Docket Nos. 29189 30329.
Bayley Kohlmeier, Esq., for the petitioner. T. M. Mather, Esq., for the respondent.
EXCESS PROFITS TAX— SECTION 721— ABNORMAL INCOME— PERIODIC PAYMENTS ON SALE OF REAL ESTATE— INCOME ATTRIBUTABLE TO OTHER YEARS.— Prior to the taxable years, the petitioner sold parcels of land under contracts under which annual payments were to be made over a period of 10 years. In 1942 and 1943, the petitioner, who reported income on a cash basis, received periodic payments in excess of those currently due in each year, additional payments representing arrearages, and accelerated payments. It consequently realized ‘abnormal income‘ from the payments received in the taxable years. Held: Upon the facts, the petitioner is not entitled, under section 721(b) of the Code, to attribute part of the ‘net abnormal income‘ it realized in 1942 and 1943 to years before and subsequent to the taxable years. Bayley Kohlmeier, Esq., for the petitioner. T. M. Mather, Esq., for the respondent.
The respondent has determined deficiencies in the petitioner's excess profits tax for the years 1942 and 1943 in the respective amounts of $52,361.77 and $28,242.18. The petitioner concedes that some of the adjustments made by the respondent are correct and contests only part of the deficiency in each year.
The question is whether the petitioner is entitled to attribute ‘net abnormal income‘ to years before and after the taxable years 1942 and 1943 under sections 721(a)(1), (3), and (b). The petitioner contends that it is entitled to exclude the amounts of $18,485.95 and $9,920.09, respectively, from excess profits net income for 1942 and 1943. The parties are agreed that the petitioner received ‘abnormal income‘ within the meaning of section 721(a) of the Code in the above amounts.
The petitioner filed its returns with the collector for the first district of California.
FINDINGS OF FACT.
The facts are found as stipulated.
The petitioner, a California corporation, was organized in 1921. Since 1921 it has been engaged in the business of farming and of selling unimproved land under land contracts. The petitioner offered small lots for sale on an annual payment plan, and it reported its income from the contracts on the ‘recovered cost‘ basis.
The petitioner's land holdings, which appear to be extensive, are situated in Yuba County, near Marysville, California. In about 1921, or shortly thereafter, the petitioner subdivided some of its property and recorded the maps describing the subdivisions. There are 14 subdivisions: Olivehurst, Tract 2, Tract 3, Tract 3-A, Tract 7, Tract 8, Tract 9, Tract 10, Tract 11, Tract 12, Trace 13, Bear River Land, Tract 4-A, and the Marysville Property. All the land in the subdivision is owned by the petitioner, except the Bear River Land in which it has a 50 per cent interest. Each tract has been further subdivided into small lots.
The record does not disclose the extent of the petitioner's land holdings.
The terms of a typical installment contract, under which a piece of land was sold by the petitioner on July 23, 1944, were, in part, as follows: The vendee agreed to retire the contract price of $250 in 10 annual payments of $25. The first payment of $25 on the principal was due on or before July 23, 1947, which was exactly 3 years after the date of the execution of the contract. Each additional payment of $25 was due annually on July 23 of each succeeding year until full payment of the contract price was completed. The vendee was charged with 6 per cent interest on the contract price during the first 3 years after the date of execution of the contract. This interest payment was due annually in advance. After July 23, 1947, the vendee was charged with 6 per cent interest on the unpaid balance of the contract price, which was due semiannually in advance. Upon execution of the contract the petitioner transferred possession of the land to the vendee; it agreed to deliver to the vendee upon completion of full payment of the contract price a grant, bargain and sale deed of the land, free and clear of encumbrances. As a condition precedent to the operation of the agreement, the vendee was required within a reasonable time either to plant fruit trees or vines upon the land or to erect substantial buildings thereon.
If the vendee defaults with respect to any of the terms of the contract, time being of the essence, the petitioner is released from any obligation to convey title; in the event of default the petitioner has the right to take immediate possession of the property and to retain all amounts which the vendee had previously paid under the contract and all improvements which the vendee had made on the land.
During 1942 and 1943, the petitioner received payments under contracts which were executed after 1930, with the exception of a few which were executed as far back as 1926. The contract prices of the parcels of land on which payments were received during 1942 and 1943 ranged from $25 to $3,750 principal amount, for which annual payments ranged from $5 per year to $375 per year.
After the execution of a land contract the petitioner does not have any expenses or perform any services relating to the parcel of land covered by the contract and does no more than receive payments.
Prior to the taxable years, the vendees under a large number of contracts defaulted in the annual contract payments. The petitioner did not, however, elect to exercise its rights under the contracts involved in this proceeding to recover any of the parcels of land, and, instead, permitted the vendees to retain possession and to make payments in such amounts and at such times as they were able. In 1942 and 1943 a substantial number of vendees made payments in amounts which had been in arrears. In addition, the petitioner received payments in 1942 and 1943 which the vendees were not required to make under the contracts until subsequent years. As a consequence, a substantial number of vendees made payments, in 1942 and 1943, in amounts which represented either arrearages, current year's payments, or accelerated payments, or a combination of arrearages, current year's payments, and accelerated payments. Vendees under 296 and 255 sales contracts made payments in 1942 and 1943, respectively.
In 1942, 62 vendees made arrearage payments; 46, current payments; 82, accelerated payments; 5, a combination of arrearage and current payments; 76, a combination of current and accelerated payments; and 25, a combination of arrearage, current, and accelerated payments. In 1943, 38 vendees made arrearage payments; 36, current payments; 47, accelerated payments; 4, a combination of arrearage and current payments; 96, a combination of current and accelerated payments; and 34, a combination of arrearage, current, and accelerated payments.
The total amounts of the payments which the petitioner received under land contracts were $34,687.91 in 1942 and $35,648.57 in 1943. The petitioner received in prior years payments in the aggregate amount of $14,322.85 on some of the contracts under which payments were received in 1942 and in the aggregate amount of $17,238.42 on some of the contracts under which payments were received in 1943.
The record is silent on this matter with respect to prior years.
In 1942 and 1943 and prior years the petitioner reported income from its land sales contracts on a ‘recovered cost‘ basis. Under this method of accounting the petitioner applied periodic payments to the cost or other basis of each parcel of land, under each contract, until the periodic payments received under a contract equalled the cost or other basis of the property. Thereafter each periodic payment represented income and was reported as such in the petitioner's income tax returns and in its excess profits tax returns for 1940 to 1943 inclusive.
In the petitioner's excess profits tax returns for 1940 and 1941 no excess profits tax was reported as due. Likewise, in its excess profits tax return for 1942 and 1943, no excess profits tax was reported as due, since in both years the petitioner computed the amount of its excess profits credit to be larger than the amount of its excess profits net income. After the respondent had made certain adjustments in the amounts reported by the petitioner as excess profits net income and excess profits credit in 1942 and 1943, he determined that the amount of the petitioner's excess profits net income exceeded the amount of its excess profits credit in both years; and he determined excess profits tax deficiencies for 1942 and 1943 in the respective amounts of $52,361.77 and $28,242.18.
The total payments received under the contract in 1942 and 1943 and the allocation thereof to cost and income are as follows:
+-------------------------------------------+ ¦ ¦ ¦ ¦Amount ¦ +----+--------------+----------+------------¦ ¦ ¦Total payments¦Amount ¦representing¦ +----+--------------+----------+------------¦ ¦Year¦received ¦applied to¦income above¦ +----+--------------+----------+------------¦ ¦ ¦ ¦cost ¦cost ¦ +----+--------------+----------+------------¦ ¦1942¦$34,687.91 ¦$6,825.32 ¦$27,862.59 ¦ +----+--------------+----------+------------¦ ¦1943¦35,648.57 ¦7,988.33 ¦27,660.24 ¦ +-------------------------------------------+
The petitioner's gross income above cost from payments received under the contracts during each of the 4 years immediately preceding 1942 was as follows:
+----------------------------+ ¦Year ¦Income above cost ¦ +-------+--------------------¦ ¦1938 ¦$1,099.27 ¦ +-------+--------------------¦ ¦1939 ¦6,333.90 ¦ +-------+--------------------¦ ¦1940 ¦8,278.31 ¦ +-------+--------------------¦ ¦1941 ¦14,293.67 ¦ +-------+--------------------¦ ¦Average¦$7,501.29 ¦ +----------------------------+
The average annual income for the 4-year period was $7,501.29, and 125 per cent thereof is $9,376.61.
The average annual income from payments received under contracts during the 4 years immediately preceding 1943 was $14,192.12, and 125 per cent thereof is $17,740.15.
The petitioner had no costs or expenses in 1942 or 1943 which are directly allocable to the income realized from the land sales contracts, and for the purpose of this proceeding ‘net abnormal income‘ is the same as ‘abnormal income.‘
The petitioner has paid deficiencies in excess profits tax in the amounts of $52,361.77 and $28,242.18 for 1942 and 1943, respectively, and has filed timely claims for refund of $14,426.81 and $6,222.83 of excess profits tax which it claims was overpaid for 1942 and 1943.
The sole question is whether the petitioner realized in 1942 and 1943 ‘net abnormal income‘ in the respective amounts of $18,485.98 and $9,920.09, which is attributable to other years within the meaning of section 721(b) of the Code.
The petitioner contends that the above amounts of income were abnormal in size under section 721(a)(1) and are attributable to years before or after the taxable years. The petitioner contends that this income is attributable to the years that the periodic payments which resulted in the abnormal income became due and payable under the terms of certain land sales contracts. The respondent has determined that the petitioner's entire income for 1942 and 1943 is to be included in its excess profits net income for those years.
Section 721(a) defines the terms ‘abnormal income‘ and ‘net abnormal income,‘ and the applicable parts of section 721(a) are set out in the margin. In this proceeding we are not so much concerned with those definitions because the parties have agreed that the amounts of $18,485.98 and $9,920.09 constituted ‘abnormal income‘ to the petitioner in 1942 and 1943 respectively. It suffices to say that under section 721(a) a certain portion of the petitioner's income for the taxable years was ‘abnormal‘ in amount. Lindstedt-Hoffman Co., 11 T.C. 584. The amount of gross income derived from the receipt of periodic payments under land sales contracts during each of the taxable years was ‘in excess of 125 per centum of the average amount of the gross income of the same class for the four previous taxable years.‘ (Section 721(a)(1)).
SEC. 721. ABNORMALITIES IN INCOME IN TAXABLE PERIOD.(a) DEFINITIONS.— For the purposes of this section—(1) ABNORMAL INCOME.— The term ‘abnormal income‘ means income of any class includible in the gross income of the taxpayer for any taxable year under this subchapter if it is abnormal for the taxpayer to derive income of such class, or, if the taxpayer normally derives income of such class but the amount of such income of such class includible in the gross income of the taxable year is in excess of 125 per centum of the average amount of the gross income of the same class for the four previous taxable years, or, if the taxpayer was not in existence for four previous taxable years, the taxable years during which the taxpayer was in existence.(3) NET ABNORMAL INCOME.— The term ‘net abnormal income‘ means the amount of the abnormal income less, under regulations prescribed by the Commissioner with the approval of the Secretary, (A) 125 per centum of the average amount of the gross income of the same class determined under paragraph (1), and (B) an amount which bears the same ratio to the amount of any direct costs or expenses, deductible in determining the normal-tax net income of the taxable year, through the expenditure of which such abnormal income was in whole or in part derived as the excess of the amount of such abnormal income over 125 per centum of such average amount bears to the amount of such abnormal income.
It is also necessary under section 721(b) for the petitioner to show that the ‘net abnormal income,‘ or some part of it, is properly attributable to other years. Ripy Bros. Distillers, Inc., 11 T.C. 326.
In about 1921, or before, the petitioner subdivided a considerable part of its land holdings. Lots were offered for sale under a ‘nothing down‘ periodic payment plan. All of the terms of sale were included in written land contracts. In general, a vendee under a contract was required to begin its payments on the contract price 3 years after the date of execution of the contract. Annual payments were to be made in 10 equal installments.
Prior to 1942 a large number of vendees under land contracts had defaulted with respect to their periodic payments. In 1942 and 1943, however, most vendees made their current payments. In addition, the petitioner received during each of the taxable years a substantial number of payments which represented arrearages. The petitioner also received a large number of accelerated payments which were not due until later years unless the vendees elected to anticipate the due dates.
In 1942 and 1943 and in prior years the petitioner kept its books of account and reported its income for income tax purposes on a cash basis of accounting. With respect to the land contract sales, the petitioner did not report taxable income under a particular contract until the periodic payments on the contract price exceeded the petitioner's cost or other basis of the parcel of land covered by the particular contract. See: Kester, Advanced Accounting, 4th ed., p. 499. Thereafter the petitioner reported all amounts received pursuant to that contract as income in the year of receipt.
The petitioner also reported its income under the contracts in the same way in its excess profits tax returns from 1940 (the first year of the excess profits tax) to 1943, inclusive. In each of these years the petitioner did not report any excess profits tax as being due, since it computed its excess profits credits to be in excess of its excess profits net income each year. After the respondent made certain adjustments in the amounts representing excess profits net income and excess profits credits for 1942 and 1943, he determined that the petitioner was liable for excess profits tax in each year, and he determined deficiencies in excess profits tax. The petitioner claimed for the first time in a claim for refund, and later in the petition filed in this Court, that it had the right to attribute to other years some of the income received in the taxable years under the land contracts.
Section 721(b) of the Code provides that:
* * * The amount of the net abnormal income that is attributable to any previous or future taxable year or years shall be determined under regulations prescribed by the Commissioner with the approval of the Secretary.
Pursuant to the above statutory authority, the Commissioner promulgated regulations governing the determination of the amount of ‘net abnormal income‘ attributable to other taxable years.
Section 35.721-3 of Regulations 112 is set out, in part, in the margin.
SEC. 35.721-3. AMOUNT ATTRIBUTABLE TO OTHER YEARS.—Items of net abnormal income are to be attributed to other years in the light of the events in which such items had their origin, and only in such amounts as are reasonable in the light of such events. To the extent that any items of net abnormal income in the taxable year are the result of high prices, low operating costs, or increased physical volume of sales due to increased demand for or decreased competition in the type of product sold by the taxpayer, such items shall not be attributed to other taxable years. Thus, no portion of an item is to be attributed to other years if such item is of a class of income which is in excess of 125 per cent of the average income of the same class for the four previous taxable years solely because of an improvement in business conditions. In attributing items of net abnormal income to other years, particular attention must be paid to changes in those years in the factors which determined the amount of such income, such as changes in prices, amount of production, and demand for the product. No portion of an item of net abnormal income is to be attributed to any previous year solely by reason of an investment by the taxpayer in assets, tangible or intangible, employed in or contributing to the production of such income.
The petitioner asserts that the method it advances for attributing the abnormal income to other years is in harmony with the regulations. It is not entirely clear from the petitioner's arguments on brief whether it would attribute the income received in 1942 and 1943 to the years in which the payments were due and payable under the contracts, or whether it would attribute income to the years in which the income would have been realized, after the recovery of cost, if the payments had been made in accordance with the terms of the contracts.
In either event, it appears that the petitioner is endeavoring to attribute ‘net abnormal income‘ in the same way as one who follows an accrual basis of accounting. As previously noted, the petitioner is on a cash basis of accounting.
The petitioner in the instant proceeding was not above to elect to report its income from land contracts on an installment basis under section 44(b). This case differs from the Bogle and South Texas Lumber Co. cases, infra, in this respect. In the first excess profits tax year, 1940, the petitioner reported its income from land contracts under the ‘recovered cost‘ method of accounting for excess profits tax purposes. It also reported its income from land contracts under the ‘recovered cost‘ method of accounting for income tax purposes. The Commissioner apparently thought that this method of accounting clearly reflected the petitioner's income from land sales, for there is no showing that he directed the petitioner to change this accounting method. Nor is there evidence that the petitioner applied for a change. The ‘recovered cost‘ method of accounting is a cash method of accounting.
The Court has had several opportunities to consider cases where the taxpayer, in effect, sought to attribute income in a manner at variance with its established accounting method.
In E. T. Slider, Inc., 5 T.C. 263, the taxpayer received income in 1940 from the proceeds of three insurance policies covering the life of its president. The insured had died in 1939, but payment of the insurance proceeds was held up, pending a claim advanced by his wife and daughter. The claim was settled in 1940, and the proceeds were paid to the taxpayer in the same year. The taxpayer kept its books and filed its tax returns on an accrual basis.
This Court said, inter alia:
The proceeds of the three insurance policies * * * were not accruable as income until 1940. They are, therefore, ‘attributable‘ only to the year 1940 and not ‘to other years.‘
The taxpayer in Geyer, Cornell & Newell, Inc., 6 T.C. 96, was on the accrual basis. In preparing advertising for a client, the taxpayer incurred about 75 per cent of the related expenses in 1939 and the remaining 25 per cent in 1940. About half of the advertising income was realized in 1939 and the other half in 1940. It was held that the taxpayer could not attribute income realized in 1940 to 1939 in proportion to the amounts expended in each year to produce the income.
In R. H. Bogle Co., 10 T.C. 1282, the taxpayer was on the accrual basis. For income tax purposes it elected under section 44(b) to report the gain from the sale of real estate in 1941 on the installment basis. In 1942 and 1943, the taxpayer sought to attribute to 1941 income derived from installment payments received in those years. This Court did not permit the taxpayer to make such allocation, holding that the election to spread the income under the installment basis applied to the excess profits tax as well as to the income tax.
Although the facts differed in each of the above proceedings, the conclusions, in effect, were the same. The taxpayer in each was not allowed to attribute income to other years, if in so doing it altered its established method of accounting.
Again, in the instant proceeding a different fact situation is presented, so that neither the Bogle, Geyer, nor Slider cases are precisely in point. However, the problem here is similar in principle to the one present in the above proceedings. Consequently, by analogy, the petitioner in the instant proceeding cannot be permitted to attribute its income on the basis it suggests.
By advancing its plan for the allocation to other years of some of the income realized under the contracts in 1942 and 1943, the petitioner may be suggesting that it is entitled to shift the income to other years under section 42 in order to reflect income clearly. If some income of 1942 and 1943 should be allocated to other years, because some of the payments received in 1942 and 1943 were due in other years, then a similar allocation of income from other years to 1942 and 1943 would have to be made for the same reason, in order to avoid a distortion of income in the taxable years. Section 721, however, does not provide for so extensive an allocation. Nor does the record supply the facts necessary for such an allocation. Yet, if only a partial allocation were made, some income would never be subject to tax. This benefit was never intended. No issue is raised under section 42, and the petitioner's accounting methods seem adequate and to comply with section 42. Cf. Geyer, Cornell & Newell, Inc., supra.
The petitioner was satisfied to take advantage of the ‘recovered cost‘ method of accounting prior to 1942. In previous years the amounts received under the contracts were comparatively small and were, no doubt, recoveries of cost and so not taxable. However, in the taxable years involved, a substantial portion of the payments represent receipts above cost and are taxable. It appears that because of the receipt in 1942 and 1943 of payments of arrearages and of amounts due in later years, a larger proportion of the payments in 1942 and 1943 represent income. Under the circumstances, an accrual method of accounting, if the petitioner were on an accrual method of accounting, would now offer a tax advantage. The petitioner seeks to reach this advantage through section 721. However, a taxpayer cannot elect to use one method of accounting in one year in order to secure a tax advantage and then change to another method for the purpose of obtaining a further tax advantage. Cf. Commissioner v. South Texas Lumber Co., 333 U.S. 496.
Moreover, unless a taxpayer secures the consent of the Commissioner, it cannot change its method of accounting for tax purposes. Section 29.42-2 of Regulations 111 promulgated under section 41 of the Code. From the evidence it does not appear that the petitioner applied for a change in its accounting method with respect to the land sales contracts. Its excess profits tax returns for 1942 and 1943 cannot be considered as applications to change the method of reporting income from the land sales contracts because the income under the contracts was reported therein on the same basis (‘recovered cost ‘) as in previous returns.
Regulations 112, section 35.721-8 provides for the treatment of abnormal income resulting from a change in a taxpayer's method of accounting, but the regulation is not applicable in this proceeding because the petitioner's problem does not result from a change in accounting method. Here the petitioner is, in effect, seeking to have this Court approve a change in its method of reporting income from the land contracts from the cash method of an accrual method for the purpose of attributing income received in the taxable years to other years.
Section 35.721-8 of Regulations 112 provides as follows:CHANGE IN ACCOUNTING PERIOD OR METHOD OF ACCOUNTING.— The third class of potentially abnormal income specifically set forth in section 721(a)(2) is income which is includible in gross income for the taxable year rather than for a different taxable year by reason of a change in the taxpayer's accounting period or method of accounting. This class may include such items of income as are includible in gross income for the taxable year by reason of a change from the installment method to the straight accrual method of accounting, a change in inventory method, or a change from the reserve method to the specific charge-off method for the treatment of bad debts. Items of net abnormal income includible in gross income for the taxable year rather than for a different taxable year by reason of a change from the installment method to the straight accrual method of accounting shall be attributed to the year or years such items accrued. The method of allocating items of net abnormal income includible in gross income for the taxable year rather than for a different year by reason of other changes in accounting method or changes in accounting period is to be determined in each particular case upon consideration of all the facts in the case.
Considering the payments of arrears apart from the accelerated payments, the question arises whether the income resulting from the overdue payments is income ‘arising out of a claim, award, judgment, or potentially abnormal income in section 721(a)(2). The manner in which income of the above class is attributable to other years is set forth in section 35.721-6 of Regulations 112. The pertinent parts of the regulation are set out in the margin. Clearly, the income under consideration does not arise out of an ‘award, judgment, or decree.‘ The question is whether it is income derived from a claim. Although it does not seem that Congress intended to restrict the meaning of the term ‘claim‘ to technical items such as litigated claims, it does appear that something more than an existing right is necessary to come within the intendment of the statute. Since the term is used in connection with ‘award, judgment, or decree,‘ it appears that at the least the statute requires that there be a bona fide dispute or an asserted demand. Cf. R. C. Harvey Co., 5 T.C. 431.
SEC. 35.721-6. INCOME ARISING OUT OF A CLAIM, AWARD, JUDGMENT, OR DECREE, OR INTERESTS THEREON.—In determining the portions of income of the class described which are attributable to other taxable years, due regard shall be given to the nature of the claim upon which the recovery is founded. Allocation will generally be made to the year or years during which occurred the exploitation, removal, or use, as the case may be, of the property right forming the subject matter of the claim, award, judgment, or decree. Thus, in the case of a judgment for infringement of a patent, the number of units produced through the use by the infringer of such patent in the respective years involved shall constitute a proper basis of allocation. Similarly, if the removal of minerals forms the basis of the recovery, the units removed in the respective years shall constitute a proper basis of allocation. The income arising from awards of the Mixed Claims Commission, United States and Germany, to the extent they constitute compensation for past losses, shall be attributable to the years during which such losses occurred.
The petitioner in this proceeding had a right under the land contracts to receive periodic payments on the dates specified in the various contracts. But the evidence does not show that the petitioner ever undertook to enforce its contract rights or even to make demands that payments be made in accordance with the terms of the contracts. In fact, the record discloses that the petitioner allowed the vendees under the contracts outstanding in 1942 and 1943 to make payments in such amounts and at such times as they were able. It is included that the income received under contracts which were in default in 1942 and 1943 is not income arising out of a ‘claim, award, judgment, or decree‘ within the purview of section 721(a)(2).
The petitioner takes the position that the income realized under the contracts in 1942 and 1943 was not intended to be subject to excess profits tax. It claims that almost all of the contracts were executed prior to the rearmament and defense program and that Congress intended the excess profits tax to embrace only income resulting from the rearmament program. The respondent contends that the petitioner's increased income in 1942 and 1943 was the result of improved business conditions and hence under the authority of section 30.721-3 of Regulations 112 cannot be attributed to other years. The respondent points to the testimony of the petitioner's president to the effect that payments increased in 1942 and 1943 because of the improved income situation in the section where the petitioner's lands are located.
Merely because certain abnormal income realized in an excess profits tax year has no connection with the rearmament program does not mean it must be excluded from excess profits net income. In both E. T. Slider, supra, and Premier Products Co., 2 T.C. 445, the question was whether certain income realized from life insurance proceeds was includible in excess profits net income for the year in which the proceeds were received. The proceeds from the policies were not affected by the rearmament program. Nevertheless, they were held includible in excess profits net income in the year of receipt. The amounts received would have been the same in the absence of a rearmament program. The same hold true in the instant case.
The determination of the respondent is sustained.
Reviewed by the Court.
Decision will be entered for the respondent.