Talley v. Commissioner

Thomas A. Talley, Petitioner, v. Commissioner of Internal Revenue, Respondent. Thomas A. Talley and Marian O. Talley, Petitioners, v. Commissioner of Internal Revenue, Respondent Talley v. Commissioner Docket Nos. 33140, 33141 United States Tax Court 20 T.C. 715; 1953 U.S. Tax Ct. LEXIS 96; June 30, 1953, Promulgated *96 Decisions will be entered under Rule 50. 1. Where the method of accounting employed by the petitioners accurately reflects income, the Commissioner may not resort to the increase in net worth method to determine income. 2. Fraud penalties disallowed. James Mullen, Esq., for the petitioners. E. M. Woolf, Esq., for the respondent. Arundell, Judge. ARUNDELL *715 The respondent has determined deficiencies in the petitioners' income taxes and has asserted fraud penalties as follows: Petitioners Year Deficiency Penalty [1939] $ 211.83 $ 170.08 Thomas A. Talley and Marion O. Talley, Docket No. 33141 [1942] 35,543.34 18,864.21 [1943] 2,447.66 565.17 [1945] 319.94 159.97 Thomas A. Talley, Docket No. 33140 [1946] 4,407.88 2,203.94 *97 The basis for the determination of the deficiencies is unreported income determined by the increase in net worth method. The fraud penalties are claimed under section 293 (b) of the Internal Revenue Code. The petitioners allege the respondent erred in determining income by the increase in net worth method and further that the returns were not false or fraudulent with intent to evade tax. With reference to the years 1939, 1942, and 1943 the petitioners also plead the statute of limitations as a bar to assessment and collection of the deficiencies determined. The cases were consolidated for hearing and opinion. *716 FINDINGS OF FACT. The petitioners are husband and wife and both reside in Richmond, Virginia. Their joint income tax returns for the calendar years 1939, 1942, 1943, and 1945 and the separate income tax return of the petitioner Thomas A. Talley for the calendar year 1946 were filed with the collector of internal revenue at Richmond, Virginia. Mr. Talley, hereinafter referred to as the petitioner, has been engaged as sole proprietor in the plumbing and heating contracting business since 1929. His wife prepared his income tax returns for all years, including the *98 years in question, and kept the books of account of the business for all years except 1942. Due to domestic difficulties, the Talleys lived apart in 1942. The petitioner was educated in a 1- or 2-room country school in Virginia. He had no training in bookkeeping and never kept the books of account or made any entries therein. He had little or no knowledge of preparing income tax returns and never attempted to prepare any. The petitioner's wife studied bookkeeping in high school. She had no experience in bookkeeping other than what she acquired in keeping petitioner's books of account and she had no training in preparing income tax returns. In 1942, the books of account were kept by a new employee, a woman approximately 35 years of age, who studied bookkeeping in high school but had no experience. Petitioner's books of account were kept on an accrual basis and income was computed on the completed contract basis for calendar years. The contract price of all contracts was included in the gross receipts of the year in which the contract was completed, and all direct costs incident to the performance of these contracts were deducted in determining the profits realized. Incidental*99 expenses were not allocated to contracts or jobs as a part of their cost but were deducted in the year paid or incurred. The books of account did not contain a separate account in which could be found all gross receipts, or a separate account including all labor costs, or a separate account for material costs. Because the books of account did not have separate accounts totaling gross receipts, labor, and material costs, the following method was adopted by the petitioner's wife for computing gross receipts for all years except 1942 and labor and material costs for all years including 1942. In the returns for all years except 1942, petitioner's wife consistently included in gross receipts the contract price of all contracts entered into and performed during the year; the total material and labor applied during the year to work in process, i. e., to contracts not completed; and a third sum representing the difference between the *717 contract price of contracts entered into in a previous year but completed during the current year and the total material and labor applied to those contracts during the previous year or years. This latter item represented the gross profit on the completed*100 long-term contracts. There was consistently taken by way of deductions for all years, including 1942, the total sum paid during the year for material and labor and all expenses paid or incurred during the year. The amount paid or incurred for work in process was included in gross receipts to counterbalance the material and labor directly applied to work in process and which under the method of reporting had been taken as a deduction. The same result would have been accomplished by inventorying the work in process. Neither the petitioner nor his wife was familiar with the use of inventories in bookkeeping or accounting. As a result of this method of computing gross receipts and material and labor costs, the net income reported on the returns was less in some years than the income computed on the books of account under the completed contract method of accounting and in excess of it in other years. In 1942, the petitioner's wife for the first time did not keep the books of account. She did, however, prepare the 1942 return from information furnished to her by the bookkeeper then employed by the plumbing and heating contracting business. The figure furnished to Mrs. Talley as the*101 total of gross receipts was the exact amount of the total cash collections in 1942 on all contracts, including those begun in a previous year and completed in 1942 as well as those entered into and completed within the year. As this figure was an amount less than the gross receipts that would be computed under the system theretofore consistently followed, it served to reduce the gross receipts and the net income reported for 1942 by approximately $ 23,000. All income of the petitioners from sources other than the plumbing and heating contracting business was accurately reported for all the years in question. By the spring of 1942, cataracts were beginning to form on petitioner's eyes and by September 1942, his sight was so impaired that he could read only with the aid of a magnifying glass and could not see to drive or supervise his business. In 1943 he was operated on to remove the cataracts. In the latter part of 1948, the respondent's agent examined the petitioner's returns and the books of account for the years 1939 through 1946. All books and records were promptly placed at his disposal and no information or assistance was withheld. The petitioners attempted no concealment*102 and cooperated fully. *718 The various transactions for the years in question were regularly entered in the books of account, including items of income, material and labor costs, and expenses. The books of account were sufficiently complete and adequate for the computation of the income of the petitioners for all years in question. The completed contract method of accounting had been regularly employed in keeping the books for all years, including 1942, and this method clearly reflected the income for all years including 1942. Because respondent's revenue agent was unable from his investigation to reconcile the returns with the books, he resorted to the increase in net worth method to determine the income for the years in question. On the basis of this computation, the respondent determined that the taxable income for the years in question was as follows: Year Thomas A. and Marian O. Talley Thomas A. Talley [1939] $ 8,922.73 [1942] $ 91,704.72 [1943] $ 28,945.55 Income tax net income $ 29,888.86 Victory tax net income [1945] $ 11,971.51 [1946] $ 15,443.97 Prior to 1948, the respondent's agents, who had examined the petitioner's returns and books for the years 1941 through*103 1944, suggested no change in his method of accounting or reporting his income. The net income reported by the petitioners for 1939, 1942, 1943, and 1945 and the net income reported by the petitioner Thomas A. Talley for 1946 was as follows: Net income of Year Net income of petitioners Thomas A. and Marian O. Talley petitioner Thomas A. Talley [1939] $ 2,941.34 [1942] $ 41,527.86 $ 27,350.81 Income tax net income [1943] $ 27,171.50 Victory tax net income [1945] $ 11,238.88 [1946] $ 174.78 None of the returns filed for the years in question was false or fraudulent with intent to evade tax, and no part of the deficiency was due to fraud with intent to evade tax. OPINION. Petitioners' income for the years in question was determined by respondent by the "increase in net worth method" because the revenue agent could not reconcile the income reported on the returns with the income shown on the books of account. *719 Our findings of fact disclose that the petitioner kept his books of account on a completed contract basis, but the books did not carry separate accounts in which could be found the complete gross receipts of petitioner or the complete expenditures for labor and*104 material. This type of information which was called for on the tax returns was available only by making computations from many accounts, and this fact may well be the reason the revenue agent found it difficult to reconcile the return with the books. The respondent puts his emphasis on the year 1942 as that was the year in which a material understatement of income occurred. His claim for the so-called fraud penalty of 50 per cent is largely based on the understatement of income for that year. The substantial understatement in 1942 resulted primarily from the omission from gross income of the cost of work in process which under the method employed by the petitioner's wife in preparing the return had been consistently included. This resulted in a difference of approximately $ 23,000. Although the understatement arose from using as gross receipts the total cash collections rather than following the usual method of reporting gross income, the books disclosed the correct figures from which the gross receipts could have been determined under the usual method. The error was due to the inexperience of the new bookkeeper who supplied the figures used in the return. This was the only *105 year in which the petitioner's wife did not keep the books and the only year in which the information placed on the returns was supplied by another person. As a result, petitioner's wife in preparing the returns unknowingly understated the gross income but there is not the slightest evidence of an intention to defraud. Turning now from the returns to the books of account, we find that for 1942 and all other years in question the income was properly computed on the books by the completed contract method of accounting. The extent to which the departure in the returns from the method of accounting followed in the books of account resulted in an understatement of net income in one year and an overstatement in another is not shown by the record before us. This, however, does not affect the basic fact that the method followed in the books was a commonly accepted method and the books were sufficiently accurate and complete for the computation of income for all the years in question. The complete set of books was immediately placed at the respondent's disposal and full assistance and cooperation were given when he audited the returns in 1948. Moreover, prior to that time, the respondent's*106 agents had conducted another examination for the years 1941 to 1944 and found no fault with the books of account or the method of computing the income reported in the return. *720 Under these circumstances, we find no authority in the respondent to disregard the books of account and resort to the increase in net worth method to determine income. The lack of conformity between returned income and income shown on the books of account and respondent's inability to reconcile the two did not in and of themselves justify the use of the increase in net worth method of reconstructing income. Section 41, Internal Revenue Code; 1 cf. Edward Walsdorf, 4 B. T. A. 367; In re Sheinman, 14 F. 2d 323; Bechelli v. Hofferbert, 111 F. Supp. 631. *107 The limitations of the increase in net worth method are well known. Often it results in an inaccurate statement of income or the placing of income in the wrong year and, at best, it yields only an approximation. It is a method of reconstructing income rather than a method of computing it. The ordinary method of computing taxable income in accordance with the general pattern of the Code is to subtract allowable deductions from a taxpayer's gross income. The increase in net worth method is, of course, not in accord with this statutory pattern and is permitted by virtue of section 41, Internal Revenue Code, only in unusual circumstances, none of which is present here. Section 41 provides that "net income shall be computed * * * in accordance with the method of accounting regularly employed in keeping the books" of the taxpayer. The Commissioner's authority under section 41 to compute the income "in accordance with such method as in the opinion of the Commissioner does clearly reflect the income" exists only if no method of accounting has been regularly employed in keeping the books of the taxpayer, or "if the method employed does not clearly reflect the income." See Regulations 111, *108 sections 29.41-1 and 29.41-2. The evidence clearly establishes that neither of those qualifying conditions existed here and we do not believe respondent seriously contends otherwise. An accurate computation of income for all years in question could have been made from the books of account. In the circumstances, we do not think respondent had authority to determine income for the years in question by the increase in net worth method. Section 41 of the Code; cf. Edward Walsdorf, supra;In re Sheinman, supra;Bechelli v. Hofferbert, supra. The years 1945 and 1946 are not barred by the statute of limitations but, having concluded that the respondent should have determined *721 petitioners' tax liability under the method of accounting regularly employed by petitioners, rather than by using the increase in net worth method, the presumptive correctness of respondent's determinations must fall and we cannot sustain his determinations. Cf. Helvering v. Taylor, 293 U.S. 507. It does not follow from what we have said that we should find that there are no deficiencies*109 for 1945 and 1946 and close the proceedings. Following the suggestion of the Supreme Court in Helvering v. Taylor, supra, we think that the parties should be given the opportunity to produce evidence as to the correct tax under the method of accounting regularly employed by the petitioner. On brief, the petitioners' counsel has stated that the petitioners are ready to pay any deficiency so found. If the parties are unable to agree as to the tax liability for the years 1945 and 1946, these proceedings will be reopened on appropriate motion of either party. After a careful study of the entire record, it is our opinion that respondent has not sustained his burden of proving that the returns as filed for the years in question were false or fraudulent with intent to evade tax or that any part of the deficiency was due to fraud, and it follows that respondent's imposition of the 50 per cent addition to the tax under section 293 (b) cannot be sustained. Absent fraud, the statute of limitations contained in section 275 (a) bars the assessment and collection of any deficiencies for the taxable years 1939, 1942, and 1943. Decisions will be entered under*110 Rule 50. Footnotes 1. SEC. 41. GENERAL RULE. The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income.↩