[Former Procedure-Continued]

"No. Interest and dividends are held to be items of current income, returnable as such, and they are not to be considered when computing the amount of profit or loss which results from a purchase and sale." (Income Tax Primer, 1918, question 84.)

Two criticisms may be urged against this procedure. The first is its complexity. It was pointed out in The Wall Street Journal, February 26, 1918, that it involves a minute analysis of brokers' statements and the submission of a schedule with a separate line for each occasion upon which one has entered the market. In the second place, it has been urged that, in a speculative venture of this sort, the interest charges and the dividend credits are all integral parts of the transaction; that they are considered not as interest payments and dividends in the ordinary sense, but rather as incidental debits and credits leading to a net gain or loss on the transaction and that all the law was intended to reach was this net result. On the other hand, when losses are fully deductible there is an advantage in reporting dividends as income, because the normal tax has been paid thereon.

Worthless bonds are bad debts deductible without limit.-Under the 1916 law losses arising out of the purchase and sale of stocks and bonds were not allowable deductions except as offsets to profits arising out of similar transactions. Bonds, however, are debts and, if they became entirely worthless, they could be charged off and the cost thereof could be entered under the heading as a deduction, irrespective of the amount. Stocks are not "debts" and credit could not be claimed for those becoming worthless, except as stated on page 645.

CHAPTER XXVIII

DEDUCTIONS FOR BAD DEBTS

The deduction for bad debts is limited by fewer restrictions than most other deductions. In the case of corporations the law prior to 1918 did not specifically mention the deduction for bad debts and consequently it fell under the general permission to deduct losses. To individuals the law gives authority to deduct worthless debts, in language broad enough to include all such debts without limitation as to amount,2 no matter whether incurred in trade or business or not. The chief problems of procedure which arise have to do, first, with a test by which the worthlessness of debts shall be judged and, second, with the manner in which the deduction shall be allowed the vexed question of a reserve as compared with the prescribed method of deducting only the specific debts charged off during the year.

LAW. Section 214.

3

(a) [Individuals] That in computing net income there shall be allowed as deductions: . . .

(7) Debts ascertained to be worthless and charged off within the taxable year;

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

Only Bona Fide Debts Deductible

If an item claimed as a bad debt partakes of the nature of a gift more than of that of a loan, or if, arising during a pe

'See page 625, footnote I.

It will be recalled that individual losses incurred outside an individual's trade or business were during 1916 and 1917, deductible only to the extent of the profits from similar undertakings. Under the 1913 law the Treasury held that they were not deductible at all. (See page 664, footnote.)

'The language of this section remained unchanged in the 1913, 1916 and 1917 laws, viz., "debts due to the taxpayer actually ascertained to be worthless and charged off within the year." The change in the 1918 law is merely verbal.

riod when it could or should have been reported, it has not been included in the federal tax reports as gross income, it is not deductible as a bad debt.

Loans to friends or relatives.-A question in the Income Tax Primer reads as follows:

RULING. If, on account of friendship or relationship I advanced a certain sum to assist a needy friend or relative, and at the time such advance was made I had little or no reason to expect that the amount so advanced would ever be returned, may I now claim a deduction to cover such advance?

No. Such an advance, partaking, as it does, somewhat of the nature of a philanthropic donation or a goodwill offering, is not held to constitute a bona fide debt. (Income Tax Primer, 1918, question 94.)

Income corresponding to bad debt must have been reported in tax returns.—

REGULATION. Worthless debts arising from unpaid wages, salaries, rents and similar items of taxable income will not be allowed as a deduction unless the income such items represent has been included in the return of income for the year in which the deduction as a bad debt is sought to be made or in a previous year. . . . . (Art. 152.)

....

This regulation applies particularly to taxpayers who have rendered returns based on cash receipts and payments. It is well illustrated by the following quotation from the Income Tax Primer:

RULING. A professional man earned a fee in 1916. As he keeps no books, he reports his income for tax purposes on an actual receipt basis. As this fee has never been reported as income, can it be claimed as a deduction if collection can not be made?

No; never having been returned as income it can not be claimed as a deduction. (Income Tax Primer, 1918, question 96.)

It must be understood, however, that the rulings quoted do not debar one from claiming the deduction of an item as a bad debt, even though the corresponding income has not been reported, in case the account arose before the federal income tax laws were in force. The effective date for corpora

tions, under the excise tax law, is January 1, 1909, and for individuals, under the general income tax law, it is March 1, 1913. Debts existing and carried as good on these dates may be treated as allowable deductions if subsequently found to be uncollectible. The entire amount may be deducted in the returns of the year during which the debt was found to be bad.

Where no reserve for bad debts has been carried, or where it has been carried and disallowed, this arrangement works out equitably. If there is to be no distinction between capital profits or losses and income profits or losses, it is obvious that the only account to which such bad debt can be charged is the profit and loss account for the year when ascertained. Taxpayers therefore should be careful when dealing with a loss occurring after January 1, 1909, if a corporation, or after March 1, 1913, if an individual, to follow this procedure, taking credit for the loss in the return, although in the books the amount may be charged against a reserve for bad debts or against surplus.

Special Types of Bad Debts-How Valued

Bankruptcy claim-Extent to which deductible.—

REGULATION.

Only the difference between the amount received in distribution of the assets of a bankrupt and the amount of the claim may be deducted as a bad debt.

Claims against decedent's estate-Extent to which deductible.

The difference between the amount received by a creditor of a decedent in distribution of the assets of the decedent's estate and the amount of his claim may be considered a worthless debt.

Accounts receivable purchased-Basis for deduction.A purchaser of accounts receivable which can not be collected and are consequently charged off the books as bad debts is entitled to deduct them, the amount of deduction to be based upon the price he paid for them and not upon their face value. (Art. 152.)

Notes receivable-Basis for deduction.—

REGULATION. . . If a taxpayer computes his income upon the basis of valuing his notes or accounts receivable at their fair market value when received, which may be less than their face value, the amount deductible for bad debts in any case is limited to such original valuation. (Art. 151.)

The entry of notes at less than their face value is equivalent to the creation of a reserve for bad debts.

Worthless bonds-Extent to which deductible.-As a bond is an obligation to pay money any failure to pay constitutes a bad debt.

REGULATION. Where bonds purchased before March 1, 1913, depreciated in value between the date of purchase and that date, and were in a later year ascertained to be worthless and charged off, the owner is entitled to a deduction in that year equal to the value of the bonds on March 1, 1913. Bonds purchased since February 28, 1913, when ascertained to be worthless, may be treated as bad debts to the amount actually paid for them, but not exceeding their amortized value if purchased at a premium. Bonds of an insolvent corporation secured only by a mortgage from which on foreclosure nothing is realized for the bondholders are regarded as ascertained to be worthless not later than the year of the foreclosure sale, and no deduction for a bad debt is allowable in computing a bondholder's income for a subsequent year. (Art. 154.)

The restriction on the amount of loss to be deducted when premiums have been amortized is equitable. The taxpayer will have deducted from income the amortization instalments and if he were to exclude the items from the computation the deduction for the loss would be excessive.

Likewise if bonds purchased at a discount have been written up and are sold at less than book value the measure of the deductible loss is the difference between the book value and the price received and not the difference between cost and the amount received, because the amortization instalments will have been reported as income.

Debts held prior to March 1, 1913.-Basis for deduction.—