The bad-debt reserve: opportunity for partial current deduction.

• Author: Randolph, David W.

The Tax Reform Act of 1986 repealed the reserve method for claiming bad-debt deductions for most taxpayers. As a result, they often mechanically calculate taxable income by adjusting book income for any change in the "allowance for bad debts" account from the prior year. However, as is discussed below, case law suggests that the charge-off requirement of Sec. 166(a)(2) and Regs. Sec. 1.166-3(a)(2)(i) may be accomplished in ways other than by recording an entry (i.e., a write-off entry) that removes the debt from both the receivable and allowance accounts maintained on the taxpayer's books. By mechanically relying on the write-off performed for financial accounting, taxpayers may be forgoing the opportunity to deduct currently the portion of the allowance account that represents partially worthless business debts.

Deduction for Partially Worthless Business Debts

Sec. 166(a)(2) and Regs. Sec. 1.1663(a)(2)(i) provide that, when satisfied that a bona fide debt (as defined in Regs. Sec. 1.166-1(c)) is recoverable only in part, the IRS may allow the amount that has become worthless as a deduction only to the extent charged off during the tax year (specific charge-off method). Assuming there is sufficient evidence to prove that a bona fide debt is in part worthless (a facts-and-circumstances determination, according to Regs. Sec. 1.166-2(a)), a question arises: what constitutes a charge-off?

The Tax Court in Findley, 25 TC 311 (1955), stated that, in the case of a debt that has become partly worthless, the charge-off is an act "to perpetuate evidence of taxpayer's election to abandon part of the debt as an asset." While merely increasing a general reserve account without specifically identifying the debt(s) to which the reserve increase relates does not provide evidence sufficient to comply with the statute (see, e.g., International Proprietaries, Inc., 18 TC 133 (1952)), increasing a reserve account for specifically identified debt(s) that are partly worthless can constitute a charge-off for purposes of Sec. 166(a)(2) and Regs. Sec. 1.166-3(a)(2)(i).

Charge-Off Required

Regs. Sec. 1.166-3(a)(3)(iii) specifies that, in the case of significantly modified debt (within the meaning of Regs. Sec. 1.1001-1(a)), the amount of deemed charge-off "is the amount by which the tax basis of the debt exceeds the greater of the fair market value of the debt or the amount of the debt recorded on the taxpayer's books and records reduced as appropriate for a...