Roth Steel Tube Co. v. C. I. R.

• Decision Date: 08 May 1980
• Docket Number: No. 77-1588,77-1588
• Parties: 80-1 USTC P 9410 ROTH STEEL TUBE COMPANY, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 1176

620 F.2d 1176

80-1 USTC P 9410

ROTH STEEL TUBE COMPANY, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 77-1588.

United States Court of Appeals Sixth Circuit.

Argued Nov. 28, 1979.

Decided May 8, 1980.

Bennet Kleinman, Laurence Glazer, Kahn, Kleinman, Yanowitz & Arnson, Cleveland, Ohio, for petitioner-appellant.

M. Carr Ferguson, Joseph L. Liegl, Michael L. Paup, Asst. Attys. Gen., Tax Div., U.S. Dept. of Justice, Washington, D. C., Gilbert E. Andrews, Stuart E. Seigel, Chief Counsel, Internal Revenue Service, Washington, D. C., for respondent-appellee.

Before CELEBREZZE, LIVELY and ENGEL, Circuit Judges.

ENGEL, Circuit Judge.

Petitioner Roth Steel Tube Company (Roth) appeals from the Tax Court's ruling disallowing a deduction of $172,443 as an addition to Roth's reserve for bad debts for the tax year ended April 30, 1972. ¹ We affirm.

I.

In its tax year ended April 30, 1972, Roth charged $172,443 against its reserve for bad debts in connection with the partial write-off of an account receivable. At the time that Roth attempted to charge off the $172,443 debt, its debtor was also its wholly owned subsidiary, operating under the name Roth American (American). American was acquired by Roth effective April 30, 1971. For 15 to 20 years prior to this acquisition, American was a substantial customer of Roth's, purchasing steel tubing for use in its toy manufacturing business. Roth acquired American from its parent corporation, Remco Industries. As a wholly owned but separate corporate subsidiary of Remco, American operated under the name Remco American.

The events leading up to Roth's acquisition of American are the same events which are claimed to justify the write-off of American's debt to Roth. Those events unfolded as follows.

In January of 1971, Remco Industries filed a petition for an arrangement under Chapter XI of the Bankruptcy Act. Remco's petition stated that a similar petition would subsequently be filed on behalf of its subsidiary, Remco American. However, Herbert Gurbst, an officer of American was convinced that the subsidiary could be turned around, and he dissuaded the officers of Remco Industries from filing a petition for American.

In order to revitalize American, Gurbst attempted to find a financially sound company to purchase American from Remco Industries, and to convince American's major creditors to forgive part of the debts owed by American. The negotiations with creditors and the search for a purchaser were inter-related, as potential purchasers were wary of acquiring a company with the substantial backlog of debts then owed by American. Gurbst's goal was to find a purchaser by the end of April, 1971, so that toy retailers would place Christmas orders for toys, assured that American would not fold in the interim.

Roth was American's largest creditor, and on April 1, 1971, Leonard Roth, then president of petitioner, wrote to Gurbst as follows:

Having done business with you for 15 years, I certainly want to be of any help I can. You are asking me to sacrifice a lot of money by taking some kind of settlement. I would agree with several conditions.

(1) I will accept the 321/2% settlement if I get it on or before June 1, 1971 and payment in full by certified check.

(2) I will only accept it if you assure me that you will be involved in the management of whatever company exists that is now called Remco American.

(3) My only hope of getting back the money I am sacrificing is the continuation of your operation and having you as a customer.

If this is acceptable to you, and the people you are talking to, use this letter as your authority to quote me on the 321/2% settlement.

By mid-April Gurbst had not yet found an acceptable purchaser for American. ² On April 14, 1971, Gurbst and Leonard Roth first discussed the possibility of Roth Steel Tube acquiring American. At some time between April 15 and April 26, 1971, Roth agreed to acquire all the stock of American from Remco Industries. Roth and Remco signed a formal agreement, effective April 30, 1971, and they closed the transaction on May 3, 1971. Roth subsequently changed the name of the acquired company to Roth American.

During the last ten days of April, 1971, Gurbst received written settlement agreements from several of American's larger creditors. The individual agreements varied considerably, forgiving from 30% to 50% of American's outstanding debt, with disparate payment terms for the remainder.

On April 30, 1971, Roth's accounts receivable showed a total of $327,500.10 as the balance due from American. This represented American's total debt to Roth before any bad debt write-offs. On September 30, 1971, Roth transferred this amount from its accounts receivable into a special account. During the tax year ended April 30, 1972, American paid approximately $500,000 to Roth on account. Approximately $150,000 was applied against the amount due on the special account, and the rest was applied against current accounts receivable. On March 31, 1972, Roth charged the amount remaining in the special account, $172,443, against its bad debt reserve as a partially worthless debt from its subsidiary, American.

Roth claimed the $172,443 as a deduction for an addition to its bad debt reserve for its tax year ending April 30, 1972. The Commissioner disallowed the deduction as not "reasonable" to the extent that it was necessitated by the charge of American's debt against the bad debt reserve, and the Tax Court upheld his decision. The court found that "Petitioner's addition to its reserve for bad debts for the taxable year ended April 30, 1972, was not a reasonable addition to such reserve, and respondent did not abuse his discretion in so determining."

II.

Section 166 of the Internal Revenue Code of 1954 (26 U.S.C. § 166) governs the deductibility of bad debts. Section 166(a)(1) sets forth the general rule that a taxpayer may deduct "any debt which becomes worthless within the taxable year." A more limited allowance is made for debts which become only partially worthless. Section 166(a)(2) provides that the Commissioner "may allow" a deduction for a partially worthless debt "(w)hen (he is) satisfied that a debt is recoverable only in part." Section 166(c) permits a taxpayer to use the vehicle of a bad debt reserve as an alternative to directly deducting bad debts in the year they become worthless. This section provides that "(i)n lieu of any deduction under subsection (a), there shall be allowed (in the discretion of the (Commissioner)) a deduction for a reasonable addition to a reserve for bad debts."

A bad debt reserve is an estimate of the future losses which are expected to result from current business debts. See Smoot Sand & Gravel v. Commissioner, 274 F.2d 495, 501 (4th Cir. 1960). The taxpayer is permitted to take a deduction when he makes a "reasonable addition" to the reserve rather than when a particular debt becomes worthless. When a debt becomes worthless, the taxpayer reduces the reserve by the amount of the worthless debt. A "reasonable addition" to the reserve "is the amount necessary to bring the reserve balance up to the level that can be expected to cover losses properly anticipated on debts outstanding at the end of the tax year." Thor Power Tool v. Commissioner, 439 U.S. 522, 546, 99 S.Ct. 773, 788, 58 L.Ed.2d 785 (1979). Because a bad debt reserve is an estimate of future losses, the taxpayer will not invariably increase the reserve by the amount of the debts which became worthless in a given year. However, absent unusual circumstances, the amount of worthless debts for one year will indicate the expected amount for the next year, and thus one year's worthless debts will often approximate that year's reasonable addition to the bad debt reserve. ³

Section 166(c) allows a deduction for an addition to a bad debt reserve "in the discretion" of the Commissioner. This grant of discretion limits the scope of judicial review over the Commissioner's determinations. In Thor Power Tool, supra, the Supreme Court summarized the interpretation which the courts have given this statutory language as follows:

(T)he courts uniformly have held that the Commissioner's determination of a "reasonable" (and hence deductible) addition must be sustained unless the taxpayer proves that the Commissioner abused his discretion. The taxpayer is said to bear a "heavy burden" in this respect. He must show not only that his computation is reasonable but also that the Commissioner's computation is unreasonable and arbitrary.

439 U.S. at 547-48, 99 S.Ct. at 789 (footnotes omitted). Roth employs the reserve method of accounting for bad debts and it must therefore bear this "heavy burden" to prevail in this appeal.

III.

The Commissioner maintains, and the Tax Court found, that Roth did not show that the $172,443 in question was uncollectible. The court reasoned that Roth's cancellation of American's debt was a voluntary action on Roth's part, which in effect constituted a capital contribution from Roth to its wholly owned subsidiary, American. Roth seeks to justify the deduction on the ground that the debt became uncollectible to the extent of $172,443, as a result of both its settlement agreement with American, and American's insolvency.

If, as the Commissioner claims, American's debt to Roth did not become partially worthless, it would not operate to reduce Roth's bad debt reserve. If the reserve were not diminished by the $172,443, an addition to the reserve of that amount would be unnecessary, and the Commissioner's action would be supportable under the standards of Section 166(c). ⁴ The crucial inquiry therefore is whether the debt owed to Roth by American became partially worthless in the amount of $172,443 in the tax year ending April 30, 1972. As indicated above, the standard of review dictated by Section 166(c) is whether the Commissioner's disallowance is "unreasonable and arbitrary." Thor...