Brainard v. Commissioner

Millar Brainard and Katharine R. Brainard, Husband and Wife, Petitioners, v. Commissioner of Internal Revenue, Respondent Brainard v. Commissioner Docket No. 10158 United States Tax Court 7 T.C. 1180; 1946 U.S. Tax Ct. LEXIS 31; November 21, 1946, Promulgated *31 Decision will be entered under Rule 50. 1. Interest payments owing by accrual basis taxpayer which were not likely to be paid because of petitioner's financial condition, held, on the facts, not allowable deductions, Zimmerman Steel Co., 45 B. T. A. 1041, notwithstanding that a different ground for the disallowance was specified by respondent in the statement attached to the notice of deficiency. Edgar M. Carnrick, 21 B. T. A. 12, and Raoul H. Fleischmann, 40 B. T. A. 672, followed. 2. Dividends on pledged securities received by creditor, pursuant to dividend order, held, to be payment of interest, under applicable law, in the absence of specific agreement otherwise, and hence deductible as interest paid. John E. Hughes, Esq., for the petitioners. *32 Arnold R. Cutler, Esq., for the respondent. Opper, Judge. OPPER *1180 By this proceeding petitioners challenge respondent's determination of deficiency in income tax in the amount of $ 13,615.25 for the year ended December 31, 1941. The principal issue is whether respondent erred in disallowing deductions for accrued interest in the amount of $ 42,123.93, and for *1181 accrued current taxes in the amount of $ 400, claimed by petitioners on their 1941 tax return, which they assert was prepared on an accrual basis. If respondent's determination on this point is upheld, an additional issue arises of whether petitioners are entitled to deduct, as interest paid, dividends in the amount of $ 18,699.38 which they reported as income for the year, but which, pursuant to agreement, were paid directly to their creditors. Some of the facts were orally stipulated. FINDINGS OF FACT. The stipulated facts are hereby found accordingly. Petitioners, husband and wife, are residents of Marion, Massachusetts. Their joint tax return for the year involved was filed with the collector of internal revenue for the eighteenth district of Ohio, their residence at that time being in Shaker*33 Heights, Ohio. In answer to question 5 on the return, as to method used in its preparation, "accrual" was checked. Katharine Brainard's gross income for the year amounted to $ 225 and her deductions to $ 281.28. Hereinafter Millar Brainard will be referred to as petitioner. For some time prior to 1929, petitioner had bought and sold securities on a large scale. He was able to make substantial purchases as a result of loans he made at various banks. Such indebtedness amounted to $ 1,047,144.06 at December 31, 1941. The loans were secured by collateral consisting generally of stock and other securities, real property, and life insurance policies. As a result of the stock market "crash" in 1929, petitioner was unable to pay either principal or interest on his obligations. He was insolvent and continued as such beyond the period here involved. On April 13, 1933, petitioner and his creditors entered into a standstill agreement, pursuant to which the creditors agreed to surrender their obligations in return for notes bearing interest at the rate of 4 per cent a year, to be secured by the collateral then held by the creditors, and to be due August 25, 1936; a majority of the creditors*34 could, however, agree to extend the time of payment of the notes for a period not to exceed 10 years from the date of the agreement. Later, an extension was granted to August 25, 1941. The agreement further provided: The Debtor [petitioner] agrees that during the period from the date of this agreement to August 24, 1936, or to such further time as the Undersigned Creditors may extend his obligations under the terms hereof, he will pay over to the Undersigned Creditors all his net earnings or income from any source whatsoever, with all income taxes deducted, in excess of Sixteen Thousand Five Hundred Dollars ($ 16,500.00), said payments to be prorated on the basis of deficiencies in the market value of the collateral held by the Undersigned Creditors as determined *1182 by Price, Waterhouse & Co., its successors or assigns, or, in the event that Price, Waterhouse & Co., declines to act, by any firm or person designated by a majority in number and amount of the Undersigned Creditors. Since substantial interest charges would be accruing under the terms of the agreement, petitioner on March 29, 1935, requested that respondent permit him to change from a cash to an accrual method*35 of accounting, and on September 12, 1935, permission was granted, effective for the calendar year 1935. From that time to and including the year involved petitioners filed joint returns prepared on the accrual basis. On May 1, 1941, respondent wrote petitioner, revoking the grant of permission to report on the accrual basis and requiring that returns be prepared on the cash basis, effective for the calendar year beginning January 1, 1941. He assigned as reasons for this action: It now develops that you have entered, or propose to enter, into compromise agreements with your creditors under which the amounts of interest actually accruing may be materially reduced, or eliminated entirely. * * * * It is held that the accrual and deduction from income of items which may be reduced or never paid results in distortion and in the elimination of income by means of theoretical accounting methods and that the continued use of the accrual method under such circumstances will not reflect your true income. During the period that returns were prepared on the accrual basis petitioners paid no tax, as the accrued interest was more than sufficient to offset gross income and thereby produce no taxable*36 income. In 1941 petitioners paid in cash interest in the amount of $ 4,476.11, but claimed as a deduction for interest the amount of $ 46,600.04. During 1941 petitioner's total income was received in cash. On either the cash or accrual basis his total income would be the same. All expenses, except the following three items, were paid out in cash: (1) Interest, (2) taxes in the amount of $ 430, of which $ 30 was paid in cash, and (3) a bill for $ 1,000 for bookkeeping services for the years 1940 and 1941, which was entered on petitioners' records, but not claimed as a deduction on the tax return. Petitioners' records consisted of a cash book, journal, and ledger, which were kept under the direction of the accounting firm of Price, Waterhouse & Co. This firm also prepared petitioners' 1941 income tax return, which was prepared in accordance with the method of keeping the books of account. In 1943 petitioner settled with his creditors, each receiving 1 per cent of the principal amount of its claim, in addition to which certain creditors were permitted to reduce to ownership the collateral which they held. In 1933 petitioner signed a dividend order directing that dividends on stock*37 held as collateral by two creditor banks be paid directly to them and since 1933 the banks have received such dividends. In 1941 *1183 dividends in the stipulated sum of $ 18,699.93 were so received. As early as 1933 petitioner conferred with one of the banks regarding the application of the dividends to interest. It did not do so, but instead used them to increase the amount of collateral held. None of the agreements required the banks to apply the dividends to interest. Under the agreement of April 19, 1933, one of the banks was to allocate a portion of the dividends received for the purpose of paying premiums on policies on petitioner's life, held in an insurance trust for the benefit of his creditors. This obligation of the bank terminated on July 19, 1937. Neither petitioner nor the banks entered the dividends on their books as interest paid in cash. In the statement attached to the notice of deficiency respondent stated: In a letter of the Commissioner of Internal Revenue dated May 1st, 1941 you were advised that, effective for the calendar year beginning January 1, 1941, he had revoked the permission previously granted to change the basis of reporting your income *38 in your Federal income tax returns from the cash receipts and disbursements basis to the accrual basis, and that, in order clearly to reflect your income for each year, you would be required to file your returns for the taxable year 1941 and subsequent years on the cash receipts and disbursements basis, unless and until permission had been secured to change to some other basis. No permission has since been granted to change to any other basis. Accordingly, the deductions claimed in your 1941 return for accrued interest of $ 42,123.93 and accrued real estate taxes of $ 400.00, which were not paid during 1941, are herein disallowed. Petitioner's financial condition removed any likelihood that the items accrued but not paid in cash would ever be paid. OPINION. After having granted permission to petitioner to change his accounting system from cash to accrual in 1935, respondent in 1941 purported to revoke the permission so granted and to direct the petitioner to employ the cash system, on the ground that to do otherwise would fail properly to reflect his income. This, petitioner refused to do, and the propriety of certain deductions accrued but not paid in cash in the year 1941 is the*39 subject of this controversy. We find it unnecessary to pass upon the propriety of respondent's action in revoking his prior approval of petitioner's application, since in our view the facts suffice to place this proceeding in a category where its disposition may rest on narrower grounds. In Zimmerman Steel Co., 45 B. T. A. 1041, it was held that, notwithstanding the accrual system employed by a taxpayer, accruals of items no part of which, in the light of the taxpayer's financial condition, would in all probability ever be paid in cash were not permissible. *1184 Cf. I. T. 3635, 1944-1 C. B. 101. Although that case was reversed on appeal, we said in Florence Pearlman, 4 T. C. 34, 54: * * * With all due deference to the Circuit Court of Appeals for the Eighth Circuit, we adhere to the view expressed in Zimmerman Steel Co., 45 B. T. A. 1041, notwithstanding the reversal in Zimmerman Steel Co.v. Commissioner. 130 Fed. (2d) 1011. In Panhandle Refining Co., 45 B. T. A. 651, we had concluded that, *40 even though a taxpayer was technically insolvent, if there was "no uncertainty as to payment," the accruals were permissible. It was on this ground that the Panhandle case was distinguished in Zimmerman Steel Co., supra. And in Butler Consolidated Coal Co., 6 T. C. 183, the facts were examined to determine to which of the authorities mentioned that proceeding most nearly corresponded, the conclusion being (p. 192), "The facts in the case at bar are more like those which obtained in Panhandle Refining Co., supra, than in Zimmerman Steel Co., supra." The upshot is that where a taxpayer, even though on the accrual method, accrues items, the payment of which is questionable because of his financial condition, the facts must be examined to determine to what extent there is a reasonable prospect that the payments will actually be made and the result reached must depend upon the ultimate conclusion of fact to which an examination of all the circumstances brings us. This means that our ultimate finding has in effect disposed of this branch of the present proceeding. *41 Petitioner's financial condition as to both assets and earnings, and the entire history of the transaction as far as it is revealed by the record, disclose the extreme improbability that the payments in question would ever be made. If we are empowered to consider the settlement with creditors made several years later, it reinforces this conclusion, since the amount finally received by them was not sufficient and was not intended to discharge the interest or in fact more than a small fraction of the principal. See Automatic Sprinkler Co., 27 B. T. A. 160; Towers & Sullivan Manufacturing Co., 25 B. T. A. 922, 925; Johnson Locke Mercantile Co. v. Burnet (App. D. C.), 51 Fed. (2d) 434. If not, there is at least nothing to impair it. Since we have found that there was no likelihood that the items accrued would ever be paid, it follows that, on the authority of Zimmerman Steel Co., supra, the deficiency should to that extent be approved. This ground, it is true, is not the one specified in respondent's statement attached to the deficiency notice. It is our*42 function, however, to redetermine a deficiency and not respondent's reasons for it. Edgar M. Carnrick, 21 B. T. A. 12; Raoul H. Fleischmann, 40 B. T. A. 672. See Dorothy Whitney Elmhirst, 41 B. T. A. 348. Once the amount of *1185 the deficiency is found to be correct, there could be only one reason for failing to give it effect, regardless of the grounds for it propounded by respondent, and that would be that the petitioner was misled in the presentation of his case. In this proceeding, although the authorities to which we have referred are not relied upon either in the deficiency notice or in respondent's brief, we have little doubt that the underlying issue of fact -- which involves the likelihood that the items in question would ever be paid -- must have been apparent at all times. In his letter to the petitioner, which purported to revoke the permission previously granted to maintain an accrual system, respondent advised petitioner that "the accrual and deduction from income of items which may be reduced or never paid results in distortion and in the elimination of income by means*43 of theoretical accounting methods * * *." We accordingly regard it as established that petitioner should have been under no misapprehension as to the scope of proof required when this proceeding was brought to hearing. If, however, we are mistaken in this, and there is additional evidence which is material, but which petitioner has been misled into failing to produce, methods are available by which the record can be reopened for this purpose. On this disposition of the case it is unnecessary to consider whether respondent's principal reliance -- his action in revoking the permission previously granted to petitioner to adopt the accrual method, coupled with the provisions of section 41 permitting him to require the use of a system which would clearly reflect the taxpayer's income -- would be adequate to sustain the deficiency. The remaining contention on behalf of petitioner, however, requires consideration. This is the claim that the dividends on the securities held as collateral by the creditor banks should be treated as having been applied by them to interest and accordingly that to that extent these payments were actually made in cash. Petitioner does not question his obligation*44 to treat the dividends received as income. Under the circumstances, general principles of law would require application of the funds paid on his behalf to the discharge of the interest obligation. Ohio Savings Bank & Trust Co. v. Willys Corporation, (C. C. A., 2d Cir.), 8 Fed. (2d) 463; Theodore R. Plunkett, 41 B. T. A. 700, 709; affd. (C. C. A., 1st Cir.), 118 Fed. (2d) 644. Even if the creditor failed to make the application, a point on which the present record is none too clear, it could still be so treated for purposes of determining the income tax consequences. Estate of Paul M. Bowen, 2 T. C. 1, 5-7. The stipulated amount of the dividends in question should accordingly be added as cash payments in computing the deficiency. Decision will be entered under Rule 50.