*854 Petitioner bank having failed to charge off partially worthless debts, held, not to be entitled to bad debt deduction under Regulations 101, article 23(k)-1(c), which substitutes directions of bank examiners for ascertainment of worthlessness but does not change charge-off requirement.
*526 Respondent determined deficiencies for 1938 of $2,399.58 and $395.15 in income and excess profits tax, respectively, which petitioner hereby challenges.
*527 Other issues having been conceded by petitioner, the only question here presented is whether it is entitled to a deduction, under Revenue Act of 1938, section 23(k), as a partially worthless debt, in the amount of a write-down made under the direction of an examiner for the Federal Deposit Insurance Corporation.
FINDINGS OF FACT.
Petitioner is a banking corporation, organized and existing under the laws of the State of Kentucky, with its principal place of business at Dawson Springs, Kentucky. It filed its return for the year in question with the collector*855 of internal revenue for the district of Kentucky.
Examiners for the Federal Deposit Insurance Corporation made a report of their examination of petitioner as of November 28, 1938, which report was submitted to petitioner's directors by letter dated December 19, 1938, for consideration at its next monthly meeting.
The report disclosed defaulted securities as follows:
| Defaulted securities | Par value | Book value less valuation allowances | Appraised value | 1 Increase (Decrease) |
| American Utilities Service Corporation voting trustee certificate | $2,000.00 | $100.00 | $40.00 | ($60.00) |
| Received for $2M in bonds of Federal Public Co | ||||
| Alleghany Corporation | 30,000.00 | 10,918.77 | 10,950.00 | 31.23 |
| Chicago Great Western R.R. Co | 5,000.00 | 1,000.00 | 962.25 | (37.75) |
| Chicago, Milwaukee, St. Paul & Pacific Railway Co | 30,000.00 | 1,237.50 | 862.50 | (375.00) |
| Chicago, Rock Island & Pacific Railway Co | 4,000.00 | 220.00 | 120.00 | (100.00) |
| Denver & Rio Grande Railway Co | 9,000.00 | 1,192.50 | 1,080.00 | (112.50) |
| Hudson & Manhattan Railway Co | 9,000.00 | 2,922.62 | 1,080.00 | (1,842.62) |
| International Great Northern Railway Co | 5,000.00 | 1,043.75 | 1,050.00 | 6.25 |
| Missouri Pacific Railway Co. certificate of deposit | 7,000.00 | 1,452.50 | 1,190.00 | (262.50) |
| Missouri Pacific Railway Co. certificate of deposit | 2,000.00 | 420.00 | 342.50 | (77.50) |
| Missouri Pacific Railway Co. certificate of deposit | 1,000.00 | 106.30 | 172.50 | 66.20 |
| Republic of Peru | 3,000.00 | 330.00 | 296.25 | (33.75) |
| Pittsburgh Hotel Corporation. certificate of deposit | 5,000.00 | 1,000.00 | 800.00 | (200.00) |
| City of Dawson Springs, Ky., street improvement bonds | 33,218.57 | 33,218.57 | 23,374.85 | (9,843.72) |
| 145,218.57 | 55,162.51 | 42,320.85 | (12,841.66) |
With respect to the Dawson Springs bonds the report stated:
* * * Attention is particularly directed to the bottom of page 6-e where the City of Dawson Springs Street Improvement Bonds are set out. The book value of these bonds is $33,218.57 of which $9,843.72 is accorded Classification III. [2] It is admitted that there will probably be a loss in these assets but as yet it is not determinable. It is recommended that a reserve be set up against this probable loss and that more adequate credit information be secured on this asset.
*528 The following comment appears after the listing of the Dawson Springs bonds in defaulted securities:
These bonds are the remainder of the outstanding of an issue of $71,218.57, issued in 1930, payable $7M a year*857 through 1938 and $8,218.57 in 1939. They are a direct lien against the property adjoining the improvements, and the bank is forced to bring suit against the property holders at the expiration of five years in default to force collection. Interest is current but the principal is in arrears $25M. The assessments were made in ten yearly payments and at this $73timeM of the principal should have been collected whereas only approximately $40M has been collected and $38M disbursed to the bondholders. The issue has been averaging about $25M in arrears since 1933 which at six per cent interest has added about $1,500 a year or $8M to the cost of the improvements. Management states that the remaining property is well improved and well worth the assessment against it, however, due to the manner of handling the issue any loss sustained in the issue would be in the latter [sic] maturities as the first maturities are being taken up as the money is available. Due to the uncertain nature of the asset, at this time, any appraised value is problematical and for this reason the difference between appraised value and book value is given Classification III. Adequate credit information should*858 be on file.
On page 6-c of the report $9,843.72 was put in classification III and $2,997.94 was put in classification IV. 3
The Federal Deposit Insurance Corporation examiner attended the meeting 4 of petitioner's board of directors and instructed petitioner "to write these bonds down." Thereafter petitioner credited to a reserve account the amount of the "write-down." This amount was not charged off on petitioner's books. The bonds were not taken out of the assets account of the bank and upon subsequent sale of any bond, its basis for gain or loss was computed on book value, and was not reduced by any portion of the reserve, which stood as a reserve against petitioner's bond account as a whole.
Petitioner does not use the reserve method*859 of charging off bad debts but charges them directly to the profit and loss account.
OPINION.
OPPER: Petitioner seeks approval of a deduction for the partial worthlessness of bonds found by an examiner of the Federal Deposit Insurance Corporation to be less valuable than the amounts at which they were carried on petitioner's books. Situations of this character *529 are the subject of a regulation. 5 To the extent that this provision has the effect of substituting the finding of regulatory authority for petitioner's own judgment in ascertaining the worthlessness of a debt, it may be argued that a sufficient showing has been made here. But cf. ; . Respondent contends that the regulation requires a direction to write down or charge off by the supervisory body and that in this case the examiner's report fails to go so far with respect to a portion of the securities which were criticized. But the evidence shows that the examiner orally directed the writedown and, in any event, for reasons about to be discussed, the contention need not be further considered. *860
Not only ascertainment but charge-off within the taxable period is required to justify a bad debt deduction. . And this is so whether the claim is made on the ground of complete or partial worthlessness. Revenue Act of 1938, sec. 23(k)(1). 6 The regulation does not purport to intrude upon this province of the statutory requirements, as in fact the unequivocal language of the legislation would forbid. That this is so seems to us to be evident from the care with which the regulation provides that the effect*861 of following the directions given to a bank by the examining agency shall be that "* * * such debts shall be conclusively presumed, for income tax purposes, to be worthless or recoverable only in part, * * *" and by a warning that nevertheless "* * * in order that any amount of the charge-off may be allowed as a deduction for any taxable year it must be shown that the charge-off took place within such taxable year." In other words, ascertainment and charge-off in the tax year are required for approval of bad debt deductions and all that the regulation supplies is a conclusive presumption as to ascertainment. Charge-off must still be shown.
*862 *530 In the present case the record on this question is meager and confused. But from the best interpretation we can put upon it it appears that petitioner used the specific charge-off method in dealing with worthless debts but that, notwithstanding, the particular items in controversy here were not dealt with by means of such a charge-off, but through the creation of a reserve in the approximate amount of the write-down proposed by the examiner. The testimony indicates that petitioner continued to use the specific charge-off method, that it never reduced the book value or basis of any of the items in question; that it apparently took or will take a deduction for the worthlessness of specific securities to their full extent upon disposition; and that the reserve will not subsequently be affected in any way, since it will continue to be carried as a general reserve for petitioner's entire bond account.
If there was more to the story than this, the burden was upon petitioner to show it. If that is all, it not only fails to demonstrate a charge-off of these items, but in fact indicates the contrary. It did not "effectually eliminate the amount of the bad debt from the*863 book assets of the taxpayer." . There is no authorization for a taxpayer to use at the same time a charge-off and a reserve method for the deduction of bad debts. ; ; . A taxpayer on the charge-off system can only comply with the statute by specific charge-off; and a reserve can not exist in such a system as an over-all general treatment disregarding specific items, even if properly created in the first instance. . These rules apply as much to banks as to any other taxpayer. . It follows that petitioner did not charge off these items, as it was required to do, and the deduction must be disallowed.
Such a result will not ultimately disadvantage petitioner. Not only may a partially worthless debt later be written off in its entirety when conclusive worthlessness or other disposition creates the*864 occasion, , but in fact it would appear that under petitioner's consistent method this very action did or will occur when it applies its specific charge-off to these items. On the contrary, to permit the claimed deduction now could only result in a duplication of benefits and the ultimate distortion of petitioner's taxable income.
Decision will be entered for the respondent.
Footnotes
1. This column did not appear in the report. ↩
2. Described as: "Book assets, or portions thereof, the ultimate collection of which is doubtful and in which a substantial loss is probable but not yet definitely ascertainable in amount." The instruction was: "Assets so classified should receive the vigorous attention of the management with a view to strengthening the items or salvaging whatever value may remain." ↩
3. Described as: "Book assets, or portions thereof, regarded by the examiner as uncollectible or worthless and as estimated losses." The instruction was: "Amounts so classified should be promptly charged off in order that the bank's books and statements may more properly reflect the bank's condition." ↩
4. A pencil notation on the letter of transmittal accompanying the report indicates the meeting was held on December 27, 1938. ↩
5. ART. 23(k)-1. Bad debts. -
* * *
(c) Where banks or other corporations which are subject to supervision by Federal authorities (or by State authorities maintaining substantially equivalent standards) in obedience to the specific orders of such supervisory officers charge off debts in whole or in part, such debts shall be conclusively presumed, for income tax purposes, to be worthless or recoverable only in part, as the case may be, but in order that any amount of the charge-off may be allowed as a deduction for any taxable year it must be shown that the charge-off took place within such taxable year. ↩
6. GENERAL RULE. - Debts ascertained to be worthless and charged off within the taxable year (or, in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts); and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction. This paragraph shall not apply in the case of a taxpayer, other than a bank, as defined in section 104, with respect to a debt evidenced by a security as defined in paragraph (3) of this subsection. ↩