (1980)), ² Gregory was bonded on its highway projects by United States Fidelity and Guaranty Co. Late in 1970 Gregory suffered severe cash shortages and was unable to meet its obligations under the highway construction contracts. As a result, USF & G took possession and control of Gregory's business in early 1971. USF & G paid all claims made against it as surety on account of Gregory's highway construction contracts, except those of Thompson & Green.

After USF & G took over Gregory, Gregory no longer had employees or assets except those in the possession of USF&G, and Gregory has not since acquired assets or resumed business operations. Gregory's corporate charter was revoked November 19, 1971, for nonpayment of franchise taxes.

In an attempt to recover its loss, Thompson & Green filed suit in early 1971 against USF&G and against Gregory for parts, services, and repairs and for unpaid equipment rentals. Gregory counterclaimed, alleging that the leases were in fact conditional sales contracts and that it had an equity interest in the equipment that Thompson & Green had repossessed. Because Thompson & Green was uncertain of recovery, it employed the law firm of Manier, Crouch, White & Herod on a contingent fee whereby they agreed to take the case for thirty percent of the final recovery, but in no event less than $10,000.

On September 14, 1973, Chancellor Drowota of the Chancery Court at Nashville, Tennessee, determined that USF&G was liable on its bond to Thompson & Green for Gregory's unpaid machine rentals and that Gregory was liable both for unpaid machine rentals and for services, parts, and repairs rendered during the terms of the leases. He also determined that Gregory had no equity in the machinery and dismissed Gregory's counterclaim against Thompson & Green. The Chancellor then referred the case to a Master to determine the amount of Thompson & Green's provable claims for the various items. After the Special Master filed his 155-page report on May 28, 1974, Thompson & Green, Gregory, and USF&G, each through its attorneys, took various exceptions to that report. As a result of these objections, the Chancellor modified the Master's report in certain respects and on April 4, 1975, entered judgment for Thompson & Green against USF&G in the amount of $273,753.84 for unpaid machine rentals and against James T. Gregory, Inc., in the amount of $403,482.23, plus interest at the legal rate from November 20, 1973, for the unpaid machine rentals and in the amount of $9,884.29, plus interest from April 8, 1971, for unpaid parts and repair services.

Only USF&G appealed the Chancellor's decree. On August 6, 1976, the Court of Appeals for the Western Section of Tennessee (sitting at Nashville) reduced the judgment against USF&G to $202,682.25 and affirmed the Chancellor's decree...