Opinion
Docket No. 92182.
1963-11-20
HOWARD H. PERELMAN AND CARRIE K. PERELMAN, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Lewis Perelman, for the petitioners. John F. Papsidero, for the respondent.
Lewis Perelman, for the petitioners. John F. Papsidero, for the respondent.
In the latter part of 1950, Howard H. Perelman and others formed a partnership to sell improved real estate. In 1951 and 1952, certain parcels of real estate were sold. In each case, the purchaser made a cash downpayment and gave a land contract to evidence the remaining balance of the purchase price. The income from the foregoing sales was reported on the basis that the receipts therefrom did not constitute taxable income until the cost or adjusted basis of the property had first been recovered. For the taxable years 1951 through 1956, petitioner reported their income in the foregoing manner where a sale was made and a land contract was received. Sometime in 1957, one of respondent's agents began an audit of the taxable years 1953, 1954, and 1955. After the audit, respondent took the position that where there was a sale of property and a land contract was received the gain therefrom should be reported in the year in which the sale was made. It was respondent's position that the contracts had a fair market value equal to their face value and consequently the entire amount of the gain should have been reported in the year in which the sale was made, rather than on a deferred basis. Deficiencies for the foregoing years were agreed to and paid by petitioners. Beginning with the taxable year 1957, petitioners began reporting the entire gain from sales where a land contract was received in the year in which the sale was made. In 1957 and 1958, petitioners attached statements to their Federal income tax returns stating that they had received proceeds from sales made in 1951 and 1952 but had not included any portion of this income in the current years because the Internal Revenue Service had changed their method of accounting. In the notice of deficiency, respondent determined that petitioners omitted income from the 1951 sale which should have been reported in 1957 and omitted income from the 1952 sales which should have been reported in 1958. Held:
Whether petitioners' method of accounting was changed or whether there was merely a correction of an error, respondent's determinations were erroneous. (1) If petitioners' method of accounting was changed, respondent initiated the change and any adjustments would be with respect to pre-1954 Code years (1951 and 1952), therefore, no adjustment to petitioners' income is required by section 481(a), 1954 Code, in order to prevent amounts from being omitted. Under the foregoing assumption, section 446(e), 1954 Code, is not applicable since respondent caused petitioners' method of accounting to be changed. (2) if it is assumed that the changes for the years 1953, 1954, and 1955 were merely ‘adjustments' or correction of errors and not a change in petitioners' method of accounting, petitioners must nevertheless prevail. It was no less an ‘adjustment’ or correction of an error when petitioners excluded the income in question and began reporting the gain from sales under land contracts in the year of sale. The evidence indicates that the land contracts from the 1951 and 1952 sales had a fair market value equal to their face amounts when received in the respective years. Therefore, the income from those sales should have been reported in 1951 and 1952 rather than 1957 and 1958 as determined by respondent.
TRAIN, Judge:
Respondent determined deficiencies in the income tax liability of petitioners for the calendar years 1957 and 1958 in the amounts of $1,238.24 and $447.50, respectively.
The sole issue for decision is whether the gain from certain sales made in 1951 and 1952 should be reported in the respective years 1957 and 1958. Other adjustments will be disposed of in the Rule 50 computation.
FINDINGS OF FACT
Petitioners Howard H. Perelman (hereinafter referred to as Howard) and Carrie K. Perelman are husband and wife and reside in Shaker Heights, Ohio. Their Federal income tax returns for the calendar years 1957 and 1958 were filed with the district director of internal revenue in Cleveland, Ohio.
In December 1950, Howard and three other individuals formed a partnership known as Howard King Realty Co. (hereinafter referred to as Realty) to engage in the business of buying and selling improved real estate in the city of Cleveland. By the end of 1953, Howard had purchased the interests of the other partners. Thereafter, he operated Realty as a sole proprietorship.
On July 23, 1951, Realty sold improved real estate located at 1255 East 111th Street, Cleveland, Ohio (hereinafter referred to as the Gaines property), to Leroy and May Lee Gaines for $12,000. The Gaines property had cost Realty approximately $7,400.
The Gaines property was sold under an executory contract of sale more commonly referred to as a ‘land contract.’ A land contract is an evidence of indebtedness in the nature of a bond or note. This type of contract generally provides for a downpayment, in this instance $2,000, with the balance of the sales price payable over a period of years together with interest on the deferred payments.
In addition to the general provisions requiring the purchasers to keep the property insured and requiring them to pay the taxes thereon, the Gaines land contract provided for interest at the rate of 6 percent per annum compounded quarterly in advance and:
payments (on the balance of $10,000) to be due and payable in monthly installments, beginning AUGUST 23, 1951, in the sum of ONE HUNDRED TEN DOLLARS ($110.00), or more which includes interest; said monthly installments of $110.00, or more, shall continue on the (23d) day of each and every month until the principal has been reduced to FIVE THOUSAND AND No/100 DOLLARS ($5,000.00); whereupon first party (Realty) will give second party (Gaines) a good and sufficient Warranty Deed, accompanied by a Title Guarantee in the sum $12,000.00, warranting the title to the within described premises to be free and clear of any and all encumbrances. liens, clouds on title, save and except zoning ordinances, if any; restrictions, conditions, limitations and easements of record, if any; taxes and assessments for the last half of 1951 and thereafter, less those paid in conformity with the provisions set forth below; and encumbrances or liens resulting from acts of commission or omission of the second party.
Simultaneously with the delivery of the deed second party shall execute and deliver to first party their note or notes, secured by mortgage or mortgages, for the balance then due, which shall be due and payable in monthly installments of $110.00 or more, which includes interest, and which monthly installments shall continue until the entire balance of principal and interest has been paid. The said note or notes shall bear interest at the rate of six percent per annum to be computed quarterly in advance.
In addition to the above mentioned monthly installments, there shall be paid each month in connection with the land contract, note or notes, one-twelfth of the annual taxes and assessments on the within described premises to establish a reserve account for the payment of taxes and assessments as same become due and payable.
In the settlement of the transaction, water rent and taxes and assessments shall be pro-rated as of the 23rd day of July, 1951 and the amount due the second party by way of these pro-rations shall be credited as a principal payment on the land contract, which credit shall not waive or affect in any way the monthly installments provided for in the payment of the balance of the land contract.
All policies of insurance covering the premises to be issued during the pendency of this contract shall be issued at the instance of the first party and the premiums thereon paid by the second party, said premiums becoming due and payable immediately upon the issuance of the policy.
The second party must obtain written permission from first party to make any necessary repairs or major improvements on said premises under an installment plan; otherwise, the balance of principal and interest shall immediately become due and payable. This, however, does not preclude or prevent second party from making any necessary repairs or major improvements on a cash basis.
On February 22, 1952, Realty sold improved real estate located at 3304 East 139th Street, Cleveland, Ohio (hereinafter referred to as the Clark property), under a land contract, to Roosevelt and Nora Ila Clark for $15,000. The Clark property had cost Realty $11,098.10. Pursuant to the provisions of the land contract, Realty received an cash downpayment of $4,000. The aforementioned land contract contained essentially the same provisions as the Gaines contract except the Clark contract provided for monthly payments of $100 and the deed to the property was to be conveyed only after the balance owed had been reduced to $7,500.
On May 15, 1952, Realty sold improved real estate located at 1358 East 111th Street, Cleveland, Ohio (hereinafter referred to as the Gregory property), under a land contract, to Sarah Gregory and Joe Gregory for $15,000. The Gregory property had cost Realty $10,000. Pursuant to the land contract, Realty received a cash downpayment of $2,000. The aforementioned land contract contained essentially the same provisions as the Gaines contract except for a lump-sum payment of $500 on November 15, 1953, the monthly payments under the Gregory contract were to be $130 until December 15, 1956, and $105 a month thereafter and a deed was to be conveyed after the balance owed had been reduced to $6,500.
There was a market in land contracts in the years 1951 and 1952. In the market which existed, land contracts such as those which were received on the Gaines, Clark, and Gregory properties had a fair market value and could have been taken to dealers in the community and converted into cash for at least the face amount of the contracts.
Where a piece of property was sold under a land contract, Realty reported the income therefrom on the basis that the receipts did not constitute taxable income until the cost or adjusted basis of the particular piece of property had first been recovered. After Howard purchased the interests of the other partners, he continued to report income from sales where a land contract was received in the foregoing manner through the taxable year ended December 31, 1956. With the exception of sales under land contracts, which were reported in the manner set forth above, petitioners reported their income on a cash basis of accounting.
Sometime in 1957, one of respondent's agents began an audit of the taxable years 1953, 1954, and 1955. After the audit, respondent took the position that, where there was a sale of property and a land contract was received, the gain therefrom should be reported in the year in which the sale was made. It was respondent's position at the time that the contracts had a fair market value equal to their face and that consequently the entire amount of the gain should have been reported in the year in which the sale was made, rather than on a deferred basis. Respondent's agent told Howard that he was being placed on an accrual method of accounting.
For each of the years 1953, 1954, and 1955, respondent included the entire gain from sales where land contracts were received in the year in which the sale was made. Deficiencies for the foregoing years were agreed to and paid by petitioners. Beginning with the taxable year 1957, petitioners began reporting the entire gain from sales where land contracts were received, in the year in which the sale was made.
During the taxable year ended December 31, 1957, Realty sold improved real estate located at 3197 East 81st Street, Cleveland, Ohio (hereinafter referred to as the Murray property), under a land contract, to Cassie B. Murray for $5,000. The Murray property had cost Realty $3,500. Pursuant to the land contract, Realty received a downpayment of $1,300. The aforementioned land contract contained essentially the same provisions as the one executed in connection with the Gaines property except interest was payable at the rate of 8 percent, the monthly payments under the Murray contract were $65, and a deed was to be conveyed only after the entire indebtedness had been paid.
In their income tax return for the taxable year ended December 31, 1957, petitioners included in income the entire gain from the sale of the Murray property. This treatment has not been disturbed by the respondent.
Neither petitioners nor Realty have ever elected to use the installment method of accounting as provided in section 44 of the 1939 Code or section 453 of the 1954 Code.
Petitioners did not report, in 1951, any gain from the sale of the Gaines property nor did they report any gain, in 1952, from the sale of the clark property or the Gregory property. Petitioners attached statements to their Federal income tax returns for the taxable years 1957 and 1958 stating that they received proceeds in those years from sales made in 1951 and 1952 but did not include these receipts in income
because of a determination by the Revenue Service putting the taxpayer on the accrual basis with respect to sales of real estate. This determination has been accepted and additional income tax paid as a result thereof. Consistent with this determination by the Revenue Service, this income tax return is filed on the accrual basis.
In the notice of deficiency, respondent made the following determinations:
(a) In your income tax return filed for the taxable year ended December 31, 1957, you failed to report income of $2,476.51 from the sale of real estate located at 1255 East 111th St., Cleveland, Ohio. Accordingly, your taxable income has been increased by this amount.
(a) In your income tax return filed for the taxable year ended December 31, 1958, you failed to report income of $2,662.41 and $2,840.63 from sales of properties located at 3304 E. 139th St., Cleveland, Ohio, respectively. Accordingly, your income has been increased by the total amount of $5,503.04.
OPINION
In their petition, petitioners alleged that the gain from the sale of the Gaines, Clark, and Gregory properties was not includable in their income for the respective years 1957 and 1958 because respondent had changed their method of accounting. On brief petitioners took somewhat of an alternative approach and contended that the gain from the respective properties should have been reported in 1951 and 1952 when the sales were made. Petitioners argue that they received, in the year of sale, cash and property equal to the total sales price of each piece of property and that this amount was in excess of the adjusted basis of each piece of property for determining gain. Therefore, petitioners contend that under sections 111
SEC. 111. DETERMINATION OF AMOUNT OF, AND RECOGNITION OF, GAIN OR LOSS.(a) COMPUTATION OF GAIN OR LOSS.— The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 113(b) for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.(b) AMOUNT REALIZED.— The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.(c) RECOGNITION OF GAIN OR LOSS.— In the case of a sale or exchange, the extent to which the gain or loss determined under this section shall be recognized for the purposes of this chapter, shall be determined under the provisions of section 112.
of the 1939 Code the gain in question should have been reported in 1951 and 1952 rather than in 1957 and 1958.
SEC. 112. RECOGNITION OF GAIN OR LOSS.(a) GENERAL RULE.— Upon the sale or exchange of property the entire amount of the gain or loss, determined under section 111, shall be recognized, except as hereinafter provided in this section.
Respondent contends that the gain from the three sales in question should be reported in 1957 and 1958 as determined in the notice of deficiency. To support his position, respondent contends that petitioners voluntarily changed their method of accounting in 1957. Respondent contends that from 1951 through 1956 petitioners reported on the cash basis and then changed to the accrual method in 1957 to avoid the payment of taxes on the income from the 1951 and 1952 sales. In his opening statement, respondent stated that the changes he himself had made in the earlier years were merely ‘adjustments' and limited solely to the years involved. Respondent asserted that ‘the adjustments were such that the respondent felt that the land contracts had value and therefore under a cash basis of accounting, they are properly includable in income’ in the year of sale. Respondent stated that, in any event, there had been no requirement that petitioners change their method of accounting. Respondent next contends that the courts have followed the rule that, where deferred payments are evidenced only by a contract, as in this case, and no other evidence of indebtedness, such as a note or bond, is given to the vendor, the amount of the deferred payments should be included in income only when the payment is received. Harold W. Johnston, 14 T.C. 560 (1950). Therefore, respondent contends the gain should be reported in 1957 and 1958. Respondent's final contention is that, in any event, petitioners have failed to prove the land contracts in question had a fair market value in 1951 and 1952.
We have concluded that respondent's contentions must be rejected.
In essence, respondent has taken the position that the changes he made for the years 1953, 1954, and 1955 were merely corrections of errors, whereas, in the later years petitioners voluntarily changed their method of accounting by taking the same action. Then, respondent apparently proceeds to accept the new method for one purpose, i.e., to tax petitioners on the gain from The Murray sale in 1957, and reject it for another, i.e., to include the income from the 1951 and 1952 sales in 1957 and 1958. This position is untenable.
Assuming, arguendo, that petitioners' method of accounting was changed, sections 446 and 481 of the 1954 Code
Unless otherwise stated, all references are to the Internal Revenue Code of 1954.
As originally enacted, section 481(a)
provided that where taxable income for any year is computed under a method of accounting different from the method under which income was computed for the preceding year, there shall be taken into account those adjustments determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted. However, an exception was made for any adjustment in respect of any taxable year to which section 481 did not apply; that is, a year not covered by the 1954 Code. Subsequently, the Technical Amendments Act of 1958 retroactively amended section 481(a)
SEC. 481. ADJUSTMENTS REQUIRED BY CHANGES IN METHOD OF ACCOUNTING.(a) GENERAL RULE.— In computing the taxpayer's taxable income for any taxable year (referred to in this section as the ‘year of the change’)—(1) if such computation is under a method of accounting different from the method under which the taxpayer's taxable income for the preceding taxable year was computed, then(2) there shall be taken into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted, except there shall not be taken into account any adjustment in respect of any taxable year to which this section does not apply.
to provide that no adjustment in respect to pre-1954 Code years would be taken into account ‘unless the adjustment is attributable to a change in the method of accounting initiated by the taxpayer.’
The amended paragraph now reads:(2) there shall be taken into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted, except there shall not be taken into account any adjustment in respect of any taxable year to which this section does not apply unless the adjustment is attributable to a change in the method of accounting initiated by the taxpayer.
If the petitioners' method of accounting were changed, the crucial inquiry, under section 481(a), is whether the taxpayers ‘initiated'
the change. It is readily apparent that they did not. Prior to 1957, petitioners' method of accounting for sales, where a land contract was received, was to report the gain on a deferred basis. Respondent changed this method and compelled petitioners to report the gain from this type of sale in the year in which it was made. Respondent's action in this respect was no mere suggestion that petitioners make a change. Cf. Irving Falk, 37 T.C. 1078 (1962), on appeal (C.A. 5, July 30, 1962). Respondent took the first step to set the change in motion and took overt steps to cause it to be made; therefore, we conclude that petitioners did not initiate the change. United States v. Lindner, 307 F2d 262 (C.A. 10, 1962); cf. Fred P. Pursell, 38 T.C. 263 (1962), affirmed per curiam 315 F.2d 629(C.A. 3, 1963). Thereafter petitioners merely began using the new method at the first available opportunity— 1957.
As used in section 481(a) (2), the word ‘initiate’ has been interpreted to mean ‘to introduce by a first act: to make a beginning with; to originate; begin.’ Fred P. Pursell, 38 T.C. 263 (1962), affirmed per curiam 315 F.2d 629 (C.A. 3, 1963); United States v. Lindner, 307 F2d 262 (C.A. 10, 1962). Changes in methods of accounting initiated by the taxpayer include a change in method of accounting which he originates, by requesting permission of the Commissioner to change, and also cases where taxpayer shifts from one method of accounting to another without the Commissioner's permission. A change in the taxpayer's method of accounting required by a revenue agent upon examination of the taxpayer's return would not, however, be considered as initiated by the taxpayer. H. Rept. No. 775, 85th Cong., 1st Sess., p.20 (1957), 1958-3 C.B. 830; S. Rept. No. 1983, 85th Cong., 2d Sess., p. 45 (1958), 1958-3 C.B.966.
It would be unreasonable to expect them to have done otherwise. Having made his decision, respondent must abide by it with all its attendant consequences. Since respondent ‘initiated’ the change and any adjustments would be with respect to pre-1954 Code years (1951 and 1952), no adjustments are required by section 481(a). Consequently, respondent's determination for 1957 and 1958 cannot be sustained under section 481.
While it is true that petitioners stated in their returns that they were reporting on an ‘accrual basis,‘ we are satisfied that they only referring to the fact that they had changed their method of reporting gain from sales where a land contract was received. The use of the label ‘accrual basis' was, no doubt, due to the revenue agent's statement that petitioners were being placed on the accrual method of accounting. Respondent made no attempt, at the trial, to refute this view; although the examining agent was present at the trial, he did not testify.
Even if we were to assume, arguendo, that a change in petitioners' method of accounting was voluntarily made by petitioners, the amounts respondent determined for the years 1957 and 1958 appear to be erroneous. The adjustments required by section 481(a) are taken into account in the year of change, unless one of the spreading provisions of section 481(b) is applicable. Thus, it is possible that no deficiency could be sustained for 1958 and the determination for 1957 be limited to the amount determined since respondent has not asked for a greater deficiency in 1957, or the deficiencies for each year could be less than determined depending on which one of the spreading provisions of section 481(b) might be applicable.
Respondent has not cited or discussed the applicability of section 446, but he appears to rely on section 446(e)
inferentially. If petitioners had changed their method of accounting without first requesting the permission of the respondent, it is possible he could have insisted that they revert to their old method. However, respondent can find no support in section 446(e) for his determinations since he was the one who caused the change to be made.
SEC. 446. GENERAL RULE FOR METHODS OF ACCOUNTING.(e) REQUIREMENT RESPECTING CHANGE OF ACCOUNTING METHOD.— Except as otherwise expressly provided in this chapter, a taxpayer who changes the method of accounting on the basis of which he regularly computes his income in keeping his books shall, before computing his taxable income under the new method, secure the consent of the Secretary or his delegate.
Even assuming, arguendo, that petitioners did change their method of accounting without first seeking the permission of the Commissioner, it is again doubtful that the correct deficiencies were determined for 1957 and 1958. The Gaines contract provided for monthly payments of $110 each, yet respondent determined that petitioners had a gain of $2,476.51 in 1957. The Clark contract provided for monthly payments of $100 each and the Gregory contract provided for monthly payments of $105 each in the later years, yet respondent determined that income from the respective contracts was $2,662.41 and $2,840.63 in 1958. At the very least, it would appear that an adjustment should have been made in petitioners' income for 1957 because of the Murray sale. The entire gain on the sale of the Murray property was taken into account in the year of sale which was contrary to petitioners' prior method.
Finally, if we assume, arguendo, that respondent is correct, and that the changes he made for the years 1953, 1954, and 1955 were merely ‘adjustments' or a correction of errors and not a change in petitioners' method of accounting, petitioners must still prevail. Certainly, if the change made by respondent in 1953-55 was merely an adjustment or correction, then the identical change made by petitioners in 1957 and 1958 can only be characterized in similar fashion. When, in 1957 and 1958, petitioners began reporting the entire gain from sales, where a land contract was received, in the year in which the sale was made, the change was entirely consistent with the position respondent took for the prior years and the method was supported fully by the evidence of fair market value of the contracts in question.
The uncontradicted testimony of petitioners' expert witness, which we accept, was that the land contracts from the 1951 and 1952 sales had a fair market value equal to their face amount in the respective years in which they were received.
Therefore, the income from the sales in 1951 and 1952 should have been reported in those years rather than in 1957 and 1958. John W. Commons, 20 T.C. 900 (1953); secs. 111 and 112, 1939 Code, supra. The fact that a taxpayer has not paid income tax on income in a previous period does not make it income in a subsequent period it it does not belong in that year. See Security Mills Co. v. Commissioner, 321 U.S. 281 (1944); Welp v. United States, 201 F.2d 128 (C.A. 8, 1953); Lauinger v. Commissioner, 281 F.2d 419 (C.A. 2, 1960), remanding on another issue 31 T.C. 934 (1959); Pacific Coast Biscuit Co., 32 B.T.A. 39 (1935); Jamieson v. United States, 10 F.Supp. 321 (D. Mass. 1935). Commissioner v. Dwyer, 203 F2d 522 (C.A. 2, 1953), affirming a Memorandum Opinion of this Court.
Although respondent took the position that in 1953, 1954, and 1955 the land contracts had a fair market value equal to their face value, he apparently now takes the position that as a matter of law the land contracts received in 1951 and 1952 could have no fair market value. Contrary to this latter view, land contracts can and do at times have a fair market value. See Darby Investment Corporation, 37 T.C. 839 (1962), affd. 315 F.2d 551 (C.A. 6, 1963); sec. 1.1001-1(a), Income Tax Regs.; cf. Nina H. Ennis, 17 T.C. 465 (1951). Whether a land contract has a fair market value is a question of fact to be decided after a consideration of all the attendant circumstances.
We conclude that respondent's determinations for 1957 and 1958 were erroneous. Accordingly, we hold for the petitioners on this issue.
Reviewed by the Court.
Decision will be entered under Rule 50.