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THOR POWER TOOL CO. v. COMMISSIONER INTERNAL REVENUE

SUPREME COURT OF THE UNITED STATES


decided: January 16, 1979.

THOR POWER TOOL CO
v.
COMMISSIONER OF INTERNAL REVENUE

CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE SEVENTH CIRCUIT.

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.

I

The Inventory Issue

A

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) 744,030

Second method (flat percentage

write-downs) 160,832

Total $926,952

Thor credited this sum to its inventory contra-account, thereby decreasing closing inventory, increasing cost of goods sold, and decreasing taxable income for the year by that amount.*fn9 The company contended that, by writing down excess inventory to scrap value, and by thus carrying all inventory at "net realizable value," it had reduced its inventory to "market" in accord with its "lower of cost or market" method of accounting. On audit, the Commissioner disallowed the write-down in its entirety, asserting that it did not serve clearly to reflect Thor's 1964 income for tax purposes.

The Tax Court, in upholding the Commissioner's determination, found as a fact that Thor's write-down of excess inventory did conform to "generally accepted accounting principles"; indeed, the court was "thoroughly convinced . . . that such was the case." Id., at 165. The court found that if Thor had failed to write down its inventory on some reasonable

[ 439 U.S. Page 531]

     basis, its accountants would have been unable to give its financial statements the desired certification. Id., at 161-162. The court held, however, that conformance with "generally accepted accounting principles" is not enough; § 446 (b), and § 471 as well, of the 1954 Code, 26 U. S. C. §§ 446 (b) and 471, prescribe, as an independent requirement, that inventory accounting methods must "clearly reflect income." The Tax Court rejected Thor's argument that its write-down of "excess" inventory was authorized by Treasury Regulations, 64 T. C., at 167-171, and held that the Commissioner had not abused his discretion in determining that the write-down failed to reflect 1964 income clearly.

B

Inventory accounting is governed by §§ 446 and 471 of the Code, 26 U. S. C. §§ 446 and 471. Section 446 (a) states the general rule for methods of accounting: "Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books." Section 446 (b) provides, however, that if the method used by the taxpayer "does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the [Commissioner], does clearly reflect income." Regulations promulgated under § 446, and in effect for the taxable year 1964, state that "no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income." Treas. Reg. § 1.446-1 (a)(2), 26 CFR § 1.446-1 (a)(2) (1964).*fn10

Section 471 prescribes the general rule for inventories. It states:

"Whenever in the opinion of the [Commissioner] the use

[ 439 U.S. Page 532]

     of inventories is necessary in order clearly to determine the income of any taxpayer, inventory shall be taken by such taxpayer on such basis as the [Commissioner] may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income."

As the Regulations point out, § 471 obviously establishes two distinct tests to which an inventory must conform. First, it must conform "as nearly as may be" to the "best accounting practice," a phrase that is synonymous with "generally accepted accounting principles." Second, it "must clearly reflect the income." Treas. Reg. § 1.471-2 (a)(2), 26 CFR § 1.471-2 (a)(2) (1964).

It is obvious that on their face, §§ 446 and 471, with their accompanying Regulations, vest the Commissioner with wide discretion in determining whether a particular method of inventory accounting should be disallowed as not clearly reflective of income. This Court's cases confirm the breadth of this discretion. In construing § 446 and its predecessors, the Court has held that "[the] Commissioner has broad powers in determining whether accounting methods used by a taxpayer clearly reflect income." Commissioner v. Hansen, 360 U.S. 446, 467 (1959). Since the Commissioner has "[much] latitude for discretion," his interpretation of the statute's clear-reflection standard "should not be interfered with unless clearly unlawful." Lucas v. American Code Co., 280 U.S. 445, 449 (1930). To the same effect are United States v. Catto, 384 U.S. 102, 114 (1966); Schlude v. Commissioner, 372 U.S. 128, 133-134 (1963); American Automobile Assn. v. United States, 367 U.S. 687, 697-698 (1961); Automobile Club of Michigan v. Commissioner, 353 U.S. 180, 189-190 (1957); Brown v. Helvering, 291 U.S. 193, 203 (1934). In construing § 203 of the Revenue Act of 1918, 40 Stat. 1060, a predecessor of § 471, the Court held that the taxpayer bears a "heavy burden of [proof]," and that the Commissioner's disallowance

[ 439 U.S. Page 533]

     of an inventory accounting method is not to be set aside unless shown to be "plainly arbitrary." Lucas v. Structural Steel Co., 281 U.S. 264, 271 (1930).

As has been noted, the Tax Court found as a fact in this case that Thor's write-down of "excess" inventory conformed to "generally accepted accounting principles" and was "within the term, 'best accounting practice,' as that term is used in section 471 of the Code and the regulations promulgated under that section." 64 T. C., at 161, 165. Since the Commissioner has not challenged this finding, there is no dispute that Thor satisfied the first part of § 471's two-pronged test. The only question, then, is whether the Commissioner abused his discretion in determining that the write-down did not satisfy the test's second prong in that it failed to reflect Thor's 1964 income clearly. Although the Commissioner's discretion is not unbridled and may not be arbitrary, we sustain his exercise of discretion here, for in this case the write-down was plainly inconsistent with the governing Regulations which the taxpayer, on its part, has not challenged.*fn11

It has been noted above that Thor at all pertinent times used the "lower of cost or market" method of inventory accounting. The rules governing this method are set out in Treas. Reg.

[ 439 U.S. Page 534]

     § 1.471-4, 26 CFR § 1.471-4 (1964). That Regulation defines "market" to mean, ordinarily, "the current bid price prevailing at the date of the inventory for the particular merchandise in the volume in which usually purchased by the taxpayer." § 1.471-4 (a). The courts have uniformly interpreted "bid price" to mean replacement cost, that is, the price the taxpayer would have to pay on the open market to purchase or reproduce the inventory items.*fn12 Where no open market exists, the Regulations require the taxpayer to ascertain "bid price" by using "such evidence of a fair market price at the date or dates nearest the inventory as may be available, such as specific purchases or sales by the taxpayer or others in reasonable volume and made in good faith, or compensation paid for cancellation of contracts for purchase commitments." § 1.471-4 (b).

The Regulations specify two situations in which a taxpayer is permitted to value inventory below "market" as so defined. The first is where the taxpayer in the normal course of business has actually offered merchandise for sale at prices lower than replacement cost. Inventories of such merchandise may be valued at those prices less direct cost of disposition, "and the correctness of such prices will be determined by reference to the actual sales of the taxpayer for a reasonable period before and after the date of the inventory." Ibid. The Regulations warn that prices "which vary materially from the

[ 439 U.S. Page 535]

     actual prices so ascertained will not be accepted as reflecting the market." Ibid.

The second situation in which a taxpayer may value inventory below replacement cost is where the merchandise itself is defective. If goods are "unsalable at normal prices or unusable in the normal way because of damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar causes," the taxpayer is permitted to value the goods "at bona fide selling prices less direct cost of disposition." § 1.471-2 (c). The Regulations define "bona fide selling price" to mean an "actual offering of goods during a period ending not later than 30 days after inventory date." Ibid. The taxpayer bears the burden of proving that "such exceptional goods as are valued upon such selling basis come within the classifications indicated," and is required to "maintain such records of the disposition of the goods as will enable a verification of the inventory to be made." Ibid.

From this language, the regulatory scheme is clear. The taxpayer must value inventory for tax purposes at cost unless the "market" is lower. "Market" is defined as "replacement cost," and the taxpayer is permitted to depart from replacement cost only in specified situations. When it makes any such departure, the taxpayer must substantiate its lower inventory valuation by providing evidence of actual offerings, actual sales, or actual contract cancellations. In the absence of objective evidence of this kind, a taxpayer's assertions as to the "market value" of its inventory are not cognizable in computing its income tax.

It is clear to us that Thor's procedures for writing down the value of its "excess" inventory were inconsistent with this regulatory scheme. Although Thor conceded that "an active market prevailed " on the inventory date, see 64 T. C., at 169, it "made no effort to determine the purchase or reproduction cost" of its "excess" inventory. Id., at 162. Thor thus failed to ascertain "market" in accord with the general rule of the

[ 439 U.S. Page 536]

     Regulations. In seeking to depart from replacement cost, Thor failed to bring itself within either of the authorized exceptions. Thor is not able to take advantage of § 1.471-4 (b) since, as the Tax Court found, the company failed to sell its excess inventory or offer it for sale at prices below replacement cost. 64 T. C., at 160-161. Indeed, Thor concedes that it continued to sell its "excess" inventory at original prices. Thor also is not able to take advantage of § 1.471-2 (c) since, as the Tax Court and the Court of Appeals both held, it failed to bear the burden of proving that its excess inventory came within the specified classifications. 64 T. C., at 171; 563 F.2d, at 867. Actually, Thor's "excess" inventory was normal and unexceptional, and was indistinguishable from and intermingled with the inventory that was not written down.

More importantly, Thor failed to provide any objective evidence whatever that the "excess" inventory had the "market value" management ascribed to it. The Regulations demand hard evidence of actual sales and further demand that records of actual dispositions be kept. The Tax Court found, however, that Thor made no sales and kept no records. 64 T. C., at 171. Thor's management simply wrote down its closing inventory on the basis of a well-educated guess that some of it would never be sold. The formulae governing this write-down were derived from management's collective "business experience"; the percentages contained in those formulae seemingly were chosen for no reason other than that they were multiples of five and embodied some kind of anagogical symmetry. The Regulations do not permit this kind of evidence. If a taxpayer could write down its inventories on the basis of management's subjective estimates of the goods' ultimate salability, the taxpayer would be able, as the Tax Court observed, id., at 170, "to determine how much tax it wanted to pay for a given year."*fn13

[ 439 U.S. Page 537]

     For these reasons, we agree with the Tax Court and with the Seventh Circuit that the Commissioner acted within his discretion in deciding that Thor's write-down of "excess"

[ 439 U.S. Page 538]

     inventory failed to reflect income clearly. In the light of the well-known potential for tax avoidance that is inherent in inventory accounting,*fn14 the Commissioner in his discretion may insist on a high evidentiary standard before allowing write-downs of inventory to "market." Because Thor provided no objective evidence of the reduced market value of its "excess" inventory, its write-down was plainly inconsistent with the Regulations, and the Commissioner properly disallowed it.*fn15

C

The taxpayer's major argument against this conclusion is based on the Tax Court's clear finding that the write-down conformed to "generally accepted accounting principles." Thor points to language in Treas. Reg. § 1.446-1 (a)(2), 26 CFR § 1.446-1 (a)(2) (1964), to the effect that "[a] method of accounting which reflects the consistent application of generally

[ 439 U.S. Page 539]

     accepted accounting principles . . . will ordinarily be regarded as clearly reflecting income" (emphasis added). Section 1.471-2 (b), 26 CFR § 1.471-2 (b) (1964), of the Regulations likewise stated that an inventory taken in conformity with best accounting practice "can, as a general rule, be regarded as clearly reflecting . . . income" (emphasis added).*fn16 These provisions, Thor contends, created a presumption that an inventory practice conformable to "generally accepted accounting principles" is valid for income tax purposes. Once a taxpayer has established this conformity, the argument runs, the burden shifts to the Commissioner affirmatively to demonstrate that the taxpayer's method does not reflect income clearly. Unless the Commissioner can show that a generally accepted method "demonstrably distorts income," Brief for Chamber of Commerce of the United States

[ 439 U.S. Page 540]

     as Amicus Curiae 3, or that the taxpayer's adoption of such method was "motivated by tax avoidance," Brief for Petitioner 25, the presumption in the taxpayer's favor will carry the day. The Commissioner, Thor concludes, failed to rebut that presumption here.

If the Code and Regulations did embody the presumption petitioner postulates, it would be of little use to the taxpayer in this case. As we have noted, Thor's write-down of "excess" inventory was inconsistent with the Regulations; any general presumption obviously must yield in the face of such particular inconsistency. We believe, however, that no such presumption is present. Its existence is insupportable in light of the statute, the Court's past decisions, and the differing objectives of tax and financial accounting.

First, as has been stated above, the Code and Regulations establish two distinct tests to which an inventory must conform. The Code and Regulations, moreover, leave little doubt as to which test is paramount. While § 471 of the Code requires only that an accounting practice conform "as nearly as may be" to best accounting practice, § 1.446-1 (a)(2) of the Regulations states categorically that "no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income" (emphasis added). Most importantly, the Code and Regulations give the Commissioner broad discretion to set aside the taxpayer's method if, "in [his] opinion," it does not reflect income clearly. This language is completely at odds with the notion of a "presumption" in the taxpayer's favor. The Regulations embody no presumption; they say merely that, in most cases, generally accepted accounting practices will pass muster for tax purposes. And in most cases they will. But if the Commissioner, in the exercise of his discretion, determines that they do not, he may prescribe a different practice without having to rebut any presumption running against the Treasury.

[ 439 U.S. Page 541]

     Second, the presumption petitioner postulates finds no support in this Court's prior decisions. It was early noted that the general rule specifying use of the taxpayer's method of accounting "is expressly limited to cases where the Commissioner believes that the accounts clearly reflect the net income." Lucas v. American Code Co., 280 U.S., at 449. More recently, it was held in American Automobile Assn. v. United States that a taxpayer must recognize prepaid income when received, even though this would mismatch expenses and revenues in contravention of "generally accepted commercial accounting principles." 367 U.S., at 690. "[To] say that in performing the function of business accounting the method employed by the Association 'is in accord with generally accepted commercial accounting principles and practices,'" the Court concluded, "is not to hold that for income tax purposes it so clearly reflects income as to be binding on the Treasury." Id., at 693. "[We] are mindful that the characterization of a transaction for financial accounting purposes, on the one hand, and for tax purposes, on the other, need not necessarily be the same." Frank Lyon Co. v. United States, 435 U.S. 561, 577 (1978). See Commissioner v. Idaho Power Co., 418 U.S. 1, 15 (1974). Indeed, the Court's cases demonstrate that divergence between tax and financial accounting is especially common when a taxpayer seeks a current deduction for estimated future expenses or losses. E. g., Commissioner v. Hansen, 360 U.S. 446 (1959) (reserve to cover contingent liability in event of nonperformance of guarantee); Brown v. Helvering, 291 U.S. 193 (1934) (reserve to cover expected liability for unearned commissions on anticipated insurance policy cancellations); Lucas v. American Code Co., supra (reserve to cover expected liability on contested lawsuit). The rationale of these cases amply encompasses Thor's aim. By its president's concession, the company's write-down of "excess" inventory was founded on the belief that many of the articles inevitably would become useless

[ 439 U.S. Page 542]

     due to breakage, technological change, fluctuations in market demand, and the like.*fn17 Thor, in other words, sought a current "deduction" for an estimated future loss. Under the decided cases, a taxpayer so circumstanced finds no shelter beneath an accountancy presumption.

Third, the presumption petitioner postulates is insupportable in light of the vastly different objectives that financial and tax accounting have. The primary goal of financial accounting is to provide useful information to management, shareholders, creditors, and others properly interested; the major responsibility of the accountant is to protect these parties from being misled. The primary goal of the income tax system, in contrast, is the equitable collection of revenue; the major responsibility of the Internal Revenue Service is to protect the public fisc. Consistently with its goals and responsibilities, financial accounting has as its foundation the principle of conservatism, with its corollary that "possible errors in measurement [should] be in the direction of understatement rather than overstatement of net income and net assets."*fn18 In view of the Treasury's markedly different goals and responsibilities, understatement of income is not destined to be its guiding light. Given this diversity, even contrariety,

[ 439 U.S. Page 543]

     of objectives, any presumptive equivalency between tax and financial accounting would be unacceptable.*fn19

This difference in objectives is mirrored in numerous differences of treatment. Where the tax law requires that a deduction be deferred until "all the events" have occurred that will make it fixed and certain, United States v. Anderson, 269 U.S. 422, 441 (1926), accounting principles typically require that a liability be accrued as soon as it can reasonably be estimated.*fn20 Conversely, where the tax law requires that income be recognized currently under "claim of right," "ability to pay," and "control" rationales, accounting principles may defer accrual until a later year so that revenues and expenses may be better matched.*fn21 Financial accounting, in short, is hospitable to estimates, probabilities, and reasonable certainties; the tax law, with its mandate to preserve the revenue, can give no quarter to uncertainty. This is as it should be. Reasonable estimates may be useful, even essential, in giving shareholders and creditors an accurate picture of a firm's overall financial health; but the accountant's conservatism cannot bind the Commissioner in his efforts to collect taxes. "Only a few reserves voluntarily established as a matter

[ 439 U.S. Page 544]

     of conservative accounting," Mr. Justice Brandeis wrote for the Court, "are authorized by the Revenue Acts." Brown v. Helvering, 291 U.S., at 201-202.

Finally, a presumptive equivalency between tax and financial accounting would create insurmountable difficulties of tax administration. Accountants long have recognized that "generally accepted accounting principles" are far from being a canonical set of rules that will ensure identical accounting treatment of identical transactions.*fn22 "Generally accepted accounting principles," rather, tolerate a range of "reasonable" treatments, leaving the choice among alternatives to management. Such, indeed, is precisely the case here.*fn23 Variances of this sort may be tolerable in financial reporting, but they are questionable in a tax system designed to ensure as far as possible that similarly situated taxpayers pay the same tax. If management's election among "acceptable" options were dispositive for tax purposes, a firm, indeed, could decide unilaterally -- within limits dictated only by its accountants -- the tax it wished to pay. Such unilateral decisions would not just make the Code inequitable; they would make it unenforceable.

[ 439 U.S. Page 545]

     D

Thor complains that a decision adverse to it poses a dilemma. According to the taxpayer, it would be virtually impossible for it to offer objective evidence of its "excess" inventory's lower value, since the goods cannot be sold at reduced prices; even if they could be sold, says Thor, their reduced-price sale would just "pull the rug out" from under the identical "non-excess" inventory Thor is trying to sell simultaneously. The only way Thor could establish the inventory's value by a "closed transaction" would be to scrap the articles at once. Yet immediate scrapping would be undesirable, for demand for the parts ultimately might prove greater than anticipated. The taxpayer thus sees itself presented with "an unattractive Hobson's choice: either the unsalable inventory must be carried for years at its cost instead of net realizable value, thereby overstating taxable income by such overvaluation until it is scrapped, or the excess inventory must be scrapped prematurely to the detriment of the manufacturer and its customers." Brief for Petitioner 25.

If this is indeed the dilemma that confronts Thor, it is in reality the same choice that every taxpayer who has a paper loss must face. It can realize its loss now and garner its tax benefit, or it can defer realization, and its deduction, hoping for better luck later. Thor, quite simply, has suffered no present loss. It deliberately manufactured its "excess" spare parts because it judged that the marginal cost of unsalable inventory would be lower than the cost of retooling machinery should demand surpass expectations. This was a rational business judgment and, not unpredictably, Thor now has inventory it believes it cannot sell. Thor, of course, is not so confident of its prediction as to be willing to scrap the "excess" parts now; it wants to keep them on hand, just in case. This, too, is a rational judgment, but there is no reason why the Treasury should subsidize Thor's hedging of its bets. There

[ 439 U.S. Page 546]

     is also no reason why Thor should be entitled, for tax purposes, to have its cake and to eat it too.

II

The Bad-Debt Issue

A

Deductions for bad debts are covered by § 166 of the 1954 Code, 26 U. S. C. § 166. Section 166 (a)(1) sets forth the general rule that a deduction is allowed for "any debt which becomes worthless within the taxable year." Alternatively, the Code permits an accrual-basis taxpayer to account for bad debts by the reserve method. This is implemented by § 166 (c), which states that "[in] lieu of any deduction under subsection (a), there shall be allowed (in the discretion of the [Commissioner]) a deduction for a reasonable addition to a reserve for bad debts." A "reasonable" addition is the amount necessary to bring the reserve balance up to the level that can be expected to cover losses properly anticipated on debts outstanding at the end of the tax year.

At all times pertinent, Thor has used the reserve method. Its reserve at the beginning of 1965 was approximately $93,000. See 64 T. C., at 162. During 1965, Thor's new management undertook a stringent review of accounts receivable. In the company's rubber division, credit personnel studied all accounts; a 100% reserve was set up for two accounts deemed wholly uncollectible, and a 1% reserve was established for all other receivables. Ibid. In the tool division, credit clerks analyzed all accounts more than 90 days past due with balances over $100; a 100% reserve was established for accounts judged wholly uncollectible, and an identical collectibility ratio was applied to accounts under $100 of the same age. A flat 2% reserve was set up for accounts more than 30 days past due, and a 1% reserve for all other accounts. Id., at 162-163. These judgments, approved by three levels of management, indicated that $136,150 should be added to

[ 439 U.S. Page 547]

     the bad-debt reserve, bringing its balance at year-end to a figure slightly below $229,000. Id., at 162. Thor claimed this $136,150 as a deduction under § 166 (c).

The Commissioner ruled that the deduction was excessive. He computed what he believed to be a "reasonable" addition to Thor's reserve by using the "six-year moving average" formula derived from the decision in Black Motor Co. v. Commissioner, 41 B. T. A. 300 (1940), aff'd on other grounds, 125 F.2d 977 (CA6 1942). This formula seeks to ascertain a "reasonable" addition to a bad-debt reserve in light of the taxpayer's recent chargeoff history.*fn24 In this case, the formula indicated that, for the years 1960-1965, Thor's annual chargeoffs of bad debts amounted, on the average, to 3.128% of its year-end receivables. 64 T. C., at 163. Applying that percentage to Thor's 1965 year-end receivables, the Commissioner determined that $154,156.80 of accounts receivable could reasonably be expected to default. The amount required to bring Thor's reserve up to this level was $61,359.20, and the Commissioner decided that this was a "reasonable" addition. Accordingly, he disallowed the remaining $74,790.80 of Thor's claimed § 166 (c) deduction. Both the Tax Court, 64 T. C., at 174-175, and the Seventh Circuit, 563 F.2d, at 870, held that the Commissioner had not abused his discretion in so ruling.

B

Section 166 (c) states that a deduction for an addition to a bad-debt reserve is to be allowed "in the discretion" of the Commissioner. Consistently with this statutory language, the courts uniformly have held that the Commissioner's determination of a "reasonable" (and hence deductible) addition

[ 439 U.S. Page 548]

     must be sustained unless the taxpayer proves that the Commissioner abused his discretion.*fn25 The taxpayer is said to bear a "heavy burden" in this respect.*fn26 He must show not only that his own computation is reasonable but also that the Commissioner's computation is unreasonable and arbitrary.*fn27

Since it first received the approval of the Tax Court in 1940, the Black Motor bad-debt formula has enjoyed the favor of all three branches of the Federal Government. The formula has been employed consistently by the Commissioner,*fn28 approved by the courts,*fn29 and collaterally recognized by the Congress.*fn30 Thor faults the Black Motor formula because of its retrospectivity: By ascertaining current additions to a reserve by reference to past chargeoff experience, the formula

[ 439 U.S. Page 549]

     assertedly penalizes taxpayers who have delayed in making writeoffs in the past, or whose receivables have just recently begun to deteriorate. Petitioner's objection is not altogether irrational, but it falls short of rendering the formula arbitrary. Common sense suggests that a firm's recent credit experience offers a reasonable index of the credit problems it may suffer currently. And the formula possesses the not inconsiderable advantage of enhancing certainty and predictability in an area peculiarly susceptible of taxpayer abuse. In any event, after its 40 years of near-universal acceptance, we are not inclined to disturb the Black Motor formula now.

Granting that Black Motor in principle is valid, then, the only question is whether the Commissioner abused his discretion in invoking the formula in this case. Of course, there will be cases -- indeed, the Commissioner has acknowledged that there are cases, see Rev. Rul. 76-362, 1976-2 Cum. Bull. 45, 46 -- in which the formula will generate an arbitrary result. If a taxpayer's most recent bad-debt experience is unrepresentative for some reason, a formula using that experience as data cannot be expected to produce a "reasonable" addition for the current year.*fn31 If the taxpayer suffers an extraordinary credit reversal (the bankruptcy of a major customer, for example), the "six-year moving average" formula will fail.*fn32 In such a case, where the taxpayer can point to conditions that will cause future debt collections to be less likely than in the past, the taxpayer is entitled to -- and the Commissioner is prepared to allow -- an addition larger than Black Motor would call for. See Rev. Rul. 76-362, supra.

[ 439 U.S. Page 550]

     In this case, however, as the Tax Court found, Thor "did not show that conditions at the end of 1965 would cause collection of accounts receivable to be less likely than in prior years." 64 T. C., at 175. Indeed, the Tax Court "[inferred] from the entire record that collectibility was probably more likely at the end of 1965 than it was [previously] because new management had been infused into petitioner" (emphasis added). Thor cited no changes in the conditions of business generally or of its customers specifically that would render the Black Motor formula unreliable; new management just came in and second-guessed its predecessor, taking a "tougher" approach. Management's pessimism may not have been unreasonable, but the Commissioner had the discretion to take a more sanguine view.*fn33

For these reasons, we agree with the Tax Court and with the Court of Appeals that the Commissioner did not abuse his discretion in recomputing a "reasonable" addition to Thor's bad-debt reserve according to the Black Motor formula. Thor failed to carry its "heavy burden" of showing why the application of that formula would have been arbitrary in this case.

The judgment of the Court of Appeals is affirmed.

It is so ordered.

Disposition

563 F.2d 861, affirmed.

Counsel FOOTNOTES

* Briefs of amici curiae urging reversal were filed by Donald E. Egan, Francis X. Grossi, Jr., Robert S. Connors, Laurence B. Kraus, and Stanley T. Kaleczyc, Jr., for the Chamber of Commerce of the United States; and by Crane C. Hauser, Arthur I. Gould, Richard D. Godown, and John Lucas for the National Association of Manufacturers of the United States.

Eric Neisser filed a brief for the Taxation With Representation Fund et al. as amici curiae urging affirmance.


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