Spring City Foundry Co. v. Commissioner

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 court.

The IRS argued that the 83% of the $40k Spring City didn't receive should not be counted against gross income until 1923.

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.