Taxpayers operating a trade or business are authorized to deduct partially worthless bad debts under Internal Revenue Code §166(a)(2). But to do so the taxpayers must be able to show that they are writing off a debt that already has gone bad, rather than simply reserving against a potentially bad debt in the future.
IRC §166(a)(2) reads as follows:
(2) Partially worthless debts
When satisfied that a debt is recoverable only in part, the Secretary may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction.
Regulation §1.166-3(a)(2) explains the requirements to take a deduction under this provision as follows:
(2) Charge-off required.
(i) If, from all the surrounding and attending circumstances, the district director is satisfied that a debt is partially worthless, the amount which has become worthless shall be allowed as a deduction under section 166(a)(2) but only to the extent charged off during the taxable year.
(ii) If a taxpayer claims a deduction for a part of a debt for the taxable year within which that part of the debt is charged off and the deduction is disallowed for that taxable year, then, in a case where the debt becomes partially worthless after the close of that taxable year, a deduction under section 166(a)(2) shall be allowed for a subsequent taxable year but not in excess of the amount charged off in the prior taxable year plus any amount charged off in the subsequent taxable year. In such instance, the charge-off in the prior taxable year shall, if consistently maintained as such, be sufficient to that extent to meet the charge-off requirement of section 166(a)(2) with respect to the subsequent taxable year.
(iii) Before a taxpayer may deduct a debt in part, he must be able to demonstrate to the satisfaction of the district director the amount thereof which is worthless and the part thereof which has been charged off.
In Field Attorney Advice 20153501F the IRS looks at the matter with a taxpayer who claimed deductions related to debts the taxpayer held.
In this particular case the taxpayer has loaned money against real estate. The value of that real estate has dropped dramatically and the taxpayer had lost money on various loans where the holders defaulted and the properties were foreclosed upon. The taxpayer established an amount that it believed represented the reduction in value in the loans that it continued to hold.
The taxpayer did so by using the following method:
To determine the "discounted fair market value," * * * estimates the date it expects to receive cash from the sale of the note or sale of the asset underlying the note after foreclosure, and then discounts from the expected date of recovery the current appraised value to the present using as the discount rate the rate of interest on the loan.
The advice describes the purpose of this provision as follows:
The purpose of the charge-off requirement is to perpetuate evidence of a taxpayer's election to abandon part of the debt as an asset. Findley v. Commissioner, 25 T.C. 311, 319 (1955), aff'd per curium, 236 F.2d 959 (3d Cir. 1956) (emphasis added). An increase in a general reserve account does not constitute the required charge off. International Proprietaries, Inc. v. Commissioner, 18 T.C. 133 (1952). The taxpayer's intent to abandon the charged-off portion of the debt must be reflected in its books and records. Id.
In this case the Advice argues the taxpayer has merely created a reserve account that does not qualify for a current deduction.
This case is not distinguishable from International Proprietaries. There, the taxpayer merely (1) increased its reserve account for bad debts, which decreased its balance sheet assets, and (2) credited surplus, which decreased its net income on its books. Similarly, * * * (1) increased its * * *, a mere reserve account, which decreased its balance sheet assets and (2) credited * * *, which decreased its net income per books. By definition, an Allowance and a Provision is nothing more than a reserve.2 Thus, * * * did nothing more than create a reserve account for anticipated loan losses, calculated with reference to its loans. Under International Proprietaries, a court would disallow * * * partial bad debt deductions.
The taxpayer argued that its case was like the case of Brandtjen & Kluge, Inc. v. Commissioner, 34 T.C. 416 (1960), but the Advice finds the case distinguishable. It notes the following:
There, the taxpayer claimed partial bad debt deductions in the amounts of $28,000 and $12,000 on its 1954 and 1955 income tax returns, respectively. On its books, the taxpayer increased its account entitled "Reserve for Doubtful Notes and Accounts" (which reduced its assets) and debited "bad debts" (which reduced its net income). Id. at 430-31. The taxpayer did not charge-off the $28,000 in its accounts receivable due from its subsidiary; however, it made an adjusting journal entry of $28,000 in a new ledger account entitled "'Reserve for Loss on B & K Canada' [the subsidiary], the explanation being 'To charge bad debts with loss from Canadian operation.'" Id. at 431.
The Tax Court in Brandtjen held that the taxpayer was entitled to the partial bad debt deductions. First, the Court held that "the title of the new account [Reserve for Loss on B & K Canada] even though designated as a reserve, was in terms of a loss which had been incurred by reason of existing partial worthlessness, and not of an anticipated future loss." Id. at 443. The Court elaborated --
[W]e are disposed to accept what was done as an effective charge off for the purposes of the deductions claimed. The entries were definitely limited to the one account. They were intended to accomplish the purpose contended for, and were described in words indicating a sustained loss, and not an anticipated future loss, in the one specific account. In these respects, the situation here is distinguishable from that which existed in International Proprietaries, Inc.. . . .Id. at 444. (Emphasis added).
The key difference, the Advice concludes, was:
As explained above, it was of paramount importance to the Tax Court's opinion in Brandtjen that there are sufficient indicia of a sustained loss. Even though the taxpayer in Brandtjen titled its account in the nature of a reserve, the taxpayer used sufficiently descriptive and contemporaneous language in its books, "to charge bad debts with loss from Canadian operations," in describing the entries made to the account "reserve for loss on B & K Canada." In the instant case, not only did * * * title its accounts in the nature of a reserve, so too was the contemporaneous explanation accompanying its journal entries. For example, in * * * and * * * the memos to the journal entries include * * * and * * * Such language indicates the anticipation of future losses.
Effectively, this Advice interprets the case results to indicate that labels on accounts and the like will matter in a case like this, as will other taxpayer actions. It is not enough to expect some debts will be repaid for less than what the notes list as repayment terms. Rather a taxpayer must show that the loss has already taken place, rather than a reasonable expectation that the item will be repaid at a lesser amount.