Thor Power Tool Co. v. C. I. R.

• Decision Date: 29 September 1977
• Docket Number: No. 76-1476,76-1476
• Citation: 563 F.2d 861
• Parties: 77-2 USTC P 9658 THOR POWER TOOL COMPANY, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 861

563 F.2d 861

77-2 USTC P 9658

THOR POWER TOOL COMPANY, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 76-1476.

United States Court of Appeals, Seventh Circuit.

Argued Dec. 7, 1976.

Decided Sept. 29, 1977.

Mark H. Berens, Chicago, Ill., for petitioner-appellant.

Crane C. Hauser, Chicago, Ill., for amicus curiae.

Scott P. Crampton, Asst. Atty. Gen., William A. Whitledge, Atty., Tax Div., Dept. of Justice, Meade Whitaker, I. R. S., Washington, D. C., for respondent-appellee.

Before TONE and WOOD, Circuit Judges, and CAMPBELL, Senior District Judge. ^*

TONE, Circuit Judge.

Thor Power Tool Company appeals from a decision of the United States Tax Court, 64 T.C. 154 (1975), which upheld the Commissioner's disallowance of portions of Thor's write-down of its closing inventory for 1964 and its 1965 addition to a reserve for bad debts. ¹ The issues presented involve the income tax treatment of "excess" inventory and the method for calculating a reasonable addition to a bad debt reserve. We affirm.

I. Inventory

A.

Thor manufactures tools and parts at three plants in its Tool Division and various rubber articles at a fourth plant in its Rubber Division. The corporation also maintains 24 sales and service branches in the United States and Canada. Inventories of parts, accessories, and completed tools are maintained at all branches and at the three Tool Division plants. Those three plants also maintain inventories of raw materials and work-in-process. The single Rubber Division plant keeps inventories of raw materials, work-in-process, and completed products. ² Much of the inventory consists of replacement parts and accessories.

When Thor discontinued the manufacture of tools of a particular model, it nevertheless continued to stock replacement parts and accessories for tools of that model that were still in service. Thor began amortizing its cost of inventories of replacement parts and accessories for out-of-production tools in its 1960 tax return. This was accomplished by establishing an inventory contra account on the books of the company, and crediting that account with ten percent of the value of a part or accessory for each year since the termination of production of the tool of which the part or accessory was a component. The closing inventory was then written down to reflect this account, thereby increasing the cost of goods sold and reducing the reported net income. This practice was continued in the 1961, 1962, 1963 tax returns, without a challenge from the Commissioner. Further additions to the account were made for the first three quarters of 1964. ³

In December of 1964 new management assumed the reins at Thor. ⁴ As part of its preparation of the 1964 financial statements, "a complete re-evaluation of the assets and liabilities of the company" was undertaken, including "a physical inventory . . . at all locations . . . ." The inventory was then "priced at 1964 inventory standards . . . ." Once this was completed the management began to adjust the inventory valuation, in order to show the inventory at its "net realizable value," as required by the standards of the accounting profession, and to price the inventory at "the lower of cost or market," as had been Thor's practice for income tax purposes.

Write-downs totaling about $2,750,000 were made for obsolescence ⁵ and other reasons. These were not questioned by the Commissioner, because the items in question were scrapped soon after they were deleted from the 1964 closing inventory. A write-down of $245,000 was made for parts for three recent products that had not sold as well as expected. This too went unchallenged because the products were sold at lowered prices soon after the write-down.

The remaining inventory, consisting of some 44,000 items, was evaluated for the purpose of ascertaining the extent to which it too was in excess of anticipated demand. Relying on its experience with manufacturing businesses, the new management estimated future demand for these items. At two of the Tool Division plants, estimates were based on 1964 sales figures, resulting in write-downs of $744,030. ⁶ Owing to the inadequacy of sales data for the other two plants, flat percentage adjustments were made to the valuations for parts, raw materials, work-in-process, and finished products in the physical inventory, resulting in write-downs of $160,832. ⁷ The $22,090 credit which the old management had entered in the inventory contra account for the first three quarters of 1964, see note 3, supra, was also subtracted from closing inventory.

These last three adjustments were disallowed by the Commissioner, as not "clearly reflecting the income" for 1964. ⁸ The Tax Court upheld the Commissioner, on the ground that Thor's write-down of excess inventory was not permitted by the Treasury Regulations.

B.

Section 446 of the Internal Revenue Code, 26 U.S.C. § 446, provides that taxes shall be computed in accordance with the taxpayer's usual method of accounting, unless that method does not clearly reflect income. ⁹ The taxpayer's method of accounting is thus given preference. Lincoln Electric Co. v. Commissioner, 444 F.2d 491, 494 (6th Cir. 1971); Photo-Sonics, Inc. v. Commissioner, 357 F.2d 656, 658 n. 1 (9th Cir. 1966). If, however, in the opinion of the Commissioner, that method does not clearly reflect income, the Commissioner may require that another method be used. Brown v. Helvering, 291 U.S. 193, 203, 54 S.Ct. 356, 78 L.Ed. 725 (1934); Bangor Punta Operations, Inc. v. United States, 466 F.2d 930, 935 (7th Cir. 1972). ¹⁰ The Commissioner possesses "broad powers in determining whether accounting methods used by a taxpayer clearly reflect income." Commissioner v. Hansen, 360 U.S. 446, 467, 79 S.Ct. 1270, 1282, 3 L.Ed.2d 1360 (1959).

The Commissioner's discretion is, if anything, greater with respect to inventory accounting. Waukesha Motor Co. v. United States, 322 F.Supp. 752, 768 (E.D.Wis.1971). Section 471, 26 U.S.C. § 471, provides:

"Whenever in the opinion of the Secretary or his delegate the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary or his delegate may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income."

The statute thus sets up a two-part standard on which the Secretary or his delegate, the Commissioner, is to act: the taxpayer's inventory method must both conform closely to the relevant "best accounting practices" and clearly reflect income. These two are usually linked, however, because an accounting method which "reflects the consistent application of generally accepted accounting principles in a particular trade or business . . . will ordinarily be regarded as clearly reflecting income . . . ." Treas.Reg. § 1.446-1(a) (2). The same principle was applied to inventory accounting in a sentence which appeared in the regulations until 1973:

"An inventory that can be used under the best accounting practice in a balance sheet showing the financial position of the taxpayer can, as a general rule, be regarded as clearly reflecting his income."

Treas.Reg. § 1.471-2(b). ¹¹ See also Commissioner v. Joseph E. Seagram & Sons, Inc., 394 F.2d 738, 742-743 (2d Cir. 1968).

As the words "ordinarily" and "as a general rule," and the two-part standard itself, suggest, however, there can be circumstances in which the best accounting practice does not clearly reflect income. Thus the accounting profession's indorsement of a practice as "the best accounting practice," even if accepted by the Commissioner, does not require him to determine that the practice clearly reflects taxable income. Schlude v. Commissioner, 372 U.S. 128, 83 S.Ct. 601, 9 L.Ed.2d 633 (1963); American Automobile Association v. United States, 367 U.S. 687, 693, 81 S.Ct. 1727, 6 L.Ed.2d 1109 (1961). This is because the goals of balance-sheet and income-tax accounting are not identical. Mr. Justice Clark, in American Automobile Association v. United States, supra, speaking of the accounting system before the Court, said that it "presents a rather accurate image of the total financial structure, but fails to respect the criteria of annual tax accounting and may be rejected by the Commissioner." 367 U.S. at 692, 81 S.Ct. at 1730. The criteria referred to were stated by Mr. Justice Brandeis in Lucas v. Kansas City Structural Steel Co., 281 U.S. 264, 268, 50 S.Ct. 263, 265, 74 L.Ed. 848 (1930):

"The Federal income tax system is based upon an annual accounting period. This requires that gains or losses be accounted for in the year in which they are realized. The purpose of the inventories is to assign to each period its profits and losses."

Whether a given method of accounting clearly reflects income is a question of fact. Artnell Co. v. Commissioner, 400 F.2d 981, 983-985 (7th Cir. 1968). As the Supreme Court has stated, it is not our role, in reviewing the Commissioner's exercise of his discretion, "to weigh and determine the relative merits of systems of accounting." Brown v. Helvering, supra, 291 U.S. at 204-205, 54 S.Ct. at 361. Thus, in order to overturn the Commissioner's disallowance, the taxpayer must show that the Commissioner's act was "plainly arbitrary." Lucas v. Kansas City Structural Steel Co., supra, 281 U.S. at 271, 50 S.Ct. 263; Bangor Punta Operations, Inc. v. United States, supra, 466 F.2d at 935.

C.

The Tax Court held in this case that under § 471 of the Internal Revenue Code of 1954 the Secretary is to prescribe the methods by which inventories are to be taken, and that the Treasury Regulations set forth those methods. While the court found that Thor's write-downs of excess inventory constituted a "best accounting practice" within the terms of the statute, it also held, without elaboration, that Thor had failed to establish that its...