Opinion ID: 109974
Heading Depth: 1
Heading Rank: 2

Heading: The Bad-Debt Issue

Text: Deductions for bad debts are covered by § 166 of the 1954 Code, 26 U. S. C. § 166. Section 166 (a) (1) sets forth the general rule that a deduction is allowed for any debt which becomes worthless within the taxable year. Alternatively, the Code permits an accrual-basis taxpayer to account for bad debts by the reserve method. This is implemented by § 166 (c), which states that [i]n lieu of any deduction under subsection (a), there shall be allowed (in the discretion of the [Commissioner]) a deduction for a reasonable addition to a reserve for bad debts. A reasonable addition is the amount necessary to bring the reserve balance up to the level that can be excepted to cover losses properly anticipated on debts outstanding at the end of the tax year. At all times pertinent, Thor has used the reserve method. Its reserve at the beginning of 1965 was approximately $93,000. See 64 T. C., at 162. During 1965, Thor's new management undertook a stringent review of accounts receivable. In the company's rubber division, credit personnel studied all accounts; a 100% reserve was set up for two accounts deemed wholly uncollectible, and a 1% reserve was established for all other receivables. Ibid. In the tool division, credit clerks analyzed all accounts more than 90 days past due with balances over $100; a 100% reserve was established for accounts judged wholly uncollectible, and an identical collectibility ratio was applied to accounts under $100 of the same age. A flat 2% reserve was set up for accounts more than 30 days past due, and a 1% reserve for all other accounts. Id., at 162-163. These judgments, approved by three levels of management, indicated that $136,150 should be added to the bad-debt reserve, bringing its balance at year-end to a figure slightly below $229,000. Id., at 162. Thor claimed this $136,150 as a deduction under § 166 (c). The Commissioner ruled that the deduction was excessive. He computed what he believed to be a reasonable addition to Thor's reserve by using the six-year moving average formula derived from the decision in Black Motor Co. v. Commissioner, 41 B. T. A. 300 (1940), aff'd on other grounds, 125 F. 2d 977 (CA6 1942). This formula seeks to ascertain a reasonable addition to a bad-debt reserve in light of the taxpayer's recent chargeoff history. [24] In this case, the formula indicated that, for the years 1960-1965, Thor's annual chargeoffs of bad debts amounted, on the average, to 3.128% of its year-end receivables. 64 T. C., at 163. Applying that percentage to Thor's 1965 year-end receivables, the Commissioner determined that $154,156.80 of accounts receivable could reasonably be expected to default. The amount required to bring Thor's reserve up to this level was $61,359.20, and the Commissioner decided that this was a reasonable addition. Accordingly, he disallowed the remaining $74,790.80 of Thor's claimed § 166 (c) deduction. Both the Tax Court, 64 T. C., at 174-175, and the Seventh Circuit, 563 F. 2d, at 870, held that the Commissioner had not abused his discretion in so ruling.
Section 166 (c) states that a deduction for an addition to a bad-debt reserve is to be allowed in the discretion of the Commissioner. Consistently with this statutory language, the courts uniformly have held that the Commissioner's determination of a reasonable (and hence deductible) addition must be sustained unless the taxpayer proves that the Commissioner abused his discretion. [25] The taxpayer is said to bear a heavy burden in this respect. [26] He must show not only that his own computation is reasonable but also that the Commissioner's computation is unreasonable and arbitrary. [27] Since it first received the approval of the Tax Court in 1940, the Black Motor bad-debt formula has enjoyed the favor of all three branches of the Federal Government. The formula has been employed consistently by the Commissioner, [28] approved by the courts, [29] and collaterally recognized by the Congress. [30] Thor faults the Black Motor formula because of its retrospectively: By ascertaining current additions to a reserve by reference to past chargeoff experience, the formula assertedly penalizes taxpayers who have delayed in making writeoffs in the past, or whose receivables have just recently begun to deteriorate. Petitioner's objection is not altogether irrational, but it falls short of rendering the formula arbitrary. Common sense suggests that a firm's recent credit experience offers a reasonable index of the credit problems it may suffer currently. And the formula possesses the not inconsiderable advantage of enhancing certainty and predictability in an area peculiarly susceptible of taxpayer abuse. In any event, after its 40 years of near-universal acceptance, we are not inclined to disturb the Black Motor formula now. Granting that Black Motor in principle is valid, then, the only question is whether the Commissioner abused his discretion in invoking the formula in this case. Of course, there will be casesindeed, the Commissioner has acknowledged that there are cases, see Rev. Rul. 76-362, 1976-2 Cum. Bull. 45, 46in which the formula will generate an arbitrary result. If a taxpayer's most recent bad-debt experience is unrepresentative for some reason, a formula using that experience as data cannot be expected to produce a reasonable addition for the current year. [31] If the taxpayer suffers an extraordinary credit reversal (the bankruptcy of a major customer, for example), the six-year moving average formula will fail. [32] In such a case, where the taxpayer can point to conditions that will cause future debt collections to be less likely than in the past, the taxpayer is entitled toand the Commissioner is prepared to allowan addition larger than Black Motor would call for. See Rev. Rul. 76-362, supra. In this case, however, as the Tax Court found, Thor did not show that conditions at the end of 1965 would cause collection of accounts receivable to be less likely than in prior years. 64 T. C., at 175. Indeed, the Tax Court infer[red] from the entire record that collectibility was probably more likely at the end of 1965 than it was [previously] because new management had been infused into petitioner (emphasis added). Thor cited no changes in the conditions of business generally or of its customers specifically that would render the Black Motor formula unreliable; new management just came in and second-guessed its predecessor, taking a tougher approach. Management's pessimism may not have been unreasonable, but the Commissioner had the discretion to take a more sanguine view. [33] For these reasons, we agree with the Tax Court and with the Court of Appeals that the Commissioner did not abuse his discretion in recomputing a reasonable addition to Thor's bad-debt reserve according to the Black Motor formula. Thor failed to carry its heavy burden of showing why the application of that formula would have been arbitrary in this case. The judgment of the Court of Appeals is affirmed. It is so ordered.