Lucas v. American Code Co

• Citation: 50 S.Ct. 202,67 A.L.R. 1010,74 L.Ed. 538,280 U.S. 445
• Decision Date: 24 February 1930
• Docket Number: No. 67,67
• Parties: LUCAS, Commissioner of Internal Revenue, v. AMERICAN CODE CO., Inc
• Court: United States Supreme Court

280 U.S. 445

50 S.Ct. 202

74 L.Ed. 538

LUCAS, Commissioner of Internal Revenue,

v AMERICAN CODE CO., Inc.

No. 67.

Argued Jan. 8, 1930.

Decided Feb. 24, 1930.

The Attorney General and Mr. Charles E. Hughes, Jr., Sol. Gen., of Washington, D. C., for petitioner.

[Argument of Counsel from page 446 intentionally omitted] Mr. Clark H. Hebner, of New York City, for respondent.

Mr. Justice BRANDEIS delivered the opinion of the Court.

When the income tax return for 1919, of the American Code Company, Inc., was being audited in 1925, the company filed with the Commissioner of Internal Revenue a claim for a refund based upon its failure to deduct from its 1919 gross income the amount for which judgment was recovered against it in 1922, on a contested liability for a breach of contract in 1919. The Commissioner of Internal Revenue rejected the claim and asserted a deficiency. His ruling was sustained by the Board of Tax Appeals. American Code Co., Inc., v. Commissioner of Internal Revenue, 10 B. T. A. 476. Its decision was reversed by the United States Circuit Court of Appeals for the Second Circuit. 30 F. (2d) 222, 224. We granted a writ of certiorari. 279 U. S. 832, 49 S. Ct. 481, 73 L. Ed. 982.

The facts on which the claim for the refund is based are as follows: The company agreed to employ Farquhar as sales manager for 18 years from January 3, 1919, the compensation to be a commission based on sales. In May, 1919, it discharged him, for alleged cause. In July, 1919, Farquhar brought suit against it in the Supreme Court of New York for wrongful discharge, claiming $100,000 damages. Affirmative defenses were interposed, and liability was contested. In October, 1919, the company notified the Commissioner of the suit and asked leave to deduct in its income tax return an amount equal to the commissions for 1919 computed on the contract basis. Permission was refused; but the company set up on its books, at the close of the year, a reserve equal to the amount of such commissions, $14,764.79. At the close of 1920, the amount in this reserve was increased by $32,994.09, computed on the same basis. In 1922, after a jury trial, judgment for $21,019.19 was entered in the trial court, and, on appeal by the company, was affirmed by the Appellate Division. The company then prosecuted a further appeal to the Court of Appeals. In 1923 the judgment was affirmed by that court and paid by the company. The judgment having been rendered by the trial court early in 1922 before the books were closed for 1921, the reserve set up was adjusted as of the close of 1921 to the amount of the recovery, $21,019.19. That sum is claimed as the deduction for 1919.

The company kept its books and made its income tax returns on the accrual basis. The Revenue Act of 1918, Act of February 24, 1919, c. 18, § 234(a), (4), 40 Stat. 1057, 1077, 1078, provides that in computing net income 'losses sustained during the taxable year and not compensated for by insurance or otherwise' shall be allowed as deductions. Section 212(b) provides that the net income shall be computed 'in accordance with the method of accounting regularly employed in keeping the books of such taxpayer,' unless the method employed does not clearly reflect the net income. And Article 111 of regulations No. 45 (1920 Ed.) of the Bureau of Internal Revenue provides that 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. * * *'

The company's argument, sustained by the Court of Appeals, is that, since the breach of the contract occurred in 1919, all the facts which gave rise to the liability were fixed in that year; that damages must be assessed as of the date of the breach; that the loss therefore occurred in that year; and that it is immaterial that the amount of the damages was not determined or paid until later. Attention is specifically called to the provision in article 111, which declares that, if after making a return '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.'

Generally speaking, the income tax law is concerned only with realized losses, as with realized gains. Weiss v. Wiener, 279 U. S. 333, 335, 49 S. Ct. 337, 73 L. Ed. 720. Exception is made, however, in the case of losses which are so reasonably certain in fact and ascertainable in amount as to justify their deduction, in certain circumstances, before they are absolutely realized. As respects losses occasioned by the taxpayer's breach of contract, no definite legal test is provided by the statute for the determination of the year in which the loss is to be deducted. The general requirement that losses be deducted in the year in which they are sustained calls for a practical, not a legal, test. And the direction that net income be computed according to the method of accounting regularly employed by the taxpayer is expressly limited to cases where the Commissioner believes that the accounts clearly reflect the net income. Much latitude for discretion is thus given to the administrative board charged with the duty of enforcing the act. Its interpretation of the statute and the practice adopted by it should not be interfered with unless clearly unlawful.

Article 111 of regulations No. 45, interpreting the provisions as to deductions for losses, states: '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. * * *' The Board of Tax Appeals has held, in a series of well-reasoned opinions, that a loss occasioned by the taxpayer's breach of contract is not deductible in the year of the breach, except under the special circumstances where, within the tax year, there is a definite admission of liability, negotiations for settlement are begun, and a reasonable estimate of the amount of the loss is accrued on the books.¹

It may be assumed that, since the company kept its books on the accrual basis, the mere fact that the exact amount of the liability had not been definitely fixed in 1919 would not prevent the deduction, as a loss of that year, of the amount later paid. But here there are other obstacles. Obviously, the mere refusal to perform a contract does not justify the deduction, as a loss, of the anticipated damages. For, even an unquestionable breach does not result in loss, if the injured party forgives or refrains from prosecuting his claim. And, when liability is contested, the institution of a suit does not, of itself, create certainty of loss. In the few cases in which the Board of Tax Appeals has allowed a deduction in the year of the breach, the contracts, involving the purchase and sale of goods, were performable in a...