Rev. Rul. 78-280

Advice has been requested as to the effect of the decision of the Supreme Court of the United States in Nash v. United States, 398 U.S. 1 (1970), 1970-1 C.B. 72, in the situation described below.

A, an individual, transferred property used in a sole proprietorship, including accounts receivable, to a newly formed corporation solely in exchange for all of the stock of such corporation in a transaction in which no gain or loss is recognized pursuant to section 351(a) of the Internal Revenue Code of 1954. A had accounts receivable with a face amount of 100x dollars and a reserve for bad debts of 5x dollars. Prior to the transfer, A used the accrual method of accounting under section 446(c) in the business and has previously deducted additions to a reserve for bad debts with respect to such accounts pursuant to section 166(c). All additions to the reserve for bad debts in prior years resulted in tax benefits. The value of the stock received for the accounts receivable was 95x dollars.

The principal question presented is the extent to which the amount of the transferor's reserve for bad debts is includible in the transferor's gross income. Related questions concern the transferor's and the transferee's basis in the transferred accounts receivable and the treatment of these accounts receivable by a transferee using the reserve method of treating bad debts under section 166(c) of the Code and by a transferee using the specific charge-off method of treating bad debts under section 166(a).

In the Nash case, the taxpayers were partners in a partnership using the accrual method of accounting and the reserve method of treating bad debts under section 166(c) of the Code. The reserve for bad debts was deemed reasonable. The assets of the partnership, including the accounts receivable, were transferred solely in exchange for corporate stock in a transaction qualifying under the nonrecognition of gain or loss provisions of section 351. The value of the stock received in exchange for the accounts receivable was equal to the net value of the accounts transferred, that is, the face amount of the accounts receivable previously included in income less the amount of the reserve for bad debts.

The Court held that although the need for the reserve ended with the transfer, this did not result in a recovery within the meaning of the tax benefit cases. That is, there was no recovery of an item that had produced an income tax benefit in a prior year and therefore nothing had to be added to income in the year of the transfer.

In essence, the decision in Nash holds that because there is no double benefit if the consideration received in exchange for the transfer of accounts receivable by a taxpayer using the accrual method of accounting is equal to the net value of the accounts receivable (the face amount of the accounts receivable previously included in income less the reserve for bad debts), there is no recovery within the meaning of the tax benefit cases. See Estate of Schmidt v. Commissioner, 355 F.2d 111 (9th Cir. 1966), Estate of Block v. Commissioner, 39 B.T.A. 338 (1939), aff'd sub nom. Union Trust Co. v. Commissioner, 111 F.2d 60 (7th Cir. 1940), cert. denied, 311 U.S. 658 (1940), and the cases cited therein.

Accordingly, A has no recovery within the meaning of the tax benefit rule.

The Nash case did not involve the determination of the transferor's basis in the accounts receivable for the purpose of applying sections 358(a)(1) and 362(a) of the Code.

Section 358(a)(1) of the Code, as it applies to the situation described above, provides that the basis of property (stock) received by the transferor in a transaction qualifying under section 351 shall be the same as that of the property exchanged.

Section 362(a) of the Code, as it applies to the situation described above, provides that the basis of property received by a corporation in a transaction qualifying under section 351 shall be the same as it would be in the hands of the transferor.

In the case of a taxpayer on an accrual method of accounting using the specific charge-off method of treating bad debts, the basis of an account receivable is reduced by the amount of a specific charge-off claimed with respect thereto. Ludlow Valve Manufacturing Co. v. Durey, 62 F.2d 508 (2d Cir. 1933). A similar approach is appropriate in the case of an accrual basis taxpayer using the reserve method of treating bad debts. In the aggregate, such a taxpayer's bad debt reserve reduces the basis of the accounts receivable to which it relates.

Furthermore, in the present situation, because the transferor has already deducted additions to the bad debt reserve with respect to the accounts receivable and because under Nash the amount of the bad debt reserve is not includible in income at the time of transfer, it is necessary to prevent the transferee from also taking a deduction with respect to the accounts receivable. The reduction of their aggregate basis by the amount of the bad debt reserve prevents this double deduction. See Charles Ilfeld Co. v. Hernandez, 292 U.S. 62 (1934), XIII-1 C.B. 139 (1934).

Accordingly, in the situation described above, for the purposes of applying sections 358(a)(1) and 362(a) of the Code, the basis of the transferor in the transferred accounts receivable is 95x dollars, their net value.

If the transferee corporation uses the reserve method of treating bad debts under section 166(c) of the Code, it must establish a bad debt reserve with respect to the transferred accounts receivable equal to the difference between their face amount (100x dollars) and their basis as determined under section 362(a) (95x dollars). The establishment of this reserve is not considered an addition to a bad debt reserve and thus the initial amount in the reserve (5x dollars) cannot be deducted. The collection of these accounts receivable will not require the inclusion in income of the excess of collections over 95x dollars, and the inability to collect an amount equal to 95x dollars will not entitle the taxpayer to specific charge-offs. Rather, these transactions will be reflected in the taxpayer's determination of a reasonable reserve for bad debts in future periods.

If the transferee corporation uses the specific charge-off method of treating bad debts under section 166(a) of the Code, in the absence of evidence to the contrary, it will be presumed that the basis of each of the transferred accounts receivable as of the date of the transfer will be the same fraction of its face amount as the total basis of all such accounts receivable, as determined under section 362(a), is to the total face amount. This same fraction of any amount collected with respect to such an account receivable will be a return of basis, and the remainder of the amount collected will be gain. See Himelick v. Commissioner, 32 B.T.A. 792 (1935). For example, if in the present situation the transferee corporation uses the specific charge-off method and one of the transferred accounts receivable has a face amount of $100, the basis of the transferee corporation in this account receivable would be $95. The collection of $70 with respect to this account receivable would reduce the transferee corporation's basis in the account receivable by $66.50 (7/10 times $95.00) and would produce $3.50 of gain ($70.00 - $66.50). If in the next taxable year the account receivable becomes totally worthless, the transferee corporation would be entitled to a deduction under section 166(a) in the amount of $28.50 ($95.00 - $66.50), its remaining basis in the account receivable.

Rev. Rul. 62-128, 1962-2 C.B. 139, holds that, in a nontaxable exchange under the provisions of section 351 of the Code, the entire amount of the transferor's reserve for bad debts is ordinary income to the transferor. Since Rev. Rul. 62-128 is not in accord with the present position of the Internal Revenue Service as expressed above, it is revoked.

Pursuant to the authority contained in section 7805(b) of the Code, this Revenue Ruling shall not apply adversely to taxpayers when, before July 24, 1978, the date of publication of this Revenue Ruling in the Internal Revenue Bulletin, accounts receivable are received in transactions to which section 351 applied and in which the transferor's tax liability, as finally determined, reflects a recovery of the bad debt reserve in accordance with Rev. Rul. 62-128. In such cases, the income recognized by the transferor will be taken into account under section 362(a) in determining the basis of the accounts receivable in the hands of the transferee. For example, if in the present situation the transferor had recognized the 5x dollars reserve for bad debts as ordinary income for the taxable year of transfer and continues to account for such transfer in accordance with Rev. Rul. 62-128, the basis of the transferor and the transferee in the accounts receivable would equal their net value of 95x dollars (100x dollars face amount less the 5x dollars reserve for bad debts) increased by the 5x dollars reserve for bad debts amount recognized by the transferor as ordinary income, or 100x dollars. Further, the transferee corporation, having a basis in the accounts receivable equal to face amount (100x dollars), may establish a reasonable reserve for bad debts with respect to the transferred accounts receivable and may deduct such amount as an addition to a bad debt reserve.

Rev. Rul. 62-128 is revoked.