AMERICAN AUTOMOBILE ASSN. v. U.S.
Legal provision: Internal Revenue Code
Argument of Fleming Bomar
Chief Justice Earl Warren: Number 288, American Automobile Association, Petitioner, versus United States.
Mr. Bomar, you may proceed with your argument.
Mr. Fleming Bomar: May it please the Court.
This is a federal income tax case.
It is before this Court on writ of certiorari to the United States Court of Claims which dismissed petitioner's suit.
Petitioner is the American Automobile Association, a nonstock membership corporation with its principal offices in the District of Columbia.
Petitioner is a national organization which renders services to its affiliated local clubs and their members and performs services of a public nature and fields relating to motoring and travel.
Separate books and records are maintained by petitioner with respect to its national activities and those activities are not involved in this proceeding.
In addition, petitioner operates directly 10 local automobile clubs as divisions of the corporation.
Those clubs include the club which serves the metropolitan area of Washington, a club which serves South Florida, went in Texas, Wisconsin, Wyoming and so forth.
Substantially, all of the income which petitioner derives from its divisions is paid in the form of dues prepaid by its members in advance, in consideration for services to be rendered by the club over the ensuing 12-month period.
Petitioner is obligated to render services over that ensuing 12-month period which include a complete travel service, trip planning, tour books, accommodation directories, maps, emergency road service, personal automobile accident insurance, bail bond protection.
The obligation of petitioner necessarily includes the duty to maintain the staff and the facilities in -- which are adequate to permit it to perform.
The issue in this case is whether petitioner in computing its income for federal income tax purposes can account for prepaid dues as taxable income in accordance with sound principles of accrual accounting.
Or whether this Court, in Automobile Club of Michigan, intended to lay down a broad general rule of law that under no circumstances can prepaid receipts, be accounted for as taxable income later than the year in which received.
And regardless of sound accounting -- accounting principles and irrespective of whether net income is clearly reflected, petitioner's entire argument will be directed toward establishing the point that this Court did not intend to lay down such a broad sweeping rule law in Automobile Club of Michigan on the accounting issue.
And that therefore, the Michigan case should not be controlling here.
Justice John M. Harlan: Could I suggest one point at this point that I --
Mr. Fleming Bomar: Yes, sir.
Justice John M. Harlan: -- hope you'll cover in your argument.
That is what you say that the Government's argument which is I recall the Michigan case was not presented as to the bearing of Sections 452 and 462 of the 1940 Code in congressional action, what bearing all that has on this case.
Mr. Fleming Bomar: Yes, sir.
I will cover it.
Chief Justice Earl Warren: Does the Commissioner take the position that under no circumstances, these can be -- be adjusted through the year?
Mr. Fleming Bomar: He does.
On page 20 of his brief.
Chief Justice Earl Warren: Under any circumstances --
Mr. Fleming Bomar: The Commissioner volunteers the definition of accrual accounting which says never later than the year of receipt.
Petitioner isn't accrual basis tax payer.
It falls --
Justice Charles E. Whittaker: I'd like to know if I might (Inaudible) as to how does this in dollars and cents affect the Government over a course of the long run?
Mr. Fleming Bomar: Inso -- in --
Justice Charles E. Whittaker: Does affect the dollars and cents (Voice Overlap) --
Mr. Fleming Bomar: It should not over the long run.
It should not except that where the Government collects money in advance of performance, it gets its money too soon and on -- and it gets its money on earning -- on what is not income.
Justice Charles E. Whittaker: What if -- even if your theory were adopted, it wouldn't lose dollars over the long (Inaudible).
Mr. Fleming Bomar: No, it would not.
Justice Potter Stewart: They would lose -- they would lose in the year the gears were shifted, wouldn't it?
It would -- it would lose in the year of transition, in other words, of changing --
Mr. Fleming Bomar: There is no transition --
Justice Potter Stewart: In this case, there is not.
Mr. Fleming Bomar: No.
If taxpayers were permitted to switchover, there would -- there could be a reduction in income in the year of the changeover.
Justice Potter Stewart: Yes.
Mr. Fleming Bomar: But a change can be made only with the approval of the Commissioner and under such conditions as he specifies.
Chief Justice Earl Warren: May I ask just one more question?
A moment ago, you said that the Commissioner took the position that under no circumstances could this be done.
Do you take the position that on the other hand, the other extreme that if consistent with the good accounting practices, it can be done in any circumstance.
Mr. Fleming Bomar: Only if income is clearly reflected and if necessary in order to match prepaid income with related cause, then it should be permitted.
Chief Justice Earl Warren: Very well, now --
Mr. Fleming Bomar: But not every circumstance.
Chief Justice Earl Warren: Well, now, is that accounting?
Is that just accounting?
Mr. Fleming Bomar: There is sound accounting principles, yes.
Chief Justice Earl Warren: Well, I say and -- and if it is sound accounting, do you claim there is no limitation upon your right to do what you seek to do in this case?
Mr. Fleming Bomar: If income is clearly reflected.
Chief Justice Earl Warren: In the accountings.
Mr. Fleming Bomar: If you compute income accurately, yes, sir, to determine what is net income.
Now, if there are no -- if there are no cost to be matched, there maybe no reason to defer even though accountants may recommend deferral.
But the problem is acute and certainly, this Court should hold that in any case where it is absolutely essential in order to match the cost of performance with the prepaid revenue that you've got to defer.
Now, the years involved in this dispute, the calendar years 1952, 1953 and 1954, the taxes in dispute, total $207,000 plus interest.
While petitioner filed its tax returns on a calendar year basis, its members join in prepaid dues for 12-month period which does not coincide with petitioner's calendar year or taxable year but extends beyond in every case.
In every case, the membership period extends beyond the petitioner's taxable year.
That single fact is the cause of the dispute and because of that fact, petitioner's method of accounting is as follows.
A member joins on July 1, prepays dues of $12.
Under petitioner's method of accounting, $6 of those prepaid dues are reflected as income in the year of receipt, the remaining $6 -- the following year.
Respondent says no, in tactual of dollars, constitutes taxable income in the year of receipts.
The difference in the two methods of accounting is best understood if we assume that cost of serving a member are $1 per member per month, in other words, an exact breakeven situation.
In -- under our method of accounting, if a member joins July 1, we have $6 of income, $6 of cost in the year the member joins, no profit.
The following year, we also have $6 of income, $6 of cost, no profit.
Under the respondent's method where a member joins July 1, we've got $12 of income, only $6 of cost and a fictitious profit of $6.
The situation is most appalling when the members joined in December and our members -- just as many joined in December as in the other month, under respondent's method of accounting, $12 of income in December.
We've incurred only $1 of cost in serving the member so we're required to pay a tax on a fictitious profit of $11.
Now, petitioner has established this effect in this case, not that its cost a $1 per member per month but that -- its costs are substantially in proportion to membership from month-to-month with reasonable constancy from year-to-year.
The exact cost per member per month, are shown in the record on pages 70 and 71 and they are quite uniform per member per month.
Petitioner in its case in the lower court went further than that and established as a fact that there is a precise matching of income and related cost in the same taxable year.
Finding of fact 26 is to the effect that if our advanced dues were recognized as income exactly as costs were incurred, the net income during the years in issue would be substantially the same as that reported by petitioner on its tax returns.
Now, despite those findings of fact, the Court of Claims felt and held that it was precluded from rendering a decision in favor of petitioner because this Court, in Automobile Club of Michigan, apparently intended to lay down a rule of law that such a method of accounting as -- as followed by petitioner is unacceptable for tax purposes.
In view of the position that the respondent takes in this case arguing that we violate the annual accounting requirements, I'd like to emphasize at this point.
Under our method of accounting, we do not wait the termination of a membership to determine whether a profit or loss is earned on the membership.
Instead, as of the end of the calendar year, we determine the profit and loss by reference to that portion of the contract which has expired within the calendar year.
Petitioner submits that its method of accounting should be and is acceptable for federal income tax purposes because it complies with the applicable statutes, complies with the Commissioner's own regulations and is in conformity with the principles of accrual accounting laid down by this Court under Section 446 (a).
The statute not only permits but requires a taxpayer to file its federal income tax returns in accordance with the method of accounting employed in keeping its books and records.
And the only two exceptions, 446 (b) state's them.
If no method of accounting is regularly employed or if the method of accounting fails to reflect income clearly then the Commissioner can substitute his own judgment and his own method.
But neither of those exceptions are applicable in this case.
Under Section 446 (c) of the Code, the accrual method of accounting is expressly authorized by the statute.
Section 451 which is entitled general rule with respect to year of inclusion of an item of gross income spells out that while in general, an item of gross income should be included in taxable income in the year received, it spells out the exception unless under the method of accounting employed by the taxpayer, it is properly accounted for as of a different period.
Certainly, a different period can be a period either before or after the year of receipt.
That is an express statutory authorization of accounting for prepaid receipts and a yet different from the year of receipt.
The Commissioner's regulations have for many, many years stated, “Approved standard methods of accounting are acceptable for federal income tax purposes as a general rule.”
That is the statement in the 1939 Code.
Under the 1954 Code, a statement which says, the Commissioner's own regulations, a method of accounting which reflects the consistent application of generally accepted accounting principles were ordinary -- ordinarily be regarded as clearly reflecting income and therefore acceptable for federal income tax purposes.
Finding 22 -- finding of fact 22 in this case which is in the record on page 66 is to the effect that our method of accounting does conform with established accounting principles.
The decisions of this Court on accrual accounting with the possible exception of Michigan clearly support petitioner's position as early as United States v. Anderson, which is in 269 U.S. and was decided in 1926, this Court explained the purpose of accrual accounting in the following language after reviewing carefully the legislative history of the statute authorizing a taxpayer to use accrual accounting.
Said this Court, “If the purpose of accrual accounting is to enable taxpayers to keep their books and records and to file their tax 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.”
Now, the finding of fact in our case conforms exactly with that language since it is found as a fact that there is a precise match of prepaid dues and related cost of serving members.
Second, the decisions of this Court from Spring City Foundry which is in 292 U.S. to the recent Hanson decision, point out that it is not the time of the actual receipt of cash that determines the year of its inclusion in income under accrual accounting.
And the cases which have been decided by this Court on the subject of accrual accounting, cash generally has been received by the taxpayer in a year following that in which performance takes place.
In our case, cash is received prior to performance.
The rules of accrual accounting are exactly the same whether or not cash precedes or follows performance.
In accordance with sound accounting principles, income under accrual accounting emerges only as goods to deliver or a services rendered.
Now, what goes on line one of an income statement is the value of goods delivered or the value of services rendered, cash is ignored whether it comes into play before or after performance.
There are two interesting decisions precisely in point of the United States Circuit Court of Appeals which have followed the decision of this Court in Automobile Club of Michigan.
First is the Bressner Radio case which was decided by the United States Court of Appeals for the Second Circuit.
That case involved prepaid television service contracts.
The contract which -- a purchase of a television set would buy at the time he bought his set was to have the seller guarantee the fixer set over the ensuing 12-month period.
These were in the days when sets were a little more fickle than they are today.
The contract was exactly for 12 months, the same as in our case.
The taxpayer's obligation to perform in that case was only upon the demand of the member which is exactly the same as in our case, the method of accounting followed by the taxpayers in the Bressner case, substantially the same as in our case.
The prepaid television service contract income was prorated over the period of the contract.
The Second Circuit reviewed in detail all of the decisions of this Court on the subject of accrual accounting and can -- and concluded that this Court in Michigan inferred that a realistic deferral would have been permissible for tax purposes if income were clearly reflected.
The starting points, said the Court, was whether income was clearly reflected and it looked at all of these contracts, found a uniform cost on a monthly basis and conclude that it was absolutely essential for the taxpayer to employ sound accrual accounting in order to reflect its income clearly.
Actually, the taxpayer was (Inaudible) in a loss but the Government was trying to collect an income tax because under its method of accounting of profit was shown.
The Eighth Circuit subsequent to this Court's decision in Michigan has decided Schlude case which involves prepaid income received by dance studios in return for lessons to be given over more than a period of one year.
The Eighth Circuit followed the Second Circuit, said, “Clearly, sound accrual accounting demands that prepaid receipts not be taken into income until the cost to incur of serving the member."
The Beacon Publish Company case in the Tenth Circuit, involved exactly the same issue insofar as prepaid subscription income was concerned.
That case was decided before this Court's decision in Michigan and this Court in a footnote in the Michigan's case, said it was not really passing upon the principle laid down in the Beacon case.
Justice Potter Stewart: There's -- there's now a statue -- there's now a statute specifically covering subscriptions, isn't there?
Mr. Fleming Bomar: There is now.
But this was decided independently of that statute --
Justice Potter Stewart: I understand.
Mr. Fleming Bomar: -- the Beacon case.
Sections 4 -- Your Honor, insofar as 452 and 462 are concerned, the -- they were enacted in an endeavor to eliminate a lot of the wrangling which has gone on in the lower courts in this area.
The losses and revenue that would have resulted from the enactment of those statutes occurred in the year of transition of a method of accounting.
There is no transitional problem involved in this case where the petitioner has consistently used the same method of accounting for 31 years even before and after it was taxable.
The Secretary of the Treasury in urging Congress to repeal Sections 452 and 462, expressly promised that no inferences whatever be drawn by the Commission of Internal Revenue or by the Department of Justice from the enactment in repeal of that legislation.
Despite those assurances, a great deal of the defendant's brief here is devoted to making just such inferences.
I think the problem is expressly answered by the Second Circuit in the Bressner case where the Second Circuit reviewed it and simply said it had no barring upon the disposition of this legally or otherwise.
Justice John M. Harlan: I don't quite understand it.
Yes, I mean one can say that.
As I -- maybe I have this wrong --
Mr. Fleming Bomar: 452 and 462 (Voice Overlap) of the statute.
Justice John M. Harlan: -- but here is -- here is what bothers me.I was in dissent in Michigan as you know and I don't recall this argument being made.
But as I read -- as I understand this problem, when 452 was proposed, it was proposed to accomplish what you're arguing for now and was seemingly recognized as being something necessary to put into the law if what you are arguing for would be permissible.
Then the Congress enacted it and the Treasury came back and said, “It had this enormous effect on revenue and Congress repealed it."
Now, to me, that has some substantial bearing on the validity of -- of your position.And just to say that it was 1954 --
Mr. Fleming Bomar: The legislative history --
Justice John M. Harlan: -- you can say it but --
Mr. Fleming Bomar: The Ways and Means Committee and the Senate Finance Committee both stated that it was to have no bearing whatsoever on the law as it existed prior to the enactment in repeal and even expressly referred to Beacon Publishing Company and said, “Where clearly not -- nothing in repeal of this legislation shall have any adverse effect on that case.”
So the principle in that case --
Justice John M. Harlan: You answer this -- do you answer the Government's argument in your reply brief?
Mr. Fleming Bomar: Yes, sir.
Justice John M. Harlan: Now, I haven't heard that yet, maybe that's --
Justice Potter Stewart: Isn't -- isn't it true that one of the things that 452 or -- and/or 462 did was to allow taxpayers to shift their method of accounting without permission of the Commissioner.
Mr. Fleming Bomar: It did.
It allowed --
Justice Potter Stewart: And it --
Mr. Fleming Bomar: And that's where the loss came out.
Justice Potter Stewart: And that's where the rub came and that --
Mr. Fleming Bomar: Yes.
Justice Potter Stewart: -- that's where the transitional loss came in.
Mr. Fleming Bomar: Furthermore, those statutes, Section 452 and 462 were drafted in very general terminology that that is -- did not identify the type of prepaid income that they were talking about and a lots of claims were being made by taxpayers because of the generality of the statutes which would not be authorized under sound accounting principles.
It was a the (Voice Overlap) --
Justice William J. Brennan: There was no reference to those statutes in Michigan, was it?
Mr. Fleming Bomar: I beg your pardon?
Justice William J. Brennan: No reference made in those statutes in Michigan, was it?
Mr. Fleming Bomar: Yes.
That point was argued before the Court in the Michigan case.
Justice William J. Brennan: It was --
Mr. Fleming Bomar: Yes.
Justice William J. Brennan: -- on 452?
Mr. Fleming Bomar: On 452 and 462 and appears in both briefs there.
In concluding, since I want to reserve some rebuttal time, since our method of accounting clearly conforms with generally accepted in accounting principles, complies with the express statutory provisions.
And in one of the few cases have had where complies with the Commissioner's very own regulations, we respectfully submit that if the Commissioner seeks to force us to change from a method of accounting which clearly reflects income to one which does not, he has exceeded the permissible limits of his discretionary authority and we, therefore, respectfully request this Court to reverse the judgment of the Court of Claims.
Chief Justice Earl Warren: Mr. Oberdorfer.
Argument of Louis F. Oberdorfer
Mr. Louis F. Oberdorfer: Mr. Chief Justice and may it please the Court.
If I may, I would advert first to the discussion of Section 452, the legislative history about which Mr. Justice Harlan inquired.
We think that the contrast between the provision there proposed and then repealed by Congress, points out one of the dangers of position which the respondent offers to the Government.
452 did not merely provide no transitional mechanism.
452 on the other hand had some specific safeguards for the revenue and that it limited the number of years over which a taxpayer could defer prepaid income.
It limited it to five years.
If -- if the rule is adopted, posed by the taxpayer here, the three A's for example could sell a life membership or sell a three-year membership or sell a five-year membership and then it would severely tax this sound -- this sound accounting principles to figure how to allocate those prepaid dues over that period of time.
As far as Mr. Justice Whittaker's question about, “Does the Government lose anything?”
The fact is that the Government loses the use of the money which would otherwise be paid by this taxpayer and all other taxpayers similarly situated if the taxpayer paid tax on realized income in the year in which we contend it was realized.
This means the use of the money does mean something from the fiscal position in the United States.
And it means something from the point of view of taxpayers but those taxpayers will have a great incentive to defer tax.
And that maybe not necessarily an issue in this case but it's an issue in other cases.
One of the thing the taxpayer suggests that there is no transition problem here because if -- the -- they're already using the method.
The -- the revenue agents didn't audit them early in the game so that they got a head start.
Now, other taxpayers who are not so fortunate shall we say and who are not now using the -- the accounting method employed by the three A's are left in a position where they suffer -- would suffer discrimination.
This actually developed in the case of prepaid publishing expense or publisher prepaid subscription prices.
There, the -- there was a sort of a grandfather clause adopted, those who had been using the method of deferring prepaid subscriptions were allowed to continue to use that method and by a ruling of the Commissioner and this practice was ratified by the courts.
That left others who hadn't gotten away with it, if I may use that word, in a severely handicapped position and newspapers, who couldn't use this method, agitated for legislation and got legislation which put them in the same position as the other.
Incidentally, the -- just deal for a moment with that detail, it can be said that the prepaid subscription of a newspaper publisher is in somewhat different category from the prepaid dues here because a newspaper publisher knows as of the end of the year, how many subscribers he has and how many days there are in a year for example and therefore specifically, how many papers he will have to deliver.
He doesn't have to wait for the subscriber to call up and ask for the paper.
Now, in the case of the three A's, there is no such specific obligation to take care of a particular member to the extent of a particular amount.
The member -- there is no liability as in that term -- that legal in that -- in a legal sense, the three A's has no liability to its member.
It only has a contingent obligation to render some unpredicted and unpredictable amount of services to particular members.
They have an experience that shows what the gross is but they don't have anything like the specificity that is required by the decisions of this Court for the accrual of an obligation.
Now, this -- this brings me to what I believe is -- is the heart of the matter here.
The three A's collects these prepaid dues during a particular tax year.
This -- these dues are paid in cash money.
They're deposited in the general banking account of the corporation.
They're available to the corporation for all of its corporate purposes.
They can pay salaries, they can build a building, they can pay off the mortgage, they can do anything with this money that they want.
The taxpayer conceives and couldn't what conceive that this money when received and as of the end of the year which it is received, all of it, is taxable income in a classic concept of that word as it's been used by the courts, by the administrative agencies and is as used more -- most important in the statute, taxable income.
They have absolute dominion and control of that money as of the end of the year.
Now, that doesn't mean that this taxpayer and every taxpayer using their accrual method for example, must pay tax on his gross income.
If this taxpayer operating on the accrual method had an obligation which had the precision and the dignity of a liability, a liability to pay an item of deductible expense in the subsequent year, the taxpayer could deduct from the gross income of $15, the then value as of the end of the year of its obligation -- legal obligation to pay an amount in the subsequent year.
Justice Potter Stewart: Well, can you give us an example of what you have in mind?
Mr. Louis F. Oberdorfer: Yes.
Suppose there was a -- the -- the -- suppose they have an obligation to pay income tax to the District of Columbia which is a deductible item.
As of the end of December -- as of December 31, in this case 1953, the year has ended.
All the things that were -- would create a liability for District of Columbia income tax, all the events will have occur.
The tax wouldn't have been assessed.
It wouldn't be paid until April 15th, 1954 but they would nevertheless, since they're on the accrual basis, be entitled to deduct from their income -- their federal income for the year 1953.
Their judgment of what they -- what they finally determined to be the tax for 19 -- the District of Columbia tax for 1953.
Justice Potter Stewart: That's just, in other words, ordinary accrual accounting.
Mr. Louis F. Oberdorfer: Accrual Accounting, of course.
Justice Potter Stewart: But how about the -- is it your position that -- as indicated on page 20 of your brief that, “An accrual-basis taxpayer has to report an item as gross income no later than the year of actual payment.”
Mr. Louis F. Oberdorfer: Well, first of all, that's not true in every case because there are some statutory exceptions.
Justice Potter Stewart: Well, one of it is of course the magazine subscriptions.
Mr. Louis F. Oberdorfer: That's correct, sir.
And there are other exceptions on account -- for instance, the statute permits someone who sells property on an installment basis to report on the installment method.
There -- there is a provision in our regulations which is of long standing and we say has a dignity of a statute so that it isn't -- it's a statutory exception to the general rule which permits a construction contractor to defer the apportion of the profit or -- and in fact -- of course the gross income from a construction contract over the life of that contract.
I -- I can't philosophically account for that except to suggest that the -- that it's in the statute and -- and -- and so that I would modify what Mr. Bomar says about our statement on page 20 to say that in the absence of a statutory provision or a regulation which has the dignity of a statute, we do say that an amount of dues for example, paid in advance for services.
I -- I want to distinguish between services and a payment for goods but an amount paid in advance for services is by definition, compensation for services and in the -- if under Section 22 of the old code and I think it's 441 of the new, that is the specifically defined as gross income.
Justice Potter Stewart: Well, it has -- Section 22 doesn't say any by plaintiffs.
Mr. Louis F. Oberdorfer: No, sir.
That's correct but it is -- it is income and it take to come specifically to -- to what is -- what is the issue.
That is because the -- this taxpayer who receives this income is on the accrual basis and we have to have here as we do a taxpayer who can't quite make it in a -- for -- can't quite make a claim that the obligation on which he relies is an accrual entitling him to a deduction, that's crucial here because if there were a legal obligation of -- of -- with which -- which has some precision, the three A's could come in and would say, “Well, would -- would have filed their return on the accrual basis by taking the prepaid income in and by deducting an expense, an accrued expense representing the value of the obligation to render -- well, in this, we don't -- I don't concede that they could deduct it but they -- they don't come close to being able to deduct it in this situation.
Incidentally, there's a -- talking about clearly reflecting income, this is the kind of little gadget that develops when we spring off from the regular accrual method into this general accounting procedure.
It's noted obscurely in our brief on page -- page 15 in a footnote.
That if the taxpayer had been able to find an accrued expense which it could deduct, it would have had all of the profit on this transaction on -- on its operations and it does make a profit towards here.
All of its profit or its transactions for the year 1953 would've been taxable in 1953 because they would've taken all the prepaid expenses and the gross income and they could've only deducted the value as of December 31 of the obligation to pay to the members.
But by spreading the whole gross income over the two years, they pick up a little of the profit out of the first year and tuck it into the second year.
I've -- I cite that as one point in for -- to support the proposition that this method does not clearly reflect income because under no stretch of the imagination that I can see can it be argued that this profit element in the case of a $15 payment of dues, the profit is somewhere between 25 and 50 cents.
That will never be consumed in rendering services to members.
It's in the bank account.
The charter says that the members don't get a refund.
This isn't income just collected under a claim of right.
There's no contest about it, its income period and there's no other way to describe it.
And its income in the year in which the -- everything that happened has happened.
So if -- if -- we had to -- if -- if we were just debating here which I think we're not, we were just debating a question of whether this method clearly reflects income, I think the Commissioner could stop right there and say it doesn't clearly reflect income.
Justice John M. Harlan: What -- what was --
Mr. Louis F. Oberdorfer: And therefore, he used his method.
Justice John M. Harlan: What were the findings of the Court of Claims as to whether it did or it did not properly reflect income?
Mr. Louis F. Oberdorfer: The -- the Court of Claims found that it did clearly reflect income in the --
Justice John M. Harlan: You didn't introduce me the evidence, did you? The Government didn't.
Mr. Louis F. Oberdorfer: No, sir.
Justice John M. Harlan: Are you arguing now that we should overturn those findings?
Mr. Louis F. Oberdorfer: No, sir.
I think that that's -- and I would construe those findings as a finding that within the -- that it clearly reflects income on -- under accounting principles but our regulations refer to principles of income tax accounting.
Justice John M. Harlan: Yes.
Well, that -- what you're saying in effect is that although under accounting principles, commercial accounting principles --
Mr. Louis F. Oberdorfer: Yes.
Justice John M. Harlan: -- this does properly reflect income.
Still, that there is a -- under tax accounting principles, as a matter of law, it doesn't.
Mr. Louis F. Oberdorfer: That's correct, sir.
Justice John M. Harlan: Is that it?
Mr. Louis F. Oberdorfer: That's correct.
Justice John M. Harlan: That depends a good deal on the validity of your argument on --
Mr. Louis F. Oberdorfer: On the --
Justice John M. Harlan: -- 452 and -- and --
Mr. Louis F. Oberdorfer: It does, although we can make this argument within the four corners where the code as it did now exist.
That is --
Justice John M. Harlan: A little more difficult without the exception.
Mr. Louis F. Oberdorfer: It -- yes, the other is --
Justice John M. Harlan: (Voice Overlap)
Mr. Louis F. Oberdorfer: The -- the specific statement of the Finance Committee and the Ways and Means Committee.
Then as of 1954, this categorically, the prepaid items with some minor exemptions are fundamentally income even to an accrual basis tax payer is we think strong medicine.
The -- the accrual -- we -- to -- to come back to -- to the fundamental, the -- the Internal Revenue Code unlike accounting generally, operates on the basis of an annual accounting period.
The taxable year is for most purposes the -- the beginning and end of -- of everything.
It's a -- it's an -- it's in -- it's the whole story and everything that -- every event and every fact which relates to a taxpayer's liability for tax for that year must have occurred within the annual accounting period.
Now, on a -- in a -- in a case of a cash-basis taxpayers, we understand the principle.
His tax liability for that year consists of the difference between the taxable gross income which is realized in cash, in hand, physically in his possession and the cash deductions for items at the expense of what she's paying out of pocket in that year.
We say that the difference between the cash basis and the accrual-basis tax payer -- well, first of all, they're -- that what we -- we insist at -- that the annual accounting period applies to both.
This Court has said that many times that the principle of annual accounting applies equally to the cash-basis taxpayer and to the accrual-basis taxpayer.
The difference is that if the taxpayer is on the accrual method, you measure his tax not precisely by what he has received in cash and what he has paid out in cash during the year.
You measure it in terms of what rights to income he's acquired during the year and what liabilities for the payment -- for the payment of expense he's incurred during the year.
Now, how do we get mixed up with this -- with the prepaid dues?
We get mixed up -- we -- we don't get -- want a way to avoid getting mixed up is to recognize that when a taxpayer has received compensation for services in cash, in hand, subject to his absolute dominion and control, he has the same or greater right to that income than he would have if all he had as of the end of the year was a promise of someone to pay him the dues.
The payment is an accrual in this -- when it's paid in advance because it -- there's nothing less to happen.
And we -- we think that if you adopted any other rule which permitted the taxpayer and has accounted to roam at large in what are called general principles of good accounting practice and determine when those prepaid items are taxable according to when some good accountant or some bad accountant decides that the income has been earned in a sense of accounting that the Court would be exposing the revenue service to a very difficult and we think unnecessary burden.
Justice Charles E. Whittaker: Mr. Oberdorfer.
Mr. Louis F. Oberdorfer: Yes, sir.
Justice Charles E. Whittaker: What would be the difference between the system you insist should be followed and the through cash basis?
Mr. Louis F. Oberdorfer: The -- the difference is that under the cash basis, this taxpayer would be taxable on the dues he received in advance but he could only deduct in the year in which he received the dues, the amounts that he'd actually spent out of -- out of pocket for all those expenses.
Justice Charles E. Whittaker: And that -- isn't that what you say you ought to do?
Mr. Louis F. Oberdorfer: No, sir.
We think that this taxpayer should be allowed to accrue items of income and to accrue items of expense if he has any.
Justice Charles E. Whittaker: Now, how would he accrue them, would you explain that to me?
I'm really trying to find out.
Mr. Louis F. Oberdorfer: I -- I don't -- I -- I don't want to tell the three A's how they could change their business so they could accrue a deduction for -- for their obligation to their members, it maybe that they could do it.
I -- I think my burden here is to demonstrate that they haven't but a taxpayer could accrue an obligation by incurring a -- well, that the example that I gave Mr. Justice Stewart about an accrued obligation to pay taxes is an example.
The three A's as I said -- the three A's pays taxes to the District of Columbia.
If it were on the cash basis, it could not deduct as of December 31 its liability for taxes which it hadn't yet calculated.
It can only deduct the actual out of pocket payment of taxes.
On the other hand, if it were on the accrual basis, it could deduct what it anticipates to be its tax liability.
Justice Charles E. Whittaker: Now, why on the same basis can it not deduct its towing cost as one example?
Mr. Louis F. Oberdorfer: We say that -- first would -- one reason in this case is that they haven't -- they -- they haven't -- they haven't set the books of that one.
But more important, they haven't incurred a liability.
They don't owe these members anything.For example, like the newspaper publisher owes his subscriber, they don't -- they -- no -- they don't owe anything to a member until the member picks up a telephone and says come tow my car, my battery has rundown.
At that point, they've incurred a liability but as of December 31, they can only guess an estimate as to what they will have to spend for the benefit of -- of -- well, some members don't ask for any service.
They're in the -- they're in the organization just to be good citizens or --
Justice Felix Frankfurter: Even there forecast on an actuarial basis as it were?
Mr. Louis F. Oberdorfer: It's conceivable.
Justice Felix Frankfurter: Yes, it isn't what the basis --
Mr. Louis F. Oberdorfer: It's conceivable -- it's conceivable that if this could be calculated with the precision that insurance companies calculate their liabilities on a scientific actuarial basis that there could be an accrual at that point.
There's no --
Justice William J. Brennan: You mean if this could be done, as -- as to whom (Inaudible) or a member.
Mr. Louis F. Oberdorfer: Or it could be done -- it could be --
Justice Felix Frankfurter: How come they're becoming mess?
Mr. Louis F. Oberdorfer: There -- but there are -- there are -- there are tests about what is an actuarial as distinguished from an accounting estimate of the future.
This Court has had this kind of problem.
I think this Court has had that some courts have about determining the value of future interest for example in -- in a state tax maters.
Justice Felix Frankfurter: This Court has divided on that proposition as you know.
Mr. Louis F. Oberdorfer: I -- I -- I'm not --
Justice Felix Frankfurter: It -- it could be allowed as to what a widow makes then.
Mr. Louis F. Oberdorfer: This is a -- this is a serious problem.
There's been no suggestion here that the three A's has made an actuarial demonstration of its -- of its liability.
And even then, it -- the liability itself might not be enough that there has to be a liability with respect to an item of expense, deductible expense.
And the -- it requires -- you -- you just can't do that in gross.
There's a case in the Second Circuit, the Spencer and White case where this has been analyzed in terms of a contract obligation to reach the conclusion that a mere contract obligation is -- does -- is in to -- to render general services, is not something that is susceptible to accrual.
Justice Charles E. Whittaker: Mr. Oberdorfer, is there anything involved, dollars and cents-wise aside from the point you made, namely a possible delay in receiving -- receiving part of the money?
Is that all that's involved here?
Mr. Louis F. Oberdorfer: Dollars and cents?
Justice Charles E. Whittaker: Yes.
Mr. Louis F. Oberdorfer: That's -- that's a lot when -- when you're -- when you're the United States but that is all that's involved.
It -- the other point in this connection is that, if -- if the taxpayer's proposal is adopted, it will -- and -- and he insists on saying that he's entitled to it because he's been doing it all these years, he infers that a new corporation or one that has been in business during at another way is not entitled to change and defer.
He sets up the -- he creates an opportunity for a -- a discrimination.
We -- we think that this, though -- though the law as we understand it makes it a great deal simpler for the revenue agent to operate, Mr. Justice Whittaker.
He can -- he can look at the man's books and tell that he's received the money but he would have a great difficulty looking at the books of barbershops and beauty parlors and taxi companies, service companies that don't have the excellent accounting system that the three A's have.
And come back with their counter as to when realistically in the accounting sense, whatever that means, when realistically, these prepaid items were earned.
Justice Potter Stewart: Well, but Mr. Oberdorfer, we're talking about an accrual-basis taxpayer and I would doubt very much that many people go to a barber shop and say, “Now, let me pay you $50 and you take care of all my haircut and shaving needs for 1961."
Mr. Louis F. Oberdorfer: I have a book of coupons from a taxi company which --
Justice Charles E. Whittaker: Well, isn't (Voice Overlap) --
Mr. Louis F. Oberdorfer: -- (Inaudible) paid in advance.
This is a -- this is not --
Justice Felix Frankfurter: Dining clubs.
Mr. Louis F. Oberdorfer: -- and isolated from it.
Justice Felix Frankfurter: Dining clubs.
Mr. Louis F. Oberdorfer: Yes, sir.
The same thing.
The -- this -- this --
Justice Potter Stewart: No, that's -- no, not -- now, we're talking about a credit (Voice Overlap) --
Mr. Louis F. Oberdorfer: But -- no.
What I'm talking about, an advance payment for coupons which -- I've got it sitting in my -- my desk floor and I'll use those -- when did the taxi company earned those?
I'm -- I don't know.
And the point -- point is not that it's impossible to determine but you open into a -- an area of negotiation and bargaining between the accountant for the taxpayer and the accountant for the Government and then that bargain has to be resolved administratively or it has to be litigated which would be, frank, they have to go into court.
It's -- it would be a -- another kind of evaluation problem in which one -- one tax -- the taxpayer would argue strenuously for one theory of accounting and the Government would argue for another and --
Justice Felix Frankfurter: Change it a dollar -- change it a dollar.
Mr. Louis F. Oberdorfer: Indeed, indeed.
Justice Charles E. Whittaker: Well, is that to condemn the principles of accrual accounting?
Mr. Louis F. Oberdorfer: This is --
Justice Charles E. Whittaker: It's not inherent and all that?
Mr. Louis F. Oberdorfer: No, sir.
This is on -- this would only -- this is -- would be inherent in -- only an accrual accounting could be administered with great position and great ease.
This is only inherent in a -- in a procedure that says that the United States must defer collection of taxes until in the opinion of accountants, the money which is -- which is clearly income has in accordance with some accounting principle been full “earned”.
And that word earned does not appear in the Internal Revenue Code.
Justice John M. Harlan: What scope do you give to Section 41 -- what scope to do you give to Section 41 under your view?
Mr. Louis F. Oberdorfer: Section 41 means to us that the method of accounting can be used provided it pays proper respect to the annual accounting period.
And the method of accounting calculates taxable income on the case of the cash-basis taxpayer, on account of his receipts and disbursements for the taxable year, in the case of the accrual-method taxpayer, on account of the creation of rights to income in him in that year or the creation of liabilities for the payment of deductions in that year.
In any method of accounting which does that is permissible.
One that does not -- doesn't pay proper respect to the annual accounting system and we think that in the absence of express statutory exception which maybe advisable but it hasn't been enacted yet except -- it was enacted and repealed.
In the absence of such a statutory exception or something that is embedded in the regulations in a precise way like the completed contract method of construction accounting that the -- the Court should follow the principles that it's laid down dealing more directly with the deduction of expenses.
And say that even though sometimes there maybe distortions, those distortions can be taken care of by net operating loss carry-forwards and the -- the taxpayer's remedy, if they have a remedy, is -- in this area we think is what's accounted.
Justice John M. Harlan: Do you agree with what -- I've -- I'm now going to pursue this reply brief on this 452.
Do you agree with what's said there that it seem to have been generally understood between the Bureau and the -- the Treasury and The Committee and what transpire there was not to deem with -- be deemed with in fact one way or the other, the preceding law?
Do you agree with that?
Mr. Louis F. Oberdorfer: I -- I was -- I was troubled by that when I saw it as the reply brief.
I didn't see this letter until the taxpayer called our attention to it.
So far as -- so far as -- as that's concerned, we would look not to what the Congress did but to what they said before they did anything.
Justice John M. Harlan: Well, what --
Mr. Louis F. Oberdorfer: That is what the House and -- House Committee exactly --
Justice John M. Harlan: Well, you can merely leave that out of account on what you're driven back to is your position that under the cases in this Court --
Mr. Louis F. Oberdorfer: And --
Justice John M. Harlan: -- your position is sustained or if not sustained, why -- and this is a new problem why we ought to -- to construe the statutes the way you talk -- you argue.
That is what it comes down to.
Mr. Louis F. Oberdorfer: That is our position, Mr. Justice.
Chief Justice Earl Warren: Mr. Bomar.
Rebuttal of Fleming Bomar
Mr. Fleming Bomar: May it please the Court.
First, there is no doubt about the fact that petitioner is obligated to render services to its members over the ensuing 12-month period.
How our petition, paragraph 4, alleges that obligation, that's record, page 2.
Record page 7, the Government concedes it so there's no doubt about the liability that we have to render services.
If we don't -- if we refuse, clearly, a member could get his money back.
You're not involved with much money so undoubtedly, we don't get suits on that score often but they would legally be entitled to it.
Second, insofar as the confusion that is in -- in the Government's brief from the point of view of equating the -- the problem of deductions with the problem of prepaid income, it helps to clarify my thinking if -- I referred to the example of an individual who orders a custom-built car.
The maker says to him, “The cost is $10,000.
Since it's custom built, pay me now but I won't be -- I can't make it until next year and I cannot deliver it until next year.”
This Court has never decided the deductibility or -- of a reserve for estimated expenses where prepaid receipts are involved.
Certainly, in that case, if the cost of making the car was $9000, either in accordance with sound accounting principle, the maker must set up a liability account for the advance and then take that money into come when the car is delivered.Or he must guess at what the cost of producing it is going to be.
One of the other two procedures is essential since the only off in it is what the Government contends for that the entire $10,000 is taxable income.
And when the Government contends that there is no provision in the code with respect to earning -- with earned income, it's a horrendous thought to think that income taxes are going to be computed on something other than net income.
The methods of accounting, the provisions of the code with respect to methods of accounting are inserted in the code to be certain that only net income is taxed.
The choice of the accrual method of accounting is given to a taxpayer to permit a precise computation of net income rather than having to compute income on a cash receipts and disbursements method.
Justice Potter Stewart: How precise is the -- is the prediction of the costs of these memberships?
Mr. Fleming Bomar: Quite accurate.
In -- they have a point --
Justice Potter Stewart: It would seem (Voice Overlap) with this.
It doesn't -- it doesn't -- the amount of the accuracy of the -- of an insurance company is actuarial experience.
Mr. Fleming Bomar: Pretty close.
Justice Potter Stewart: I assume that's correct.
Mr. Fleming Bomar: In the years involved, the cost of serving one member for a 12-month period was something like $14.50 one year and $14.61 the next.
The Budget Committee can estimate with precise accuracy.
In other words, with -- and as close as 10 cents per member per year, what the average cost of serving a member over any 12-month period will be.
Chief Justice Earl Warren: What would you say about to Mr. Oberdorfer's illustration in his taxicab book?
Mr. Fleming Bomar: Generally speaking, if the principles of accrual accounting aren't followed, the -- Mr. Oberdorfer is paying for 10 taxicabs rides in advance of performance.
The taxicab driver would report 1/10th his income as each trip was made and if some trips were made the following taxable year, the entire prepayment would not be included an income until the following taxable year.
Justice Potter Stewart: That -- assuming the taxicab driver wanted to be on accrual basis.
Mr. Fleming Bomar: Was an accrual-basis taxpayer.
Justice Potter Stewart: Yes.
Mr. Fleming Bomar: Otherwise, you're taxing an advance as “net income” when it's not income at all, it's simply an advance like a loan from a bank.
It's an advance from a customer.
It is a borrowing from a customer when you obtain money in advance of performing what the money was paid for.
And there's no difference in principle between where goods are being delivered or where services of being rendered so long as the deferral in essential in order to match cost with related revenue.
There is no difficulty of administration involved if advances are not taken into income at the moment of -- of receipt.
They are taken into income as goods are delivered or if services are rendered.
And that's the way every accrual accounting tax return is made out.
That's standard practice in all of the accrual accounting tax returns that are in existence today.
That it isn't difficult to identify performance.Counsel doesn't worry about violating annual accounting rules when cash comes in a year following performance if the sale has been made or if the goods had been delivered.
The respondent properly argues that the income is earned and the tax payers got to pay his tax whether or not he has received the cash.
Well, if that doesn't violate the annual accounting principle, it doesn't violate it to get the money in advance of performance and not report it as taxable income until performance takes place.
So the --
Justice Charles E. Whittaker: Do you have the circumstances of that kind?
Are there circumstances in your business of that kind where you got the money without having -- before you run the service?
Mr. Fleming Bomar: In every case.
Justice Charles E. Whittaker: Well, you run the service first.
Mr. Fleming Bomar: In every case since the member prepays --
Justice Charles E. Whittaker: No, (Voice Overlap)
Mr. Fleming Bomar: -- for a 12 --
Justice Charles E. Whittaker: Are there any instances wherein you run in the service in a particular year and do not get the money until the year subsequent.
Mr. Fleming Bomar: No, sir.
Substantially, all of our gross income is prepaid receipts and that is the reason the problem is difficult in our sir.
It's hard to find this --
Justice Hugo L. Black: Mr. Bomar, one of the questions asked by Mr. Justice Whittaker, the Government counsel told me to ask this one.
I suppose it had nothing to do with it but he asked what the difference in dollars and cents in the Government in the two systems that reporting the taxes.
Is there a particular difference or was your -- your association (Inaudible) on the cash basis and accrual basis?
Mr. Fleming Bomar: There should be no loss of revenue to the Government in the long run if --
Justice Hugo L. Black: Any gain -- any gain to the association in the long run?
Mr. Fleming Bomar: There's no gain to the -- there's a tremendous gain to the association in the sense that we only have to pay net income -- income taxes on what's net income and we don't have -- I mean, take the case of the December member again, if you've got to pay an income tax on $11 out of $12 of advance dues, you don't have money enough leftover after 52% tax with which to pay the cost in the following year of serving the member, so it makes a tremendous difference to it.
We would --
Justice Hugo L. Black: I don't quite understand it yet.
On a case basis, you would support all the case you get in the year and only when you pay out?
Mr. Fleming Bomar: Yes.
Justice Hugo L. Black: And on your accrual basis as it's (Inaudible) quite difference to you.
Why do you -- why does it make that much difference to you, you say.
I don't --
Mr. Fleming Bomar: It makes this difference.
To a club that's growing, you're paying taxes in advance of earning a profit and you're paying taxes on a substantially higher figure than your accountants tell you is net income.
Justice Hugo L. Black: Suppose (Voice Overlap) --
Mr. Fleming Bomar: Then you level out -- then when you level out, it makes no difference to you which you never pick up what you have prepaid to the Government on something that's not income and it never evens out --
Justice Hugo L. Black: Suppose the clubs knew because I'm sure yours is not but suppose if instead growing fast, it's losing the members.
Mr. Fleming Bomar: When in the years when the membership declines, you finally are correcting the inequity to the extent of the decline and the inequity is not finally washed out until the last member leaves the club.
Justice Hugo L. Black: I heard a lot of talk about the profits here.
I didn't know anything about it (Inaudible) in your association.[Laughs]
Mr. Fleming Bomar: Well, we are -- we tempt to break even obviously but sometimes it -- when you don't know how you're going to have to pay your income taxes for example, you may have charged enough to -- [Laughter]
Justice Hugo L. Black: Well, the part -- the part -- the part was interested to me was you said the members didn't get it.
Mr. Fleming Bomar: It is a membership.
Justice Hugo L. Black: And I don't understand that.
Mr. Fleming Bomar: It is a membership association.
Justice Hugo L. Black: Yes.
Mr. Fleming Bomar: And the members would get the benefit of it.
And there is nothing in the charter which restricts reimbursements to members, refunds to the members?
Justice William J. Brennan: Do they get refunds?
Mr. Fleming Bomar: Yes, they get refunds in all proper cases asides when member dies or he moves to another city, a refund is made.
There is no automatic right to claim a refund because you use the services of the club for example for six months and decides you don't want to use it for no good reason, the next six months and ask if I had dues back.
That automatic right is not given to the member but the refunds are made in any case where it's regarded as in all equitable.
Justice Hugo L. Black: I don't suppose that profit is enough to disqualify judge.
Mr. Fleming Bomar: I beg your pardon?
Justice Hugo L. Black: I don't suppose that profit if prospective profit is enough to disqualify judges.
Mr. Fleming Bomar: I would hope not sir.