Simplified Tax Records, Inc. v. Commissioner

Simplified Tax Records, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent Simplified Tax Records, Inc. v. Commissioner Docket No. 84145 United States Tax Court 41 T.C. 75; 1963 U.S. Tax Ct. LEXIS 35; October 17, 1963, Filed *35 Decision will be entered for the respondent. Petitioner sold accounting systems to small businesses throughout the country and also agreed to prepare the income tax returns of the subscribers for 2 years on request, all for a single package price, all of which was included in petitioner's gross sales for the year of sale. In 1954 petitioner established a reserve for the estimated future cost of preparing subscribers' returns and deducted additions thereto as a part of the cost of goods sold on its returns for 1954 and 1956. Held, respondent did not err in disallowing the deductions. Stevens H. Weiss, Henry W. Steingarten, and Robert J. Wolpert, for the petitioner. Stephen M. Miller, for the respondent. Drennen, Judge. DRENNEN *75 Respondent determined deficiencies in petitioner's income tax for the taxable years 1954 and 1956 in the respective amounts of $ 6,843.39 and $ 30,040.24. The only issue for decision is whether petitioner is entitled to accrue and deduct, as of the end of its fiscal years ended September 30, 1954, and September 30, 1956, additions to a reserve for*37 estimated future expenses to be incurred in preparing tax returns for petitioner's subscribers. FINDINGS OF FACT Some of the facts have been stipulated and are so found. Petitioner is a corporation organized in 1937 under the laws of New York. Its principal office during the period in controversy was located in New York, N.Y. Petitioner maintained its books on the accrual method of accounting using a fiscal year ending September 30. It filed timely Federal corporation income tax returns for the taxable years ended September 30, 1954, and September 30, 1956, with the *76 district director of internal revenue for the Lower Manhattan district of New York. During the period here involved petitioner was engaged in the business of selling an accounting service designed for small businesses. The service consisted of an accounting system, which included single entry books, bookkeeping forms, and supplemental records, together with an agreement that petitioner would prepare the income tax returns of the subscriber for 2 years. The service was sold to small businesses throughout the country through regional distributors at a cost of $ 79.50 covering a 2-year period. Petitioner prepared*38 returns for its subscribers only upon the request of subscribers. In order to have its returns prepared, a subscriber was required to submit a completed "Income Tax Information Sheet" no later than February 1 of the year in which its returns were to be prepared. Petitioner was not obligated to prepare a subscriber's returns unless this information sheet was received. The years for which petitioner agreed to prepare a subscriber's income tax returns were not specified in the subscription agreement. All subscribers did not request petitioner to prepare their returns during the years of the subscription and sometimes a subscriber would request petitioner to prepare its returns after its 2-year subscription period had expired. If such a subscriber had not availed itself of petitioner's services during the 2-year period of its subscription, petitioner would usually prepare its returns although the subscription period had expired. From 1943 through early 1956 petitioner contracted with a public accounting firm for the latter to prepare subscribers' income tax returns on a fixed-fee-per-return basis. The amount of this fee was agreed upon from year to year. During a filing period a*39 representative of the accounting firm would go to petitioner's office and pick up any information sheets which had been sent in by subscribers. Based on the information contained on the information sheets the firm prepared subscribers' returns in pencil and delivered the penciled copies to petitioner. Petitioner typed the returns in final form and mailed them from its office. Petitioner hired typists and clerical help for this purpose during a filing period. During its taxable year 1954 petitioner paid the accounting firm $ 2.10 for each Federal return and $ 1 for each State return prepared by the firm in penciled form. At the end of each week the accounting firm presented a bill to petitioner for the returns prepared during that week and received a check in payment. The accounting firm never received payments for preparing returns in advance of preparation and submission of a bill to petitioner, and had not billed petitioner by September 30, 1954, for any returns which they might prepare subsequent to that date. Petitioner's contract with the accountants *77 did not call for any specified number of returns. On its income tax return for fiscal 1954, and for years prior*40 thereto, petitioner deducted as a portion of its cost of goods sold the actual cost incurred during that year for the preparation of subscribers' income tax returns, including payments to the accounting firm and salaries for typing, clerical, and mailing employees. The accounting firm which prepared the subscribers' returns for petitioner was retained by petitioner in 1954 to audit its books and prepare its own tax returns. As of September 30, 1954, the accountants set up on petitioner's books a reserve in the amount of $ 26,981.33, representing the estimated cost of preparing subscribers' income tax returns during its taxable year 1955. Petitioner reported this amount on its return for its fiscal year 1954 as a portion of its cost of goods sold for that year. The amount of $ 26,981.33 added to petitioner's reserve as of the end of its fiscal year 1954 was arrived at by the accounting firm retained by petitioner by the following method: The number of systems sold in each of the taxable years 1950, 1951, 1952, and 1953 were determined, together with the total number of tax returns prepared in those years; the average number of sales of systems and the average number of returns prepared*41 were calculated. The percentage of tax returns prepared to the number of systems sold was computed by dividing the average number of returns prepared by the average number of systems sold. The percentage was found to be 68.9 percent for Federal returns and 35.3 percent for State returns. It was found that 8,348 systems had been sold in the taxable year 1954, and the accounting firm estimated that 68.9 percent of the sales figure, or 5,779, would be the number of Federal income tax returns to be prepared in 1955 and that 35.3 percent of the sales figure, or 2,947, would be the number of State income tax returns to be prepared in 1955. The accounting firm multiplied the resulting figure by $ 2.10 to get its estimated charge to petitioner for preparing Federal returns during 1955 and multiplied the number of estimated State income tax returns by $ 1 to arrive at the estimated cost of its preparation of State returns. The total estimated cost for preparing returns in 1955 was $ 15,377.60. 1The accounting firm then computed the extra clerical payroll for the filing periods for the 4 previous years and arrived at an average figure for this payroll. This average payroll expense, *42 in the amount of $ 11,603.73, was added to the estimated charges for preparation of the returns, and the resulting total was $ 26,981.33, which was the amount added to the reserve for the estimated expenses of preparing returns in 1955. The accounting firm actually prepared 6,314 Federal returns and 3,002 State returns during the 1955 tax-reporting season. *78 Prior to the preparation of petitioner's 1954 returns, no reserve for this purpose had ever been established on its books. Petitioner reported all the income from sales of the systems in the years such sales were made. No request was ever made to the Commissioner of Internal Revenue for petitioner to change its method of accounting, nor was the Commissioner's consent to a change ever received by petitioner. In 1956 petitioner retained another accounting firm and decided to prepare returns for its subscribers itself under*43 a mass production system devised by these accountants. At September 30, 1955, the reserve for the expenses of preparing subscribers' income tax returns was $ 22,229.98. 2 In arriving at the amount to be added to the reserve as of the end of petitioner's taxable year 1956, petitioner's accountant estimated the clerical costs (including extra payroll, typewriter rental, and supplies) involved in preparing, typing, and mailing the returns which petitioner would have to prepare for its subscribers in the year 1957. Based upon the number of returns prepared in the year 1956 and the fact that petitioner's sales were holding up, the accountant estimated that 8,700 returns, Federal and State, would be prepared in 1957. The estimated cost of preparing 8,700 returns was approximately $ 40,000 and the accountant decided that since petitioner's obligation to prepare returns extended over a 2-year period, the reserve for the expenses of the future preparation of returns should be $ 80,000 as of the end of the taxable year 1956. Because the amount of $ 22,229.98 was then reflected in the reserve, petitioner added to the reserve as of September 30, 1956, the amount of $ 57,770.02, and this*44 amount was deducted as a part of its cost of goods sold on its return for fiscal 1956. During the 1957 tax season petitioner actually prepared about 11,000 returns. The actual cost of preparing subscribers' returns in 1957 was about $ 115,000, which included extra accounting fees as a result of a breakdown in the internal operation of the mass production system. In the statutory notice of deficiency issued herein respondent has disallowed as a deduction in arriving at taxable income for the years 1954 and 1956 the respective amounts of $ 26,981.33 and $ 57,770.02, with the explanation that "deductions for estimated expenses claimed as part of the cost of goods sold in your returns for the taxable years * * * 1954 and * * * 1956, are not allowable under any provision of the Internal Revenue Code of 1939 with respect to your taxable year * * * 1954*45 or under any provision of the Internal Revenue Code of 1954 with respect to the taxable year * * * 1956." Petitioner stated at the trial that should a deduction be allowed for the addition to its reserve in 1954, then the amount deducted on its *79 return for that year for expenses actually incurred and paid for preparation of 1953 returns should be disallowed. OPINION The principal issue is whether respondent erred in disallowing a deduction for estimated future expenses of preparing subscribers' income tax returns which petitioner had claimed as a part of its cost of goods sold on its income tax returns for 1954 and 1956. This is another of the plethora of cases coming before the courts in recent years involving the deferral of income or the accrual of expenses to cover the estimated cost of rendering services in the future. We think the issue here is controlled by the recent decisions of the Supreme Court in Schlude v. Commissioner, 372 U.S. 128 (1963), American Automobile Assn. v. United States, 367 U.S. 687 (1961), and Commissioner v. Milwaukee & Suburban Transport Corp., 367 U.S. 906 (1961),*46 which require a decision against the taxpayer herein. While it is true that the Schlude and American Automobile cases were concerned with the deferral of income rather than the deduction of estimated future expenses, the Court remanded the Milwaukee & Suburban Transport case, which did involve the deductibility of estimated expenses, "in the light" of the American Automobile case, and on remand the Court of Appeals for the Seventh Circuit vacated its prior decision permitting the deduction of anticipated damage claims and reinstated the decision of this Court denying such deduction on the authority of the American Automobile case. See Milwaukee & Suburban Transport Corporation v. Commissioner, 293 F. 2d 628 (C.A. 7, 1961). While it can be argued that there are technical distinctions in deferring prepaid income and deducting estimated future expenses in cases like this the net result is the same and we think the same principles of tax accounting and the Commissioner's authority should be applied to both techniques. 3 As said in American Automobile Assn. v. United States, supra, the prepaid*47 dues were credited to a reserve "as deferred or unearned income reflecting an estimated future service expense to members." In Automobile Club of Michigan v. Commissioner, 353 U.S. 180 (1957), the Supreme Court held that the taxpayer could not defer its membership dues ratably over the year for which they were paid because the pro rata allocation of dues in monthly amounts was "purely artificial" and bore no relationship to the services which the taxpayer in fact might be called on to render its members, and therefore the Commissioner had not abused his discretion in determining that taxpayer's system of accounting did not clearly reflect its income. In American Automobile Assn. v. United States, supra, under similar facts but with evidence that the pro rata deferral of income did correspond *80 substantially with the cost and time of rendering services to its members, the Court*48 said that, although it was admitted that the method used by taxpayer was in accord with generally accepted commercial and accounting principles, it failed to "respect the criteria of annual tax accounting and may be rejected by the Commissioner." The Court emphasized that the services were rendered solely upon a member's demand. It also discussed at length the enactment and repeal of sections 452 4*49 and 462 5 of the 1954 Code, which specifically permitted deferral of income and accrual of estimated future expenses, and the implications thereof, and concluded by saying, "Finding only that, in light of existing provisions not specifically authorizing it, the exercise of the Commissioner's discretion in rejecting the Association's accounting system was not unsound." In its most recent decision in Schlude v. Commissioner, supra, the Court framed the question for decision as being, "Was it proper for the Commissioner, exercising his discretion under § 41, 1939 Code, and § 446(b), 1954 Code, to reject the studio's accounting system as not clearly reflecting income and to include as income in a particular year advance payments." The Court found the issue to be squarely controlled by American Automobile Assn. v. United States, supra, and answered the question in the affirmative. Again the Court discussed the implications of the repeal of section 452 of the 1954 Code, and the recent enactment of section 456, 1954 Code, and also emphasized that the taxpayer's system of accounting was artificial since*50 the advance payments related to services which were to be performed only upon customers' demands without relation to fixed dates in the future. *81 Whether these more recent decisions of the Supreme Court will lay these problems to rest is problematical because the Court speaks in broad terms and it is not always clear just what the fundamental bases for the decisions are -- hence other cases may be distinguished. See Automobile Club of New York v. Commissioner, 304 F. 2d 781 (1962), affirming 32 T.C. 906 (1959), wherein the Court of Appeals for the Second Circuit, while relying on American Automobile Assn. v. United States, supra, to hold against the taxpayer, distinguished its own prior decision in favor of the taxpayer in Bressner Radio, Inc. v. Commissioner, 267 F. 2d 520 (1959), reversing and remanding 28 T.C. 378 (1957). 6 *51 But in any event we think these recent decisions of the Supreme Court are clearly dispositive of the issue in this case on narrower and more specific grounds. Here the petitioner changed its long-established treatment of these expenses in 1954; the services which would give rise to the expenses were to be rendered only on the demand of the subscribers; and petitioner's method of estimating expenses was purely artificial and bore no relationship to the actual expenses incurred in rendering the services in the subsequent years. All of these factors have been specifically mentioned by the Court in the above cases in disallowing deferral of income to cover the estimated cost of future expenses. There can be no question that the first two factors mentioned above were present here. And the latter factor is well established by the petitioner's experience. In 1954 it established a reserve for the estimated cost of preparing subscribers' returns for only 1 year, although the contract obligated it to prepare them for 2 years. The actual cost of preparing returns in 1955 exceeded the reserve established. Then in 1956 petitioner not only changed its method of computing a reserve, estimating*52 it on the basis of the cost of preparing returns for 2 years instead of 1, but also changed the method of having the returns prepared; it began preparing the returns itself instead of having *82 accountants prepare them, which would seem necessarily to change the cost of preparing them. Also its actual cost of preparing returns in 1957 was far in excess of the amount set up in its reserve for 2 years' returns. Petitioner's reliance on such cases as Schuessler v. Commissioner, 230 F. 2d 722 (C.A. 5, 1956), reversing 24 T.C. 247 (1955); Pacific Grape Prod. Co. v. Commissioner, 219 F. 2d 862 (C.A. 9, 1955), reversing 17 T.C. 1097 (1952); and Denise Coal Co. v. Commissioner, 271 F. 2d 930 (C.A. 3, 1959), affirming in part and reversing in part 29 T.C. 528 (1957), is misplaced. Whether or not those cases are all distinguishable from the American Automobile and Schlude cases, they are all distinguishable from this case. In each of those cases the "operative facts" which gave rise to the future*53 expenses had occurred in the year of accrual; in Schuessler the furnaces had been installed and there was a fixed obligation to turn them on and off; in Pacific Grape Products the fruit had been sold and there was a fixed obligation to pack and ship the merchandise to the customers; and in Denise the land had been stripped and there was a statutory obligation to rehabilitate the land. But here, as in the Automobile Club cases and the Schlude case, the operative facts which gave rise to the obligation, i.e., the demands by the subscribers for the service, had not occurred in the years of accrual. Where the operative facts giving rise to the future expenses have not occurred in the year of accrual, the estimated expenses cannot be deducted even though they can be estimated with reasonable certainty and even though prudent business requires that a reserve be set up. Brown v. Helvering, 291 U.S. 193 (1934). We conclude that respondent did not err in disallowing the deductions claimed by petitioner on its returns for 1954 and 1956 for additions to reserves for estimated future expenses of preparing subscribers' income tax returns. *54 Our conclusion above makes it unnecessary for us to decide whether petitioner's change in its method of treating these expenses constituted a change in its method of accounting, which would require the consent of the Commissioner, or was merely a correction of the prior erroneous treatment of these expenses under the accrual method of accounting, as claimed by petitioner. See American Can Co., 37 T.C. 198 (1961), affirmed in part and reversed in part 317 F. 2d 604 (C.A. 2, 1963). Decision will be entered for the respondent. Footnotes 1. This figure is accurate. The number of returns estimated was taken from oral testimony which was apparently not entirely accurate.↩ 2. Fiscal year 1955 is not before us. The actual expenses of preparing returns for 1955 charged against the reserve were apparently greater than the amounts credited to it.↩ 3. Compare secs. 451(a) and 461(a), and see sec. 446, I.R.C. 1954↩. 4. SEC. 452. PREPAID INCOME. (a) Prepaid Income to be Earned Over Short or Indefinite Period. -- (1) Short Period. -- In the case of any prepaid income to which this section applies, if the liability described in subsection (e)(2) is (at the time the income is received) to end before the first day of the sixth taxable year after the taxable year in which such income is received, then such income shall be included in gross income for the taxable year in which received, and for each of the 5 succeeding taxable years, to the extent proper under the method of accounting used under section 446 in computing taxable income for such year. If the liability does not in fact end before the first day of such sixth taxable year, such income shall be included in gross income for the taxable years specified in the preceding sentence except that with the consent of the Secretary or his delegate it shall be included in gross income in such proportions, and for such taxable years, as are specified in such consent. * * * * (e) Definitions. -- For purposes of this section -- (1) Prepaid income. -- The term "prepaid income" means any amount (includible in gross income) which is received in connection with, and is directly attributable to, a liability which extends beyond the close of the taxable year in which such amount is received. Such term does not include any income treated as gain from the sale or other disposition of a capital asset. (2) Liability to render services, etc. -- The term "liability" means a liability to render services, furnish goods or other property, or allow the use of property.↩ 5. SEC. 462. RESERVES FOR ESTIMATED EXPENSES, ETC. (a) General Rule. -- In computing taxable income for the taxable year, there shall be taken into account (in the discretion of the Secretary or his delegate) a reasonable addition to each reserve for estimated expenses to which this section applies.↩ 6. We suspect, because of its repeated emphasis on the Commissioner's discretion under sec. 41 of the 1939 Code and sec. 446 of the 1954 Code, and the legislative history of secs. 452 and 462, that the majority of the Supreme Court stand for the principle that, absent statutory sanction for it, unless the taxpayer can show that the Commissioner clearly abused his discretion in disallowing deferral of prepaid income or accrual of estimated future expenses, this exercise of the Commissioner's discretion will not be disturbed by the Court even though the taxpayer's method of accounting is in accord with generally accepted principles of commercial accounting. We also suspect that this principle, if such it be, will meet with some resistance in the courts. See the dissenting opinions of Mr. Justice Stewart in American Automobile Assn. v. United States, 367 U.S. 687, 698 (1961), and Schlude v. Commissioner, 372 U.S. 128, 137 (1963), and the opinions of various Courts of Appeals in Bressner Radio, Inc. v. Commissioner, 267 F. 2d 520 (C.A. 2, 1959), reversing and remanding 28 T.C. 378 (1957), Beacon Publishing Co. v. Commissioner, 218 F. 2d 697 (C.A. 10, 1955), reversing 21 T.C. 610 (1954), Schuessler v. Commissioner, 230 F. 2d 722 (C.A. 5, 1956), reversing 24 T.C. 247 (1955), and Pacific Grape Prod. Co. v. Commissioner, 219 F. 2d 862 (C.A. 9, 1955), reversing 17 T.C. 1097↩ (1952). The application of such a principle to the facts here would certainly require a decision for respondent on this issue.