Davey v. Commissioner

WILLIAM M. DAVEY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Davey v. Commissioner Docket No. 48550. United States Board of Tax Appeals 30 B.T.A. 837; 1934 BTA LEXIS 1262; May 31, 1934, Promulgated *1262 Petitioner purchased certain mortgage securities at a discount and sold them at a discount which would net a profit. Such sales were made upon the condition that upon default in payments or trouble with collections petitioner would replace the securities sold with other securities of equal value, or repurchase same. The vendees, upon 90 days' notice, could require petitioner to replace the securities and, upon the same notice, petitioner could repurchase from his vendees. Held, the transactions constituted sales upon conditions subsequent, and did not create the relation of debtor and creditor. Held, further, that the entire gain derived from the sales was income to the petitioner in the year in which the securities were sold, and that no part thereof could be deferred to future years because of the conditions in the sales agreements. Frank Mergenthaler, Esq., and G. O. Carlson, C.P.A., for the petitioner. C. H. Curl, Esq., for the respondent. MARQUETTE *837 The respondent has determined a deficiency herein for the year 1926 in the amount of $3,506.86. The only question for decision is whether the amount of $19,403.03 included*1263 by the respondent in gross income is to be treated as deferred discount returnable as income in subsequent years under the facts herein. The facts were stipulated, and such stipulation is incorporated herein by reference. From the stipulation we make the following findings of fact. FINDINGS OF FACT. In 1926 William M. Davey, the petitioner herein, was engaged in the business of dealing in trust deeds and mortgages in Hollywood, California. In the course of his business petitioner acquired a number of trust deeds and mortgages at varying discounts. Some of the securities so acquired were held until maturity and others were disposed of as hereinafter described. Among the securities thus acquired there were mortgages the principal of which was due as a whole at maturity, and trust deeds the principal of which was payable in installments. In all cases it was the practice of the petitioner to take up the discount as taxable income only when and as payments were received on the principal. In the case of mortgages due as a whole, the discount was taken into income when the mortgage was paid. In the case of installment paper the discount rate was applied to installments of principal*1264 received to determine the realized profit. *838 This had been the consistent practice of petitioner in 1926 and prior years. Some of the trust deeds and mortgages were sold without recourse and the entire amount of the discount realized upon such sales was taken into income. Other sales of paper were made with records. With respect to these sales, the petitioner's consistent practice was to carry the discount as a deferred profit until and as the principal was reduced, thereby reducing or eliminating his liability to repurchase the paper. On April 16, 1926, petitioner entered into an agreement in writing with Charles W. Bryson and Myrtle Bryson, his wife, as follows: THIS AGREEMENT made and entered into this 16th day of April, 1926, by and between William M. Davey, party of the first part, and Charles W. Bryson and Myrtle F. Bryson, his wife, parties of the second part, all of Los Angeles, California, WITNESSETH: THAT, WHEREAS, the party of the first part is engaged in the business of buying and selling trust deeds and mortgages; and WHEREAS, the parties of the second part or either of them intend from time to time for investment to purchase from the party of the*1265 first part notes secured by trust deeds and mortgages: NOW, THEREFORE, in consideration of the mutual covenants and agreements hereinafter contained, the parties hereto hereby agree to and with each other as follows: 1. That the party of the first part will sell to the parties of the second part or either of them notes secured by trust deeds or mortgages when and as requested by the parties of the second part, and in such amounts as the party of the first part may be able to sell, dependent upon the condition of his business; 2. That all notes secured by trust deeds or mortgages sold by the party of the first part to the parties of the second part will net the parties of the second part not less than ten per cent (10%) per annum on the money actually invested by them, and for this purpose such paper as may be sold to the parties of the second part shall be discounted accordingly, to-wit: all notes bearing interest at the rate 7% will be discounted at the rate of not less than 1/4 of 1% for each month of the unexpired term thereof, and all notes bearing interest at the rate of 8% will be discounted at the rate of not less than 1/6 of 1% for each month of the unexpired term thereof; *1266 3. That should default occur in the payments due on or any other trouble arise in connection with the collection of any of such notes sold by the party of the first part to the parties of the second part, the party of the first part will, on demand, either replace the said note and trust deed or mortgage with paper of equal value or will repurchase the same at the same rate of discount at which it was sold to the parties of the second part; 4. That the parties of the second part may at any time on ninety (90) days written notice, require the party of the first part to repurchase from them or either of them all trust deeds, notes and mortgages theretofore sold to them by the party of the first part under this agreement; provided, however, that upon any repurchase from the parties of the second part, the party of the first part shall be allowed the same discount, as was received by the second parties; 5. That the party of the first part may at any time on ninety (90) days written notice to the parties of the second part, repurchase from them or either of them any or all notes secured by trust deeds or mortgages therefore sold *839 them by him at the same rate of discount*1267 at which the same were sold to the parties of the second part. In the year 1926 the petitioner, pursuant to the terms of the agreement, transferred to Charles W. Bryson or Myrtle Bryson trust deeds or mortgages having a balance of face value aggregating $74,503.72. At December 31, 1926, petitioner's books showed unearned discount on the trust deeds and mortgages totaling $13,875.86, which was not included in income for the year 1926, but was carried as deferred income to be reported as the trust deeds and mortgages were paid. The petitioner did not endorse to the Brysons the notes secured by the trust deeds or mortgages, but in lieu thereof attached to each note a form of rider as follows: For Value Received, I, Wm. M. Davey, do hereby transfer and assign to Dr. Charles W. Bryson and Myrtle F. Bryson, the within note, together with all rights accrued or to accrue under the Deed of Trust securing same, so far as the same relate to this note, and do hereby agree to re-purchase this note at any time should a default occur in the payment of same as set out in our agreement of April 16, 1926, covering the sale of this note. This method was pursued by petitioner because he*1268 expected to have to take back a number of the notes secured by the trust deeds and mortgages and he did not want the endorsement to appear on the note when called upon to take it back. In 1926 petitioner transferred to other persons mortgages and trust deeds having a balance of face value aggregating $36,417.15. At December 31, 1926, petitioner's books showed unearned discount on these mortgages and trust deeds totaling $5,527.17, which was not included in income for the year 1926, but was carried as deferred income to be reported as the trust deeds and mortgages were paid. These transfers were made upon the same terms and conditions and in a like manner as those made to the Brysons as hereinbefore set forth. Petitioner was obligated to take back any of the securities so transferred upon request of the transferees thereof. All of the trust deeds and mortgages sold by petitioner were second liens and had a fair market value at the time of the transfers herein ranging from 60 to 87 percent of the unpaid balance. Petitioner made his income tax return for the year 1926 upon the cash receipts and disbursements basis. OPINION. MARQUETTE: The petitioner relies upon four*1269 points to support his position: (1) That the arrangement entered into between himself, on the one hand, and Bryson and others, on the other, established, in fact, the relationship of debtor and creditor; (2) that the alleged profit derived from the transactions was deferrable for income tax *840 purposes; (3) that where a taxpayer consistently reports his income in accordance with a particular plan which reflects the true income, he should be permitted to continue to report it upon that basis; and (4) that where a doubt arises in the application of a taxing statute, the doubt should be resolved in favor of the taxpayer. Given facts which would warrant the application of points (3) and (4), we would have no quarrel as to the correctness of the points stated herein, but we are of opinion that the facts herein do not warrant the conclusions stated in those points. The decision of the case rests primarily upon points (1) and (2). As appears from the findings of fact, petitioner purchased mortgage securities at a discount which he later sold to the Brysons and others at a discount which would net him a profit. As a condition of the sales, petitioner agreed, in case of default*1270 in payments due or trouble with collections, either to replace the securities sold with other securities of equal value, or to repurchase the same at the same rate of discount at which they were sold to his vendees. Upon 90 days' notice the vendees could require petitioner to repurchase all securities sold to them, and, upon like notice, petitioner could repurchase from his vendees. We see nothing in this situation which at all resembles the relation of debtor and creditor. The agreement purports to sell and the conditions therein are all conditions subsequent. Whether the contingencies provided for will ever occur is problematical. Upon the sale of the securities the purchase price becomes the property of the petitioner, without restriction upon its use, and any gain derived in the transaction is income at that time. The petitioner claims the right to report this gain as amounts are paid to his vendees upon the security sold. This, in effect, is not different from a reserve to take care of the contingent liability to repurchase. While such a reserve may be good accounting practice, it is not permitted by the taxing statute, and such income may not be deferred to await the*1271 possibility of the happening of the contingency. . Nor do we think the method of accounting adopted by petitioner reflects true income. Income taxes are laid upon an annual basis, and here the petitioner derived the gain from his capital which constituted gross income in the year in which received, and income is not truly reflected by deferring a part thereof to future years. This proceeding does not differ in principle from that of ; affd., ; . In that case Edward Browne & Sons acted as Pacific Coast general agent for fire insurance companies. The geveral agent received as compensation a so-called "overriding commission" on the net premiums derived from business written through local agents. The Commissioner held that in *841 determining income the gross overriding commissions on business written during the year should not be subjected to any deductions on account of cancellations subject to occur in later years. The petitioner contended that either the gross overriding commissions should be subjected to such a deduction*1272 or that parts of gross overriding commissions should be allocated as earnings of future years. The Supreme Court stated: The overriding commissions were gross income of the year in which they were receivable. As to each such commission there arose the obligation - a contingent liability - to return a proportionate part in case of cancellation. But the mere fact that some portion of it might have to be refunded in some future year in the event of cancellation or reinsurance did not affect its quality as income. Compare . When received, the general agent's right to it was absolute. It was under no restriction, contractual or otherwise, as to its disposition, use or enjoyment. Compare . The refunds during the tax year of those portions of the overriding commissions which represented cancellations during the tax year had, prior to the tax return for 1923, always been claimed as deductions; and they were apparently allowed as "necessary expenses paid or incurred during the taxable year." The right to such deductions is not now questioned. *1273 Those which the taxpayer claims now are of a very different character. They are obviously not "expenses paid during the taxable year." They are bookkeeping charges representing credits to a reserve account. We think this case is decisive of the proceeding before us and we therefore hold that no part of the gain derived from the sale of securities herein may be deferred to future years but is income in the year of its receipt by the petitioner. Judgment will be entered for the respondent.