Thor Power Tool Co. v. Commissioner - 439 U.S. 522, 99 S. Ct. 773 (1979)

Rule:

The Tax Code, 26 U.S.C.S. § 446(a) states the general rule for methods of accounting is that, taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books. 26 U.S.C.S. § 446(b) provides, however, that if the method used by the taxpayer does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the commissioner of internal revenue, does clearly reflect income, and no method of accounting is acceptable unless, in the opinion of the commissioner, it clearly reflects income.

Facts:

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 "[whenever] 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 excessive, 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. 

Issue:

Was the disallowance of petitioner's write-downs and bad-debt deductions proper?

Answer:

Yes

Conclusion:

The Court affirmed the commissioner of Internal Revenue's disallowance of petitioner taxpayer's write down offset and bad-debt deduction. Petitioner used a lower of market or cost method of valuing inventories and instituted a write-down procedure for replacement parts and accessories for models no longer produced, which resulted in an increase in cost of goods sold and a decrease in closing inventory taxable income. The commissioner of Internal Revenue disallowed the write-downs because they did not clearly reflect petitioner's income. The tax court found that petitioner's write-down conformed to accepted accounting principles, but that petitioner's method did not clearly reflect income. On review, the Court found that a method of accounting must clearly reflect income, and petitioner could not use market cost because inventory was not defective and had not yet been sold at a discounted price. The commissioner ruled that petitioner's bad-debt deductions based on a flat rate and age of account method were excessive and the six-year moving average was more appropriate, and that determination was not found to be arbitrary or an abuse of the commissioner's broad discretion.