Lovejoy v. Commissioner

JULIA STOW LOVEJOY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Lovejoy v. Commissioner Docket No. 27242. United States Board of Tax Appeals 18 B.T.A. 1179; 1930 BTA LEXIS 2515; February 14, 1930, Promulgated *2515 1. In deciding whether an item is a deduction in determining taxable net income, the taxpayer's method of accounting is not controlling unless it clearly reflects income, notwithstanding the categorical statement that the taxpayer's accounts were kept and the return made on the "cash basis." 2. Commissions, fees, and printing costs paid in one year by a taxpayer in securing a loan for ten or fifteen years covered by a mortgage on property to be leased, are not deductible in full in the year of payment. Olinger Corporation,9 B.T.A. 170, overruled. Pierpont J. E. Wood, Esq., for the petitioner. Harold Allen, Esq., for the respondent. STERNHAGEN *1179 The Commissioner determined a deficiency in income tax for 1924 of $3,951.43. Petitioner attacks this because respondent has disallowed the deduction of amounts paid in borrowing on mortgage to construct a building. FINDINGS OF FACT. Petitioner is an individual citizen of the United States and resides in Janesville, Wis. For all years, including 1924, she has kept her accounts and made her income-tax returns on the cash basis for a calendar year. Petitioner has investments*2516 in stocks, bonds, and mortgages and was the owner of real estate in Chicago and elsewhere, and was engaged in its administration and improvement. She had, prior to 1924, sometimes borrowed money on mortgage on her property. In 1923 and prior thereto she owned, among other property, a piece of land in Chicago, adjoining a C.B. & Q. switch track. In 1923 she began negotiations with a prospective lessee looking toward *1180 the occupancy under lease of a warehouse building to be constructed by petitioner on the land. During 1924 she built such a warehouse at a cost, without the land, of between $325,000 and $350,000. The occupancy began in 1924 and the building has ever since been occupied under lease. Petitioner owned sufficient securities to have enabled her to finance this cost without a mortgage if she had so desired. She borrowed $175,000 from a trust company at 6 per cent interest upon serial notes maturing over a period of ten or fifteen years secured by a mortgage on the property. The transaction was subject to a commission or brokerage charge of 5 per cent and certain expenses. The notes were taken by the bank at par. During 1924 petitioner paid in cash*2517 $8,750 to the bank for services in selling the notes, $558.20 for a guaranty policy covering title to the property, $300 to the trustee under the mortgage as a fee for certifying the notes, and $171.38 for printing the mortgage and notes. All of these payments were necessary to secure the loan and none was regarded as discount on the notes. OPINION. STERNHAGEN: In filing her return the petitioner took as a deduction $9,779.58, the aggregate of the four items paid in 1924 in connection with the mortgage loan of $175,000. The respondent, after audit, made several adjustments, among which was the disallowance of this deduction. It is not entirely clear but what respondent substituted a deduction of part of this amount upon some basis of apportionment; but whatever the method of computation, the essence of the adjustment is that the amounts paid were called capital expenditures and hence the deduction was disallowed in their entirety for the year paid. The respondent in his brief for the first time urges that petitioner was not engaged in business and that therefore the payment is not deductible as a business expense. But the evidence is in our opinion clear that petitioner*2518 was carrying on a business and that these payments, whatever their character under the revenue act, were made in business transactions. The question of their treatment under the statute in determining net income is a difficult one. It can not be decided on the ground that petitioner chose to use an accounting method of actual cash receipts and disbursements and to charge off the amounts in the year of payment. There must be, for judicial purposes, a more universal standard; for it to permit this taxpayer to deduct in the year of payment would result in requiring another taxpayer to do so, it must be because the deduction is fair and proper in all cases. *1181 This is among the reasons for section 212. While the taxpayer's regular method of accounting is a first consideration in determining income, it must give way if it does not clearly reflect income. Thus, even although a taxpayer were to adopt a pure cash method, recording only cash receipts and disbursements and ignoring all else, he would not be permitted to deduct a cash disbursement for a substantial asset, such as machinery, the effect of which is to be felt in the business of future years. This would be called*2519 a capital expenditure, and it is illogical that it should be charged against the earnings of a single year and accounted for as if it were gone and had no continuing ownership and value. The statute does not sanction any method of accounting unless it clearly reflects income. When, therefore, an item is sought to be deducted, it is not sufficiently supported buy a showing that taxpayer's accounting method is categorically called the "cash method" or that the entry on the accounts is consistent with such method. It must be shown further that the method employed and the entry result in a clear and legally correct income. However important or unimportant it may be to an individual for his own uncontrolled purpose whether on his books an item is charged off or carried along, when he comes to the determination of taxable income it must be computed as the statute prescribes and his figures must be adjusted to that end. Manifestly, the standard for a fairly distributed Federal tax burden was not intended to be the varying accounts of individual taxpayers but the uniform statutory method. Consistently with the statute, the methods of accounting may vary widely and may yet be given recognition. *2520 But the variation may not go outside the field of the statute; and when it does, its sanction is lost. The petitioner in 1924, for the purpose of securing the use of capital and applying it to the construction of a building from which she was to derive rent over a long period of years, spent $9,779.58 for commissions, fees, and printing. The loan is for a period of years which is stated in one place in the revenue agent's report put in evidence by petitioner to be fifteen years and in another place to be ten years. She contends that since she kept her accounts and made her return on a so-called "cash basis" and charged this item off, she is entitled to deduct it in determining 1924 income. As statutory net income admits of only the deductions enumerated and described in section 214, she seeks to bring the item within the statute as an "ordinary and necessary expense paid or incurred during the taxable year in carrying on" her business. Although this language is broad enough to require constant interpretation, it still falls short of including items like this, which are not among current operating costs, are not ordinary but only occasional and infrequent, and have their effect*2521 upon, *1182 and are therefore related to, not only the income of the year but also the income of the future. This item, notwithstanding the accounting charge-off, may not be forgotten, and throughout the period of the loan at least it will be remembered that the amount of $9,779.58 is an inherent cost of its financing. The petitioner argues that this can not be treated as a capital investment because it resulted in no asset and did not increase the value of her property. It is unnecessary to become involved in terminology. The language of the statute may not be so precise as to result in perfect correlation. There is no reason to say that a disbursement which is not a statutory "expense" must therefore be a "capital expenditure" or "investment." Nor does it follow that, because an item is not enumerated in section 215 as nondeductible, it must be deductible. Conceivably, an item may elude all of the statutory categories, although short of doing violence to the express provisions, it is the function of judicial construction to harmonize the law so as to preserve its essential plan and purpose. The result of this disbursement was that petitioner had for ten or fifteen*2522 years the use of another's money as the basis of deriving income. Presumably, she believed, when she incurred these items of cost and paid them, that she would secure income enough to enable her to pay interest on the loan and recoup these initial payments either out of income or ultimate sale. The reasonableness of such a supposition persists even if in the science of accounting there were no device for recording the continuing effect of the payment. That ordinarily such a payment is not reflected among the assets of of a balance sheet is not controlling. If, notwithstanding petitioner's so-called cash basis, she had prepared a balance sheet and had included in her assets this item by whatsoever designation so long as it disclosed the facts, such a schedule would have been beyond reproach. In its essence such a disbursement is not unlike bond discount, prepaid rent, cost of acquiring or disposing of a leasehold or term contract and many other transactions. They should be spread over the definite period of the loan, lease, or contract. *2523 ; ; ; ; Bonwit Teller & co.,. This is on the theory that they result in property of a sort and its cost is being exhausted proportionately over a period of years and should be provided for on the basis of time, production, or otherwise. Sec. 214(a)(8). While they are in some respects similar to commissions paid for the issuance of stock, the difference is in the definiteness of the fact *1183 of exhaustion and of period over which provision can be made for its recovery. See ; ; affd., ; certiorari denied, . We are of opinion that the respondent correctly disallowed the deduction in 1924 of the items in question as ordinary and necessary expenses. This is to some extent inconsistent with *2524 , and . The McNeill case has already been limited by ; and the Olinger case is now overruled. Upon further thought, we regard , and , as not requiring the conclusion reached in the Olinger case, and our opinion in the present case is, we think, supported by those decisions. Reviewed by the Board. Judgment will be entered under Rule 50. SMITH SMITH, dissenting: The petitioner made her income-tax returns upon the basis of cash receipts and disbursements. In such returns she could deduct from gross income as ordinary and necessary expenses only amounts actually paid out. in Olinger Corporation,9 B.T.A. 170, we held that a note given for securing a loan was deductible as an expense in the year given where the petitioner was on the accrual basis. In Robert H. McNeill,16 B.T.A. 479, involving the same point as is involved in this proceeding, *2525 we held that amounts paid out in obtaining lessees are deductible expenses of the year in which paid. The decision in the McNeill case was followed by the United States District Court, Southern District of New York, in Daly v. Anderson, 37 Fed.(2d) 728, in which the court held that a commission paid in 1923 to a broker for obtaining a 21-year lease on the taxpayer's property to begin in 1931 was deductible in 1923 by the taxpayer where on a cash receipts and disbursements basis. Those decisions are, I think, in line with American National Co. v. United States,274 U.S. 99, and United States v. Anderson,269 U.S. 422. It is not to be presumed that Congress contemplated the spread of an expense of the nature of that paid out by the petitioner in 1924 over a series of years. Such a method of charging off the expense is entirely foreign to the petitioner's method of keeping her books of account and making her tax returns. It needlessly complicates the administration of the income-tax law. If the petitioner were on an accrual basis it might be proper to treat the amount as a deferred expense and then to spread the charge. *2526 But the petitioner was not on an accrual basis. The income tax is levied not on economic income *1184 but upon net income to be determined in the manner prescribed by the taxing statutes. In years subsequent to 1924, the petitioner is not entitled to deduct any part of the amount expended by her in 1924 in securing the money borrowed. The expense paid in 1924 is a legal deduction from income of 1924. LANSDON, TRUSSELL, LOVE, and VAN FOSSAN agree with this dissent.