E. W. Schuessler and Aline Schuessler v. Commissioner of Internal Revenue
1956 U.S. App. LEXIS 5175, 230 F.2d 722, 49 A.F.T.R. (P-H) 322 (1956)
Rule of Law:
An accrual basis taxpayer may deduct a reasonably estimated expense for future services if a legal liability for those services is incurred in the tax year, the liability is not contested, and its amount can be estimated with reasonable accuracy, as this method most accurately reflects annual income.
Facts:
- In 1946, E.W. Schuessler (taxpayer) was in the gas furnace business.
- Schuessler sold 665 furnaces during 1946.
- Each furnace sale included a guarantee to turn the furnace on and off each year for five years.
- The cost of performing this service was established at $2.00 per call.
- Schuessler, an accountant, kept his books on the accrual method.
- Schuessler sold his furnaces for $20.00 to $25.00 more than competitors because of his guarantee.
- Schuessler set up a reserve of $13,300.00 in 1946 to cover the estimated cost of fulfilling these guarantees in subsequent years.
- Schuessler claimed this reserve as a deduction against his 1946 income.
Procedural Posture:
- The Commissioner of Internal Revenue disallowed a deduction claimed by E.W. Schuessler for a reserve set up in 1946.
- E.W. Schuessler filed a petition with the Tax Court contesting the Commissioner's disallowance.
- The Tax Court issued a decision disallowing the deduction, adhering to its prior views as expressed in Curtis A. Andrews v. Commissioner.
- E.W. Schuessler filed a petition for review of the Tax Court's decision with the United States Court of Appeals for the Fifth Circuit.
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Issue:
Does an accrual basis taxpayer correctly reflect annual income by establishing a reserve and deducting the estimated cost of future services, for which a legal liability was incurred and the cost was reasonably ascertainable in the year of sale, even though the services themselves will be performed in subsequent years?
Opinions:
Majority - Tuttle, Circuit Judge
Yes, an accrual basis taxpayer correctly reflects annual income by establishing a reserve and deducting the estimated cost of future services, for which a legal liability was incurred and the cost was reasonably ascertainable in the year of sale, even though the services themselves will be performed in subsequent years. The court found that Schuessler's method of accounting more accurately reflected his income than a system that would require reporting inflated receipts in the sales year and taking deductions in later service years. The court relied on the principle that the Internal Revenue Code (1939) Sections 41 and 43, and Treasury Regulation 111, require accounting methods that clearly reflect annual income. The court cited precedent from other circuits, including Harrold v. Commissioner and Pacific Grape Products Co. v. Commissioner, which permitted the accrual of reasonably ascertainable future expenses necessary to earn or retain income. The court also preferred the reasoning of Beacon Publishing Co. v. Commissioner, which rejected the Commissioner's 'claim of right' theory in similar cases involving prepaid income. The court emphasized that a legal liability was created in 1946, the cost was reasonably established, and purchasers paid extra for the service, justifying the reserve.
Analysis:
This case is significant for clarifying the application of the accrual method of accounting to future expenses directly tied to current income. It reinforces the principle that income should be matched with the expenses incurred to generate that income, even if the actual disbursement occurs in a later tax period. The decision provides flexibility for businesses with well-defined, estimable future liabilities, moving away from a strict 'mathematical certainty' requirement for expense accrual. This ruling can influence future cases involving reserves for warranties, service contracts, or other contingent liabilities where a legal obligation is fixed and the cost is reasonably estimable.
