Opinion
3327-22
10-19-2023
A.C.M.E., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
ORDER
Christian N. Weiler Judge
By Order dated January 10, 2023, the Court struck this case for trial from the March 27, 2023, Los Angeles, California trial session, continued the case, and retained jurisdiction. Respondent has moved for summary judgment on all issues in this case pursuant to Rule 121. On August 14, 2023, respondent filed a Motion for Summary Judgment and Declarations in support thereof. On September 15, 2023, petitioner filed its Opposition to Motion for Summary Judgment and Affidavits in support thereof. Based on the reasoning below, we will deny respondent's Motion for Summary Judgment.
Unless otherwise indicated, statutory references are to the Internal Revenue Code, Title 26 U.S.C. (I.R.C.), in effect at all relevant times, regulation references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant times, and Rule references are to the Tax Court Rules of Practice and Procedure.
Background
The following facts are derived from the parties' motion papers. They are stated solely for purposes of deciding respondent's Motion for Summary Judgment and not as findings of fact in this case. See Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520 (1992), aff'd, 17 F.3d 965 (7th Cir. 1994).
A.C.M.E. (petitioner) is a corporation that consists of two businesses, one operating under its own name and the second as Cal Ag Packaging (CAP). Barbara J. Thompson was the CFO and sole shareholder of A.C.M.E. in 2015 and 2016 (years at issue). James C. Thompson was the President and Secretary of A.C.M.E. and a 30% owner of Well-Pict. Well-Pict is a berry wholesaler and is not a party in this case.
A.C.M.E. provides consulting and payroll services in the form of leasing employees to other companies and paying salaries, payroll taxes, and workers compensation insurance for its employees. While CAP, as a division of A.C.M.E., manufactures berry crates, baskets, and wires (packaging supplies), and sells these packaging supplies to unrelated fruit growers. In the years at issue, the growers sold their berries to Well-Pict and often purchased their packaging supplies from CAP. Growers had the option to prepay for packaging supplies and Well-Pict would deduct the grower's packaging supplies costs from the grower's gross sales and provide payment to CAP. If a grower's made prepayment of packaging supply costs directly to CAP; however, the prepayment did not cover the total cost of packaging supplies, Well-Pict would also deduct the remaining costs for packaging supplies from the gross sale price of the berries and pay CAP.
Growers made advance payments with CAP to "lock in rates" for the following year's harvest CAP considered these prepayments refundable upon request of the grower, where circumstances supported a refund. However, these advance payments were refunded to growers if the growers experienced lower-than-average crop yields or reduced acreage for production. The grower was also able to elect, in lieu of a refund, to apply the prepayment to the purchase of materials. For example, in 2013, CAP refunded an advance payment made in 2011 in the amount of $4,368,500 following the grower's inability to secure suitable farmland.
Respondent issued a notice of deficiency, dated October 25, 2021, in which he determined deficiencies in petitioner's 2015 and 2016's income tax of $22,473,491 and $5,902,805, respectively. The deficiencies arise from four adjustments to income: (1) whether prepayments made by growers should have been included in petitioner's income in the year received, (2) whether petitioner was eligible for net operating loss carryforwards in tax year 2016, (3) whether petitioner was entitled to deductions for cost of sales for tax years 2015 and 2016 under section 481(b), and (4) whether petitioner was entitled to deductions for outside services for tax year 2016. Additionally, respondent asserted accuracy-related penalties under section 6662(a) for tax years 2015 and 2016 of $4,494,698 and $1,180,561, respectively. [Petition, 6]
On January 31, 2022, petitioner timely filed a Petition seeking redetermination of the adjustments found in the notice of deficiency. In its Petition, petitioner does not assert the affirmative defense of equitable recoupment. Respondent filed his Answer to the Petition on April 15, 2022. On August 14, 2023, respondent filed a Motion for Summary Judgment and Declarations in support thereof. On its 2015 and 2016 tax returns, CAP did not recognize the advance payments made by growers as income. Respondent argues that these advance payments received were includable in gross income in the year received. Respondent contends that "no customer has requested a refund" and that "CAP has never returned an advance payment." Furthermore, respondent argues that petitioner has not substantiated its deduction for outside services in tax year 2016 and is not entitled to a net operating loss carryforward in 2016 because it was exhausted in 2015.
On September 15, 2023, petitioner filed its Opposition to Motion for Summary Judgment and Affidavits in support thereof. Petitioner argues that the growers tendered advance "deposits," which were not includable in gross income in the year the payments were received. Petitioner further argues how respondent cannot meet his burden regarding the deposits from growers, since CAP did not exercise complete dominion over the deposits and since the growers were able to request a refund. Petitioner provides that in 2013, CAP refunded a deposit to a grower that was originally deposited with CAP in 2011, in the amount of $4,368,500. Moreover, petitioner asserts equitable recoupment and seeks to present this doctrine at trial to avoid the double counting of more than $38,000,000 in income.
Discussion
I. Summary Judgment
The purpose of summary judgment is to expedite litigation and avoid unnecessary and time-consuming trials. FPL Grp., Inc. & Subs. v. Commissioner, 116 T.C. 73, 74 (2001); Fla. Peach Corp. v. Commissioner, 90 T.C. 678, 681 (1988). We may grant summary judgment when there is no genuine dispute of material fact, and a decision may be rendered as a matter of law. Rule 121(a)(2); Elec. Arts, Inc. v. Commissioner, 118 T.C. 226, 238 (2002). However, it is not a substitute for trial; it should not be used to resolve genuine disputes over material factual issues. Elec. Arts, Inc., 118 T.C. at 238. When determining whether to grant summary judgment, we must view factual materials and inferences drawn therefrom in the light most favorable to the nonmoving party. See FPL Grp., Inc. & Subs., 116 T.C. at 75; Bond v. Commissioner, 100 T.C. 32, 36 (1993). The nonmoving party may not rest upon the mere allegations or denials of his pleadings but must set forth specific facts showing that there is a genuine dispute for trial. Rule 121(d); Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520 (1992), aff'd, 17 F.3d 965 (7th Cir. 1994).
II. Advance Payments v. Deposit
Section 61(a) provides that "gross income means all income from whatever source derived." Where a taxpayer uses the accrual method of accounting, income should be included in the tax year in which "all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy." Treas. Reg. § 1.446-1(c)(ii)(A). Typically, all events that fix the right to receive income have occurred upon the earliest of the following: (1) actually or constructively received, (2) due, or (3) earned by performance. Schulde v. Commissioner, 372 U.S. 128, 133 (1963). Amounts that constitute advance payments for goods or services are includable in gross income in the year received. Id. While on the other hand, amounts that are properly characterized as deposits are not includable in income upon receipt. See Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203, 207-08 (1990). The rationale behind this principle is that money received in the capacity of a depository is accompanied by an obligation to repay or restriction as to its disposition and should not be considered income in the year the deposit is received. See Id. at 208. In sum, the question becomes whether the funds received from third party growers were prepayments (as contended by respondent) or whether they were deposits (as contended by petitioner).
A. Advance Payments
Under financial accounting, income from services does not accrue until the services are rendered. In contrast, the rules for income tax reporting commonly require advance payments (but not mere "deposits") to be included in income when they are received. There are two legal foundations for this divergence from financial accounting theory. The first being the claim of right doctrine, under which amounts received by an accrual method taxpayer under a claim of right and without restriction as to disposition or use are includible in gross income in the year of receipt even though at the time of receipt conditions exist that might require the taxpayer to return part or all of the amounts. See N. Am. Oil Consol. v. Burnet, 286 U.S. 417 (1932); Safety Tube Corp. v. Commissioner, 8 T.C. 757 (1947); Mensik v. Commissioner, 37 T.C. 703 (1962); Marquardt Corp. v. Commissioner, 39 T.C. 443 (1962). Second, under section 446(b), the IRS may modify a taxpayer's accounting method in order to clearly reflect income. To avoid application of the claim of right doctrine, a taxpayer must establish the existence of a fixed obligation to repay the amount. A contingent obligation to repay is insufficient. See Hope v. Commissioner, 55 T.C. 1020 (1971).
Advance payments are to be included in income in the taxable year of receipt unless an exception under Treasury Regulation § 1.451-5(c) applies. Respondent, in his Motion for Summary Judgment, contends that petitioner cannot adopt an accounting method exception under this Regulation, since petitioner failed to include an information schedule (tracking the advance payments) on its tax return as required by Treasury Regulation § 1.451-5(d).
B. Deposits
The Supreme Court in Commissioner v. Indianapolis Power & Light Co., 490 U.S. 203 (1990), held that certain deposits were not taxable. In its decision, the Supreme Court stated that the utility company was obligated to pay interest on the deposit and that customers could control timing of the return of the deposit by paying their electric bills. It also identified the dispositive factor as the fact that the utility company acquired the deposit subject to an express obligation to repay at some future date, such as termination of service or earlier, if the customer established good credit. Essentially, the Supreme Court established what has sometimes been referred to as the "complete dominion" test for identifying a payment as a deposit.
We have similarly emphasized the importance of which party controls the conditions under which repayment or refund of the disputed amounts will be made. See, e.g., Herbel v. Commissioner, 106 T.C. 392, 413-14 (1996), aff'd, 129 F.3d 788 (5th Cir. 1997); Highland Farms, Inc. v. Commissioner, 106 T.C. 237, 251-52 (1996); Kansas City S. Indus., Inc. v. Commissioner, 98 T.C. 242, 261-62 (1992); Michaelis Nursery, Inc. v. Commissioner, T.C. Memo. 1995-143. We have summarized that "if the payor controls the conditions under which the money will be repaid or refunded, generally, the payment is not income to the recipient." Herbel, 106 T.C. at 413. "On the other hand, if the recipient of the payment controls the conditions under which the payment will be repaid or refunded, we have held that the recipient has some guaranty that it will be allowed to keep the money, and hence, the recipient enjoys complete dominion over the payment." Id. at 414.
As to other potential indicia, both the Supreme Court in Commissioner v. Indianapolis Power & Light Co. and this Court have held that factors such as control over deposits (i.e., absence of a trust fund), unrestricted use, nonpayment of interest, and later application of the moneys to services are probative but not dispositive in evaluating the existence of complete dominion. See Perry Funeral Home v. Commissioner, T.C. Memo. 2003-340, 2003 WL 22953114, at *8.
While it seems that respondent may have the better argument here in seeking to classify these payments as taxable prepayment rather than deposits; we agree with petitioner that there appears to be a material dispute of fact regarding the true character of the payments made by the growers. It is inappropriate for us to weigh countervailing evidence in a motion for summary judgment. Accordingly, we will refrain from doing so and will deny respondent's Motion for Summary Judgment.
III. Prepayments and Equitable Recoupment
In his Motion for Summary Judgment, respondent contends that an accrual method taxpayer cannot deduct prepayments until the "all events test" is satisfied. See Gregory v. Commissioner, 149 T.C. 43, 47 (2017). Respondent directs our attention to Garber Inc. v. Commissioner, 51 T.C. 733, 736-37 (1969) and contends that petitioner cannot deduct prepayments of $4.8 million in 2015 and $2 million in 2016, since there was no genuine liability of these payments and economic performance by the vendor did not occur until the following year. Respondent also seeks to include the entire beginning accounts payable credit balance of $34 million as income for tax year 2015.
Petitioner's Opposition does not specifically address respondent's disallowance of these deductions for cost of sales in tax years 2015 and 2016. However, the Opposition notes-generally-how the principle of equitable recoupment precludes summary judgment in this matter.
Equitable recoupment is an equitable solution where, under certain circumstances, a taxpayer can avoid the bar of an expired statute of limitations. Menard, Inc. v. Commissioner, 130 T.C. 54, 62 (2008). Section 6214(b) provides that this Court may apply the doctrine of equitable recoupment to the same extent that is available in civil tax cases before the District Courts and the U.S. Court of Federal Claims. The doctrine requires a party to prove the following elements: (1) the overpayment or deficiency for which recoupment is sought by way of offset is barred by an expired period of limitation, (2) the time-barred overpayment or deficiency arose out of the same transaction, item, or taxable event as the overpayment or deficiency before the Court, (3) the transaction, item, or taxable event has been inconsistently subjected to two taxes, and (4) if the transaction, item, or taxable event involves two or more taxpayers, there is sufficient identity of interest between the taxpayers subject to the two taxes that the taxpayers should be treated as one. Dalm v. United States, 494 U.S. 596, 604-05 (1990); Menard, 130 T.C. at 62-63. A party is permitted to raise the affirmative defense of equitable recoupment if it is properly set forth in the party's pleadings. Rule 39; Menard, 130 T.C. at 63.
We have reservations ruling on the disallowance of these prepayment accounts of $4.8 million and $2 million in 2015 and 2016, respectively, as well as the inclusion of the entire beginning accounts payable credit balance of $34 million as income for 2015, through summary judgment and without understanding the full impact of these adjustments to other taxable periods. Petitioner now seeks to raise the issue of equitable recoupment and furnished a sworn statement indicating how these adjustments would result in the inclusion of some $38 million in income reported in tax years 2018 and 2019, which are now closed. Although the issue of equitable recoupment is not properly before us; at a minimum, petitioner has created a material issue of fact, precluding summary adjudication of these "prepayment" issues.
Petitioner seeks to raise the affirmative defense of equitable recoupment for the first time in its Opposition to Motion for Summary Judgment. However, petitioner has not affirmatively pleaded this defense as it was not set forth in the Petition. Accordingly, we refrain from ruling on the merits of the affirmative defense of equitable recoupment since it is not properly before the Court.
IV. Accuracy-Related Penalty
Respondent determined that petitioner is liable for an accuracy-related penalty under section 6662(a) for 2015 and 2016 on the grounds of negligence or disregard of rules or regulations or a substantial understatement of income tax.
Section 6662(a) and (b)(1) impose a penalty equal to 20% of the portion of an underpayment that is attributable to negligence or disregard of rules or regulations. "Negligence" includes "any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return." Treas. Reg. § 1.6662-3(b)(1). Negligence also includes a failure of the taxpayer to keep adequate books and records to substantiate items. Id.
Section 6662(a) and (b)(2) also imposes a penalty equal to 20% of the portion of an underpayment of tax required to be shown on a taxpayer's return that is attributable to a "substantial understatement of income tax." An understatement of income tax is a "substantial understatement" if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. I.R.C. § 6662(d)(1)(A).
The Commissioner bears the burden of production with respect to a penalty imposed on an individual taxpayer under section 6662(a) and is required to present sufficient evidence showing that the penalty is appropriate. See I.R.C. § 7491(c); Higbee v. Commissioner, 116 T.C. 438, 446-47 (2001). This includes showing compliance with the procedural requirements of section 6751(b). See I.R.C. § 7491(c); Graev v. Commissioner, 149 T.C. 485, 493 (2017), supplementing and overruling in part 147 T.C. 460 (2016).
Respondent did not address his compliance with the procedural requirements of section 6751(b) in his Motion for Summary Judgment, and we find it premature to decide whether petitioner is liable for the accuracy-related penalty under section 6662(a). Accordingly, we will refrain from deciding these issues.
V. Conclusion
In its Opposition to Motion for Summary Judgment, petitioner does not specifically address the remaining relief sought by respondent. Therefore, we could deem petitioner to have conceded two issues: (1) the disallowance of the deduction for outside services in tax year 2016 and (2) the disallowance of the net operating loss carryforward in 2016, now before the Court. In denying the principal relief sought by respondent, it is unclear whether the purpose of summary judgment would be accomplished here, by us ruling on these additional issues in a piece meal fashion. See, e.g., FPL Grp., Inc. & Subs. 116 T.C. at 74. Accordingly, we refrain from ruling on these remaining issues.
Upon due consideration of the foregoing, it is
ORDERED that respondent's Motion for Summary Judgment, filed August 14, 2023, is denied. It is further
ORDERED that on or before November 20, 2023, the parties shall file a joint report (or separate reports if preferred) outlining the then-present status of this case.