Decision will be entered for the respondent.
Held, the balance in the amount of $ 27,445.71 in a reserve for bad debts account of petitioners' proprietorship was includable in petitioners' taxable income in 1959 when, in that year, the business of the proprietorship was transferred to a corporation in a transaction which qualified under section 351.
*1130 Respondent determined a deficiency in income tax for the year ended December 31, 1959, in the amount of $ 17,251.05.
At issue is whether a balance in the amount of $ 27,445.71 1 in a reserve for bad debts account of a proprietorship was includable in petitioners' taxable income in 1959 when in that year the business of the proprietorship, including accounts receivable, was transferred to a corporation in a transaction which qualified under section 351.
FINDINGS OF *37 FACT
The facts have been stipulated.
Charlotte Schmidt is the executrix of the estate of her late husband, Heinz Schmidt, who died on July 11, 1961. Heinz and Charlotte, residing in San Francisco, Calif., timely filed their joint income tax return for the taxable year ended December 31, 1959, with the district director of internal revenue at San Francisco.
From 1935 to June 30, 1959, Heinz had operated a proprietorship under the fictitious name of Mohns Commercial Co. The principal place of business of this proprietorship, at all times involved herein, was at 24 California Street, San Francisco, Calif. The business of the proprietorship was the importing of steel and wire products. Most of its sales were to jobbers or wholesalers. For purposes of operating its business, the proprietorship did not usually take an inventory. Orders would be obtained from the jobbers or wholesalers; they would then be booked with the mill and the products would later be shipped to the customers.
The proprietorship was on an accrual and calendar year basis of accounting.
On December 12, 1958, Heinz and Charlotte received permission from respondent to employ the reserve method of accounting for bad *1131 debts *38 for Federal income tax purposes, beginning with their taxable year ended December 31, 1958. The reserve for bad debts was set up by entry dated December 31, 1958, as follows:
| Debit -- bad debt expenses | $ 21,968.48 | |
| Credit -- reserve for bad debts | $ 21,968.48 |
Also, by entry dated December 31, 1958, accounts in the total amount of $ 3,470.03 were written off and charged against the reserve for bad debts as follows:
| Debit -- reserve for bad debts | $ 3,470.03 | |
| Credit -- accounts receivable | $ 3,470.03 |
As of December 31, 1958, the proprietorship had accounts receivable in the amount of $ 609,429.12 and a credit balance in the amount of $ 18,498.45 in its reserve for bad debts account.
On June 30, 1959, there was a credit to the reserve for bad debts in the amount of $ 10,427.90 and, also on that date, accounts in the total amount of $ 1,480.64 were written off by a debit to the reserve for bad debts and a credit to accounts receivable. As of June 30, 1959, the proprietorship had accounts receivable in the amount of $ 914,564.38 and a credit balance in the amount of $ 27,445.71 in its reserve for bad debts account.
The Mohns Commercial Corp. was formed under the laws of California on February 24, 1956. *39 At all times involved herein, the corporation had its principal place of business at 24 California Street, in San Francisco. It was on an accrual basis of accounting and employed a fiscal year ending June 30. The corporation was engaged in the business of warehousing steel and wire products, principally nails, and selling them to retailers. In operating this business the corporation usually carried an inventory. However, the business of the corporation did not develop.
From the date of its incorporation to June 29, 1959, all of the corporation's outstanding stock, namely 600 shares $ 10 par value, was owned one-half by Heinz Schmidt and one-half by Harold Paschkes. On June 29, 1959, Heinz purchased 300 shares of the corporation's stock from Paschkes.
Heinz also, by letter dated June 29, 1959, offered to transfer to the corporation all of the proprietorship's assets, as of June 30, 1959, on the condition that the corporation assume all of the proprietorship's liabilities, as of June 30, 1959, and agree to issue to Heinz its $ 10 par value common stock in an amount equal to the net worth of the business transferred. He also authorized the corporation to change its name to Mohns Commercial *40 Co. if it accepted his offer. In no event was the number of shares to be issued to Heinz to exceed 5,500 shares.
*1132 Among the liabilities to be assumed by the corporation in respect of the transfer of the business was a debt in the amount of $ 14,000 owed to an employee of the proprietorship, Fred Leimbrock, for services he had rendered to it. Leimbrock made an offer to the corporation to cancel this indebtedness in exchange for 1,400 shares of the corporation's stock.
The corporation was also to assume proprietorship obligations to another of its employees, Joseph Grisay, in the amount of $ 68,880, of which $ 64,880 constituted commissions due him, and the remainder a loan made by him to the proprietorship. Subsequent to July 1, 1959, the corporation had borrowed $ 8,028 from Grisay. Grisay offered to cancel $ 10,000 of the indebtedness due him for commissions, $ 4,000 of the indebtedness due him from a loan to the proprietorship, $ 8,028 of the indebtedness owed to him by the corporation in respect of the loan made subsequent to July 1, 1959, and to transfer to the corporation furniture and fixtures and a motor vehicle having an aggregate fair market value of $ 2,972, in exchange *41 for 2,500 shares of stock of the corporation.
On June 30, 1959, Heinz transferred all the assets of the proprietorship to the corporation in accordance with his letter of June 29, 1959.
The balance sheet of the corporation as of June 30, 1959, prior to the transfer, showed total assets in the amount of $ 6,621.10. The balance sheet of the proprietorship as of June 30, 1959, showed total assets of $ 989,589.39.
Among the assets transferred were accounts receivable in the amount of $ 914,564.38, subject to the reserve for bad debts in the amount of $ 27,445.71.
On or about August 7, 1959, the name of Mohns Commercial Corp. was changed to the Mohns Commercial Co.
The officers and directors of the corporation, as of August 10, 1959, were as follows:
Heinz Schmidt -- president-director
Joseph Grisay -- vice-president-director
Fred Leimbrock -- secretary-treasurer-director
The corporation accepted the foregoing offers of Heinz Schmidt, Leimbrock, and Grisay at a special meeting of its board of directors on August 10, 1959.
Subsequent to the transfer of the proprietorship's business the corporation continued the same operations as that of the proprietorship.
The amounts of accounts receivable, sales *42 on account, additions to the reserve for bad debts, and writeoffs against the reserve for bad debts, by the corporation for the 3 years subsequent to the foregoing transfer were as follows: *1133
| Accounts receivable | ||
| Fiscal year ended June 30 -- | ||
| Beginning of | End of year | |
| year | ||
| 1960 | $ 915,039.58 | $ 1,203,940.88 |
| 1961 | 1,203,940.88 | 932,954.56 |
| 1962 | 932,954.56 | 705,830.24 |
| Additions | Writeoffs of | ||
| Sales on | to reserve | accounts | |
| Fiscal year ended June 30 -- | account | for bad | receivable against |
| debts | reserve for bad | ||
| debts | |||
| 1960 | $ 8,889,859.41 | $ 4,657.25 | $ 8,084.58 |
| 1961 | 5,191,604.77 | 29,383.89 | 34,743.54 |
| 1962 | 5,464,441.54 | 32,081.49 | 29,565.31 |
The accounts receivable of both the proprietorship and the corporation were 30-day accounts with maximum credit extending to 90 or 120 days.
An application by the corporation to the commissioner of corporations of California bearing the date November 23, 1959, indicated that the corporation proposed to issue 8,400 shares of stock as follows:
| Shares | |
| Heinz Schmidt | 4,500 |
| Joseph Grisay | 2,500 |
| Fred Leimbrock | 1,400 |
From June 29, 1959, to May 3, 1960, Heinz was the owner of 600 shares of the corporation's stock, such stock representing all of the corporation's then outstanding stock.
From May 3, 1960, to June 30, 1962, the corporation's *43 stock was owned as follows:
| Shares | |
| Heinz Schmidt | 1 5,100 |
| Joseph Grisay | 2,500 |
| Fred Leimbrock | 1,400 |
Heinz and Charlotte reported taxable income for 1958 and 1959 in the amounts of $ 27,957.98 and $ 48,279.28, respectively.
OPINION
The sole issue before us is whether the balance in the proprietorship's reserve for bad debts account in the amount of $ 27,445.71, as of June 30, 1959, was includable in petitioners' taxable income in 1959 when, on June 30, 1959, the business of the proprietorship, including accounts receivable, was transferred to the corporation in a transaction which qualified for nonrecognition under section 351. 2*45 *46 The Government concedes that the transfer qualifies under section 351 and it does not challenge the amount in the reserve for bad debts as of June 30, 1959, as an unreasonable one. However, *1134 its position is that when the proprietorship terminated, the need for maintaining the reserve for bad debts ceased and therefore the balance in the account at the time of termination should be restored to income. Petitioners, on the other hand, contend that *44 no restoration of income in respect of the balance in the reserve for bad debts account should be made because all of the assets of the proprietorship, including accounts receivable subject to the reserve for bad debt, were transferred to a corporation in a tax-free exchange under section 351 and the transferee carried on the business of the transferor and maintained the foregoing accounts receivable and reserve for bad debts in the same manner as had petitioners. For reasons hereinafter stated, we agree with the Government.
The Government's position follows Rev. Rul. 62-128, 2 C.B. 139">1962-2 C.B. 139, 3*48 and is in accord with our decision in West Seattle National *1135 , 33 T.C. 341">33 T.C. 341, affirmed 288 F. 2d 47 (C.A. 9). In the West Seattle case the corporate taxpayer disposed of all its business in a tax-free transaction pursuant to a plan of complete liquidation under section 337 of the 1954 Code. It had a reserve for bad debts composed of amounts added thereto from time to time which had been deducted annually from its gross income, and it was there held that when the corporation disposed of its business "there was no longer any need for the reserve, and the amount thereof should be restored to income" (33 T.C. at 343). The Court further ruled that the nonrecognition provisions of section 337 did not apply to such income. Those provisions were intended to relieve *47 from tax the gain realized upon disposition of the corporation's assets, but (33 T.C. at 344) --
The income here sought to be taxed did not arise from the sale of assets. The only relation the sale of petitioner's assets had to this income is that it removed the necessity for maintaining the reserve for bad debts because petitioner no longer held receivables, the full collection of which might be doubtful.
A like result is called for in the present case. Here, too, there was a nonrecognizable transaction, and pursuant to the applicable provisions of section 351, 4 no gain or loss was recognized upon the transfer of the proprietorship to the corporation. The income here in question is similarly not gain upon the transfer of assets. Rather, this case, like West Seattle, involves amounts of income realized under the taxpayers' system of accounting prior to the transfer, income which had been relieved of tax by reason of offsetting *49 bookkeeping entries in a reserve account; and the Commissioner's adjustment merely restored the balance in that account to income when it became clear that the reserve was no longer required by the taxpayers.
It is true, as petitioners point out, that in Citizens Federal S. & L. Ass'n of Cleveland v. United States, 290 F. 2d 932 (Ct. Cl.), which followed the West Seattle case, there is a dictum (p. 937) which distinguishes a sale of the type involved therein from a nonrecognizable transaction where the same interests continue to operate the business in a different form and where the need for the reserve continues. The difficulty with that dictum, however, is that it does not appear to be based upon any statutory provision, nor have the parties herein called our attention to any statutory language providing for the carryover *1136 of *50 the bad debt reserve to the transferee. Although the Code contains various provisions dealing with the carryover of basis of transferred assets, 5 we have found none requiring or sanctioning the carryover of a bad debt reserve account into the hands of the transferee corporation in a section 351 transaction.
If the result for which petitioners contend is correct, then the transferee corporation must start out with the $ 27,445.71 reserve, without obtaining a deduction *51 therefor. Such reserve would then serve as a base for determining the reasonableness of future additions thereto; and when the business is finally wound up the balance in the reserve would be restored to income in the hands of the transferee. Thus, the $ 27,445.71 balance at the time of the transfer would either be absorbed by bad debts sustained by the transferee or it would ultimately be included in income of the transferee. But we know of nothing in the statute that would require or permit any such practice, regardless of how the parties have in fact handled the matter. Such result would appear to be desirable, but we are dealing with a statute characterized by a high degree of specificity, 6*52 and we must take it as we find it. In the absence of any provision for carryover of the reserve account, we must hold that an adjustment to income, otherwise proper, is not to be disapproved merely because there was a tax-free transaction pursuant to section 351. 7 We follow our prior decision in the West Seattle case, and hold that the revenue ruling involved herein represents a proper interpretation of the statute as it is presently formulated.
Decision will be entered for the respondent.
Footnotes
1. The parties have stipulated that the balance in the reserve was $ 27,445.71, but the deficiency was determined upon the assumption that the balance was $ 27,437.38. However, the Commissioner has not asked for any increased deficiency based upon the comparatively minor difference.↩
1. 600 shares owned prior to June 30, 1959, plus 4,500 shares received in the exchange involving the transfer of his business.↩
2. SEC. 351. TRANSFER TO CORPORATION CONTROLLED BY TRANSFEROR.
(a) General Rule. -- 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 (as defined in section 368(c)) of the corporation. For purposes of this section, stock or securities issued for services shall not be considered as issued in return for property.
(b) Receipt of Property. -- If subsection (a) would apply to an exchange but for the fact that there is received, in addition to the stock or securities permitted to be received under subsection (a), other property or money, then --
(1) gain (if any) to such recipient shall be recognized, but not in excess of --
(A) the amount of money received, plus
(B) the fair market value of such other property received; and
(2) no loss to such recipient shall be recognized.
(c) Special Rule. -- In determining control, for purposes of this section, the fact that any corporate transferor distributes part or all of the stock which it receives in the exchange to its shareholders shall not be taken into account.
(d) Cross References. --
(1) For special rule where another party to the exchange assumes a liability, or acquires property subject to a liability, see section 357.
(2) For the basis of stock, securities, or property received in an exchange to which this section applies, see sections 358 and 362.
(3) For special rule in the case of an exchange described in this section but which results in a gift, see section 2501 and following.
(4) For special rule in the case of an exchange described in this section but which has the effect of the payment of compensation by the corporation or by a transferor, see section 61(a)(1).
SEC. 368. DEFINITIONS RELATING TO CORPORATE REORGANIZATIONS.(c) Control. -- For purposes of part I (other than section 304↩), part II, and this part, the term "control" means the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.
3. Rev. Rul. 62-128, 2 C.B. 139">1962-2 C.B. 139, provides:
"A taxpayer, engaged in a business as a sole proprietor, transferred all of the assets of his business, subject to its liabilities, to a corporation controlled by the transferor in a nontaxable exchange under the provisions of section 351 of the Internal Revenue Code of 1954. Prior to the transfer, the business had, on its books of account, a reserve for bad debts which had been accumulated by additions for which the taxpayer had derived full tax benefits in prior taxable years. Held, under these circumstances the reserve for bad debts is not transferable to any other entity. Accordingly, the reserve for bad debts represents ordinary income to the taxpayer for the taxable year during which the transfer of the accounts receivable was made since, during such time, his need for the reserve ceased. See Geyer, Cornell & Newell, Inc. v. Commissioner, 6 T.C. 96">6 T.C. 96, acquiescence, C.B. 1946-1, 2; Rev. Rul. 57-482, C.B. 1957-2, 49; and C. Standlee Martin, Inc. v. Riddell, 56-2, U.S.T.C. 9989, 51 A.F.T.R. (P-H) 1376">51 A.F.T.R. 1376. Under similar circumstances, a partnership must likewise include such reserve for bad debts in its final return as ordinary income. However, to the extent that the additions to the reserve for bad debts in prior years may not have resulted in tax benefits, they need not be included in the transferor's gross income. See M. & E. Corporation v. Commissioner7 T.C. 1276">7 T.C. 1276, acquiescence, C.B. 1947-1, 3↩."
4. Whether sec. 351 was applicable in view of the emergence of Leimbrock and Grisay as stockholders with an aggregate interest of some 46 percent, all in accord with an apparently preexisting plan, would seem to raise a serious question. However, the parties have agreed that sec. 351↩ was satisfied, and we accept that position for the purpose of this case only.
5. Thus, sec. 362(a)(1) provides that the basis of the assets received by a corporation in a sec. 351↩ transfer "shall be the same as it would be in the hands of the transferor." Indeed, pursuant to these provisions the basis for the $ 914,564.38 receivables of the proprietorship transferred to the corporation would remain the same in the hands of the transferee; but neither these provisions nor any other provisions require any adjustment in such basis upon transfer by reason of the bad debt reserve relating to such receivables. Moreover, the original basis of these receivables in the hands of the proprietorship was in no way affected by the bad debt reserve (see secs. 1012 and 1016), nor do petitioners contend otherwise.
6. In addition to the provisions dealing with carryover of basis, the Code contains a number of highly specific provisions relating to carryovers of net operating losses, earnings and profits, capital losses, methods of accounting, inventories, and other items. Sec. 381. But regardless of whether the carryover of "methods of accounting" would justify a carryover of a bad debt reserve -- a matter on which we express no opinion -- the provisions of sec. 381 are explicitly limited to certain types of corporate readjustments that do not include sec. 351↩ transfers.
7. The dictum in the Citizens Federal case was followed in Home Savings and Loan Ass'n v. United States, 223 F. Supp. 134">223 F. Supp. 134 (S.D.Calif.), and the reason for the Government's failure to pursue an appeal therein has not been disclosed. Similarly, there has been no explanation of the Commissioner's position in Calavo, Inc. v. Commissioner, 304 F. 2d 650, 652↩ (C.A. 9), reversing on other grounds a Memorandum Opinion of this Court.