372 U.S. 128 (1963), 80, Schlude v. Commissioner of Internal Revenue

Docket Nº:No. 80
Citation:372 U.S. 128, 83 S.Ct. 601, 9 L.Ed.2d 633
Party Name:Schlude v. Commissioner of Internal Revenue
Case Date:February 18, 1963
Court:United States Supreme Court

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372 U.S. 128 (1963)

83 S.Ct. 601, 9 L.Ed.2d 633



Commissioner of Internal Revenue

No. 80

United States Supreme Court

Feb. 18, 1963

Argued December 10, 1962




Petitioners, who operated dance studios, kept their books and made their income tax returns on a fiscal year accrual basis. They obtained from students contracts for dancing lessons over periods of years, to be paid for partly in cash and partly in installments, sometimes represented by negotiable notes which were discounted at banks. For the years 1952, 1953 and 1954, they reported as gross income only that portion of the advance payments received in cash and the amounts of notes and contracts executed during the respective years which corresponded with the number of hours taught. The balance was reserved for accrual in future years when additional lessons were taught, waived or forfeited.

Held: it was proper for the Commissioner, in the exercise of his discretion under § 41 of the Internal Revenue Code of 1939 and § 446(b) of the Internal Revenue Code of 1954, to reject petitioners' 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. America Automobile Association v. United States, 367 U.S. 687. Pp. 129-137.

296 F.2d 721 affirmed in part, reversed in part, and remanded.

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WHITE, J., lead opinion

MR. JUSTICE WHITE delivered the opinion of the Court.

[83 S.Ct. 602] 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. Following the American Automobile Association case, certiorari in this case was granted, the judgment of the lower court vacated, 367 U.S. 911, and the cause remanded for further consideration in light of American Automobile Association. 368 U.S. 873. 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

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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.

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 downpayment 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 downpayment to be paid in cash. The remainder of the downpayment 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 per month 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 [83 S.Ct. 603] specific dates, which were arranged from time to time as lessons were given.

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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

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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 [83 S.Ct. 604] 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

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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 includability 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,

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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.

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 longstanding 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...

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