Guardian Investment Corporation v. Phinney, 16859.

Citation253 F.2d 326
Decision Date14 April 1958
Docket NumberNo. 16859.,16859.
PartiesGUARDIAN INVESTMENT CORPORATION, Appellant, v. Robert L. PHINNEY, District Director of Internal Revenue, Appellee.
CourtUnited States Courts of Appeals. United States Court of Appeals (5th Circuit)

Charles N. Avery, Jr., Austin, Tex., Charles W. Hall, M. S. McCorquodale, C. W. Wellen, Houston, Tex. (Fulbright, Crooker, Freeman, Bates & Jaworski, Houston, Tex., on the brief), for appellant, Guardian Inv. Corp.

Charles K. Rice, Asst. Atty. Gen., Lee A. Jackson, Harry Baum, Carolyn R. Just, Attys., Dept. of Justice (Russell B. Wine, U. S. Atty., John R. Locke, Jr., Asst. U. S. Atty., San Antonio, Tex., on the brief), for appellee.

Before CAMERON, JONES, and WISDOM, Circuit Judges.

WISDOM, Circuit Judge.

This appeal presents a question of accrual accounting under Sections 23(b), 41, and 43 of the Internal Revenue Code of 1939. Section 23(b) permits the deduction from gross income of "all interest paid or accrued within the taxable year on indebtedness".1 Section 41 allows the taxpayer to compute net income "upon the basis of the taxpayer's annual accounting period" (fiscal or calendar year), provided the method of accounting shall "clearly reflect the income".2 Section 433 provides:

"The deductions and credits * * shall be taken for the taxable year in which `paid or accrued\' or `paid or incurred\', * * * is computed, unless in order to clearly reflect the income the deductions or credits should be taken as of a different period. * * *"
I.

The facts were stipulated. Guardian Investment Corporation, a Texas corporation with its principal place of business at Houston, Texas, is on an accrual basis of accounting. It is in the business of investing in real estate and financing sales of single family homes. Guardian is a wholly owned subsidiary of Home Owned Properties, a homebuilder or contractor specializing in constructing small homes on a large scale; transactions concerning some five hundred houses gave rise to this dispute.

Home Owned Properties sells a home to an individual purchaser, say for $6,000, payments to be made by installments over a period of years, title not to pass to the purchaser until the price is fully paid. For an agreed price, say $4,000 in cash, plus a second mortgage in the amount of $2,000, Home Owned Properties conveys to Guardian its title and its rights under its contract with the purchasing home owner. Guardian then negotiates a loan for $4,000, executing in favor of the bank or other lending agency a promissory note for $4,000 secured by a deed of trust lien or first mortgage on the property. Guardian agrees to pay the lender all amounts received from the purchaser until the first mortgage note is fully paid. Since the cash received by the loan from the bank is $2,000 less than the amount to be paid the builder, Guardian executes in favor of Home Owned Properties a second mortgage non-negotiable note for $2,000, carrying six per cent interest, bearing no maturity date. Payment of the note is subject to the following stated conditions:

"This promissory note is non-negotiable, and is payable only out of the total amount received by maker from the sale (under presently existing contract or otherwise) of the above listed tract of land over and above the amount of principal and interest and other charges payable to said Bank by reason of the indebtedness as above set forth.
"No payments whatsoever, either of principal or of interest, shall be due and owing on this note until such time as there has been paid, out of the proceeds of the sale of the above described property, the entire indebtedness of Guardian Investment Corporation to said Bank, as above set forth.
"* * * * * *
"By the execution and delivery of this note, the maker hereof does not guarantee to sell the above listed property at a price sufficient to pay off and satisfy this note; nor is this note in any way or under any circumstances an obligation binding upon the general credit of the maker hereof. The entire and only obligation and undertaking of the maker hereof is to pay to * * after payment has been made as above provided to said Bank, all moneys received and collected by the maker hereof from the sale of said above listed property until such time as this note, both as to principal and interest, is fully paid and satisfied."

Thus, no payments of principal and interest are "due and owing" on the second mortgage note until the first mortgage note is paid in full. Even then the second mortgage note is payable only out of the net proceeds of any sale of the mortgaged properties, and Guardian does not undertake to sell the property at a price sufficient to satisfy the note.

In reporting its income for the fiscal years ending February 28, 1953 and February 28, 1954, Guardian accrued and deducted the interest on the second mortgage note. The Commissioner of Internal Revenue disallowed the deduction, taking the position that the interest was not accruable because the taxpayer's liability on the second mortgage note was contingent. After payment of the deficiency assessment, Guardian sued Phinney, District Director of Internal Revenue, in the United States District Court for the Western District of Texas, for a refund of federal income taxes in the amount of $4,016.67 plus interest for the fiscal years ending February 28, 1953 and February 28, 1954.

The case was submitted to the jury on the single issue proposed by the taxpayer: "Is it a reasonable certainty that the principal and interest of the second mortgage notes will be paid in full?" The jury answered affirmatively, returning a verdict in favor of the taxpayer. The District Court entered judgment for the Director of Internal Revenue sustaining the disallowance of the deduction notwithstanding the verdict of the jury. Guardian appeals from that judgment.

II.

For better or for worse, the federal income tax system is married to the principle of computing net income on an annual basis. "Income and deductions must be placed in neatly compartmented segments — usually years — for which income and consequent liability can be determined."4 Business judgment, supported by conventional commercial accounting practices, may impel a taxpayer to accelerate or defer a deduction from one year to another. Deductions, however, are a matter of legislative grace, and if the Federal Income Tax Law requires a deduction to be placed in a particular compartmented segment, the taxable year in which liability becomes fixed, there it must be placed, neatly or not.

Courts and Congress5 have said that effect should be given to accepted accounting practices. Thus, in discussing Section 41, this Court observed: "Clearly what is sought by Section 41 of of this statute is an accounting method that most accurately reflects the taxpayer's income on an annual accounting." Schuessler v. Commissioner, 5 Cir., 1956, 230 F.2d 722, 724. But commercial accounting and tax accounting just are not always the same.6 Conservative business policies may require a taxpayer to set aside annually a reserve for future conditional expenses. Proper commercial accounting practices may require accrual of certain items to meet contingent liabilities, in order that the balance sheet or statement of profit and loss will reflect the true condition of a business for credit purposes or for other reasons. To "clearly reflect" income for tax purposes, however, a deduction may not be taken for accrued interest on an indebtedness unless the debt is definite, fixed, and existing in the taxable year for which the deduction is sought. A contingent obligation may be a liability, but it is not a debt; and accrual is improper for tax deductions when the liability is contingent. "The prudent business man often sets up reserves to cover contingent liabilities. But they are not allowable as tax deductions." Lucas v. American Code Co., 1930, 280 U.S. 445, 452, 50 S.Ct. 202, 204, 74 L.Ed 538.

III.

When a taxpayer uses the accrual method, "it is the right to receive not the actual receipt" that is determinative; and "when the right to receive an amount becomes fixed the right accrues". Spring City Foundry Co. v. Commissioner, 1934, 292 U.S. 182, 184, 54 S.Ct. 644, 645, 78 L.Ed. 1200. Similarly, a deduction for interest may be taken on an accrual basis only in the year in which the taxpayer's liability to pay becomes fixed or is already existing; not in the year when the taxpayer decides that it is convenient or good business to pay or accrue the interest. An obligation is not sufficiently definite for accrual until all events occur which fix and determine the liability. United States v. Anderson, 1926, 269 U.S. 442, 46 S.Ct. 131, 70 L.Ed. 347; Lucas v. North Texas Lumber Co., 1930, 281 U. S. 11, 50 S.Ct. 184, 74 L.Ed. 668. A liability that is uncertain, indefinite, or contingent, may not be accrued and deducted until the year when it becomes certain, definite, and no longer contingent. Security Flour Mills Co. v. Commissioner, 1944, 321 U.S. 281, 64 S.Ct. 596, 88 L.Ed. 725; Dixie Pine Prods. Co. v. Commissioner, 1944, 320 U.S. 516, 64 S.Ct. 364, 88 L.Ed. 270; Lucas v. American Code Co., 1930, 280 U.S. 445, 50 S.Ct. 202, 74 L.Ed. 538; David J. Joseph Co. v. Commissioner, 5 Cir., 1943, 136 F.2d 410; Commissioner v. Brooklyn Radio Service Corporation, 2 Cir., 1935, 79 F.2d 833; Noxon Chem. Prods. Co. v. Commissioner, 3 Cir., 1935, 78 F.2d 871, certiorari denied 296 U.S. 647, 56 S.Ct. 307, 80 L.Ed. 460.

IV.

This is not a case for roaming through the tax field. The problem before us is one of factual interpretation: Does the second mortgage note, as worded, create a definite, fixed, existing debt in the taxable years in question? The taxpayer contends that it does and that any uncertainty or contingency relates not to the existence but to the performance — that is, payment — of the obligation. Risk of payment by a borrower or purchaser is in every debt and in most commercial transactions....

To continue reading

Request your trial
40 cases
  • West Texas Marketing Corp., Matter of, 94-10089
    • United States
    • United States Courts of Appeals. United States Court of Appeals (5th Circuit)
    • May 31, 1995
    ...occupying a lower position on the hierarchy is the return of any remaining assets to the debtor. 7 In Guardian Investment Corp. v. Phinney, 253 F.2d 326 (5th Cir.1958), a taxpayer sought to deduct interest on a second mortgage, even though no payments of principal or interest would be due u......
  • Putoma Corp. v. C. I. R., 77-1591
    • United States
    • United States Courts of Appeals. United States Court of Appeals (5th Circuit)
    • August 27, 1979
    ...516, 64 S.Ct. 364, 88 L.Ed. 270 (1944); Trinity Construction Co. v. United States, 424 F.2d 302 (5 Cir. 1970); Guardian Investment Corp. v. Phinney, 253 F.2d 326 (5 Cir. 1958); United States v. Consolidated Edison Co., 366 U.S. 380, 385, n. 5, 81 S.Ct. 1326, 6 L.Ed.2d 356 (1961); Clevite Co......
  • In re Dow Corning Corp., 95-20512.
    • United States
    • United States Bankruptcy Courts. Tenth Circuit. U.S. Bankruptcy Court — Eastern District of Michigan
    • October 30, 2001
    ...accrued expenses. See, e.g., Mooney Aircraft v. United States, 420 F.2d 400, 410 n. 38 (5th Cir.1969); Guardian Inv. Corp. v. Phinney, 253 F.2d 326, 330 (5th Cir.1958); In re Southwestern States Mktg. Corp., 179 B.R. 813, 817-18 (N.D.Tex.1994), aff'd, 82 F.3d 413 (5th Cir.1996) (unpublished......
  • Baker v. United States, 88-78.
    • United States
    • Court of Federal Claims
    • January 23, 1980
    ...386 F.2d 841, 181 Ct.Cl. 652, 658 (1967); Trinity Construction Co. v. United States, 424 F.2d 302 (5 Cir. 1970); Guardian Investment Corp. v. Phinney, 253 F.2d 326 (5 Cir. 1958); Turtle Wax, Inc. v. Commissioner, 43 T.C. 460, 466-67 (1965); and Denver & Rio Grande Western Railroad Co. v. Co......
  • Request a trial to view additional results
1 books & journal articles
  • Interest deductions for bankrupt corporations.
    • United States
    • The Tax Adviser Vol. 33 No. 6, June 2002
    • June 1, 2002
    ...right under Sec. 163 to deduct accrued expenses; see, e.g., Continental Vending; Mooney Aircraft; Guardian Inv. Corp. v. Phinney, 253 F2d 326 (5th Cir. 1958); and In re Southwestern States Mktg. Corp., 179 BR 813 (1994), aff'd, 82 F3d 413 (5th Cir. The court acknowledged that if a "taxpayer......

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT