Portland Golf Club v. Commissioner
497 U.S. 154 (1990)

Annotate this Case

U.S. Supreme Court

Portland Golf Club v. Commissioner, 497 U.S. 154 (1990)

Portland Golf Club v. Commissioner of Internal Revenue

No. 89-530

Argued April 17, 1990

Decided June 21, 1990

497 U.S. 154

CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR

THE NINTH CIRCUIT

Syllabus

As a nonprofit corporation that owns and operates a private social club, petitioner's income derived from membership fees and other receipts from members is exempt from income tax. However, all other income is nonexempt "unrelated business taxable income," defined in § 512(a)(3)(A) of the Internal Revenue Code as

"the gross income (excluding any exempt function income), less the deductions allowed by this chapter which are directly connected with the production of the gross income (excluding exempt function income)."

Petitioner has nonexempt income from sales of food and drink to nonmembers, and from return on its investments. During its 1980 and 1981 tax years, petitioner offset net losses on nonmember sales against the earnings from its investments, and reported no unrelated business taxable income. In computing its losses, petitioner identified two categories of expenses incurred in nonmember sales: (1) variable (direct) expenses, such as the cost of food, which, in each year in question, were exceeded by gross income from nonmember sales; and (2) fixed (indirect) overhead expenses, which would have been incurred whether or not sales had been made to nonmembers. It determined what portions of fixed expenses were attributable to nonmember sales by employing an allocation formula known as the "gross-to-gross method," based on the ratio that nonmember sales bore to total sales. The total of these fixed expenses and variable costs exceeded petitioner's gross income from nonmember sales. On audit, the Commissioner determined that petitioner could deduct expenses associated with nonmember sales up to the amount of receipts from the sales themselves, but could not use losses from those activities to offset its investment income because it had failed to show that its nonmember sales were undertaken with an intent to profit. Petitioner sought redetermination, and the Tax Court ruled in petitioner's favor, concluding that petitioner had adequately demonstrated that it had a profit motive, since its gross receipts from nonmember sales consistently exceeded the variable costs associated with those activities. The Court of Appeals reversed, holding that the Tax Court had applied an incorrect legal standard in determining that petitioner had demonstrated an intent to profit, because profit in this context meant the production of gains in excess of all direct and indirect

Page 497 U. S. 155

costs. The court remanded the case for a determination whether petitioner engaged in its nonmember activities with the required intent to profit from those activities.

Held: Petitioner may use losses incurred in sales to nonmembers to offset investment income only if those sales were motivated by an intent to profit, which is to be determined by using the same allocation method as petitioner used to compute its actual profit or loss. Pp. 497 U. S. 163-166.

(a) The statutory scheme for the taxation of social clubs was intended to achieve tax neutrality by ensuring that members are not subject to tax disadvantages as a consequence of their decision to pool their resources for the purchase of social or recreational services, but was not intended to provide clubs with a tax advantage. Pp. 497 U. S. 160-163.

(b) By limiting deductions from unrelated business income to those expenses allowable as deductions under "this chapter," § 512(a)(3)(A) limits such deductions to expenses allowable under Chapter 1 of the Code. Since only § 162 of Chapter 1 serves as a basis for the deductions claimed here, and since a taxpayer's activities fall within § 162's scope only if an intent, to profit is shown, see Commissioner v. Groetzinger,480 U. S. 23, 480 U. S. 35, petitioner's nonmember sales must be motivated by an intent to profit. Dispensing with the profit-motive requirement in this case would run counter to the principle of tax neutrality underlying the statutory scheme. Pp. 497 U. S. 163-166.

(c) The Commissioner correctly concluded that the same allocation method must be used in determining petitioner's intent to profit as in computing its actual profit or loss. It is an inherent contradiction to argue that the same fixed expenses that are attributable to nonmember sales in calculating actual losses can also be attributed to membership activities in determining whether petitioner acted with the requisite intent to profit. Having chosen to calculate its actual losses on the basis of the gross-to-gross formula, petitioner is foreclosed from attempting to demonstrate its intent to profit based on some other allocation method. Pp. 497 U. S. 166-170.

(d) Petitioner has failed to show that it intended to earn gross income from nonmember sales in excess of its total costs where fixed expenses are allocated using the gross-to-gross method. P. 497 U. S. 171.

876 F.2d 897, (CA9 1989) affirmed.

BLACKMUN, J., delivered the opinion of the Court, in which REHNQUIST, C.J., and BRENNAN, WHITE, MARSHALL, and STEVENS, JJ., joined, and in which O'CONNOR, SCALIA, and KENNEDY, JJ., joined except as to Parts III-B and IV. KENNEDY, J., filed an opinion concurring in part and concurring in the judgment, in which O'CONNOR and SCALIA, JJ., joined, post, p. 497 U. S. 171.

Page 497 U. S. 156

Justice BLACKMUN delivered the opinion of the Court.

This case requires us to determine the circumstances under which a social club, in calculating its liability for federal income tax, may offset losses incurred in selling food and drink to nonmembers against the income realized from its investments.

I

Petitioner Portland Golf Club (Portland Golf) is a nonprofit Oregon corporation, most of whose income is exempt from federal income tax under § 501(c)(7) of the Internal Revenue Code of 1954, 26 U.S.C. § 501(c)(7). [Footnote 1] Since 1914, petitioner has owned and operated a private golf and country club with a golf course, restaurant and bar, swimming pool, and tennis courts. The great part of petitioner's income is derived from membership dues and other receipts from the club's members; that income is exempt from tax. Portland Golf also has two sources of nonexempt "unrelated business taxable income": sales of food and drink to nonmembers, and return on its investments. [Footnote 2]

Page 497 U. S. 157

The present controversy centers on Portland Golf's federal income tax liability for its fiscal years ended September 30, 1980, and September 30, 1981, respectively. Petitioner received investment income in the form of interest in the amount of $11,752 for fiscal 1980 and in the amount of $21,414 for fiscal 1981. App. 18. It sustained net losses of $28,433 for fiscal 1980 and $69,608 for fiscal 1981 on sales of food and drink to nonmembers. Petitioner offset these losses against the earnings from its investments, and therefore reported no unrelated business taxable income for the two tax years. In computing these losses, petitioner identified two different categories of expenses incurred in selling food and drink to nonmembers. First, petitioner incurred variable (or direct) expenses, such as the cost of food, which varied depending on the amount of food and beverages sold (and therefore would not have been incurred had no sales to nonmembers been made). For each year in question, petitioner's gross income from nonmember sales exceeded these variable costs. [Footnote 3] Petitioner also included, as an unrelated business expense, a portion of the fixed (or indirect) overhead expenses of the club -- expenses which would have been incurred whether or not petitioner had made sales to nonmembers. In determining what portions of its fixed expenses were attributable to nonmember sales, petitioner employed an allocation formula, described as the "gross-to-gross method," based on the ratio that nonmember sales bore to total sales. [Footnote 4] When fixed

Page 497 U. S. 158

expenses, so calculated, were added to petitioner's variable costs, the total exceeded Portland Golf's gross income from nonmember sales. [Footnote 5]

On audit. the Commissioner took the position that petitioner could deduct expenses associated with nonmember sales up to the amount of receipts from the sales themselves, but that it could not use losses from those activities to offset its investment income. The Commissioner based that conclusion on the belief that a profit motive was required if losses from these activities were to be used to offset income from other sources, and that Portland Golf had failed to show that its sales to nonmembers were undertaken with an intent to profit. [Footnote 6] The Commissioner therefore determined deficiencies of $1,828 for 1980 and $3,470 for 1981; these deficiencies

Page 497 U. S. 159

reflected tax owed on petitioner's investment income. App. 48-51.

Portland Golf sought redetermination in the Tax Court. That court ruled in petitioner's favor. 55 TCM 212 (1988). The court assumed, without deciding, that losses incurred in the course of sales to nonmembers could be used to offset other nonexempt income only if the sales were undertaken with an intent to profit. The court, however, held that Portland Golf had adequately demonstrated a profit motive, since its gross receipts from sales to nonmembers consistently exceeded the variable costs associated with those activities. [Footnote 7] The court therefore held that

"petitioner is entitled to offset its unrelated business taxable income from interest by its loss from its nonmember food and beverage sales computed by allocating a portion of its fixed expenses to the nonmember food and beverage sales activity in a manner which respondent agrees is acceptable."

Id. at 217.

The United States Court of Appeals for the Ninth Circuit reversed. App. to Pet. for Cert. 1a. The Court of Appeals held that the Tax Court had applied an incorrect legal standard in determining that Portland Golf had demonstrated an intent to profit from sales to nonmembers. The appellate court relied on its decision in North Ridge Country Club v. Commissioner, 877 F.2d 750 (1989), where it had ruled that a social club

"can properly deduct losses from a nonmember activity only if it undertakes that activity with the intent to profit, where profit means the production of gains in excess of all direct and indirect costs."

Id. at 756. The same court in the

Page 497 U. S. 160

present case concluded:

"Because Portland Golf Club could have reported gains in excess of direct and indirect costs, but did not do so, relying on a method of allocation stipulated to be reasonable by the Commissioner, we REMAND this case to the tax court for a determination of whether Portland Golf Club engaged in its nonmember activities with the intent required under North Ridge to deduct its losses from those activities."

App. to Pet. for Cert. 2a-3a. [Footnote 8]

Because of a perceived conflict with the decision of the Sixth Circuit in Cleveland Athletic Club, Inc. v. United States, 779 F.2d 1160 (1985), [Footnote 9] and because of the importance of the issue, we granted certiorari. 493 U.S. 1041 (1990).

II

Virtually all tax-exempt business organizations are required to pay federal income tax on their "unrelated business taxable income." The law governing social clubs, however, is significantly different from that governing other tax-exempt entities. As to exempt organizations other than social clubs, the Code defines "unrelated business taxable income" as

"the gross income derived by any organization from any unrelated trade or business (as defined in section 513) regularly carried on by it, less the deductions allowed by this chapter which are directly connected with the carrying on of

Page 497 U. S. 161

such trade or business."

26 U.S.C. § 512(a)(1). [Footnote 10] As to social clubs, however, "unrelated business taxable income" is defined as

"the gross income (excluding any exempt function income), less the deductions allowed by this chapter which are directly connected with the production of the gross income (excluding exempt function income)."

§ 512(a)(3)(A). [Footnote 11] The salient point is that § 512(a)(1) (which applies to most exempt organizations) limits "unrelated business taxable income" to income derived from a "trade or business," while § 512(a)(3)(A) (which applies to social clubs) contains no such limitation. Thus, a social club's investment income is subject to federal income tax, while the investment income of most other exempt organizations is not.

This distinction reflects the fact that a social club's exemption from federal income tax has a justification fundamentally different from that which underlies the grant of tax exemptions to other nonprofit entities. For most such organizations, exemption from federal income tax is intended to encourage the provision of services that are deemed socially beneficial. Taxes are levied on "unrelated business income" only in order to prevent tax-exempt organizations from gaining an unfair advantage over competing commercial enterprises. [Footnote 12] See United States v. American College of Physicians,

Page 497 U. S. 162

475 U. S. 834, 475 U. S. 838 (1986) ("Congress perceived a need to restrain the unfair competition fostered by the tax laws"). Since Congress concluded that investors reaping tax-exempt income from passive sources would not be in competition with commercial businesses, it excluded from tax the investment income realized by exempt organizations. [Footnote 13]

The exemption for social clubs rests on a totally different premise. Social clubs are exempted from tax not as a means of conferring tax advantages, but as a means of ensuring that the members are not subject to tax disadvantages as a consequence of their decision to pool their resources for the purchase of social or recreational services. The Senate Report accompanying the Tax Reform Act of 1969, 83 Stat. 536, explained that that purpose does not justify a tax exemption for income derived from investments:

"Since the tax exemption for social clubs and other groups is designed to allow individuals to join together to provide recreational or social facilities or other benefits on a mutual basis, without tax consequences, the tax exemption operates properly only when the sources of income of the organization are limited to receipts from the membership. Under such circumstances, the individual is in substantially the same position as if he had spent his income on pleasure or recreation (or other benefits) without the intervening separate organization. However, where the organization receives income from sources outside the membership, such as income from investments . . . upon which no tax is paid, the membership receives a benefit not contemplated by the exemption, in that untaxed dollars can be used by the organization to provide pleasure or recreation (or other benefits) to its membership. . . . In such a case, the exemption is

Page 497 U. S. 163

no longer simply allowing individuals to join together for recreation or pleasure without tax consequences. Rather, it is bestowing a substantial additional advantage to the members of the club by allowing tax-free dollars to be used for their personal recreational or pleasure purposes. The extension of the exemption to such investment income is, therefore, a distortion of its purpose."

S.Rep. No. 91-552, p. 71 (1969), U.S.Code Cong. & Admin. News 1969, pp. 1645, 2100.

In the Tax Reform Act of 1969, Congress extended the tax on "unrelated business income" to social clubs. As to these organizations, however, Congress defined "unrelated business taxable income" to include income derived from investments. Our review of the present case must therefore be informed by two central facts. First, Congress intended that the investment income of social clubs should be subject to federal tax, and indeed Congress devised a definition of "unrelated business taxable income" with that purpose in mind. Second, the statutory scheme for the taxation of social clubs was intended to achieve tax neutrality, not to provide these clubs a tax advantage: even the exemption for income derived from members' payments was designed to ensure that members are not disadvantaged as compared with persons who pursue recreation through private purchases rather than through the medium of an organization.

III

Petitioner's principal argument is that it may deduct losses incurred through sales to nonmembers without demonstrating that these sales were motivated by an intent to profit. In the alternative, petitioner contends (and the Tax Court agreed) that, if the Code does impose a profit-motive requirement, then that requirement has been satisfied in this case. We address these arguments in turn.

A

We agree with the Commissioner and the Court of Appeals that petitioner may use losses incurred in sales to nonmembers

Page 497 U. S. 164

to offset investment income only if those sales were motivated by an intent to profit. The statute provides that, as to social clubs,

"the term 'unrelated business taxable income' means the gross income (excluding any exempt function income), less the deductions allowed by this chapter which are directly connected with the production of the gross income (excluding exempt function income)."

§ 512(a)(3)(A) (emphasis added). As petitioner concedes, the italicized language limits deductions from unrelated business income to expenses allowable as deductions under Chapter 1 of the Code. See Brief for Petitioner 21-22. In our view, the deductions claimed in this case -- expenses for food, payroll, and overhead in excess of gross receipts from nonmember sales -- are allowable, if at all, only under § 162 of the Code. See North Ridge Country Club v. Commissioner, 877 F.2d 750, 753 (CA9 1989); The Brook, Inc. v. Commissioner, 799 F.2d 833, 838 (CA2 1986). [Footnote 14] Section 162(a) provides a deduction for "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." Although the statute does not expressly require that a "trade or business" must be carried on with an intent to profit, this Court has ruled that a taxpayer's activities fall within the scope of § 162 only if an intent to profit has been shown. See Commissioner v. Groetzinger,480 U. S. 23, 480 U. S. 35 (1987) ("to be engaged in a [§ 162] trade or business, . . . the taxpayer's primary purpose for engaging in the activity must be for income or profit"). Thus, the losses that Portland Golf incurred in selling food and drink to nonmembers will constitute "deductions allowed by this chapter" only if the club's nonmember sales were performed with an intent to profit. [Footnote 15]

Page 497 U. S. 165

We see no basis for dispensing with the profit-motive requirement in the present case. Indeed, such an exemption would be in considerable tension with the statutory scheme devised by Congress to govern the taxation of social clubs. Congress intended that the investment income of social clubs (unlike the investment income of most other exempt organizations) should be subject to the same tax consequences as the investment income of any other taxpayer. To allow such an offset for social clubs would run counter to the principle of tax neutrality which underlies the statutory scheme.

Petitioner concedes that "[g]enerally a profit motive is a necessary factor in determining whether an activity is a trade or business." Brief for Petitioner 23. Petitioner contends, however, that, by including receipts from sales to nonmembers within § 512(a)(3)(A)'s definition of "unrelated business taxable income," the Code has defined nonmember sales as a "trade or business," and has thereby obviated the need for an inquiry into the taxpayer's intent to profit. We disagree. In our view, Congress' use of the term "unrelated business taxable income" to describe all receipts other than payments from the members hardly manifests an intent to define as a "trade or business" activities otherwise outside the scope of § 162. Petitioner's reading would render superfluous the words "allowed by this chapter" in § 512(a)(3)(A): if each taxable activity of a social club is "deemed" to be a trade or business, then all of the expenses "directly connected" with those activities would presumably be deductible. Moreover, Portland Golf's interpretation ignores Congress' general intent to

Page 497 U. S. 166

tax the income of social clubs according to the same principles applicable to other taxpayers. We therefore conclude that petitioner may offset losses incurred in sales to nonmembers against investment income only if its nonmember sales are motivated by an intent to profit. [Footnote 16]

B

Losses from Portland Golf's sales to nonmembers may be used to offset investment income only if those activities were undertaken with a profit motive -- that is, an intent to generate receipts in excess of costs. The parties and the other courts in this case, however, have taken divergent positions as to the range of expenses that qualify as costs of the nonexempt activity and are to be considered in determining whether petitioner acted with the requisite profit motive. In the view of the Tax Court, petitioner's profit motive was established by the fact that the club's receipts from nonmember

Page 497 U. S. 167

sales exceeded its variable costs. Since Portland Golf's fixed costs, by definition, have been incurred even in the absence of sales to nonmembers, the Tax Court concluded that these costs should be disregarded in determining petitioner's intent to profit.

The Commissioner has taken no firm position as to the precise manner in which Portland Golf's fixed costs are to be allocated between member and nonmember sales. Indeed, the Commissioner does not even insist that any portion of petitioner's fixed costs must be attributed to nonmember activities in determining intent to profit. [Footnote 17] He does insist, however, that the same allocation method is to be used in determining petitioner's intent to profit as in computing its actual profit or loss. See Brief for Respondent 44-46. In the present case, the parties have stipulated that the gross-to-gross method provides a reasonable formula for allocating fixed costs, and Portland Golf has used that method in calculating the losses incurred in selling food and drink to nonmembers. The Commissioner contends that petitioner is therefore required to demonstrate an intent to earn gross receipts in excess of fixed and variable costs, with the allocable share of fixed costs being determined by the gross-to-gross method.

Although the Court of Appeals' opinion is not entirely clear on this point, see n. 8, supra, that court seems to have taken a middle ground. The Court of Appeals expressly rejected the Tax Court's assertion that profit motive could be established

Page 497 U. S. 168

by a showing that gross receipts exceeded variable costs; the court insisted that some portion of fixed costs must be considered in determining intent to profit. The court appeared, however, to leave open the possibility that Portland Golf could use the gross-to-gross method in calculating its actual losses while using some other allocation method to demonstrate that its sales to nonmembers were undertaken with a profit motive. [Footnote 18]

We conclude that the Commissioner's position is the correct one. Portland Golf's argument rests, as the Commissioner puts it, on an "inherent contradiction." Brief for Respondent 44. Petitioner's calculation of actual losses rests on the claim that a portion of its fixed expenses is properly regarded as attributable to the production of income from nonmember sales. Given this assertion, we do not believe that these expenses can be ignored (or, more accurately, attributed to petitioner's exempt activities) in determining whether petitioner acted with the requisite intent to profit. Essentially the same criticism applies to the Court of Appeals' approach. That court required petitioner to include some portion of fixed expenses in demonstrating its intent to profit, but it left open the possibility that petitioner could employ an allocation method different from that used in calculating its actual losses. Under that approach, some of petitioner's fixed expenses could be attributed to exempt functions in determining intent to profit and to nonmember sales in establishing the club's actual loss. This, like the rationale of the Tax Court, seems to us to rest on an "inherent contradiction."

Petitioner's principal response is that § 162 requires an intent to earn an economic profit, and that this is quite different from an intent to earn taxable income. Portland Golf emphasizes that numerous provisions of the Code establish

Page 497 U. S. 169

deductions and preferences which do not purport to mirror economic reality. Therefore, petitioner argues, taxpayers may frequently act with an intent to profit, even though the foreseeable (and, indeed, the intended) result of their efforts is that they suffer (or achieve) tax losses. Much of the Code, in petitioner's view, would be rendered a nullity if the mere fact of tax losses sufficed to show that a taxpayer lacked an intent to profit, thereby rendering the deductions unavailable. In Portland Golf's view, the parties have stipulated only that the gross-to-gross formula provides a reasonable method of determining what portion of fixed expenses is "directly connected" with the nonexempt activity for purposes of computing taxable income. That stipulation, Portland Golf contends, is irrelevant in determining the portion of fixed expenses that represents the actual economic cost of the activity in question.

We accept petitioner's contention that § 162 requires only an intent to earn an economic profit. We acknowledge, moreover, that many Code provisions are designed to serve purposes (such as encouragement of certain types of investment) other than the accurate measurement of economic income. A taxpayer who takes advantage of deductions or preferences of that kind may establish an intent to profit even though he has no expectation of realizing taxable income. [Footnote 19] The fixed expenses that Portland Golf seeks to allocate

Page 497 U. S. 170

to its nonmember sales, however, are deductions of a different kind. The Code does not state that fixed costs are allocable on a gross-to-gross basis irrespective of economic reality. Rather, petitioner's right to use the gross-to-gross method rests on the club's assertion that this allocation formula reasonably identifies those expenses that are "directly connected" to the nonmember sales, § 512(a)(3)(A), and are "the ordinary and necessary expenses paid or incurred" in selling food and drink to nonmembers, see § 162(a). [Footnote 20] Language such as this, it seems to us, reflects an attempt to measure economic income -- not an effort to use the tax law to serve ancillary purposes. Having calculated its actual losses on the basis of the gross-to-gross formula, petitioner is therefore foreclosed from attempting to demonstrate its intent to profit by arguing that some other allocation method more accurately reflects economic reality. [Footnote 21]

Page 497 U. S. 171

IV

We hold that any losses incurred as a result of petitioner's nonmember sales may be offset against its investment income only if the nonmember sales were undertaken with an intent to profit. We also conclude that, in demonstrating the requisite profit motive, Portland Golf must employ the same method of allocating fixed expenses as it uses in calculating its actual loss. Petitioner has failed to show that it intended to earn gross income from nonmember sales in excess of its total (fixed plus variable) costs, where fixed expenses are allocated using the gross-to-gross method. [Footnote 22] The judgment of the Court of Appeals is therefore affirmed.

It is so ordered.

[Footnote 1]

Section 501(c)(7) grants an exemption from federal income tax to

"[c]lubs organized for pleasure, recreation, and other nonprofitable purposes, substantially all of the activities of which are for such purposes and no part of the net carnings of which inures to the benefit of any private shareholder."

[Footnote 2]

Section 511 of the Code provides that the "unrelated business taxable income" of an exempt organization shall be taxed at the ordinary corporate rate. The term "unrelated business taxable income," as applied to the income of a club such as petitioner, is defined in § 512(a)(3)(A). That definition encompasses all sources of income except receipts from the club's members.

[Footnote 3]

For 1980, gross receipts from nonmember sales in the bar and diningroom totalled $84,422, while variable expenses were $61,821. For 1981, gross receipts totalled $106.547, while variable expenses were $78,407. App. 85.

[Footnote 4]

For example, if 10% of petitioner's gross receipts were derived from nonmember sales, 10% of petitioner s fixed costs would be allocated to the nonexempt activity. That method of allocation appears rather generous to Portland Golf. The club charges nonmembers higher prices for food and drink than members are charged, even though nonmembers' meals presumably cost no more to prepare and serve. It therefore seems likely that the gross-to-gross method overstates the percentage of fixed costs properly attributable to nonmember sales. The parties, however, stipulated that this allocation method was reasonable. Id. at 17.

[Footnote 5]

The following table shows petitioner's losses when fixed costs are allocated using the gross=to-gross method:

19801981

Gross income $ 84,422 $ 106,547

Variable expenses (61,821) (78,407)

Allocated fixed expenses (51,034) (97,748)

Net loss ($ 28,433) ($ 69,608)

It is of interest to note that, if petitioner's fixed costs had been allocated using an alternative formula, known as the "square foot and hours of actual use" method, see id. at 29, its gross receipts exceeded the sum of variable and allocated fixed costs for both years:

19801981

Gross income $ 84,422 $ 106,547

Variable expenses (61,821) (78,407)

Allocated fixed expenses ( 3,153) ( 4,666)

Net loss $ 19,448 $ 23,474

[Footnote 6]

The general rule under the Code is that losses incurred in a profit-seeking venture may be deducted from unrelated income; expenses of a not-for-profit activity may be offset against the income from that activity, but losses may not be applied against income from other sources. See 1 B. Bittker & L. Lokken, Federal Taxation of Income, Estates and Gifts

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