Petitioners were members of a partnership that reported its
income on the accrual method and used the reserve method of
accounting for bad debts provided in § 166(c) of the Internal
Revenue Code, permitting a taxpayer to take a current deduction for
the amount of accounts receivable that it is estimated will become
worthless in later years. Petitioners formed corporations and
transferred partnership assets, including the net worth of the
accounts receivable (the face value less the amount of the
reserve), to the corporations in exchange for the corporations'
stock. The transfer was within the terms of § 351 of the Code,
which provides that no gain or loss shall be recognized if property
is transferred to a corporation in exchange for stock, if after the
exchange the transferors are in control of the corporation. The
Commissioner of Internal Revenue determined that the partnership
should have included in income the amount of the bad debt reserve
because the partnership no longer needed the reserve account.
Petitioners paid the deficiencies assessed and sued for refunds.
The District Court allowed recovery, but the Court of Appeals
The so-called tax benefit rule, that recovery of
an item that has produced an income tax benefit in a prior year is
to be added to income in the year of recovery, is not applicable
here, as the partnership, although its business
Page 398 U. S. 2
terminated and it had no "need" for the reserve, received no
gain as a result of the transaction, and there was thus no
"recovery" of the benefit of the bad debt reserve. Pp. 398 U. S. 3
414 F.2d 627, reversed.
MR. JUSTICE DOUGLAS delivered the opinion of the Court.
Petitioners were partners operating eight finance offices in
Alabama. The partnership reported its income on the accrual method
of accounting, and, instead of deducting bad debts within the
taxable year, as permitted by § 166(a) of the Internal Revenue Code
of 1954, it used the reserve method of accounting as permitted by §
166(C). Under the reserve method of accounting, a taxpayer includes
in his income the full face amount of a receivable on its creation
and adjusts at the end of each taxable year the reserve account so
that it equals that portion of current accounts receivable that is
estimated to become worthless in subsequent years. Any additions
necessary to increase the reserve are currently deductible. When an
account receivable becomes worthless during the year, the reserve
account is decreased and no additional bad debt deduction is
allowed. As of May 31, 1960, the partnership books showed accounts
receivable of $486,853.69 and a reserve for bad debts of
On June 1, 1960, petitioners formed eight new corporations and
transferred the assets of the eight partnership
Page 398 U. S. 3
offices, including the accounts receivable, to the corporations
in exchange for shares of the corporations -- a transfer that
concededly provided no gain or loss under § 351 of the Code.
The Commissioner determined that the partnership should have
included in income the amount of the bad debt reserve ($73,028.05)
applicable to the accounts receivable that had been transferred.
Tax deficiencies were computed; and petitioners, having paid them,
brought this suit for refunds. The District Court allowed recovery,
and the Court of Appeals reversed, 414 F.2d 627. We granted the
petition for certiorari to resolve the conflict between the Fifth
and the Ninth Circuits [Footnote
] on this question of law. 396 U.S. 1000. We share the view of
the Ninth Circuit, and reverse the present judgment.
There is no provision of the Code that deals precisely with this
question. But the Commissioner's basic premise [Footnote 2
] rests on the so-called tax benefit
that a recovery of an item that has produced
an income tax benefit in a prior year is to be added to income in
the year of recovery. [Footnote
] The Commissioner argues that that rule, applicable here,
means that unused amounts in a bad debt reserve must be restored to
income when the reserve is found to be no longer necessary, as it
was here, when the partnership's "need" for the reserve ended with
the termination of its business. Congress could make the end of
"need" synonymous with "recovery" in the meaning of the tax benefit
rule, and make
Page 398 U. S. 4
the rule read:
"[A] bad debt reserve that has produced an income tax benefit in
a prior year is to be added to income in the year when it was
recovered or when its need is ended."
The semantics would then be honored by the Commissioner's
ruling. But we do not feel free to state the tax benefit rule in
those terms in the present context. We deal with § 351(a) of the
Code which provides:
"No gain or loss shall be recognized if property is transferred
to a corporation by one or more persons solely in exchange for
stock or securities in such corporation and immediately after the
exchange such person or persons are in control . . . of the
All that petitioners received from the corporations were
securities equal in value to the net worth of the accounts
transferred, that is the face value less the amount of the reserve
for bad debts. If, as conceded, there is no "gain" or "loss"
recognized as a result of the transaction, it seems anomalous to
treat the bad debt reserve as "income" to the transferor. [Footnote 4
Deduction of the reserve from the face amount of the receivables
transferred conforms to the reality of the transaction, as the risk
of noncollection was on the transferee. Since the reserve for
purposes of this case was deemed to be reasonable and the value of
the stock received upon the transfer was equal to the net
of the receivables, there does not seem to us to have
been any "recovery." A tax benefit was received by the
Page 398 U. S. 5
partnership when the bad debt reserve was originally taken as a
deduction from income. There would be a double benefit to the
partnership if securities were issued covering the face amount of
the receivables. We do not, however, understand how there can be a
"recovery" of the benefit of the bad debt reserve when the
receivables are transferred less the reserve. [Footnote 5
] That merely perpetuates the status
and does not tinker with it for any double benefit out of
the bad debt reserve.
For these reasons, the Court of Appeals in the Schmidt
case [Footnote 6
] held that,
although the "need" for the reserve ended with the transfer, the
end of that need did not mark a "recovery" within the meaning of
the tax benefit cases, 355 F.2d at 113. We agree, and accordingly
reverse the judgment below.
MR. JUSTICE BLACK and MR. JUSTICE STEWART, dissenting.
We agree with the reasoning of Judge Tuttle's opinion for the
Court of Appeals in this case, 414 F.2d 627, and with Judge Raum's
opinion for the Tax Court in Schuster v. Commissioner,
T.C. 98. Accordingly, we would affirm the judgment.
Page 398 U. S. 6
Estate of Schmidt v. Commissioner,
355 F.2d 111.
Rev.Rul. 62-128, 1962-2 Cum.Bull. 139.
Section 111(a) of the 1954 Code provides:
"Gross income does not include income attributable to the
recovery during the taxable year of a bad debt, prior tax, or
delinquency amount, to the extent of the amount of the recovery
exclusion with respect to such debt, tax, or amount."
As stated in Geyer, Cornell & Newell, Inc. v.
6 T.C. 96, 100:
"A reserve consists of entries upon books of account. It is
neither an asset nor a liability. It has no existence except upon
the books, and, unlike an asset or a liability, it cannot be
transferred to any other entity."
"[T]he infirmities in the accounts receivable which justify the
bad debt reserve carry over to those accounts in the hands of the
corporation. Presumably the amount that will ultimately be
collected by the corporation will not be the gross amount of the
receivables, but rather the net amount after deducting the bad debt
reserve. Thus, the stock received in exchange for such accounts
receivable can only be worth what the receivables themselves are
worth, namely, the net collectable amount, rather than the gross
Arent, Reallocation of Income and Expenses in Connection with
Formation and Liquidation of Corporations, 40 Taxes 995, 998