Opinion
Docket No. 39575.
1954-04-8
CLEMENT A. BAUMAN AND MABEL BAUMAN, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
John S. Murtha, Esq. , for the petitioners. Lester H. Salter, Esq. , for the respondent.
The petitioners made their returns on the cash basis. The petitioners' business required the use of inventories. The respondent determined a deficiency for 1949 by adding to the petitioners' income reported on the cash basis a sum arrived at by adding to the cash income reported, closing accounts receivable and inventory on hand on December 31, 1949, and deducting accounts payable as of that date. Held, the petitioners' books and records were kept on an accrual basis and petitioners' net income should be computed on that basis for the taxable year, and the respondent's determination is in error because it was not computed on an accrual basis. Commissioner v. Dwyer, 203 F. 2d 522, and Caldwell v. Commissioner, 202 F. 2d 112, followed. John S. Murtha, Esq., for the petitioners. Lester H. Salter, Esq., for the respondent.
The respondent determined a deficiency in income tax for 1949 of $19,680.84. The deficiency is due to three adjustments made by the Commissioner to the net income reported by petitioners on their joint return filed for the year 1949. These adjustments were:
+------------------------------+ ¦(a) Wages ¦$15.78 ¦ +--------------------+---------¦ ¦(b) Dividends ¦12.00 ¦ +--------------------+---------¦ ¦(c) Business income ¦49,183.17¦ +------------------------------+ Adjustment (c) was computed in the deficiency notice as follows:
+-----------------------------------------------------------------------------+ ¦Interest expense included repayment of principal ¦$1,227.11 ¦ +------------------------------------------------------------------+----------¦ ¦Deduction for depreciation was overstated due to error in ¦275.58 ¦ ¦computation ¦ ¦ +------------------------------------------------------------------+----------¦ ¦Accounts receivable not previously reported as income ¦67,978.83 ¦ +------------------------------------------------------------------+----------¦ ¦Cost of inventory on hand Dec. 31, 1949 not previously reported ¦18,927.66 ¦ +------------------------------------------------------------------+----------¦ ¦Total additions ¦$88,409.18¦ +------------------------------------------------------------------+----------¦ ¦[Less] Accounts payable not previously deducted as expense ¦39,226.01 ¦ +------------------------------------------------------------------+----------¦ ¦Net adjustment to income ¦$49,183.17¦ +-----------------------------------------------------------------------------+
Of the foregoing adjustments petitioners do not contest adjustments (a) and (b). The Commissioner concedes error as to that part of adjustment (c) which relates to interest and the parties are agreed as to petitioners' deduction for interest. Petitioners do not contest that part of adjustment (c) which relates to depreciation. Petitioners by appropriate assignments of error contest the remainder of the adjustments made by the Commissioner in adjustment (c).
The issues for decision are whether the petitioners' books were kept on the cash or an accrual basis and, if kept on an accrual basis, whether the respondent was correct in determining a deficiency for 1949 by adding to the petitioners' income for that year as reported on the cash basis, closing accounts receivable and inventory and deducting closing accounts payable without computing petitioners' net income for that year on an accrual basis.
FINDINGS OF FACT.
The petitioners are residents of Lakeville, Connecticut. They filed with the collector of internal revenue at Hartford, Connecticut, a joint income tax return for the calendar year 1949 on the cash basis, reporting an adjusted gross income of $10,492.75 and a tax of $1,146.60. Clement A. Bauman is the sole proprietor of a business in Lakeville under the name of ‘A. E. Bauman, Sons,’ engaged in plumbing, heating, sheet metal work, and the sale of appliances.
In the taxable year 1949, A. E. Bauman, Sons, kept the following books and records: Cash receipts book, cash disbursements book, payroll records, combination sales and accounts receivable records and books, and accounts payable records. Accounts payable consisted of purchase invoices which were filed together and which were placed in a separate paid ledger account as they were paid. Accounts payable were separate and distinct from both the monthly statements of creditors and the slips of drivers delivering purchases to A. E. Bauman, Sons.
In the conduct of petitioners' business, inventories were taken in December 1949 and in preceding years. The opening inventory for January 1, 1949, could not be found and from the best records available petitioners arrived at an estimated inventory for that date of $15,142.13.
Accounts receivable consisted of combination sales and accounts receivable records. The account consisted of a file arranged in alphabetical order of job orders performed on credit. All accounts receivable were kept in two small books alphabetically arranged by customer's name. When an account was paid in full the account receivable was removed from the appropriate book and filed elsewhere in alphabetical order. Accounts receivable records contained entries for every sale except immediate cash sales. The limited number of sales for cash was entered in a cash receipts book. The aggregate accounts receivable outstanding at any particular date in 1949 could be ascertained by examining the current combination sales and accounts receivable books and adding the individual accounts.
From the business records, balance sheets were prepared during 1949 showing the financial condition of the business as of December 31, 1948, and June 30, 1949. A formal record of accounts payable as of December 31, 1948, 1949, and 1950 was later prepared as well as a record of accounts receivable for 1949 including opening and closing totals; so were a general ledger on an accrual basis for 1949 and a profit and loss statement as of December 31, 1949. These records were accurate. Bauman's books were kept on an accrual basis.
Bauman prepared financial statements for the purpose of borrowing money from banks. These statements indicated that the principal assets of the business were the accounts receivable and the inventory.
Bauman engaged an accountant who examined the books and records of Bauman from which he made up a profit and loss statement for 1949 on an accrual basis and a balance sheet as of December 31, 1949, on an accrual basis. He set up formal books on an accrual basis covering the business operations from January 1, 1949. The following is a condensed form of the balance sheet as at the end of 1949, prepared by the accountant:
+------------------------------------------+ ¦Assets: ¦ ¦ +------------------------------+-----------¦ ¦Cash ¦$2,596.61 ¦ +------------------------------+-----------¦ ¦Accounts receivable ¦74,177.21 ¦ +------------------------------+-----------¦ ¦Inventory ¦18,927.66 ¦ +------------------------------+-----------¦ ¦Fixed assets less depreciation¦28,285.53 ¦ +------------------------------+-----------¦ ¦Other assets ¦546.00 ¦ +------------------------------+-----------¦ ¦Total assets ¦$124,533.01¦ +------------------------------+-----------¦ ¦Liabilities: ¦ ¦ +------------------------------+-----------¦ ¦Accounts payable ¦44,003.21 ¦ +------------------------------+-----------¦ ¦Other current liabilities ¦20,372.08 ¦ +------------------------------+-----------¦ ¦Mortgages payable ¦18,987.50 ¦ +------------------------------+-----------¦ ¦Total liabilities ¦$83,362.79 ¦ +------------------------------+-----------¦ ¦Net worth: ¦ ¦ +------------------------------+-----------¦ ¦Balance Jan. 1 ¦54,297.53 ¦ +------------------------------+-----------¦ ¦Profit 1949 ¦3,310.92 ¦ +------------------------------+-----------¦ ¦Less drawings ¦(16,438.23)¦ +------------------------------+-----------¦ ¦Balance ¦41,170.22 ¦ +------------------------------+-----------¦ ¦Liabilities and net worth ¦$124,533.01¦ +------------------------------------------+
The profit and loss statement for 1949 made on an accrual basis by the accountant was introduced in evidence and we find that it correctly reflects petitioners' net income for the year 1949. The accountant in preparing this profit and loss statement on an accrual basis placed in one column the figures on an accrual basis and in another column the figures on a cash basis as reported by the taxpayers on their income tax return. This profit and loss statement is as follows:
+------------------------------------------------------------------+ ¦ ¦As per our figures¦Income tax filed¦ +------------------------------+------------------+----------------¦ ¦Sales—Less discounts ($401.33)¦$196,840.65 ¦$190,545.89 ¦ +------------------------------+------------------+----------------¦ ¦Cost of Sales: ¦ ¦ ¦ +------------------------------+------------------+----------------¦ ¦Inventory Jan. 1 ¦15,142.13 ¦ ¦ +------------------------------+------------------+----------------¦ ¦Purchases ¦127,768.43 ¦112,558.47 ¦ +------------------------------+------------------+----------------¦ ¦Frt. & ctg ¦710.92 ¦889.81 ¦ +------------------------------+------------------+----------------¦ ¦Total purchase cost ¦143,621.48 ¦113,448.28 ¦ +------------------------------+------------------+----------------¦ ¦Deduct: Inventory Dec. 31 ¦18,927.66 ¦ ¦ +------------------------------+------------------+----------------¦ ¦Cost of sales ¦124,693.82 ¦113,448.28 ¦ +------------------------------+------------------+----------------¦ ¦Gross profit ¦72,146.83 ¦77,097.61 ¦ +------------------------------+------------------+----------------¦ ¦Expense: ¦ ¦ ¦ +------------------------------+------------------+----------------¦ ¦Labor ¦52,218.32 ¦52,210.67 ¦ +------------------------------+------------------+----------------¦ ¦Interest paid ¦1,485.32 ¦1,644.02 ¦ +------------------------------+------------------+----------------¦ ¦ ¦ ¦126.90 ¦ +------------------------------+------------------+----------------¦ ¦Auto expense—repairs ¦2,242.77 ¦706.87 ¦ +------------------------------+------------------+----------------¦ ¦Office expense ¦1,098.40 ¦499.35 ¦ +------------------------------+------------------+----------------¦ ¦Insurance ¦2,124.84 ¦1,649.46 ¦ +------------------------------+------------------+----------------¦ ¦Light—power—heat ¦589.51 ¦617.45 ¦ +------------------------------+------------------+----------------¦ ¦Telephone ¦789.21 ¦769.38 ¦ +------------------------------+------------------+----------------¦ ¦Gas & oil ¦1,467.43 ¦1,467.43 ¦ +------------------------------+------------------+----------------¦ ¦Travel and entertainment ¦781.72 ¦781.72 ¦ +------------------------------+------------------+----------------¦ ¦Advertising ¦1,360.77 ¦1,106.81 ¦ +------------------------------+------------------+----------------¦ ¦Taxes ¦2,146.44 ¦1,765.89 ¦ +------------------------------+------------------+----------------¦ ¦ ¦ ¦24.64 ¦ +------------------------------+------------------+----------------¦ ¦Misc. expense ¦134.16 ¦584.11 ¦ +------------------------------+------------------+----------------¦ ¦Dues & subscriptions ¦27.00 ¦ ¦ +------------------------------+------------------+----------------¦ ¦Accounting & legal ¦188.90 ¦228.40 ¦ +------------------------------+------------------+----------------¦ ¦Accounting & legal ¦ ¦125.00 ¦ +------------------------------+------------------+----------------¦ ¦Depreciation ¦2,891.78 ¦2,986.67 ¦ +------------------------------+------------------+----------------¦ ¦ ¦69.546.57 ¦67,294.77 ¦ +------------------------------+------------------+----------------¦ ¦Net taxable profit—business ¦2,600.26 ¦9,802.84 ¦ +------------------------------+------------------+----------------¦ ¦Other Income: ¦ ¦ ¦ +------------------------------+------------------+----------------¦ ¦Rents ¦855.00 ¦855.00 ¦ +------------------------------+------------------+----------------¦ ¦Less: Lt.—heat—expense ¦144.34 ¦315.09 ¦ +------------------------------+------------------+----------------¦ ¦Net other income ¦710.66 ¦539.91 ¦ +------------------------------+------------------+----------------¦ ¦Total taxable profit ¦3,310.92 ¦10,342.75 ¦ +------------------------------------------------------------------+
The accounts receivable, accounts payable, and inventory as of January 1, 1949, and December 31, 1949, were:
+------------------------------------------+ ¦ ¦January 1 ¦December 31¦ +-------------------+----------+-----------¦ ¦Accounts receivable¦$72,308.78¦$74,177.21 ¦ +-------------------+----------+-----------¦ ¦Accounts payable ¦27,272.42 ¦44,003.28 ¦ +-------------------+----------+-----------¦ ¦Inventory ¦15,142.13 ¦18,927.66 ¦ +------------------------------------------+
The accountant who prepared the foregoing profit and loss statement prepared petitioners' returns for the years 1950 and 1951 on an accrual basis and these returns are not here in dispute.
OPINION.
TIETJENS, Judge:
Respondent states in his brief the primary issue as follows:
Did the respondent err in adding to petitioners' gross profit from business, as reported on the cash basis of accounting, the sum of $47,680.48, composed by adding accounts receivable and inventory on hand at December 31, 1949 in the respective amounts of $67,978.83 and $18,927.66, and deducting accounts payable at December 31, 1949 of $39,226.01?
On the basis of the respondent's primary and alternative contentions, it is not easy exactly to define the differences between the parties. As we view the situation, it is this. The taxpayers filed their return for 1949 on the cash basis. The respondent was of the opinion that the taxpayers should have kept books and reported income on an accrual basis. He was of the further opinion, however, that he could not determine from the books the proper income on an accrual basis. Therefore, accepting as correct the income which had been reported on the cash basis, the respondent added to that income the closing accounts receivable for 1949, plus the closing inventory and deducted therefrom closing accounts payable. This resulted in an addition to the income as reported by the taxpayers of $47,680.48, and the deficiency here in question was mainly determined on the basis of that adjustment. That adjustment is here challenged. There were other minor adjustments which are not in controversy.
The taxpayers argue that the books and records were kept on an accrual basis and that the respondent could have accurately determined income on that basis from the books and records. The taxpayers contend that in requiring the reporting of the income on an accrual basis (to which no objection is made) the respondent's adjustment is erroneous because it failed to compute petitioners' income for 1949 on an accrual basis. Petitioners contend that there is no warrant in law for what the Commissioner has done in this respect and that it distorts and greatly overstates petitioners' net income for the taxable year. Petitioners contend that their books and records having been kept on an accrual basis, the Commissioner must compute 1949 income on an accrual basis and that he cannot use the method which he has used in an effort to prevent income which may not have been reported in a prior year on the cash basis from escaping taxation.
The respondent objects that the pleadings do not raise the issue as petitioners are now contending but we think the issue is sufficiently stated. On the issue thus stated, we think the taxpayers' position is correct. We have found that Bauman's books were kept on an accrual basis. The taxpayers' position that in the changeover from cash to accrual reporting of income, an accrual method must be used throughout in computing income without any effort to bring into account income of a prior year to prevent it from escaping taxation is amply sustained by Commissioner v. Dwyer, (C. A. 2, 1953) 203 F. 2d 522, affirming a Memorandum Opinion of this Court, and Caldwell v. Commissioner, (C. A. 2, 1953) 202 F. 2d 112, affirming a Memorandum Opinion of this Court; also by Welp v. United States, (C. A. 8, 1953) 201 F. 2d 128. The Dwyer decision expressly overruled Hardy v. Commissioner, 82 F. 2d 249, reversing a Memorandum Opinion of this Court, which is relied on by the respondent here. The basis for these holdings is that the authority of the respondent to require a taxpayer to use an accrual basis of reporting income in cases where his books and records are kept on an accrual basis does not include the authority to add to the income for the year of changeover items which were income of a preceding taxable period. See David W. Hughes, 22 T. C. 1; Commissioner v. Schuyler, 196 F. 2d 85, affirming a Memorandum Opinion of this Court. It should be remembered that this is not a case where the taxpayers have been keeping their books and records on the cash basis and have sought to change over to an accrual basis without securing the consent of the Commissioner to make such a change. If it were that kind of a case, the situation might be different. As we have already pointed out, petitioners have been keeping their books and records on an accrual basis but in 1949, and prior years, erroneously filed their income tax returns on the cash basis. It follows that the respondent erred in refusing to allow the taxpayers to compute their income for the year 1949 on an accrual basis. The figures necessary to make the computation for 1949 on an accrual basis have been produced by the taxpayers and the profit and loss statement complied by their accountant from the taxpayers' books and records should be used in a computation under Rule 50. This profit and loss statement is contained in our Findings of Fact.
Bauman's inventory as of December 31, 1949, was a listing of the items of stock on hand with a price opposite each item. There is no dispute as to the amount of this, as both parties accept the inventory total of $18,927.66. An inventory taken as of January 1, 1949, was lost. Bauman estimated the inventory of that date as $15,142.13. The respondent says this figure is not supported by any convincing evidence. However, the business was one of many years' standing and Bauman made statements of his financial condition at times during 1949 for the purpose of borrowing from banks, which statements showed accounts receivable and inventories. His estimate was made in 1951 at the time of the revenue agent's examination. It is clear that there was some inventory and this is the best figure available. We have found that this was the amount of the inventory.
We also deem the other year-end figures derived by the taxpayers' accountant reliable; and, as stated above, they are to be used in the Rule 50 computation.
Reviewed by the Court.
Decision will be entered under Rule 50. FISHER, J., concurs in the result.
OPPER, J., concurring:
I concur in the result solely on the authority of David W. Hughes, 22 T. C. 1, which I find indistinguishable in principle.