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decided: January 16, 1979.



Blackmun, J., delivered the opinion for a unanimous Court.

Author: Blackmun

[ 439 U.S. Page 524]

 MR. JUSTICE BLACKMUN delivered the opinion of the Court.

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

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

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

[ 439 U.S. Page 525]

     what he regarded as a lesser but "reasonable" amount to be added to Thor's reserve.

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

calendar year 1963 $494,055.99

calendar year 1965 $59,287.48

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


The Inventory Issue


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

Thor's tools typically contain from 50 to 200 parts, each of which taxpayer stocks to meet demand for replacements. Because of the difficulty, at the time of manufacture, of predicting the future demand for various parts, taxpayer produced liberal quantities of each part to avoid subsequent production

[ 439 U.S. Page 526]

     runs. Additional runs entail costly retooling and result in delays in filling orders. App. 54-55.

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

In late 1964, new management took control and promptly concluded that Thor's inventory in general was overvalued.*fn1 After "a physical inventory taken at all locations" of the tool and rubber divisions, id., at 52, management wrote off approximately $2.75 million of obsolete parts, damaged or defective tools, demonstration or sales samples, and similar items. Id., at 52-53. The Commissioner allowed this writeoff because Thor scrapped most of the articles shortly after their removal from the 1964 closing inventory.*fn2 Management also wrote down $245,000 of parts stocked for three unsuccessful products.

[ 439 U.S. Page 527]

     these percentages or this time frame. In the Tax Court, Thor's president justified the formula by citing general business experience, and opined that it was "somewhat in between" possible alternative solutions.*fn5 This first method yielded a total write-down of $744,030. 64 T. C., at 160.

[ 439 U.S. Page 529]

     At two plants where 1964 data were inadequate to permit forecasts of future demand, Thor used its second method for valuing inventories. At these plants, the company employed flat percentage write-downs of 5%, 10%, and 50% for various types of inventory.*fn6 Thor presented no sales or other data to support these percentages. Its president observed that "this is not a precise way of doing it," but said that the company "felt some adjustment of this nature was in order, and these figures represented our best estimate of what was required to reduce the inventory to net realizable value." App. 67. This second method yielded a total write-down of $160,832. 64 T. C., at 160.

Although Thor wrote down all its "excess" inventory at once, it did not immediately scrap the articles or sell them at reduced prices, as it had done with the $3 million of obsolete and damaged inventory, the write-down of which the Commissioner permitted. Rather, Thor retained the "excess" items physically in inventory and continued to sell them at original prices. Id., at 160-161. The company found that, owing to the peculiar nature of the articles involved,*fn7 price reductions were of no avail in moving this "excess" inventory.

[ 439 U.S. Page 530]

     As time went on, however, Thor gradually disposed of some of these items as scrap; the record is unclear as to when these dispositions took place.*fn8

Thor's total write-down of "excess" inventory in 1964 therefore was:

Ten-year amortization of parts for

discontinued tools $22,090

First method (aging formula based

on 1964 usage) ...

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