Spring City Foundry Co. v. Commissioner
292 U.S. 182 (1934)
In 1920, Spring City sold some
goods to a company called Cotta for about $40k. Before Cotta could pay
the entire bill, they went bankrupt. By 1923, they paid about 17% of the
entire bill, and that was all Spring City was going to ever get.
Spring City used the accrual
method of accounting. Under the accrual
method of accounting, the taxpayer
only counts income when all of the events that entitle the taxpayer to
receive the income have occurred
When they filed their 1920
taxes, Spring City took a deduction for the entire $40k. The IRS
disagreed and assessed a deficiency.
Spring City first argued
that the loss should be considered a bad debt (under what is now 26 U.S.C. §166).
Spring City also argued that
when Cotta went bankrupt, based on the accrual method, they could count the entire loss as soon as
Cotta went bankrupt.
The IRS argued that Cotta
had never been required to pay the entire $40k in 1920, they had a
payment schedule that went out a few years. Therefore, Spring City was
not allowed to claim the loss until 1923, when Cotta had paid all they
were going to pay and the debt had been discharged by the bankruptcy
The IRS argued that the 83%
of the $40k Spring City didn't receive should not be counted against gross
income until 1923.
The Tax Court found for Spring
City, the IRS appealed.
The Appellate Court found for the
IRS. Spring City appealed.
The US Supreme Court affirmed.
The US Supreme Court found
that taxpayers using the accrual method must count income when they earn the right to receive the money,
not when they actually get the money.
The Court found that in
1920, Cotta's debt was not entirely worthless. No one knew how much
Cotta would eventually be able to pay. It wasn't until 1923 that it was
known that Cotta would pay 17% and not pay 83%. Therefore, it was
premature to write off the entire debt in 1920. The taxpayer had to wait
until what was left of the debt was wholly uncollectible.
Therefore, Spring City
wasn't allowed to write off the debt as a loss against gross income until 1923.
This case highlights one of
the problems with the accrual method
of accounting. You have to count the income as soon as you earn it, even
though you don't know if you will ever actually receive it. The only
thing an accrual method
taxpayer can do about potentially bad debts is to count the income in the
year it is earned, and then, years later, once it is certain that the
money won't be collected, take a deduction.