Schlude v. Commissioner of Internal Revenue/Dissent Stewart

by Potter Stewart

United States Supreme Court

372 U.S. 128

Schlude  v.  Commissioner of Internal Revenue

 Argued: Dec. 10, 1962. --- Decided: Feb 18, 1963

Mr. Justice STEWART, with whom Mr. Justice DOUGLAS, Mr. Justice HARLAN, and Mr. Justice GOLDBERG join, dissenting.

As the Court notes, this case is but the most recent episode in a protracted dispute concerning the proper income tax treatment of amounts received as advances for services to be performed in a subsequent year by a taxpayer who is on an accrual rather than a cash basis. The Government has consistently argued that such amounts are taxable in the year of receipt, relying upon two alternative arguments: It has claimed that deferral of such payments would violate the 'annual accounting' principle which requires that income not be postponed from one year to the next to reflect the long-term economic result of a transaction. Alternatively, the Government has argued that advance payments must be reported as income in the year of receipt under the 'claim-of-right doctrine,' which requires otherwise reportable income, held under a claim of right without restriction as to use, to be reported when received despite the fact that the taxpayer's claim to the funds may be disputed. ^[1]

As I have elsewhere pointed out, neither of these doctrines has any relevance to the question whether any reportable income at all has been derived when payments are received in advance of performance by an accrual-basis taxpayer. ^[2] The most elementary principles of accrual accounting require that advances be considered reportable income only in the year they are earned by the taxpayer's rendition of the services for which the payments were made. The Government's theories would force upon an accrualbasis taxpayer a cash basis for advance payments in disregard of the federal statute which explicitly authorizes income tax returns to be based upon sound accrual accounting methods. ^[3]

Apparently the Court agrees that neither the annual accounting requirement nor the claim-of-right doctrine has any relevance or applicability to the question involved in this case. For the Court does not base its decision on either theory, but rather, as in two previous cases, ^[4] upon the ground that the system of accrual accounting used by these particular taxpayers does not 'clearly reflect income' in accord with the statutory command. ^[5] This result is said to be compelled both by a consideration of legislative history and by an analysis of the particular accounting system which these taxpayers employed.

For the reasons I have elsewhere stated at some length, ^[6] to rely on the repeal of §§ 452 and 462 as indicating congressional disapproval of accrual accounting principles is conspicuously to disregard clear evidence of legislative intent. The Secretary of the Treasury, who proposed the repeal of these sections, made explicitly clear that no inference of disapproval of accrual accounting principles was to be drawn from the repeal of the sections. ^[7] So did the Senate Report. ^[8] The repeal of these sections was occasioned solely by the fear of temporary revenue losses which would result from the taking of 'double deductions' during the year of transition by taxpayers who had not previously maintained their books on an accrual basis. ^[9]

The Court's decision can be justified, then, only upon the basis that the system of accrual accounting used by the taxpayers in this case did not 'clearly reflect income' in accordance with the command of § 41. In the Automobile Club of Michigan case ^[10] the taxpayer allocated yearly dues ratably over 12 months, so that only a portion of the dues received during any fiscal year was reported as income for that year. In the absence of any proof that services demanded by the Automobile Club members were distributed in the same proportion over the year, the Court held that the system used by the taxpayer did not clearly reflect income. In the American Automobile Association case ^[11] the taxpayer offered statistical proof to show that its proration of dues reasonably matched the proportion of its yearly costs incurred each month in rendering services attributable to those dues. The Court discounted the validity of this statistical evidence because the amount and timing of the services demanded were wholly within the control of the individual members of the Association, and the Court thought that the Association could not, therefore, estimate with accuracy the costs attributable to each individual member's demands.

In the present case the difficulties which the Court perceived in Automobile Club of Michigan and American Automobile Association have been entirely eliminated in the accounting system which these taxpayers have consistently employed. The records kept on individual students accurately measured the amount of services rendered-and therefore the costs incurred by the taxpayer-under each individual contract during each taxable year. But, we are told, there is a fatal flaw in the taxpayers' accounts in this case too: The individual contracts did not provide 'for lessons on fixed dates * * *, but left such dates to be arranged from time to time by the instructor and his student.' Yet this 'fixed date of performance' standard, it turns out, actually has nothing whatever to do with those aspects of the taxpayers' accounting system which the Court ultimately finds objectionable.

There is nothing in the Court's opinion to indicate disapproval of the basic method by which income earned by the rendition of services was recorded. On the contrary, the taxpayers' system was admittedly wholly accurate in recording lessons given under each individual contract. It was only in connection with lessons which had not yet been taught that the taxpayers were 'uncertain whether none, some, or all' of the contractual services would be rendered, and the condemned 'arbitrariness' therefore is limited solely to the method by which cancellations were recognized. ^[12] It is, of course, true of all businesses in which services are not rendered simultaneously with payment that the number and amount of cancellations are necessarily unknown at the time advances are received. But surely it cannot be contended that a contract which specified the times at which lessons were to be given would make any more certain how many of the remaining lessons students would in fact demand. Indeed, the Court does not suggest that a schedule fixing the dates of all future lessons would, if embodied in each contract, suffice to make petitioners' accounting system 'clearly reflect income.'

Instead, the cure suggested by the Court for the defect which it finds in the accounting system used by these taxpayers is that estimated cancellations should be reported as income in the year advance payments are received. I agree that such estimates might more 'clearly reflect income' than the system actually used by the taxpayers. But any such estimates would necessarily have to be based on precisely the type of statistical evaluations which the Court struck down in the American Automobile Association case. Whatever other artificialities the exigencies of revenue collection may require in the field of tax accounting, it has never before today been suggested that a consistent method of accrual accounting, valid for purposes of recognizing income, is not equally valid for purposes of deferring income. Yet in this case the Court says that the taxpayers, in recognizing income, should have used the very system of statistical estimates which, for income deferral purposes, the American Automobile decision held impermissible.

It seems to me that this decision, the third of a trilogy of cases purportedly decided on their own peculiar facts, in truth completes the mutilation of a basic element of the accrual method of reporting income-a method which has been explicitly approved by Congress for almost half a century. ^[13]

I respectfully dissent.

Notes

1. The Commissioner has sometimes been successful in urging the 'claim-of-right doctrine' as a bar to the deferral of advances by accrual-basis taxpayers. See e.g., Andrews v. Commissioner, 23 T.C. 1026, 1032-1033; South Dade Farms v. Commissioner, 138 F.2d 818 (C.A.5th Cir.); Clay Sewer Pipe Ass'n v. Commissioner, 139 F.2d 130 (C.A.3d Cir.); Automobile Club of Michigan v. Commissioner, 230 F.2d 585, 591 (C.A.6th Cir.), aff'd on other grounds, 353 U.S. 180, 77 S.Ct. 707, 1 L.Ed.2d 746.
2. See American Automobile Ass'n v. United States, 367 U.S. 687, at 699-702, 81 S.Ct. 1727, at 1733-1735, 6 L.Ed.2d 1109 (dissenting opinion).
3. '§ 446. General rule for methods of accounting
4. Automobile Club of Michigan v. Commissioner, 353 U.S. 180, 77 S.Ct. 707, 1 L.Ed.2d 746, and American Automobile Ass'n v. United States, 367 U.S. 687, 81 S.Ct. 1727, 6 L.Ed.2d 1109.
5. See note 3, supra. See also § 41, 1939 Code.
6. See American Automobile Ass'n v. United States, 367 U.S. at 703-711, 81 S.Ct. at 1735-1739 (dissenting opinion).
7. H.R.Rep.No.293, 84th Cong., 1st Sess. 5.
8. S.Rep.No.372, 84th Cong., 1st Sess. 5-6. See also H.R.R.ep.No.293, 84th Cong., 1st Sess. 4-5, U.S.Code Congressional and Administrative News 1955, p. 2046.
9. Since the taxpayers in the present case have consistently maintained their books on an accrual basis, they could not have taken advantage of a 'double deduction' even under the repealed sections.
10. 353 U.S. 180, 77 S.Ct. 707, 1 L.Ed.2d 746.
11. 367 U.S. 687, 81 S.Ct. 1727, 6 L.Ed.2d 1109.
12. The Court also urges that the taxpayers' treatment of the commissions paid to sales personnel and royalties paid to Arthur Murray, Inc., were inconsistent with an accrual accounting system. It should be noted that § 1.461-1(a)(3), Treas.Reg., 1954 Code, specifically provides: '* * * However, in a going business there are certain overlapping deductions. If these overlapping items do not materially distort income, they may be included in the years in which the taxpayer consistently takes them into account.' If, however, the Court is holding that these items do 'materially distort income,' then the case should be remanded for recomputation as to these items.
13. See § 13(d) of the Revenue Act of 1916, 39 Stat. 771.