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For an accrual basis taxpayer, it is the right to receive and not the actual receipt that determines the inclusion of the amount in gross income.
The partners in a dancing studio offered lessons under contracts providing that they were noncancelable and that no refunds would be made thereunder, the student being obligated either (1) to make a cash down payment in full, with the balance due in instalments, or (2) to make a partial down payment in cash, pay the remainder of the down payment in stated instalments, and pay the balance due as designated in a negotiable note. Although the contracts designated the period during which the lessons had to be taken, there was no schedule of specific dates for the lessons, which were arranged by the instructor and his student. The partners followed an accrual method, crediting a "deferred income" account for the total contract price in each instance, and reporting as income for each fiscal period amounts representing lessons taught and cancellations made during the period. They deducted, in the year paid, percentage royalties and sales commissions paid by them. The Commissioner of Internal Revenue increased the 1952, 1953, and 1954 ordinary income of the partners by including in the gross income for these years amounts received or receivable under contracts executed during these years despite the fact that the contracts obligated the taxpayers to render performance in subsequent years. These increases produced tax deficiencies which the partners unsuccessfully challenged in the Tax Court. (32 TC 1271.) The Court of Appeals for the Eighth Circuit reversed, but after its judgment was vacated by the Supreme Court of the United States for reconsideration, the Court of Appeals affirmed.
Was it proper for the Commissioner, in the exercise of his discretion under § 41 of the Internal Revenue Code of 1939 and § 446 (b) of the Internal Revenue Code of 1954, to reject petitioners' accounting system as not clearly reflecting income and to include as income in a particular year advance payments by way of cash, negotiable notes and contract installments falling due but remaining unpaid during that year?
The United States Supreme Court affirmed in part and reversed in part. Pursuant to I.R.C. § 446, if no method of accounting was used by the taxpayers, or if the method used had not clearly reflected the taxpayers' income, the computation of taxable income should have been made under such method as did clearly reflect income in the opinion of the Commissioner. The Court held that, under the accrual method, it was the right to receive and not the right to actual receipt that determined the inclusion of the amount in gross income. The Court affirmed the part of the Commissioner's decision that included income amounts representing cash and notes due and payable. The Court reversed and remanded the part of the decision that included cash and notes not due and payable during the respective tax year.