Petit v. Commissioner

William Justin Petit and Loretta N. Petit, Petitioners, v. Commissioner of Internal Revenue, Respondent Petit v. Commissioner Docket No. 7046 United States Tax Court 8 T.C. 228; 1947 U.S. Tax Ct. LEXIS 292; January 31, 1947, Promulgated *292 Decision will be entered under Rule 50. Petitioners were on the accrual basis and on or about November 30, 1939, certain property owned by them was condemned by the United States for public purposes. The price which the United States offered for the property was contested. An award was rendered on June 30, 1941, in the amount of $ 189,177, on which interest was paid from November 30, 1939, to date of payment on or about July 30, 1941, in the amount of $ 17,756.73. Of the amount awarded, $ 11,949.46 was retained in the registry of the court pending the determination of tax liens which petitioners were contesting. Petitioners paid attorney fees in the amount of $ 11,266.86, which was a contingent fee of 50 per cent computed upon the excess of the award, including interest, over a minimum amount of $ 184,400. Petitioners in 1941 were sued upon two notes executed in 1940 in the respective amounts of $ 15,000 and $ 5,750, which were settled in 1941 for the amount of $ 15,200. Held: (1) Petitioners were taxable upon the entire amount of the interest of $ 17,756.73 in 1941 when the judgment in the condemnation proceeding was rendered and became final. (2) No part of the taxes*293 in the amount of $ 11,949.46 was accruable in 1941 by petitioners as a tax liability because the same was being contested: and no part of the $ 11,949.46 held in the registry of the court should be accrued by petitioners in 1941 as part of the proceeds of the condemnation award. It was not until 1942 that the tax controversy was settled and it became certain that petitioners were entitled to the $ 11,949.46. (3) No part of the amount of $ 15,200 paid in 1941 in settlement of the notes was accruable as interest. It was considerably less than the face amount of the notes and there was no agreement that any part of the payment should be allocated to interest. (4) Petitioners are not entitled to deduct any part of the attorney fees as a business expense. The attorney fees should be deducted as a capital expenditure in arriving at the gain resulting from the condemnation award. Wendell P. Hubbard, Esq., for the petitioners. Byron M. Coon, Esq., for the respondent. Black, Judge. BLACK *229 Respondent determined a deficiency in petitioners' income tax for the year 1941 in the amount of $ 11,630.29. The deficiency is due to five adjustments to petitioners' net income *294 as disclosed by their return for the year 1941. These adjustments are explained in the deficiency notice as follows: (a) Net long-term capital gain is increased $ 8,243.73 representing 50 per cent of $ 16,487.46 gain from the sale of capital assets omitted from the return. The increased gain is represented by an award for severance damages in the amount of $ 4,538.00 and amounts withheld for payment of real property taxes, $ 11,949.46. (b) Net long-term capital gain is increased $ 53.14 due to the disallowance of losses from sales made in 1939, not deductible for the taxable year. (c) The deduction claimed for interest paid during the taxable year on a loan from the Pacific Mutual Life Insurance Company is $ 6,741.41 in excess of the amount allowable. (d) The deduction for bad debts due from Blenkiron and Walters claimed in amount of $ 30,100.00 is allowed in the amount of $ 12,900.00 and the excessive amount claimed, $ 17,200.00, is disallowed. (e) A deduction is allowed for additional bad debts, not previously claimed, in the amount of $ 6,210.49. The original petition, by appropriate assignments of error, contested the correctness of adjustments (a) and (c) shown above. Assignment*295 of error (a) was as follows: (a) That the additional long term capital gain under Subdivision (a) of the statements attached to the Notice of Deficiency was erroneously added as an adjustment to net income. Assignment of error (b) is not copied herein because it is no longer insisted upon. Also, the petition contained two other assignments of error as follows: (c) That the Commissioner erred in including in the gross income $ 17,756.73 as interest on the condemnation award for the year 1941 instead of including only the sum of $ 4,829.63. (d) The Commissioner erred in not allowing as deductions from the gross income the sum of $ 11,949.46, being the amount of taxes withheld on the condemnation award. The amended petition filed at the hearing assigns an additional error as follows: (e) The Commissioner erred in not treating the sum of $ 2,388.50 as a deduction from the award in determining the capital gain and in not allowing a full deduction as against the interest on the award, of the sum of $ 8,878.36, representing a portion of the fees paid to Hill, Morgan and Bledsoe. At the hearing petitioner waived his assignment of error (b) as to adjustment (c) in the deficiency notice wherein*296 the Commissioner disallowed $ 6,741.41 of the interest which petitioner had claimed as a deduction based on his indebtedness to Pacific Mutual Life Insurance Co. The pleadings, as completed, leave for our decision the following issues: (1) Whether interest allowed on the condemnation award in *230 1941 in the amount of $ 17,756.73 was entirely accruable as income in 1941, or whether it should have been accrued over the years 1939, 1940, and 1941; (2) whether the petitioners are entitled to deduct in 1941 as accrued taxes an amount which was withheld in the registry of the court pending the determination of tax liens, if any, against the parcels asserted by Los Angeles County, or, if they are not entitled to deduct this amount as taxes, whether it should be excluded from petitioners' gross income because it was not accruable, being held in the registry of the court and uncertain in 1941 whether petitioners would ever receive it; (3) whether the petitioners are entitled to deduct as interest any part of the sum of $ 15,200 paid by the petitioners in 1941 in settlement of two notes dated August 13, 1940, in the total amount of $ 20,750; and (4) whether or not certain fees paid to*297 attorneys for services in the condemnation proceeding represented deductible business expenses. FINDINGS OF FACT. The petitioners, husband and wife, reside in Van Nuys, California, and they filed their joint income tax return for the year 1941 with the collector of internal revenue at Los Angeles, California. The return was made on the accrual basis. William Justin Petit will sometimes herein be referred to as petitioner. Issue 1. -- Prior to 1939 the petitioners owned certain property in San Fernando, California, which was encumbered by a mortgage to the Pacific Mutual Life Insurance Co. in the amount of $ 150,000. On November 10, 1939, the United States instituted a condemnation proceeding in the District Court for the Southern District of California for the purpose of acquiring the land owned by the petitioners. Petitioners employed the law firm of Hill, Morgan & Bledsoe to represent them in the proceeding. It was agreed that the attorneys should receive as a fee for their services 50 per cent of any amount recovered in excess of $ 184,400, including any items allowed as interest or compensation made for taking immediate possession of said parcels. It was also agreed*298 that all of the moneys or proceeds awarded by the Government in connection with the condemnation proceedings should be paid to the Pacific Mutual Life Insurance Co., mortgagee of the land, to be disbursed by it to the parties entitled thereto. On June 30, 1941, the District Court entered judgment in the condemnation proceedings, awarding to the petitioners the sum of $ 189,177, together with interest on the award for the period of time between seizure of the land by the Government on November 30, 1939, and the date of payment on or about July 30, 1941, in the amount of $ 17,756.73. The interest was computed as follows: 1*231 Nov. 10, 1939, to Dec. 31, 1939 $ 1,576.48 Jan. 1, 1940, to Dec. 31, 1940 11,350.62 Jan. 1, 1941, to Feb. 18, 1941, and from Apr. 15, 1941, to July 30, 1941 4,829.63 *299 Issue 2. -- Subsequent to the entry of the award judgment, the court entered an order requiring the withholding in the registry of the court of $ 11,949.46 which the County of Los Angeles was claiming as a tax lien against the property condemned. Thereupon the United States attorney filed a certificate addressed to R. S. Zimmerman, clerk of the United States District Court for that district, which provided as follows: Judgment having been entered herein in behalf of W. J. Petit and Loretta N. Petit, his wife, at Civil Order Book 5, Page 766, in the sum of One Hundred Eighty-three [sic] Thousand One Hundred Seventy-seven Dollars ($ 189,177.00) representing the awards for the taking of the above parcels in the above action, together with interest thereon as provided in said Judgment; and The sum of Two Hundred Six Thousand Nine Hundred Thirty-three and 73/100 Dollars ($ 206,933.73) having heretofore on July 30, 1941, been deposited in the registry of this court as and for said awards, plus interest; and The above entitled court having on the 15th day of August, 1941, ordered that said awards should be paid to defendant Pacific Mutual Life Insurance Company, a corporation, *300 rather than to defendants W. J. Petit and Loretta N. Petit, his wife, which said Order was filed herein and entered on the 18th day of August, 1941, You Are Hereby Authorized and Directed to pay to said Pacific Mutual Life Insurance Company, a corporation, the sum of One Hundred Ninety-four Thousand Nine Hundred Eighty-four and 27/100 Dollars ($ 194,984.27), retaining in the registry pending the determination of tax liens, if any, against said parcels, the sum of Eleven Thousand Nine Hundred Forty-nine and 46/100 Dollars ($ 11,949.46). The County of Los Angeles was claiming that $ 4,841.78 was due and payable in 1940 as taxes on the property and $ 7,107.68 in 1941. The petitioners did not pay these taxes but contested them, claiming that the County of Los Angeles had no right to the tax after 1939, when the United States took possession of the property. Petitioner, in computing his gain which resulted from the amount of the award accrued and received in 1941, did not include as part of the amount accrued the $ 11,949.46 retained in the registry of the court to await the settlement of the tax controversy between petitioner and the County of Los Angeles. Petitioner in his income tax*301 return for 1941 did not accrue as a liability any amount of taxes due the County of Los Angeles on this property. In March 1942 the County of Los Angeles released its claim for taxes and on or about March 18, 1942, the amount withheld in the registry of the court was paid to the petitioners and included in their 1942 return as capital gain from the condemnation award and tax was paid thereon. Issue 3. -- On April 13, 1940, the petitioners signed two notes to the *232 California Group Corporation in the total amount of $ 20,750, one being a renewal note in the amount of $ 15,000, representing the principal of an indebtedness, and a note of $ 5,750, representing delinquent interest on the original indebtedness for prior years. Each note drew interest at the rate of 5 per cent per annum from date. On or about August 21, 1941, the California Group Corporation brought suit to collect these notes. In the settlement there was no agreement between the parties as to whether part of the payment was to apply on the principal of the notes and part to the interest due on the notes. The suit and notes were settled in full by payment of the sum of $ 15,200. Petitioners in their amended*302 return for 1941 filed on February 28, 1944, claimed as a deduction for interest the amount of $ 4,742.40 on settlement of the above suit with the California Group Corporation. Issue 4. -- The law firm of Hill, Morgan & Bledsoe was paid a fee for its services in the proceeding in the amount of $ 11,266.86. Of this amount, $ 2,388.50 was the contingent fee of 50 per cent computed on the excess of the award in the amount of $ 189,177 over the minimum amount specified by agreement of $ 184,400, or $ 4,777. The additional amount of $ 8,878.36 was computed on 50 per cent of the interest paid of $ 17,756.73. Petitioner, in his income tax return, treated the entire amount of $ 11,266.86 which he paid his attorneys as capital expenditures and reduced the amount of the condemnation award by this amount. Respondent in his determination of the deficiency has not disturbed this treatment by petitioner. Petitioner now claims that he should have only thus used $ 2,388.50 of the fee paid his attorneys and that he is entitled to a separate deduction as a business expense of $ 8,878.36 of the fees paid. General findings. -- Petitioner, in his income tax return, reported his capital gain*303 from the condemnation award as follows: Received from District Court Aug. 1941 $ 194,984.27 Less Severance Damage parcel 60 $ 3,656.00 Less Severance damage parcel 63 882.00 4,538.00 190,446.27 Please note: The severance damage $ 4,538.00 is mentioned in Question 7 page 2. This amount is credited to the land affected. Less interest (Entered item 4 page 1 17,756.73 172,689.54 Less Attorneys Fees Hill, Morgan & Bledsoe $ 5,633.43 Less Costs, expense""&" 5,633.43 11,266.86 Net amount received 161,422.68 From the net amount received costs of $ 86,497.35 were deducted, resulting *233 in a capital gain of $ 74,925.33, of which $ 37,462.67 was taken into account. As has already been stated, the Commissioner, in his determination of the deficiency, has disallowed the severance damages of $ 4,538. That action is not contested by petitioner. Respondent also added to the amount received by petitioner the $ 11,949.46 which was placed in the registry of the court to await the outcome of the contest about taxes. He has also taxed petitioner separately with the $ 17,756.73 interest and has not treated that as a part of*304 the sale price of the land covered by the condemnation award. OPINION. We discuss the issues in the order of their statement. Issue 1. -- Petitioner contends that, of the interest on the award in the amount of $ 17,756.73, only that part which was attributable to the calendar year 1941 in the amount of $ 4,829.63 should be included in his 1941 return. Petitioner concedes that since the decision of the Supreme Court in Kieselbach v. Commissioner, 317 U.S. 399, there is no longer any question but that interest received on a condemnation award is separately taxed as interest and not as a part of the sale price resulting from the condemnation award. That principle of law certainly seems now to be well established. See Johnson & Co. v. United States (C. C. A., 2d Cir.), 149 Fed. (2d) 851. Respondent contends that the entire amount of interest of $ 17,756.73 constitutes taxable income in the year 1941 when the award was made and that none of it was properly accruable in the prior years of 1939 and 1940. When a taxpayer is on the accrual basis it is the right to receive the income and not the actual receipt that*305 determines the inclusion of the amount in gross income. Spring City Foundry Co. v. Commissioner, 292 U.S. 182. However, in order for items to be accrued as income the event must occur which determines the amount due. When the amount to be received depends upon a contingency or future events, it is not to be accrued until such contingency or the events have occurred and fixed with reasonable certainty the fact and amount of income. U. S. Cartridge Co. v. United States, 284 U.S. 511. In the instant proceeding the amount of the award was in litigation until 1941. Both the award and the amount of interest thereon were uncertain until 1941, the year the final court decree was entered and the amount of the award became fixed. In Winter Realty & Construction Co., 2 T. C. 38, modified on appeal on other issues, the precise issue now raised by petitioner was involved and was decided against the taxpayer. Therefore, following our decision in that case, we hold that the entire amount of $ 17,756.73 interest was income to petitioner in 1941 as the Commissioner has determined. Petitioner *306 strongly urges in support of his contention Williams *234 v. United States, 31 Fed. Supp. 154. That case, which was decided by the United States Court of Claims, has been read and carefully considered by us. It is in no way contrary to what we have decided above. It is clearly distinguishable on its facts and need not be further discussed. Issue 2. -- Petitioners contend that since they were on the accrual basis they are entitled to deduct as accruable tax expenses at least the amount of $ 7,107.68 attributable to 1941 which was withheld in the registry of the court pending the determination of tax liens, if any, asserted by Los Angeles County against these parcels, even though these taxes were being contested by petitioners and were subsequently waived by Los Angeles County in 1942. Respondent contends that petitioners are not entitled to deduct as a tax expense in 1941 any part of the sum of $ 11,949.46 which was retained in the registry of the court pending a determination of possible tax liens by Los Angeles County. A taxpayer who is on the accrual basis may and should deduct from gross income a liability which accrues in*307 the taxable year. United States v. Anderson, 269 U.S. 422. However, all the events must occur in the year which fix the amount and fact of the taxpayers' liability to pay such items of indebtedness and this could not be the case herein, where the liability for the taxes was denied by the petitioners and contested. In Security Flour Mills Co. v. Commissioner, 321 U.S. 281, the Supreme Court said: It is settled by many decisions that a taxpayer may not accrue an expense the amount of which is unsettled or the liability for which is contingent, and this principle is fully applicable to a tax, liability for which the taxpayer denies, and payment whereof he is contesting. * * * We, therefore, hold that petitioner is not entitled to accrue on his income tax return for 1941 any taxes due Los Angeles County on this property. As a matter of fact, petitioner did not accrue on his 1941 income tax return any taxes on this property. In failing to do so, he acted properly. What petitioner actually did was to accrue $ 194,984.27 as having been due and received from the condemnation award and did not accrue $ 11,949.46 which*308 the court directed to be kept in the registry of the court to await the outcome of the dispute which existed between petitioner and the County of Los Angeles as to these taxes. These taxes were claimed to be a lien against the property by the County of Los Angeles and the United States Government wanted this in rem claim settled before it paid over this $ 11,949.46 to petitioners. That dispute was not settled until 1942. Under these circumstances, we think petitioner was correct in not accruing in 1941, as part of the condemnation award due, the $ 11,949.46 held in the registry of the court for taxes. At the close of 1941 petitioner did not know whether he would ever receive this $ 11,949.46 or any part thereof, *235 and, therefore, there was no properly accruable receipt. We, therefore, hold that the respondent erred in including this $ 11,949.46 as a part of the condemnation award in 1941. See Liebes & Co. v. Commissioner, 90 Fed. (2d) 932, affirming 34 B. T. A. 677. Cf. also United States v. Safety Car Heating & Lighting Co., 297 U.S. 88; Dixie Pine Products Co. v. Commissioner, 320 U.S. 516;*309 Security Flour Mills Co. v. Commissioner, supra;E. T. Slider, Inc., 5 T. C. 263. In a recomputation under Rule 50, in arriving at petitioners' gain in 1941 from the condemnation of this property, the $ 11,949.46 should not be included as part of the accrued sale price resulting from the condemnation award. The dispute was settled in 1942. The $ 11,949.46 was then paid to petitioner out of the registry of the court and it was included as part of the receipts from the condemnation award by petitioners on their income tax return for 1942. That appears to us to have been as soon as it could have been properly accrued. Issue 3. -- Petitioners on April 13, 1940, signed two demand notes, one in the amount of $ 15,000, representing the principal of an indebtedness owed to the California Group Corporation, and the other in the amount of $ 5,750, representing delinquent interest on the original indebtedness for years prior to 1940. Both notes were to bear interest at the rate of 5 per cent. On or about August 21, 1941, the California Group Corporation brought suit on the notes and the obligations were compromised in the*310 amount of $ 15,200. Petitioners claim that part of the sum of $ 15,200 paid in settlement of the above notes represents interest deductible in 1941. In their petition they state that "the proportion of said settlement attributable to interest in said settlement" was $ 4,742.40. However, on brief they only claim the right to accrue the amount of $ 1,469.68 as interest on the indebtedness, treating the payment as first applicable to the interest and the remainder as applicable to the principal. In the alternative they claim that if they are not entitled to accrue interest in the amount of $ 1,469.68, they should be allowed to accrue the amount of $ 200 as representing the excess over the principal of the obligation. Respondent claims that neither of the above amounts is deductible as interest. He argues that the payment of $ 15,200 was in compromise of a larger indebtedness which was being contested and any amount for interest is not deductible; that no interest was paid or properly accruable because petitioner was contesting his liability; and that the $ 200 paid on the note of $ 5,750 is a part of an interest expense deductible or accruable prior to 1940, when the note was executed. *311 We doubt if the state of the pleadings warrants us in treating this issue as having been properly raised. However, both parties have treated it in their briefs as having been raised and for the purpose of deciding it, we shall assume that it was raised. *236 The evidence shows that petitioners made a lump sum settlement in compromise of both notes and there was nothing in the settlement which indicated how the amount of $ 15,200 was to be allocated. Moreover, petitioners in their brief state that "there was no agreement as to how the settlement should be applied, whether first on interest due or first on principal." Under these circumstances we do not think that any part of the settlement is applicable to interest accrued in 1941. Cf. Automatic Sprinkler Co. of America, 27 B. T. A. 160. Petitioners are apparently relying on the doctrine that, when both principal and interest are due on a debt, undesignated partial payments thereon must first be appropriated to interest before any part is applied to the principal. Cf. George S. Groves, 38 B. T. A. 727; Theodore R. Plunkett, 41 B. T. A. 700;*312 affd., 118 Fed. (2d) 644. However, we do not think this doctrine is applicable here, where the payment was not a partial payment upon the indebtedness, but a lump sum settlement of the entire debt, and was considerably less than the face value of the two notes which aggregated $ 20,750. Issue 4. -- Petitioners contend that of the total legal fees paid to Hill, Morgan & Bledsoe in the amount of $ 11,266.86, the amount of $ 2,388.50 should be treated as a capital expenditure and $ 8,878.36 as a business expense. 1 Respondent contends that no part of the total fee of $ 11,266.86 paid by the petitioners for attorney fees in the condemnation proceedings represents a deductible business expense for tax purposes in the year 1941, but should be treated as a capital expenditure, deductible from the sale price in computing petitioners' capital gain on the transaction. *313 An examination of our findings of fact will show that petitioner in his computation of gain from the award on his income tax return reduced the total amount of the award by using these attorney fees as a deduction. This was proper. See Johnson & Co. v. United States, supra.What petitioner now wants to do is to use only $ 2,388.50 of the attorney fees in the above manner and then have allowed as a separate deduction $ 8,878.36 of the attorney fees and thus offset to that extent respondent's addition to petitioner's income of the $ 17,756.73 interest. There is no warrant in law for this. The attorney fees which petitioner paid to Hill, Morgan & Bledsoe were for their entire services in the condemnation proceeding and there is no *237 basis for allocating $ 8,878.36 of the fee for the collection of interest. The entire amount paid the attorneys for their services must be treated as capital expenditures. Johnson & Co. v. United States, supra.Cf. Williams v. Burnet, 59 Fed. (2d) 357; Washington Market Co., 25 B. T. A. 576; Mary W. T. Connally, 32 B. T. A. 920.*314 Of course, if petitioner's gain from the condemnation award were ordinary income it would make no difference in the tax liability whether petitioner was allowed the deduction of the attorney fees as a capital expenditure in the computation of gain from the sale or whether he was allowed the fees as a business expense deduction. However, petitioner's gain from the condemnation award is taxable as a capital gain and only 50 per cent thereof is taken into account. Therefore, the manner in which these attorney fees are treated does make a difference in petitioner's tax liability. For reasons already stated, petitioner's contention on this point can not be sustained. On issue 4 we sustain respondent. Decision will be entered under Rule 50. Footnotes 1. The reason that no interest was computed for the period of February 18 to April 15, 1941, was because petitioner requested a continuance of the hearing of the proceeding from February 18 to April 15, 1941, and the court in granting the motion required petitioner to waive interest for such period.↩ 1. SEC. 23 [I. R. C.]. DEDUCTIONS FROM GROSS INCOME. In computing net income there shall be allowed as deductions: (a) Expenses. -- (1) Trade or business expenses. -- (A) In General. -- All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, * * * * * * * (2) Non-trade or non-business expenses. -- In the case of an individual, all the ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income, or for the management, conservation, or maintenance of property held for the production of income.↩