Peoples Federal Sav. and Loan Ass'n of Sidney v. C.I.R.

Decision Date09 April 1992
Docket NumberNo. 90-1939,90-1939
Citation948 F.2d 289
Parties-5807, 60 USLW 2341, 91-2 USTC P 50,541 PEOPLES FEDERAL SAVINGS AND LOAN ASSOCIATION OF SIDNEY, Petitioner-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.
CourtU.S. Court of Appeals — Sixth Circuit

John F. Coverdale (argued), Alan S. Kader (briefed), Fried, Frank, Harris, Shriver & Jacobson, Washington, D.C., Ralph F. Keister, Faulkner, Garmhausen, Keister & Shenk, Sidney, Ohio, for petitioner-appellee.

Abraham N.M. Shashy, Jr., Chief Counsel, I.R.S., Office of Chief Counsel, Gary R. Allen, Acting Chief (briefed), Richard Farber, Bruce R. Ellisen (argued), Shirley D. Peterson, U.S. Dept. of Justice, Appellate Section Tax Div. (argued and briefed), Washington, D.C., for respondent-appellant.

Before MILBURN and SUHRHEINRICH, Circuit Judges, and JORDAN, District Judge *.

MILBURN, Circuit Judge.

The Commissioner of Internal Revenue ("Commissioner") appeals the decision of the United States Tax Court determining that the appellee, Peoples Federal Savings and Loan Association of Sidney, Ohio ("taxpayer"), owed a tax deficiency for 1978, but was entitled to refunds for 1979 and 1980.

From 1964 to 1978, the Commissioner had in force a regulation, 26 C.F.R. § 1.593-6(b)(2)(iv), which provided that, for purposes of the "percentage of taxable income" method of computing the deduction for additions to loan loss reserves under 26 U.S.C. § 593, a carryback year's taxable income would not be reduced by a net operating loss carryback to such year under 26 U.S.C. § 172. However, in 1978, the Commissioner issued new regulations, 26 C.F.R. § 1.593-6(A)(b)(5)(vi)-(vii), which, in effect, reversed the old regulation and provided that net operating loss carrybacks under section 172 reduced the taxable income of a carryback year before the "percentage of taxable income method" deduction was computed thereon. The sole issue in this case is whether the regulations issued by the Commissioner in 1978 are valid. For the reasons that follow, we reverse and remand.

I.

The facts in this case are stipulated and not in dispute. Taxpayer is a mutual savings and loan association which, during the taxable years 1971-1980, claimed deductions for additions to its reserve for loan losses. It calculated the amounts of those deductions using the "percentage of taxable income" method prescribed by 26 U.S.C. § 593(b)(2)(A) of the Internal Revenue Code. 1 Section 593(b) governs the computations of the amount of the deduction available for additions to loan loss reserves and provides that a deduction taken for an addition to loan loss reserves with respect to loans secured by real property may be computed using one of three different methods. One of these, the "percentage of taxable income" method established in section 593(b)(2)(A), allows a deduction for loan loss reserves computed as a particular percentage of the taxpayer's "taxable income" for the year. It is this "percentage of taxable income" method that taxpayer used to compute all the deductions for additions to loan loss reserves here in issue. 2

In 1981, 1982, and 1983, taxpayer sustained net operating losses in the amounts of $410,791, $563,491, and $379,652, respectively. By virtue of section 172(b)(1)(F), each net operating loss could be carried back to the ten years preceding each of the loss years and treated as a deduction under section 172(a), thereby reducing the taxpayer's taxable income, and accordingly its income tax liability, for the year. A net operating loss is carried first to the earliest permissible year where it is used to neutralize taxable income. If the net operating loss carryback exceeds the taxable income for that earliest permissible year, the excess of the net operating loss is carried forward year by year in chronological order to succeeding years until the net operating loss is expended in neutralizing each successive year's taxable income or, stated another way, until the net operating loss is fully "absorbed" by the taxable income of the carryback year or years. Thus, a net operating loss carryback reduces the taxable income in the carryback year and usually results in an amended return re-computing the taxpayer's income tax liability and seeking a refund of any taxes previously paid.

In this case, taxpayer took deductions for additions to loan loss reserves from 1971 through 1980 and in each instance used the "percentage of taxable income" method of section 593(b)(2)(A). When it carried back to those years the net operating losses it sustained in 1981, 1982, and 1983, it used the losses to reduce or eliminate taxable income, but it did not re-compute the loan loss reserve deductions it had previously taken based on the original, and therefore higher, taxable income levels. As a result of the net operating loss carrybacks, taxpayer had much less taxable income in the carryback years, and, accordingly, it filed amended returns claiming income tax refunds for those years. The Commissioner determined deficiencies for the tax years 1978-80, and this litigation followed.

The problem in this case has to do with accounting mechanics and arises out of the interaction between the "percentage of taxable income" method for computing loan loss reserve deductions under section 593 and the net operating loss carryback provisions of section 172. Because a net operating loss carryback reduces the taxable income for the year to which it is carried back, the question arises as to whether a taxpayer using the "percentage of taxable income" method for computing deductions for loan loss reserves should compute the deduction for the carryback year before or after the net operating loss carryback is applied to reduce the taxable income for that year. The Commissioner's position is that the taxpayer must re-compute its loan loss reserve deductions to take into account a net operating loss carryback that has reduced the taxable income of the carryback year. Because the deduction is computed as a percentage of taxable income, this position results either in a smaller loan loss reserve deduction or no loan loss reserve deduction, depending on whether the net operating loss carryback merely reduces or extinguishes the taxable income of the carryback year. The taxpayer's position is that any loan loss reserve deduction it has taken in conformity with the "percentage of taxable income" method is presumptively reasonable and therefore need not be re-computed, even when a net operating loss is carried back to that year and results in a reduction or a complete neutralization of the taxable income for that year.

The statutes involved do not expressly provide a solution to the problem in this case. The Commissioner's regulations do solve the problem, but there is a question raised concerning their validity.

The most recent regulations promulgated under the Commissioner's broad authority to "prescribe all needful rules and regulations for the enforcement of [the Internal Revenue Code]," 26 U.S.C. § 7805(a), provide that taxable income, for the purposes of the "percentage of taxable income" method, is computed "by taking into account ... any other deduction or loss allowed under subtitle A of the Code, such as any deduction allowable under § 172." 26 C.F.R. § 1.593-6A(b)(5)(vii). 3 Thus, the current regulations expressly require that taxable income reflect the section 172(a) net operating loss ("NOL") deduction prior to the calculation of the deduction for an addition to loan loss reserves. This regulation was proposed, in substance, in 1971. Prop.Treas.Reg. § 1.593-6A(b)(5), 36 Fed.Reg. 15050, 15052-15053 (1971). The final regulation was issued in May 1978, T.D. 7549, 43 Fed.Reg. 21453, 21455 (1978), and amended in May 1979. T.D. 7626, 44 Fed.Reg. 31177 (1979).

Prior to the issuance of the current regulations in 1978, the Commissioner had issued regulations that provided for the opposite result. Promulgated in 1964, 26 C.F.R. § 1.593-6(b)(2)(iv) provided that, for purposes of the "percentage of taxable income" method, taxable income for the year would be computed "[w]ithout regard to any net operating loss carryback to such year under section 172." This regulation ("old regulation") was based on an even earlier revenue ruling, Rev.Rul. 58-10, 1958-1 C.B. 246, in which the Commissioner ruled that, for purposes of the "percentage of taxable income method," taxable income would not be reduced by a net operating loss carryback.

From all of the foregoing, it is clear that the Commissioner changed course in 1978 when he issued 26 C.F.R. § 1.593-6(A)(b)(5)(vi)-(vii) ("new regulations"). The differences between the applications of the old regulation and the new regulation may be seen in the following computations involving a hypothetical net operating loss carryback of $1.0 million from the loss year 1981.

                Returns as originally filed:                    1971              1972
                Income before percentage method deduction     1,000,000         1,000,000
                Percentage method deduction at 54% for 1971   (540,000)         (510,000)
                  and 51% for 1972
                Taxable income before carrybacks               460,000           490,000
                Tax at 46%                                     211,600           225,400
                Carryback effect under the old regulation:
                Taxable income before carryback                460,000           490,000
                NOL carryback absorbed                         460,000           490,000
                                                             -----------  ---------------------
                Taxable income                                   "0"               "0"
                Tax                                              "0"               "0"
                Refund due to carryback                        211,600           225,400
                NOL carried to next year                      (540,000)         (50,000)
                Carryback effect under the new regulation:
                  Income before carryback and
...

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