Sowers Mfg. Co. v. Commissioner

SOWERS MANUFACTURING CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Sowers Mfg. Co. v. Commissioner Docket No. 14464. United States Board of Tax Appeals 16 B.T.A. 268; 1929 BTA LEXIS 2612; April 29, 1929, Promulgated *2612 Where the petitioner, which keeps its books of account on an accrual basis, has a claim for loss of profits caused by the breach of a contract, accepted and allowed as a general claim by the receiver of an insolvent corporation, recovery of which is uncertain, held that the dividends on said claim should be reported as income for the year in which paid by the receiver. A. E. Graupner, Esq., and John L. Kenefick, Esq., for the petitioner. James A. O'Callaghan, Esq., for the respondent. GREEN *268 In this proceeding the petitioner seeks a redetermination of its income taxes for the calendar years 1922 and 1923, in which the respondent has determined a deficiency in the amount of $26,845.09 for *269 the year 1922, and an overassessment in the amount of $10,352.61, for the year 1923. The petitioner alleges that the respondent erred (1) in including in gross income for the year 1922, the sum of $193,500, being the difference between the amount of a claim filed against and accepted by the receivers of the Willys Corporation, based upon the alleged loss of anticipated profits under a contract breached by the said Willys Corporation, *2613 and the amount of payments actually received by the petitioner during the year 1922, and (2) in disallowing certain deductions claimed in the amount of $13,798.65, or a total error in net income of $207,298.65. All of the facts have been stipulated. The respondent determined that there should be included in income the amount of $500,000, that being the amount of the petitioner's claim allowed by the receivers. FINDINGS OF FACT. The Sowers Manufacturing Co., the petitioner herein, is a corporation organized under and existing by virtue of the laws of the State of New York, with its principal office at No. 1300 Niagara Street, in the City of Buffalo, and was and still is engaged in the manufacture, among other things, of castings for gasoline motors. On October 31, 1919, petitioner entered into a written agreement with the Willys Corporation, a Delaware corporation, with its principal office in the City of Toledo, Ohio, for the manufacture and delivery to said Willys Corporation of 50 to 100 sets per day of Willys six-cylinder castings, each set comprising one six-cylinder block casting, one cylinder head, one fly wheel, and six pistons. The contract was to run for a period*2614 of five years from the 1st day of July, 1920. On the 31st day of October, 1919, petitioner, the Willys Corporation, one D. W. Sowers (president of petitioner), and the Bank of Buffalo entered into a certain trust agreement whereby the Willys Corporation agreed to advance moneys to petitioner from tiem to time for the purpose of enabling petitioner to erect additions to its plant and otherwise prepare for the execution of the agreement up to an aggregate of $275,000, and petitioner agreed to issue its second preferred stock of a par amount equal to the moneys so advanced to the said D. W. Sowers, and the said D. W. Sowers agreed to deposit said stock with the Bank of Buffalo as trustee for the Willys Corporation. By the terms of the second preferred stock, petitioner agreed to redeem at par in cash at least $12,500 on January 1, 1921, and thereafter a like amount on each first day of July and January up to and including July 1, 1925, and all of said second preferred *270 stock not redeemed by July 1, 1925, was agreed to be redeemed at par in cash on or before September 1, 1925. On or about the 24th day of November, 1921, and before any of the castings had been manufactured*2615 and/or delivered, the Willys Corporation, being unable to meet its obligations, receivers were appointed for it by decree duly made and entered in the United States District Court for the Northern District of Ohio, Western Division, in an action entitled "The Ohio Savings Bank & Trust Company, Plaintiff, v. Willys Corporation, Defendant," and the agreement of October 31, 1919, as aforesaid, was thereupon breached. At the time of the appointment of the receivers and the breaching of the agreement, petitioner had issued, pursuant to the terms of the trust agreement, $250,000, par amount of second preferred stock, which had been deposited with the trustee, and had redeemed $12,500 thereof, leaving outstanding and subject to the terms of the trust agreement, $237,500 par amount of said second preferred stock. The petitioner duly filed a proof of claim against the receivers of said Willys Corporation in the sum of $943,025.24, based in part upon certain expenditures made by the petitioner in anticipation of the execution of the contract and the balance of said claim was based upon an alleged loss of profits which petitioner claimed it would have earned, had it been permitted to*2616 enter upon and complete the performance of the contract. Negotiations were had between petitioner and the receivers of the Willys Corporation, resulting in an offer from the receivers to compromise petitioner's claim in the sum of $500,000. Petitioner agreed to accept the offer to compromise and the receivers thereupon submitted it to the United States District Court for the Northern District of Ohio, Western Division, for approval. The court, by a decree dated December 27, 1922, authorized and approved the compromise, with the provision that $50,000 of the amount of the claim allowed should be paid by the cancellation and transfer to petitioner of any interest of the Willys Corporation or its receivers in the said $237,500 par amount of the second preferred stock of petitioner then outstanding under the terms of the trust agreement. The balance of $450,000 was allowed by the court as a general claim against the Willys Corporation receivers, which sum so allowed represented that part of the claim relating to the loss of profits and did not include anything relating to the expenditures claimed to have been paid out by the petitioner in anticipation of the execution of the contract. *2617 Between the date of entry of the decree and the 31st day of December, 1922, the receivers of the Willys Corporation paid to the petitioner a dividend of 57 per cent on the sum of $450,000, amounting *271 to $256,500, said rate being the rate of dividends theretofore paid to other general creditors whose claims had been allowed, and the petitioner included in its income-tax return for the year 1922 the $306,500 paid to it by the receivers, as aforesaid, during the year 1922. On the 31st day of December, 1922, the Willys Corporation had properties located in various States and ancillary receivers were appointed in the Southern District of New York, the Northern District of New York, and the State of New Jersey. At or about the time of the allowance of petitioner's claim, petitioner was advised by the receivers that they had the following assets: Cash on hand by receiver in Ohio $ 4,500,000 Cash on hand by the receiver of the South District of New York 600,000 Cash on hand by receiver in New Jersey as a result of the sale of the plant at Elizabeth 2,750,000 Property at Syracuse, New York, which has been sold for $2,000,000, subject to the approval of the court 2,000,000 Willys Overland notes 750,000 740,000 shares of the Willys Overland Co. and other stocks and securities, which the receiver states had a value of approximately 5,000,000 Total 15,600,000 *2618 Petitioner was also advised by the receivers that the total unadmitted claims against the receivers amounted to upwards of $18,000,000, of which approximately $14,000,000 were unadjudicated, and that the expenses of the receivers would amount to approximately $1,000,000. Petitioner sought, but was unable to obtain, a balance sheet of the receivers as at December 31, 1922, or any estimate from the receivers of the probable amount of additional dividends on its claim. Petitioner was advised by the receivers that it was not known if and when and to what extent other dividends would be paid. During the years 1923 and 1924 the receivers rejected and refused to pay various claims and compromised large contingent claims for various amounts. In compromising such claims the receivers did not use a ratio of allowance to the amounts of claims filed, but adjusted each claim upon the most satisfactory basis which the receivers could obtain. During the year 1923 the receivers paid further dividends of 33 per cent on claims of general creditors and petitioner received $148,500. During the year 1924 a further dividend of 10 per cent was paid, and petitioner received a sum of $45,000, *2619 thereby liquidating petitioner's claim in full. These amounts were included in petitioner's income-tax returns for the years 1923 and 1924, respectively. All claims allowed against the Willys Corporation were paid in full. *272 The petitioner's accounts were kept on an accrual basis, and it filed its returns on that basis. OPINION. GREEN: The petition alleges and the answer admits that "the taxes in controversy are income taxes for the calendar years 1922 and 1923, and amount to the sum of $16,492.48." The respondent has proposed no deficiency for the year 1923. Neither has he rejected an abatement claim for that year. We must, therefore, on our own motion, dismiss the petition for lack of jurisdiction as far as it pertains to the year 1923. . The question involved in this proceeding is whether the petitioner should report, as taxable income for the year 1922, the allowed amount of a general claim filed by the petitioner against the receivers of the Willys Corporation and allowed by the latter during the year 1922, as contended for by the respondent, or whether the petitioner should only report the dividends*2620 on the claim as income as and when they were paid by the receivers, as contended for by the petitioner. The circumstances surrounding the contract and its breach, have been set out fully in the findings of fact. The claim as originally filed with the receivers amounted to $943,025.24 and was based, in part, upon certain expenditures made by the petitioner in anticipation of the execution of the contract. The balance of the claim and the major portion thereof was based upon the alleged loss of profits, which the petitioner contended it would have earned had the contract not been breached. After negotiations, the receivers offered to compromise petitioner's claim for the sum of $500,000. The court authorized the receivers to allow the claim, provided that $50,000 thereof should be applied against the cancellation and the transfer to the petitioner of any interest which the Willys Corporation or the receivers had in the $237,500 preferred stock of the petitioner then outstanding. The balance of the $450,000 was allowed as a general claim and represented only a settlement for loss of anticipated profits arising out of the breach of the contract. It did not include any sum for*2621 the expenditures claimed to have been made by the petitioner in getting ready to perform the contract. Upon the allowance of the claim the petitioner was paid, during 1922, the same percentage that had been previously paid to the general creditors, namely, 57 per cent, amounting to $256,500. The petitioner, in its tax return for 1922, reported as income the sum of $306,500, which represented $50,000 fixed as a consideration upon the preferred stock redeemed by the petitioner, in accordance with the terms of the settlement with the receivers, and the $256,500 representing the 57 per cent dividend paid in 1922. *273 On December 31, 1922, the petitioner had received 57 per cent of its claim as allowed. The liquid assets then remaining in the hands of the receivers amounted to approximately half the amount of the claims filed and the expenses of the receivership. If full credence were given to the receivers' estimates of the value of all assets, it would not then have appeared that more than 75 per cent of the amount of the claim would be recovered. The receivers made no promises or forecasts, and were unwilling and unable to say when and if further dividends would be*2622 paid. The petitioner reported as income only the amount of the cash dividends received. The petitioner at all times kept its accounts and filed its income-tax returns upon the accrual basis. The general rule is that a taxpayer reporting on an accrual basis must report items of income at the time they accrue, without regard to the time they are paid. ; ; and . A taxpayer who keeps its books and reports its income on the accrual basis is not, however, required to report as income that which in all probability it may never receive. . In the latter case, the Great Northern Railway Co. kept its books upon an accrual basis, in accordance with the requirements of the Interstate Commerce Commission. It did not, however, in accordance with section 20 of the Act to Regulate Commerce, effective July 1, 1914, accrue certain interest on certain debts owing it by certain nonaffilated subsidiaries, for the reason that it was very doubtful whether it would ever be able to collect such interest*2623 on account of the financial condition of the debtor companies. The Commissioner contended that, notwithstanding the requirements of the Interstate Commerce Commission, the Great Northern Railway Co. should, for income-tax purposes, report the interest as income for the years in which it accrued. In rejecting the Commissioner's determination on that point, we said in part: As indicated by the income-taxing statutes, corporations keeping books of account may make their returns upon the basis of actual receipts and disbursements or upon some other basis which truly reflects income. There are two methods of accounting in general use, (1) the cash basis commonly used by individuals and small concerns, and (2) the so-called "accrual basis." Both methods have for their object the same purpose, which is the recording of the financial transactions of a business and the summarizing of the results so as to show the effect of these transactions upon the business. The principal difference between them is the period of time to which a given transaction is allocated. Under either method the taxpayer must have before him some definitely ascertained item of income to record before it can be*2624 reported and if a given transaction does not correspond to the definition of income then there is no income to record whether the taxpayer keeps its books on a cash or an accrual *274 basis. Where books are kept on the accrual basis there is no requirement that there shall be accrued as income that which may never be received. The position of the respondent in this case carried to its logical conclusion would require a taxpayer keeping its books of account upon the accrual basis to accrue as income interest on bonds held as an investment which it did not collect and which in all probability it never would collect. If the theory of the respondent is correct an insolvent corporation keeping its books of account upon the accrual basis might merely by the purchase of bonds of insolvent corporations upon which interest was neither being earned or paid, easily show a large income. (Italics added.) In cases of sales where part of the consideration received has no fair market value, a taxpayer on the accrual basis is not required to report all of the profit from the sale that may eventually be realized but is entitled to report on the "return of capital" theory, which contemplates*2625 the receipt by the taxpayer of its entire cost or other basis before there can be any taxable income. See ; and . In the instant case, we are of the opinion that the probable amount of recovery on the bankruptcy claim was so uncertain that either an accrual in part or in full would not properly reflect income. The deficiency should be recomputed by excluding from gross income, as determined by the respondent, the amount of $193,500, representing the difference between the $500,000 claim allowed and the dividends paid during the year of $306,500. No evidence was offered with respect to the deductions of $13,798.65 and on this point the respondent's determination is approved. Reviewed by the Board. Judgment will be entered under Rule 50. STERNHAGEN dissents.