Thor Power Tool Company v. Commissioner of Internal Revenue

• Decision Date: 16 January 1979
• Docket Number: No. 77-920,77-920
• Citation: 439 U.S. 522,99 S.Ct. 773,58 L.Ed.2d 785
• Parties: THOR POWER TOOL COMPANY, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE
• Court: U.S. Supreme Court

58 L.Ed.2d 785

99 S.Ct. 773

439 U.S. 522

THOR POWER TOOL COMPANY, Petitioner,

v COMMISSIONER OF INTERNAL REVENUE.

No. 77-920.

Argued Nov. 1, 1978.

Decided Jan. 16, 1979.

Syllabus

Inventory accounting for tax purposes is governed by §§ 446 and 471 of the Internal Revenue Code of 1954. Section 446 provides that taxable income is to be computed under the taxpayer's normal method of accounting unless that method "does not clearly reflect income," in which event taxable income is to be computed "under such method as, in the opinion of the [Commissioner], does clearly reflect income." Section 471 provides that "[w]henever in the opinion of the [Commissioner] the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventory shall be taken by such taxpayer on such basis as the [Commissioner] may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting income." The implementing Regulations require a taxpayer to value inventory for tax purposes at cost unless "market" (defined as replacement cost) is lower. The Regulations specify two situations in which inventory may be valued below "market" as so defined: (1) where the taxpayer in the normal course of business has actually offered merchandise for sale at prices lower than replacement cost; and (2) where the merchandise is defective. In 1964, petitioner, a tool manufacturer, wrote down in accord with "generally accepted accounting principles" what it regarded as "excess" inventory to its own estimate of the "net realizable value" (generally scrap value) of the "excess" goods (mostly spare parts), but continued to hold the goods for sale at their original prices. It offset the write-down against 1964 sales and thereby produced a net operating loss for that year. The Commissioner disallowed the offset, maintaining that the write-down did not reflect income clearly for tax purposes. Deductions for bad debts are covered by § 166. Section 166(c) provides that an accrual-basis taxpayer "shall be allowed (in the discretion of the [Commissioner]) a deduction for a reasonable addition to a reserve for bad debts." In 1965, petitioner added to its reserve and asserted as a deduction under § 166(c) a sum that presupposed a substantially higher charge-off rate for bad debts than it had experienced in immediately preceding years. The Commissioner ruled that the addition was exces- sive, and determined, pursuant to the "six-year moving average" formula derived from Black Motor Co. v. Commissioner, 41 B.T.A. 300, what he regarded as a lesser but "reasonable" amount to be added to petitioner's reserve. On petitioner's petition for redetermination, the Tax Court upheld the Commissioner's exercise of discretion with respect to both the inventory write-down and the bad-debt deduction, and the Court of Appeals affirmed. Held :

1. The Commissioner did not abuse his discretion in determining that the write-down of "excess" inventory failed to reflect petitioner's 1964 income clearly, since the write-down was plainly inconsistent with the governing Regulations. Pp. 531-546.

(a) Although conceding that "an active market prevailed" on the inventory date, petitioner made no effort to determine the replacement cost of its "excess" inventory and thus failed to ascertain "market" in accord with the general rule of the Regulations. Petitioner, however, failed to bring itself within either of the authorized exceptions for valuing inventory below "market." Whereas the Regulations demand concrete evidence of reduced market value, petitioner provided no objective evidence whatever that its "excess" inventory had the value management ascribed to it. Pp. 535-538.

(b) There is no presumption that an inventory practice conformable to "generally accepted accounting principles" is valid for tax purposes. Such a presumption is insupportable in light of the statute, this Court's past decisions, and the differing objectives of tax and financial accounting. Pp. 538-544.

(c) While petitioner argues that it should not be forced to defer a tax benefit for inventory currently deemed unsalable until future years, when the "excess" items are actually disposed of, petitioner's "dilemma" is nothing more than the choice every taxpayer with a paper loss must face. Pp. 545-546.

2. The Commissioner did not abuse his discretion in recomputing a "reasonable" addition to petitioner's bad-debt reserve according to the Black Motor formula. Because petitioner did not show why its debt collections in 1965 would be less likely than in prior years, it failed to carry its "heavy burden" of showing that application of the Black Motor formula would have been arbitrary. Pp. 546-550.

7th Cir., 563 F.2d 861, affirmed.

Mark H. Berens, for petitioner.

Stuart A. Smith, Washington, D. C., for respondent.

Mr. Justice BLACKMUN delivered the opinion of the Court.

This case, as it comes to us, presents two federal income tax issues. One has to do with inventory accounting. The other relates to a bad-debt reserve.

The Inventory Issue. In 1964, petitioner Thor Power Tool Co. (hereinafter sometimes referred to as the taxpayer), in accord with "generally accepted accounting principles," wrote down what it regarded as excess inventory to Thor's own estimate of the net realizable value of the excess goods. Despite this write-down, Thor continued to hold the goods for sale at original prices. It offset the write-down against 1964 sales and thereby produced a net operating loss for that year; it then asserted that loss as a carryback to 1963 under § 172 of the Internal Revenue Code of 1954, 26 U.S.C. § 172. The Commissioner of Internal Revenue, maintaining that the write-down did not serve to reflect income clearly for tax purposes, disallowed the offset and the carryback.

The Bad-debt Issue. In 1965, the taxpayer added to its reserve for bad debts and asserted as a deduction, under § 166(c) of the Code, 26 U.S.C. § 166(c), a sum that presupposed a substantially higher charge-off rate than Thor had experienced in immediately preceding years. The Commissioner ruled that the addition was excessive, and determined, pursuant to a formula based on the taxpayer's past experi- ence, what he regarded as a lesser but "reasonable" amount to be added to Thor's reserve.

On the taxpayer's petition for redetermination, the Tax Court, in an unreviewed decision by Judge Goffe, upheld that Commissioner's exercise of discretion in both respects. 64 T.C. 154 (1975). As a consequence, and also because of other adjustments not at issue here, the court redetermined, App. 264, the following deficiencies in Thor's federal income tax:

calendar year 1963—$494,055.99

calendar year 1965—$59,287.48

The United States Court of Appeals for the Seventh Circuit affirmed. 563 F.2d 861 (1977). We granted certiorari, 435 U.S. 914, 98 S.Ct. 1466, 55 L.Ed.2d 504 (1978), to consider these important and recurring income tax accounting issues.

I

The Inventory Issue

A.

Taxpayer is a Delaware corporation with principal place of business in Illinois. It manufactures hand-held power tools, parts and accessories, and rubber products. At its various plants and service branches, Thor maintains inventories of raw materials, work-in-process, finished parts and accessories, and completed tools. At all times relevant, Thor has used, both for financial accounting and for income tax purposes, the "lower of cost or market" method of valuing inventories. App. 23-24. See Treas.Reg. § 1.471-2(c), 26 CFR § 1.471-2(c) (1978).

Thor's tools typically contain from 50 to 200 parts, each of which taxpayer stocks to meet demand for replacements. Because of the difficulty, at the time of manufacture, of predicting the future demand for various parts, taxpayer produced liberal quantities of each part to avoid subsequent pro- duction runs. Additional runs entail costly retooling and result in delays in filling orders. App. 54-55.

In 1960, Thor instituted a procedure for writing down the inventory value of replacement parts and accessories for tool models it no longer produced. It created an inventory contra-account and credited that account with 10% of each part's cost for each year since production of the parent model had ceased. 64 T.C., at 156-157; App. 24. The effect of the procedure was to amortize the cost of these parts over a 10-year period. For the first nine months of 1964, this produced a write-down of $22,090. 64 T.C., at 157; App. 24.

In late 1964, new management took control and promptly concluded that Thor's inventory in general was overvalued.¹ After "a physical inventory taken at all locations" of the tool and rubber divisions, id., at 52, management wrote off approximately $2.75 million of obsolete parts, damaged or defective tools, demonstration or sales samples, and similar items. Id., at 52-53. The Commissioner allowed this writeoff because Thor scrapped most of the articles shortly after their removal from the 1964 closing inventory.² Management also wrote down $245,000 of parts stocked for three unsuccessful prod- ucts. Id., at 56. The Commissioner allowed this write-down too, since Thor sold these items at reduced prices shortly after the close of 1964. Id., at 62.

This left some 44,000 assorted items, the status of which is the inventory issue here. Management concluded that many of these articles, mostly spare parts,³ were "excess" inventory, that is, that they were held in excess of any reasonably foreseeable future demand. It was decided that this inventory should be written down to its "net realizable value," which, in most cases, was scrap value. 64 T.C., at 160-161; Brief for Petitioner 9; Tr. of Oral Arg. 11.

Two methods were used to ascertain the quantity of excess inventory. Where accurate data were available, Thor forecast future demand for each item on the basis of actual 1964 usage, that is, actual sales for tools and service parts, and actual...