ductions 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."

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, secţion 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

10Italics are the author's.

"Reg. 33, January 4, 1914, Art. 126.

See page 258, footnote 17.

Reg. 45, Art. 141. (See page 654.)

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.

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.

Until the Treasury permits the deduction of bad debts reserves the returns will not reflect good accounting practice.

PRACTICE IN GREAT BRITAIN.-The English income tax law allows a deduction for bad debts "actually incurred." The interpretation under the British act is in line with sound accounting.

Schedule D of the Income Tax (Consolidated) Act, 1918, (Great Britain), provides that:

3. In computing the amount of the profits or gains to be charged, no sum shall be deducted in respect of . . . .

(i) any debts, except bad debts proved to be such to the satisfaction of the commissioners and doubtful debts to the extent that they are respectively estimated to be bad. In the case of the bankruptcy or insolvency of a debtor, the amount which may reasonably be expected to be received on any such debt shall be deemed to be the value thereof: In effect the British law leaves the provision for bad debts to the honesty of the taxpayer.

SUPREME COURT DECISIONS.-The Supreme Court of the United States in construing the federal income tax law of 1864 (amended in 1867), decided that in ascertaining profits a company was "entitled to deduct from the earnings items of loss and depreciation on book accounts and other choses in action." [Little Miami, Columbus & Xenia R. R. Co. v. U. S., 108 U. S. 277 (1883).]

The wording of the act of March 2, 1867, is as follows:

losses actually sustained during the year arising from fires, shipwreck, or incurred in trade and debts ascertained to be worthless, but excluding all estimated depreciations of values and losses within the year on sales of real estate . . .

The word "depreciation" seems to cover fully the setting up of a reserve for bad debts, as that is precisely the object for which such a reserve is created, i.e., to reflect on the books the depreciation known to exist in the value of the accounts receivable as a whole.

Another decision of the Supreme Court is in accord with the one quoted above.

DECISION. In United States v. Frost, 9 Int. Rev. 31 (1869), it was held that promissory notes, book accounts, etc., due during the year, are the evidences of debts. Whether or not they are gains, profits or income for that year, within the meaning of the internal revenue law, depends upon their value intrinsically or their convertibility into money, property or available assets. If they have only a nominal, and not a real value or convertible quality, and a man has realized nothing from them, and, therefore, does not return them as a part of his income, because he fairly and honestly believes they are not real gains or profits, he cannot be convicted of an untrue

return.