Berry Trust v. Commissioner

Selma Berry Trust, Transferee, Betty Berry, Trustee, et al., 1 Petitioner, v. Commissioner of Internal Revenue, Respondent Berry Trust v. Commissioner Docket Nos. 41026, 410027, 41028, 41150 United States Tax Court 26 T.C. 344; 1956 U.S. Tax Ct. LEXIS 187; May 25, 1956, Filed *187 Decisions will be entered under Rule 50. Petitioner Dixie Shops, Inc., held entitled to elect to compute income from installment sales made during 1942 on an accrual basis under section 736 (a), I. R. C. 1939, for purposes of reporting its excess profits tax liability for the taxable year ended December 31, 1942. *188 Charles L. Levin, Esq., and Morris Garvett, Esq., for the petitioners. Peter K. Nevitt, Esq., for the respondent. Withey, Judge. WITHEY *344 The respondent has determined deficiencies in the tax of Dixie Shops, Inc., for the indicated years as follows: Declared value excess-profits Excess profits Petitioner Year Income tax tax tax Dixie Shops, Ended Dec. 31, 1942 $ 1,010.16 $ 28,958.51 Inc., Docket Jan. 1-31, 1943 55.16 1,730.78 No. 41150. Jan. 31, 1943-Jan. 31, [1944] $ 228.87 15,890.05 *345 Respondent further determined that Selma Berry Trust, Betty Berry, Trustee; Harold Berry Trust, Betty Berry, Trustee; and Herbert O. Schlager, as transferees of the assets of Dixie Shops, Inc., were liable in the amounts of $ 9,617.74, $ 9,617.75, and $ 19,235.49, respectively, for the foregoing deficiencies. The sole issue presented for our decision is the correctness of the respondent's action in determining that petitioner Dixie Shops, Inc., was not entitled to elect to compute income from installment sales on an accrual basis under section 736 (a) of the Internal Revenue Code of 1939 for purposes of reporting its excess*189 profits tax liability for 1942. All other issues presented by the pleadings have been disposed of by stipulation of the parties. FINDINGS OF FACT. Some of the facts are stipulated and are found accordingly. Dixie Shops, Inc., sometimes hereinafter referred to as the corporation, was a Michigan corporation with its principal place of business located at Ypsilanti, Michigan, and was dissolved on January 31, 1944. The corporation and the transferee petitioners filed their Federal income and excess profits tax returns for 1942 with the collector of internal revenue for the district of Michigan at Detroit, Michigan. Dixie Shops, Inc., was engaged in the retail sale of men's, women's, and children's clothing from 1936 until its dissolution on January 31, 1944. The corporation regularly sold a substantial part of its merchandise on the installment plan and returned its income on the installment basis in accordance with the provisions of section 44 (a) of the 1939 Code. Dixie Shops, Inc., filed with its excess profits tax return for 1942 an election to compute its excess profits net income for that year on an accrual basis as provided by section 736 (a) of the 1939 Code. The corporation*190 conducted all of its selling activities from a store located at Detroit, Michigan, until the fall of 1941 when it opened another store in Ypsilanti, Michigan. In January 1942, the corporation decided to discontinue the operation of its Detroit store and transferred the lease under which it had occupied the Detroit store premises to H. Butler Stores, Inc. On or about February 1, 1942, Dixie Shops, Inc., sold installment accounts receivable then owned by it with a face value of $ 34,952.36 arising from sales at the Detroit store. The corporation realized $ 22,315.33 from the sale of the foregoing accounts receivable. Accounts in the face amount of $ 25,980.64 were sold to the Personal Finance Company and accounts valued at $ 8,971.72 were sold to the H. Butler Stores, Inc. The corporation retained accounts receivable arising from the operation of its Detroit store in the amount of $ 4,294.39. It was not *346 the practice of Dixie Shops, Inc., to sell, hypothecate, or otherwise dispose of its installment accounts receivable. The accounts receivable of the corporation's Detroit store were sold in February 1942 to obtain additional cash for investment in an anticipated new store*191 in Ann Arbor, Michigan, and further because it was unable to handle collection of the Detroit store accounts from Ypsilanti. The Ann Arbor store commenced operations in July 1942. Dixie Shops, Inc., extended credit to its customers in the majority of its retail sales. The terms of payment extended by the corporation to its credit customers required weekly or monthly payments and payment in full within 2 1/2 to 5 months. The terms of payment were extended beyond 5 months in isolated instances where a customer made an exceptionally large purchase. The average period required for the extinguishment of an installment obligation was 3 months. The following schedule reflects the collection experience of Dixie Shops, Inc., in the period January 1, 1942-January 31, 1944, and shows the balances of outstanding installment accounts receivable at the end of the 12-month fiscal year next subsequent to the fiscal period of sale (column 5), and shows the amount thereof expressed as a percentage (column 7) of the balances of outstanding installment accounts receivable at the end of the fiscal period of sale (column 3): [4] Balances of Bad debt Total accounts charge-off amount of receivable in 12-month Store location, year of sale credit sales outstanding fiscal year for entire at end next fiscal of fiscal subsequent to period period of fiscal sale period of sale Ypsilanti: Year ended 12/31/41 $ 31,410.80 $ 15,490.84 $ 1,722.23 Year ended 12/31/42 113,043.24 22,079.88 1,524.97 Ann Arbor: Year ended 12/31/42 34,520.01 12,876.58 901.09 Ypsilanti: Fiscal period 1/1/43-1/31/43 1 9,974.58 1 6,560.54 606.35 Ann Arbor: Fiscal period 1/1/43-1/31/43 1 6,821.04 1 4,602.54 535.79 *192 [7] Balances of accounts Dates of receivable column outstanding 5 figures at end and of year Per cent Store location, year of sale of 12-month ending date of column fiscal year of years of 5 of next charge-off column 3 subsequent to of column fiscal 4 figures period of sale Ypsilanti: Year ended 12/31/41 $ 207.02 12/31/42 1.336 Year ended 12/31/42 161.32 1/31/44 .73 Ann Arbor: Year ended 12/31/42 117.00 1/31/44 .909 Ypsilanti: Fiscal period 1/1/43-1/31/43 53.60 1/31/44 .817 Ann Arbor: Fiscal period 1/1/43-1/31/43 46.56 1/31/44 1.011 Within the 9-month period January 1, 1942, through September 30, 1942, the corporation collected 97.95 per cent of the accounts receivable balance outstanding on December 31, 1941, attributable to sales made through its Ypsilanti store in 1941. The Detroit and Ypsilanti customers were essentially the same type in the sense that they were engaged in the same type*193 of employment and in general had the same *347 economic status. The credit policies and terms of payment and the kinds and type of merchandise sold in the Ypsilanti store and the general character of its accounts were similar to those of the Detroit store in 1941. Inasmuch as the Ypsilanti 1941 accounts were basically the same as the Detroit 1941 accounts, if Dixie Shops, Inc., had not sold the Detroit store accounts on February 1, 1942, but instead had retained them, the balance of the outstanding installment accounts receivable for the Detroit sales as of December 31, 1942, would not have exceeded 1.336 per cent of the amount sold ($ 34,952.36). One hundred twenty-five per cent of the accounts receivable balance on the books of Dixie Shops, Inc., on December 31, 1942 ($ 35,317.72), is $ 44,147.15. The total of the accounts receivable balance outstanding on the books of the corporation on December 31, 1942 ($ 35,317.72), and 1.336 per cent of the face amount of the accounts receivable sold on February 1, 1942 ($ 466.96), is $ 35,784.68. One hundred twenty-five per cent of that amount is $ 44,730.85. The installment accounts receivable outstanding on the books of the corporation*194 at the close of the years ended December 31, 1938, through December 31, 1941, after adjustment for worthless accounts, were as follows: Outstanding installment Year accounts receivable [1938] $ 40,614.70 [1939] 46,564.75 [1940] 43,330.63 [1941] 58,218.80 Total $ 188,728.88 The average of the accounts receivable outstanding at the close of the foregoing taxable years was $ 47,182.22. At the end of 1942, Dixie Shops, Inc., charged off all accounts receivable upon which no payment had been made for 2 calendar months prior to the end of the year. The books of account of Dixie Shops, Inc., show that it owned installment accounts receivable on December 31, 1942, in the amount of $ 35,317.72. Some of the amounts charged off as bad debts at the close of 1942 were later recovered. One hundred twenty-five per cent of the accounts receivable balance outstanding on the books of Dixie Shops, Inc., on December 31, 1942 ($ 35,317.72), is $ 44,147.15. The average of the outstanding installment accounts receivable at the end of the 4 base years, 1938, 1939, 1940, and 1941 ($ 47,182.22), exceeded 125 per cent of the accounts receivable outstanding on the corporation's books at the*195 end of 1942. *348 OPINION. Section 736(a) 2 of the Internal Revenue Code of 1939 granted to installment basis taxpayers who came within its terms an election to report income on an accrual basis for excess profits tax purposes. Taxpayers so electing were required to recompute their income on an accrual basis for all previous excess profits tax taxable years. The portion of section 736 (a) here pertinent provides that any taxpayer computing income from installment sales under the method provided by section 44 (a) of the 1939 Code who establishes that -- the average outstanding installment accounts receivable at the end of each of the four taxable years preceding the first taxable year beginning after December 31, 1941, was more than 125 per centum of the amount of such accounts receivable at the end of the taxable year * * * may elect to compute, in accordance with the regulations prescribed by the Commissioner, its income from installment sales on an accrual basis, in lieu of the installment basis. *196 The parties agree that the average amount of outstanding installment accounts receivable of Dixie Shops, Inc., at the end of each of the 4 taxable years ended December 31, 1938, through December 31, 1941, *349 was more than 125 per cent of the amount of such accounts receivable appearing on the books of account of the corporation on December 31, 1942. The respondent contends, however, that although the outstanding installment accounts receivable set forth on the books of account of Dixie Shops, Inc., on December 31, 1942, was $ 35,317.72, for the purpose of determining eligibility for relief under section 736 (a) of the 1939 Code, that amount must be increased by $ 34,952.36, representing the face amount of accounts receivable sold by the corporation on February 1, 1942, to the Personal Finance Company and H. Butler Stores, Inc. In support of his position the respondent relies upon section 35.736 (a)-1 (b) (3) of Regulations 112, which states, in part, as follows: In determining the amount of installment accounts receivable at the end of the taxable year for which eligibility for relief under section 736(a) is being determined, no credit shall be allowed based upon the *197 sale, hypothecation, or other disposition (other than by payment by the purchaser) of any installment account receivable unless it is the practice of the taxpayer to sell, hypothecate, or make other disposition of a portion of its installment accounts receivable * * * Petitioner contends that the foregoing regulation, insofar as it requires the inclusion of accounts receivable sold by the corporation on February 1, 1942, in its 1942 year-end accounts receivable balance, is invalid because it attaches to qualification for section 736(a) relief a condition not found in the statute and exceeds the Commissioner's authority to prescribe regulations. The respondent argues that Congress intended that the Commissioner by regulation should define the terms of section 736 (a) because it specifically included in that section three references to "regulations prescribed by the Commissioner with the approval of the Secretary." The circumstances surrounding the enactment of section 736 (a) and the purpose which Congress intended by its enactment to accomplish have been aptly described in our Opinion in Mackin Corporation, 7 T. C. 648, at page 651: Section 736 (a) is*198 a relief provision, expressly so entitled. The circumstances which brought about its enactment, as explained in the committee reports, were, first, the adoption in the latter part of 1941 of Government credit restrictions increasing the size of down payments and shortening the payment period on installment contracts and, second, the shifting of many business concerns from civilian production into war production. The result to installment basis taxpayers who reported profits for taxation as installments were collected was that there was a bunching of income in one or more taxable years without normal installment selling costs to offset the profits collected. Thus, an installment basis taxpayer might have current taxable income in an amount much larger than in previous years, although the amount of current business done was smaller. *350 Furthermore, the effect of the existing situation in respect of an installment basis taxpayer was to subject to excess profits tax income arising from sales made in years when there was no such tax -- that is, income which in reality accrued before the adoption of the excess profits tax legislation. * * * Recognizing the hardship which thus*199 befell installment basis taxpayers as compared with other taxpayers, Congress gave relief in section 736 (a) by providing that those installment basis taxpayers who could meet certain qualifications might elect to report their income, for excess profits tax purposes, on the accrual basis in lieu of the installment basis. The provisions of section 736 (a) and the language of the accompanying committee reports 3 disclose a clear congressional intent to grant relief to taxpayers who experienced a reduction in installment sales in the normal course of business operations during excess profits tax taxable years beginning after December 31, 1941. It does not appear that Congress intended to grant relief in those instances where the qualifying diminution in the outstanding accounts receivable balance resulted (apart from conditions due to the wartime economy) from events other than those occurring in the ordinary course of business operations. *200 It is unquestioned that Dixie Shops, Inc., was not in the practice of selling or otherwise disposing of its accounts receivable, and that the disposition by it of a portion of its accounts on February 1, 1942, was an event which did not occur in the normal conduct of its business. However, it is equally clear from the record before us that the sale by Dixie Shops, Inc., of outstanding accounts receivable in the face amount of $ 34,952.36 on February 1, 1942, did not produce the qualifying reduction in its accounts receivable balance. The record clearly demonstrates that in the ordinary course of its business activities the corporation would have either collected or charged off as worthless all but 1.336 per cent of the accounts sold on February 1, 1942, leaving only $ 466.96 to be added to its accounts receivable balance on December 31, 1942. When so increased, the 1942 year-end accounts receivable balance would have amounted to $ 35,784.68. One hundred twenty-five per cent of that amount is $ 44,730.85, an amount substantially less than the average of the outstanding installment accounts receivable balances of the corporation at the end of the 4 base years ($ 47,182.22). Consequently, *201 if the corporation had not sold the $ 34,952.36 worth of accounts receivable on February 1, 1942, it nevertheless would have qualified for relief within the provisions of section 736 (a) in the normal course of business. The regulation in question, by requiring the addition to accounts receivable outstanding at the end of the year of the entire face amount of accounts previously sold, gives the taxpayer no credit whatever for the portion of the accounts sold which its collection experience *351 demonstrates it normally would either have collected or charged off in the ordinary conduct of its business. It is not within the province of the Commissioner under section 736 (a) to seize upon events abnormal in the course of the taxpayer's business, to ignore its normal business experience, and thereby to deny the relief which it was the manifest intention of Congress by the enactment of that section to grant. While it is obvious from the wording of section 736 (a) that Congress intended regulatory provision should be made by the Commissioner with respect to installment basis taxpayers who deliberately diminish their accounts receivable for the sole purpose of qualification under *202 that section to compute their excess profits tax liability on an accrual basis, we think he has regulated beyond that intention of Congress; and we are of the opinion that the portion of the regulations, Regulations 112, section 35.736 (a)-1 (b) (3), here in issue bears no reasonable relation to the clearly expressed purpose of section 736 (a) of the 1939 Code. For the foregoing reasons, we hold that the Commissioner's regulation limiting relief under section 736 (a) by requiring the inclusion in accounts receivable outstanding at the end of the year accounts which previously were sold by the petitioner, in determining its qualification for relief under section 736 (a), is without statutory warrant and is therefore invalid. Accordingly, Dixie Shops, Inc., was entitled to elect to compute income from installment sales on an accrual basis under section 736 (a) of the 1939 Code for purposes of reporting its excess profits tax liability for the taxable year ended December 31, 1942. Decisions will be entered under Rule 50. Footnotes 1. The proceedings of the following petitioners are consolidated herewith: Harold Berry Trust, Transferee, Betty Berry, Trustee, Docket No. 41027; Herbert O. Schlager, Transferee, Docket No. 41028; Dixie Shops, Inc., a Michigan corporation, Docket No. 41150.↩ 1. This is a 1-month operation -- Dixie Shops filed a 1-month return for the 1-month fiscal period ended January 31, 1943, after obtaining permission to change to a fiscal year ending January 31.↩ 2. SEC. 736. RELIEF FOR INSTALLMENT BASIS TAXPAYERS AND TAXPAYERS WITH INCOME FROM LONG-TERM CONTRACTS. (a) Election to Accrue Income. -- In the case of any taxpayer computing income from installment sales under the method provided by section 44 (a), if such taxpayer establishes, in accordance with regulations prescribed by the Commissioner with the approval of the Secretary, that the average volume of credit extended to purchasers on the installment plan in the four taxable years preceding the first taxable year beginning after December 31, 1941, was more than 125 per centum of the volume of such credit extended to such purchasers in the taxable year, or the average outstanding installment accounts receivable at the end of each of the four taxable years preceding the first taxable year beginning after December 31, 1941, was more than 125 per centum of the amount of such accounts receivable at the end of the taxable year, or if the taxpayer was not in existence for four previous taxable years, the taxable years during which the taxpayer was in existence, in either case including only such years for which the income was computed under the method provided in section 44 (a), it may elect, in its return for the taxable year, for the purposes of the tax imposed by this subchapter, to compute, in accordance with regulations prescribed by the Commissioner with the approval of the Secretary, its income from installment sales on the basis of the taxable period for which such income is accrued, in lieu of the basis provided by section 44 (a). Except as hereinafter provided, such election shall be irrevocable when once made and shall apply also to all subsequent taxable years, and the income from installment sales for each taxable year before the first year with respect to which the election is made but beginning after December 31, 1939, shall be adjusted for the purposes of this subchapter to conform to such election. In making such adjustments, no amount shall be included in computing excess profits net income for any excess profits tax taxable year on account of installment sales made in taxable years beginning before January 1, 1940. If the taxpayer establishes, in accordance with regulations prescribed by the Commissioner with the approval of the Secretary, that in a taxable year subsequent to the year with respect to which an election has been made under the preceding provisions of this subsection it would not be eligible to elect such accrual method, the taxpayer may in accordance with such regulations elect in its return for such year to abandon such accrual method. Such election shall be irrevocable when once made and shall preclude any further elections under this subsection. For the taxable year for which the latter election is made and subsequent taxable years, income shall be computed in accordance with section 44 (c).↩ 3. H. Rept. No. 2333, 77th Cong., 1st Sess. (1942), p. 26; S. Rept. No. 1631, 77th Cong., 2d Sess. (1942), p. 42.↩