Rev. Rul. 74-593

Advice has been requested regarding the computation of the bad debt reserve of the surviving bank in a merger, under the circumstances described below.

On September 30, 1966, X and Y, two commercial banking corporations, entered into a statutory merger qualifying as a reorganization under the provisions of section 368(a)(1)(A) of the Internal Revenue Code of 1954. Prior to the merger, X and Y reported income on a calendar year basis and used the reserve method of computing bad debts. Pursuant to section 381(c)(4) and the regulations thereunder, the balance in Y's bad debt reserve was carried over by X, the surviving bank in the merger. As of December 31, 1964, both X and Y had bad debt reserves in excess of 2.4 percent of their outstanding loans. On September 30, 1966, the balance in Y's bad debt reserve was less than 2.4 percent of its outstanding loans and also less than the balance in its bad debt reserve as of December 31, 1964.

Specifically, the question presented is whether X, the surviving bank in the merger, may combine the December 31, 1964, balance of both its own and Y's bad debt reserves in computing the limits prescribed in section 5 of Rev. Rul. 65-92, 1965-1 C.B. 112.

Rev. Rul. 65-92 provides a specific method for computing a reasonable addition to a reserve for bad debts by banks. Section 5 of Rev. Rul. 65-92 specifically provides, in part, that if the dollar balance of a bank's bad debt reserve, as of the close of its taxable year ending in 1964, exceeds 2.4 percent of loans outstanding at such time, the addition to the reserve in any taxable year shall not increase the reserve above the greater of (i) such dollar balance, or (ii) 2.4 percent of loans outstanding at the close of the taxable year.

Section 381 of the Code provides for carryovers in certain corporate acquisitions. Section 381(c)(4) provides for the carryover of methods of accounting. Section 1.381(c)(4)-1(a)(2) of the Income Tax Regulations provides that, for the purpose of section 381(c)(4), the term "method of accounting" has the same meaning as provided under section 446 and the regulations thereunder. The reserve method of accounting for bad debts is a method of accounting for this purpose. Section 1.381(c)(4)-1(b)(1), Example 1.

In the instant case, since the merger is a transaction described in section 381(a) of the Code, with only X surviving the merger, the bad debt reserves would be combined pursuant to section 381(c)(4) and section 1.381(c)(4)-1(b) of the regulations. Thus, in applying section 5 of Rev. Rul. 65-92, the combined December 31, 1964, bad debt reserve balances of X and Y would have to be used in applying the limitations on additions to the reserve for bad debts.

For example, assume that X had a December 31, 1964, reserve balance of 1,000x dollars, which was in excess of 2.4 percent of outstanding loans at that date. Y had a reserve balance of 100x dollars at December 31, 1964, which was also in excess of 2.4 percent of outstanding loans. On September 30, 1966, the date of merger, Y's reserve was 50x dollars, which was less than 2.4 percent of outstanding loans at that date, and X's reserve was still 1,000x dollars. As the surviving bank after the merger, X will use 1,100x dollars in computing the dollar balance limit prescribed in section 5 of Rev. Rul. 65-92.

Accordingly, for taxable years ending after September 30, 1966, the date of the merger, X may use the combined balances as of December 31, 1964, of its own and Y's bad debt reserves in determining the dollar balance limitation prescribed in section 5 of Rev. Rul. 65-92 that is applicable in computing the current addition to the bad debt reserve balance.

Rev. Rul. 65-92, as supplemented by Rev. Rul. 66-26, 1966-1 C.B. 41, Rev. Rul. 68-630, 1968-2 C.B. 84, and Rev. Rul. 70-495, 1970-2 C.B. 53, and as modified by Rev. Rul. 68-524, 1968-2 C.B. 83, is hereby further modified.