tioned among the several members of the group which, considered separately, sustained net losses, in proportion to the net loss sustained by each, and the part of the net loss attributable to each of such members may be applied against the net income of each such members for the year 1922, and any excess over the net income for that year may be applied against net income for 1923.16

Claim for net loss to be filed with succeeding year's re

turn.

REGULATION. A taxpayer sustaining for any taxable year a "net loss" as defined in article 1621 may file a claim therefor with his return for the succeeding taxable year (designated in section 206 as the "second year"). The claim should contain a concise statement setting forth the amount of the net loss, and all pertinent facts relative thereto, including a schedule showing the computation of the net loss in accordance with section 206 and articles 1621 and 1626 of these regulations. If the evidence furnished satisfies the Commissioner that the taxpayer has sustained a "net loss" the amount of such net loss may be allowed as a deduction in computing the net income of the taxpayer for the succeeding taxable year, and if such net loss is in excess of the net income for that year, the amount of the excess may be carried over and allowed as a deduction in computing the net income for the next succeeding taxable year (designated in section 206 as the "third year"). It should be noticed, however, that a "net loss" for a preceding year may not be considered in computing a "net loss" for a succeeding year. . . . (Art. 1622.)

The net loss is to be shown as an ordinary deduction in the return for the subsequent year and the explanatory schedule referred to in article 1622 is to be attached. No formal claim is required if the deduction is taken in the return for the subsequent year; but if not so deducted, a claim for refund should be filed.

16 C. B. II-1, page 128; I. T. 1655. For ruling dealing with apportionment of net losses under 1918 law, see III-32-1712; L. O. 1113.

The law specifically provides regarding bad debts that taxpayers may deduct: 1

1. A reasonable addition to a reserve for bad debts.

2. Debts ascertained to be worthless in whole or in part. Taxpayers may, if they choose, continue on the old basis, i.e., they may deduct only those bad debts ascertained to be worthless and charged off during the year. This chapter will deal with the procedure to be followed when reserves are maintained, with the types of bad debts which may be deducted in whole or in part, and with the determination of their deductibility.

LAW. Section 214. [Individuals] (a) In computing net income there shall be allowed as deductions:

1

[Former Procedure] The 1913, 1916 and 1917 laws read: "debts due to the taxpayer actually ascertained to be worthless and charged off within the year." The change in the 1918 law was merely verbal. The 1921 law is similar to the 1924 law.

(7) Debts ascertained to be worthless and charged off within the taxable year (or, in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts); and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt to be charged off in part; . .

The deduction for corporations [section 234 (a-5)] is exactly the same as that allowed individuals.

REGULATION. Bad debts may be treated in either of two ways—(1) by a deduction from income in respect of debts ascertained to be worthless in whole or in part, or (2) by a deduction from income of an addition to a reserve for bad debts. Taxpayers were given an option for 1921 to select either of the methods mentioned for treating such debts. See article 151, Regulations 62. The method used in the return for 1921 must be used in returns for subsequent years and for returns under the Revenue Act of 1924 unless permission is granted by the Commissioner to change to the other method. A taxpayer filing a first return of income may select either of the two methods subject to approval by the Commissioner upon examination of the return. If the method selected is approved, it must be followed in returns for subsequent years, except as permission may be granted by the Commissioner to change to another method. . . . . (Art. 151.)

The change in procedure became effective with returns for the year 1921.2 For that year, taxpayers were permitted to elect the method on which bad debt deductions would be claimed for 1921 and subsequent years. The method used in preparing the 1921 return therefore constituted an election of method and consequently no change can now be made unless express permission to do so is obtained from the Commissioner, presumably before the close of the year in which the change is proposed to be made. Taxpayers who elected the reserve method for 1921 may deduct, in the taxable year, a reasonable addition to the reserve and also any accounts in existence prior to January 1, 1921 which prove to be worthless during the taxable year. Taxpayers electing the other method, charge off such debts as are ascertained to be worthless in whole or in part during the taxable year.

Reserves for Bad Debts

It may be assumed that taxpayers in active business carry reserves for bad debts and that those who are not in active business do not.

Those who are not required under good accounting practice to

2

[Former Procedure] As to the effect on invested capital for 1921, sec Income Tax Procedure, 1922, page 981, footnote 5.

keep books on an accrual basis are not affected by the charge inaugurated by the 1921 law and contained in the 1924 law. When a debt is bad, it may be charged off. Taxpayers who do not keep books on an accrual basis should not ordinarily attempt to charge off only part of a debt but if they care to do so the law permits it.

When accounts are kept on an accrual basis, a reserve for bad debts is set up annually or oftener. If the reserve method is used, or permission to change to that method was secured during 1924, the addition to the reserve may be claimed as a deduction in the return for that year.

REGULATION. Taxpayers who have, prior to 1924, established the reserve method of treating bad debts and maintained proper reserve accounts for bad debts, may deduct from gross income a reasonable addition to such reserves in lieu of a deduction for specific bad debt items. A taxpayer who, in accordance with article 151, or upon securing permission from the Commissioner, adopts the reserve method of treating bad debts, shall determine the amount of the reserve that should reasonably have been set up at the close of the preceding taxable year (which shall not be deducted in computing net income) and for the current and subsequent taxable years may add a reasonable addition to such reserve and deduct the amount so added from gross income in computing taxable net income. . . . . (Art. 155.)

The reserve method cannot be used for one specific debt.

RULING. Permission to adopt the reserve method of charging off bad debts is restricted to taxpayers having a large number of accounts where credit has been extended to cover a considerable period of time and it is not granted for the purpose of handling one specific bad debt."

A REASONABLE ADDITION TO THE RESERVE.

REGULATION. What constitutes a reasonable addition to a reserve for bad debts must be determined in the light of the facts, and will vary as between classes of business and with conditions of business prosperity. A taxpayer using the reserve method should make a statement in his return showing the volume of his charge sales (or other business transactions) for the year and the percentage of the reserve to such amount, the total amount of notes and accounts receivable at the beginning and close of the taxable year, and the amount of the debts which have been ascertained to be wholly or partially worthless and charged against the reserve account during the taxable year. (Art. 155.)

In a specific case, it was held that the addition to the reserve should be computed by ascertaining the percentage which the total bad debts written off (less recoveries) for the four-year period ended

1

December 31, 1921, bore to the total accounts and notes receivable outstanding at the end of each year for the four-year period ended December 31, 1920. It was further held that consideration must be given to abnormal business conditions which may affect collections for any year.

The ruling uses outstanding accounts and notes receivable as the basis for setting up the reserve for bad debts. Article 155 provides for the submission with taxpayers' returns of data relating to sales as well as to outstanding accounts. Form 1120 provides only for information as to sales, no mention of outstanding accounts being made.

As the establishment of a reserve based upon sales is preferable to that based on accounts and notes outstanding at the end of the year, the ruling above quoted must not be considered as placing exclusive approval on the latter method. All the factors having a bearing on the probable losses in realizing on the outstanding receivables should be considered.

At the end of each year the balance in the reserve account naturally will have to be reviewed for the purpose of determining whether the percentage used in computing the credit to the reserve for the year is adequate or whether it is either too high or too low, in view of more recent experience. The percentage will, of course, need to be modified to whatever extent additional experience indicates to be

necessary.

A reserve is excessive or insufficient in 99 out of 100 cases. If grossly excessive, it would be proper to file amended tax returns; but, if at the time the reserve was set up the reserve was a proper one, any subsequent favorable change would be reported, in effect, as income for the subsequent year. If the reserve was insufficient, the Treasury holds that amended returns must be made. This would not apply unless the insufficiency was substantial.

7

AMOUNT TO BE DEDUCTED IN RETURNS.-A reasonable addition to the reserve is deductible in accordance with article 155, quoted in a previous paragraph, and also the amount of any debts outstanding at December 31, 1920 (or the date at which the change was effective, if made in a year later than 1921), which are ascertained to be worthless in the taxable year.

C. B. I-1, page 160; I. T. 1341; C. B. I-2, page 119; I. T. 1442.