## Facts

- Loyal H. Chapman and Mildred A. Chapman, Minnesota residents, filed a joint federal income tax return using the cash method of accounting.
- In 1973, Chapman arranged to purchase cattle feed from Sun River Cattle Company (the Company) for a total stated price of $30,000.
- Chapman paid $15,000 in cash to the Company during 1973.
- The remaining $15,000 was due later, tied to the sale of specified lots of cattle; the unpaid feed cost was to be taken from sale proceeds before any remainder was paid to Chapman.
- On November 19, 1973, to secure the $15,000 balance, Chapman gave the Company a $15,000 promissory note and caused First National Bank of Minneapolis to issue a secured letter of credit to the Company for $15,000.
- The Company never drew on the letter of credit, and it expired by its terms on May 15, 1974.
- On their 1973 return, the Chapmans deducted the full $30,000 as feed expense: $15,000 paid in cash and $15,000 represented by the letter of credit and note.
- When the letter of credit expired unused in 1974, Chapman increased 1974 income by $15,000 to reverse the portion deducted in 1973.
- The IRS disallowed the $15,000 part of the 1973 deduction tied to the letter of credit and correspondingly reduced 1974 income by $15,000.
- After the IRS assessed an additional tax and interest, the Chapmans paid the assessment, filed a refund claim, and then brought a federal tax refund suit under 28 U.S.C. § 1346(a)(1) after the claim was denied.
- The parties stipulated to the material facts and filed cross-motions for summary judgment.

## Issues

1. For a cash-basis taxpayer, does delivering a promissory note and a secured bank letter of credit (that is never drawn upon) constitute “payment” in the year delivered, allowing a current deduction for the related expense?

## Decision

- The court granted the United States’ motion for summary judgment and denied the Chapmans’ motion.
- The court held the Chapmans could not deduct in 1973 the $15,000 represented solely by the promissory note and undrawn letter of credit because it was not “paid” in that year under the cash method.
- The IRS’s corresponding adjustment (disallowing the 1973 deduction and reversing the Chapmans’ attempted 1974 income inclusion) was sustained.

## Legal Principles

- Cash-basis taxpayers generally may deduct an expense only in the year it is actually paid, meaning an outlay of cash or a true cash equivalent.
- A taxpayer’s promissory note is ordinarily a promise to pay, not payment itself, and does not satisfy the cash-method payment requirement.
- A letter of credit that merely secures a future obligation—and is not drawn upon—functions as contingent security rather than a present transfer of money (or its equivalent) to the payee.
- Tax liability is determined on an annual basis; a taxpayer cannot validate an improper cash-method deduction in one year by reporting an offsetting income inclusion in a later year.
- When material facts are stipulated and only a legal question remains, summary judgment is an appropriate means of decision.

## Conclusion

The district court held that, for a cash-basis taxpayer, a secured letter of credit and promissory note given to a seller do not constitute payment when no funds are actually disbursed and the letter of credit expires unused; therefore, the Chapmans were not entitled to deduct the additional $15,000 feed expense in 1973, and judgment was entered for the United States.


Chapman v. United States, 527 F.Supp. 1053 (1981)