Ambase Corp. v. United States

• Citation: 731 F.3d 109
• Decision Date: 09 September 2013
• Docket Number: Docket No. 12–3563–cv.
• Parties: AMBASE CORP., Plaintiff–Appellant, v. UNITED STATES of America, Defendant–Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (2nd Circuit)

731 F.3d 109

AMBASE CORP., Plaintiff–Appellant,

v.UNITED STATES of America, Defendant–Appellee.

Docket No. 12–3563–cv.

United States Court of Appeals, Second Circuit.

Argued: June 10, 2013.

Decided: Sept. 9, 2013.

Peter H. Winslow (Samuel A. Mitchell, Gregory K. Oyler, on the brief), Scribner, Hall & Thompson, LLP, Washington, DC, for Plaintiff–Appellant.

Jennifer M. Rubin, Attorney, Tax Division (David Fein, United States Attorney for the District of Connecticut, Kathryn Keneally, Assistant Attorney General, Tax Division, Jonathan S. Cohen, Attorney, Tax Division), Department of Justice, Washington, DC, for Defendant–Appellee.

Before: POOLER, CARNEY, Circuit Judges, and KORMAN,^* District Judge.

POOLER, Circuit Judge:

Plaintiff–Appellant AmBase Corp. (“AmBase”) brought a refund claim for tax year 1989 based on a carryback ¹ generated from a proposed amendment to its consolidated federal income tax return for the 1992 tax year. The proposed amendment seeks to increase the bad debt deduction claimed on the return by AmBase's affiliate, Carteret Savings Bank F.A. (“Carteret”). Carteret, a “thrift” ² which calculates its bad debt deduction under the reserve method, seeI.R.C. §§ 585, 593, was seized by the Resolution Trust Corporation (“RTC”) on December 4, 1992. The United States District Court for the District of Connecticut (Warren W. Eginton, J.), through its November 30, 2011 memorandum of decision, AmBase Corp. v. United States, 834 F.Supp.2d 71 (D.Conn.2011), May 23, 2012 memorandum of decision, AmBase Corp. v. United States, No. 3:08–cv–651–WWE, 2012 WL 1884874 (D.Conn. May 23, 2013), and July 5, 2012 final judgment and order, granted AmBase's claim to the extent that the bad debt deduction offset Carteret's additional post-seizure income in tax year 1992 but denied the claim in all other respects. On appeal, we hold that the district court had subject-matter jurisdiction and affirm its grant of AmBase's claimed deduction to the extent that it offsets Carteret's post-seizure income for the 1992 tax year. We further hold that the district court should grant AmBase's claimed deduction to the extent that it derives from Carteret's post-seizure bad debts for the 1992 tax year. Accordingly, we AFFIRM in part and VACATE in part the judgment of the district court and REMAND the case for further proceedings consistent with this opinion.

BACKGROUND

I. Factual Background

In August 1988, AmBase, the successor corporation to The Home Group, Inc., purchasedCarteret, a federally chartered stock savings bank or thrift. After acquisition, AmBase filed consolidated federal income tax returns with Carteret. On December 4, 1992, the Office of Thrift Supervision seized Carteret and put it into the conservatorship of the RTC due to Carteret's failure to satisfy capital requirements under the Financial Institutions Reform, Recovery, and Enforcement Act. In 1996, the RTC transferred receivership to the Federal Deposit Insurance Company (“FDIC”).

The dispute in this appeal relates to AmBase's 1992 consolidated federal income tax return, filed on August 30, 1993. On its return, AmBase reported Carteret's tax items from January 1, 1992 through December 4, 1992. It did not, however, include Carteret's post-seizure tax items, as AmBase did not control Carteret post-seizure, and the RTC had not provided AmBase with the relevant records.³ At the time of filing, proposed regulations under I.R.C. § 597 allowed a consolidated group to elect irrevocably to disaffiliate from an institution in its affiliated group that had been placed in receivership. SeeTreatment of Acquisition of Certain Financial Institutions; Certain Tax Consequences of Federal Financial Assistance to Financial Institutions, 57 Fed.Reg. 14,804, 14,812–814 (proposed April 23, 1992). However, such an election could not become binding until the regulations had been finalized, see id. at 14,817–818, which did not occur until December 1995, T.D. 8641, 1996–6 I.R.B. 4, 60 Fed.Reg. 66,091;see alsoTreas. Reg. § 1.597–4 (the final regulation). On its original 1992 return, AmBase included a statement electing to disaffiliate from Carteret. On April 28, 1997, after having received an extension of time, AmBase timely notified the Commissioner of Internal Revenue (the “Commissioner”) of its decision to reverse its previous decision to disaffiliate from Carteret.

On March 14, 2000, AmBase filed an amended consolidated federal return for 1992 in which it sought to amend its 1992 consolidated federal income tax return to increase Carteret's claimed bad debt deduction, calculated under the reserve method, and generate a net operating loss. On that same date, AmBase also filed an amended consolidated federal income tax return for 1989, on which it sought to apply the 1992 net operating loss and create a refund. The IRS denied the refund claim, and, on April 29, 2008, AmBase filed a complaint in the district court against the United States (the “Government”).

Consideration of AmBase's refund claim requires an understanding of the reserve method for calculating bad debt deductions. We turn now to a description of the applicable law.

II. Bad Debt Deductions and the Reserve Method

The Internal Revenue Code allows taxpayers to take a deduction relating to worthless or “bad” debts. I.R.C. §§ 166, 585, 593. Two methods exist for calculating this deduction: the specific charge-off method and the reserve method. The specific charge-off method allows taxpayers to deduct the basis of a bad debt in the year in which the debt becomes worthless. I.R.C. § 166. The reserve method allows taxpayers to create a “reserve” of funds in anticipation of bad debts, and deduct, instead of the basis in a particular bad debt, a “reasonable addition to the reserve” for the year (the “Reasonable Addition”). I.R.C. §§ 585(a), 593(a). A bad debt must be accounted for in the year in which it becomes worthless. SeeI.R.C. § 166(a)(1) (specific charge-off method); Calavo, Inc. v. Comm'r, 304 F.2d 650, 654 (9th Cir.1962) (the reserve method). However, it can be difficult for a taxpayer to determine the year in which a particular debt becomes worthless. See, e.g., Boehm v. Comm'r, 326 U.S. 287, 292, 66 S.Ct. 120, 90 L.Ed. 78 (1945); Young v. Comm'r, 123 F.2d 597, 600 (2d Cir.1941). The advantage of the reserve method over the specific charge-off method is that, under the former, the taxpayer's bad-debt deduction is not tied to a determination of worthlessness of any particular debt. It allows the taxpayer to make a reasonable prediction of the amount of debt that will become worthless in a given year without having to identify specific worthless loans, and claim a deduction based on that amount.

Specific bad debts are still relevant to the reserve method. In the year in which a bad debt becomes worthless, the taxpayer, instead of a taking another deduction, charges off the debt by reducing the amount of the reserve. Nash v. United States, 398 U.S. 1, 3–4, 90 S.Ct. 1550, 26 L.Ed.2d 1 (1970). This increases the Reasonable Addition otherwise allowable for the year. See Smith Elec. Co. v. United States, 198 Ct.Cl. 644, 461 F.2d 790, 791 (1972). Similarly, in any year in which a bad debt is recovered, specific charge-off method taxpayers include the recovery in gross income, while reserve method taxpayers instead increase the amount of the reserve, decreasing the Reasonable Addition otherwise allowable for the year. See United States v. Bank of Am. Trust & Sav. Ass'n, 303 F.2d 304, 306 (9th Cir.1962); see also1 Mertens, Law of Federal Income Taxation § 7:35 (2013). Upon liquidation, the taxpayer's unused bad debt reserve is included in gross income. W. Seattle Nat. Bank of Seattle v. Comm'r, 288 F.2d 47, 48–50 (9th Cir.1961). But see Nash, 398 U.S. at 3–4, 90 S.Ct. 1550 (declining to apply this “tax benefit rule” when accounts receivable net of reserves were transferred by partnership during liquidation).

Use of the reserve method was formerly available to a broader group of taxpayers, but in 1987 its use was restricted. SeePub.L. No. 99–514, § 805, 100 Stat.2085, 2361 (1986) (repealing I.R.C. § 166(c)); see also Staff of J. Comm. on Taxation, 99th Cong., Tax Reform Proposals: Accounting Issues, 68 (Comm. Print 1985). However, certain financial institutions are still allowed to use the reserve method. I.R.C. §§ 581, 585(a)(1), 593(a)(1). AmBase's affiliate, Carteret, is a thrift eligible to use the reserve method under I.R.C. § 593 and Treasury Regulation § 1.593–4. Thrifts are required to establish two separate reserves, one for “nonqualifying loans” and one for “qualifying real property loans.” ⁴Treas. Reg. § 1.593–7(a)(1); see alsoTreas. Reg. § 1.593–11 (defining terms).

The reserve method gives the taxpayer a considerable degree of discretion to determine the amount of its bad debt deduction and reduce tax liability. This discretion is restricted by several requirements. First, the taxpayer must earmark the amounts of the reserves, which “are not to be used for any purpose other than to apply against bad debts as they occur.” Levelland Sav. & Loan Ass'n v. United States, 421 F.2d 243, 246 (5th Cir.1970) (citing Rio Grande Bldg. & Loan Ass'n v. Commissioner of Internal Revenue, 36 T.C. 657 (1961)).

Second, the Reasonable Addition must be “reasonable,” as defined by the Internal Revenue Code and Treasury Regulations, which describe several methods for calculating the Reasonable Addition.⁵ Relevant to this appeal is the “experience method,” also called the “six-year moving average” formula, seeI.R.C. §§ 585(b)(2), 593(b)(3), which “seeks to ascertain a ‘reasonable’ addition to a bad-debt reserve in light of the taxpayer's recent chargeoff history.” Thor Power Tool Co. v. Comm'r, 439 U.S. 522, 547, 99 S.Ct. 773, 58 L.Ed.2d 785 (1979) (citing Black Motor Co. v. Comm'r, 41 B.T.A. 300, 302 (1940)). The experience method starts with the balance of the reserve at the close of the taxable year and then calculates a...