Thus, as of August 4, 1969, Neely had on hand accounts receivable totaling $125,137.41 ($137,661.13 less $39,625.79 plus $27,102.07).

Agway purchased all of Neely's accounts receivable except accounts having a face value of $37,422.45 (all of which had been turned over to its attorney or an agency for collection). The purchase price was determined in accordance with the formula set forth in the above-quoted portion of paragraph 15 of the Option To Purchase agreement,2 as follows:

1 The $27,102.07 paid by Agway represented accounts receivable generated from sales by Neely during the period from July 1, 1969, to Aug. 4, 1969.

On its return for the taxable year ended June 30, 1969, Neely claimed a deduction for an addition of $27,860.96 to its bad debt reserve, bringing its balance to $58,001.86 at the end of the taxable year. This addition consists of the aggregate face amount ($7,281.55) of the accounts receivable turned over to an attorney or agency for collection, plus the difference ($20,579.41) between the face amount ($63,164.72) of Neely's accounts receivable as of June 30, 1969, purchased by Agway (reduced by the service charges of $2,551.83) and the amount paid by Agway ($40,033.48) for those accounts.

As shown in the first table set forth above, the balance of Neely's bad debt reserve as of June 30, 1968, was $32,803.14. This amount plus the total face amount ($7,281.55) of the accounts receivable turned over to Neely's attorney or an agency

2 The accounts receivable total ($137,661.13) as of June 30, 1969, included service charges of $2,551.83. The amount paid by Agway was computed by first adjusting the face amount of the receivables by the service charges and then applying the appropriate percentage to the remaining balance.

for collection during the taxable year ended June 30, 1969, less the amount charged against the reserve in that year ($2,662.24) equals the face amount ($37,422.45) of the accounts receivable refused by Agway.

On July 29, 1969, all of Neely's directors and shareholders formally voted unanimously to sell the corporate assets and completely liquidate within 12 months. On August 4, 1969, Brooks, as treasurer and on behalf of Neely, executed and delivered to Agway a bill of sale covering Neely's tangible personal property. On August 11, 1969, Neely filed with the district director of internal revenue, Buffalo, N. Y., a Form 966 stating that Neely was being liquidated pursuant to section 337.

Petitioners have executed a Transferee Agreement (Form 2045) whereby they have assumed and agreed to pay the amounts of any Federal income taxes finally determined as due and payable by Neely for the taxable year ended June 30, 1969, to the extent of their liability in law or in equity as transferees of Neely's assets.

Respondent determined that the deduction claimed by Neely for bad debts for its taxable year ended June 30, 1969, was unreasonable and excessive in the amount of $20,579.41 and is not allowable to that extent as a deduction under section 166.

OPINION

Section 166(a) permits the deduction of debts which become wholly worthless during the taxable year and, in stated circumstances, debts recoverable only in part, to the extent they are charged off during the taxable year. However, section 166(c) 3 provides that "in the discretion of the Secretary or his delegate" there shall be allowed "a deduction for a reasonable addition to a reserve for bad debts." This provision permits a taxpayer to obtain the benefit of a deduction for his estimated bad debt losses in advance of actual worthlessness. Bird Management, Inc., 48 T.C. 586, 594 (1967).

Under the reserve method provided by section 166(c), the taxpayer includes in his income the full face amount of a receivable on its creation. He then makes "a reasonable addition" to his

SEC. 166. BAD DEBTS.

(c) RESERVE FOR BAD DEBTS.-In lieu of any deduction under subsection (a), there shall be allowed (in the discretion of the Secretary or his delegate) a deduction for a reasonable addition to a reserve for bad debts.

reserve for bad debts. This addition reflects an estimate of the losses which can reasonably be expected to result from the worthlessness of debts outstanding at the close of the taxable year. Any additions necessary to replenish the reserve are deductible. When an account receivable becomes worthless during a later year, the reserve account is decreased by the amount of that debt, and no additional deduction therefor is allowed. Nash v. United States, 398 U.S. 1, 4-5 (1970); J. E. Hawes Corp., 44 T.C. 705, 707 (1965).

What constitutes "a reasonable addition" to a reserve for bad debts must be determined at the close of the taxable year of the proposed addition. The reasonableness of the addition depends upon whether the balance in the reserve at the end of the taxable year is sufficient to cover the expected worthlessness of outstanding debts. If the balance in the reserve is sufficient for that purpose, no deduction for an addition to the reserve is allowable for the taxable year. Roanoke Vending Exchange, Inc., 40 T.C. 735, 740 (1963); Platt Trailer Co., 23 T.C. 1065, 1070 (1955). The determination must be made in the light of all relevant facts, including the nature of the business, past experience of the taxpayer, conditions of business prosperity, the total amount of debts outstanding at the close of the taxable year, and the total amount of the existing reserve. Sec. 1.166-4(b), Income Tax Regs.; Lenamon v. Commissioner, 296 F.2d 844, 846 (C.A. 5, 1961), affirming a Memorandum Opinion of this Court.

As the text of section 166(c) declares, the Commissioner, as a delegate of the Secretary, is vested with a discretion in determining the reasonableness of additions to a bad debt reserve. Where a taxpayer challenges the Commissioner's determination, he has the heavy burden of showing an abuse of that discretion. Dixie Furniture Co. v. Commissioner, 390 F.2d 139, 141 (C.A. 8, 1968); Consolidated-Hammer Dry Plate & Film Co. v. Commissioner, 317 F.2d 829, 834 (C.A. 7, 1963), affirming on this issue a Memorandum Opinion of this Court. Petitioners' evidence must be weighed accordingly.

In support of the claimed deduction, petitioners emphasize section 1.166-4(b)(2), Income Tax Regs., which provides for errors in prior estimates of bad debt losses as follows:

In the event that subsequent realizations upon outstanding debts prove to be more or less than estimated at the time of the creation of the existing reserve,

the amount of the excess or inadequacy in the existing reserve shall be reflected in the determination of the reasonable addition necessary in the current taxable year.

Petitioners argue that Neely had for years followed a liberal credit policy without carefully examining its accumulation of accounts receivable. They maintain that they were not aware of the infirmities in Neely's accounts receivable until they classified them according to age on Sunday, June 22, 1969. As a result of this discovery, Neely updated its records, "the mechanical vehicle therefor being the inclusion within the current year's bad debt charge of an additional amount representing the difference between the face amounts of certain accounts receivable sold to Agway and the lower amount agreed upon as a realistic present value." In sum, petitioners argue that the additional amount deducted was necessary to correct errors in prior estimates of bad debt losses.

We recognize, as do petitioners, the import of section 1.166-4(b)(2), Income Tax Regs. However, that regulation does no more than pose the factual issue to be resolved: whether the balance in Neely's bad debt reserve was inadequate due to prior errors, so as to justify the $20,579.41 portion of the addition for the taxable year ended June 30, 1969. This sum was the amount of the discount allowed Agway on the sale of the receivables.

We do not think that petitioners have satisfied their burden of proving the inadequacy of the bad debt reserve for the taxable year ended June 30, 1969. At the outset, petitioners err, as a matter of law, in assuming that the discount to be given Agway on the disposition of Neely's accounts receivable justified an addition to the bad debt reserve. We have consistently held that losses stemming from the sale of receivables at a discount are not bad debt losses. Their proper tax treatment depends upon specific provisions of the Code which describe the character, extent, and limitations on the deductibility of such losses. John T. Dodson, 52 T.C. 544, 559-560 (1969); Bird Management, Inc., 48 T.C. at 597; J. E. Hawes Corp., 44 T.C. at 708-709.

It is only logical that a taxpayer cannot justify an addition to the bad debt reserve which merely anticipates such a loss. Deductions for additions to a bad debt reserve are intended ultimately to reflect only the amounts actually lost from worthless debts. A discount on the sale of receivables, on the other hand, may reflect a variety of factors, e.g., loss of use of the funds

pending collection of the accounts, the cost and inconvenience of making collections, possible losses attributable to change of ownership of the business, the problem of taking over disputes with dissatisfied customers, and the like. Thus, unless the taxpayer can show that the claimed deduction represents something other than mere anticipation of the loss which he would suffer on the sale of the receivables, his petition must fail.

As we view the evidence, there is no factual basis for equating the discount allowed Agway with anticipated bad debt losses on the accounts receivable. Prior to the year here in controversy, Neely had deducted as an addition to its bad debt reserve a sum equal to the amount of the accounts referred to an attorney or agency for collection. Had Neely, at the end of the taxable year June 30, 1969, the year in controversy, added to the reserve only the amount of the accounts referred during that year to an attorney or agency for collection ($7,281.55), the reserve still would have stood at a figure higher than at the end of any of the 5 preceding years ($37,422.45). The past experience of the taxpayer indicates that the reserve measured in this manner was adequate, and the evidence does not show any real change in business conditions in 1969 adversely affecting the collectibility of Neely's accounts.

The record does not support petitioners' contention that the study conducted on June 22, 1969, resulted in a more realistic estimate of the anticipated worthlessness of Neely's accounts receivable. The formula utilized in the study was conceived by the representatives of Agway who had neither access to the accounts receivable nor prior experience with Neely's accounts. The study was conducted by petitioners with the use of this formula in order to see the effect it would have on the value of the accounts, i.e., to determine the desirability of executing the option agreement. Petitioners did not attempt to apply their own experience in the aging process. Rather, the formula presented by Agway was strictly and mechanically applied. In view of the nature of the Agway formula, the discount simply did not reflect the expected worthlessness of Neely's outstanding accounts receivable.

4 On direct examination by counsel, Brooks described the purpose of the June 22, 1969, "inquiry" as follows: "To find what this formula that Agway was proposing to buy it on, what it was going to do to us. Could we afford to sign the option, or should we stay in business and collect them ourselves."