Schlude v. Commissioner of Internal Revenue

• Citation: 372 U.S. 128,9 L.Ed.2d 633,83 S.Ct. 601
• Decision Date: 18 February 1963
• Docket Number: No. 80,80
• Parties: Mark E. SCHLUDE et al., Petitioners, v. COMMISSIONER OF INTERNAL REVENUE
• Court: United States Supreme Court

372 U.S. 128

83 S.Ct. 601

9 L.Ed.2d 633

Mark E. SCHLUDE et al., Petitioners,

v COMMISSIONER OF INTERNAL REVENUE.

No. 80.

Argued Dec. 10, 1962.

Decided Feb. 18, 1963.

Carl F. Bauersfeld, Washington, D.C., for petitioners.

Louis F. Oberdorfer, Washington, D.C., for respondent.

Mr. Justice WHITE delivered the opinion of the Court.

This is still another chapter in the protracted problem of the time certain items are to be recognized as income for the purposes of the federal income tax. The commissioner of Internal Revenue increased the 1952, 1953 and 1954 ordinary income of the taxpayers¹ by including in gross income for those years amounts received or receivable under contracts executed during those years despite the fact that the contracts obligated taxpayers to render performance in subsequent periods. These increases produced tax deficiencies which the taxpayers unsuccessfully challenged in the Tax Court on the ground that the amounts could be deferred under their accounting method. On appeal, the Court of Appeals for the Eighth Circuit agreed with the taxpayers and reversed the Tax Court, 283 F.2d 234, the decision having been rendered prior to ours in American Automobile Ass'n v. United States, 367 U.S. 687, 81 S.Ct. 1727, 6 L.Ed.2d 1109. Following the American Automobile Association case, certiorari in this case was granted, the judgment of the lower court vacated, 367 U.S. 911, 81 S.Ct. 1915, 6 L.Ed.2d 1248, and the cause remanded for further consideration in light of American Automobile Association. 368 U.S. 873, 82 S.Ct. 25, 7 L.Ed.2d 72. In a per curiam opinion, the Court of Appeals held that in view of American Automobile Association, the taxpayers' accounting method 'does not, for income tax purposes, clearly reflect income' and affirmed the judgment for the Commissioner, 296 F.2d 721. We brought the case back once again to consider whether the lower court misapprehended the scope of American Automobile Association, 370 U.S. 902, 82 S.Ct. 1248, 8 L.Ed.2d 399.

Taxpayers, husband and wife, formed a partnership to operate ballroom dancing studios (collectively referred to as 'studio') pursuant to Arthur Murray, Inc., franchise agreements. Dancing lessons were offered under either of two basic contracts. The cash plan contract required the student to pay the entire down payment in cash at the time the contract was executed with the balance due in installments thereafter. The deferred payment contract required only a portion of the down payment to be paid in cash. The remainder of the down payment was due in stated installments and the balance of the contract price was to be paid as designated in a negotiable note signed at the time the contract was executed.

Both types of contracts provided that (1) the student should pay tuition for lessons in a certain amount, (2) the student should not be relieved of his obligation to pay the tuition, (3) no refunds would be made, and (4) the contract was noncancelable.² The contracts prescribed a specific number of lesson hours ranging from five to 1,200 hours and some contracts provided lifetime courses entitling the student additionally to two hours of lessons permonth plus two parties a year for life. Although the contracts designated the period during which the lessons had to be taken, there was no schedule of specific dates, which were arranged from time to time as lessons were given.

Cash payments received directly from students and amounts received when the negotiable notes were discounted at the bank or fully paid³ were deposited in the studio's general bank account without segregation from its other funds. The franchise agreements required the studio to pay to Arthur Murray, Inc., on a weekly basis, 10% of these cash receipts as royalty and 5% of the receipts in escrow, the latter to continue until a $20,000 indemnity fund was accumulated. Similarly, sales commissions for lessons sold were paid at the time the sales receipts were deposited in the studio's general bank account.

The studio, since its inception in 1946, has kept its books and reported income for tax purposes⁴ on an accrual system of accounting. In addition to the books, individual student record cards were maintained showing the number of hours taught and the number still remaining under the contract. The system, in substance, operated as follows. When a contract was entered into, a 'deferred income' account was credited for the total contract price. At the close of each fiscal period, the student record cards were analyzed and the total number of taught hours was multiplied by the designated rate per hour of each contract. The resulting sum was deducted from the deferred income account and reported as earned income on the financial statements and the income tax return. In addition, if there had been no activity in a contract for over a year, or if a course were reduced in amount, an entry would be made canceling the untaught portion of the contract, removing that amount from the deferred income account, and recognizing gain to the extent that the deferred income exceeded the balance due on the contract, i.e., the amounts received in advance. The amounts representing lessons taught and the gains from cancellations constituted the chief sources of the partnership's gross income. ⁵ The balance of the deferred income account would be carried forward into the next fiscal year to be increased or decreased in accordance with the number of new contracts, lessons taught and cancellations recognized.

Deductions were also reported on the accrual basis except that the royalty payments and the sales commissions were deducted when paid irrespective of the period in which the related receipts were taken into income. Three certified public accountants testified that in their opinion the accounting system employed truly reflected net income in accordance with commercial accrual accounting standards.

The Commissioner included in gross income for the years in question not only advance payments received in cash but the full face amounts of notes and contracts executed during the respective years. The Tax Court and the Court of Appeals upheld the Commissioner, but the United States in this Court has retreated somewhat and does not now claim the includibility in gross income of future payments which were not evidenced by a note and which were neither due by the terms of the contract nor matured by performance of the related services.⁶ The question remaining for decision, then, is this: Was it proper for the Commissioner, exercising his discretion under § 41,⁷ 1939 Code, and § 446(b),⁸ 1954 Code to reject the studio's accounting system as not clearly reflecting income and to include as income in a particular year advance payments by way of cash, negotiable notes and contract installments falling due but remaining unpaid during that year? We hold that it was since we believe the problem is squarely controlled by American Automobile Association, 367 U.S. 687, 81 S.Ct. 1727, 6 L.Ed.2d 1109.

The court there had occasion to consider the entire legislative background of the treatment of prepaid income. The retroactive repeal of § 452 of the 1954 Code, 'the only law incontestably permitting the practice upon which (the taxpayer) depends,' was regarded as reinstating long-standing administrative and lower court rulings that accounting systems deferring prepaid income could be rejected by the Commissioner.

'(T)he fact is that § 452 for the first time specifically declared petitioner's system of accounting to be acceptable for income tax purposes, and overruled the long-standing position of the Commissioner and courts to the contrary. And the repeal of the section the following year, upon insistence by the Treasury that the proposed endorsement of such tax accounting would have a disastrous impact on the Government's revenue, was just as clearly a mandate from the Congress that petitioner's system was not acceptable for tax purposes.' 367 U.S., at 695, 81 S.Ct. at 1731.

Confirming that view was the step-by-step approach of Congress in granting the deferral privilege to only limited groups of taxpayers while exploring more deeply the ramifications of the entire problem.

Plainly, the considerations expressed in American Automobile Association are apposite here. We need only add here that since the American Automobile Association decision, a specific provision extending the deferral practice to certain membership corporations was enacted, § 456, 1954 Code, added by § 1, Act of July 26, 1961, 75 Stat. 222, continuing, at least so far, the congressional policy of treating this problem by precise provisions of narrow applicability. Consequently, as in the American Automobile Association case, we invoke the 'longestablished policy of the Court in deferring, where possible, to congressional procedures in the tax field,' and, as in that case, we cannot say that the Commissioner's rejection of the studio's deferral system was unsound.

The American Automobile Association case rested upon an additional ground which is also controlling here. Relying upon Automobile Club of Michigan v. Commissioner, 353 U.S. 180, 77 S.Ct. 707, 1 L.Ed.2d 746, the Court rejected the taxpayer's system as artificial since the advance payments related to services which were to be performed only upon customers' demands without relation to fixed dates in the future. The system employed here suffers from that very same vice, for the studio sought to defer its cash receipts on the basis of contracts which did not provide for lessons on fixed dates after the taxable year, but left such dates to be arranged from time to time by the instructor and his student. Under the contracts, the student could arrange for some or all of the additional lessons or could simply allow their rights under the contracts to lapse. But even though the student did not demand the remaining lessons, the contracts permitted the studio to insist upon payment in...