Hastie and Aldisert, Circuit Judges and Ditter, District Judge. Hastie, Circuit Judge, concurring.
This appeal by an accrual basis taxpayer from an adverse decision of the United States Tax Court, 56 T.C. 1083, requires that we decide whether the court erred in disallowing as deductions for business expenses certain liabilities accrued but not actually paid during 1962 and 1963. The Tax Court sustained the contention of the Commissioner of Internal Revenue that certain accrued royalties due an artist under contract to a recording company were contingent liabilities for which no deduction was permissible.
ABKCO Industries, Inc., is engaged in the business of recording and selling phonograph records of the performances of a number of popular musical artists. In 1961, through a statutory merger, taxpayer succeeded to the business of Bernard Lowe Enterprises, Inc., and Parkway Records, Inc. As a result of this merger, taxpayer assumed the obligation of these companies to pay royalties to recording artist Ernest Evans, popularly known as "Chubby Checker," under a pre-existing contract between Evans and the merged corporations.
Appellant reported as income the sale price of all "records shipped less records returned," and accrued for purposes of deducting as cost of sales all royalties payable on "records shipped less records returned." During 1962 and 1963, the taxpayer deducted royalties payable to Evans in the amount of $433,712 and $187,065 respectively. Under the contract only $95,000 and $120,000 were actually paid to the artist during these years. The Commissioner disallowed taxpayer's deductions for royalties accrued in excess of the amounts actually paid. His contention was sustained by the Tax Court.
Sections 446(a) and (c) of the Internal Revenue Code of 1954 authorize an accrual basis taxpayer to deduct an obligation in the taxable year in which all the events have occurred which are necessary to establish the fact of liability and the amount thereof with reasonable accuracy. See Treas. Reg. § 1.446-1(c) (1) (ii). The Commissioner and the Tax Court rely upon the settled principle that a taxpayer using the accrual method of accounting may not deduct any liability until the contingencies relating to such liability are removed. Security Mills Co. v. Commissioner, 321 U.S. 281, 284, 88 L. Ed. 725, 64 S. Ct. 596 (1944); Dixie Pine Co. v. Commissioner, 320 U.S. 516, 518-19, 88 L. Ed. 270, 64 S. Ct. 364 (1944); Lucas v. American Code Co., 280 U.S. 445, 449-51, 74 L. Ed. 538, 50 S. Ct. 202 (1930); American National Co. v. United States, 274 U.S. 99, 104-05, 71 L. Ed. 946, 47 S. Ct. 520 (1927); United States v. Anderson, 269 U.S. 422, 440-41, 70 L. Ed. 347, 46 S. Ct. 131 (1926); Lustman v. Commissioner, 322 F.2d 253, 258 (3d Cir. 1963); Noxon Chemical Products Co. v. Commissioner, 78 F.2d 871 (3d Cir. 1935). These cases hold that if all the events necessary to establish the fact of liability have not occurred, the liability is "contingent" and may not be accrued for purposes of deduction. The Commissioner argues that the accrued royalties deducted in this case fit into the classic mold of contingent liabilities. The taxpayer contends that all the events necessary to establish the fact of liability and the amount thereof with reasonable accuracy in fact occurred during the years in question.
The conflicting contentions of the Commissioner and the taxpayer result from divergent interpretations of the contract between taxpayer and Evans set forth in the margin.*fn1
Without implying any substantive characterization to the forms of compensation provided by these contractual provisions, we will label, for the purpose of this discussion, the compensation provided in paragraph 5 as "monthly payments"; the compensation provided by paragraph 6, as "royalties"; and the amended figure of $575,000, as "aggregate of the monthly payments."
The taxpayer contends paragraph 6 (a) should be read as establishing liabilities in the form of royalties at the rate of five percent of the suggested retail price per record on ninety percent of all records "paid for and not subject to return.*fn2 It urges us to view paragraph 5 as merely providing a method of payment by which the liabilities created by paragraph 6 (a) may be discharged. In accord with this construction of the contract, the taxpayer views unlettered paragraph 6 as merely an accounting expedient by which taxpayer would be given credit for the monthly payments at the time specified in unlettered paragraph 6 and paragraph 7 for an accounting and payment of royalties. From this analysis of the contract, taxpayer concludes that all the events necessary to establish the fact of liability had occurred during the years in question. Stated differently, the taxpayer construes the contract as establishing a liability for royalties under paragraph 6 (a) directly proportional to the number of records sold; and that only in the event that the sum of the monthly payments exceeded the liability for royalties would the taxpayer begin to accrue the monthly payments for purposes of deduction, for only then would these payments operate as a form of minimum compensation.
The Commissioner argues that it is paragraph 5 which establishes a form of compensation at the rate of $7,500 per month and, as amended, at the rate of $10,000 per month. He views the royalties as "additional compensation" payable March 1, 1967, only "in the event the Artist shall have fulfilled all his obligations under this Agreement until December 28, 1966, the expiration date hereof." He contends that this additional compensation is not payable until the liability for royalties exceeds the aggregate of the monthly payments. The Commissioner concludes, therefore, that royalties are a contingent liability which may not be accrued until the liability for royalties exceeds the aggregate of the monthly payments.
It should be observed that the Commissioner recognizes the then existing possibility that record sales could decline and no royalties would be payable as additional compensation. In that event, the monthly compensation alone would have been payable. So construed, the accrued liability for royalties was indeed contingent.
The taxpayer counters this analysis by emphasizing that the royalties computed under paragraph 6 were at all times substantially in excess of the compensation made in the form of monthly payments. Alternatively, the taxpayer suggests that in the event of a sudden decrease in sales, initially the liability for royalties would be discharged via the monthly payments. Finally, addressing itself to the realities of this contract, taxpayer points to the increase of the monthly payments and the aggregate of those payments from $7,500 per month and $450,000, to $10,000 per month and $575,000. Taxpayer contends that this modification is indicative of the realization of the parties that the monthly payments would have to be increased in order to discharge the liability for royalties which were accruing more rapidly than anticipated.
The Tax Court construed the contract in accord with the view of the Commissioner. The court ruled that no royalties were payable until the liability for royalties exceeded the aggregate of the monthly payments, making the aggregate in effect a $575,000 guaranteed compensation. So construing the contract, the court disallowed royalties accrued in 1962 in excess of the sum of the monthly payments made in that year because by December 31, 1962, the liability for accrued royalties was still $123,000 below the $575,000 aggregate. The same treatment was accorded that portion of the royalties accrued in 1963 which did not raise total accrued royalties above the $575,000 minimum. That portion of the royalties accrued in 1963 which did exceed the $575,000 figure amounted to $64,000. The Tax Court disallowed deductions of this excess, stating that it too was a contingent liability for two reasons. First, under the contract, royalties were payable only on "records paid for and not subject to return," but were accrued on the basis of "records shipped less records returned." To the extent that "records shipped less records returned" might not be paid for or subsequently might be ...