MR. JUSTICE BRANDEIS delivered the opinion of the Court.
When the income-tax return for 1919, of the American Code Company, Inc., was being audited in 1925, the Company filed with the Commissioner of Internal Revenue a claim for a refund based upon its failure to deduct from its 1919 gross income the amount for which judgment was recovered against it in 1922, on a contested liability for a breach of contract in 1919. The Commissioner of Internal Revenue rejected the claim and asserted a deficiency. His ruling was sustained by the Board of Tax Appeals. 10 B.T.A. 476. Its decision was reversed by the United States Circuit Court of Appeals for the Second Circuit. 30 F.2d 222. We granted a writ of certiorari. 279 U.S. 832.
The facts on which the claim for the refund is based are as follows: The Company agreed to employ Farquhar as sales manager for eighteen years from January 3, 1919, the compensation to be a commission based on sales. In May, 1919, it discharged him, for alleged cause. In July, 1919, Farquhar brought suit against it in the Supreme Court of New York for wrongful discharge, claiming $100,000 damages. Affirmative defenses were interposed and liability was contested. In October, 1919, the Company notified the Commissioner of the suit and asked leave to deduct in its income-tax return an amount equal to the commissions for 1919 computed on the contract basis. Permission was refused; but the Company set up on its books, at the close of the year, a reserve equal to
The Company kept its books and made its income-tax returns on the accrual basis. The Revenue Act of 1918, Act of February 24, 1919, c. 18, § 234 (a) (4), 40 Stat. 1057 1077-8, provides that in computing net income "losses sustained during the taxable year and not compensated for by insurance or otherwise" shall be allowed as deductions. Section 212 (b) provides that the net income shall be computed "in accordance with the method of accounting regularly employed in keeping the books of such taxpayer," unless the method employed does not clearly reflect the net income. And Article 111 of Regulations No. 45, (1920 ed.), of the Bureau of Internal Revenue provides that a "person making returns on an accrual basis has the right to deduct all authorized allowances, whether paid in cash or set up as a liability. . . ."
The Company's argument, sustained by the Court of Appeals, is that, since the breach of the contract occurred in 1919, all the facts which gave rise to the liability were fixed in that year; that damages must be assessed as of the date of the breach; that the loss therefore occurred in that year; and that it is immaterial that the amount of the damages was not determined or paid until later.
Generally speaking, the income-tax law is concerned only with realized losses, as with realized gains. Weiss v. Wiener, 279 U.S. 333, 335. Exception is made however, in the case of losses which are so reasonably certain in fact and ascertainable in amount as to justify their deduction, in certain circumstances, before they are absolutely realized. As respects losses occasioned by the taxpayer's breach of contract, no definite legal test is provided by the statute for the determination of the year in which the loss is to be deducted. The general requirement that losses be deducted in the year in which they are sustained calls for a practical, not a legal test. And the direction that net income be computed according to the method of accounting regularly employed by the taxpayer is expressly limited to cases where the Commissioner believes that the accounts clearly reflect the net income. Much latitude for discretion is thus given to the administrative board charged with the duty of enforcing the Act. Its interpretation of the statute and the practice adopted by it should not be interfered with unless clearly unlawful.
Article 111 of Regulations No. 45, interpreting the provisions as to deductions for losses, states: "Any amount paid pursuant to a judgment or otherwise on account of damages for personal injuries, patent infringement or otherwise, is deductible from gross income when the claim is put in judgment or paid. . . ." The
It may be assumed that, since the Company kept its books on the accrual basis, the mere fact that the exact amount of the liability had not been definitely fixed in 1919 would not prevent the deduction, as a loss of that year, of the amount later paid. But here there are other obstacles. Obviously, the mere refusal to perform a contract does not justify the deduction, as a loss, of the anticipated damages. For, even an unquestionable breach does not result in loss if the injured party forgives or refrains from prosecuting his claim. And, when liability is contested, the institution of a suit does not, of itself, create certainty of loss. In the few cases in which the
In the case at bar, the contract had nearly eighteen more years to run, at the time of his breach. Liability for the breach was denied and strenuously contested, the litigation being carried to the highest court of the State. The amount of the damages, if any, was wholly unpredictable. While the facts determining liability had occurred in the year of the breach, the amount to be recovered, if there was legal liability, depended in large part on the course of future events. Farquhar was under a duty to mitigate damages. He might have procured new employment which would have reduced his recovery to a nominal amount. Or, recovery might have been reduced or defeated by his death. Finally, the Company did not accrue on its books, within the tax year, a liability in the estimated amount of the loss. The reserve set up had no relation to the apprehended total loss. It constituted simply the amount of the commissions which would have
The prudent business man often sets up reserves to cover contingent liabilities. But they are not allowable as deductions.