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Steven J. Willis (willis@law.ufl.edu,

http://nersp.nerdc.ufl.edu/~acadian) is aProfessor of Law at the University ofFlorida College of Law. He holds a C.P.A.Certificate (inactive license) in the state ofLouisiana. He argues that Tax Law show pay more,not less, deference to accountingprinciples. This contrasts with opinionoffered in an earlier Tax Notes article. Hedemonstrates that accrual methodtaxpayers subject to the Schluderequirement of income recognition uponreceipt suffer: they effectively pay highertaxes than are economically justified. Hesuggests that the same analysis holds foraccrual taxpayers affected by section461(h), dealing with the economicperformance requirement for deductions.While careful planning can reduce theseadverse impacts, the author suggests achange in law. One approach, deferral accounting,would solve much of the problem, althoughnot all of it. Ideally accrual taxpayersshould be taxed on the economicsubstance of the transaction, whichinvolves both deferral accounting plusapplication of time value of moneyprinciples, particularly those dealing withdiscount loans. But both approaches arefar preferable to current law whichdistinguishes between taxpayers whoborrow from their customers as opposedto those who seek capital elsewhere. Thisartificial distinction is poor tax policy andresults in unnecessary economicdistortions.

IT’S TIME FOR SCHLUDE TO GO

By Steven J. Willis

Three recent TAX NOTES articles and a recent case illuminate the need for a major change in the way we view accounting and finance issues as they relate to tax law.

1. Professor Deborah Geier1 forcefully argued for less application of accounting and financial considerations to tax analysis; but through her examples and arguments she proved the need for more.

2. Burgess and William Raby,2 in their

cogent criticism of the opinions in Westpac Pacifc Foods3 and Daniel Harkins,4 also demonstrated the need for more accounting planning for tax issues.

1 Deborah A. Geier, “Why the Matching Principle has no Place in the Income Tax World,” 91 Tax Notes 343 (Apr. 9, 2001). Deborah A. Geier, "The Myth of the Matching Principle as a Tax Value," 15 Am. J. Tax Pol'y (1998). See also, the convincing response to Professor Geier, W. Eugene Seago, "A Modest Proposal Regarding the Matching Principle," Tax Notes, Mar. 26, 2001, p. 1855.

2 Burgess J. W. Raby and William L. Raby, “Taxable Advance Payments vs. Deposits and Deferrals”, 92 Tax Notes 1209 (August 27, 2001).

3 Westpac Pacific Foods v. Comm’r, T.C. Memo. 2001-175.

4 Harkins v. Comm’r, T.C. Memo. 2001-100.

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3. Professor W. Eugene Seago,5 pointedly

disagreed with Professor Geier, arguing for more deference to financial accounting in tax law.

4. The Federal Circuit decided American

Express v. United States,6 denying the taxpayer the right to change to an accounting method that clearly reflected income and away from one that did not.

I agree with Professor Seago and would

go further than the Rabys recommend.7 Tax law should more closely follow accounting and financial measurements and definitions of income, particularly the matching principal. This new approach should apply to Congress in developing statutes, the Treasury in drafting regulations, and to Courts in “interpreting” the above (or in “legislating, depending on one’s perspective). As a result, the Schlude8 approach to “pre-paid income” received by accrual methods taxpayers should be relegated to history. As a result, the Indianapolis Power9 (and Westpac/Harkins) line of cases debating whether an item is a pre-payment or a deposit would become cash method issues only, and no longer would affect accrual users, mooting the controversy ably argued by the Rabys.

The arguments I make apply equally to

deductions as they do to income. In fact, the taxpayer-adverse consequences of 461(h)10 are

much more profound than those of the Schlude doctrine because they are more insidious and thus less understood. As a result, section 461(h) should likewise be repealed and the unfortunate Albertsons11 decision should be reversed. The examples and analysis presented below, however, apply only to the income side. Because the calculations needed to prove the same points from the perspective of deductions is less intuitive and more complicated, I leave that portion of the argument to a separate article.

5 W. Eugene Seago, "A Modest Proposal Regarding the Matching Principle," Tax Notes, Mar. 26, 2001.

6 American Express v. U.S., _____ F.3d. _____ (Fed. Cir. 2001).

7 The Raby article argued for practitioners to be more active in planning to avoid adverse tax accounting consequences. I would change the law so that the proper planning would be automatic.

8 Schlude v. Commissioner, 372 U.S. 128 (1963).

9 Indianapolis Power & Light Company v. Commissioner, 493 U.S. 203 (1990).

10 I.R.C. § 461(h).

A summary of my argument is this:

The absence of the matching principle in tax law12 – particularly through the Schlude doctrine and section 461(h) – amounts to a tax on ignorance. Whenever economically feasible, those who understand accounting

11 Albertson’s, Inc. v. Commissioner, 42 F.3d 537 (9th Cir. 1995), reversing, Albertson's, Inc. v. Commissioner, 12 F.3d 1529, 1534 (9th Cir. 1993).

12 In an astonishing misuse of terminology, the Ninth Circuit in the Albertsons reversal relied upon the “matching principle” to justify forcing consistent treatment between a payor and payee. Id. at 541-43. Of course, no such “principle” exists in tax law, let alone financial accounting. The existence of a few code provisions, e.g., sections 267 and 404 which accomplish such multiple taxpayer “consistency” proves no such “principle” exists: the sections would be superfluous with such a principle. The “matching principle” for accounting requires that income and the expenses that produce that income be recorded in the same period; naturally, it applies only to a single entity at a time. At most, the court should have spoken of a “consistency principle,” which forms the basis for some code sections, but does not exist as a general principle to be relied upon to overcome statutory language. Calling its concept “matching” confuses it with the foundation of financial accounting, which serves a very different purpose. For a more detailed discussion of “related party” transactions, including a discussion of statutorily required “consistency” see Willis, RELATED PARTY TRANSACTIONS, http://nersp.nerdc.ufl.edu/~acadian/tulane1999/show.pdf, previously presented to the 1999 Tulane Tax Institute and, in modified format to the 2000 CBIZ National Tax Institute.

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and finance issues will modify their behavior to counterbalance adverse Schlude/461(h) effects. Those who are not well informed will effectively pay a higher tax, almost certainly without even knowing they do so. While such a tax on ignorance is certainly tempting, it is also irresponsible. It results in economic distortions that serve no real purpose. For Congress to single out and to reward certain behaviors – such as through section 17913 encouraging the purchase of business assets – is Congress’ prerogative. It matters very little whether we label such actions a consumption tax or an income tax or whether we label them at all. But taxing accrual taxpayers who receive advance “payments” or who defer payment of expenses celebrates form over substance. That rewards unnecessary paperwork, forces inefficient business decisions, and taxes ignorance, none of which is consistent with responsible government.

A. Background

a) Geier Articles

Professor Geier twice argued for rejection of

the matching principle in tax. Acknowledging its nature as the foundation of generally accepted accounting principles, she argued that tax law exists not to reflect income, as does financial accounting, but rather for other aims (presumably to raise revenues). Hence, she rejected the relevance of the matching principle.

A primary example involved prepaid

amounts received by accrual method taxpayers. Criticized by Professor Seago, Professor Geier defended her arguments:

13 I. R. C. § 179. Professor Geier cited section 179 as an example of a consumption tax, i.e., that it provides a deduction for investment. She compared this to the Schlude Doctrine, which imposed income tax on advanced “payments” received by accrual taxpayers, suggesting that the absence of the doctrine would likewise be a consumption tax.

Using untaxed dollars to earn an investment return is inappropriate under income tax principles, effectively garnering the taxpayer consumption-tax treatment instead. To query why the literature does not talk about the problem of inappropriately requiring a taxpayer to include cash when received when it ought to be included later than the year of receipt is to fundamentally misunderstand the consumption tax/income tax distinction in the first place.14

Whether her critics (or anyone else for

that matter) understand (or even care about) the “fundamental” distinctions between consumption taxes and income taxes is not the point with which I quarrel. Rather, I agree with Professor Geier that we have a hybrid consumption/income tax system; so much so, I suspect the consumption/income classifications probably make no real difference other than to academics. Instead, I’d rather focus on the actual impact of specific examples – the impact on taxpayers and their consequent reactions. Indeed, what else matters?

b) Raby Article

In an August 27, 2001, TAX NOTES

article, Burgess and William Raby covered the risk of accrual method taxpayers receiving payments in advance: to wit, such payments constitute income upon which taxes must be paid currently. They also covered several of the few exceptions to this harsh rule, i.e., Rev. Proc. 71-2115 and the Artnell16 / Boise Cascade17 line of cases. They ended with the wise advice:

14 Geier, supra note 1, at 344.

15 Rev. Proc. 71-21, 1971-2 C.B. 549.

16 Artnell Co. v. Commissioner, 400 F.2d 981 (7th Cir. 1968).

17 Boise Cascade Corp. v. United States, 530 F.2d 1367 (Ct. Cl. 1976).

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Beyond the situations covered by specific rules, however, clients who attempt to structure their transactions and documents to maximize income deferral may find themselves embroiled in a tax controversy regardless of the practitioner’s best efforts. One thing is certain though – clients who do not attempt to maximize their tax deferrals will likely maximize the taxes they pay, at least when viewed in present value terms.18

That last sentence should be posted on every tax lawyer’s wall. Judges who decide cases involving timing issues should have it quoted to them repeatedly. It makes the case that the Schlude Doctrine amounts to a tax increase (which is an astonishing thing to have arisen from a Court, considering that tax legislation is supposed to originate in the House of Representatives.19) The only quarrels I have with the Raby statement involves four words. Clients who fail to defer income will not just “likely” maximize their taxes; they will most assuredly do so. They will not just maximize taxes; they will over-pay. And why use the qualification “at least” when viewed in present value terms? What other way is there to view it? Comparing present tax payments with future tax payments without considering the time value of money is a silly alternative, laden with malpractice, as the authors undoubtedly assume.20 Indeed such an

unsophisticated approach is what caused the problems resulting from Schlude. That silly alternative is also what prompted the need for section 461(h) (although the drafters of that unfortunate statute solved one problem by creating another because they apparently miscalculated time value of money rules).

18 Raby, supra note 2 at 1212.

19 As explained in the Background, the Schlude Doctrine is arguably defensible as legislative interpretation based on the repeal of section 452 and 462. That plausible argument, however, conflicts with the plain meaning of the clear Congressional approval of the “accrual” method of accounting. Construing “accrual method” in section 446(c)(2) to support the Schlude Doctrine is an unorthodox use of the traditional term “accrual.”

20 I suspect they were being politely delicate with the two qualifications. Considering the tendency for Courts and many academics to ignore accounting and finance implications, polite delicacy is probably ill advised. The points made by the authors are

quite well taken: they just need to be a bit more blunt. Surprising as it seems, some people believe that accelerated income and deferred deductions produce proper, rather than excess, tax liability.

c) Schlude Doctrine

A full understanding of the rules

governing the accrual of income from services (and the adverse consequences of those rules) requires an historical perspective. This is true because the rules emanate mostly from a series of Supreme Court decisions and their progeny, spanning several decades. While for many years the rules were both controversial and unclear, they can now be described as merely controversial and unwise.

The following background is lengthy, but

necessary for those well-informed taxpayers who would rather not “maximize” their taxes. Well-informed taxpayers, however, must navigate the many competing and inconsistent rules. Such ridiculous complexity, illustrated by the following pages, demonstrates the harm resulting from the Schlude doctrine: the only real revenue it raises is a tax on ignorance; otherwise, its workfare for tax lawyers (who understand accounting and finance) and accountants (not a bad program as government welfare goes, but hardly justifiable with a straight face).

d) Current Tax Accounting Income Accrual Rules

A summary of the rules is:

An accrual taxpayer must include income from the performance of services at the earliest of three dates:

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o The date the income is earned under the traditional “all events” test.

o The date an amount is paid for the services.

o The date an amount is due for the services.

(1) Rule One: “All Events”

The first of these dates - the “all events”

test is consistent with Generally Accepted Accounting Principles, as used for financial accounting. It provides that:

Income must be recognized when all

events have occurred such that the earner has the right to payment and the amount involved can be determined with reasonable accuracy.

Consistent with this rule, the proper book entry - for both financial and tax accounting - would be a debit to Accounts Receivable (or some other asset account) and a credit to Income (or some other revenue account). As a result, the accrued income would be reported in the same year as – and thus would “match with” - the correspondingly accrued costs required to produce the income. In turn, both the Income Statement and Tax Return would fairly present the result of operations for that period as a net profit or loss. Investors, managers, and creditors could then appropriate judge those operational results.

(2) Rule Two “Payment”

The second of these dates - the “payment” date - is not consistent with Generally Accepted Accounting Principles. If a taxpayer were to receive an advance payment for services, the financial accounting book entry would involve a debit to Cash (or some other asset account) and a credit to Unearned Income (or some other liability account). No entry would properly affect earnings or any Owner=s Equity account. As such, the entries would have no impact on the Income Statement or on the Equity portion of the Balance Sheet.

In a later period in which the amount was earned, the accountant would record a debit to Unearned Income and a credit to Income. As a result, the income would be reported on the Income Statement for the period in which it was earned. Correspondingly, the applicable costs would likewise be accrued or deferred to match with the income. Once again, investors, managers, and creditors could fairly utilize the resulting financial statements to judge operational results for the affected periods.

In contrast, for Tax Accounting, the proper entry for a services prepayment would be a debit to Cash and a credit to Income (or some other revenue account). In the later period in which the amount was earned, no entry would be appropriate. Because the tax rules for the accrual of deductions differs from those involving income, the corresponding expenses would not likely be reported in the same period as would the income. As a result, the tax return would not fairly present the results of operations for the period. Investors, managers, or creditors who relied on such returns for information regarding the entity would risk misjudgments.21 While financial statements prepared on the basis of generally accepted accounting principles are themselves subject to many estimates, judgments, and potential inaccuracies, they would likely better reflect income than would tax returns in nearly all cases.22

21 Although tax returns are not meant to supplant financial statements as a measure of operations, many people unfortunately treat them as such. For example, for many family law purposes, the tax returns form the basis for the division of marital assets or for the determination of child support obligations. To the extent such returns diverge from generally accepted accounting principles, they may inaccurately reflect income or losses. The extent to which they are inaccurate is, of course, difficult to gage. As a result, litigants forced to rely on such information are well advised to seek competent accounting advice to interpret the returns.

22 While the ultimate purpose of tax accounting is to aid in the raising of revenues, clear reflection of income is nevertheless a statutory cornerstone of the effort. I.R.C. § 446(b). The Schlude Doctrine –

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(3) Rule Three: “Due”

The third of the dates - the date on

which an amount is “due” - also does not conform to generally accepted accounting principles as an income item. If a taxpayer were entitled to receive an amount that was unearned and not yet received, the proper financial accounting treatment would require some accounting judgment. In many instances, no journal entry would be appropriate: after all, nothing would yet have actually happened. In such a case, some notion in the footnotes to financial statements might be advisable to disclose the existence of the contract and the lateness of the promised pre-payment. In other instances, a financial accountant might debit Accounts Receivable (or some other asset account) and debit Unearned Income (or some other liability account). The problem with this approach is that it reports both an arguably non-existent asset and a non-existent liability. No entry, along with footnote disclosure, would likely present a fairer picture. But, in no instance would a financial accountant make an entry to “income” or any other account affecting Retained Earnings or the Equity portion of the Balance Sheet.

In contrast, for Tax Accounting, the proper book entry for service payments that are due but unearned and unpaid would be a debit to Accounts Receivable (or some other asset account) and a credit to Income (or some other revenue account). In a later period in which the amount was paid, an entry would be appropriate debiting Cash and crediting Accounts Receivable; however, this set of entries would have no impact on the tax return.

Also, in the later period in which the

amounts were earned, no entry would be appropriate for Tax Accounting. As a result, the tax returns for both the “Due” year and for the “earning” year would not fairly present the results of operations for the period. Investors,

managers, or creditors who relied on such returns for information regarding the entity would risk misjudgments.

and section 461(h) – do not “clearly reflect income” in any rational sense of that phrase.

e) History of the Accrual of Service

Income

(1) The Failed Experiment with Sections 452 and 462

Prior to 1954, accrual method taxpayers

included in income amounts pre-paid for services. They could not, however, deduct estimated expenses that they anticipated to be required to later earn the pre-paid amounts. This resulted in an unfair mismatch of income and expenses. As part of the 1954 Code, Congress attempted to alleviate this unfairness through the enactment of two code provisions: sections 45223 and 462.24 The experiment was a failure and Congress repealed both sections in 1955.

Section 452 permitted, during its brief life, the deferral of income from pre-payments until the year of earning. This largely conformed the Internal Revenue Code to generally accepted accounting principles. In the alternative, for taxpayers choosing not to defer prepayments, section 462 permitted the early accrual of estimated future expenses that the taxpayer anticipated as ordinary and necessary in the earning of the prepaid amounts. This section did not conform to generally accepted accounting principles because it resulted in both the early accrual of income and expenses. It did, however, adequately match income with the appropriate expenses. In so doing, the use of section 462 resulted in a proper measure of income, albeit in the wrong year.

The two sections, however, resulted in a significant short-term revenue loss. Taxpayers who elected to use the deferral mechanism of section 452 paid less tax in the short run than

23 I.R.C. § 452 (1954).

24 I.R.C. § 462 (1954).

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they otherwise would have. This effect was short term because, eventually, the income would all be reported: future years for which deferral was elected would include income deferred from prior elections. Nevertheless, for a short but significant transition period, the government anticipated substantial revenue losses.

Similarly, taxpayers who elected to use the estimated accruals of section 462 also paid less tax in the short run than they otherwise would have. This effect resulted because, in the initial years of the election, they would deduct both the newly anticipated expenses and also the expenses properly deductible, but attributable to prepaid income recognized in years prior to the election. This effect was also short term because, eventually, in the future years in which the expenses would otherwise have been deducted, additional expenses would then be anticipated, but no “old” expenses would be left to deduct.

The combined anticipated revenue losses were more than the government felt it could afford. Consequently, in 1955 - the year following enactment - Congress repealed both sections 452 and 462. Several later Supreme Court decisions relied heavily on this repealed experiment, reasoning that Congress clearly intended not to permit either the deferral of prepaid income or the early accrual of anticipated expenses.

(2) Beacon Publishing Company:25 Deferral Permitted in 1955

Beacon Publishing Company sold

newspapers. Many subscribers paid in advance for newspapers to be delivered up to five years subsequent. An accrual method taxpayer, Beacon chose to defer recognition of the income from the prepaid amounts until it printed and delivered the applicable newspapers. This accounting method

conformed to generally accepted accounting principles, matched revenues with the appropriate expenses, and thus properly reflected income.

25 Beacon Publishing Co. v. Commissioner, 218 F.2d

697 (10th Cir. 1955).

The Commissioner rejected Beacon=s

accounting method as contrary to law, claiming it failed to properly reflect income. The Tax Court held for the Commissioner; however, the Court of Appeals for the Tenth Circuit reversed, holding for the taxpayer and permitting the income deferral. The court ably explained:

[I]f the tax court's application of the rule is carried to its logical conclusion, the prepaid receipts, because the taxpayer received them under a claim of right, would be taxable during the year in which they were received, even though the taxpayer kept his books on an accrual basis. . . . This would produce an incongruous result. It would permit the collection of taxes during periods not contemplated by the accrual method of accounting . . .. Such an application of the rule requires the taxpayer to report its prepaid income on a cash basis and to accrue its deductions. It creates a hybrid bookkeeping system and results in a tax return which does not clearly reflect income. . . . To a large extent, it destroys the principle inherent in the accrual method of accounting.26

This interesting case, while decided in

1955, dealt with years 1943 and 1944 - prior to the 452/462 experiments. Nevertheless, and contrary to tradition, the Tenth Circuit permitted deferral of amounts prepaid for subscriptions. The importance of the decision is limited for several reasons:

1) It is old.

2) It pre-dates both the sections 452/462 failed experiment and the Supreme Court trilogy, which held the other way.

26 Id. at 700-701 (emphasis added).

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3) Congress later enacted section 455 to accomplish what this case permitted.

Thus, as applied to its set of facts, the case is unimportant.

Still, the decision is noteworthy because it dealt with the law absent section 452 and 462 - precisely the situation faced currently. Also, the appellate court recognized the harshness and unfairness of requiring accrual taxpayers to recognize income prior to earning it and prior to deducting the relevant expenses. A litigant seeking deferral can ignore none of the few cases exits that so hold. Taxpayers planning a transaction, however, would be well advised not to rely on this decision, as it is best viewed as unusual. That it is correct is of little comfort, considering the mass of contrary authority.

(3) Schuessler v. Commissioner:27

Deduction for Estimated Expenses Permitted in 1956

Schuessler sold gas furnaces, along

with a service contract. During 1946, he sold 665 furnaces, each with the guarantee that he would turn the equipment on and off each year for five years. This service, if provided separately, would cost approximately $2.00 for each of the ten trips. He priced his furnaces approximately $20.00 to $25.00 more than his competitors, who did not provide the same service.

Although clearly a portion of the sale=s price was attributable to the service agreement, Schuessler did not seek to defer that portion of the income. Had he done so, he would have been consistent with generally accepted accounting principles. Instead, he chose to deduct, in the year of sale, a reserve for the estimated future cost of providing the guarantee. While this did not conform to GAAP and thus did not “clearly reflect income,” it

nevertheless properly matched income and expenses, albeit in the wrong year.

27 Schuessler v. Commissioner, 230 F.2d 722 (5th Cir. 1956).

The Tax Court sided with the

Commissioner in denying the deductions.28 The Court of Appeals for the Fifth Circuit, however, held for the taxpayer and permitted the estimated deductions. The court explained:

We think it quite clear that petitioner's method of accounting comes much closer to giving a correct picture of his income than would a system in which he sold equipment in one year and received an inflated price because he obligated himself, in effect, to refund part of it in services later but was required to report the total receipts as income on the high level of the sales year and take deductions on the low level of the service years. The reasonableness of taxpayer's action, however, is not the test if it runs counter to requirements of the statute.

We find that not only does it not offend any statutory requirement, but, in fact, we think it is in accord with the language and intent of the law. Clearly what is sought by this statute is an accounting method that most accurately reflects the taxpayer's income on an annual accounting basis. 29

The Circuit Court relied on the then

recent Beacon Publishing case from the Tenth Circuit. Also, while the court noted the 1954-55 passage and repeal of sections 452 and 462, it asserted that those Congressional actions added nothing to the interpretation of law under the 1939 Code, which then applied.30

Although the decision dealt with deductions, it is nevertheless noteworthy in an analysis of services income accrual. First, it provided an analysis of law absent section 452

28 17 T.C. 1097 (1955).

29 230 F.2d at 723-24 (footnote omitted).

30 Id. at 725.

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and 462. Although it dealt with the 1939 Code, the statute then controlling accrual of income and deductions was very similar to the ones that currently exist. Second, as did the Beacon Publishing court, the Fifth Circuit ably explained the unfairness of mismatching income and deductions, which would result under the system proposed by the Commissioner (and later imposed by the Schlude Doctrine and exacerbated by section 461(h)). As is true of Beacon Publishing, litigants seeking either deferral of prepaid amounts or early accrual of expenses should note the decision.31 However, taxpayers planning a transaction, however, would be well advised not to rely on it, as it is best viewed as unusual. That it is persuasive and defensible is of little comfort, considering the mass of contrary authority.

(4) Automobile Club of Michigan:32 Supreme Court Required Accrual of Prepaid Amounts for Services, in 1957

The Automobile Club of Michigan was

originally a tax exempt entity. In 1945, the Commissioner withdrew the club=s tax exempt status retroactive to 1943.33 In an opinion of considerable procedural importance, the Supreme Court dealt with one very significant accounting issue: the accrual treatment of membership dues that were paid in advance for one year.

The taxpayer deposited the funds in a general bank account, which was available for

general corporate uses. Consistent with generally accepted accounting principles, for both bookkeeping and tax purposes, it credited the amounts to a liability account designated “Unearned Membership Dues.” Then, at the beginning of each of the following eleven months, it debited the liability account for one-twelfth of the amount and credited a revenue account designated “Membership Income.”34

31 Litigants seeking deferral will have a tough, but

possibly winnable fight, considering the Schlude Doctrine is Court-made. Those seeking accrual of future expenses probably face a hopeless battle because of section 461(h). In either case, however, modification of the contract to accomplish the same goals, but with different form, could achieve the desired result, avoiding both the Schlude and 461(h) adverse consequences.

32 Automobile Club of Michigan v. Commissioner, 353 U.S. 180 (1957).

33 Id. at 182-83.

The Commissioner challenged the

taxpayer=s accounting method, asserting the application of the North American Oil35 “claim of right”36 doctrine. The Supreme Court agreed:

The petitioner does not deny that it has the unrestricted use of the dues income in the year of receipt, but contends that its accrual method of accounting clearly reflects its income, and that the Commissioner is therefore bound to accept its method of reporting membership dues. We do not agree. Section 41 of the Internal Revenue Code of 1939 required that "the net income shall be computed . . . in accordance with the method of accounting regularly employed in keeping the books . . . but . . . if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income. . . ." The pro rata allocation of the membership dues in monthly amounts is purely artificial and bears no relation to the services which petitioner may in fact be called upon to render for the member.37 Section 41 vests

34 Id. at 188.

35 North American Oil v. Burnet, 286 U.S. 417(1934).

36 "If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, . . . [it]has received income which . . . [it] is required to return . . . ." Id. at 424.

37 In note 20 of its opinion, the Court explained: “Beacon Publishing Co. v. Commissioner, 218 F.2d 697, and Schuessler v. Commissioner, 230 F.2d 722, are distinguishable on their facts. In Beacon,

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the Commissioner with discretion to determine whether the petitioner's method of accounting clearly reflects income. We cannot say, in the circumstances here, that the discretionary action of the Commissioner, sustained by both the Tax Court and the Court of Appeals, exceeded permissible limits.38

Although the Court held for the

Commissioner, it did not expressly agree that the “claim or right” doctrine generally controls accounting methods, or even specifically the accrual method. That doctrine deals more specifically with the effect of contested monies received by a taxpayer in an otherwise income producing transaction. The North American Oil Court - in a profoundly important error correction decision - held that amounts received under a colorable claim constituted income despite the possibility the taxpayer might lose the funds. While the Court then apparently asserted that the rule applied to both cash and accrual taxpayers, it did so obliquely. The Court dealt more with the effect of the opposing claim than on the specific timing issue. Essentially, the case held that the opposing claim itself was insufficient to cause the deferral of an amount that would otherwise constitute income, but for the claim. In other words, the doctrine applied to amounts which, but for the flaw, were income.

In this case, however, the items are not necessarily income because they have not yet been earned. Thus the existence of a “claim of right” to the money should not be sufficient to

cause income by such an accrual taxpayer. In this case, it was merely a factor in determining whether the accrual method chosen by the taxpayer clearly reflected income. It did not.

performance of the subscription, in most instances, was, in part, necessarily deferred until the publication dates after the tax year. In Schuessler, performance of the service agreement required the taxpayer to furnish services at specified times in years subsequent to the tax year. In this case, substantially all services are performed only upon a member's demand and the taxpayer's performance was not related to fixed dates after the tax year. We express no opinion upon the correctness of the decisions in Beacon or Schuessler.”

38 353 U.S. at 189-90.

(5) Congress Enacts ' 455 39 in 1958:

Permitted Deferral of Prepaid Amounts for Subscriptions

Congress enacted this provision -

allowing deferral for pre-paid subscription income - to reverse the harsh effects of the Automobile Club of Michigan case. By affirmatively permitting deferral in such a limited area, Congress arguably approved the Supreme Court=s decision to require general inclusion of pre-paid items. Current taxpayers who seek deferral of pre-paid items must deal with this notion that Congress implicitly approved of what became the Schlude Doctrine.

(6) Bressner v. Commissioner:40 Second Circuit Permitted Deferral of Prepaid Amounts for Services in 1959

This decision is of historical significance:

it no longer represents controlling authority in the Second Circuit, having been overruled by the 1981 R.C.A.41 decision. Nevertheless, the opinion is helpful to a full understanding of the great struggle the U.S. tax system has faced regarding proper treatment of pre-paid items. The court not only approved a deferral method,

39 I.R.C. ' 455. The regulations suggest that a publisher can use its “experience” in allocating the payments. This could be on a straight line basis, or perhaps on an increasing basis, reflecting higher prices for future issues. Treas. Reg. § 1.455.3(a). Section 467, dealing with prepayments for rent, generally presumes a constant rental amount in an analogous situation, and thus fully repeals the Schlude effect.

40 Bressner v. Commissioner, 267 F.2d 520 (2nd Cir. 1959).

41 RCA Corp. v. United States, 664 F.2d 881 (2d Cir., 1981).

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it also harshly criticized the government=s proposed treatment requiring early accrual, denominating it a “gross distortion.”42 In addition, the court flirted with the possibility of permitting accrual of estimated future expenses. In so doing, the court emphasized the importance of the matching principle to the clear reflection of income.

An accrual method taxpayer, Bressner Radio, Inc. sold television sets in the early days of television. During its fiscal years 1948 through 1951 it sold a substantial number of twelve-month service contracts for prices averaging $80 to $100 each. Consistent with its experience and financial accounting treatment, it accrued 25% of these amounts as income at the time of installation, deferring the remainder. Bressner then accrued the remaining income ratably over the ensuing twelve months. On average, its customers required eight to twelve service calls during the initial year of service.

Following Automobile Club of Michigan, the Commissioner asserted deficiencies for the early years involved, claiming that the entire prepaid amounts should have been reflected in income upon receipt. The taxpayer resisted, claiming that its method closely approximated the true pattern of earning the funds and thus more clearly reflected income than did the Commissioner=s method. In the alternative, the taxpayer suggested that it be allowed to accrue estimated future expenses to match with any early-accrued income.

The Second Circuit permitted the deferral of income recognition, finding that the deferral method adequately reflected income. In fact, the court explained that the proposed government method would actually “grossly” distort income: it would create large profits in the early years to be followed by large losses in the latter years.43 The court added:

42 Id. at 524.

43 Id.

The . . . crucial issue in this case is whether the pro-rata monthly deferral employed by the petitioner did 'clearly reflect' income, or whether, as the Commissioner finally contends, it was 'purely artificial' within the meaning of the Automobile Club decision. There is nothing apparently artificial about the petitioner's method of deferral here. Drawing on its experience with thousands of contracts it has demonstrated that it was subjected to a reasonably uniform demand for services, so that it could and did anticipate that the expenses incident to the performance which alone would entitle it to regard the sum received as earned would be distributed across the life of the contract. It therefore deferred revenues until they were earned, and thus matched them with foreseeably related expenses, which is the essential purpose of accrual accounting.44

The court then distinguished Automobile Club of Michigan on three grounds:

1. In Automobile Club, only a small portion of the pre-paid fees were for actual service later provided at the customer=s demand; hence, they were not necessarily “earned” in the future. In Bressner, however, all the services were truly on demand.

2. The Club had no clear obligation to

refund terminated contracts and even had the apparent right to terminate its obligation to provide services on demand. As such, it substantially earned the fees at the beginning of the contract. Bressner apparently had no such contractual provisions.

3. The Club had no evidence in support

of its pro rata deferral to show that this actually matched the cost of servicing the contracts. In contrast, Bressner had substantial evidence that its deferral method closely matched its costs.

44 Id. at 528.

11

Finally, the court considered the viability

of a method of accounting in which prepaid amounts would be matched with estimated future expenses:

As an alternative argument petitioner urges that if service contract receipts are held to be taxable income when received, it should be entitled to accrue and deduct the costs incurred to earn the service contract receipts. It may well be that had petitioner regularly employed such an accounting method whereby from reliable experience reserves were set up to meet future costs such a method would have clearly reflected income. See Schuessler v. Commissioner. 5 Cir., 1956, 230 F.2d 722. But this is not the issue. The problem is not to decide what kind of a system the Commissioner, the Tax Court or the appellate courts might choose to have a taxpayer adopt. The sole question is: does the system actually employed clearly reflect income? Conversely, the question is not: would some other system have been better? Petitioner's accounting method met the statutory test.45

(7) American Automobile

Association:46 Supreme Court Again Required Accrual of Prepaid Amounts for Services in 1961

The American Automobile Association is

the national organization of automobile clubs. During the years involved in this litigation, it also operated ten local affiliates. As did the Auto Club of Michigan, it received dues pre-paid for twelve months. Pursuant to its accounting method, it initially credited a liability account for the prepayments and then ratably accrued the amounts as income over the periods involved: 1/12th for each month. The

organization also ratably accrued expenses attributable to the prepaid items - such as the costs of commissions and insurance.47

45 Id. at 529-30 (emphasis added).

46 American Automobile Association v. U.S., 367 U.S. 687 (1961).

While the accounting method used by

the Association was essentially the same as that disallowed by the Supreme Court in the Michigan case as “purely artificial,” this litigant insisted it had better proof. The costs incurred by the Association in servicing the members were fairly stable throughout the year; hence, the ratable inclusion of income accurately reflected the actual earning of that income. In contrast, in the Michigan case, the lack of proof as to when the prepaid amounts were actually earned supported the notion that ratable deferral was too arbitrary.

Despite this additional proof, the Court

sided with the Commissioner and rejected the accrual accounting method for such prepaid services. Although the Court acknowledged the substantial evidence regarding the timing of the earnings, it considered it largely irrelevant because it focused on the total prepaid amounts rather than upon the individual accounts. For the masses, demand for services was generally regular throughout the year; however, for the individual it was highly irregular. Thus for any one prepaid item, the chosen accounting method was arbitrary and did not reflect how the income was ultimately earned. That the accounting system worked in a macro sense did not matter: a micro viewpoint was the focus of the Court.48

Also of great importance to this Court was the 1954 enactment of section 452 and 462 followed by their retroactive 1955 repeal:

This repeal, we believe, confirms our view that the method used by the Association could be rejected by the Commissioner. While the claim is made that Congress did not "intend to disturb prior law as it affected permissible accrual accounting provisions

47 Id. at 690.

48 Id. at 691-92.

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for tax purposes," H. R. Rep. No. 293, 84th Cong., 1st Sess. 4-5, the cold fact is that it repealed the only law incontestably permitting the practice upon which the Association depends. To say that, as to taxpayers using such systems, Congress was merely declaring existing law when it adopted ' 452 in 1954, and that it was merely restoring unaffected the same prior law when it repealed the new section in 1955 for good reason, is a contradiction in itself, "varnishing nonsense with the charm of sound." Instead of constituting a merely duplicative creation, the fact is that ' 452 for the first time specifically declared petitioner's system of accounting to be acceptable for income tax purposes, and overruled the long-standing position of the Commissioner and courts to the contrary. And the repeal of the section the following year, upon insistence by the Treasury that the proposed endorsement of such tax accounting would have a disastrous impact on the Government's revenue, was just as clearly a mandate from the Congress that petitioner’s system was not acceptable for tax purposes. To interpret its careful consideration of the problem otherwise is to accuse the Congress of engaging in sciamachy.

We are further confirmed in this view by consideration of the even more recent action of the Congress in 1958, subsequent to the decision in Michigan, supra. In that year ' 455 was added to the Internal Revenue Code of 1954. It permits publishers to defer receipt as income of prepaid subscriptions of newspapers, magazines and periodicals. An effort was made in the Senate to add a provision in ' 455 which would extend its coverage to prepaid automobile club membership dues. However, in conference the House Conferees refused to accept this amendment. Senator Byrd explained the rejection of the amendment to the Senate:

"It was the position of the House conferees that this matter of prepaid dues and fees received by non-profit service

organizations was a part of the entire subject dealing with the treatment of prepaid income and that such subject should be left for study of this entire problem. . . ."

It appears, therefore, that, pending its

own further study, Congress has given publishers but denied automobile clubs the very relief that the Association seeks in this Court.49

Also of note, the Court considered and

specifically rejected the Second Circuit=s Bressner decision.50 As noted below, however, the Second Circuit later re-affirmed its disagreement with the Supreme Court=s position.

(8) Congress enacts ' 456:51

Permitted Limited Deferral of Prepaid Dues for Automobile Clubs.

Congress enacted this provision -

allowing up to 36 months of deferral for pre-paid dues income - to reverse the harsh effects of the Automobile Club of Michigan case. By affirmatively permitting deferral in such a limited area and for such a limited time, Congress arguably approved the Supreme Court=s decision to require general inclusion of pre-paid items. This argument is consistent with that of the Supreme Court in the AAA case, quoted above.

49 Id. at 696-97 (footnotes omitted).

50 Id. at 689.

51 I. R. C. § 456. A full discussion of this provision is beyond this article. Suffice it say that the straight-line allocation method used only partially alleviates the damage of Schlude.

13

(9) Auto Club of New York: 52 Second Circuit Follows AAA, but Insists Bressner Remains Good Law in 1962

In 1962, the Second Circuit somewhat

reluctantly followed the Supreme Court=s AAA opinion, facing almost identical facts. The court described its position as:

While this appeal was pending, the Supreme Court . . . decided that, even though a method of reporting income from the receipt of dues substantially identical to that used by petitioner, conformed to accepted accounting principles, it was a purely artificial means of reporting income for tax purposes because the obligation to perform services was not fixed but was dependent upon the demands of the members. The decision in American Automobile Association controls this case and compels us to uphold the Commissioner's determination that the full amount of the dues payments should be included in income in the year they are received.53

The court nevertheless insisted that

Bressner remained viable authority because it relied on accurate statistics to predict the future pace of earning pre-paid amounts.54 Because the circuit later overruled Bressner in the 1981 R.C.A. decision, its 1962 statements are of only historical importance.

(10) Schlude v. Commissioner:55

Supreme Court Reiterates the

Required Inclusion of Prepayments in 1963

52 Auto Club of New York, 304 F.2d 781 (2nd Cir. 1962).

53 Id. at 783 (emphasis added).

54 Id. at 784.

55 Schlude v. Commissioner, 372 U.S. 128 (1963). See also, Travis v. Commissioner, 406 F.2d 987 (6th Cir. 1969), in which the Sixth Circuit agreed with the Schlude opinion, even to the extent it involved unenforceable obligations!

For the third time in six years, the

Supreme Court considered a tax case involving the accrual method and accounting for amounts prepaid for services. Unlike the Michigan and AAA cases, this matter involved a dance studio. More importantly, it also involved amounts that had not yet been prepaid. Specifically, the taxpayer received from various customers, for future dance lessons, three different forms of “payment”:

1. Cash (as did the taxpayers in Auto

Club of Michigan and AAA).

2. Promissory notes.

3. Non-transferable (and unenforceable) contract rights for payments that were due, but unpaid.

As to each form of “payment,” services

were to be performed largely “on demand,” as was true in the Michigan and AAA cases. Predictably, the Court affirmed its prior decisions as to the cash prepayments. Of great significance, it also expanded its holding, applying it not only to cash, but also to promissory notes and to contracts rights which were due but unpaid. As to these latter two issues, the case has been particularly controversial. Nevertheless, it continues, unabated.

(11) Artnell Company:73 Seventh Circuit Permits Deferral of Amounts Prepaid for Services, in 1968

This is likely the most cited - and arguably the most important - of the exceptions to the Supreme Court=s trilogy requiring the inclusion of advance payments. Reversing the Tax Court,74 the Court of Appeals for the

73 Artnell Co. v. Commissioner, 400 F.2d 981 (7th Cir. 1968).

74 Artnell Co. v. Commissioner, 48 T.C. 411(1967).

14

Seventh Circuit permitted an accrual taxpayer to defer inclusion of amounts prepaid for services to be rendered the following year on specific dates.

Artnell Company, an accrual method taxpayer, owned the Chicago White Sox baseball team. Prior to May 31, 1962, a separate corporation - Chicago White Sox, Inc. - operated the team. By that date, Artnell had acquired all the stock in the corporation, which it then liquidated. The corporation, also an accrual taxpayer, used a fiscal year ending October 31. Until the time of liquidation, the corporation sold season and single tickets to future games. Consistent with generally accepted accounting principles, for both financial and tax purposes, it debited cash and credited a liability account. As the games were played, the corporation debited the liability and credited income.75 The Commissioner - supported by the Tax Court - rejected this method of tax accounting, relying on Schlude and its sister cases.

The Seventh Circuit, however, carved out an important exception to those decisions. Relying specifically on the “on demand” nature of the services considered by the Supreme Court, the Circuit emphasized the scheduled nature of baseball games. Because the taxpayer knew in advance precisely when it would perform the services for which it received prepayments, deferral was appropriate. On remand, the Tax Court, in finding additional facts, determined the game dates to be sufficiently certain so as to permit deferral of the income.

(12) Hagan Advertising Displays, Inc.:76 the Sixth Circuit Follows the Trilogy, but Suggests Anticipated Expenses May Be Deductible, in 1969

75 400 F.2d at 983.

76 Hagan Advertising Displays, Inc. v. Commissioner, 407 F.2d 1105 (6th Cir. 1969).

Hagan Advertising manufactured signs, for which some customers paid in advance. Hagan deferred recognition of the corresponding income until shipment of the product. Relying of the trilogy of Supreme Court decisions, the Sixth Circuit rejected the taxpayer=s treatment and required accrual of income on receipt of the advance payments. Significantly, this case involved the sale of inventory, rather than the performance of services - as did each of the three Supreme Court decisions. Nevertheless, the Circuit following the logic of those cases, emphasizing the repeal of I.R.C. section 452, which would have permitted deferral of amounts pre-paid for inventory sales.77

The most important part of this decision involved the court=s discussion of the costs related to the advance payments. Correctly, the court noted that only a portion of the payments represented profit, the remainder being a return of the cost of the goods sold. It rejected the possibility of accruing estimated future costs of goods sold on the basis of a lack of proof:

Taxpayer has made no attempt to estimate the cost of goods sold of the signs for which advances were received. . . . Since it is clear that taxpayer, not the Commissioner, must bear the burden of reporting in the proper tax year amounts which it claims are costs of goods sold, taxpayer cannot complain in this petition for review of the consequences of its failure to do so.78

Implicitly, the court appeared willing to permit the accrual of estimated expenses for which a taxpayer could meets its burden of proof - at least in the accounting of inventories. Whether the court would entertain such a system for future expenses matched with pre-paid service income was not evident in the opinion.

77 Id. at 1108-09.

78 Id. at 1110.

15

Significantly, however, this is the precise sort of system - for both inventories and for services - rejected by Congress in the repeal of section 452; hence, substantial doubt exists whether the Supreme Court would ever approve such estimated expense accruals without specific Congressional approval, which has indeed been subsequently granted in limited - and somewhat dissimilar - cases.79 What is remarkable about Hagan Advertising is the court=s struggle with the matching principle - the fundamental notion of financial accounting that income must be matched with the cost of producing that income. The taxpayer=s argument centered on this principle. In rejecting the taxpayer position, however, the court did not reject its argument; indeed the court acknowledge the importance of matching - so much so that it was willing to consider a system of artificial expense accrual to match with the artificial income accrual imposed by the Supreme Court in its trilogy of cases. The taxpayer=s unfortunate lack of proof in no way lessens this profound part of the case.

(13) Revenue Procedure 71-21:80 Treasury Permits Limited Deferral of Amounts Prepaid for Services, in 1971, Reversing the Trilogy in Part

79 See I.R.C. '' 468 and 468A, which provide for accrual of estimated future expenses in relation to Nuclear Power Decommissioning costs, Solid Waste Reclamation costs. Additionally relevant is section 468B, dealing with accrual of future Tort Structured Settlement Payments. In each case, however, the expenses involved significantly differ from those in Hagan Advertising. The Hagan expenses involved amounts properly accrued in the future, for they were to be incurred then and the income to which they related was to be earned in the future, albeit paid early. The expenses contemplated by the three code sections, however, involve deferred but incurred amounts: they may be paid in the future, but they properly relate to income earned in the present. As such, they are analytically very different; nevertheless, they represent a similar struggle with the matching principle.

80 Rev. Proc. 71-21, 1971-2 C.B. 549.

In 1971, the Treasury issued an important Revenue Procedure reversing, in part, the requirement that accrual taxpayers currently include amounts prepaid for services. Several restrictions, limitations, and special rules apply, so taxpayers hoping to rely on the limited deferral should read the document carefully. A summary of the new rule is:

Accrual taxpayers may elect to defer, until “all events” occur, amounts received for services, all of which are required by contract to be completed by the end of the year following receipt.

The importance of the ruling, besides its use as a planning tool, is the government’s recognition of the unfair burden placed on accrual taxpayers by the Schlude Doctrine.

(14) Treasury Regulation Section 1.451-5:84 Treasury Promulgates a Regulation Permitted Limited Deferral for Amounts Prepaid for Goods, and Limited Accrual of Estimated Future Costs

This important regulation applies to inventory accounting, a subset of accrual accounting. In general, the regulation permits the deferral of amounts prepaid for inventoriable goods until such time as the prepaid amounts become “substantial.” A complex formula defines “substantial.” In addition, the regulation permits the inclusion in “cost of goods sold” - and thus the effective deduction - of an amount sufficient to satisfy agreements involving substantial prepayments for goods.

This regulation is particularly noteworthy for two reasons:

First, it reverses, in part, the trilogy of Supreme Court cases requiring accrual taxpayers to include prepaid amounts. It is thus further evidence that even the Treasury recognizes the harshness of the Schlude rule

84 Treas. Reg. ' 1.451-5.

16

and the need for exceptions. But, its very existence also reinforces the rule: as the Supreme Court consistently noted, the Commissioner has broad discretion to disallow a deferral method of accounting for prepayments; hence, the Treasury=s limited choice to permit limited deferral supports the argument that in all other cases, the Treasury has chosen not to permit deferral. This contrasts with the Seventh Circuit view - in Artnell - that other exceptions to the trilogy apply.

Second, it adopts the expense accrual method contemplated by the Sixth Circuit in Hagan Advertising by permitting the accrual of future costs for which Aall events@ have not occurred. This evidences the Treasury=s recognition of the unfairness of requiring accrual of substantial prepaid amounts without the concomitant accrual of matching deductions. This aspect of the regulation is consistent with section 465, repealed in 1955. It is not consistent with generally accepted accounting principles, but nevertheless is fair. Essentially it relies on the proposition that “two wrongs make a right”: a taxpayer must include “substantial” prepayments for goods - which is inconsistent with GAAP; hence, the taxpayer may also deduct estimated future costs - also inconsistent with GAAP, albeit a proper match.

(15) Automated Marketing System, Inc.:85 District Court Permits Deferral of Amounts Prepaid for Services, in 1974

In an unpublished order, the Seventh Circuit re-affirmed Artnell in this unreported 1974 district court opinion.86 As such, the decision is barely noteworthy; however,

because so few reported decisions have approved the deferral of pre-paid income, this unreported decision might carry some weight for those needing authority for such deferral, however slight it may be.

85 Automated Marketing System, Inc. v. United States, 34 AFTR 2d 74-542 (Dist. Ill. 5/13/74), 1974 U.S. Dist. LEXIS 8553.

86 Collegiate Cap & Gown Co. v. Commissioner, 37 T.C.M. 960, (1978) (CCH). In note 4, the Tax Court questioned whether the Automated Marketing case amounted to a Abinding@ opinion of the Seventh Circuit.

The decision involved a seller of “sales follow-up programs” for automobile dealers. The taxpayer received payment for services rendered during the following twelve to thirty months. In particular, the Commissioner objected to the taxpayer=s deferral of “billings attributable to future expenses.” Thus the case involved pre-billed income, rather than pre-paid income, as was the case in Artnell. The pre-billed amounts, even if collected, were subject to refund if the customer canceled the agreement. The court approved deferral without citation to any authority other than generally accepted accounting principles. The decision explained:

Under generally accepted accounting principles, revenue is generally recognized upon its realization, namely when the earning process is complete and an exchange has taken place. Under this principle, revenue from services rendered is recognized when the services have been performed and are billable. Thus revenue which has been billed or received but not earned need not be recognized under generally accepted accounting principles until the period in which the earning process has been completed by performance of whatever services or production are associated with the earning of that revenue.

[****]

The action of the defendant in collecting the deficiencies asserted for 1963-1966 was improper, illegal and erroneous because [the taxpayer], in accordance with its accrual method of determining income for income and tax purposes, properly took billings into income for each of those years

17

as the mailings to which such billings related occurred.88

While this opinion is both correct in its statement of generally accepted accounting principles and fair in its result, it is not correct in finding those principles to be controlling. Numerous courts have held that GAAP, while influential to tax accounting, are not determinative.89

(16) Boise Cascade Corp.:90 Claims Court Permits Deferral of Amounts Prepaid for Services, in 1976

While not as often cited as Artnell, this exception to the Supreme Court=s trilogy rule is often more useful:

1. Artnell dealt with pre-paid amounts to be earned at very specific subsequent dates - a limited set of facts. Boise Cascade, in contrast, dealt with some pre-paid amounts for which the future services were to be on demand. For the most part, however, the distinction deals with when the services were to be performed. In Artnell, the dates were in the near future and set in advance. In Boise Cascade, the services - which involved construction of power plants - could not be scheduled with such precision and were not necessarily so near-term; however, it was clear to all that the services would indeed be performed at some point.91 This distinction is significant in that it

supports the “matching principle” as paramount: in financial accounting, that principle concerns itself with ultimate matching of income and expenses in the same year, hindsight being sufficient and precise foresight being unimportant.

88 Automated Marketing, 1974 U>S> Dist. LEXIS at *18-19.

89 Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 542 (1979)

90 Boise Cascade Corp. v. United States, 530 F.2d 1367 (Ct. Cl. 1976).

91 Unlike the services in each of the trilogy cases - which involved small amounts of money and which were truly on demand of the customer.

2. Rev. Proc. 71-21 administratively approved most situations covered by Artnell, though not those covered by the facts of Boise Cascade, which involved longer periods of time. Hence, the court=s willingness to approve the taxpayer=s method of accounting is particularly noteworthy.

Boise Cascade - and its predecessor Ebasco - received advance payments for future engineering and consulting services. Most of the work - some 94% - was to be performed by specific dates (as opposed to on specific dates, as in Artnell) or at least “expeditiously.” The remainder were on demand. Upon receipt of the amounts, the taxpayer debited cash and credited an “unearned income” account, which it reported as a liability - consistent with generally accepted accounting principles. The government, however, rejected this deferral method for tax purposes and demanded inclusion upon receipt. The court sided with the taxpayer, permitting deferral until performance.

(17) Morgan Guaranty Trust Company:84 Claims Courts Permits Deferral of Amounts Prepaid for Interest, in 1978

This case is an additional exception to the general rule disallowing deferral of prepaid amounts received by accrual taxpayers. The decision, however, has limited application because it applies to prepaid interest income, an issue now largely controlled by sections 1271-86 and 7872.85

84 Morgan Guaranty Trust Co. v. United States, 585 F.2d. 988 (Ct. Cl 1978).

85 I.R.C. '' 1271-86, 7872. .

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(18) Collegiate Cap & Gown:86 Tax Court Permits Deferral of Amounts Prepaid for Services, in 1978

This Tax Court Memorandum opinion is most remarkable for its nature as a Memorandum Opinion: a status often reserved for non-controversial issues. In this case, the Tax Court apparently assigned Memorandum status to the opinion because the court did not seem to agree with the result reached:

We are confronted with an extremely difficult issue as to the applicability and effect of Golsen v. Commissioner, 54 T.C. 742 (1970), aff=d. 445 F.2d 985 (10th Cir. 1971), cert. denied 404 U.S. 940 (1971), on the facts before us. Golsen 'requires us to follow a Court of Appeals decision which is squarely in point where appeal from our decision lies to that Court of Appeals and to that court alone.'

In this case appeal lies to the Seventh Circuit which has previously dealt with the taxability of advance payments in the case of Artnell Co. v. Commissioner, 400 F.2d 981 (7th Cir. 1968), rev=g. and remanding 48 T.C. 411 (1967), supp. opinion T.C. Memo. 1970--85. Thus, that decision must be carefully examined to see if it controls our decision herein.

[****]

Because Golsen mandates that we follow Artnell (without necessarily implying that we accept the Seventh Circuit's approach in comparable cases not appealable to that Circuit S. Garber, Inc. v. Commissioner, 51 T.C. 733 (1969); Quality Chevrolet Co. v. Commissioner, 50 T.C. 458 (1968); New England Tank Industries, Inc. v. Commissioner, 50 T.C. 771 (1968)) and because the same factors which led us to find the accounting system in Artnell clearly reflected income exist herein, we hold Cap

and Gown's method of accounting clearly reflected income.88

86 Collegiate Cap & Gown Co. v. Commissioner, 37

T.C.M. 960 (1978) (CCH).

Despite the apparent reluctance of the Tax Court, the decision is logically supportable, albeit contrary to the general spirit of the trilogy. The case is also noteworthy for its distinctions with Boise Cascade. As did Artnell, Cap and Gown involved pre-paid amounts to be earned in the near future at very precise dates. Boise Cascade, in contrast, had certainty of future earning, but uncertainty as to the timing. Hence, five things are important about this case:

1. It is a Memorandum Opinion and thus of very limited authority.

2. The Tax Court=s reluctance to approve deferral of income.

3. The Tax Court=s limited view of permissible exceptions to the trilogy: those based on pinpoint accuracy based on foresight.

4. Rev. Proc. 71-21 would likely control the Cap and Gown facts, thus limiting the importance of the opinion. Planners and litigators looking for support would be more helped by a case permitting deferral beyond that permitted by the revenue procedure. Boise Cascade, however, seems to be the only such reported case.

5. Ultimately, however, the opinion supports deferral of pre-paid income - something only a handful of reported decisions do.

Collegiate Cap and Gown sold and rented both academic and religious regalia. The bulk of its rental business - the subject of the opinion - was for high school graduation gowns. The company, which used a fiscal year ending July 31st, collected approximately 10% of the rental fees in the fiscal year prior to year of actual use by the customer. In such cases, it did not include the advance payments in

88 Id.

19

income; instead, it recorded them as a liability, consistent with generally accepted accounting principles. Although the company had a written policy requiring 21 days advance notice for cancellation of an order, it rarely, if ever, enforced the policy. The Commissioner argued in favor of accrual upon receipt, but the court approved the taxpayer=s accounting method of deferral.

(19) RCA Corp.:87 Second Circuit Follows the Trilogy, Reversing Bressner

In a 1980 opinion, the District Court for the Southern District of New York approved a deferral method of tax accounting for pre-paid service income.88 Of particular note, support for the deferrals was statistical rather than pinpoint foresight or hindsight. As such, the taxpayer did not attempt to match pre-paid amounts with specific future services rendered for a specific customer - as was the case in both Artnell89 and Boise Cascade.90 Instead, RCA - which sold television service contracts - had very good statistics to show the future service demands attributable to large numbers of contracts. The contracts ranged from three to twenty-four months.91 Such statistics could not be accurate

as to a particular television - which may never require service or which may require frequent service; however, they were very accurate when applied to many contracts.

87 RCA Corp. v. United States, 664 F.2d 881 (2d Cir., 1981).

88 RCA Corp. v. United States, 499 F. Supp. 507 (S. D. N.Y. 1980).

89 In Artnell, the taxpayer deferred and matched pre-paid ticket income with expenses attributable to specific baseball games scheduled in advance. Hence, the taxpayer used “pinpoint accuracy” known in advance.

90 In Boise Cascade, the taxpayer deferred and matched pre-paid service income with expenses attributable to specific engineering service performed in the future. Although the taxpayer did not know in advance specifically when such services were to be performed, it knew approximate dates and deadlines.

91 RCA, 664 F.2d at 882-83. The case involved tax years 1958-59. Rev. Proc. 71-21 - providing for limited deferral of pre-paid amounts - would have

permitted the taxpayer=s deferral method had it existed at the time.

Some commentators predicted an affirmation by the Second Circuit, which would then breathe new life into cases challenging or distinguishing the trilogy. It was not, however, to be: the circuit court reversed, requiring inclusion of the pre-paid items.

Arguably, the court was reluctant in it reversal. Notably, it did not find RCA=s method failed to “clearly reflect income.” Instead, the court found that not to be the issue:

The task of a reviewing court . . . is not to determine whether in its own opinion RCA's method of accounting for prepaid service contract income "clearly reflect(ed) income," but to determine whether there is an adequate basis in law for the Commissioner's conclusion that it did not.92

In a similar vein, the circuit court never itself argued that statistics could not provide adequate support for deferral accounting; instead, it relief on quotations from Supreme Court opinions:

When (the) receipt (of prepaid dues) as earned income is recognized ratably over two calendar years, without regard to correspondingly fixed individual expense or performance justification, but consistently with overall experience, their accounting doubtless 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. (Findings) merely reflecting statistical computations of average monthly cost per member on a group or pool basis are without determinate significance to our decision that the federal revenue cannot,

92 Id. at 886.

20

without legislative consent and over objection of the Commissioner, be made to depend upon average experience in rendering performance and turning a profit.93

Ultimately, the Second Circuit felt compelled to overrule its prior reasoning in Bressner, supporting the use of statistics:

We think, however, that the Supreme Court's post-Bressner decisions in AAA and Schlude have deprived Bressner of controlling force.94

This noteworthy reluctance to follow the Supreme Court=s lead does not diminish the importance of RCA: the decision marked the end of significant reported cases attacking and distinguishing the trilogy.

f) American Express Decision

American Express charges card users a refundable annual fee, paid in advance. Customers who cancel a card receive a partial refund. For financial accounting purposes, the fees are not income until the appropriate time passes; hence, the proper accounting entry for a $24.00 fee involves a debit to cash and a credit to a liability called fees paid in advance. As months pass, the fees are earned, and the books reflect a debit to the liability account and a credit to cash.

For tax purposes American Express recognized the full amount of the fees when received. The litigation involved the company’s attempt to change its accounting method to one more consistent with generally accepted accounting principles and Rev. Proc. 71-21: ratable56 recognition of the fees. The government denied the request, interpreting the

Revenue Procedure as allowing limited deferral for prepaid services but not prepaid credit card fees (which it classified as non-services.) Both the Claims Court and the Federal Circuit supported the government denial of the accounting change.

93 Id. at 887, quoting its prior opinion in AAA, 367 U.S. at 692-93.

94 Id. at 888.

56 Ratable recognition would not be a perfect solution, although it would far more clearly reflect income than would advance recognition.

B. Analysis 1) Present Day Deferral: a Conclusion

The background pages chronicle the development of current rules regarding accounting for service income. While occasionally lambasted in the literature, those rules have largely survived attacks in the lower and appellate courts. As such, they are as settled as court created rules tend to be. Nevertheless, some limited hope for exceptions exists.

Revenue Procedure 71-21 - with its one-year deferral - looms large as the outside boundary for government approval of deferral accounting. Other than Boise Cascade in 1976, no reported decisions have exceeded that boundary.

Equity remains the most compelling argument in a deferral-seeking taxpayer’s arsenal: accrual prior to earning is unfair because it does not match with the related expenses. As such, it does not clearly reflect income - a standard that the Court and Commissioner at least claim to apply.

A recent twist in the equity argument directly involves the matching principle and the timing of deductions. Until the mid-1980's, taxpayers were in the unfortunate situation of applying the early-accrual trilogy rules to income and applying the more traditional “all events” test of accounting to deductions. While this mismatched income and expenses, at least the expenses tended to be timed correctly. Since the mid-1980's, however, accounting for incurred but deferred expenses - those owed but unpaid or “unperformed” has changed dramatically. With the enactment of section 461(h)96 and the promulgation of regulations

96 I.R.C. ' 461(h).

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there under, accrual taxpayers have faced the deferral of expenses beyond the years in which they properly accrue. When viewed alongside the trilogy=s requirement of income accrual prior to the years in which it properly accrues, the lack of equity can become profound.

Even if this equitable argument never succeeds in Congress, the Treasury, or the courts, it nevertheless should be compelling to practitioners in planning situations. Accounting measures income and the Internal Revenue Code taxes income. Taxing items before they amount to economic income is not just unfair, but it is also a measurable and avoidable cost: accepting advance payments is contractual and voluntary. In a similar vein, taxable income is a net figure - at least under the Internal Revenue Code for its entire history. Taxing amounts prior to allowing a deduction for appropriate expenses is also not only unfair, but it, too, is often an easily measurable and avoidable cost.

Also, even if a tax advisor were to believe in the futility of challenging the trilogy or the section 461(h) deferral of incurred expenses, and even if such an advisor were to believe these rules were politically or administratively proper, he would be unwise to ignore their costs. At the very least, taxpayers should measure the excess tax cost of receiving pre-paid items along with the excess cost of deferring incurred but unpaid or unperformed expenses. If such costs do not outweigh whatever utility comes from their nature as being pre-paid or unperformed, then contracts involving such items should not be entered.

2) Calculating the Cost of the Schlude Doctrine: Present Day Deferral

Consider the following hypothetical:

Accrual Method Taxpayer received

$1000 in advance for services to be rendered in year three, two years hence. o For all purposes Taxpayer is

subject to a 40% tax bracket.

o All taxes are paid immediately from income.

o Taxpayer’s agreement with the customer provided for a discount for prepayments, computed using an interest rate of 10% nominal annual interest paid annually.

o For all purposes, taxpayer can earn 10% nominal annual interest on investments.

o Ignore all costs of performing the services.57

Compute the economic

consequences to taxpayer based on: o Current law using the Schlude

Doctrine. o Deferral Accounting, using a

method consistent with GAAP and repealed section 452, but without the application of section 1272.

o Deferral Accounting with the application of section 1272.

Compare these consequences to

what would happen if taxpayer and customer agreed to payment upon rendering of the services, priced consistent with the contractual discount.

a) Method One: Current law using the

Schlude Doctrine.

Year One o Taxpayer receives $1000. o Taxpayer immediately pays $400

tax. o Taxpayer invests the $600 at

10% nominal annual interest paid annually, but with an after-tax effective rate of 6%, earning $36.

Year Two 57 I will deal with the costs and the adverse impact of section 461(h) in a separate article.

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o Taxpayer begins the year with $636, which includes the $600 invested plus the after-tax interest income of $36 from Year One.

o Taxpayer invests the $636 at 10% nominal annual interest paid annually, but with an after-tax effective rate of 6%, earning $38.14

Year Three o Taxpayer begins the year with

$674.16, which includes the $600 invested plus the after-tax interest income of $36 from Year One, and the after-tax interest income of $38.14 from Year Two.

o Taxpayer immediately performs the services.

Taxpayer ends up with $674.16.58

b) Method Two: Deferral Accounting, using a method consistent with GAAP and repealed section 452, but without the application of section 1272.59

Year One

58 Taxpayer earns no further interest at this point because he performs the services at the beginning of Year Three.

59 Professor Geier, relying on an earlier article by Professor Halperin, argued that an ideal solution might involve the application of section 7872, but that the Schlude Doctrine is an acceptable second place alternative. Actually, section 7872 would not apply because the hypothetical does not involve an interest free loan; instead, it involves a discount loan (interest deferred). In real-life, customers expect a discount for early payment, so the hypothetical is most realistic. If this were not the case, however, section 7872 principles, if not section 7872(b) itself, would impute a discount, consistent with section 1274 principles. As a result, section 1272 would apply. Thus the correct comparison is to the application of section 1272, not section 7872.

o Taxpayer receives $1000. o Taxpayer immediately pays no

tax, electing deferral under the fictitious section 452.

o Taxpayer invests the $1000 at 10% nominal annual interest paid annually, but with an after tax effective rate of 6%, earning $60.

Year Two o Taxpayer begins the year with

$1060, which includes the $1000 invested plus the after-tax interest income of $60 from Year One.

o Taxpayer invests the $1060 at 10% nominal annual interest paid annually, but with an after tax effective rate of 6%, earning $63.60.

Year Three o Taxpayer begins the year with

$1123.60, which includes the $1000 invested plus the after-tax interest income of $60 from Year One and the after-tax interest income of $63.60 from Year Two.

o Taxpayer immediately performs the services.

o Taxpayer immediately pays $400 tax on the $1000 income deferred from Year One.

Taxpayer is left with $723.60.

c) Method Three: Deferral Accounting with the application of section 1272.

Year One o Taxpayer receives $1000. o Taxpayer immediately pays no

tax, electing deferral under the fictitious section 452.

o Taxpayer invests the $1000 at 10% nominal annual interest paid annually, earning $100 before taxes.

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o Section 163(e)60 imputes a $100 interest deduction, consistent with the hypothetical application of section 1272 and section 467(g).61 This deduction cancels the interest income of $100, leaving no taxes due or paid.

Year Two o Taxpayer begins the year with

$1100, which includes the $1000 invested plus the after-tax interest income of $100.62

o Taxpayer earns $110 interest on the investment.

o Section 163(e) imputes an interest deduction of $110, consistent with sections 1272 and 467(g). This deduction cancels the interest income of $110, leaving no taxes due or paid.

Year Three o Taxpayer begins the year with

$1210 which includes the $1000

invested plus the after-tax interest income of $100 from Year One and the after-tax interest income of $110 from Year Two.

60 I. R.C. § 163(e) provides the interest deduction consistent with section 1272 interest accrual for discount loans. In the hypothetical, Taxpayer has borrowed $1000 from Customer, agreeing to provide services in the future. The $1000 is the discounted value of the future services. Consistent with section 1272 and 1274, Customer would have interest income imputed annually and Taxpayer would have an interest deduction imputed annual per section 163(e). Section 1274 would not actually apply to the hypothetical facts because of the dollars amounts involved.

61 I.R.C. § 467(g) applies section 1272 principles to deferred payments for services, imputing only the interest component (leaving the compensation element covered by section 404). Ideally, this would be amended to apply to service prepayments as well. Sections 7872, 1272, 1274, and 163(e), however, could accomplish the same result as they are based on the identical formulae.

62 The $100 interest income was actually received, while the $100 interest deduction was imputed; hence, the $100 remained for investment.

o Taxpayer immediately performs the services.

o Taxpayer immediately pay $484 tax on the $1210 income,63 consistent with the hypothetical application of sections 1272, 467(g), and 1274.

Taxpayer is left with $726.

d) What would happen if taxpayer and

customer agreed to payment upon rendering of the services, priced consistent with the contractual discount.

Year One o Taxpayer receives nothing. o Taxpayer pays no tax.

Year Two o Taxpayer begins and ends the

year with no income and no cash resulting from this activity.

Year Three o Taxpayer receives $1,210, the

future value of the services performed.64

o Taxpayer immediately performs the services.

o Taxpayer immediately pays $484 in tax.

Taxpayer ends up with $726.

63 Taxpayer has income of $1210 from the performance of services because that is the value of the services performed. Sections 1272, 1274 and 467 would produce this result, which is economically correct.

64 With a Financial Calculator, enter PV=$1000, I/yr=10, n=2, P/YR=1, press FV.

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e) Summary

Accounting

Method

Description of

Method

After-Tax Result to Taxpayer

Rank in Comparison

to Actual Deferral

Method One

Prepayment,

Schlude Doctrine

(current law)

$ 674.16

3

Method

Two

Prepayment with

deferral accounting

$ 723.60

2

Method Three

Prepayment with

deferral accounting plus economic and tax application of time value of money sections.

$ 726.00

1

Actual Deferral, no prepayment

(current law, deferral

accounting, or economic deferral)

$ 726.00

Taxpayers who apply Method Three - as recommended by Professors Geier and Halperin (and me) - end up in the same position as those who contract for Actual Deferral. This reflects the economic reality that the two methods are identical in all important respects. While Method Three Taxpayers receive actual cash from their customers, Actual Deferral Taxpayers may receive other forms of security: e.g., property, co-signers, or deposits, or they can limit their businesses to more credit worthy customers. Or, if liquidity were they motivation for prepayments, they can borrow from sources other than their customers.65

65 The Burgess/Battlestein line of cases might even

permit them to borrow from the customers themselves; however, this plan is not without risk. Burgess v. Commissioner, 8 T.C. 47 (1947);

Battelstein v. United States, 631 F.2d 1182 (5th Cir. 1980).

Taxpayers who apply Method Two – as recommended by Mssrs. Raby and Raby – end up in a slightly worse position than those who select Actual Deferral. Deferral accounting will generate an economically correct result only with the application of 467(g) or 1272-1274 and 163(e). Using the assumed facts, Deferral Accounting Taxpayers pay an effective tax rate of 40.198% rather than the legislated 40% rate. The slight difference may be acceptable, considering the differences in form, particularly the source of capital. Taxpayers who apply Method One – as also recommended by Professor Geier – end up in a particularly bad position when compared to those who select Actual Deferral. Effectively, they pay a tax rate of 44.484% based on the assumed facts. Naturally, Taxpayer may so need the “prepayment” funds from the Customer (rather than from some other source) that it is willing to accept the higher effective tax rate. Or, the taxpayer may have a cost of capital higher than the 10% nominal annual interest agreed to by the customer (or the ability to earn more than 10% on its investments). If this rate is sufficiently, high, taxpayer may desire the prepayment. However, the rate must be at least 16.667% nominal annual interest for taxpayer to break even with these facts. A common mistake is to assume that anything greater than a 10% return will justify accepting the prepayment. C. Conclusions

Counsel must understand both the legal and economic/financial implications of a transaction. Much of tax practice involves planning, rather than compliance; hence, counsel must be able to advise clients of the after-tax economic costs of a transaction. Simply advising a client of the tax consequences is insufficient because those consequences can be misleading if not

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translated to a common dollar year: one cannot compare year one dollars to year three dollars.

Because the Schlude Doctrine is a

current reality, counsel who advise accrual method taxpayers must understand accounting and finance issues or else they subject their clients to an extra tax. Justifying this “tax on ignorance” as representing an income rather than consumption tax proves nothing (even assuming the analysis is correct). The alternative situations have no important economic differences; hence no justification exists for different tax consequences. Remember, money is fungible. The only real differences between the scenarios involve the sources of capital and that is hardly an important difference justifying an extra tax.66

Congress and Courts should heed

similar, if not harsher, cautionary words. When counsel, ignorant of accounting and finance consequences, advises a client poorly, the client suffers and potentially counsel pays. But when Courts (such as in Schlude) or Congress (such as through 461(h)) adopt rules based on their own inadequate knowledge, we all suffer.

The same analysis applies for deductions, albeit more difficult to follow because it involves many negatives. The calculations are far less simple and often appear counter-intuitive. As I will show in a separate article, however, section 461(h) is similarly harmful to accrual method taxpayers, albeit avoidable with proper planning. As such, it, too, amounts to a “tax on ignorance.”

66 Of course, Professor Geier repeats the academic theory that a consumption tax should include borrowed funds, while acknowledging the lack of political reality in such an approach. Pending a change in that political reality, her suggestion that we act properly when we tax accrual taxpayers who borrow from their customers differently than we tax those who borrow elsewhere is not justifiable.

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