US SUPREME COURT DECISIONS

Inventory accounting for tax purposes is governed by §§ 446 and 471 of the Internal Revenue Code of 1954. Section 446 provides that taxable income is to be computed under the taxpayer's normal method of accounting unless that method "does not clearly reflect income," in which event taxable income is to be computed "under such method as, in the opinion of the [Commissioner], does clearly reflect income." Section 471 provides that

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

The implementing Regulations require a taxpayer to value inventory for tax purposes at cost unless "market" (defined as replacement cost) is lower. The Regulations specify two situations in which inventory may be valued below "market" as so defined: (1) where the taxpayer in the normal course of business has actually offered merchandise for sale at prices lower than replacement cost; and (2) where the merchandise is defective. In 1964, petitioner, a tool manufacturer, wrote down in accord with "generally accepted accounting principles" what it regarded as "excess" inventory to its own estimate of the "net realizable value" (generally scrap value) of the "excess" goods (mostly spare parts), but continued to hold the goods for sale at their original prices. It offset the write-down against 1964 sales, and thereby produced a net operating loss for that year. The Commissioner disallowed the offset, maintaining that the writedown did not reflect income clearly for tax purposes. Deductions for bad debts are covered by § 166. Section 166(c) provides that an accrual-basis taxpayer "shall be allowed (in the discretion of the [Commissioner]) a deduction for a reasonable addition to a reserve for bad debts." In 1965, petitioner added to its reserve and asserted as a deduction under § 166(c) a sum that presupposed a substantially higher charge-off rate for bad debts than it had experienced in immediately preceding years. The Commissioner ruled that the addition was excessive, chanrobles.com-red

Page 439 U. S. 523

and determined, pursuant to the "six-year moving average" formula derived from Black Motor Co. v. Commissioner, 41 B.T.A. 300, what he regarded as a lesser but "reasonable" amount to be added to petitioner's reserve. On petitioner's petition for redetermination, the Tax Court upheld the Commissioner's exercise of discretion with respect to both the inventory write-down and the bad debt deduction, and the Court of Appeals affirmed.

Held:

1. The Commissioner did not abuse his discretion in determining that the write-down of "excess" inventory failed to reflect petitioner's 1964 income clearly, since the write-down was plainly inconsistent with the governing Regulations. Pp. 439 U. S. 531-546.

(a) Although conceding that "an active market prevailed" on the inventory date, petitioner made no effort to determine the replacement cost of its "excess" inventory, and thus failed to ascertain "market" in accord with the general rule of the Regulations. Petitioner, however, failed to bring itself within either of the authorized exceptions for valuing inventory below "market." Whereas the Regulations demand concrete evidence of reduced market value, petitioner provided no objective evidence whatever that its "excess" inventory had the value management ascribed to it. Pp. 439 U. S. 535-538.

(b) There is no presumption that an inventory practice conformable to "generally accepted accounting principles" is valid for tax purposes. Such a presumption is insupportable m light of the statute, this Court's past decisions, and the differing objectives of tax and financial accounting. Pp. 439 U. S. 538-544.

(c) While petitioner argues that it should not be forced to defer a tax benefit for inventory currently deemed unsalable until future years, when the "excess" items are actually disposed of, petitioner's "dilemma" is nothing more than the choice every taxpayer with a paper loss must face. Pp. 439 U. S. 545-546.

2. The Commissioner did not abuse his discretion in recomputing a "reasonable" addition to petitioner's bad debt reserve according to the Black Motor formula. Because petitioner did not show why its debt collections in 1965 would be less likely than in prior years, it failed to carry its "heavy burden" of showing that application of the Black Motor formula would have been arbitrary. Pp. 439 U. S. 546-550

563 F.2d 861, affirmed.

BLACKMUN, J., delivered the opinion for a unanimous Court. chanrobles.com-red

Page 439 U. S. 524