Erlich v. Commissioner

¶1OPINION

¶2Respondent determined a deficiency in petitioners’ Federal income tax for the calendar year 1965 in the amount of $1,911.34.

¶3The only issue for decision is whether a sole proprietorship using the reserve method for bad debts is required to restore the reserve to income when it transfers its accounts receivable to a corporation in a section 3511 transfer.

¶4All of the facts have been fully stipulated. The stipulation of facts and the exhibit attached thereto are incorporated herein.

¶5Israel J. Erlich (Erlich) and Ruth Erlich, husband and wife, resided in Los Angeles, Calif., at the túne they filed their petition herein. Petitioners, who are cash-'basis taxpayers, filed a joint Federal income tax return for 1965 with the district director of internal revenue, Los Angeles, Calif.

¶6Prior to May 31, 1965, Erlich was a broker in the poultry business. He operated as a proprietorship known as I. J. Erlich Co., which generally employed the accrual method of accounting. As to bad debts, however, the proprietorship used the reserve method of accounting for Federal income tax purposes. After forming a corporation known as I. J. Erlich Co., Inc., Erlich on May 31,1965, terminated his business operations as a proprietorship. He transferred the property of the proprietorship to the corporation solely in exchange for stock in the corporation. This exchange qualified for tax-free treatment under section 351. Included in the assets transferred were accounts receivable subject to a reserve for bad debts.

¶7In his statutory notice of deficiency for 1965, respondent restored to petitioners’ income the amount of the proprietorship’s reserve for bad debts, as corrected, at the time of the transfer.

¶8Until recently a conflict existed as to the issue presented in the instant case. The U.S. Supreme Court has now held that in a section 351 transfer where the value of the securities received by the transferor with respect to the accounts receivable was limited to the face value of the receivables less the amount of the reserve for bad debts, then the transferor does not have to add back to income unused amounts in Iris bad debt reserve computed under section 166 (c). Nash v United States, 398 U.S. 1 (1970). The Supreme Court specifically reasoned:

AH tliat petitioners received from tlie corporations were securities equal in value to the net worth of the accounts transferred, that is the face value less the amount of the reserve for had debts. If, as conceded, there is no “gain” or “loss” recognized as a result of the transaction, it seems anomolous to treat the bad debt reserve as “income” to the transferor.'1 [Footnote omitted.]

¶9The facts in Nash are indistinguishable from those in the case at bar. We therefore hold that respondent erred in restoring to petitioners’ income the amount of the proprietorship’s reserve for bad debts at the time of the transfer.

¶10Decision will be entered wnderRule 50.