Tax Impact of a Transfer of a Bad Debt Reserve to a Controlled Corporation: An Analysis of Schuster v. Commissioner

Max Schuster operated a wholesale business in semi-precious stones in the form of a sole proprietorship. He employed the accrual method of accounting for items of income and expense, and utilized the reserve method of accounting for bad debts for federal income tax purposes. On October 31, 1961, Schuster transferred the assets of his business, including its accounts receivable, to a corporation in a transaction which qualified as a tax-free exchange under section 351 of the Internal Revenue code of 1954. The Commissioner of Internal Revenue disallowed a deduction of $7,432.04 claimed as an addition to the proprietorship\u27s bad debt reserve in 1961, and restored the $4,052.29 balance which remained in the bad debt reserve to gross income. In a decision reviewed by the court, with two dissenting opinions, the Tax Court held for the Commissioner: Proper accounting principles require the restoration of a reserve for bad debts to income when events render the reserve no longer necessary. Schuster v. Commissioner, 50 T.C. 98 (1968)