Opinion
Docket Nos. 38641, 38642.
Filed April 7, 1954.
From January 1, 1944, through the taxable year 1947 the petitioners were members of a partnership which reported its income on the cash basis. The purchase and sale of merchandise was an income producing factor of the partnership business during 1947 and prior years. For 1947 the respondent recomputed the partnership's income on the accrual basis of accounting and in doing so included in income the accounts receivable which were outstanding at the beginning of the year and which had accrued in 1946 and prior years. Held, respondent's inclusion in the partnership income for 1947 of accounts receivable which had accrued in prior years is not authorized by law or by regulation. E. S. Iley, 19 T.C. 631, overruled. Caldwell v. Commissioner, 202 F.2d 112, and Commissioner v. Dwyer, 203 F.2d 522, followed.
Raymond A. Fox, Esq., for the petitioners.
John L. King, Esq., for the respondent.
The respondent determined deficiencies in petitioners' income taxes for the year 1947 as follows:
Docket No. 38641, David W. Hughes ........... $28,923.22
Docket No. 38642, Lucile Hughes ............. 28,518.56
The issues presented are the correctness of the respondent's action (1) in determining that the income for 1947 of a partnership of which petitioners were members, and which had reported its income on the cash basis, should be determined on the accrual basis and that there should be included in income for said year the accounts receivable which were outstanding at the beginning of the year and which had accrued in 1946 and prior years, and (2) in determining that petitioner David W. Hughes received certain wages which were not reported. The respondent concedes error as to the latter issue.
FINDINGS OF FACT.
A portion of the facts was stipulated and is incorporated herein by this reference. Other facts are found from oral evidence.
During the taxable year 1947, the petitioners were husband and wife and resided in Highland Park, Michigan. Petitioners' individual and partnership returns for the taxable year 1947 were filed with the collector of internal revenue at Detroit, Michigan.
Sometime prior to 1938, petitioner David W. Hughes engaged in the conduct of a laundry business known as Van Dale Laundry. In 1938, with some machinery he had retained from the sale of the Van Dale Laundry, he began a laundry supply business under the name of Hughes Laundry Machinery in Highland Park, Michigan. He conducted the business as a sole proprietorship until January 1, 1944, when he and Lucile Hughes entered into a partnership for the conduct of the business which was so conducted under the name of "Hughes Laundry Machinery" thereafter and throughout 1947. The partnership sold and serviced new and used laundry equipment.
In 1939, Lucile Hughes set up books and records for the sole proprietorship and thereafter kept them. Occasionally she also made sales. After its formation the partnership continued to use the books and records she had set up for the sole proprietorship and she continued to keep them.
The books of the partnership were kept on a hybrid basis. They are not recognizable as either cash or accrual books.
The records consisted of invoices which were consecutively numbered upon which were entered all pertinent information relating to each sale made from the business. An invoice register was maintained for the purpose of posting information contained in the invoices in order that the loss of any particular invoice would not result in the absence of the record of that sale from the books of the business. A ledger sheet was maintained for each non-cash customer. Postings were made to this ledger from the invoice register. It contained a record of all accounts receivable, the amount of the sale and the balance due thereon, including the amount of the downpayment, be it in the way of a trade-in or cash, date of each sale, and the amount and date of each payment made. In addition, the ledger sheets contained, as to each customer noted therein, a complete list and record of all promissory notes executed by him in connection with a sale. A cash book was maintained in which was recorded the amount and date of all receipts of money by petitioner. As to disbursements, petitioners kept and filed all bills payable of the business which had been paid. All bills paid were inserted in an envelope which was designated thereon as the container for all bills paid for each separate month. In addition, a disbursement record was kept by petitioner in which a separate entry was made for each bill as it was paid. The disbursement record contained only records of payments which were repeatedly or often made but did not contain a record of all payments and disbursements made by petitioners. For the latter disbursements a miscellaneous record was maintained in which were entered the amounts, dates, and name of the creditor for each of all other disbursements paid by petitioners. An inventory was also maintained by petitioners which recorded all of the merchandise on hand and each purchase of new merchandise, and also included used merchandise acquired by petitioners which had been reconditioned or otherwise fitted for sale. As for new merchandise, inventory values were fixed at the cost price thereof. As for used or reconditioned merchandise, the petitioners placed a fair market value thereon.
Although inventories were kept and maintained by petitioners they were used only for the determination of cost of goods sold. The partnership return was filed on the cash basis; accounts receivable were not included in determining total sales for the taxable year in issue; only actual cash received was reported.
"Merchandise Bought for Sale," as reported on line 2 (b), as well as all expense deductions claimed in the partnership return of income, Form 1065, filed by Hughes Laundry Machinery for the taxable year included only merchandise and expenses for which payment was actually made during the calendar year.
Accounts receivable as of January 1, 1947, amounted to $84,854.73. Of this amount, there was still owing on December 31, 1947, $26,875.10. Accounts receivable from sales during 1947 amounted to $63,185.59. The total accounts receivable outstanding on December 31, 1947, was $90,060.69.
Respondent determined that the partnership, Hughes Laundry Machinery, should report its net income for Federal income tax purposes upon the accrual basis of accounting, and using the accrual basis determined its ordinary net income for the taxable year at issue to be $118,027.73. In so computing the partnership income respondent included the amount of $84,854.73, which represented accounts receivable still owing and unpaid on December 31, 1946, which accounts receivable had accrued in 1946 or prior years.
The partnership kept and maintained adequate books and records from which an accounting for petitioners' taxable distributive shares of partnership income could be readily made upon either the cash or accrual basis of accounting.
OPINION.
The partnership reported its income for 1947 on the cash basis. The Commissioner has recomputed its income for that year on the accrual basis. In so doing he has included in income that portion of partnership accounts receivable which remained uncollected at the close of 1946 and at the beginning of 1947. Respondent claims the authority for so doing under E. S. Iley, 19 T.C. 631, and William Hardy, Inc. v. Commissioner, (C. A. 2, 1936) 82 F.2d 249.
We do not consider the fact that the partnership may have kept its business records on the wrong basis to be particularly pertinent to the issue. Regardless of the method of accounting it used in keeping its business records, the fact is apparent from the evidence in this case that it was required under Regulations 111, section 29.41-2, to compute and report its income on the accrual basis, for petitioners admit that the purchase and sale of merchandise was an income producing factor in the business. The partnership did not compute its income on the accrual basis and, therefore, failed to report its true income in accordance with the cited regulation. It is also apparent from the record that the partnership did not report its true income under the regulation for several years prior to 1947, as its method of bookkeeping and reporting income has been consistent since its formation in 1944 and the purchase and sale of merchandise has been an income producing factor since that date.
There is no doubt here concerning the fact that the opening accounts receivable sought to be included in the 1947 income of the partnership by respondent were, under the proper accrual method of accounting, income to it in the taxable year 1946 or prior years. In Caldwell v. Commissioner, 202 F.2d 112, and Commissioner v. Dwyer, 203 F.2d 522, respectively, the respondent was denied the right to include as taxable income in a tax year that which was actually income in a prior year. In John W. Commons, 20 T.C. 900, this Court held income of a prior year, under a proper accounting method, not to be includible in the income of a later year. Following those cases we here hold that the respondent may not include the closing accounts receivable for the year 1946 as opening accounts receivable for the year 1947.
In E. S. Iley, supra, in a factual situation which is indistinguishable in principle from the one at bar, this Court came to a contrary decision. It is true that in the Iley case the taxpayer kept his books and records upon the cash basis of accounting but that fact alone does not distinguish that case. The question of the Commissioner's authority to tax in the year of changeover that which was properly income for a prior year was there squarely before the Court and our decision there is contrary to Caldwell, Dwyer, and Commons, supra. We decline henceforth to follow the Iley decision. William Hardy, Inc. v. Commissioner, supra, relied on by respondent, has been expressly overruled by the Court of Appeals for the Second Circuit in Commissioner v. Dwyer, supra.
Reviewed by the Court.
Decisions will be entered under Rule 50.
TURNER, J., dissents.
Fictions are of course a familiar tool of the law. But they are created in order to achieve some beneficent or equitable result.
legal fictions have an appropriate place in the administration of the law when they are required by the demands of convenience and justice. [ Helvering v. Stockholms Enskilda Bank, 293 U.S. 84, 92.]
We are here resorting to a fiction which produces a gross inequity and in order to do so we are required to overrule a recent decision. E. S. Iley, 19 T.C. 631.
"All fictions of the law, we have been taught, were created to enable the court to do justice, and where, to indulge a fiction, is to cause injustice, its just limit has been found." In re Walker's Estate, 125 Cal. 242, 57 P. 991.
The fiction upon which the present result rests is that accounts receivable not yet collected are income of the prior year merely because petitioner in the current year is placed on the accrual basis by respondent and both parties apparently now agree that such procedure is correct. The sums which became due to petitioner in the prior years were not income to him in those years since an accrual method of accounting was not then employed by petitioner. And they were not income of the prior year under petitioner's cash system since they were not then collected. Respondent, on the other hand, has determined that they are income in the current year because they have been collected in that year and because they have never previously been recorded as income under any accounting system employed by this petitioner.
This is the practical effect of what respondent did by including the opening accounts receivable which would presumably be collected during the current year. If they were not it was incumbent on petitioner to show it.
The first question in the application of section 41 is whether petitioner's system of computing its income according to its books properly reflected its income. This the opinion appears to answer in the negative.
The next question, although it is not dealt with, is whether respondent had no rational basis for determining that petitioner's income for the current taxable year would be correctly reflected by including not only accrual items but also currently collected cash items which would have been included in prior years under a nonexistent accrual system. Since this was the year of changeover it is difficult to see how any other system could accurately reflect petitioner's income except one which will take account both of the accrual items accruing in that year and the cash items collected but not yet accounted for. This is what respondent has accomplished. He has not "attempted to revise liability for earlier years closed by the statute of limitations." Dobson v. Commissioner, 320 U.S. 489, 493. In fact, Commissioner v. Dwyer, (C. A. 2) 203 F.2d 522, 524, which is relied upon by the majority opinion, says:
The inclusion of cash items is not necessarily inconsistent with an accrual system of accounting. See North American Oil Consolidated v. Burnet, 286 U.S. 417.
The question does not simply concern income tax accounting. No stockholder would be satisfied to have the profits of his business disappear because there was a changeover in a given year from cash accounting to accrual. And no method other than the one employed by respondent has, so far as I know, been suggested here.
Those courts that have refused to follow that decision [ William Hardy, Inc. v. Commissioner, (C. A. 2) 82 F.2d 249] have answered that not to allow the credit would be to assess a tax upon the income of an earlier year; but, strictly speaking, that is not true, for the income assessed would be limited to the proceeds of the sales of the articles carried over * * *
The finding by the majority that adequate books and records were kept upon which "an accounting for petitioners' taxable distributive shares of partnership income could be readily made upon either the cash or accrual basis of accounting" seems to me meaningless since almost any system of keeping records, as distinguished from the method by which "the net income shall be computed," will furnish the material from which a computation on either the cash or the accrual method could be arrived at. In my view the finding should have been made that petitioner's books were kept on the cash basis, and accordingly, the majority is also overruling the distinction made by this Court and courts of appeals between C. L. Carver, 10 T.C. 171, affd. (C. A. 6) 173 F.2d 29, and Z. W. Koby, 14 T.C. 1103, on the one hand, and Estate of Samuel Mnookin, 12 T.C. 744, affd. (C. A. 8) 184 F.2d 89, and Robert G. Frame, 16 T.C. 600, affd. (C. A. 3) 195 F.2d 166, on the other. And if petitioner's books were kept on a hybrid system, the majority opinion is, according to the Mnookin case, contrary to Schuman Carriage Co., Ltd., 43 B. T. A. 880.
SEC. 41. GENERAL RULE.
The net income shall be computed * * * in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income. * * * [Emphasis added.]
That case ( William Hardy, Inc. v. Commissioner, (C. A. 2) 82 F.2d 249) involved a change in the method of keeping the taxpayer's books, not merely, as here, a change in the method of reporting income in the taxpayer's return. Subsequent decisions of the Tax Court, two of which have been affirmed by Courts of Appeals, have noted that distinction and limited the scope of the Hardy case to its precise facts. * * * We agree that it should be so limited." ( Commissioner v. Schuyler, (C. A. 2) 196 F.2d 85, 87-88.)
Because the present result seems to me to defy the plain language of section 41 that under these circumstances "the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income"; because it improvidently overrules a case decided scarcely more than a year ago; because it employs a fiction to produce the inequitable result of permitting a sizable portion of petitioner's income to escape tax entirely; and because it places a premium upon the disregard by a taxpayer of both regulation and statute to the detriment of all painstaking taxpayers and the possible hazard of our self-assessing tax system, I respectfully note my dissent.
VAN FOSSAN and RAUM, JJ., agree with this dissenting opinion.