Decision Date20 March 1975
Docket NumberCiv. No. 70-773-H.
CourtU.S. District Court — District of Maryland

Theodore W. Hirsh, Jacques T. Schlenger, Harry D. Shapiro and Venable, Baetjer & Howard, Baltimore, Md., for plaintiff.

Edward J. Snyder and Jerome Fink, Dept. of Justice, Washington, D. C., and George Beall, U. S. Atty., Baltimore, Md., for defendant.


Loyola Federal Savings and Loan Association (Loyola Federal) is here seeking to recover income taxes and interest previously paid the District Director of Internal Revenue. Specifically at issue in this case is whether this taxpayer was entitled to make certain deductions in the taxable years 1963 and 1964 as bad debt reserves.1

As a domestic building and loan association, Loyola Federal was entitled to avail itself of the provisions of § 593 of the Internal Revenue Code, 26 U.S.C. § 593.2 In computing its income taxes for the years 1963 and 1964, Loyola Federal included as deductions certain reserves for bad debts and pursuant to § 593(b)(3)(A) used as one of the factors in the computation of each annual addition to such reserves an amount equal to 3% of what it determined to be its outstanding "qualifying real property loans".

A deficiency was thereafter assessed by the Internal Revenue Service for both 1963 and 1964. The District Director claimed that Loyola Federal had overstated its bad debt reserve for each year by including as qualifying real property loans certain amounts which the District Director claimed did not constitute "loans" under the applicable law. In its audit of the plaintiff's returns, the Internal Revenue Service eliminated from the eligible loan base used by the taxpayer to compute its bad debt reserve for each year that portion of its construction mortgage loans outstanding which was reflected in accounts designated "Funds Held by Trustees under Deeds of Trust", as of December 31, 1963 and December 31, 1964. Loyola paid the deficiencies together with interest for each year and duly filed claims for refund with the District Director at Baltimore, Maryland. Thereafter, Loyola Federal timely filed suit in this Court to recover the full amount paid plus interest. This Court has jurisdiction under 28 U.S.C. § 1346(a)(1), and venue lies in this District pursuant to 28 U.S.C. § 1402(a).

The Facts3

During the years in question, Loyola Federal was a federally chartered savings and loan institution, with its principal offices located in Baltimore, Maryland. Like other lending institutions, Loyola Federal regularly made loans secured by interests in real property. Indeed, as required by law if Loyola Federal was to be taxed as a building and loan association under the Internal Revenue Code, substantially all of its loans were in 1963 and 1964 and other taxable years secured by interests in real property.

A borrower seeking from Loyola Federal a construction loan secured by real property would first file an application on a prescribed form. One of the institution's inspectors would then examine the real property in question and submit a report to Loyola Federal. Once the loan had been approved, the borrower was advised that at settlement the entire proceeds of the construction loan would be placed with trustees under a trust agreement which would provide, inter alia, that disbursements would be made at such times and in such amounts as set forth in a schedule attached to the notification of approval. At settlement, a note would be executed by the borrower, together with a deed of trust securing the entire loan.4 A check for the full amount of the construction loan would thereupon be issued by Loyola Federal to the borrower. Another and separate trust agreement would then be executed by the borrower, such trust being created to hold the loan proceeds and disburse them from time to time in accordance with the agreed schedule for payment of such proceeds during the period of time that construction was under way. The trustees under such irrevocable trust agreement were officers of Loyola Federal.

Upon receipt at settlement of a check representing the proceeds of the loan, the borrower would immediately endorse and deliver such check to the individual trustees, who would hold the proceeds under the aforementioned trust agreement. The trustees would then deposit such check in an account in their names at Loyola Federal. For accounting purposes, all such deposits were carried on Loyola Federal's books in a general ledger liability account entitled "Funds Held for Trustees under Deed of Trust Agreements". The officers of the institution named in these trust agreements received no compensation out of the trust funds for services they rendered as trustees but were paid by Loyola Federal their regular salaries which covered their ordinary duties and any additional services rendered to the trusts. During the tax years in question, all of the funds held by the trustees under agreements such as these were deposited with Loyola Federal and were included in and commingled with other deposits held by the institution. No interest was paid by Loyola Federal on any of these accounts opened by these trustees.

The funds held by the trustees were disbursed to a borrower in accordance with a schedule which linked payments to different stages of the construction work under way. The trust agreement required that payments for the improvements be in strict compliance with the plans and specifications. When a particular stage of completion had been reached, the borrower would present a request for payment of a particular installment. Upon receipt of the certificate of an inspector that the actual stage of completion had in fact been reached, the trustees would sign an authorization form which empowered Loyola Federal to disburse trust funds in a particular amount to the borrower. No interest was charged by Loyola Federal on any installment until actual disbursement had been made to the borrower, at which time interest at a specific rate would commence only on amounts advanced. The inspectors employed for the purpose of submitting certificates were either employees of Loyola Federal or independent construction engineers or architects hired by it. When all of the funds in a particular trust had been advanced to the borrower, the account was closed. At that point, the required monthly principal and interest payments in a particular dollar amount would become payable for the number of months specified. Most construction loans were fully disbursed within a 12-month period after the settlement dates, with a few being disbursed within a period of 13 to 18 months.

In the event of default at any time while the trustees were in possession of undisbursed funds, the trustees were empowered in their discretion to pay the entire fund over to Loyola Federal to be applied against indebtedness under the note or to use the funds to complete construction under way. On two occasions before 1960, defaults had in fact occurred on construction loans made by Loyola Federal. In both instances, Loyola Federal foreclosed on the secured real property, and the undisbursed funds held by the trustees were paid over to it and applied as offsets against the borrowers' total indebtedness under the notes.

During 1963, the plaintiff was a party to 440 construction loans aggregating in excess of 27 million dollars. In 1964, these figures were 567 loans amounting to over 38 million dollars.

In its 1963 federal income tax return, Loyola Federal computed its bad debt reserve by using a figure of $215,101,831.79 as qualifying real property loans under § 593(b)(3).5 Included in that amount was $14,753,368, which at the end of the year was held in the trust accounts carried on the taxpayer's books as "Funds Held by Trustees under Deeds of Trust".6 In 1964, the similar figure used as qualifying real property loans was $282,797,066.98, which included $24,256,739.58 held in the various trust accounts.7 In both 1963 and 1964, the Internal Revenue Service reduced the amount of the bad debt reserves, claiming that those portions of the taxpayer's construction loans which were held in the various trust accounts at the end of the year and not disbursed were not properly includible as qualifying real property loans. Thus, in computing the bad debt reserve for 1963, the Internal Revenue Service subtracted $14,753,368, which was the amount carried by Loyola Federal on its books as "Funds Held by Trustees under Deeds of Trust". In 1964, the amount subtracted was $24,256,739.58.8

The Law

§ 166(a)(1) of the Internal Revenue Code of 1954 allows as a deduction any debt which becomes worthless within the taxable year. As an alternative method of computation, § 166(c) allows a deduction for a reasonable addition to a reserve for bad debts. Using this alternative, a taxpayer may include in such reserve for bad debts that sum necessary to bring the balance in the reserve to an amount which can be reasonably expected to cover anticipated losses with respect to debts outstanding at the end of the year. See Dixie Furniture Co. v. Commissioner, 390 F.2d 139 (8th Cir. 1968). The reserve method of deducting bad debts thus permits the taxpayer to take the deduction in the year in which the transaction occurs rather than in the year in which a debt comes worthless.

§ 593 of the Code contains provisions relating to reserves for losses on loans of certain banking institutions and domestic building and loan associations like Loyola Federal. For the years in question, § 593(b) provided in pertinent part as follows:

(b) Addition to reserves for bad debts—
(1) In general—For purposes of section 166(c), the reasonable addition for the taxable year to the reserve for bad debts of any taxpayer described in subsection (a) shall be an amount equal to the sum of—
(A) the amount determined under section 166(c

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