Centralia Fed. Sav. & Loan Ass'n v. Comm'r of Internal Revenue, Docket Nos. 1685-74

• Decision Date: 28 June 1976
• Docket Number: 1686-74.,Docket Nos. 1685-74
• Citation: 66 T.C. 599
• Parties: CENTRALIA FEDERAL SAVINGS AND LOAN ASSOCIATION, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENTEVERGREEN FIRST FEDERAL SAVINGS AND LOAN ASSOCIATION, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

66 T.C. 599

CENTRALIA FEDERAL SAVINGS AND LOAN ASSOCIATION, PETITIONER
v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENTEVERGREEN FIRST FEDERAL SAVINGS AND LOAN ASSOCIATION, PETITIONER
v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket Nos. 1685-74

1686-74.

United States Tax Court

Filed June 28, 1976.

[66 T.C. 600]

William H. Kinsey, for the petitioners.

Leo A. Reinikka, Jr., for the respondent.

Petitioners, domestic building and loan associations, elected the reserve method for bad debts, and computed their annual additions to reserves under the ‘percentage of taxable income method.’ However, instead of crediting such additions to their ‘reserve for losses on qualifying real property loans,’ petitioners, during the years in issue, credited such additions to different reserve accounts denominated ‘Federal Insurance Reserve’ and ‘Reserve for Contingencies.’ These two accounts were considered as constituting together a single reserve account— the federal insurance reserve— and were intended to serve as the statutory bad debt reserve on qualifying loans. These accounts had pre-existing balances dating from years prior to the adoption of this practice, but no extraneous credits or charges to the accounts were made after such adoption. The credits to these accounts took the form of yearend approximations of the year's bad debt deductions, but no adjusting entries were made on the book accounts when the precise amounts of available deductions became known at the time returns were filed. Instead, reconciling entries were made on Schedule M of their corporate income tax returns. Moreover, petitioner Evergreen never charged its reserve accounts for bad debts. Petitioner Centralia had no bad debts or recoveries in the years in issue. Under sec. 593, petitioners should have credited their bad debt deductions to the ‘reserve for losses on qualifying real property loans.’ Held: To the extend the amounts credited to the reserve account were less than the maximum deduction otherwise available on the percentage of taxable income method, the deduction is limited by the amount so credited. Reconciling entries on Schedule M do not substitute for book adjustment entries. Held, further: The federal insurance reserve served during the years in issue as, in effect, a reserve for losses on qualifying real property loans. Neither the irregular nomenclature, the original extraneous balance in this reserve, nor Evergreen's failure to charge bad debts against the reserve is fatal to the deduction. The theoretical potential for charges against the federal insurance reserve of losses other than bad debts does not warrant disallowance of the bad debt deduction in the absence of any such charges in practice.

HALL, Judge:

Respondent determined deficiencies in petitioners' income taxes in the amounts and for the years as follows:

+----------------------------------------------------------------+
                ¦Petitioner ¦Year ¦Deficiency ¦
                +--------------------------------------------+------+------------¦
                ¦ ¦ ¦ ¦
                +--------------------------------------------+------+------------¦
                ¦Centralia Federal Savings & Loan Association¦1969 ¦$71,011.26 ¦
                +----------------------------------------------------------------+
                

 1970 47,023.66
                 1971 70,213.52
                Evergreen First Federal Savings & Loan Association 1969 52,619.41
                

 1970 41,115.65
                 1971 38,352.30
                

These cases were consolidated for trial, briefing, and opinion.

The principal issue in these cases is whether the federal insurance reserve and the reserve for contingencies as maintained by each of the petitioners constitute reserves for bad debts within the requirements of section 593 ¹ and the regulations thereunder.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

Centralia Federal Savings & Loan Association (Centralia) and Evergreen First Federal Savings & Loan Association (Evergreen) are domestic building and loan associations within the meaning of section 593. Centralia's principal place of business when it filed its petition was Centralia, Wash. Evergreen's principal place of business when it filed its petition was Chehalis, Wash.

Petitioners filed their Federal corporate income tax returns for the years in issue with the Internal Revenue Service Center in Ogden, Utah. These returns were kept as part of the petitioners' permanent records and books of account. Petitioners reported their income on the calendar year basis, used the accrual method of accounting, and employed the reserve method for bad debts. By reference to petitioners' records, it was possible to reconstruct their reserves for losses on qualifying real property loans as they should have been maintained. However, no single ledger card or subsidiary ledger account was maintained by means of which the correct balance in such accounts could be seen at a glance.

[66 T.C. 601]

On their returns for the years in issue the petitioners claimed the following bad debt deductions:

+----------------------------------------+
                ¦Petitioner ¦Year ¦Bad debt deduction ¦
                +------------+------+--------------------¦
                ¦ ¦ ¦ ¦
                +------------+------+--------------------¦
                ¦Centralia ¦1969 ¦$134,491.00 ¦
                +----------------------------------------+
                

 1970 103,994.46
                 1971 160,957.13
                Evergreen 1969 99,658.00
                

 1970 90,167.81
                 1971 84,852.89
                

These claimed bad debt deductions were disallowed in full. Respondent does not question the mathematical computation of the claimed bad debt deductions as a percentage of income under section 593(b)(2). The computations of the petitioners' bad debt deductions are clearly set forth on their tax returns for the years in issue.

Petitioners' deposits are insured by the Federal Savings & Loan Insurance Corp., and petitioners are subject to the regulatory powers of the Federal Home Loan Bank Board. Under applicable regulations, petitioners are required to maintain an adequate ‘Federal Insurance Reserve’ to protect the interests of depositors related to losses generally, including (but not confined to) bad debt losses. The federal insurance reserve was a sum determined as a function of the percentage of income in certain accounts and the volume of qualified loans.

Petitioners maintained general ledger reserve accounts as follows: (1) Federal insurance reserve, and (2) reserve for contingencies. Commencing prior to the years in issue, the reserve for contingencies has been considered by petitioners as part of their federal insurance reserve. The amount added annually to the reserve for contingencies represented the excess of the estimated bad debt deduction for the year over the amount added to the federal insurance reserve proper. Thus the sum of the two annual additions represented the estimated bad debt deduction. The two reserves combined were intended by both petitioners to constitute their statutory bad debt reserve for qualifying real property loans as to the years in issue. Aggregate additions to the general ledger federal insurance reserve account and to the general ledger reserve for contingencies account were made by petitioners as follows:

+--------------------------------+
                ¦Petitioner ¦Year ¦Additions ¦
                +-------------+------+-----------¦
                ¦ ¦ ¦ ¦
                +-------------+------+-----------¦
                ¦Centralia ¦1969 ¦$134,800.00¦
                +--------------------------------+
                

 1970 106,108.32
                 1971 160,623.59
                Evergreen 1969 95,900.00
                

 1970 92,350.00
                 1971 84,450.00
                

[66 T.C. 602]

Petitioners intended that the aggregate additions to the general ledger reserve accounts (federal insurance reserve and reserve for contingencies) would equal the estimated bad debt deduction allowable for additions to a reserve for losses on qualifying real property loans. Certain minor differences between such aggregate additions to these general ledger reserve accounts and the claimed bad debt deductions resulted from the more accurate determination of the allowable bad debt deduction made when the tax returns were prepared as compared to the computation made at the time of the prior posting to the general ledger accounts. These differences are reflected in the analysis of unappropriated retained earnings per books on Schedule M-2 of the tax returns of both petitioners.² However, no corresponding adjusting entries were ever made to any ledger reserve accounts.

The federal insurance reserve and the reserve for contingencies were restricted to absorbing losses on qualifying real property loans, and could not be used for any other purpose without the prior approval of the Federal Home Loan Bank Board. With such prior approval, however, these reserves could be used for other losses. In fact, no such use was ever made of these reserves. Dividends could not be paid from these accounts. The only entries made to those general ledger reserve accounts during the years in issue were additions to equal (and which approximately did equal) the bad debt deductions allowable under section 593 for additions to a reserve account for losses on qualifying real property loans.

[66 T.C. 603]

Qualifying real property loans are secured by mortgages on real property. When any of such loans go bad, the result is reflected as a profit or a loss on the sale of the foreclosed real property. Such profits and losses were recorded by petitioners on general ledger cards, and reflected on Schedule M-1 (reconciling book income to taxable income) of petitioners' tax returns. Such profits and losses were not added to or subtracted from the reserve accounts. During the years in issue, neither petitioner charged its federal insurance reserve or reserve for contingencies with any amounts, related to bad debts or otherwise.

Centralia and Evergreen maintained the following...