Legal ruling 417

Retroactive Changes to Bad-Debt reserve for Savings and Loan Associations

Facts

Advice has been requested in two cases where savings and loan associations have attempted to modify in a later year the bad-debt reserve claimed on a return for an earlier year:

1. The first case involves an association that seeks to increase the bad-debt deduction to an amount greater than the addition it made to the reserve for bad debts on the savings and loan's books for that year;
   
   
2. The second case involves an association that seeks to increase the bad-debt deduction to an amount equal to or less than the addition it made to the reserve for bad debts on the savings and loan's books for that year.

In neither case have there been any assessments of additional tax for the year involved or a change of the taxpayer's bad debt loss ratio.

Questions

1. May a savings and loan association retroactively increase the amount of its bad-debt deduction, after the date prescribed for filing the return has expired, to an amount greater than the addition it made to the reserve for bad debts on the savings and loan's books for that year?
   
   
2. May a savings and loan association retroactively increase the amount of its bad-debt deduction, after the date prescribed for filing the return has expired, to an amount equal to or less than the addition it made to the reserve for bad debts on the savings and loan's books for that year?

Decisions

1. No.
2. Yes.

Discussion

Regulation 24348(b) allows a savings and loan association to deduct each year a reasonable addition to its reserve for bad debts. The purpose of the reserve is to allow the taxpayer to exclude from gross income loans which foreseeably will not be repaid. The taxpayer is initially given the privilege to determine the amount of the yearly addition. That determination should be made at or near the close of the income year, based upon facts existing at that time. The best evidence of the taxpayer's determination generally will be the amount shown on its books, reflecting actual loss experience. A determination fairly made at the close of the year may not be enlarged or diminished at a later date, for then the reserve would cease to be a true reserve and the taxpayer, contrary to the spirit of the statute, would be permitted to deduct worthless debts in a year other than that in which their worthlessness would be realized. Therefore, when considering retroactive increases to additions to bad-debt reserves on returns, the amount of increase allowed is limited to the amount of addition already entered on the savings and loan association's books, provided the increase is otherwise allowable by the Bank and Corporation Tax Law and the regulations promulgated thereunder and within the period of the statute of limitations.

Question #1 requires an adjustment to the self-determined addition entered on the association's books. Therefore, an increase on the return is not allowable as it would not reflect the experiential loss on the association's books. Farmville Oil & Fertilizer Co. v. Commissioner, 78 Fed.2d 83, 85 (4th Cir. 1935); Rogan v. Commercial Discount Co., Fed.2d 585 (9th Cir. 1945), cert, den. 326 U.S. 764 (1945).

Question #2 requires no adjustment to the association's books. As long as there is no retroactive adjustment to the association's addition for bad-debt reserve on its books the bad-debt deduction claimed on the return may be amended provided it is within the period of statute of limitations for such amendments and otherwise allowable by our laws and regulations. Appeal of Culver Federal Savings and Loan Association, Cal. St. Bd. of Equal., February 14, 1966, CCH 203-256, P-H 13,383.

This opinion is not meant to apply for a year in which additional assessments have been proposed or for any year not barred by the statute of limitations where the association's loan loss ratio is revised by this department.

Given a hypothetical of:

Example	1977	1978
Bad-Debt Deduction Claimed on Books	$76,000	$10,000
Bad-Debt Deduction Claimed Original State Return	-0-	-0-
Bad-Debt Deduction Claimed Amended State Return(within the period of statute of limitations)	76,000	33,000

In applying these legal rules to this hypothetical situation, the retroactive deduction of the previously determined addition to the bad-debt reserve made in 1977 for $10,000 and in 1978 for $76,000 may be allowed, as long as this is done within the statute of limitations and otherwise allowable by the Bank and Corporation Tax Law and the regulations promulgated thereunder (particularly Reg. 24348(b) ). However, the subsequently desired reasonable reserve addition of an additional $23,000 for 1977 cannot be allowed as this would constitute a retroactive increase to the determination on the books, which is not allowed.