Rev. Rul. 78-279

Advice has been requested regarding 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 situations described below.

In each situation, (i) the shareholders of the corporation adopt a plan of complete liquidation under section 337 of the Internal Revenue Code of 1954; (ii) within the 12-month period beginning on the date of the adoption of such plan the corporation sells its accounts receivable for 95x dollars; (iii) prior to the sale the corporation used the accrual method of accounting under section 446(c) and the reserve method of treating bad debts under section 166(c); and (iv) all additions to the reserve for bad debts in prior years resulted in tax benefits.

Situation 1. The corporation had accounts receivable with a face amount of 100x dollars and a reserve for bad debts of 5x dollars.

Situation 2. The corporation had accounts receivable with a face amount of 100x dollars and a reserve for bad debts of 7x dollars.

The question in each situation is the extent to which the balance in the corporation's reserve for bad debts is includible in the corporation's gross income.

Section 337 of the Code provides that, in general, no gain or loss is recognized to a corporation on a sale or exchange in connection with a liquidation to which section 337 applies.

In Rev. Rul. 57-482, 1957-2 C.B. 49, a corporation sold its accounts receivable at face value pursuant to a plan of complete liquidation governed by section 337 of the Code. Rev. Rul. 57-482 holds that the entire reserve for bad debts is ordinary income to the corporation in its final Federal income tax return because the need for maintaining the reserve ceased when the taxpayer disposed of the accounts receivable.

However, as Rev. Rul. 78-280, page 139, this Bulletin, notes, the decision in Nash holds that, where 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 accounts receivable (the face amount of the receivables previously included in income less the amount of 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. of Indianapolis v. Commissioner, 111 F.2d 60 (7th Cir. 1940), cert. denied, 311 U.S. (1940), and the cases cited therein; and Tennessee Carolina Transportation, Inc. v. Commissioner, 65 T.C. 440 (1975), 582 F.2d 378 (6th Cir. 1978). The Court in Nash agreed with the decision of the United States Court of Appeals for the Ninth Circuit in Schmidt, wherein the Schmidt Court stated, in part, "We think that whether the sale be for cash or stock, no income is received, unless the consideration received exceeds the net amount of the receivables." It is consistent with the Nash and Schmidt decisions to find a recovery where the consideration received for the accounts receivable is in excess of their net value.

Although Rev. Rul. 78-280 involves a transfer of assets, including accounts receivable, solely in exchange for corporate stock in a transaction qualifying under the nonrecognition provisions of section 351 of the Code, the same principles are equally applicable to sales of accounts receivable pursuant to plans of complete liquidation governed by section 337. See Citizens' Acceptance Corp. v. United States, 320 F. Supp. 798 (D. Del. 1970), rev'd on other grounds, 462 F.2d 751 (3d Cir. 1972). Applying Nash the district court in Citizens' Acceptance Corp. held that there is a recovery only to the extent that the consideration received exceeds the net value of the accounts receivable (their face value less the amount of the bad debt reserve).

Accordingly, in the situations described above, the results are as follows:

Situation 1. The corporation has no recovery within the meaning of the tax benefit rule.

Situation 2. The corporation has a recovery of 2x dollars in its gross income.

Rev. Rul. 57-482, in holding that the entire bad debt reserve was includible in the income of the taxpayer, reached the correct result in that case, bad debt reserve was recovered through the sale of the accounts receivable at their face amount. The burden is on the taxpayer to show that the amount received in excess of the net value of the accounts receivable is not a recovery of a tax benefit but rather attributable to economic factors such as appreciation in value of interest bearing accounts receivable resulting from changes in prevailing interest rates. In using the "end of the need" rationale, however, Rev. Rul. 57-482 relied on a theory that was rejected by the Court in Nash. Accordingly, Rev. Rul. 57-482 is superseded.