SMITH ELECTRIC COMPANY v. United States

• Decision Date: 16 June 1972
• Docket Number: No. 474-69.,474-69.
• Citation: 461 F.2d 790,198 Ct. Cl. 644
• Parties: SMITH ELECTRIC COMPANY, Inc. v. The UNITED STATES.
• Court: U.S. Claims Court

198 Ct. Cl. 644, 461 F.2d 790 (1972)

SMITH ELECTRIC COMPANY, Inc. v. The UNITED STATES.

No. 474-69.

United States Court of Claims.

June 16, 1972.

Herman H. Copelon, New Haven, Conn., attorney of record, for plaintiffs; Copelon & Schiff, New Haven, Conn., of counsel.

Robert N. Dorosin, with whom was Asst. Atty. Gen. Scott P. Crampton, for defendant; Philip R. Miller, Washington, D. C., of counsel.

Before COWEN, Chief Judge, and DAVIS, SKELTON, NICHOLS, KASHIWA, and KUNZIG, Judges.

OPINION

KUNZIG, Judge.^*

This case is before us on a stipulation of facts. Plaintiff is suing for the recovery of Federal Income taxes for the years 1957 and 1958 in the respective amounts of $5,738.01 and $10,960.19, plus interest.

The sole issue in this case is whether the special seven-year statute of limitations,¹ with respect to filing claims for refund on account of the deductibility of a worthless debt, is applicable to taxpayers on the reserve method as well as to those on the direct charge-off method.

Plaintiff is an accrual basis taxpayer who utilizes the reserve method of treating bad debts. In 1960, plaintiff properly added $81,943.79 to its reserve for bad debts. The largest part of that deduction was brought about by a single worthless note ($80,050) which was charged against the reserve account during the year.

On March 11, 1966, plaintiff filed claims for refund for the taxable years 1957 and 1958 arising out of a net operating loss in 1960 due to that bad debt deduction. These claims were disallowed by the Commissioner on November 15, 1967, on the ground that they were not filed within the three-year limitation period of Section 6511 of the Internal Revenue Code of 1954.² Plaintiff filed his petition in this court on November 10, 1969.

The Reserve Method

Under the reserve method a taxpayer is allowed to deduct each year a reasonable addition to the reserve for bad debts. The taxpayer may not, in addition to the reserve, take a deduction for specific debts. See Rogan v. Commercial Discount Co., 149 F.2d 585 (9th Cir. 1945). However, specific debts which become worthless during the taxable year are chargeable against the reserve. See Calavo, Inc. v. Commissioner of Internal Revenue, 304 F.2d 650 (9th Cir. 1962). This indirectly results in a higher bad debt deduction because the reasonable addition to the reserve is the amount necessary to bring the balance in the reserve to its proper level. The ultimate question is always "whether the balance in the reserve at the end of the year is adequate to cover the expected worthlessness on outstanding debts * * *." Roanoke Vending Exchange, Inc., 40 T.C. 735 (1963). See also R. Gsell & Co., 34 T.C. 41, 56 (1960); Platt Trailer Co., Inc., 23 T.C. 1065 (1955).

It should be noted that a specific debt cannot be taken into account, even in this indirect manner, unless it becomes worthless during that particular taxable year. Calavo, Inc. 19 CCH Tax Ct.Mem. 1359 (1960), rev'd on other grounds, 304 F.2d 650 (9th Cir.1962); New York Water Service Corp., 12 T.C. 780 (1949); William Purvin, 6 T.C. 21 (1946). The reserve level is usually determined either by past experience or by a current evaluation of the accounts receivable and is computed as a percentage of sales or receivables.

Statute of Limitations

Section 6511(d) provides:

(1) Seven-year period of limitation with respect to bad debts and worthless securities.—If the claim for credit or refund relates to an overpayment of tax imposed by subtitle A on account of—

(A) The deductibility by the taxpayer, under Section 166 * * * of a debt as a debt which became worthless * * *, or

(B) The effect that the deductibility of a debt or loss described in subparagraph (A) has on the application to the taxpayer of a carryover,

in lieu of the 3-year period of limitation prescribed in subsection (a), the period shall be 7 years from the date prescribed by law for filing the return for the year with respect to which the claim is made. If the claim for credit or refund relates to an overpayment on account of the effect that the deductibility of such a debt or loss has on the application to the taxpayer of a carryback, the period shall be * * * 7 years from the date prescribed by law for filing the return for the year of the net operating loss which results in such carryback * * *.

The reason for this special statute of limitations with respect to bad debts was enunciated in the Committee Report to the Revenue Act of 1942. (Section 322(b) (5) of the Internal Revenue Code of 1939 was the predecessor section to Section 6511(d) (1) and was added by Section 169(a) of the Revenue Act of 1942, c. 619, 56 Stat. 798.) H.R. Rep. No. 2333, 77th Cong., 2d Sess. 44-45 (1942-2 Cum.Bull. 372, 408).

Under the existing law, the taxpayer may be whipsawed out of a deduction for a bad debt because of the uncertainty as to the time at which the debt becomes worthless. Later evidence often discloses that present decisions as to the year in which a debt becomes worthless are erroneous. For example, the taxpayer concludes that a debt has become bad and takes the deduction in that year, only to discover by later evidence that the debt actually became worthless three years previously. The statute of limitations having run on such previous year, this deduction is lost forever to the taxpayer. Conversely, where the debt actually became worthless in a year later than the year chosen by the taxpayer, the 3-year statute of limitations may operate against the Government.

To relieve this inequitable situation, the bill replaces the present 3-year statute of limitations in such cases with a 7-year statute, giving a considerably greater flexibility to the allowance of bad debt deductions in the proper year.

Revision of the Reserve

It is necessary for the taxpayer to determine the proper reserve level at the end of each taxable year. Estimates which are reasonably made at that time may not be increased in light of subsequent events. Farmville Oil and Fertilizer Co. v. Commissioner of Internal Revenue, 78 F.2d 83, 85 (4th Cir. 1935). See also Wengel, Inc. v. United States, 306 F.Supp. 121 (E.D.Mich.1969); Consolidated Dry Goods Co. v. United States, 35 F.Supp. 523 (D.Mass.1940); Rio Grande Building and Loan Assoc., 36 T.C. 657 (1961). Otherwise taxpayer would be able to go back and increase his reserve on account of debts which went bad in subsequent years, thereby deducting them by way of the reserve in a year prior to the one in which they became worthless. Farmville Oil and Fertilizer Co., supra.

Taxpayer, must, however, be able to go back and correct the year in which he charged wholly worthless debts against the reserve.³ The reason for the difference in treatment is because "debts may not be charged off against the reserve until they have become worthless." Calavo, Inc. v. Commissioner of Internal Revenue, 304 F.2d at 654. Both taxpayers using the direct charge-off method and those utilizing the reserve method must charge-off specific debts in the year they become worthless. Those on the reserve method charge the debts against the reserve account rather than directly against income. Both taxpayers, however, are equally vulnerable to being whipsawed by having the Commissioner disallow in year 5 a debt which was charged off (against income or reserve) in year 2, on the grounds that it went bad in year 1. We feel that Section 6511(d) granted the seven-year statute of limitations to both taxpayers since the whipsaw problem afflicts them both equally.

Defendant contends that a taxpayer under the reserve method can support his addition to his reserve by relying on past...