Tunningley v. Commissioner

Melvin E. Tunningley, Petitioner, v. Commissioner of Internal Revenue, Respondent Tunningley v. Commissioner Docket No. 41354 United States Tax Court 22 T.C. 1108; 1954 U.S. Tax Ct. LEXIS 117; August 30, 1954, Filed. August 30, 1954, Filed *117 Decision will be entered under Rule 50. 1. Held: (a) Petitioner, the sole proprietor of an automobile agency, maintained his books in accordance with an accrual method of accounting for 1949 and 1950 and must report his income on that accrual basis. (b) Certain adjustments (unrelated to the method of accounting used) determined in petitioner's business net income as recorded in his books for those years. 2. Held, no books or records having been produced for 1946 or 1948, petitioner's automobile business net income is properly determined by applying to reported sales, for each of those years, the average percentage of net income to sales for 1949 and 1950. 3. Held, the 5-year statute of limitations (section 275 (c), Internal Revenue Code of 1939) applies to 1946 since petitioner omitted gross income from his 1946 return in excess of 25 per cent of that reported therein. George R. Graves, Esq., for the petitioner. S. Jarvin Levison, Esq., for the respondent. Black, Judge. BLACK *1108 The Commissioner has determined the following deficiencies in petitioner's income taxes: Year Deficiency [1946] $ 430.15 [1947] 563.99 [1948] 419.30 [1949] 1,095.92 [1950] 2,204.80 In his brief the Commissioner concedes that the *118 year 1947 is barred by the statute of limitations. The remaining questions for consideration are: 1. (a) Did the Commissioner err in determining that the petitioner, in 1949 and 1950, maintained books by the accrual method of accounting which (with certain adjustments unrelated to that method of accounting) clearly reflected business net income pursuant to section 41 of the Internal Revenue Code of 1939? (b) Did the Commissioner err in making the following adjustments (unrelated to the method of accounting used) in petitioner's business net income for 1949 and 1950: [1949] Deduction for repairs disallowed (capital improvement) $ 2,638.92 Deduction for taxes disallowed 95.97 Deduction for insurance disallowed 923.90 [Petitioner claimed no depreciation deduction but the Commissioner allowed $ 865.97 for 1949.] [1950] Deduction for petitioner's drawing account disallowed $ 4,000.00 (Of total drawing account of $ 5,228.07, the amount of $ 1,228.07 was allowed as travel and entertainment expense) Deduction for insurance disallowed 763.99 Depreciation deductions disallowed 2,525.00 *1109 *119 2. Did the Commissioner err in using the percentage of sales method to determine petitioner's business net income for 1946 and 1948? 3. Does the 5-year statute of limitations (section 275 (c), 1939 Code) apply to 1946, thereby enabling a deficiency to be assessed for that year? FINDINGS OF FACT. Petitioner is an individual who, during the years in issue, resided at Nunda, New York, and filed his income tax returns with the collector of internal revenue at Buffalo, New York. Petitioner claimed dependency exemptions for his wife and three daughters in the tax returns here pertinent. Since 1933, petitioner has been an automobile dealer in Nunda. He filed income tax returns for 1933 and every year thereafter but none of those returns reported taxable net income. During the years in issue petitioner operated, as a sole proprietor, a De Soto automobile agency under a franchise agreement, dated January 3, 1946, with the Chrysler Corporation, De Soto Division. His only other source of income during those years was a frame dwelling from which he received minor sums of net rent. Paragraph 4 of the aforementioned franchise agreement provides, in pertinent part, as follows: DIRECTOR DEALER [petitioner] *120 recognizes the value of proper records and accounts and agrees to keep up to date De Soto uniform standard accounting system and procedure or some other system or procedure which will accomplish the same result. DE SOTO undertakes to cooperate with those dealers who furnish regular quarterly statements of their operations for comparative purposes in developing data and information for the purpose of improving dealer operations and profit possibilities through consultation and advice based on the comprehensive study of the information furnished by the reporting dealers. Prior to 1948, petitioner did not conform to the "De Soto uniform standard accounting system." There is no reliable evidence as to what system was used by him for those prior years since the books and records applicable thereto were never produced either for respondent's inspection or at the hearing of this case. Beginning sometime in 1948, petitioner endeavored to conform with the De Soto accounting system and employed a bookkeeper to maintain his books and records. However, no books or records for 1948 were ever produced but those for 1949 and 1950 were inspected by respondent and *1110 were available at the hearing. *121 The "De Soto uniform standard accounting system" is an accrual method of accounting. In 1949 and 1950, petitioner maintained a journal and a ledger, the entries to which were supported by daily sales and expense vouchers. He maintained a memorandum book which listed the new cars received from the De Soto factory, the names and addresses of the purchasers to whom sold, and the dates of receipt and sale, but not the sales prices. The book revealed that 23 new cars were sold in 1949 and 29 were sold in 1950. No new cars were in stock on the first day of either of those years; in fact, new cars were seldom in stock since petitioner's practice was to obtain them from the factory only after an order had been placed with him by a customer. The memorandum book reveals that two new cars were on hand at the close of 1950, which were sold in early 1951. Petitioner's journal for 1949 and 1950 was kept as follows: For each of the following four categories, a separate column was maintained recording individual sales of the items therein -- new and used cars, repair parts, accessories, miscellaneous merchandise. Total sales prices, not merely cash received, were recorded in those sales columns. *122 For each of the four sales columns there was a corresponding column in which the cost of the particular item sold was recorded. The totals of the aforementioned sales and cost columns were transferred to corresponding accounts in the ledger. The cost of the two new cars on hand at the close of 1950 was not charged against 1950 income. Finally, petitioner's expenses were recorded on his books on an accrual basis. Petitioner prepared 1949 and 1950 operating and net worth statements pursuant to De Soto's standard accounting system and submitted them to De Soto. The operating statements, prepared on an accrual basis, may be summarized as follows: [1950] Sales $ 92,305.38 $ 126,157.28 Cost of sales 70,825.93 102,422.55 Gross profit $ 21,479.45 $ 23,734.73 Less itemized expenses (excluding depreciation) 14,341.28 14,481.57 Operating profit $ 7,138.17 $ 9,253.16 Profit on insurance sales 1,829.62 Net profit $ 7,138.17 $ 11,082.78 A part-time assistant to petitioner's bookkeeper prepared a 1949 operating statement for tax purposes from petitioner's books which agrees with the above figures for 1949 with the one exception that itemized expenses were totaled as $ 14,245.71 instead of $ 14,341.28. Both that computation *123 and an amended one, the only change in which *1111 was to reduce "Sales" to $ 77,590.33 (thus reflecting a net loss of $ 7,481.34), were submitted to petitioner's attorney who prepared the tax return for 1949. The amended "Sales" figure of $ 77,590.33 was intended to represent cash receipts only, rather than total sales, but nowhere in petitioner's books or records are there entries substantiating that such figure constituted actual cash receipts. Petitioner's return for 1949 agrees with none of the aforementioned statements. Rather, it contains figures which result in the showing of a net profit of $ 58.43. For 1950, petitioner's return shows a net profit of $ 3,106.70 which is based on a sales figure, intended to represent cash receipts only, of $ 87,301.76. As with 1949, there are no substantiating entries in petitioner's books or records for that alleged cash receipts figure. The 1949 and 1950 operating statements prepared for De Soto constitute, with two exceptions, a true reflection of petitioner's books and records. 1 Those books and records were kept on an accrual basis and, with exceptions unrelated to the accounting method used and hereinafter noted, clearly reflect the business *124 income for those years. Respondent adopted the aforementioned operating statements. He made the two adjustments necessary to conform the statements to the books and made certain other adjustments in the statements, which adjustments were unrelated to the issue of the accounting method used. All those adjustments are discussed immediately following. Among the itemized expenses listed in the 1949 operating statement were the following: Repairs and upkeep $ 2,638.92 Taxes 516.04 Insurance 1,564.61 Respondent disallowed the deduction for "Repairs and Upkeep," determining that the $ 2,638.92 constituted expenditure for a capital improvement. He also disallowed $ 95.97 of the deduction for taxes because petitioner's books contained no entry therefor. Petitioner failed to introduce any evidence relating to those adjustments and respondent's determination is sustained. Respondent disallowed $ 923.90 of the claimed $ 1,564.61 deduction for insurance on the ground that that sum was expended *125 to pay premiums on life insurance policies of petitioner and his wife. The correct amount to be disallowed is, however, $ 578.22, which is all that was paid for the life insurance premiums. No deduction for depreciation was either listed on the operating statement for 1949 or claimed in petitioner's return. Respondent determined that a depreciation deduction of $ 865.97 was allowable. *1112 In addition thereto, a depreciation deduction of $ 500 is allowable on a 1948 model car, costing $ 2,000, which was used in the business and not held in inventory or as stock in trade for sale. Apparently a second car, costing $ 2,000, and a truck, costing $ 1,800, were acquired for use in the business sometime in 1949, but there is no evidence as to date of acquisition and the proper depreciation deductions cannot be determined. Among the itemized expenses listed in the 1950 operating statement adopted by respondent were the following: Salaries -- executive $ 5,228.07 Insurance 1,731.74 The salary item was derived from an account in petitioner's books labeled "M. E. T. house account." Respondent disallowed $ 4,000 thereof as representing nondeductible personal living expenses and allowed the remainder ($ *126 1,228.07) as deductible travel and entertainment expenses. Petitioner introduced no evidence substantiating this deduction, and respondent's disallowance of $ 4,000 thereof is sustained. Respondent disallowed $ 763.99 of the $ 1,731.74 insurance deduction after an inspection of petitioner's books revealed that only $ 967.75 was recorded therein for such insurance. Respondent's disallowance was proper. No depreciation expense was listed in the aforementioned 1950 operating statement but petitioner claimed deductions for depreciation in his 1950 return. The deductions claimed, respondent's determinations with respect thereto, and our findings are as follows: Respondent's determination Item Petitioner's claim Allowed Disallowed Frame garage $ 1,100 $ 450.00 $ 650 Equipment [600] 350.00 [250] Office [175] Truck (1949 -- cost $ 1,800) [450] 2 cars (1948 and 1949 -- cost $ 4,000) 1,000 1,000 Capital improvement (1949 -- cost $ 2,638.92) 131.94 Total $ 3,325 $ 931.94 $ 2,525 Our findings Item Allowed Disallowed Frame garage $ 450.00 $ 650 Equipment 350.00 [250] Office [175] Truck (1949 -- cost $ 1,800) 450.00 2 cars (1948 and 1949 -- cost $ 4,000) 1,000.00 Capital improvement (1949 -- cost $ 2,638.92) 131.94 Total $ 2,381.94 $ 1,075 Petitioner *127 introduced no evidence contrary to respondent's determinations regarding depreciation on the frame garage, equipment, and office. The truck and two cars, however, were used in the business in 1950 and were not held in inventory or as stock in trade for sale. Depreciation deductions are allowable thereon and the amounts of those deductions claimed by petitioner are proper. The following shows petitioner's correct net profit from the automobile business for 1949 and 1950 as determined above, his net rentals from the frame dwelling (not in issue here), his resulting adjusted *1113 gross income, the adjusted gross income reported on his returns, and the differences therein: [1949] Net profit per automobile business books (recorded in aforementioned operating statement) $ 7,138.17 Add: Disallowed deduction for repairs $ 2,638.92 Disallowed deduction for taxes 95.97 Disallowed deduction for insurance 578.22 3,313.11 10,451.28 Deduct: Depreciation 1,365.97 Correct automobile business net profit 9,085.31 Net rent 300.00 Correct adjusted gross income 9,385.31 Adjusted gross income per tax return 358.43 Difference $ 9,026.88 [1950] Net profit per automobile business books (recorded in aforementioned operating statement) $ 11,082.78 Add: Disallowed deduction for salary $ 4,000.00 Disallowed deduction for insurance 763.99 4,763.99 15,846.77 Deduct: Depreciation 2,381.94 Correct automobile business net profit 13,464.83 Net rent 77.58 Correct adjusted gross income 13,542.41 Adjusted gross income per tax return 3,184.28 Difference 10,358.13 *128 Since petitioner produced no books or records for 1946 or 1948, respondent determined that net profit from the automobile business for each of those years equaled 11 per cent of the reported sales, 2*129 to wit: [1948] Reported sales $ 45,885.99 $ 54,817.44 Net profit percentage .11 .11 Net profit $ 5,047.46 $ 6,029.92 *1114 The 11 per cent figure was arrived at by taking the average percentage of net profit to sales (both as adjusted by respondent) for 1949 and 1950, which equaled 11.29 per cent, and rounding it down. As a result of our findings, however, the net profits for 1949 and 1950 have been reduced and the average percentage thereof to sales is 10.26 per cent. Therefore, 10 per cent (the rounded down figure) we think should be applied to reported sales for 1946 and 1948, and the correct net profit from the automobile business for those 2 years we find is, consequently, $ 4,588.60 and $ 5,481.74, respectively. Adding reported net rents (not here in issue) for those years results in correct adjusted gross income of $ 4,781.10 for 1946 and $ 5,591.74 for 1948. Petitioner reported adjusted gross income of only $ 1,994.32 for 1946 and $ 554.92 for 1948. Petitioner filed his 1946 income tax return on March 5, 1947. The deficiency notice in this case was mailed on March 14, 1952. In his 1946 return petitioner reported gross income of $ 3,587.77. Petitioner's correct adjusted gross income for 1946 was $ 4,781.10. Petitioner omitted gross income from his 1946 return in excess of 25 per cent of the gross income reported therein. OPINION. Respondent does not contend, as he might, that petitioner was required to use an accrual method of accounting for the 1949 and 1950 income from his automobile business. 3*130 Rather, he argues that petitioner in fact did keep his books according to an accrual method and must report his net income for those years "in accordance with the method of accounting regularly employed in keeping the books" (Sec. 41, I. R. C. 1939). 4Diamond A Cattle Co., 21 T. C. 1. *1115 Sometime in 1948 petitioner, who operated a dealership under a franchise from the Chrysler Corporation, De Soto *131 Division, endeavored to conform with the "uniform standard accounting system" provided for in that franchise, which system was one of accrual. He hired a bookkeeper to maintain his books and records which consisted primarily of a journal and ledger, supported by vouchers for each entry made therein. Petitioner sold items falling into four general categories -- new and used cars, repair parts, accessories, and miscellaneous merchandise. The sale of each item was recorded in the journal at the full sales price even when that price or a portion thereof was not immediately collected. Petitioner, on the other hand, was unable to point to any book entries substantiating the figures listed in his returns as gross receipts for 1949 and 1950 and claimed by him to represent actual cash received. As each item was sold the cost of that item was also recorded in the journal; in other words, such cost was not recorded when the item was purchased by petitioner but, rather, was charged against the income derived from the particular sale thereof. The total sales and cost figures in the journal were transferred to appropriate accounts in the ledger. As for expenses, they were recorded on an accrual *132 basis. No formal inventory records were maintained, but a memorandum book kept by petitioner for new cars showed that none were on hand either at the beginning of 1949 or the beginning of 1950. Although two new cars were in stock at the end of 1950, they were not charged against income for that year. For new cars, therefore, it is clear that petitioner's accounting method, though not employing all the formal recording devices of accrual, was nevertheless an accrual method in substance. Concerning the other items sold there is no evidence whatever as to opening and closing inventories thereof for 1949 and 1950. Considering the evidence as a whole we are of the opinion that for the taxable years 1949 and 1950, (a) petitioner's recording of total sales prices, rather than only cash received, (b) his charging to each sale the particular cost thereof, rather than charging items against income at the time purchased without regard to when sold, and (c) his accrual of expenses constituted an accounting method which contained the necessary requisites of accrual accounting and which clearly reflected income. United States v. Anderson, 269 U.S. 422; Spring City Foundry Co. v. Commissioner, 292 U.S. 182; *133 H. H. Brown Co., 8 B. T. A. 112. On this issue, therefore, we sustain respondent in his contention that petitioner's books were kept according to an accrual method of accounting for 1949 and 1950 and that petitioner's returns for those years must be made on the same basis. Deakman-Wells Co., 20 T. C. 610, 612. We deem of no consequence *1116 the assertion in petitioner's brief that, prior to 1949 and 1950, he filed his returns on the cash basis and was never asked to change them. C. L. Carver, 10 T. C. 171, affd. (C. A. 6) 173 F. 2d 29. Petitioner prepared operating statements for 1949 and 1950 which he submitted to De Soto. With two exceptions (taxes for 1949 and insurance for 1950) those statements accurately reflected petitioner's book entries and correctly showed net profit, as recorded in those books, from the automobile business. Respondent made the two adjustments necessary to conform the statements to the books and made certain other adjustments in the statements, unrelated to the issue of the accounting method used by petitioner, all of which are hereinafter discussed. Respondent determined that $ 2,638.92, listed as a deduction for repairs and upkeep in 1949, was actually expended *134 for a capital improvement, the cost of which was properly recoverable only through depreciation deductions, and that $ 95.97 of the deduction for taxes listed on the 1949 operating statement was nondeductible because not supported by any entry in petitioner's books. Petitioner failed to introduce any evidence to sustain his burden of proving that respondent erred in these determinations and respondent, therefore, must be sustained therein. Burnet v. Houston, 283 U.S. 223; Welch v. Helvering, 290 U.S. 111. Respondent also disallowed $ 923,90 in deductions for insurance on the ground that that sum was expended not for business insurance but to pay premiums on life insurance policies of petitioner and his wife. We have found that only $ 578.22 was expended for such life insurance premiums. Respondent erred, therefore, to the extent that he disallowed more than that amount. In addition to $ 865.97 not claimed by petitioner but allowed by respondent as a depreciation deduction for 1949, we have found that petitioner used a 1948 model car, costing $ 2,000, in his business and did not hold that car in inventory or as stock in trade for sale. Regs. 111, sec. 29.23 (l)-2. A depreciation *135 deduction of $ 500 for that car is consequently allowable for 1949 under section 23 (l) (1) of the 1939 Code. Our findings also indicate that a second car (costing $ 2,000) and a truck (costing $ 1,000) were acquired sometime in 1949 for use in the business. There being no evidence regarding when in 1949 those vehicles were acquired, however, depreciation deductions cannot be determined for them. Burnet v. Houston, supra;Welch v. Helvering, supra. For 1950, respondent disallowed $ 4,000 of $ 5,228.07 listed on the operating statement for that year as executive salaries because he determined that that sum, derived from a book account labeled "M. E. T. house account," was expended for nondeductible personal living expenses. Sec. 24 (a) (1), I. R. C. 1939. Petitioner failed to introduce *1117 evidence establishing respondent's determination to be in error and, consequently, that determination must be sustained. Burnet v. Houston, supra;Welch v. Helvering, supra.Similarly, respondent's disallowance of $ 763.99 of claimed insurance expenses, after inspection of petitioner's books revealed that entries supporting that sum were lacking, must be sustained for petitioner's failure to produce *136 any convincing evidence that respondent erred. Finally, respondent made certain adjustments in depreciation deductions which were not contained in the 1950 operating statement but were claimed in petitioner's return for that year. Disallowance of portions of the deductions claimed for depreciation of a "frame garage" and "equipment," and disallowance of the entire deduction claimed for "office," is sustained because petitioner failed to introduce evidence indicating respondent's determinations to be in error. Burnet v. Houston, supra;Welch v. Helvering, supra. On the other hand, we have found that respondent erred in disallowing depreciation deductions, totaling $ 1,450, claimed by petitioner on two cars and one truck. Since those vehicles were used in the business, and not held in inventory or as stock in trade for sale (Regs. 111, sec. 29.23 (l)-2), depreciation deductions therefor are allowable under section 23 (l) (1) of the 1939 Code. The amounts of the deductions thereon claimed by petitioner are correct. Petitioner failed to produce at any time books or records bearing upon his automobile business income for 1946, 1947, or 1948. Respondent, therefore, determined petitioner's *137 net business profit for those years by the net profit percentage method, as follows: He computed the average percentage of net profit to sales for 1949 and 1950 as 11 per cent (to the nearest whole number), and applied that 11 per cent to sales as reported in petitioner's returns for each of the years 1946 through 1948. It is clear, in view of petitioner's lack of books and records, that respondent was justified in determining income pursuant to that method (sec. 41, I. R. C. 1939, supra; Maurice Cross, 24 B. T. A. 1079) and that petitioner's complaint that the deficiencies for those years were determined by respondent "without any regard to actual figures and conditions as shown by the original returns" has no legal validity. Louis Halle, 7 T. C. 245, 249, 250, 5*139 *1118 affd. (C. A. 2) 175 F. 2d 500, certiorari denied 338 U.S. 949. Our findings and opinion regarding 1949 and 1950, however, indicate that the correct average net profit percentage for those years (to the nearest whole number) was 10 per cent, rather than 11 per cent. Consequently, we have redetermined petitioner's net profit for 1946 and 1948 on that basis. Respondent conceded in his brief that following the method used *138 by him in determining petitioner's income for 1947 leads to the conclusion that that year was barred by the statute of limitations. We, therefore, hold that any deficiency for the year 1947 is barred by the statute of limitations. The final issue concerns the applicability of the statute of limitations to the deficiencies for 1946. Our findings indicate that the deficiency notice for 1946 was mailed more than 3, but less than 5, years following the date petitioner's return for that year is deemed to have been filed. 6*140 Petitioner reported in that return gross income of $ 3,587.77, whereas we have found that his correct adjusted gross income for 1946 was $ 4,781.10. It is obvious, therefore, that he omitted from the 1946 return gross income in excess of 25 per cent of the gross income reported therein. Consequently, the 5-year statute of limitations in section 275 (c) of the 1939 Code applies and assessment of the deficiency for 1946 is not barred. Decision will be entered under Rule 50. Footnotes 1. The two instances in which the operating statements are not corroborated by entries in petitioner's books and records are with regard to taxes for 1949 and insurance for 1950. These items are discussed below.↩ 2. The same method was used to determine net profit for 1947, but respondent now concedes that year to be barred by the statute of limitations. 3. Internal Revenue Code of 1939. SEC. 22. GROSS INCOME. * * * * (c) Inventories. -- Whenever in the opinion of the Commissioner the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer * * * Treasury Regulations 111. Sec. 29.22 (c)-1. Need of Inventories. -- In order to reflect the net income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor. * * * Sec. 29.41-2. Bases of Computation and Changes in Accounting Methods. -- * * * in any case in which it is necessary to use an inventory, no method of accounting in regard to purchases and sales will correctly reflect income except an accrual method. * * *↩ 4. 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. * * *↩ 5. "This petitioner, like every other taxpayer, was required by law to file an income tax return for each of the years involved herein and to report thereon, fully and honestly, every item of gross income received by him. Inherent in that requirement was the further requirement that he maintain adequate records of some kind to show to him and to the Commissioner the amount of income received by him in each year and the nature and the basis for any deductions claimed. The Commissioner need not accept, as complete, correct, and accurate, the returns filed or the sworn statement of the taxpayer that his returns completely and correctly disclose his tax liability. The Commissioner has authority to check the returns against the records of the taxpayer and, if no records have been kept or if the records are incomplete, inaccurate, or otherwise unsatisfactory, he may seek information elsewhere to discover, assess, and collect the full tax liability imposed by law. Estate of Robert Lyons Hague, 45 B.T.A. 104; affd., 132 Fed. (2d) 775↩." 6. Internal Revenue Code of 1939. SEC. 275. PERIOD OF LIMITATION UPON ASSESSMENT AND COLLECTION. Except as provided in section 276 -- (a) General Rule. -- The amount of income taxes imposed by this chapter shall be assessed within three years after the return was filed, and no proceeding in court without assessment for the collection of such taxes shall be begun after the expiration of such period. * * * * (c) Omission from Gross Income. -- If the taxpayer omits from gross income an amount properly includible therein which is in excess of 25 per centum of the amount of gross income stated in the return, the tax may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time within 5 years after the return was filed. * * * * (f) For the purposes of subsections (a), (b), (c), (d), and (e), a return filed before the last day prescribed by law for the filing thereof shall be considered as filed on such last day.↩