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matter was taken up by the national office which, through its Washington representative, has obtained a ruling as follows:

"If in any or all of the forms of settlement described-1. Where the creditor corporation individually effects a compromise settlement with a debtor; 2. where the judgment creditor is one of a class in a general settlement with an insolvent debtor accepting a certain percentage of his claim; 3. where compositions and compromises are effected by means of bankruptcy or other court proceedings, where the proceedings discharge the debtor from any further liability and the definite amount fixed has been paid, the creditor corporation accepts the amount paid him in pursuance of settlement as full payment of his claim so that no further liability exists on the part of the debtor to the creditor and the excess of the claim over the amount paid is charged off as a loss, it will be permissible for the creditor corporation to deduct from its gross income of the year in which the settlement is made, the amount of the loss thus ascertained and charged

off.

Compromises.—The preceding paragraph mentions certain compromises under which it is possible to deduct as a bad debt the excess of the claim over the amount paid. This type of compromise, where there is no disagreement concerning the validity of the charge, is to be distinguished from the compromises mentioned in the following article taken from the old regulations.

REGULATION. Where an indebtedness is claimed and contested and a settlement is had by way of compromise whereby an amount, less than the debt claimed, is accepted in full payment and satisfaction of the debt, the difference between the amount paid and that claimed is not allowable as a deduction for bad debts. Where the settlement in compromise consists of a promise to pay an amount less than the debt claimed, the amount promised to be paid forms the basis of a new transaction, and upon failure to make good this promise the question will arise as to the deductibility of the new amount only. (Reg. 33, 1918, Art. 8.)

The foregoing ruling can apply only to compromises in which the amount claimed was in excess of the amount carried on the books as an asset. Of course, if the claim were merely for the amount carried on the books any settlement for a smaller amount would justify the entry of the uncollected balance as a bad debt.

Recoveries.- In some cases debts presumably "definitely ascertained to be worthless” have unexpectedly proved to be collectible in whole or in part. The following regulation provides for the taxation of such collections.

REGULATION. . . . . Bad debts or accounts charged off because of the fact that they were determined to be worthless, which are subsequently recovered, whether or not by suit, constitute income for the year in which recovered, regardless of the date when the amounts were charged off. .. .. (Art. 52.)

• An exception to this rule would arise if a collection were made of a debt charged off prior to March 1, 1913, which as of that date could be considered good. If so, it would not be taxable as income when subsequently collected.

Loss of endorser or guarantor—When determined.—Upon the failure of the maker of a note to take it up at maturity, the endorser may have to pay and thereupon a debt due to the endorser arises. Strictly speaking, it may not be "ascertained to be worthless” immediately, but everyone knows that ordinarily the chances are at least 99 to i that it will be a bad debt and usually it takes very little time to reach this conclusion. After allowing a reasonable time in which to ascertain why the maker does not make good, the endorser should charge it off as a bad debt, taking credit for it in his return.

The right to deduct the bad debt is governed by the regulations cited. There is no requirement that the obligation to pay a note as endorser or guarantor shall have arisen from business or trade, so that the restrictions of past years as to losses would not apply in any case.

Debts Must Be Charged Off Within the Year Charging off bad debts.—The 1918 law requires in the case of individuals and corporations that bad debts must be charged off within the taxable year. These words would seem to require that actual book entries be made by both corporations and individuals in case they desire to claim deductions for bad debts. However, the answer to question 90 of the Income Tax Primer interpreting the 1917 law which used the same phrase in describing the conditions which are necessary to claim a debt as a deduction reads: "If books are kept it must be charged off within the year," plainly inferring that it is still deductible when no books at all are kept.

"Within the year.”—The phrase "within the year” refers to "the year for which the return is made." To be deductible the debts must not have been "recognized as worthless or without value prior to the beginning of the year for which the return is made."9

In the case of corporations, deductions for bad debts prior to the 1918 law were classified as business losses and these, it will be recalled, had to be “actually sustained and charged off within the year." [1917 law, section 12 (a) second.]

The term "within the taxable year” should be construed in an accounting sense, that is, if books of account are closed as of December 31 and an entry written in the books during January is dated December 31, the entry is deemed to have been made within the year ended December 31.

Reserves for bad debts not deductible.—Under the previous rulings of the Treasury, amounts credited to a reserve fund for bad debts are not deductible. There is no specific ruling on reserves for bad debts in Regulations 45, but the language of the law is unchanged and in the absence of a specific ruling the following regulation represents the official interpretation.

REGULATION. The reserves contemplated by the foregoing ruling are those reserves only which are set up to meet some actual liability incurred, the amount necessary to discharge which cannot at the time be definitely determined, and do not contemplate reserves to meet losses contingent upon shrinkage in values, losses from bad debts, capital investments, etc., which losses are deductible only when

'Reg. 33, 1918, Art. 151.
'Reg. 45, Art. 151, see page 674.

definitely determined as the result of a closed or completed transaction, and are charged off. (T. D. 2433, January 8, 1917.) 10

The fact that in the case of individuals the law deals with bad debts in a special provision which uses the word "worthless" has doubtless influenced the Treasury in making this narrow decision. It first took this position under the 1913 law." But the 1916 law explicitly provided for the acceptance of returns on the accrual basis, subject only to the approval of the Commissioner of Internal Revenue. 12 This basis was immediately recognized in the regulations, but subject to the limitations quoted above. Had bad debts been included under subsection fourth of the 1916 law, “losses actually sustained," the more liberal interpretation given to losses would probably have extended to bad debts.13 However, even then, it is believed that the Treasury's interpretation of the word "worthless” is not in accord with common usage, and, if this is so, it will not ultimately stand. The judgment of a business man or credit man as to when a debt is worthless is the final test.

Great disappointment was felt at this decision, as in many cases the only difference between the net profit shown on the books of account and the income tax returns has been the item of bad debts, and it was expected that the Treasury, having full power to permit the deduction of the reserve for bad debts, would grant the allowance. While in a new business it would for one year make some difference, the difference would not be great enough to justify the government in following the course it has adopted. The law purports to tax net income only. Without an allowance for accrued bad debt losses, based on actual experience and at an amount fixed in good faith, accounts cannot be properly stated.

As most persons and most corporations are honest, it is proper to permit as an allowable deduction accrued losses as well as those finally ascertained to be worthless and charged off within the year. Every individual or corporation keeping books properly sets up a reserve to meet the losses which have not fully 'materialized but, judging by experience, will surely occur. Bad debts account is debited and reserve for bad debts account is credited. All accounts which are to be charged off are debited to reserve for bad debts account. Where such a reserve account is not kept, accounts when charged off are usually debited direct to bad debts account or to profit and loss account.

'Italics are the author's. "Reg. 33, January 4, 1914, Art. 126. "See page 258, footnote 17. 1Reg. 45, Art. 141. (See page 654.)

The failure to set up reserves is opposed to sound accounting. If a proper reserve for doubtful accounts is not reflected in a balance sheet, in some states the person who signs such a statement will be subject to severe penalties, including imprisonment, for obtaining credit upon a false financial statement. These laws are the result of many years of effort on the part of lawyers, credit men, business men and bankers. United States district attorneys who prosecute fraudulent bankruptcy cases have been particularly interested in securing legislation of this character.

Under the Treasury regulations the income tax returns must ignore the net results shown in the books. That is, one is to claim as deductions only debts charged off within the year and omit the amount set up as a reserve for debts not yet charged off.

To comply with existing regulations, taxpayers should be careful to include in their 1919 returns all accounts charged off as bad during the year, whether debited in the books to reserve accounts, to bad. debts account or to profit and loss account.

In the opinion of the author the Commissioner has the same authority now to permit a deduction for "accrued” bad debts, as he had in former years. The '1918 law permits accounts to be kept in a manner which reflects good accounting practice, but the phrase "ascertained to be worthless and charged off within the taxable year” still remains in the law.

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