Opinion
Docket Nos. 46065 46066.
1955-03-15
CURTIS R. ANDREWS AND CAROL W. ANDREWS, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.CURTIS R. ANDREWS, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Pell Hollingshead, Esq., for the petitioners. Charles Speed Gray, Esq., and Arthur Clark, Jr., Esq., for the respondent.
Pell Hollingshead, Esq., for the petitioners. Charles Speed Gray, Esq., and Arthur Clark, Jr., Esq., for the respondent.
1. Petitioner Curtis R. Andrews and another individual formed a partnership in 1938, which thereafter conducted several dancing schools. The partnership kept its books on the accrual system. It treated prepaid tuition receipts as deferred income, reporting as income each year that portion of the receipts which represented lessons taught during the year. When the partnership was terminated in 1948, it had prepaid tuition receipts in the amount of $272,958.80 in its Unearned Tuition account, which had not yet been taken into income. Petitioner operated one of the schools as a sole proprietor in 1948 and reported as income on his return for that year that portion of his prepaid tuition receipts allocable to lessons taught during the year. Held, the prepaid tuition fees were received under a claim of right, without restriction as to their use or disposition and, therefore, constituted income in the year of receipt. Petitioners' income for the years here in issue must be increased by petitioner's distributive share of prepaid tuition fees which were not reported as income during each of such years.
2. In 1948, petitioner and his partner entered into a contract terminating their partnership. Under the terms of this contract, petitioner received one of the partnership's schools and sold his remaining interest in the partnership to his partner for cash in the amount of $26,914.42, plus her contractual agreement to pay him $100,000 in monthly installments of not less than $1,000. The payment of the $100,000 was guaranteed by another individual but the contractual agreement to pay this sum was not supported by any negotiable instrument. Nine monthly installments of $1,000 each were paid to petitioner during 1948. Respondent determined that petitioner realized a capital gain on the sale of his partnership interest measured by the difference between his adjusted basis ($82,486.95) and the sum of the various assets received by petitioner on the termination of the partnership ($164,300.14). Held, the $100,000 contractual obligation is not the equivalent of cash, and petitioner realized no capital gain in 1948 on the sale of his partnership interest since the amount realized during that year was less than his basis for such interest.
These consolidated proceedings involve deficiencies in taxes determined against Curtis R. Andrews and Carol W. Andrews as follows:
+-----------------------------------------------------------------+ ¦Petitioners ¦Docket¦ ¦Year¦Tax ¦Deficiency¦ +---------------------+------+-+----+------------------+----------¦ ¦ ¦No. ¦ ¦ ¦ ¦ ¦ +---------------------+------+-+----+------------------+----------¦ ¦ ¦ ¦(¦1943¦Income and Victory¦$4,056.99 ¦ +---------------------+------+-+----+------------------+----------¦ ¦Curtis R. Andrews ¦46066 ¦(¦1944¦Income ¦15,427.26 ¦ +---------------------+------+-+----+------------------+----------¦ ¦ ¦ ¦(¦1945¦-----do ¦18,523.47 ¦ +---------------------+------+-+----+------------------+----------¦ ¦ ¦ ¦(¦1946¦-----do ¦51,972.27 ¦ +---------------------+------+-+----+------------------+----------¦ ¦Curtis R. Andrews and¦ ¦ ¦ ¦ ¦ ¦ +---------------------+------+-+----+------------------+----------¦ ¦Carol W. Andrews ¦46065 ¦ ¦1948¦-----do ¦83,377.84 ¦ +-----------------------------------------------------------------+
The issues to be decided are: (1) Whether advance tuition fees, received by a partnership of which petitioner Curtis R. Andrews was a member, constituted income in the year of receipt; and (2) whether petitioner Curtis R. Andrews realized a long-term capital gain in the amount of $81,813.19 upon the sale of his interest in the partnership.
Some of the facts were stipulated.
FINDINGS OF FACT.
The stipulated facts are so found and are incorporated herein by this reference.
Curtis R. Andrews (hereinafter referred to as petitioner) and Carol W. Andrews are husband and wife, now residing in Ann Arbor, Michigan. Petitioner filed individual income tax returns for the taxable years 1942 through 1946, and he and his wife filed a joint return, on the cash basis, for the taxable year 1948 with the collector of internal revenue for the district of Michigan.
In May 1938, petitioner and one Doris Eaton entered into an oral agreement (subsequently formalized by a written agreement) for the formation of a copartnership to engage in the business of furnishing dancing instruction under the name of Arthur Murray Studios of Michigan. Thereafter, the partnership operated dance studios in Detroit, Birmingham, and Flint, Michigan, and in Toledo, Ohio. The partnership furnished dancing instruction principally on a private-lesson basis to individual students, although there was some class instruction. The students contracted for a specified number of lessons and paid the tuition fees in advance, either by lump-sum payments of cash or by the execution of promissory notes. If payment was made by note, the note was immediately negotiated by sale to a bank, with full recourse, at a discount of 6 per cent. The discounted proceeds of such notes were deposited in the partnership's general bank accounts without segregation from other partnership funds and without restriction as to their use.
Under the direction of a certified public accounting firm employed by the partnership, its books were set up on the accrual system, and advance tuition payments (including the proceeds of discounted notes) were treated as deferred income. By means of individual records maintained for each student, an inventory was prepared at the end of each year showing the total number of prepaid lessons still to be taught. The receipts, with respect to the lessons which had been taught during the year, were reflected in income for that year on the books of the partnership and on its returns. The balance of the prepaid receipts was designated as Unearned Tuition and credited to income in subsequent years as the lessons were taught. In the opinion of the accountant who set up this system, it represented proper accounting practice.
Occasionally, students would fail to pay balances due on notes which had been discounted. The partnership redeemed such notes and charged the unpaid balances due on them to the Unearned Tuition account. The partnership discouraged the cancellation of students' contracts and tuition fees were refunded only as a matter of maintaining good public relations. The receipts given to students were marked ‘No Cash Refunds'; and, beginning in 1947, the notes executed by the students were, by their terms, ‘Non-Cancellable.’ Refunds were made in hardship cases where students became incapacitated through illness, where students entered military service before completing their course of instruction, and when the contracts of minors were disavowed. The record does not disclose the extent to which the partnership was obliged to redeem students' notes which had been discounted or to refund advance tuition payments.
When a student discontinued the course before taking all the lessons for which he had paid, if no question of a refund was involved, the balance of prepaid receipts on his record would be credited to income for that year. Also taken into account each year were all prepayments of $20 or less credited to the accounts of inactive students. Upon inventorying the students' cards at the end of the year, it would occasionally be discovered that a student had received more lessons than he had paid for. The amount due on such additional lessons would be taken into income for that year.
In keeping its books, the partnership treated prepaid deductible items such as taxes, rent, and insurance as an asset account and deducted such expenses pro rata over the balance of the period for which they had been prepaid.
The following table sets forth, for each of the years 1942 through 1947 and for the period January 1 through January 31, 1948, the total amounts of prepaid income received by the partnership, the amounts reported as gross income, the balance in the Unearned Tuition account at the end of each of such periods, and the increase or decrease in the Unearned Tuition account during each of such periods:
+----+ ¦¦¦¦¦¦ +----+
Closing balance Increase (or Year or period Prepaid Amount of unearned decrease) in ended income reported as tuition unearned received income account tuition account Dec. 31, 1941 $22,363.99 Dec. 31, 1942 $120,804.01 $113,146.79 30,021,21 $7,657.22 Dec. 31, 1943 181,084.88 168,227.42 42,878.67 12,857.46 Dec. 31, 1944 236,792.82 182,767.04 96,904.45 54,025.78 Dec. 31, 1945 343,317.70 288,702.81 151,519.34 54,614.89 Dec. 31, 1946 727,801.70 580,564.73 298,756.31 147,236.97 Dec. 31, 1947 450,365.23 472,897.21 276,224.33 (22,531.98) Jan. 31, 1948 50,708.11 53,973.64 272,958.80 (3,265.53)
Partnership returns of income for the taxable years 1942 through 1947, treating prepaid income as hereinabove described, reported the following amounts as net income for such years, and the amounts credited to the partners' investment accounts as follows:
+----------------------------------------+ ¦Year¦Net income ¦Andrews ¦Eaton ¦ +----+-------------+----------+----------¦ ¦1942¦$21,104.91 ¦$10,887.70¦$10,217.21¦ +----+-------------+----------+----------¦ ¦1943¦34,298.48 ¦17,812.53 ¦16,485.95 ¦ +----+-------------+----------+----------¦ ¦1944¦27,409.93 ¦13,704.97 ¦13,704.96 ¦ +----+-------------+----------+----------¦ ¦1945¦49,142.07 ¦24,571.04 ¦24,571.04 ¦ +----+-------------+----------+----------¦ ¦1946¦50,844.67 ¦25,422.33 ¦25,422.34 ¦ +----+-------------+----------+----------¦ ¦1947¦1 54,061.12¦27,030.56 ¦27,030.56 ¦ +----+-------------+----------+----------¦ ¦ ¦ ¦ ¦ ¦ +----------------------------------------+ According to the records of the partnership for the period January 1 to January 31, 1948, a net income of $12,187.45 was earned for such period. One-half of this amount was credited to the investment account of each partner.
The partners' drawings from the partnership during the years 1942 through 1947 and the period January 1 to January 31, 1948, were in the following amounts:
+------------------------------+ ¦Year ¦Andrews ¦Eaton ¦ +--------+----------+----------¦ ¦1942 ¦$15,000.23¦$13,671.33¦ +--------+----------+----------¦ ¦1943 ¦25,373.44 ¦23,680.96 ¦ +--------+----------+----------¦ ¦1944 ¦23,178.27 ¦25,139.63 ¦ +--------+----------+----------¦ ¦1945 ¦29,429.94 ¦26,538.68 ¦ +--------+----------+----------¦ ¦1946 ¦37,488.48 ¦31,606.04 ¦ +--------+----------+----------¦ ¦1947 ¦28,522.92 ¦27,994.92 ¦ +--------+----------+----------¦ ¦1948 1 ¦7,042.21 ¦7,104.16 ¦ +------------------------------+
Respondent also determined that petitioner's income from the operation of the Toledo studio as a sole proprietor during 1948 was understated by reason of his failure to include $10,965.12 in advance tuition sales when received.
OPINION.
RICE, Judge:
The first issue to be decided is the correctness of respondent's determination that the entire amount of the partnership's advance tuition fees must be included in income in the year of receipt, regardless of the number of prepaid lessons remaining to be taught at the end of such year. Petitioner argues that an accrual basis taxpayer's treatment of prepaid tuition receipts as deferred income is in accord with generally accepted accounting practice and that respondent erred in determining that, as a matter of law, such system failed to clearly reflect income.
Irrespective of the merits of the generally accepted commercial accounting treatment of prepaid income, it has been clearly established that, under the ‘claim of right’ doctrine, prepaid income must be reported as income in the year of receipt. South Dade Farms v. Commissioner, 138 F.2d 818 (C.A. 5, 1943); Wallace A. Moritz, 21 T.C. 622 (1954); Your Health Club, Inc., 4 T.C. 385 (1944); South Tacoma Motor Co., 3 T.C. 411 (1944). The essential criterion of these cases is present here; namely, that there was no restriction as to the use or disposition of the prepaid receipts. See Brown v. Helvering, 291 U.S. 193 (1934); North American Oil v. Burnet, 286 U.S. 417 (1932). The fact that some portion of such receipts might have to be refunded in the future did not affect their nature as income. North American Oil v. Burnet, supra.
The record before us indicates that the members of the partnership made unrestricted use of their prepaid receipts despite the tenets of their accounting system that such receipts were to be considered as deferred income, a liability account, until services were actually rendered therefor. Thus, upon dissolution of the partnership, the aggregate amount of prepaid receipts deferred as Unearned Tuition was $272,958.80; whereas the cash account of the partnership amounted to only $47,495.82. Although the partnership recorded a total net income of $249,048.63 for the period from 1942 until its dissolution in 1948, the partners had withdrawn a total of $321,771.21 during this period and their capital accounts showed a deficit of $107,945.70 on January 31, 1948.
Notwithstanding this unrestrained use of prepaid receipts, the partnership's accounting system may well have ‘clearly reflected income’ according to generally accepted commercial accounting practice. However, accounting practice must bow to established rules of law in the determination of taxable income. The ‘claim of right’ doctrine is firmly established and must govern the result herein. We agree with the dissenting opinion in Beacon Publishing Co. v. Commissioner, 218 F.2d 697 (C.A. 10, 1955), reversing 21 T.C. 610 (1954), that, ‘under the settled law in force at the time, the entire amount received for prepaid subscriptions constituted income returnable for the year in which it was received, even though the taxpayer kept its books and made its returns on the accrual basis.’ Respondent did not err in determining, pursuant to section 41 of the Internal Revenue Code of 1939, that the method employed by the partnership did not clearly reflect its income and that the entire amount of prepaid tuition fees constituted income in the years in which received. Automobile Club of Michigan, 20 T.C. 1033 (1953), on appeal (C.A. 6, Mar. 4, 1954). The divergencies which have developed between the tax and accounting methods of computing income have been recognized by the Congress
and a change in the law was made in the Internal Revenue Code of 1954 for the deferral of prepaid income.
The record does not disclose why, for the purpose of this computation, respondent determined that petitioner's share of the partnership's distributive income in 1947 should be decreased by $10,860.43 whereas, in Docket No. 46066, he determined that the decrease for 1947 should be in the amount of $3,574.61.
But petitioner is governed by the Internal Revenue Code of 1939 for the years here in issue and, consequently, his distributive share of partnership income for each of such years must be increased by his proportionate share of prepaid income not reported as income by the partnership in the year of receipt. A similar adjustment must be made with respect to the prepaid receipts received by petitioner in the operation of his sole proprietorship in 1948.
The second issue herein concerns respondent's determination that petitioner realized a capital gain in the amount of $81,813.19 upon the sale of his interest in the partnership. Respondent computed such gain by subtracting the adjusted basis of petitioner's investment account in the partnership ($82,486.95) from the sum of the various assets received by petitioner upon the termination of the partnership ($164,300.14).
However, petitioner reported his income on the cash basis during the year in issue, 1948; and, consequently, only cash or its equivalent can be used in computing gain or loss realized by him.
Respondent's actual computation is somewhat more complex because he first reduces the adjusted basis of petitioner's partnership interest by one-half the book value of the Toledo studio on the theory that petitioner did not sell his interest in this particular partnership asset. In computing the amount received by petitioner, he makes a compensating adjustment and includes only one-half the book value of the Toledo studio.
John B. Atkins, et al., 9 B.T.A. 140 (1927). He, therefore, contends that the $100,000 contractual agreement which he received as part payment for his partnership interest cannot be considered as the equivalent of cash or as having any ascertainable fair market value. He argues that only the $9,000 actually received on the $100,000 contractual agreement during 1948 can be included in the computation of gain for that year and that no taxable gain is reportable for the year 1948 since the ‘amount realized’ during that year was less than the basis for his partnership interest. Estate of Clarence W. Ennis, 23 T.C. 799 (1944); Nina J. Ennis, 17 T.C. 465 (1951); Harold W. Johnston, 14 T.C. 560 (1950); Dudley T. Humphrey, 32 B.T.A. 280 (1935).
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 * * *(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.
Petitioner relies on Nina J. Ennis, supra, wherein we stated that ‘in determining what obligations are the ‘equivalent of cash’ the requirement has always been that the obligation, like money, be freely and easily negotiable so that it readily passes from hand to hand in commerce.' The promise of petitioner's partner to make deferred payments to him aggregating $100,000 was embodied in the agreement terminating their partnership. Although accompanied by the guaranty of another individual, this was merely a contractual obligation. It ‘was not embodied in a note or other evidence of indebtedness possessing the element of negotiability and freely transferable.’ Nina J. Ennis, supra. In computing the ‘amount realized from the sale, of property by a cash basis taxpayer, we do not consider that a promise such as here to make a series of deferred payments, which is embodied solely in a contract of sale of a type not commonly sold and with no readily ascertainable fair market value, constitutes ‘property (other than money) received.’
We, therefore, conclude that petitioner realized no taxable gain on the dissolution of the partnership in 1948 because the sum of the $9,000 paid on the contract in that year plus the other property received during that year did not exceed his adjusted basis in the assets of the partnership.
Decisions will be entered under Rule 50.
+---------------------------------+ ¦Year ¦Andrews ¦Eaton ¦ +--------+------------+-----------¦ ¦1942 ¦($14,052.30)¦($9,075.96)¦ +--------+------------+-----------¦ ¦1943 ¦(21,613.21) ¦(16,270.97)¦ +--------+------------+-----------¦ ¦1944 ¦(31,086.51) ¦(27,705.64)¦ +--------+------------+-----------¦ ¦1945 ¦(35,998.91) ¦(29,726.79)¦ +--------+------------+-----------¦ ¦1946 ¦(53,880.71) ¦(35,999.99)¦ +--------+------------+-----------¦ ¦1947 ¦(55,606.34) ¦(50,380.44)¦ +--------+------------+-----------¦ ¦1948 1 ¦(56,554.83) ¦(51,390.87)¦ +---------------------------------+
+--------------------------------------------------------------------+ ¦Cash from Eaton ¦$26,914.42 ¦ +--------------------------------------------------------+-----------¦ ¦Eaton's contractual obligation ¦100,000.00 ¦ +--------------------------------------------------------+-----------¦ ¦Net book value of Toledo studio (including cash in bank)¦36,985.72 ¦ +--------------------------------------------------------+-----------¦ ¦Adjustment of drawing account ¦1 400.00 ¦ +--------------------------------------------------------+-----------¦ ¦Total ¦$164,300.14¦ +--------------------------------------------------------+-----------¦ ¦ ¦ ¦ +--------------------------------------------------------------------+
+------------------------+ ¦Year¦Increase ¦Decrease ¦ +----+---------+---------¦ ¦1942¦$4,217.81¦ ¦ +----+---------+---------¦ ¦1943¦6,857.36 ¦ ¦ +----+---------+---------¦ ¦1944¦26,928.32¦ ¦ +----+---------+---------¦ ¦1945¦27,430.40¦ ¦ +----+---------+---------¦ ¦1946¦73,810.17¦ ¦ +----+---------+---------¦ ¦1947¦ ¦$3,574.61¦ +------------------------+
In Docket No. 46065, involving the year 1948, respondent determined that petitioner's distributive share of partnership income for the period January 1 to January 31, 1948, should be increased by $136,479.40 to reflect one-half the balance in the partnership's Unearned Tuition account on January 31, 1948.
Respondent allocated 55 per cent of the balance in the Unearned Tuition account as of December 31, 1941, to petitioner on the basis that his share of partnership profits and losses was larger than Eaton's during the earlier years.
This determination is inconsistent with that in Docket No. 46066 relating to the years 1942 through 1946. Thus, respondent seeks to tax prepaid receipts in each of the years in which they were received or, alternatively, to tax in the year of the partnership's dissolution, the balance of such amounts which had not been reported as income. 2. S. Rept. No. 1622, 83d Cong., 2d Sess. (1954), pp. 62, 63:Present law provides that the net income of a taxpayer shall be computed in accordance with the method of accounting regularly employed by the taxpayer, if such method clearly reflects the income, and the regulations state that approved standard methods of accounting will ordinarily be regarded as clearly reflecting taxable income. Nevertheless, as a result of court decisions and rulings, there have developed many divergencies between the computation of income for tax purposes and income for business purposes as computed under generally accepted accounting principles. The areas of difference are confined almost entirely to questions of when certain types of revenue and expenses should be taken into account in arriving at net income.Under present law payments received in advance for the use of property in future years or for services to be rendered in future years are includible in the income of the recipient in the year they are received. This is true regardless of the taxpayer's method of accounting. However, well-established accounting procedure provides that in the case of those on an accrual accounting system payments for rentals, club dues, warehouse fees, and the like should be included in income in the year in which the income is earned and in the year in which the related expenses are incurred. This is not necessarily the year of receipt.The House and your committee's bill permit accrual-basis taxpayers to defer the reporting of advance payments as income until the year, or years, in which, under the taxpayer's regular method of accounting, the income is earned. * * * 3. Sec. 452.
Respondent further determined that petitioner realized capital gains in the amount of $81,813.19 in 1948 upon the dissolution of the partnership. Such gains were computed by subtracting the adjusted cost basis of petitioner's investment account in the partnership ($82,486.95) from the sum of the assets received by petitioner upon the termination of the partnership ($164,300.14). Respondent determined the adjusted cost basis of petitioner's capital investment account in the partnership, in the foregoing computation, by adding to his capital account the advance tuition fees deferred by the partnership since its inception, as follows:
+--------------------------------------------------------------------------+ ¦Petitioners' capital investment account, as of Jan. 31, 1948,¦ ¦ +-------------------------------------------------------------+------------¦ ¦per partnership books ¦ ¦($56,554.83)¦ +------------------------------------------+------------------+------------¦ ¦55 per cent of balance in ¦ ¦ ¦ +------------------------------------------+------------------+------------¦ ¦Unearned Tuition account ¦ ¦ ¦ +------------------------------------------+------------------+------------¦ ¦as of Dec. 31, 1941 ¦1 $12,300.19 ¦ ¦ +------------------------------------------+------------------+------------¦ ¦Increases (or decreases) in ¦ ¦ ¦ +------------------------------------------+------------------+------------¦ ¦petitioner's distributive ¦ ¦ ¦ +------------------------------------------+------------------+------------¦ ¦share of partnership income: ¦ ¦ ¦ +------------------------------------------+------------------+------------¦ ¦1942 ¦4,217.81 ¦ ¦ +------------------------------------------+------------------+------------¦ ¦1943 ¦6,857.36 ¦ ¦ +------------------------------------------+------------------+------------¦ ¦1944 ¦26,928.32 ¦ ¦ +------------------------------------------+------------------+------------¦ ¦1945 ¦27,430.40 ¦ ¦ +------------------------------------------+------------------+------------¦ ¦1946 ¦73,810.17 ¦ ¦ +------------------------------------------+------------------+------------¦ ¦1947 ¦2 (10,860.43) ¦ ¦ +------------------------------------------+------------------+------------¦ ¦January 1 through January 31, 1948 ¦(1,642.04) ¦139,041.78 ¦ +------------------------------------------+------------------+------------¦ ¦Adjusted basis ¦ ¦$82,486.95 ¦ +------------------------------------------+------------------+------------¦ ¦ ¦ ¦ ¦ +--------------------------------------------------------------------------+