Schlude v. Commissioner of Internal Revenue

PETITIONER:Schlude
RESPONDENT:Commissioner of Internal Revenue
LOCATION:Beaumont Mills

DOCKET NO.: 80
DECIDED BY: Warren Court (1962-1965)
LOWER COURT: United States Court of Appeals for the Eighth Circuit

CITATION: 372 US 128 (1963)
ARGUED: Dec 10, 1962
DECIDED: Feb 18, 1963

Facts of the case

Question

Audio Transcription for Oral Argument – December 10, 1962 in Schlude v. Commissioner of Internal Revenue

Earl Warren:

Number 80, Mark E. Schlude, et al., Petitioners, versus Commissioner of Internal Revenue.

Mr. Bauersfeld.

Carl F. Bauersfeld:

May it please the Court.

This is an income tax case.

The issue is whether the accrual method of accounting be continue to be used for income tax purposes where advance receipts are involved.

By the accrual method of accounting is meant the taxpayer’s recognition of income when earned by performance whether before or after payment and the deduction of expenses as incurred whether before or after actual payment.

The facts necessary to understand the issue here present may be very briefly stated.

The taxpayer is — of partner in a partnership that gave them instruction services under a contract for students.

The students made down payment and agreed to pay the balance of the contract price in installments.

The service contract is given rise to the tax controversy here where those as to which the student — the taxpayer’s performance extended beyond the taxable period in which the contracts were entered into.

Certified public accounting firm designed to partnerships bookkeeping system on the accrual basis accurately to match partnerships revenue derived from services rendered in each tax year with the costs of rendering services in such year.

And I will explain the exact detail of the accounting system shortly in the course of my argument.

The respondent initially required the partnership to include as income the entire face amount of each contract in the tax year in which it was entered into.

The respondent has now retreated from that position in this Court, but his confession does not, in any way, change or alter the basic issue.

The respondent now says that the entire face amount of each contract need not be taken into consideration or into income at the time that is signed but he still contends that all advance receipts actually received by a partnership for future instruction must be reported as income no later than the year in which the receipt — receipt is obtained and that all other amounts under the contracts are to be reportable in the tax year when the students were obligated to make payments.

The respondent relying on the American Automobile Associate versus the United States in 367, U.S. urges that any accrual accounting system for deferring recognition of advance receipts must be rejected as violating tax accounting principles.

Here, we differ very greatly with the respondent.

If that case is read as we believe is proper then it is clear that the prior decisions of this Court in relevant tax statute authorized an accrual-basis taxpayer to be taxed on advanced receipts only in the year in which they are earned.

On the other hand, if the respondent is correct as to the meaning of the A.A.A. case, accrual-basis taxpayers will be required to use the cash method of accounting when that — whenever they are paid advance receipts by their customers.

Now, incidentally by advance receipts, I mean any payments received before being earned by performance either by rendering services or providing goods as the case may be.

The American Automobile Association, we believe, did not reject the use of the accrual principle as such for reporting advance receipts of income in the tax year in which they are earned.

It did reject the application of that principle because of defects in bringing together the specific — the costs of earning them with the receipts in that particular case.

We contend that in A. A. A., the Court ruled only that the Commissioner of Internal Revenue was incurred to disregard the method of accrual accounting for advance receipt used by the taxpayer there because the method did not precisely match the portion of the costs of performing services or the association’s individual members in the tax year with the proper portion of advance dues paid by each member.

The association’s accrual accounting procedures required only that dues be recorded as income for tax purposes on a month-by-month basis ratably over the membership period.

Without regard to the actual costs of services rendered of the members for performance require, the Court found that the accounting system used by the association did not accurately and precisely matched revenues with related costs because the system would base on statistical computations and calculations and averages reflecting the overall costs of rendering services to all its members on a (Inaudible) — accrual basis.

The association I emphasized was unable to show that the method of deferral used for any relationship to the services yet to be performed or that the services to be performed would be equal for each member.

For this reason, we believe, the case stands only for the proposition that the accrual method of accounting they’re use was so imprecise that the Commissioner’s decision to set it aside was not arbitrary.

Now, by contrast here —

Which case are you talking about?

The Michigan case or the —

Carl F. Bauersfeld:

The American Automobile Association case.

By contrast here, the taxpayer’s accrual accounting system precisely match revenues from services they performed in each tax year with related costs of performance.

This was accomplished primarily through the use of individual or accounting cards for each student.

At each contract was signed, the total contract price was recorded in an account entitled “deferred income”.

The individual student accounting cards identified each student, the hours of dancing instruction contracted for, the total contract price, the hours of instruction given, the payments made under each contract and at the end of each partnership tax year, the accounting card for each student was reviewed.

And the amount of income earned under each contract was determined by multiplying the number of hours those instruction given by the rate per hour on that contract.

And whether cash in the amount of such income had been paid by the student or not, the deferred income account was reduced by the actual amount earned and earned income account increased by the same amount.

Such earned income from all contracts was totaled and reported as income on the accrual basis in the partnerships tax return for that year.

Since expenses were incurred in the period that the partnership rendered the services under the contract, the accounting method used precisely matched receipts and expenses for that period.

In addition, I should point out that all gains arising from the cancelation of a contract by a student or by the studio where there was no activity on the contract for a year was also reported as income on the tax return.

As a result, there was absolutely no way the studio could defer reporting receipts as income indefinitely.

It could not therefore avoid any taxes.

And so the issue here is only the year of taxability.

We do not believe that the respondents seriously dispute the accuracy of the partnership system in — system in matching revenues with related costs.

William O. Douglas:

Would your system be similar to a — or where would the — the theory from A. A. A.?

Carl F. Bauersfeld:

Our system is different from the A. A. A. in that we have a definite obligation to perform specific services for a specific individual members not based upon a member’s demand.

We contract to give dancing lessons and they are taken in the subsequent year.

Tom C. Clark:

So many dancing lessons?

Carl F. Bauersfeld:

Yes, sir.

Tom C. Clark:

Do you have a specific date like to Tuesday night or others?

Carl F. Bauersfeld:

The contracts do not provide a schedule of date.

They do provide that all the lessons must be taken within a certain period of time.

There is an expiration date in each con — contract in there — contract provided that the studio will give the lessons required within that period.

Tom C. Clark:

So that is true in A. A. A. they — you had to perform — you had to make the man for a service within a year as I remember it, and you got so many calls and so much of this and that and the other?

Carl F. Bauersfeld:

In the A. A. A. case sir, there was just a mere availability of services, a member might demand — ban the services or he might not depending upon his individual needs.

Here, the studio and the students enters into a direct contract for — to give so many hours of dancing lessons.

And the studio did those lessons.

Potter Stewart:

In A. A. A., the projected costs were based on averages, weren’t they?

Carl F. Bauersfeld:

Yes, Your Honor.

Potter Stewart:

Which were — the Court held too speculative?

Carl F. Bauersfeld:

Yes, Your Honor.

Potter Stewart:

Here, you have an individual record on an individual card of each customer of the studio each student, so-called dance student, with an obligation to give that student the number of lessons for which he had contracted?

Carl F. Bauersfeld:

Yes, Your Honor.

Potter Stewart:

Within a specified time?

Carl F. Bauersfeld:

Yes, sir.

Potter Stewart:

So, there was no projection of averages or — none of that speculative element in this case that which was the point upon which the A. A. A. case turned, is that correct?

Carl F. Bauersfeld:

That is the way we read them as this was offered them.

What are these guy’s confession perhaps is a little off the scene but I noticed you got life contracts for dancing which is astonishing thing to me —

Carl F. Bauersfeld:

When I explain that —

I’ve been urging too but what amount of money or what kind of a fee that is represented in that?

Carl F. Bauersfeld:

Sir, it vary from time to time as all costs over the years.

I understand the costs about $5000.

$5000 and you would —

Carl F. Bauersfeld:

And — and the —

Sometimes you get that all in advance?

Carl F. Bauersfeld:

Sometimes, yes sir.

Now, let me — I would like to say this that a lifetime contract implemented 1000 to 1200 hours of specific lessons and then thereafter the student was entitled to two lessons a month for life with two parties a year.

But at the time of the completion of the 1000 hours or the 1200 hours all the income under that contract had been taken into consideration.

Considering that, you ought to be a magnificent dancer after that.

Carl F. Bauersfeld:

Respondent’s real argument is —

Tom C. Clark:

(Inaudible)

Carl F. Bauersfeld:

I beg your pardon, sir.

Tom C. Clark:

May I ask you about what the Congress has done?

I think in A. A. A. we consider the fact that the Congress had taken some interest?

Carl F. Bauersfeld:

Yes, sir.

Tom C. Clark:

Did they examine the A. A. A. or how did they figure that out?

Carl F. Bauersfeld:

I did not —

Tom C. Clark:

What did they do with reference to A. A. A.?

Carl F. Bauersfeld:

In the Congress in A. A. A. passed a set — special statute that authorized the use of the accounting system A. A. A. had, yes sir.

Tom C. Clark:

Did they change it in any other way, the statute?

Carl F. Bauersfeld:

No sir, not to my knowledge.

William J. Brennan, Jr.:

So that this — the amendment then benefits if that’s the right word only A. A. A., is that —

Carl F. Bauersfeld:

Yes, sir.

William J. Brennan, Jr.:

— (Voice Overlap) organization?

Carl F. Bauersfeld:

A. A. A. or similar membership club.

William J. Brennan, Jr.:

But you don’t have — you don’t have — you don’t (Voice Overlap) —

Carl F. Bauersfeld:

We do not qualify under that, yes sir.

Respondent’s real argument is that the American Automobile Association has a far broader meaning.

The respondent says that the Court intended to proscribe the use of any accrual accounting method no matter how precisely it match the revenues with the expenses where advance receipts are involved.

Respondent points to the discussion in the opinion regarding the legislative history of the enactment and the repeal of Sections 452, 462 of the Internal Revenue Code of 1954.

This portion of the Court’s opinion, the respondent asserts, recognized as in the Commissioner the discretionary power to bar the use for tax purposes of any method of accounting or advance receipts no matter how accurate and how precise if it may involve the reporting of such receipts of income in a subsequent tax year.

We believe the respondent misinterprets the opinion and that the actual holding of the Court in A. A. A. was stated clearly and succinctly by Mr. Justice Clark at page 693 and I quote, “The Federal Revenue cannot without legislative consent and over objection of the Commissioner be made to depend upon average experience in rendering performance and turning a profit”.

The Court’s concern was with the method of accrual accounting that is dependent upon average experiences of relating costs and revenue.

Accordingly, we believe the consideration in the American Automobile of the legislative history, of the June 1954 Code provisions had relevance only to the particular type of accrual accounting method that was there at issue in which overall activities and averages of expense where relied upon in determining reportable income.

Now, the case at bar does not depend upon statistical calculations, estimates, or average experienced.

We are correct in our interpretation of American Automobile decision and we submit that the applicable revenue statutes in the long line of decisions of this Court support our position that an accrual-basis taxpayer having a precise and accurate accounting met — system may defer the recognition of advance receipts to the tax year in which those receipts are earned by performance.

The respondent’s argument that income of accrues at the time payments are received is in conflict with Sections 41 and 42 of the 1939 Code and 446 and 451 — 51 of the 1954 Code.

And 4 — Section 42 of the 1939 Code, is short and I like to read it, “The amount of all items of gross income shall be included in the year — year in the tax full — included gross income for the tax full year in which received by the taxpayer unless under methods of accounting permitted under Section 41 and the accrual method is such a method, any such amounts are to be properly accounted for as of a different period”.

Section 41 directs that the method of accounting used by the taxpayer in keeping his books shall govern the computations of his net income.

And it is only when that method of accounting used by the taxpayer in keeping his books does not clearly reflect income that the Commissioner has a discretion to compute his tax by another method.

The decisions of this Court, Court interpreting these provisions of a taxing statute, which this — which have remained substantially unchanged since 1918 sustain our position that advance receipts are to be reported as income only when earned by performance.

In United States versus Anderson, in 269 U.S., this Court interpreted the tax accounting provisions of the Revenue Act of 1960, which was the first tax statute that permitted accrual accounting.

The Court there required the taxpayer to accrue munitions taxes as a deduction in a year prior to the year in which the tax became due and prior to the year in which the taxpayer actually pay the munitions taxes.

In ruling that the taxes had accrued in the year that the munitions to which the taxes related were sold, the Court declared the purpose of Congress in authorizing the use of the accrual method was and I quote, “To enable taxpayers to keep their books and make their returns according to scientific accounting principles by charging against income earned during the taxable period, the expenses incurred in, and properly attributable to the process of earning income during that period”.

This case further pointed out that the statute was not concerned with due date for payment of the tax in a technical legal sense, rather, the accounting provisions of the statute were to be interpreted in an economic and bookkeeping sense.

And it is significant to note as pointed out in the brief for the amicus that the position that the Government is now taking is diametrically opposed to its position in Anderson.

In the Government’s brief there, it said that the accrual accounting methods are designed to reflect income definitely earned.

Another case Spring City Foundry Co. versus Commissioner in 292 U.S. involved the use of the accrual accounting methods in determining when income was to be reported.

It recognized that the accrual accounting might require the taxpayer to report income before he receives any payment as a result of transaction that gives rise to tax.

The Court declared that for an accrual-basis taxpayer, it is the right to receive not the actual receipt that determines the inclusion of amount in gross income.

Carl F. Bauersfeld:

When the right to receive an amount becomes fixed, the right accrued.

And then the Court made it clear that it understood the right to receive to be related to the earning of income because the opinion continues and says, “When a merchandising concern make sales, its inventory is reduced and a claim for the purchase price arises”.

Now, such sales do not occur merely by the signing of a contract or even when payment is due under a contract as the respondent here urges but rather when a taxpayer performs under the contract or in the accounting terms used by the Court in that case, when there are accounts receivable arising from sale.

Finally and most recently, in United States versus Consolidated Edison in 366 U.S., it was held that the accrual-basis taxpayer’s deduction for a contested tax is properly taken in the tax year to which a final determination of liability for the tax is made even though the tax had been paid in a prior year.

This Court rejected the Commissioner’s position that the liability accrued not later than the year of payment and said neither the Government nor an accrual-basis taxpayer may cause an item to be deducted in a year other than one in which it accrue.

Now, this statement although made in a case involving the timing of deductions by an accrual-basis taxpayer is equally applicable in determining the tax year for which the taxpayers are to report advance receipts as income.

In addition, I call the Court’s attention to several decisions involving cash basis taxpayer such as United States versus Lewis and Burnet versus Sanford & Brooks Company in 282 U.S., which the respondent has cited frequently in his brief.

In these cases, the Court explicitly recognized the difference between — the difference between tax accounting for cash basis taxpayers and accrual-basis taxpayers.

In particular, that taxes are to be paid on a basis of receipts only by cash basis taxpayers.

For example, in Burnet versus Sanford & Brooks Company, the Court said that items of gross income are required to be included in gross income for the taxable year in which receipt by the taxpayer unless they may be accounted for on the accrual basis.

We urge that these decisions and others cited in our brief and in the brief of the amicus call for the rejection of the respondent’s position that the Commissioner may set aside a method of accrual accounting solely because it postponed the reporting as income of amounts received to a tax year subsequent to the year of the receipt.

This, in essence, completes the taxpayer’s position.

Before closing, I should say that the Government’s dispute with our position apart from the American Automobile Association case is grounded basically on two legal doctrines which are repeatedly referred to throughout its brief.

These are the annual accounting requirement and the claim-of-right doctrine.

We do not understand the relevancy of these doctrines to this case.

We believe that they have been discredited as the basis for taxing advance receipts of accrual-basis taxpayer in the year of receipt.

In here, the same opinion in the American Automobile Association case, Mr. Justice Stewart pointed out that the Court does not base its decision on this theory referring into the annual accounting requirement presumably because the Court believes as I do that the theory is not valid.

Likewise, in the American Automobile, the respond — the respondent pointing to the dissenting opinion of Mr. Justice Harlan in the Automobile Club of Michigan, there agreed that the so-called claim-of-right doctrine was not applicable and in the dissenting opinion in American Automobile, it was specifically pointed out the Government had abandon the claim-of-right doctrine in that case.

Now, we will reserve until later our reputation of what the Government has to say about these two doctrines.

We do hope, however, that Government will explain why it is that it now seeks to ground its case on the annual accounting requirement in the claim-of-right doctrine.

Byron R. White:

Excuse me, could you tell me what difference it will make to your clients over the long run which accounting whether they have to report these sums (Voice Overlap) —

Carl F. Bauersfeld:

It will make a very — sir (Voice Overlap) —

Byron R. White:

In over the years?

Carl F. Bauersfeld:

Over the long run, it will make a tremendous — tremendous difference.

In fact this company would probably be bankrupt.

It could make that much difference.

Byron R. White:

How does that make this much difference as to whether you report the income this year and next year?

Carl F. Bauersfeld:

The — under the determination of the Commissioner they, determined that all — I — all — the entire contract price of the contracts was income at the time it was signed.

And we show in — the record shows that over 20% of all contracts that was — were so signed were cancelled, a student never went and — went through with it, never made payments and if you don’t match the costs in the same tax year, you get a complete distortion of income.

Byron R. White:

And you have an earned — and when a student cancels out there is no adjustment to — there would be no way of adjusting to get back the money you paid in taxes in the first year?

Carl F. Bauersfeld:

No sir, (Voice Overlap), not under the method we used.

Byron R. White:

Thank you.

Potter Stewart:

Well, there is one aspect of this case in which the Government concedes that the Commissioner was in error that is the —

Byron R. White:

Yes.

Potter Stewart:

— the future installments?

Byron R. White:

Yes, sir.

Potter Stewart:

And it’s that aspect that would cause such an impact upon your business, isn’t it?

Byron R. White:

Yes.

Potter Stewart:

Rather than the basic payment you’ve been arguing?

Byron R. White:

Yes, well —

Potter Stewart:

And all the Government concedes you’re right about that.

Byron R. White:

They — oh, I misunderstood you.

The concessions — concession would mean very, very little to us as far as money is concerned, sir.

Surprising as it seems because there — a substantial amount had been paid on the contracts in advance.

Earl Warren:

Mr. Oberdorfer.

Louis F. Oberdorfer:

Mr. Chief Justice, may it please the Court.

I would like to go back over the facts just briefly to use them, to illustrate the principles and there is a principle that is at issue between the Government and a taxpayer in this case.

The question, as we understand it, is whether this accrual payer — accrual-basis taxpayer can defer or postpone to a subsequent taxable year or years amounts which the taxpayer has received in cash or in the equivalent of cash pursuant to a contract, a very strict contract which makes it crystal clear that under no circumstances does the taxpayer or does the student have a right to get any of the money back.

And — so that everything that would entitle the taxpayer to own that money, to use that money, to spend that money, to invest that money has occurred.

A student who paid — to pay installments still remain obligated to pay his installments?

Louis F. Oberdorfer:

Yes, sir.

If the company falls down in its dancing lesson?

Louis F. Oberdorfer:

Well, this is the place where — where we parted from our original position, Mr. Justice Harlan.

There are three elements to the compensation: one, the cash payments; two, notes, negotiable promissory notes with some waiver of defenses in many of them, which are enforceable as notes irrespective of the underlying contract; and thirdly, the promise to pay.

Now, our original — the Commissioner originally set this up by taking in to income the face amount of each executory contract.

We, having looked at that more closely, and the service having looked at that more closely, concluded that there was a distinction between the prepayment in cash and the equivalent of cash and the mere executory right.

If I may invite the Court’s attention —

Byron R. White:

(Inaudible)

Louis F. Oberdorfer:

We end up with — in the position that the amount accrued includes the cash paid under this contract, the equivalents of cash, namely the negotiable notes and any installment due on a particular — as of a particular time or the value of any lesson, which has been rendered.

The mere executory promise of the student before the installment is due and before the services are rendered are not included in income.

William J. Brennan, Jr.:

(Inaudible)

Louis F. Oberdorfer:

I beg your pardon, sir?

William J. Brennan, Jr.:

What happens to them?

Louis F. Oberdorfer:

They accrue when either a payment, an installment becomes due or a lesson is rendered.

William J. Brennan, Jr.:

Meaning a subsequent taxable tax year?

Louis F. Oberdorfer:

It could be in — it would — this would only involve subsequent tax year — yes.

Byron R. White:

But if it say — but if he makes the payment on an installment note which has been transferred in banks, that’s already been —

Louis F. Oberdorfer:

That’s already income.

Byron R. White:

That’s already been (Inaudible) — and even though the bank, even though he does — the studio does not get face value from the note?

Louis F. Oberdorfer:

That’s correct.

The note is included under our — under the Commissioner’s theory, the note is included in income.

William J. Brennan, Jr.:

But what would the practice be, Mr. Oberdorfer?

I take it the notes would be sold, would they not?

Louis F. Oberdorfer:

They are in fact —

William J. Brennan, Jr.:

(Voice Overlap)

Louis F. Oberdorfer:

— discounted or they would —

William J. Brennan, Jr.:

That being true, in dollars and cents I gather most of it comes into the taxable year and the contracts made them, doesn’t it?

Louis F. Oberdorfer:

Well, actually these are the way that note operates in the way — in this particular case, the notes are I think “discounted” is the correct word.

In any event, they are turned over to a bank for collection endorsed to the bank.

And the bank immediately pays 50% of the face amount of the note less some charges and interests and then as the bank collects on the note or when the bank is collected on the note, I’m not clear whether it happens as payments are made or after the whole note is paid in full, the bank remits to the taxpayer the balance of the 50%.

But the taxpayer has — this is the way this taxpayer deals with these negotiable notes.

These are negotiable notes and they would theoretically be subject to discount or sale in the normal commercial channels.

William O. Douglas:

And all that would be according to a year in which the note is signed and the contract is made?

Louis F. Oberdorfer:

When a note — the note part of it, the Commissioner would include an income when the note is executed.

William O. Douglas:

Now, where does your concession come in then, I don’t —

Louis F. Oberdorfer:

With respect to the installments due in the future, in subsequent years on accountable essence to be given in subsequent years with respect to which there’s been no cash payment and no note, there are such element.

William O. Douglas:

That’s another way of contracting altogether then?

Louis F. Oberdorfer:

Yes, sir.

Arthur J. Goldberg:

(Inaudible)

Louis F. Oberdorfer:

The — this is where the — this — the short answer, Mr. Justice Goldberg, is that the Government is delayed in its use of tax revenues and if you multiply the deferral enjoyed — which would be enjoyed by this taxpayer by the other taxpayers similarly situated who would be able to — talking now about the prepayments, who would be able to defer tax on money that they had completely in control and in possession, there would be the — the lost of the use of the money for how long it took the Government — took this earning process which they advocate to work itself out.

Louis F. Oberdorfer:

It’s the — and the Government as Your Honor well knows operates on a fiscal budget and this is why the annual accounting period, the annual accounting rule comes into the picture.

This is the annual accounting period, the annual accounting rule is a part of the formulation here because the Government as many cases — many opinions of this Court have ever cited, the Government must look to it’s — to the ability of taxpayers in a particular year to pay the tax for that year.

And when taxpayers have a big reserve or account of deferred incomes and don’t pay tax on it and this is — this taxpayer and millions of others do the same thing that becomes a fiscal problem.

Earl Warren:

I just want to ask you if only so called “life contracts” where they get as much as $5000 for a life contract do they — do they set up the cash or the notes in the same way that they do these yearly contracts?

Louis F. Oberdorfer:

Well, I think as taxpayer’s counsel pointed out Mr. Chief Justice, the — in this — under this — in — on the facts of this case the life contract is always worked out with over a period of — this is determinable period beyond which they do not defer.

Earl Warren:

Yes, but do they — do they pay for it sometimes at the beginning?

Louis F. Oberdorfer:

Yes, sir, I understood counsel to say that sometimes they get a $5000 payment —

Earl Warren:

And it — under the —

Louis F. Oberdorfer:

— on the signing of the contract and work it out over a period of time that at least 1200 lessons which is a lot of lessons.

Earl Warren:

And they would negotiate those notes in the same way they would the yearly contract?

Louis F. Oberdorfer:

Well, in sometime — I assume that they can have $5000 in case or —

Earl Warren:

Yes, yes.

Louis F. Oberdorfer:

— or negotiable notes, that’s correct.

Earl Warren:

That’s what I was asking.

Hugo L. Black:

According to their view, is that taxable when it’s paid?

Louis F. Oberdorfer:

Which, sir?

Hugo L. Black:

In cash, that $5000?

Louis F. Oberdorfer:

No, sir.

It’s the — the only the portion —

Hugo L. Black:

— spread out?

Louis F. Oberdorfer:

It spread — let’s suppose — let’s take the 1200 lessons that would go for four years presumably if you had a lesson everyday.

I suppose it would take long.

Hugo L. Black:

400 lessons a year?

Louis F. Oberdorfer:

300 lessons a year.

Hugo L. Black:

300.

Louis F. Oberdorfer:

I don’t know how long these — but however the term of the contract is, they have the $5000 and when the payment is made and they take into income a portion of it, a numerator, a fraction — numerator which is a — the denominator is 1200 and the numerator is a number of lessons given in a particular taxable year.

What — in your theory what statute for the accrual taxpayer is there any such thing anymore —

Louis F. Oberdorfer:

Oh, yes.

Mr. Justice Harlan this is the place where — this is why I say this is an issue of principle.

The tax concept of accrual accounting is that — and it’s stated in the opinions of this Court that just to — by a cash basis taxpayer takes in the income what he receives in cash.

Louis F. Oberdorfer:

An accrual-basis taxpayer takes in the income amounts which — to which he has become entitled during the year, all the — the all-events test applies to income just as it does to deductions.

An accrual-basis taxpayer under our theory is: one, who includes an income the amounts he’s received plus the amounts he is entitled to.

And we think that by definition, this just go — the whole, including the part a taxpayer who has obligated himself in the way that the taxpayers under these contracts which I was going to point out specifically and who has received the cash, if you apply the all-events test to that kind of accrual-basis taxpayer, he has accrued income as we interpret the — and as we interpret these prior decisions of this Court.

Potter Stewart:

A receipt though doesn’t have anything to do with whether something is accrued, doesn’t it?

Louis F. Oberdorfer:

It — in this con — in this —

Potter Stewart:

One way or the other?

Louis F. Oberdorfer:

— context — in this context where the taxpayer is — just possession is 9/10ths of the law, they see he’s got possession in all the other rights too.

Possession is not the thing that defeats and can’t possibly —

Potter Stewart:

I don’t say — I don’t say receipt, it means that it hasn’t been accrued but it does — nor does it mean that it has been.

I just think I had —

Louis F. Oberdorfer:

Well, if it —

Potter Stewart:

I was asking you whether receipt had anything to do with (Voice Overlap) —

Louis F. Oberdorfer:

Our position is that it has — it adds — it makes the cheese more binding.

It adds to accrual considerably.

Earl Warren:

Mr. Oberdorfer, you may continue.

Louis F. Oberdorfer:

Thank you, Mr. Chief Justice.

Mr. Justice Stewart in connection with the last — the last remarks about the effect of payment, we thought that the Court’s disposition on the Consolidated Edison problem perhaps is an illustration of the — at least our view that — of the — of one aspect of the role of payment.

In that case, if Your Honor will recall there was a payment of a state tax in one year and under protest —

(Inaudible)

Louis F. Oberdorfer:

And a contest which continued into subsequent years.

And the question was whether the payment by itself in that context in no circumstances was the occasion for an accrual.

And the Court held that the — in that kind of a situation where the taxpayer resisted the idea that he owed the tax.

And the payment was really the key to the courthouse.

He had to make the payment in order to get into Court that in that case the payment was not the occasion for an accrual.

But just taking it back to the income side, it’s our position that where a payment is made with no legal right or no legal liability for the return of it as where somebody borrows money that that payment is ordinarily an accrual even though —

Potter Stewart:

Well, (Inaudible) — I’m thinking of some any other areas, some any other possible examples, for example a lease with a payment to the lessor of more than a year’s lease in advance payment and those (Inaudible) — and it accrue, assuming accrual-basis taxpayer?

Louis F. Oberdorfer:

Well, there on the deduction side, of course of the theory and this is something that maybe this system is subject to criticism as one of the reasons because of this complex, it is that we tried to take the position that this is — this whole area is something that can be better —

Potter Stewart:

Left to Congress?

Louis F. Oberdorfer:

— corrected by legislation.

But the prepaid rent on the deduction side has been considered traditionally as a — like any other expenditure which has a — which buy something whether the value or usefulness for more than one year is a capital expenditure and the formulation is that that’s capitalized and spread over the years.

Louis F. Oberdorfer:

I don’t believe that in the law at least the same idea has been honored up to now on the income side.

Potter Stewart:

To the lessor?

Income —

Louis F. Oberdorfer:

Yes.

Potter Stewart:

— to the lessor?

Louis F. Oberdorfer:

That’s right.

William O. Douglas:

366

Potter Stewart:

I mean —

Louis F. Oberdorfer:

On the —

Potter Stewart:

— an accrual basis assuming the lessor is an accrual-basis taxpayer?

Louis F. Oberdorfer:

That is correct.

Now, the —

Potter Stewart:

The payment wouldn’t be or would it be, under your view?

Louis F. Oberdorfer:

Well, the Commissioner has ruled in a ruling, it’s quoted at length in our brief that this prepayment of rent is income in full on receipt to a lessor.

Potter Stewart:

Even though in the accrual basis?

Louis F. Oberdorfer:

I beg your pardon, sir?

Potter Stewart:

If — assuming on accrual basis.

Louis F. Oberdorfer:

Yes, prepayment is income to an accrual-basis taxpayer.

Potter Stewart:

How about prepayment of say a five-year insurance premium?

Louis F. Oberdorfer:

That is treated I believe as income also.

That’s ruling which in fact located —

Hugo L. Black:

Page 51.

Louis F. Oberdorfer:

On — it was quoted at length on page 51 of our brief.

I believe describes the peti — the Commissioner’s policy on this issue.

This was published in 1960.

The service will continue as policy of taxing pre (Inaudible) — general policy of taxing prepaid income in the year of receipt.

This policy applies to income from contracts to furnish services and to other types of prepaid income such as prepaid royalties, rents, bonuses, etcetera regardless of whether the period of proration is definite or indefinite.

Byron R. White:

(Inaudible)

Louis F. Oberdorfer:

That’s correct, this is merely — this assumes that premises that this is income sooner or later, it’s a question of when.

Byron R. White:

And what difference (Inaudible)

Louis F. Oberdorfer:

Well —

Byron R. White:

(Inaudible)

Louis F. Oberdorfer:

— it just takes — it just pushes the receipt of revenue back to another or some other several fiscal years and it —

Byron R. White:

(Inaudible)

Louis F. Oberdorfer:

That’s — that would be the effect of a general ruling of this Court in — to the — on the basis that the taxpayers have asked the Court to rule.

In other words, the legislative proposals that have been under consideration, the bill that was passed by Congress and then repealed would have protected the revenue against that consequence by providing for transition adjustments or at least its failure to provide that causes them to repeal it.

Now, the bill that was passed after the enactment of the — at decision of this — by this Court in the three A’s case for the relief of membership corporations has a transition adjustment in it so that the revenue that — it’s faced out.

If — there would be a subs — I don’t have this in dollars and cents but if every taxpayer can now defer tax on prepaid income although he has complete possession of it and has the ability to pay the tax from it, it would have — I’m sure have noticeable fiscal consequences.

Byron R. White:

But the — isn’t it — isn’t it possible that the studio or at least the partners will have to pay taxes on money they haven’t received but the bank may give them 50% in their financing arrangement with the bank but there was no bank involved certainly taxing the studio on the face value of $5000 note only as thousand dollars that was paid in cash means that — it means if they pay taxes on money they haven’t received and they may not have the money to pay it.

Louis F. Oberdorfer:

Well, actually the basis for the tax should be the market value of that note, not its face value.

Byron R. White:

Yes, but the — on a negotiable note — on a negotiable note endorsed to the bank, doesn’t the Commissioner pretty regularly pays the face amount?

Louis F. Oberdorfer:

I believe the position is market value.

I think we have a (Voice Overlap) —

Byron R. White:

Yes, but what is the — do you know what the market value is normally on this notes in relation to the face?

Louis F. Oberdorfer:

I do not.

Somewhere I suppose above 50% since they get 50% right out.

Byron R. White:

But to the extent that — to the extent that the studio pays taxes on money that it hasn’t received and then the note is not collected, I assume these are endorse with recourse then the — the bank doesn’t suffer.

And the person who signed the note can’t pay the note or won’t pay it and it is never paid.

Then how can the taxpayer reflect in its tax for later years that (Voice Overlap) —

Louis F. Oberdorfer:

They get a — they get a deduction in the year in which the note — they get a bad debt deduction in the year in which the note becomes uncollectable.

And of course, accrual-basis taxpayers assume never — most people who are in business make a profit.

Accrual-basis taxpayers are accruing more — ordinarily are accruing income and accruing expenses in advance to the actual — in addition to the actual cash receipts and payments and in advance of them so that in every year the accrual-basis taxpayer is presumably paying tax on some money that he doesn’t have or at least his tax is measured in that way, this is the connection between the claim-of-right theory.

This keeps cropping up in the discussions of this issue and we are pilloried for claiming that this case is governed by the claim-of-right or because we fail to stick to our guns on the claim-of-right theory.

We don’t — it isn’t our position that this is controlled by the claim of right but the claim of right concept is filtered through the idea of an accrual-basis taxpayer accruing amounts which he has completely in his possession dominion and control.

The system presumably would — operates when an — when a taxpayer includes an income all of the items with respect to which all the events entitling him to the income have occurred.

That includes naturally some items which he’s actually received in cash thus (Inaudible) —

Byron R. White:

(Inaudible)

Louis F. Oberdorfer:

Excused from payment by whom?

Byron R. White:

(Inaudible)

Louis F. Oberdorfer:

By the —

Byron R. White:

(Inaudible)

Louis F. Oberdorfer:

Now, and — you’re assuming a case where this is a negotiated arrangement between the bank and the studio on one side, and the student on the other.

This isn’t a matter of —

Byron R. White:

No, but these leaves the fact out of it (Inaudible)

Louis F. Oberdorfer:

There would be a — presumably an adjustment.

I can’t stand here and say how it would be adjusted but there should be an adjustment for that taxpayer.

Byron R. White:

(Inaudible)

Louis F. Oberdorfer:

He’s liable.

Byron R. White:

The studio does not recognize.

Louis F. Oberdorfer:

Oh, well, that’s — I would think he — that the studio would then get a bad debt deduction having a debt that is — having accrued an item which is not collectable.

The law allows a deduction in those circumstances at that time.

Hugo L. Black:

That’s the way it’s ordinarily handled, isn’t it, on an accrual basis?

Louis F. Oberdorfer:

Yes, sir.

That’s our theory of how the accrual basis should work and I believe that’s the way the law is administered.

Hugo L. Black:

I meant, so far as deduction is concerned —

Louis F. Oberdorfer:

Yes, sir.

Hugo L. Black:

— to the law.

Louis F. Oberdorfer:

Yes, sir.

William J. Brennan, Jr.:

What about the law that Congress considers (Inaudible)

Louis F. Oberdorfer:

The three A’s?

William J. Brennan, Jr.:

Yes.

(Inaudible)

Louis F. Oberdorfer:

No, sir.

William J. Brennan, Jr.:

(Inaudible)

Louis F. Oberdorfer:

That is — I’m not aware of it but I don’t believe that it appears in the face of that legislative history.

However, the provision of the 1954 Code that was enacted and then repealed would have given relief here.

You said earlier, with rather force I thought that this is the question could not be dealt with by Congress.

Louis F. Oberdorfer:

Yes.

And I suppose you got come to the questions as to whether the Congress has dealt with it?

Louis F. Oberdorfer:

Well, we — we have — we believe that Section 41 ex — I say dealt with it.

Louis F. Oberdorfer:

Section 41 — as we construe Section 41 it authorizes the — it — if as interpreted by this Court, it operates the accrual system in the way that I thought I described it which has some hardships in it.

That is the taxpayer accrues items of income as all the events entitling him to that income occur.

And accrues items of expense and deducts them as all of the events which create an obligation on him to pay the expense occurred.

Congress would — could, as it did briefly in the 1954 Code, as it has with respect to prepaid subscriptions, and as it had with respect to membership corporations specifically authorized the deferral of tax on certain prepayments.

Or as the Treasury has by regulations which it now become embodied in the law by a virtue of long acceptance by the Congress permitted taxpayers to defer income on certain long term contracts, the percentage of completion method for treatment of some construction contracts or the completed contract method under which the tax on that the — that the income from performance of a construction contract if the taxpayers so elects is not taxed until the contract is completed and the taxpayer adds up how much he received for performing the contract and how much the contract costs him and then includes an income in the year of completion they met and nothing more.

But the Congress is doing this by — on a selective basis and it seems — we feel that the — that sort of division of labor if I may between the judicial process, the administrative process and the legislative process is something that we would advocate.

We — the one final point so far as the comparison between this system which has in terms of its artificiality as that word is used in the three A’s and in the Automobile Club case is concerned, we point out that the contract provides unless you make an appointment, your lesson is canceled that the performance is that the demand of the student and they — as the — as counsel has said the — there is no day-by-day specificity for performance.

This system doesn’t even take into account what they concede to be an experience of about 17% cancelations.

There is no adjustment to the amount deferred on account of the expectation that as experiences demonstrated that about 17% of the students either die or become disabled or just quit.

And we think that while this is a different kind of artificiality from that which the Court described in the three A’s case, it still doesn’t meet the standards that were inferred in Automobile Club of Michigan and the three A.

Thank you, sir.

Earl Warren:

Mr. Bauersfeld.

Carl F. Bauersfeld:

May it please the Court.

One of the things that show the distortion of income that would result is in the case of where we have a note which is discounted — not discounted but negotiated with the bank.

In those cases, the record specifically found that the studio could not receive the 50% that was retained by the bank until after the student made the full payment on the contract.

So for example, if we had a contract which provided with a note for $50 which was negotiated with the bank and the studio would receive $50 and then it would not get the other $50 until the student have made a complete payment on account, therefore, we didn’t have a legal right to receive the amount even under the Commissioner’s theory of the balance of the $50 in the tax year or at the time the contract was signed.

And the — as a result of this and other things the — it ends up with — the effect of it is to buildup income at the time the contracts are signed in one year and then have that income subjected to tax rate at a higher rate and then when the performance is given in a subsequent tax year, we have a distortion.

And because of the tax rates, it means much more revenue would accrue to the Government.

The 1951 statute authorizing membership organizations to use an accrual accounting system as that — that found in American Automobile Association dealt with that particular type of accrual accounting system where they had to use statistics and other things we feel.

Here, we have the statute 41 and 42 which is always are permitted the use of the accrual accounting system.

Tom C. Clark:

It wanted to turn down anybody (Inaudible)

Carl F. Bauersfeld:

Not to my knowledge, sir.

I can’t answer you positively but I have no knowledge that they did.

Lifetime courses which we have mentioned here are only — really unusual.

We don’t have many of that type most of them are for a lots — less amount involved.

In — and the whole system, I don’t believe, should look — to be looked just through lifetime course alone.

Tom C. Clark:

Is there a number of times that you’ve been (Inaudible)

Carl F. Bauersfeld:

I think the record in this case will show that it was a growing business over the years that we had involved sir, five-year period that it’s disclosed by the record.

Sales increased — decreased each year but since then some times have not been so good.

Hugo L. Black:

(Inaudible)

Carl F. Bauersfeld:

In a good broad way, they were about the same sir, yes sir.

Byron R. White:

Suppose there’s an area that a (Inaudible)

Carl F. Bauersfeld:

It would not be near so harsh as in the — in —

Byron R. White:

(Inaudible)

Carl F. Bauersfeld:

It would completely distort it.

Byron R. White:

(Inaudible)

Carl F. Bauersfeld:

The rate of tax would have a lot to do with the job.

Hugo L. Black:

What does the bank get aside from the interest?

I don’t understand.

Carl F. Bauersfeld:

I think they make some service charge, sir.

Hugo L. Black:

Did you get the money after the 50% is reimbursed to the bank?

Did you get the money out when it’s paid or do you get it at the end of the period?

Carl F. Bauersfeld:

The end of the period and it so specifically stipulated in the case.

Byron R. White:

Does that make (Inaudible) as in the note?

Carl F. Bauersfeld:

Yes, sir.

In fact there was a collection procedure because the students would be more readily inclined to pay the bank they would the studio.

(Inaudible)

Carl F. Bauersfeld:

That is correct.

The full recourse of the notes are transferred, the bank fully because it was really I think in the — and the record shows where the collection procedure in a large — to a large extent.

Hugo L. Black:

When the bank pays you the second 50%, does it pay you with that interest that the student has paid in?

The student pays interest, does he not?

Carl F. Bauersfeld:

Yes, sir.

Hugo L. Black:

And the bank collects it?

Carl F. Bauersfeld:

Yes, sir.

Hugo L. Black:

Does it hold that interest when it pays you the second 50% —

Carl F. Bauersfeld:

I —

Hugo L. Black:

— or does it go to the — to you, to your client?

Carl F. Bauersfeld:

I’m sorry, sir.

I can’t answer the question, I just don’t know.

I’m not sure the record shows.

Hugo L. Black:

You said, it had nothing to do with cases (Inaudible)

Carl F. Bauersfeld:

I think that they do have progressive courses and they give them awards and have other sales features.

We — the — this case really presents the questions as I stated in the beginning as to whether an accrual basis of method of accounting may continue to be used where there are advanced receipts involved.

Now, we don’t care what — what the system may be designated as but it certainly is not the accrual method of accounting if you’re required to take in advance receipts before they are earned by performance.