LILLY ET AL. v. COMMISSIONER OF

INTERNAL REVENUE.

CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR

THE FOURTH CIRCUIT.

No. 158. Argued December 3, 1951.—Decided March 10, 1952.

Petitioners were engaged in the optical business in North Carolina and Virginia in 1943 and 1944. Pursuant to agreements reflecting an established and widespread practice in that industry in those localities, they paid to the respective doctors who prescribed the eyeglasses which they sold one-third of the retail sales price received for the glasses. Held:

1. Such payments were deductible by petitioners as "ordinary and necessary" business expenses under § 23 (a) (1) (A) of the Internal Revenue Code. Pp. 91–94.

2. Disallowance of the deductions on the ground that the payments violated or frustrated "public policy" was unwarranted, since in 1943 and 1944 there was no governmentally declared public policy, national or state, proscribing such payments. Textile Mills Corp. v. Commissioner, 314 U. S. 326, distinguished; Commissioner v. Heininger, 320 U. S. 467, followed. Pp. 94–97. 188 F. 2d 269, reversed.

The Commissioner's determination of a deficiency in petitioners' income tax was sustained by the Tax Court. 14 T. C. 1066. The Court of Appeals affirmed. 188 F. 2d 269. This Court granted certiorari. 342 U. S. 808. Reversed and remanded, p. 98.

Randolph E. Paul argued the cause for petitioners. With him on the brief was Louis Eisenstein.

Solicitor General Perlman argued the cause for respondent. With him on the brief were Acting Assistant Attorney General Slack, James L. Morrisson and I. Henry Kutz.

90

Opinion of the Court.

MR. JUSTICE BURTON delivered the opinion of the Court.

Petitioners, Thomas B. Lilly and Helen W. Lilly, his wife, were engaged in the optical business in North Carolina and Virginia in 1943 and 1944. Pursuant to agreements reflecting an established and widespread practice in that industry in those localities, they paid to the respective doctors, who prescribed the eyeglasses which they sold, one-third of the retail sales price received for the glasses. The question here is whether such payments were deductible by petitioners as ordinary and necessary business expenses under § 23 (a)(1)(A) of the Internal Revenue Code. For the reasons hereafter stated we hold that they were.

Petitioners owned and operated as partners the City Optical Company with offices in Wilmington, Fayetteville and Greensboro, North Carolina, and Richmond, Virginia. Petitioner Helen W. Lilly also owned and operated the Duke Optical Company in Fayetteville.

Since long before 1922 when Thomas B. Lilly established his business in Wilmington, eye doctors, in that locality and to a substantial extent throughout comparable communities in North Carolina, Virginia and elsewhere in the United States, not only examined their patients' eyes and prescribed glasses, but also sold them the glasses. The doctors bought the frames and lenses at wholesale, prepared and fitted the glasses to the patients and sold the glasses at a profit.

1"SEC. 23. DEDUCTIONS FROM GROSS INCOME.

"In computing net income there shall be allowed as deductions: "(a) EXPENSES.—

"(1) TRADE OR BUSINESS EXPENSES.—

"(A) In General.-All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business...." 53 Stat. 12, 56 Stat. 819, 26 U. S. C. § 23 (a) (1) (A).

Opinion of the Court.

343 U.S.

Lilly and other opticians offered to fill the prescriptions for the doctors and to supply and fit the frames to the patients. To compensate the doctors for their loss of profit on the sales, the opticians generally paid the doctors one-third of the retail price of the glasses. While information as to this arrangement was not volunteered to the patients, it was freely disclosed on inquiry. The doctors made it a practice to ask their patients to bring in their new glasses for verification of the prescriptions and to enable the doctors to see that the frames were properly fitted. Without further charge, they made whatever reexaminations and modifications were needed.

For income tax purposes, petitioners treated their payments to the doctors as ordinary and necessary expenses of carrying on business and deducted them from their gross incomes. The doctors, in turn, included them in their taxable gross incomes. However, in 1943 and 1944, the respondent Commissioner of Internal Revenue disallowed these deductions in petitioners' returns and thereby increased petitioners' taxable income as follows: City Optical Duke Optical Company Company

The Tax Court sustained the Commissioner on the ground that the payments to the doctors were contrary to public policy. One judge dissented. 14 T. C. 1066. The resulting tax deficiences totaled $124,107.78. The Court of Appeals affirmed. 188 F. 2d 269. We granted certiorari, 342 U. S. 808, to resolve the disputed question of statutory construction and to pass upon the application.

2 The year 1942 was involved in the calculation of the tax for 1943 because of § 6 of the Current Tax Payment Act of 1943, 57 Stat. 145-149.

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Opinion of the Court.

to these facts of the principles announced in Textile Mills Corp. v. Commissioner, 314 U. S. 326, and Commissioner v. Heininger, 320 U. S. 467.

The facts are not in dispute. The payments to the doctors were made by petitioners monthly in the regular course of their business. Under the long-established practice in the optical industry in the localities where petitioners did business, these payments, in 1943 and 1944, were normal, usual and customary in size and character. The transactions from which they arose were of common or frequent occurrence in the type of business involved. They reflected a nationwide practice.3 Consequently, they were "ordinary" in the generally accepted meaning of that word. See Deputy v. du Pont, 308 U. S. 488, 495; Welch v. Helvering, 290 U. S. 111, 114.

The payments likewise were "necessary" in the generally accepted meaning of that word. It was through making such payments that petitioners had been able to establish their business. Discontinuance of the payments would have meant, in 1943 or 1944, either the resumption of the sale of glasses by the doctors or the doctors' reference of their patients to competing opticians who shared profits with them. Several doctors testified that they had recommended petitioners and petitioners' competitor, the American Optical Company, simultaneously. Both were sharing profits with the doctors on substantially the same basis. If either had stopped making the payments while the other continued them, there is no reason to doubt that the doctors thereafter would have omitted their recommendation of the nonpaying optician. In 1943 and 1944

3 The American Optical Company, with more than 250 outlets distributed over 47 states, followed this practice, both in competition with petitioners and elsewhere. See also, Snell, Some Principles of Medical Ethics Applied to the Practice of Ophthalmology, 117 A. M. A. J. 497–499 (1941); "What Do You Pay for Eyeglasses?" Fortune Magazine, Oct. 1940, p. 103.

Opinion of the Court.

343 U.S.

the continuance of these payments was as essential to petitioners as were their other business expenses. As has been said of legal expenses under somewhat comparable circumstances, "To say that this course of conduct and the expenses which it involved were extraordinary or unnecessary would be to ignore the ways of conduct and the forms of speech prevailing in the business world." Commissioner v. Heininger, 320 U. S. 467, 472.*

There is no statement in the Act, or in its accompanying regulations, prohibiting the deduction of ordinary and necessary business expenses on the ground that they violate or frustrate "public policy."

The Tax Court in the instant case made no finding of fact that the payments to the doctors were not ordinary and necessary business expenses. It sustained the Commissioner's disallowance of their deductibility because it held that, as a matter of law, the contracts under which the payments were made violated public policy."

We do not have before us the issue that would be presented by expenditures which themselves violated a federal or state law or were incidental to such violations."

4".. . Without this expense, there would have been no business. Without the business, there would have been no income. Without the income, there would have been no tax. To say that this expense is not ordinary and necessary is to say that that which gives life is not ordinary and necessary." Heininger v. Commissioner, 133 F. 2d 567, 570.

5 "We conclude that the payments under the contracts between the two optical businesses, composed of petitioners, and the oculists are not deductible as ordinary and necessary expenses because the contracts under which these payments were made violated public policy." (Emphasis supplied.) 14 T. C. at 1086.

6 Deductions to cover penalties for unlawful conduct were disallowed in Commissioner v. Longhorn Portland Cement Co., 148 F. 2d 276 (penalties for violation of state antitrust laws); and Great Northern R. Co. v. Commissioner, 40 F. 2d 372 (penalties against railroad for violating federal statutes or regulations). Cf. Rossman