American Code Co. v. Commissioner of Internal Revenue

• Decision Date: 14 January 1929
• Docket Number: No. 109.,109.
• Parties: AMERICAN CODE CO., Inc., v. COMMISSIONER OF INTERNAL REVENUE.
• Court: U.S. Court of Appeals — Second Circuit

30 F.2d 222 (1929)

AMERICAN CODE CO., Inc., v. COMMISSIONER OF INTERNAL REVENUE.

No. 109.

Circuit Court of Appeals, Second Circuit.

January 14, 1929.

Clark H. Hebner, of New York City, for appellant.

Mabel Walker Willebrandt, Asst. Atty. Gen. (Sewall Key and John Vaughan Groner, Sp. Asst. Attys. Gen., and C. M. Charest, Gen. Counsel, Bureau of Internal Revenue, of Washington, D. C., of counsel), for respondent.

Before MANTON, SWAN, and AUGUSTUS N. HAND, Circuit Judges.

SWAN, Circuit Judge (after stating the facts as above).

The correctness of the action of the Commissioner depends upon the construction of the Revenue Act of 1918. Section 234 (a) of that act (40 Stat. 1077) permits a corporation to deduct from its gross income:

"(1) All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. * * *

"(4) Losses sustained during the taxable year and not compensated for by insurance or otherwise. * * *"

The act also permits taxpayers to file returns on the accrual basis if their books are so kept. Section 232 (40 Stat. 1077) directs that the net income of corporations shall be computed on the same basis as is provided in subdivision (b) of section 212. That subdivision (40 Stat. 1064) provides:

"(b) The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income. * * *"

Under the authority of section 1309 (40 Stat. 1143), the Commissioner, with the approval of the Secretary of the Treasury, promulgated regulations for the enforcement of the provisions of the act. Article 111 of Regulations (1920 Ed.) reads in part as follows:

"Art. 111. When Charges Deductible. * * * The expenses, liabilities or deficit of one year can not be used to reduce the income of a subsequent year. A person making returns on an accrual basis has the right to deduct all authorized allowances, whether paid in cash or set up as a liability, and it follows that if he does not within any year pay or accrue certain of his expenses, interest, taxes or other charges, and makes no deduction therefor, he can not deduct from the income of the next or any subsequent year any amounts then paid in liquidation of the previous year's liabilities. A loss from theft or embezzlement occurring in one year and discovered in another is deductible only for the year of its occurrence. Any amount paid pursuant to a judgment or otherwise on account of damages for personal injuries, patent infringement or otherwise, is deductible from gross income when the claim is put in judgment or paid, less any amount of such damages as may have been compensated for by insurance or otherwise. If subsequently to its occurrence, however, a taxpayer first ascertains the amount of a loss sustained during a prior taxable year which has not been deducted from gross income, he may render an amended return for such preceding taxable year, including such amount of loss in the deductions from gross income, and may file a claim for refund of the excess tax paid by reason of the failure to deduct such loss in the original return. See section 252 of the statute and articles 1031-1038."

The problem presented is whether the foregoing provisions of the statute and the regulations permit a taxpayer, who has committed a breach of contract in 1919, and sets up on its books a reserve for such liability, and files a return on the accrual basis, to deduct from its gross income for such year the amount of its liability as established by judgment rendered in a subsequent year.

If the judgment had been rendered early in 1920 and prior to the time when the taxpayer was required to file its 1919 return, it would seem clear that the liability should be considered as a business expense incurred, or a loss sustained, during the year when the contract was broken. Although the amount of the damages was determined later, all the facts which gave rise to the liability occurred in 1919. It is settled contract law that damages are suffered when the contract is broken, and are assessed as of that time; their amount being the value of the contract to the plaintiff at the time of the breach. Parker v. Russell, 133 Mass. 74, 75; Pierce v. Tenn. Coal Co., 173 U. S. 1, 16, 19 S. Ct. 335, 43 L. Ed. 591. Under the regulation above quoted, a taxpayer making returns on the accrual basis is required to deduct all authorized allowances "whether paid in cash or set up as a liability," and provision is made in the final sentence of article 111 for corrections by amended returns when the amount...