Patchen v. Commissioner

Josef C. Patchen and Aleyne E. Patchen, et al., 1 Petitioners, v. Commissioner of Internal Revenue, Respondent Patchen v. Commissioner Docket Nos. 55767, 55768, 55769, 55770 United States Tax Court 27 T.C. 592; 1956 U.S. Tax Ct. LEXIS 10; December 21, 1956, Filed *10 Decisions will be entered under Rule 50. 1. Petitioners are members of a partnership which kept its books and filed its returns for 1946 and 1947 on the cash basis. In 1948, it installed, and thereafter maintained, an accrual system of accounting, but it continued to file its returns on the cash basis. The partnership's income would be clearly reflected for income tax purposes by use of either the cash or accrual system of accounting. Held, pursuant to section 41 of the 1939 Code, the partnership is required to report its income according to such system as it used in maintaining its books, and respondent's determination that petitioners were required to compute and report their distributable shares of the partnership's income pursuant to an accrual system for the years 1948, 1950, and 1951 is sustained. 2. Respondent made various adjustments in determining the partnership's income on an accrual basis. Held, certain additional adjustments must be made to correctly reflect items of income and expense which had accrued during the years in issue. 3. Respondent determined additions to tax for the failure to file a declaration of estimated tax and for the substantial underestimate*11 of estimated tax in Docket No. 55768. Held, both such additions to tax may be imposed against a taxpayer for the same taxable year. Harold E. Smith, Esq., for the petitioners. W. Preston White, Jr., Esq., for the respondent. Rice, Judge. RICE *592 These consolidated proceedings involve the following deficiencies in income tax and additions to tax determined against petitioners: Additions to tax Docket No. Year Income tax Sec. 294 Sec. 294 Sec. 294 (d) (1) (A) (d) (2) (d) (1) (B) 55767 [1948] $ 10,261.32 [1950] 5,862.54 [1951] 19,924.72 55768 [1948] 5,221.06 [1950] 2,981.48 [1951] 11,026.92 $ 1,786.56 $ 928.44 55769 [1948] 10,425.50 [1950] 6,540.68 497.76 [1951] 20,231.04 1,830.27 55770 [1948] 5,353.56 [1950] 3,004.66 123.85 [1951] 11,266.12 973.07 $ 37.31 *12 The issues to be decided are: (1) Whether the income of the partnership, Patchen and Zimmerman, was properly reported on the cash receipts and disbursements basis for the years involved herein; (2) if not, whether respondent's computation of the partnership income *593 on an accrual basis was correct; and (3) whether the additions to tax under section 294 (d) (1) (A) and section 294 (d) (2) may both be held applicable against petitioners in Docket No. 55768 for the taxable year ended December 31, 1951. Certain other issues raised by the pleadings have been conceded and such concessions will be taken into account under a Rule 50 computation. Some of the facts were stipulated. FINDINGS OF FACT. The stipulated facts are so found and are incorporated herein by this reference. The petitioners are residents of Augusta, Georgia. They filed their joint Federal income tax returns for each of the taxable years ended December 31, 1948, to December 31, 1951, inclusive, with the former collector of internal revenue for the district of Georgia. During these years, petitioners Josef C. Patchen, Frank C. Mingledorff, Harry F. Zimmerman, and John J. Evans were members of a partnership known *13 as Patchen and Zimmerman, Engineers. The partnership was formed on November 15, 1946, and since that time has engaged in the practice of professional engineering. It designs airports, sewage treatment plants, and chemical plants. Most of its clients are State and local governments, Federal agencies, and major industrial firms. United States partnership returns of income for the partnership were filed with the former collector of internal revenue for the district of Georgia for the taxable period ended December 31, 1946, and for the taxable years ended December 31, 1947, to December 31, 1951, inclusive. The taxable net income of the partnership for these years was distributable and taxable to the partners in the following proportions: Per cent Josef C. Patchen [30] Harry F. Zimmerman [30] Frank C. Mingledorff [20] John J. Evans [20] The growth of the partnership's business and the size of its operation are reflected in the total annual fees reported, as follows: Year Total fees [1946] $ 100.00 [1947] 53,729.54 [1948] 402,715.06 [1949] 292,172.35 [1950] 385,159.15 [1951] 730,260.07 *594 The bookkeeping records kept by the partnership for the taxable period ended *14 December 31, 1946, and the taxable year ended December 31, 1947, were limited and incomplete. In order to compile the necessary information for the partnership's Federal income tax returns for 1946 and 1947, its accountants had to make a complete analysis of every transaction. These returns were filed on the cash receipts and disbursements basis. In the early part of 1948, the partnership directed its accountants to install a formal system of accounting which would enable the partners to ascertain the cost of each individual job and correctly bill their clients. An essentially accrual system of accounting was established which included accrual accounts for accounts receivable, vouchers payable (synonymous with accounts payable), interest payable, and taxes payable, and, in addition to reserves for depreciation, reserve accounts for such items as slack-time pay, 2 vacation pay, vacation pay-partners, and a reserve for litigation. All expenses attributable to the various jobs on which the firm was engaged were charged to a jobs-in-progress account, and then allocated to the specific jobs in a jobs-in-progress subsidiary ledger. The additions to the reserves for slack-time pay, *15 vacation pay, and liability litigation were also treated as expenses and were charged to the jobs-in-progress account and then allocated to the accounts maintained for the various jobs in the jobs-in-progress subsidiary ledger. When bills for services were issued by the partnership, income was accrued by entering the amounts billed as accounts receivable. At the same time, the estimated items of expense incurred in connection with earning the amounts billed were transferred from the jobs-in-progress account to the job costs account. In determining its income per its books, the partnership treated the amounts in the job-costs account as deductible expenses, whereas the amounts in the jobs-in-progress account were treated as deferred charges and appeared under the current assets listed on its balance sheet. At the end of each of the years December 31, 1948, to December 31, 1951, inclusive, the balances of the deferred charges in the jobs-in-progress account were as follows: Year ended Dec. 31 [1948] $ 25,421.41 [1949] 21,319.62 [1950] 35,991.86 [1951] 72,747.16 *16 In general, the partnership had four types of fee arrangements with its clients. These were: (1) Lump-sum fee; (2) hourly rate for work performed; (3) cost-plus lump sum; and (4) percentage of *595 cost of construction. Billing methods and practices varied with the type of contracts. Contracts for services on an hourly basis were invoiced periodically on the basis of man-hours performed. Contracts predicated on a percentage of construction costs were not billed ordinarily until the plans and specifications were completed; but where the terms of the contract provided for interim billings, periodic invoices were prepared based upon a partner's evaluation of the percentage of completion. If a contract permitted the client to retain a portion of the fee until the construction of the project was finished, it was the practice of the partnership to enter these billings on its books net, i. e., after deducting the amount to be withheld by the client. In some instances, the partnership had to make adjustments in the amounts billed due to disputes with clients. These adjustments were the usual adjustments made by any business. At the end of each of the years December 31, 1948, *17 to December 31, 1951, inclusive, the balances in the partnership's accounts receivable account were as follows: Year ended Dec. 31 [1948] $ 59,977.04 [1949] 24,933.50 [1950] 59,457.64 [1951] 123,695.58 Some of the contracts which were performed by the partnership contained provisions for the reimbursement of the partnership for salaries of engineers, travel, or other expenses. At the end of each of the years set forth below, the jobs-in-progress account had been charged with the following aggregate amounts for certain of the contracts being performed by the firm, part of such amounts being for reimbursable items: [1948] $ 1,014.32 [1950] 2,518.15 [1951] 16,215.01 The partnership did not, at any time, hold merchandise inventories which would require the use of an accrual method in keeping its books or reporting its income. At the end of each of the years here involved, the accounting firm employed by it audited its books and determined its income according to an accrual method. On its returns for these years, the partnership continued to use the cash receipts and disbursements method. It did not, at any time, request permission from the Internal Revenue Service to *18 change its method of accounting from the cash to an accrual method, and it did not desire to change the method used in preparing its returns. In preparing the partnership income tax returns for the years in issue, the partnership's accountants prepared memorandum journal entries converting *596 all elements of income and expense to the cash receipts and disbursements method. Such adjusting entries are shown in the accountants' working papers, but are not entered on the partnership's books. These working papers and memorandum journal entries were kept by the accountants as a permanent part of their records and were available and furnished to the respondent's examining officers in the course of their examination. Without such working papers, the partnership's net income on the cash method was not readily ascertainable from its records. Respondent determined that the partnership's income tax returns for the taxable years 1948 through 1951, inclusive, should have been prepared on an accrual basis since, during such years, its books were kept predominantly on that method. In determining the partnership's income on an accrual basis, respondent accepted the income reflected on its*19 books with certain minor adjustments. These adjustments included the disallowance of the various deductions appearing on the partnership's books for partners' salaries and the additions to the reserves for slack-time pay, vacation pay, and liability litigation. Respondent treated the balances in the jobs-in-progress account in the same manner in which they were handled on the firm's books, thus, as deferred charges rather than deductions. Set forth below is the net income of the partnership for the years 1948 through 1951, as reported on its returns on the cash basis, as disclosed by its books, and as determined by respondent on an accrual basis: Net income Net income Net income Year per returns per books per notice of deficiency [1948] $ 88,832.35 $ 80,414.71 $ 165,967.71 [1949] 76,979.87 (14,779.53) 32,317.26 [1950] 75,563.21 68,310.68 125,311.02 [1951] 141,434.41 183,205.59 248,147.74 OPINION. The principal issue to be decided is whether respondent can require a taxpayer, 3 which has changed its method of accounting, to adopt a conforming change in the method by which it reports its income. The partnership whose returns are here in issue was*20 formed on November 15, 1946, to engage in the practice of professional engineering. During the period ended December 31, 1946, and the year ended December 31, 1947, such books and records as were kept by it were extremely rudimentary. However, they appear to have been essentially on the cash basis, and the returns which it filed were prepared on the cash basis. By 1948, the partnership's business had expanded *597 substantially and an accounting firm was employed to install a more detailed system of accounting. An essentially accrual system of accounting was thereafter maintained during the years 1948 through 1951, inclusive, but, in preparing its income tax returns for such years, the partnership continued to use the cash receipts and disbursements method. *21 Section 41 of the 1939 Code 4 requires that a taxpayer report its income "in accordance with the method of accounting regularly employed in keeping the books of such taxpayer * * *." There is no ambiguity in that language and we accordingly hold that it was entirely proper for respondent to determine that the partnership income should have been reported on the accrual method for the years here in issue. Charles D. Mifflin, 24 T. C. 973 (1955); Melvin E. Tunningley, 22 T. C. 1108 (1954); Deakman-Wells Co., 20 T. C. 610 (1953), reversed on other grounds 213 F. 2d 894 (C. A. 3, 1954); Bradstreet Co. of Maine, 23 B. T. A. 1093 (1931), reversed on other grounds 65 F. 2d 943 (C. A. 1, 1933); Louis Kamper, 14 B. T. A. 767 (1928); Ribbon Cliff Fruit Co., 12 B. T. A. 13 (1928). In Ribbon Cliff Fruit Co., supra, the following pertinent statement appears, at page 16: The provisions of section 212 (b) of the Revenue Act of 1921*22 are controlling in the decision of this issue, and, so far as material here, are as follows: The net income shall be computed upon the basis of the taxpayer's annual accounting period * * * in accordance with the method of accounting regularly employed in keeping the books of such taxpayer * * * There can be no question but that a taxpayer is privileged to adopt any method of accounting which it deems necessary for its business and that truly reflects its income. The statute contemplates that each taxpayer shall adopt such forms and methods of accounting as are in its judgment best suited to its purposes. Having adopted a particular method of accounting, and regularly employed that method in keeping its books, the statute requires that the taxpayer shall compute its net income, for the purposes of the tax, in accordance with that method, if income is clearly reflected thereby. *23 The partnership's income could, on the facts of this case, be clearly reflected by use of either the cash or accrual methods. Regs. 111, sec. 29.41. Having initially chosen to file its returns on the cash basis, it could not require respondent to accept subsequent returns prepared on an accrual basis unless it had first requested and received respondent's consent to such change. Regs. 111, sec. 29.41-2. This is true even though it had changed its accounting method and the method used in preparing its returns no longer coincided with that used in its books. National Airlines, Inc., 9 T. C. 159 (1947); Ross B. Hammond, Inc., *598 36 B. T. A. 497 (1937), affd. 97 F. 2d 545 (C. A. 9, 1938); American Conservation Service Corporation, 24 B. T. A. 183 (1931). But the taxpayers' difficulty is of their own making and they are in no position to complain, as they do, that this result gives the respondent the option of accepting cash basis returns which are consistent with those previously filed, or of requiring that the returns be prepared on the accrual method in*24 conformity with the partnership's books. If the accrual method proved to be a more accurate method for the taxpayers, then the respondent should also be entitled to the benefits of this increased accuracy. Moreover, respondent should not be burdened with the often difficult task of reconciling a cash basis return with a taxpayer's books maintained on some other system. It is not enough to say that either the cash method used by the partnership in its returns or the accrual method proposed by the respondent will clearly reflect income, and that consistency requires the continued acceptance of the partnership returns on the cash method. The requirements of section 41 are clear and must be followed. Petitioners also argue that the partnership's books were not actually maintained on an accrual basis since, in computing the income taxable to the partners, adjustments had to be made by respondent to eliminate such book items as the deductions for partners' salaries and deductions for reserves for slack-time pay and vacation pay. This argument is without merit because the system used was clearly an accrual system even though the treatment of some items was not in accord with income *25 tax requirements. Net income shown on a taxpayer's books need not coincide exactly with net income reportable for income tax purposes, and the adjustments made herein by respondent were no more than those frequently made in reconciling book income to taxable income. See Geometric Stamping Co., 26 T. C. 301 (1956). In determining the partnership's income on an accrual basis, respondent included in income for each of the years in issue the annual increase in its accounts receivable account. Petitioners contend that, even if an accrual system must be used in computing partnership income, the accounts receivable should not be regarded as income. They argue that the accounts receivable were merely interim billings based entirely on estimates, and that, in many instances, they represented amounts which were in dispute. However, the record indicates that the bills which the partnership rendered for its services were issued strictly in accordance with the contractual arrangements which it had with its clients and that it had a fixed or determinable right to the income included in such bills. Even if that may not have been the case with respect to some of*26 the accounts receivable here in issue, no evidence to the contrary has been presented and respondent's inclusion of the total amounts of the accounts receivable in income must *599 be sustained. Moreover, the mere fact that in some instances the partnership subsequently had to make adjustments in the amounts billed does not negate the fact that the amounts billed represented taxable income under an accrual system. The record establishes that these adjustments were nothing more than the usual adjustments made by any business. Under our system of annual accounting for income tax purposes, the partnership could not postpone the reporting of accrued items of income solely because there was a possibility that adjustments might, in some instances, have to be made in a later year. See Spring City Foundry Co. v. Commissioner, 292 U.S. 182 (1934). The next matter to be discussed relates to the treatment of the balances in the partnership's jobs-in-progress account at the end of each of the years in issue. This account was created to enable the partnership to ascertain the precise costs incurred by it on each of the jobs on which it was engaged. *27 All expenses attributable to the various jobs, such as wages, telephone, and travel, were charged to this account and then allocated to the specific jobs in a jobs-in-progress subsidiary ledger. Also charged to this account were those portions of partners' salaries attributable to specific jobs rather than general overhead. The additions to the various reserves for slack-time pay, vacation pay, and liability litigation were also treated as expenses and charged to the jobs-in-progress account. In an effort to match expenses with income, the items in this account were not taken as deductions on the partnership's books until such time as a bill was rendered to the firm's client. At that time, income was accrued by entering the bill in the firm's accounts receivable account, and the expenses attributable to the particular job were transferred from the jobs-in-progress account to the job-costs account, resulting in an expense deduction. Thus, the various items in the jobs-in-progress account were held in suspense and treated as deferred charges on its books, and the balance in the account appeared as a current asset on the partnership's balance sheet. In preparing the partnership's*28 cash basis returns at the end of each of the years in issue, its accountants deducted the balances in the jobs-in-progress account. The effect of this was to claim a deduction for all the items remaining in the account as of the end of the year even though, on the partnership's books, such items were treated as deferred charges. Respondent determined that the balances in the jobs-in-progress account at the end of each of the years in issue should be treated in the same manner in which they were treated on the partnership's books (as deferred charges) and he disallowed the deduction taken by the partnership on its returns for such items. Insofar as the amounts remaining in the jobs-in-progress account, which represented charges to various as yet unbilled jobs, for partners' salaries and the reserves for slack-time pay, vacation pay, and liability litigation, respondent's action *600 in disallowing such amounts is clearly correct. 5Partners' salaries are not deductible by a partnership in determining the distributable share of income to be reported by the partners. Karl Pauli, 11 B. T. A. 784 (1928). As for the aforementioned reserves, no proof*29 has been introduced showing that a fixed or determinable liability existed, and their deduction was properly disallowed. Morrisdale Coal Mining Co., 19 T. C. 208 (1952); E. H. Sheldon & Co., 19 T. C. 481 (1952), reversed on another issue 214 F. 2d 655 (C. A. 6, 1954). However, the remaining items in the jobs-in-progress account (with the qualification hereinafter discussed regarding reimbursable items) constitute expenses which are deductible in the year in which incurred, even though the partnership's clients may not have been billed for the jobs to which such expenses related until a subsequent year. There is no provision in the Code permitting the postponement, by an accrual basis taxpayer, of the deduction of expenses from one year to another in order to obtain a precise matching of income and expenses. Respondent therefore erred in disallowing the deduction claimed by the partnership for wages, telephone, and other such expenses contained in the jobs-in-progress account. *30 One more item must be discussed, namely, the various reimbursable expenses which were included in the jobs-in-progress account and also in the job-costs account. It has been firmly established that where a taxpayer makes expenditures under an agreement that he will be reimbursed therefor, such expenditures are in the nature of loans or advancements and are not deductible as business expenses. Glendinning, McLeish & Co., 24 B. T. A. 518 (1931), affd. 61 F. 2d 950 (C. A. 2, 1932); Henry F. Cochrane, 23 B. T. A. 202 (1931). The record indicates the aggregate dollar amount of contracts charged to the jobs-in-progress account at the end of each of the years 1948 through 1951, inclusive, which contained reimbursable items such as salaries of engineers and travel. Since there is nothing in the record which permits us to find the exact amounts of these reimbursable items, petitioner having introduced no evidence on this point, the entire amount of the charges for contracts containing reimbursable items must be excluded from the total amounts deductible by the partnership. As for the erroneous inclusion*31 of reimbursable expenditures in the job-costs account, the partnership made a balancing error by also including such reimbursable expenditures in its accounts receivable, and, consequently, no adjustment need be made here. *601 The last item here in issue is whether the additions to tax prescribed by section 294 (d) (1) (A) for failure to file a declaration of estimated tax, and by section 294 (d) (2) for substantial underestimate of estimated tax can both be imposed in the same taxable year. This issue has been decided against the taxpayer in Harry Hartley, 23 T. C. 353 (1954), modified 23 T. C. 564 (1954); and in G. E. Fuller, 20 T. C. 308 (1953), affirmed on other grounds 213 F. 2d 102 (C. A. 10, 1954). No arguments have been presented in the instant proceeding to cause us to change our position, and respondent's determination of both of these additions to tax is sustained. Decisions will be entered under Rule 50. Footnotes 1. The following proceedings have been consolidated: Josef C. Patchen and Aleyne E. Patchen, Docket No. 55767; Frank C. Mingledorff and Edna S. Mingledorff, Docket No. 55768; Harry F. Zimmerman and Winifred R. Zimmerman, Docket No. 55769; John J. Evans and Rosalie J. Evans, Docket No. 55770.↩ 2. This account is described as a reserve to provide pay for the engineers employed by the partnership during periods when there is no work available for them because it was necessary to keep them on the payroll so that they would be available for new jobs.↩ 3. Though the taxpayers herein are the members of the partnership rather than the partnership itself, they do not question the fact that they are required to compute and report their distributable shares of partnership income according to whichever system of accounting the partnership is required to use.↩ 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 income. * * *↩ 5. In addition to disallowing the deduction of the amounts in the jobs-in-progress account at the end of each of the years in issue which represented charges to various as yet unbilled jobs for partners' salaries and the reserves for slack-time pay, vacation pay, and liability litigation, respondent made another adjustment with respect to such items which resulted in adding to the firm's income, a second time, those portions of the jobs-in-progress account represented by such latter adjustment. Respondent now concedes this latter adjustment was erroneous and it will be taken into account in the Rule 50 computation.↩