Whitaker v. Commissioner

Estate of B. F. Whitaker, Deceased, First National Bank in Dallas and Lanham Croley, Co-Executors, and Florence D. Whitaker, Petitioners, v. Commissioner of Internal Revenue, Respondent Whitaker v. Commissioner Docket No. 51381 United States Tax Court 27 T.C. 399; 1956 U.S. Tax Ct. LEXIS 29; November 29, 1956, Filed *29 Decision will be entered for the respondent. 1. The petitioner's stallion performed breeding services in the spring of the year and the foal was born to the mare in the following year. The petitioner guaranteed a live foal to the owners of the mares. He reported fees received in the year of breeding in the following year after the foal was born since he was required to refund the fees if a live foal was not born. The respondent determined that fees received in the year of breeding were income in that year. Held, the petitioner's method of reporting these fees did not clearly reflect his income; the contingent liability does not justify the postponing of reporting the fees as income to periods subsequent to the periods in which they were both earned and received. The respondent is sustained. 2. Petitioner was the owner of a racehorse which he purchased in 1948 and took depreciation thereon in 1948 and 1949, on the straight-line method. In 1950, the racehorse bowed a tendon. Petitioner determined that the injury rendered the racehorse valueless for racing purposes and sold the horse for $ 1,000. Petitioners, on their joint income tax return, took accelerated depreciation*30 on the horse which they deducted and accounted for the sale price of the horse as salvage. Petitioners' method results in taking the loss as an ordinary loss in full. Respondent, in his determination of the deficiency, allowed petitioners depreciation on the straight-line method which petitioners had been using, and computed petitioners' loss as a capital loss under section 117 (j), Internal Revenue Code of 1939. Held, accelerated depreciation disallowed since the shortening of the racehorse's useful life was due to an accidental injury, and not to depreciation. The Commissioner's computation of petitioners' loss as a capital loss resulting from the sale of a capital asset is sustained. Sec. 117 (j), 1939 Code. Llewellyn A. Luce, Esq., and Lanham Croley, Esq., for the petitioners. Frank C. Allen, Esq., for the respondent. Black, Judge. BLACK *400 The respondent determined deficiencies in income tax as follows: Year Deficiency — 1948 — $ 8,468.64 — 1949 — 19,442.18 — 1950 — 1,228.20 The adjustments to the petitioners' income were conceded at the trial with two exceptions, leaving the following issues to be decided: (1) Whether fees received in cash from breeding contracts guaranteeing a live foal were income in the year of breeding and receipt or in the following year in which the foal was born, and (2) whether petitioners are entitled to accelerated depreciation on a racehorse in the year in which the racehorse ceased to have any useful life as a racehorse due to an injury. The petitioners state issue (2) in their brief, as follows: 2. Whether the respondent erred by refusing to allow the decedent to deduct for the year 1950 the sum of $ 6,000 for depreciation on the race horse Baby Jeanne*32 ($ 7,000 depreciation less salvage value of $ 1,000), the year 1950 being the year during which Baby Jeanne ceased to have any useful life or value as a race horse. FINDINGS OF FACT. B. F. Whitaker (sometimes hereinafter referred to as petitioner), now deceased, 1 and Florence D. Whitaker were husband and wife during the years involved herein and resided in Dallas, Texas. They filed joint income tax returns for the years 1948, 1949, and 1950 with the then collector of internal revenue for the second district of Texas at Dallas. Hugh M. Frye, a certified public accountant, prepared the returns for the Whitakers from the mid-1930's through all of the years in question. Issue 1. The petitioner was engaged in the hotel business, the oil business, the horseracing business, and the horse-breeding business. The income from all of his *33 activities was reported on the joint returns of the petitioners. The income from each activity was compiled on a separate schedule which was attached to the return. The hotel business income was included in the returns on the accrual basis; the oil business income was reported on the cash basis; and the income from horseracing was reported on the accrual basis (recorded as income *401 when a purse was won rather than when the purse was received). The income from horseracing and from breeding was included on the same schedule with all the expenses of stable operation deducted to arrive at net income from stable operation. The record does not indicate whether the expenses were attributable to racing or breeding, or both, or whether they were recorded on the cash or accrual basis. During the years 1944 through 1951, the decedent owned and bred a stallion named Requested. The stallion stood for breeding purposes at Spendthrift Farm, Lexington, Kentucky, which farm was owned by Leslie Coombs. Coombs took care of Requested, secured the services of the mares, sent out the statements, and made the collections for the breeding. The collections were forwarded to petitioner. It takes*34 11 months for a mare, after being bred, to produce a foal. The mare would usually be bred in the spring of the year and the foal would be born in the subsequent year. Under the terms of the breeding transactions, a live foal was guaranteed. If the mare was in foal (in the process of producing foal) in the fall of the year, the owner of the mare would generally pay the breeding fee then. If, during the subsequent year, a foal was not born alive the petitioner would be required to refund any fees previously paid. The fees received (with the exceptions below) were reported as income in the year in which the foal was born. Most of the fees were paid in the year of breeding and the petitioner recorded those amounts, which he treated as deposits, in a suspense account on the books. During a couple of years he purchased cashier's checks for those amounts and held them until the subsequent year when the foals were born. These cashier's checks were not, however, put into any kind of trust fund. The breeding services of Requested were first made available in 1944 on a complimentary basis. Beginning in 1945, a fee of $ 250 was sometimes charged. In 1948, the fee, when charged, was *35 $ 1,000, and in 1949 and 1950, it was $ 2,500. The first year that petitioner collected breeding fees was 1946. The amount of $ 1,250 was collected for foals bred in 1945 and born in 1946. He reported that amount as income in 1946. In that year he also received $ 250 for foal bred in 1946, to be born in 1947. He deferred reporting that $ 250 until 1947, when the foal was born. In 1947, $ 2,750 was collected, $ 2,250 being for foals bred in 1946 and born in 1947, and $ 500 being for foals bred in 1947 to be born in 1948. The entire $ 2,750 was reported as income in 1947, but the petitioner's bookkeeper testified that she had made a mistake in recording the $ 500 that was collected for foals to be born in 1948. The amounts of $ 8,000, $ 30,000, and $ 26,250 were collected as breeding fees for foals bred in the years 1948, 1949, and 1950, respectively. The amounts were returned as income in the year in which the foals *402 were born, namely, $ 8,000 in 1949, $ 30,000 in 1950, and $ 26,250 in 1951. Any fees that were collected in the year in which the foals were born were reported as income in that year. The respondent determined that the fees collected in 1948, 1949, and 1950*36 should be reported as income in the year received and that any refunds made because of no live foal being born in a subsequent year could be deducted from income in the year the refund was made. The same method of accounting was used by the petitioner, and later by his executors, in the years subsequent to 1950, the last year involved here. The executors did pay additional taxes for the years 1951-1953, in accordance with the respondent's audit which was an extension of his determinations involved here. They did so upon the advice of counsel. No claim for refund had been filed as of March 13, 1956, but the executors believed that there was still time in which to do so. Issue 2. Baby Jeanne, a racehorse, was acquired by petitioner by purchase on August 23, 1948, at a cost of $ 9,000. The depreciation on the racehorse allowed by the respondent aggregated $ 3,500, as follows: — 1948 — $ 500 — 1949 — 1,500 — 1950 — 1,500 Total $ 3,500 Baby Jeanne won no race purses during 1949. During that year she had a partial bow of a tendon and was placed on a farm in Kentucky from April to October 1949, for treatment of the tendon in order that she might race again. During 1950, Baby*37 Jeanne raced in 19 races and placed twice, winning $ 750. The petitioner entered Baby Jeanne in a race for the last time on October 14, 1950. On that day she bowed a tendon and was unable to race any more. The petitioner determined that the horse was completely valueless as a racehorse and in December 1950 the horse was sold for $ 1,000. On the joint income tax return filed by decedent and his wife, the sale of Baby Jeanne was reported as follows: Acquired Cost Depreciation Sale price — 1948 — $ 9,000 $ 8,000 $ 1,000 Thus, the accelerated depreciation which petitioner took in 1950 plus depreciation in prior years plus sale price of the horse equaled the original cost of the horse and petitioner reported no gain or loss on the sale of the horse. In his determination of the deficiency for the taxable year 1950, the Commissioner determined that the sale of Baby Jeanne resulted in a long-term capital loss of $ 4,500, which he computed as follows: *403 Selling Description Date acquired Cost Depreciation price (Loss) Baby Jeanne Aug. 23, 1948 $ 9,000 $ 3,500 $ 1,000 ($ 4,500) OPINION. Issue 1. The first question presented is whether*38 breeding fees received in the year of breeding are income in that year or in the following year when the foal is born. (Mares were bred in the spring and foals were born 11 months later, in the following year.) The respondent determined that the fees are income in the year received on the ground that the petitioner was on the cash basis or, on the alternative ground, that the petitioner received the fees under a "claim of right" and they are income in the year received regardless of the basis of accounting used. The petitioner contends he has consistently reported the breeding fees on the completed contract basis; that the contract was not completed until the foal was born alive because he guaranteed a live foal and was required to repay any fee if the foal was not born alive; and that the completed contract method clearly reflects his income. We think the record supports the respondent's determination that the breeding fees received in the year of breeding are income in that year rather than in the following year when the foal was born. Section 42 of the Internal Revenue Code of 1939 provides: SEC. 42. PERIOD IN WHICH ITEMS OF GROSS INCOME INCLUDED. (a) General Rule. -- The *39 amount of all items of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under methods of accounting permitted under section 41, any such amounts are to be properly accounted for as of a different period. * * * If the petitioner was on the cash basis the fees would be income in the year received. However, the petitioner contends that the method he used is one that is permissible under section 41, since it clearly reflects income. The petitioners, in their brief, argue: Clearly this taxpayer had a right under the established law to return his income on a completed contract basis which, we submit, clearly reflected his income. The taxpayer, since 1946 (when his breeding activities began), has consistently adhered to the completed contract basis of reporting the breeding fee income. The Commissioner now seeks to destroy the taxpayers' right to return the income on the completed contract basis by erroneously determining that the taxpayer kept his books and filed his returns on the cash receipts and disbursements basis and that the completed contract basis did not correctly reflect income. It is true that Treasury regulations*40 do provide in certain situations for reporting income on the long-term contract basis. It seems perfectly clear, however, that petitioners' income from breeding contracts *404 does not come within the provisions of these regulations. In Regulations 111, the long-term contracts regulations are as follows: Sec. 29.42-4. Long-Term Contracts. -- Income from long-term contracts is taxable for the period in which the income is determined, such determination depending upon the nature and terms of the particular contract. As used in this section the term "long-term contracts" means building, installation, or construction contracts covering a period in excess of one year from the date of execution of the contract to the date on which the contract is finally completed and accepted. Persons whose income is derived in whole or in part from such contracts may, as to such income, prepare their returns upon either of the following bases: * * * * (b) Gross income may be reported for the taxable year in which the contract is finally completed and accepted if the taxpayer elects as a consistent practice so to treat such income, provided such method clearly reflects the net income. If*41 this method is adopted there should be deducted from gross income all expenditures during the life of the contract which are properly allocated thereto, taking into consideration any material and supplies charged to the work under the contract but remaining on hand at the time of completion. A taxpayer may change his method of accounting to accord with paragraph (a) or (b) of this section only after permission is secured from the Commissioner as provided in section 29.41-2. It is obvious that petitioners' income from breeding fees does not come within the purview of the foregoing regulations. The regulations are not intended to cover the treatment of the kind of income here involved. The petitioner's evidence leaves something to be desired with regard to the use of one method consistently; but assuming that he consistently reported the fees in the year the foals were born, we do not think that that method clearly reflected his income. Therefore, it cannot be used. The petitioner's stallion performed the breeding service in the spring of the year. After that service was performed the petitioner's performance of the contract was completed. The fees were earned at that time. *42 In addition, he received the fees in question in the same year when it was determined the mares were in foal. All that remained was a contingent liability; if the foal was not born alive the fee would have to be refunded. It is well established that such a contingency is not sufficient to defer the reporting of income. See Brown v. Helvering, 291 U.S. 193 (1934); Vang v. Lewellyn, (C. A. 3, 1929) 35 F. 2d 283; S. B. Heininger, 47 B. T. A. 95, 100 (1942), reversed on another issue (C. A. 7) 133 F. 2d 567, affd. 320 U.S. 467 (1943). We cannot see how a method of accounting that defers the reporting of fees as income to a period subsequent to that period in which the service is completed, the fees earned, and the fees received could clearly reflect income. The petitioner's accounting method is not justified by merely calling the contract complete at the time the contingency is removed. *405 One of the cases, among others, relied upon by petitioners in support of their contention is Schuessler v. Commissioner, (C. A. 5) 230 F. 2d 722,*43 reversing 24 T. C. 247. In that case, the taxpayers had set up a reserve of $ 13,000 to represent their estimated cost of carrying out a guarantee given with each of the furnaces sold by them during the year to turn the furnace on and off each year for 5 years. The Tax Court had disallowed the accrued reserve as a deduction in the taxable year. The Fifth Circuit reversed the Tax Court with direction to enter judgment for the taxpayers. It is manifest that that case is not in point with the facts which we have in the instant case. We do not have here a reserve set up to take care of future expenses which the taxpayer was obligated to pay under the terms of the contract. In the instant case, we have no reserve set up at all to take care of future expenses. We have here merely a contract which obligated the taxpayer to make certain refunds in case a contingency happened, namely, the birth of a dead foal. This contingency only happened occasionally and the return of fees which petitioner had to make under the terms of the contract were few in number, as the evidence shows. Therefore, to sum up, it seems to us that the fees in question were clearly income*44 in the year of breeding and receipt; this is true whether petitioners kept their breeding fees records on the cash or the accrual basis. The respondent's determination is, therefore, sustained. Issue 2. Petitioner's racehorse, Baby Jeanne, bowed a tendon in 1950 and the petitioner sold her for $ 1,000, after he determined that she was valueless as a racehorse. The respondent allowed a normal depreciation deduction on a straight-line basis for that year and determined that the difference between the adjusted basis and the sales price was a capital loss. Respondent relies upon section 117 (a) (5) and (j) (1), Internal Revenue Code of 1939, printed in the margin. 2 The petitioner contends that he is entitled to accelerated depreciation in 1950 in the amount of the difference between the adjusted basis and *406 the sales price. The practical question is whether the petitioner can deduct his loss in full or in part. The method used by petitioner would deduct it in full. *45 Section 23, Internal Revenue Code of 1939, provides that in computing net income there shall be allowed as deductions: (l) Depreciation. -- A reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) -- The proper allowance for depreciation is the amount which should be set aside in each taxable year in accordance with a reasonably consistent plan whereby the aggregate of such amounts plus the salvage value will at the end of the useful life of the property be equal to the cost or other basis of the property. Regs. 111, sec. 29.24 (l)-1. The petitioner computed the depreciation on Baby Jeanne on a straight-line basis. To be entitled to additional depreciation when computing it on a straight-line basis, the petitioner must show that additional exhaustion, wear, and tear have shortened the previously estimated useful life of the asset. Copifyer Lithograph Corporation, 12 T. C. 728 (1949). The petitioner has shown the useful life of Baby Jeanne as a racehorse had been shortened. But the useful life had been shortened by an accidental injury, not by depreciation, i. e., exhaustion, wear, and tear. Petitioner's*46 loss, as respondent has determined, is a capital loss, deductible as provided in section 117 (j) of the 1939 Code. Accordingly, the respondent's determination is sustained. Decision will be entered for the respondent. Footnotes 1. B. F. Whitaker died on April 20, 1954. First National Bank in Dallas and Lanham Croley, co-executors of the decedent's will, were substituted as parties in place of B. F. Whitaker.↩ 2. SEC. 117. CAPITAL GAINS AND LOSSES. (a) Definitions. -- As used in this chapter -- * * * * (5) Long-term capital loss. -- The term "long-term capital loss" means loss from the sale or exchange of a capital asset held for more than 6 months, if and to the extent such loss is taken into account in computing net income; * * * * (8) Net long-term capital gain. -- The term "net long-term capital gain" means the excess of long-term capital gains for the taxable year over the long-term capital losses for such year; * * * * (j) Gains and Losses From Involuntary Conversion and From the Sale or Exchange of Certain Property Used in the Trade or Business. -- (1) Definition of property used in the trade or business. -- For the purposes of this subsection, the term "property used in the trade or business" means property used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 23 (l)↩, held for more than 6 months, * * *