ANSWER: Yes, to both questions. REFERENCE: Sec. 214 (a) (4) (Quoted under Problem 103) PROBLEM 119 Illustrating Manner in Which Deductions from Gross Income May Be Taken on Account of Bad Debts FACTS: The Leather Goods Specialties Corporation manufactured leather novelties to be used for advertising purposes. Its sales were usually in small amounts and were made on a credit basis to customers throughout the United States. The percentage of gross profit on sales was very large. However, as many of the customers of the company were small tradesmen and to a large extent, new in business, bad debts were rather frequent and heavy. The company in fixing the sales price of its product took into consideration the fact that its percentage of bad debts was large. The records of the company for the last ten years showed that the bad debts per annum ranged from 5% of the gross sales to 10% of the gross sales and that the total bad debts for this period represented 6% of the total gross sales. The company files its return for 1921 on the calendar-year basis. The analysis of its Reserve for Bad Debts Account for the year shows the following: Jan. 1, 1921, Reserve for Bad Debts, credit ... $146,000 Credit to Reserve for Bad Debts and charge Charge to Reserve for Bad Debts and credit 65,000 $211,000 to accounts receivable (for details see Balance 95,000 $116,000 An analysis of the accounts written off by a charge against Reserve for Bad Debts shows that $35,000 was written off on account of debts ascertained in 1921 to be wholly worthless and that $60,000 was written off Accounts Receivable on account of debts ascertained in 1921 to be only partly worthless. Of this total of $95,000 ascertained in 1921 to be worthless, $70,000 consisted of debts (or portions of debts) outstanding December 31, 1920. QUESTION: What amount may be taken as a deduction from gross income for the year 1921 on account of bad debts? ANSWER: The company may compute its deduction from gross income for tax purposes on account of bad debts on either one of the two following bases, namely: (1) on the basis of the debts ascertained to be worthless in whole or in part during 1921, or (2) on the basis of the addition to the Reserve for Bad Debts set up by it in 1921. Under (1) the deduction in 1921 would be (a) Debts found to be worthless in (b) Debts found to be worthless in Under (2) the deduction in 1921 would be: Credit to Reserve for Bad Debts in 1921 $95,000 $65,000 Total Debts outstanding December 31, 1920, which proved in 1921 to ..... 70,000 $135,000 Whichever method is elected by the taxpayer in 1921, will be required to be continued in later years, unless permission to change to the other method is granted by the Commissioner. If the first method above mentioned is adopted a statement should accompany the return showing the propriety of the deduction claimed. If the second method is adopted a statement should accompany the return showing the volume of the company's charge sales (or other business transactions) for the year and the percentage of the reserve to such amount, the total amount of notes and accounts receivable at the beginning and close of the taxable year, and the amount of the debts which have been ascertained to be wholly or partially worthless and charged against the reserve account during the taxable year. In connection with the debts charged against the reserve, the statement should show the date on which each of the debts was incurred. REFERENCES: Art. 151 Regulations 62: "Bad debts.-Bad debts may be treated in either of two ways-(1) by a deduction from income in respect of debts ascertained to be worthless in whole or in part, or (2) by a deduction from income of an addition to a reserve for bad debts. For the year 1921 taxpayers may, regardless of their previous practice, elect either of these two methods and will be required to continue the use in later years of the method so elected unless permission to change to the other method is granted by the Commissioner. "Where all the surrounding and attending circumstances indicate that a debt is worthless, either wholly or in part, the amount which is worthless and charged off or written down to a nominal amount on the books of the taxpayer shall be allowed as a deduction in computing net income. There should accompany the return a statement showing the propriety of any deduction claimed for bad debts. No deduction shall be allowed for the part of a debt ascertained to be worthless and charged off prior to January 1, 1921, unless and until the debt is ascertained to be totally worthless and is finally charged off or is charged down to a nominal amount, or the loss is determined in some other manner by a closed and completed transaction. Before a taxpayer may charge off and deduct a debt in part, he must ascertain and be able to demonstrate, with a reasonable degree of certainty, the amount thereof which is uncollectible. Any amount subsequently received on account of a bad debt or on account of a part of such debt previously charged off, and allowed as a deduction for income tax purposes, must be included in gross income for the taxable year in which received. In determining whether a debt is worthless in whole or in part the Commissioner will consider all pertinent evidence, including the value of the collateral, if any, in securing the debt and the financial condition of the debtor. Partial deductions will be allowed with respect to specific debts only. "Where the surrounding circumstances indicate that a debt is worthless and uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment, a showing of these facts will he sufficient evidence of the worthlessness of the debt for the purpose of deduction. Bankruptcy is generally an indication of the worthlessness of at least a part of an unsecured and unpreferred debt. Actual determination of worthlessness in bankruptcy cases is sometimes possible before and at other times only when a settlement in bankruptcy shall have been had. Where a taxpayer ascertained a debt to be worthless and charged it off in one year, the mere fact that bankruptcy proceedings instituted against the debtor are terminated in a later year, confirming the conclusion that the debt is worthless, will not authorize shifting the deduction to such later year. In the case of debts existing prior to March 1, 1913, only their value on that date may be deducted upon subsequently ascertaining them to be worthless. See article 51. If a taxpayer computes his income upon the basis of valuing his notes or accounts receivable at their fair market value when received, which may be less than their face value, the amount deductible for bad debts in any case is limited to such original valuation." Art. 155, Regulations 62: "Reserve for bad debts.-Taxpayers who have, prior to 1921, maintained reserve accounts for bad debts may deduct a reasonable addition to such reserves in lieu of a deduction for specific bad-debt items. Taxpayers who have not heretofore maintained such reserve accounts may now elect to do so, and in such case shall proceed to determine the amount of the reserve that should reasonably have been set up as at December 31, 1920 (which shall not be deducted in computing net income), and in respect of 1921 and subsequent years may add a reasonable addition to such reserve and deduct the amount in computing taxable net income. Where、 a reserve account is maintained, debts ascertained after December 31, 1920, to be worthless in whole or in part, (a) if such debts were outstanding at December 31, 1920, should be charged against the reserve and may be deducted from income, in accordance with article 151; (b) if such debts arose after December 31, 1920, should be charged against the reserve, and not deducted from income. What constitutes a reasonable addition to a reserve for bad debts must be determined in the light of the facts, and will vary as between classes of business and with conditions of business prosperity. A taxpayer using the reserve method should make a statement in his return showing the volume of his charge sales (or other business transactions) for the year and the percentage of the reserve to such amount, the total amount of notes and accounts receivable at the beginning and close of the taxable year, and the amount of the debts which have been ascertained to be wholly or partially worthless and charged against the reserve account during the taxable year." NOTE: The Revenue Act of 1921, is the first to recognize a deduction for bad debts on account of anticipated losses through the setting up of a reserve for bad debts. This recognition is in conformity with accounting and business practice. PROBLEM 120 Illustrating Capital Sum Which Forms Basis for Depreciation Deduction FACTS: Frank Van Horsen constructed an office building in 1908, at a cost of $540,000. Its estimated period of usefulness at the end of the time of construction was fifty years. The building was kept in exceptionally good repair and this fact, together with an appreciation in values, enabled Mr. Van Horsen to satisfy the Commissioner that the fair market value of the building on March 1, 1913, was $600,000. Mr. Van Horsen owned this building during the entire calendar year 1921. QUESTION: What was the basis for computation of the depreciation suffered during 1921? ANSWER: Since the property was acquired prior to March 1, 1913, its value on that date is the capital sum to be depreciated. The |