Monday, September 07, 2015

Taxpayers Must Correctly Write-Off Balances for Partial Bad Debt Deduction

Code Section 166(a)(2) allows for a deduction for partially worthless debts for business debts. One of the requirements to be able to deduct is that the amount deducted “was charged off” on the books during the tax year.

In a recent Legal Advice issued by Field Service Attorneys, the taxpayer put a contra-asset account on its balance sheet to reflect a partial loss. The issue was whether that was sufficient to be a charge off on the books for this purpose.

The government attorneys noted  the case of International Proprietaries, Inc. v. Comm., 18 TC 133 (1952) that the creation of a reserve account, without an actual reduction in the accounts receivable account, was not enough to constitute a charge off – even though it did reduce net income. In the current analysis, the attorneys equated the creation of a contra-asset account as nothing more than a reserve.

The taxpayer sought to rely on Brandtjen & Kluge, Inc., 34 T.C. 416 (1960). In that case, the taxpayer increased its account entitled “Reserve for Doubtful Notes and Accounts” and debited bad debts, reducing its income. So far, pretty similar facts to our taxpayer. However, there, the taxpayer also made an adjusting journal entry in a new ledger account entitled “Reserve for Loss” with an explanation being “To charge bad debts with loss fro Canadian operation.” The court found that such account and explanation indicated a “sustained loss and not an anticipated future loss” and allowed the deduction.

The Legal Advice concludes that the current facts were closer to International Proprietaries than to Brandtjen, and thus disallowed the current loss.  

Thus, what the IRS and courts are trying to determine is whether the book entry shows a provision for losses anticipated in the future, or whether it shows a current loss and write-off. To avoid the issue entirely, taxpayers would be best served by actually reducing the balance of the receivable account to obtain partial worthlessness loss treatment.

As an aside, a taxpayer can defer the charge-off and deduction to a later year when partial worthlessness is greater, or wait to deduct the entire debt amount in the year of total worthlessness. For the taxpayer at issue here, the loss of the deduction for partial worthless should not result in a total loss – it should be able to deduct it in a later year (not beyond the year of total worthlessness) by doing the correct charge off on its books.

Legal Advice Issued by Field Attorneys 20153501F

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