Comm'r of Internal Revenue

Tax Court of the United States.Dec 31, 1952
19 T.C. 631 (U.S.T.C. 1952)

Docket No. 28727.1



Ben F. Foster, Esq., for the petitioners. D. Louis Bergeron, Esq., and M. C. Maxwell, Esq., for the respondent.

Ben F. Foster, Esq., for the petitioners. D. Louis Bergeron, Esq., and M. C. Maxwell, Esq., for the respondent.

1. Held, respondent's determination that deficiencies in the petitioners' income tax were due to fraud with intent to evade tax not sustained where the evidence shows only ignorance and negligence on the part of the taxpayers.

2. Held, the respondent's determination that the method of reporting income by a partnership should be changed from the cash to the accrual basis is proper where the method of accounting employed by the partnership does not clearly reflect income.

3. Held, in the instant situation inclusion in income of the partnership's opening accounts receivable in the year of change from the cash to the accrual basis is proper.

The respondent determined deficiencies and penalties against the petitioners. The petitioners paid portions of the deficiencies and allege overpayments of income taxes. By amendments to his answers the respondent determined additional deficiencies and penalties. The deficiencies and penalties are as follows:

+------------------------------------------------------------------------------+ ¦ ¦ ¦ ¦Original ¦Additional ¦ +------------------------+------+----+--------------------+--------------------¦ ¦ ¦Docket¦ ¦ ¦ ¦ +------------------------+------+----+--------------------+--------------------¦ ¦Petitioner ¦No. ¦Year¦Deficiency¦50% ¦Deficiency¦50% ¦ ¦ ¦ ¦ ¦ ¦penalty ¦ ¦penalty ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦E.S. Iley ¦28727 ¦1944¦$1,141.52 ¦$570.76 ¦ ¦ ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦ ¦ ¦1945¦4,073.73 ¦2,036.86 ¦$196.66 ¦$98.33 ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦E.S. Iley and Cecil Iley¦28728 ¦1942¦5,619.06 ¦2,809.53 ¦254.07 ¦127.04 ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦ ¦ ¦1943¦3,460.40 ¦1,730.20 ¦703.07 ¦351.59 ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦ ¦ ¦1946¦4,318.70 ¦2,159.35 ¦ ¦ ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦T.W. Iley, Sr ¦28729 ¦1942¦5,903.98 ¦2,951.99 ¦266.62 ¦133.31 ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦ ¦ ¦1944¦4,476.06 ¦2,238.03 ¦ ¦ ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦ ¦ ¦1945¦12,996.78 ¦6,498.39 ¦ ¦ ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦T.W. Iley, Sr. and ¦28730 ¦1943¦12,278.12 ¦6,139.06 ¦2,100.57 ¦1,050.29 ¦ ¦Regina Iley ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦ ¦ ¦1946¦6,319.49 ¦3,159.74 ¦ ¦ ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦B.W. Iley ¦28731 ¦1942¦2,063.95 ¦1,031.97 ¦87.04 ¦43.52 ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦ ¦ ¦1944¦1,443.51 ¦721.75 ¦ ¦ ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦ ¦ ¦1945¦6,022.78 ¦3,011.39 ¦220.47 ¦110.24 ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦B.W. Iley and Inez Iley ¦28732 ¦1943¦5,098.90 ¦2,549.45 ¦808.18 ¦404.09 ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦ ¦ ¦1946¦3,907.53 ¦1,953.76 ¦ ¦ ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦G.R. Iley ¦28733 ¦1944¦1,218.45 ¦609.22 ¦ ¦ ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦ ¦ ¦1945¦4,609.65 ¦2,304.82 ¦196.66 ¦98.33 ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦G.R. Iley and Orline ¦28734 ¦1942¦5,418.57 ¦2,709.28 ¦250.28 ¦125.14 ¦ ¦Iley ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦ ¦ ¦1943¦3,126.34 ¦1,563.17 ¦670.45 ¦335.23 ¦ +------------------------+------+----+----------+---------+----------+---------¦ ¦ ¦ ¦1946¦4,129.79 ¦2,064.89 ¦ ¦ ¦ +------------------------------------------------------------------------------+

The issues in these proceedings are (1) whether any part of the deficiencies were due to fraud with intent to evade tax, and (2) whether the respondent erred in changing the method of reporting income of the partnership owned by the taxpayers from the cash to the accrual basis and including accounts receivable in income in the year of change.


Petitioner T. W. Iley, Sr., and his sons, B. W. Iley, G. R. Iley, and E. S. Iley, also petitioners, were partners in the firm of T. W. Iley & Sons, engaged in the poultry business in Gonzales, Texas, during the taxable years. The firm bought and sold chickens and other poultry. The petitioners also raised chickens for sale and dealt in chicken feed and supplies. The returns of partnership income were filed with the collector of internal revenue for the first collection district of Texas. T. W. Iley, Jr., entered the partnership in 1946. Prior to 1937, when the poultry business was initiated, T. W. Iley, Sr. was a farmer. After the business was organized, petitioners G. R. Iley, E. S. Iley and B. W. Iley each owned a 20 per cent interest in the partnership. T. W. Iley, Sr., owned a 40 per cent interest in the firm which was reduced to 20 per cent when T. W. Iley, Jr., became a partner in 1946 and received a 20 per cent interest. The operations of the partnership were carried on by the partners who devoted all their time to carrying on the various functions of the business.

The petitioner had not received business educations nor were they trained in bookkeeping or accounting. The books of the firm were originally kept by B. W. Iley and consisted of simple records of purchases. About 1940, G. R. Iley began keeping the firm's books, and in 1941 he sought outside advice. He consulted J. R. Collins, who instituted a set of books and records for the firm and instructed G. R. Iley, to some extent, in bookkeeping methods. The bookkeeping system set up consisted of a cash journal, an accounts receivable ledger and auxiliary records, such as bank statements and sales and purchase invoices. Collins had previously been engaged in bookkeeping work and had performed public accounting services. He was not a certified public accountant but was a registered accountant under the laws of Texas.

The partnership returns and individual returns of the partners for the years in question, with the exception of 1945, were prepared by Collins chiefly from data compiled by G. R. Iley. The returns for 1945 were made out by G. R. Iley. Collins did not audit the books of the firm nor did he verify the data he employed in making out the income tax returns.

In 1947 a revenue agent examined the records of the partnership and its members for the years 1942, 1943, and 1944. He stated that the firm's records were incomplete and that an adequate bookkeeping system should be installed. An effort was made by G. R. Iley to install a more complete set of books and records to meet Government requirements. At a later date another revenue agent examined the records and, as a result, deficiencies and fraud penalties were determined against the petitioners for the years 1942 and 1946. The revenue agent's determination of partnership income was made by means of the net worth mentioned. The petitioners engaged the services of a firm of certified public accountants to audit the books and records of the firm. The independent audit, employing the specific adjustments method of determining partnership income, arrived at substantially the same amount determined by the revenue agent, with a difference of but $353.65.

The partnership books were kept on the cash basis. Inventories were employed in the determination of cost of goods sold. Its returns were filed on the cash basis. Accounts receivable were not included in the determination of total sales for the taxable years in question. The respondent determined that the partnership income should be reported on the accrual basis, and in determining the gross income for 1942, included accounts receivable on hand January 1, 1942, in the amount of $33,231.83. A total of $137,801.78 in accounts receivable would be includible in gross income during the years in question if the accrual method of reporting is used.

The partnership reported total income of $140,715.76 during the five years from 1942 to 1946. As a result of the recomputations of partnership income carried out by respondent and petitioners, total income for the years involved was arrived at and the difference of $353.65 of unreported income between the two computations is agreed to by the petitioners. An amount of $67,900.98 in farm and joint venture income was not reported.

The partnership also raised poultry in conjunction with other persons. The firm provided chicks, feed, and medicine to the person raising the poultry. After the chickens were raised and marketed, the operator and firm shared equally in the profits. The firm recorded such transactions by charging accounts receivable and crediting sales with feed and chickens sold. When the chickens were raised and marketed, accounts receivable were credited and purchases charged, leaving a credit balance in accounts receivable, half of which was paid to the operator who raised the chickens. The other half remained as a credit balance in accounts receivable instead of being reflected as a profit.

The partnership owned farms of its own and the method of accounting was similar. The profits derived from the operations were reflected only as a credit balance in accounts receivable without regard to the fact that the firm had an interest in these operations. The general books of the firm did not show the net profits from these operations and income was consequently understated.

Over the 5-year period other errors were made in keeping partnership records. Errors in determining the total accounts receivable were made in the amount of $14,917.47 in favor of the Government. Excess depreciation was taken by the firm in the amount of $4,842.59. Errors in recording disbursements, including duplications, totaled $19,693.49. Misclassification of entries in the records resulted in $18,000 in unreported income. Deposits to the firm's bank account were made from time to time from cash on hand. Due to the failure to write sales invoices and misplacement of sales tickets and invoices, resulting in incomplete sales records, an overdraft in cash on hand of $127,585.92 was reflected in the books. This net of unrecorded cash sales was not reported as income.

The partnership, until 1946, maintained only one bank account which was with the Gonzales State Bank. Late in 1946 an account was opened with the First National Bank of George West, Texas.

The books and records of the partnership did not clearly reflect its income. The petitioners were not guilty of fraud with intent to evade tax.



The first issue involves the question of fraud. Fraud is never to be presumed. It must be proved by clear and convincing evidence. Moreover, the burden of proving fraud rests on the Government. Addressing ourselves in the facts established, we find abysmal ignorance on the part of the partly charged with keeping petitioner's accounts; the business had grown from small beginnings to large proportions, but the capacity of the member of the firm keeping the books did not grow in proportion. He was a farm boy, with a high school education, who had neither training nor experience in keeping proper books. There is ample proof of inaccuracies in the books, most of them to the benefit of petitioners, some, however, of benefit to the Government. Although the bookkeeping was inadequate by any standard, there is no evidence of intentional concealment or deliberate misrepresentation. The errors were patent to any one versed in accountancy. The petitioners were guilty of poor judgment in not having the books audited but poor judgment and ignorance are not tantamount to fraud. There is lacking one essential element, the very heart of the fraud issue, namely, the intent to defraud the Government by calculated tax evasion.

Although intent is a state of mind, it is nonetheless a fact to be proven by the evidence. It must appear as a positive factor. In determining the presence or absence of fraud the trier of the facts must consider the native equipment and the training and experience of the party charged. The whole record is to be searched for evidence of the intent to defraud. In this case, we have studied the record with the extra care such a case deserves; we have noted the demeanor of the witnesses on the stand; we have tested petitioners' conduct by approved standards of ascertainment and have come to the conclusion that petitioners were not motivated by an intent to defraud. Our finding of fact to record this conclusion is dispositive of this issue. Respondent has not proved by clear and convincing evidence that petitioners were guilty of fraud.

The second issue to be determined is the correctness of the respondent's determination that the accrual rather than the cash basis method of reporting should be used in the taxable years in issue. The partnership returned its income and kept its books and records on the cash receipts and disbursement basis. The firm's books and records reflected inventories which were employed to determine gross income. The applicable section of the Internal Revenue Code provides that if the method of accounting employed by the taxpayer does not clearly reflect the income, the computation shall be made in accordance with such a method as in the respondent's opinion clearly reflects income. Where the purchase and sale of merchandise is an income-producing factor, the accrual method is required to reflect the income of the business. Z. W. Koby, 14 T.C. 1103; Regulations 111, sec. 29.22 (c)-1, 29.41.2.

The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) 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. * * *

The partnership bought and sold poultry and also dealt in chicken feed and supplies. It is evidence that the purchase and sale of this merchandise was an incoming-producing factor and that inventories were required properly to reflect income. It is similarly evident that the cash basis method employed did not clearly reflect the partnership's income. The petitioners' objection that the amount of inventories carried at any one time was small in comparison with total sales, does not preclude the proper exercise of the respondent's discretion. Petitioners have not proven respondent's determination to be erroneous. On this issue respondent is sustained.

The third and last issue presented is whether the respondent correctly included $33,231.83 in partnership income for the year 1942. That amount constituted the balance of the firm's accounts receivable as of January 1, 1942. The partnership kept its books and records on the cash basis. Accounts receivable and inventories were reflected on its books and inventories were employed in the determination of gross profit. Accounts receivable were not included in sales. This method of accounting did not clearly reflect income for a business in which the purchase and sale of merchandise was an income-producing factor. In such a situation, under the principles set forth in Estate of Samuel Mnookin, 12 T.C. 744, affd. 184 F. 2d 89; and Robert G. Frame, 16 T.C. 600 affd. 195 F. 2d 166, the respondent may properly include in gross income the accounts receivable as of January 1, 1942. To accomplish accuracy and consistency, the partnership's method of keeping books and records, as well as its method of reporting its income, must undergo a change to the accrual basis. Inasmuch as the method of accounting employed in the partnership's books did not properly reflect income, the respondent is held to have correctly included the opening inventory of 1942 in the partnership's income for that year. Z. W. Koby, supra; C. L. Carver, 10 T.C. 171, affd. 173 F. 2d 29.

Decisions will be entered under Rule 50.