Pioneer Auto. Service Co. v. Commissioner

PIONEER AUTOMOBILE SERVICE COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Pioneer Auto. Service Co. v. Commissioner Docket Nos. 78866, 79001. United States Board of Tax Appeals 36 B.T.A. 213; 1937 BTA LEXIS 751; June 24, 1937, Promulgated *751 1. During the taxable years 1931 and 1932, petitioner entered into contracts with automobile owners whereby, for a stated consideration payable in installments, it agreed to render certain services during the lives of the respective owners. Petitioner kept its books and made its income tax returns on an accrual basis. It accrued as gross income the entire amount of the consideration paid or to be paid on each contract and set up on its books a "reserve for life memberships", thereafter making annual additions thereto on the basis of the number of contracts written each year. Held, petitioner is not entitled to deduct from the accrued gross income the amount of additions to such reserve fund for the taxable years. 2. On the facts, held, that petitioner is subject to the 25 percent delinquency penalty for failure to file its return for the year 1931 within the time prescribed by law. Stanley S. Waite, Esq., for the petitioner. Harold F. Noneman, Esq., and W. S. Alt, Esq., for the respondent. HILL *214 These are consolidated proceedings for the redetermination of deficiencies in income tax and delinquency penalty as follows: *752 Year Docket No. Deficiency Penalty [1931] 78866 $6,732.23 $1,683.06 [1932] 79001 1,131.73 The issues raised by the pleadings are (1) whether respondent erred in denying as deductions from gross income the increase to the life membership reserve of petitioner for each of the taxable years, and, if such deductions are not allowable, whether petitioner's accounts should be put upon a cash basis in order properly to reflect its income; and (2) whether respondent erred in asserting a penalty of 25 percent for failure to file petitioner's income tax return for the year 1931 on time. FINDINGS OF FACT. Petitioner was incorporated under the laws of the State of Missouri on December 27, 1927. Petitioner kept its accounts and filed its income tax returns upon the basis of accrued income and expense. Since its incorporation, and during the calendar years 1931 and 1932, petitioner operated an automobile service, furnishing its customers, among other services, (a) a day and night emergency road service such as motor starting, ignition trouble, battery deficiencies, and out of gasoline; (b) towing from place of breakdown; (c) mechanical inspection; (d) touring*753 information; (e) battery service; (f) bail bond for customers under arrest; (g) discounts on purchase of tires, tubes, and accessories. It offered its services under contracts as follows: (a) A contract for one year, under which its regular charge ranged from $16 to $18; (b) a contract for two years, under which its regular charge was $29.50; and (c) a contract for the life of the customer, under which its regular charge was $110. Under contracts written after December 25, 1931, the charge was increased to $160. It employed solicitors upon a commission basis to solicit such contracts in its behalf from the owners of automobiles. During the year 1931 petitioner entered into 1,130 contracts, under which it agreed to furnish its services to the other parties to such contracts for and during their natural lives. The other parties to such contracts agreed to pay to petitioner, in consideration of petitioner's obligation, the total sum of $124,300. During the year 1931 petitioner also entered into 5,689 contracts under which it obligated itself to furnish its services to the other parties to such contracts for the period of two years from the date *215 of such contracts. *754 The other parties to such contracts agreed to pay to petitioner, in consideration of petitioner's obligation, the total sum of $167,750.50. During the year 1931 petitioner also entered into 1,584 contracts under which it obligated itself to furnish its services to the other parties to such contracts for a period of one year from their date. The other parties to such contracts agreed to pay to petitioner, in consideration of petitioner's obligation, the total sum of $26,769.50. During the year 1931 petitioner also entered into 24 contracts under which it obligated itself to render such services upon two cars belonging to the other parties to such contracts and under which the other parties to such contracts agreed to pay to it the total sum of $1,241. During the year 1932 petitioner entered into 513 contracts, under which it agreed to furnish service to other parties to such contracts for and during their natural lives. The other parties to such contracts agreed to pay to petitioner, in consideration of petitioner's obligations, the total sum of $82,080. The amounts due upon the contracts were not paid in full at the time the contracts were signed. The amount unpaid*755 at the end of 1931 upon all existing contracts was $79,022.06. The amount unpaid at the end of 1932 was $84,910.28. The full contract obligation assumed by the persons who contracted with petitioner under the contracts above described, whether or not such amount was paid at that time, was credited by petitioner in its accounts to sales and was included by petitioner and has been included by respondent in petitioner's income of that year in which the contract was executed. Petitioner's accounts with relation to the contracts were set up and maintained in the following manner: (a) In connection with sales of one-year and two-year and life membership contracts, the contract price thereof was credited to the account sales, regardless of whether or not the cost of the contracts was paid in cash or upon the installment basis. A corresponding charge was made to accounts receivable. A charge was then made to the cash account in the amount of cash actually received and a corresponding credit was made to accounts receivable in order to record the payments received. (b) Contracts were sold in every month of the year, obligating the petitioner to render and pay the cost of service*756 under such contracts for the terms thereof. Many contracts were conceled. Petitioner set up three reserves as follows: One was called "Cancellation of Contracts." This account was credited with the amount estimated to be necessary to care for cost of collection and losses due to cancellation of contracts. Corresponding charges were made to the account "Refunds and Cancellations." *216 Another reserve was called "Prepaid Dues." When a contract for one or two years was signed, prepaid dues was first credited with 25 cents per month for the term of such contract (and later with 50 cents per month), being the estimated cost of rendering the service called for during the term of such contract. At the end of each month this account was charged with the same amount for which it was credited for each contract as the earned portion of such prepaid dues. A third reserve was called "Reserve for Life Memberships." When petitioner entered into a life membership contract, it credited this reserve with $60, which it estimated to be the average cost for the rendition of the service required during the term of such contract. The reserve for life memberships was set up pursuant*757 to resolution of the board of directors. From the minutes of the meeting of the board of directors held on October 7, 1930, the following is quoted: Mr. Raymond Rodin spoke of the need of a plan for life membership. After a discussion, it was voted by the directors unanimously that the company provide a life membership and it be offered for sale at some amount, approximately $100.00, and that out of each life membership received, not less than $40.00 should be put aside and held by the company in a separate reserve fund and used for no purpose whatever except the servicing of contract of such life memberships. It was believed that the average life of a life membership would not exceed 10 years and that this would be covered by the reserve of $40.00. From the minutes of the meeting of the board of directors held on May 28, 1931, the following is quoted: Accordingly, after this discussion two motions were made by Mr. Barrett and seconded by Mr. Carl Rodin and unanimously carried; the first providing that the Company should set aside $60.00 on every full paid life membership, said $60.00 to be held intact for the guaranteeing of life service contracts until the Board of Directors*758 otherwise ordered. The other motion also unanimously carried was that Mr. Barrett be instructed and authorized to prepare some form of trust arrangement whereby for a period of one or two years these funds should be placed in trust with some bank or trust company for the exclusive benefit of the life contract holders. At the end of the year 1931, 1,195 of such contracts were in full force and effect and the total amount set up in such reserve, and deducted by petitioner from its income for that year was $71,700. During the year 1932, on account of the 513 contracts entered into by petitioner in that year, petitioner added to its reserve for life memberships and deducted from its income the sum of $30,780. During that year 128 contracts were canceled, on account of which petitioner deducted from the reserve $7,680, so that the net addition to the reserve made by petitioner during the year 1932 and deducted from its income for that year, was $23,100. *217 Balance sheets taken from petitioner's books (before any adjustments made by respondent) as of January 1, 1931, December 31, 1931, and December 31, 1932, are as follows: Balance Sheet of Pioneer Automobile Service Co. as of January 1, 1931. Assets Liabilities Petty cash $400.00 Bank overdraft $2,685.91 Cash reserve fund 3,595.00 Accounts payable 1,031.07 Cash reserve fund hospital 343.65 Notes payable 111.04 Cash reserve fund life member 128.00 Reserve for depreciation 7,501.09 Accounts receivable 35,700.70 Prepaid dues 42,670.25 Miscellaneous loans 655.80 Reserve for cancellation 8,925.00 Furniture and fixtures 8,058.57 Surplus 206.18 Permanent signs 575.23 Capital stock 50,000.00 Service signs 156.59 Total 114,130.54 Garage equipment 13,700.00 Automobile 654.00 Springfield office 163.00 Good will 50,000.00 Total 114,130.54 *759 Balance Sheet of Pioneer Automobile Service Co. as of December 31, 1931. Assets Liabilities Petty cash $300.00 Bank overdraft $769.72 Cash reserve fund general 653.89 Accounts payable 1,295.00 Cash reserve fund hospital 1,213.31 Reserve for depreciation 7,779.79 Cash reserve fund life member 9,900.00 Reserve for cancellation 19,755.75 Cash reserve fund insurance 2,767.14 Reserve for life membership 71,700.00 Cash reserve fund bonds 300.00 Prepaid dues 41,201.00 Accounts receivable 79,022.06 Deficit (23,659.80) Furniture and fixtures 8,372.96 Capital stock 50,000.00 Permanent signs 479.00 Service signs 100.00 Garage equipment 14,900.00 Springfield office 833.10 Good will 50,000.00 Total 168,841.46 Balance Sheet of Pioneer Automobile Service Co. as of December 31, 1932. Assets Liabilities Cash, petty $300.00 Accounts payable $980.76 Cash, reserve fund general 115.78 Reserve for depreciation 7,779.79 Cash, reserve fund hospital 752.60 Reserve for cancellation 21,227.00 Cash, reserve fund life membership 2,074.38 Reserve for life membership 94,800.00 Cash, reserve fund insurance 304.70 Prepaid dues 29,645.00 Cash, reserve fund bond 300.00 Capital stock 50,000.00 Accounts receivable 84,910.28 Surplus deficit (29,484.18) U.S. bonds (life member reserve) 12,500.00 Total 174,948.37 Springfield office 1,022.90 Furniture and fixtures 8,446.46 Garage equipment 15,050.00 Signs permanent 479.00 Signs service 172.00 Good will 50,000.00 Bank overdraft (1,479.73) Total 174,948.37 *760 All the assets listed on these balance sheets were under the domination and control of the corporation. Nothing was done to establish a trust with respect to these assets except as such trusts may *218 arise under the resolutions of the board of directors, as set forth above. In determining petitioner's taxable net income for the years 1931 and 1932, respondent has denied the deduction of the amounts added to the reserve for life memberships and has increased petitioner's income for those years, to wit, for the year 1931 by the sum of $71,700, added by petitioner to reserve in 1931, and the year 1932 by the sum of $23,100, added by petitioner to the reserve in the year 1932. During 1931, and continuously until about April 1933, petitioner had in its employ one O. Dean Johnson, who acted in the capacity of auditor and attended to the filing of its income tax returns. He was a trusted employee. In the early part of 1932 Ray Rodin, president of the petitioner, and Jesse Barrett, its attorney, spoke to Johnson about filing the Federal income tax return for the petitioner for the year 1931. Johnson was then completely occupied, attending to obtaining automobile licenses*761 for automobile operators. He advised Rodin and Barrett that he had taken care of this matter, and that he had obtained an extension of time for the filing of the return. Johnson later prepared a return, and upon filing the return prepared a statement, which was signed by Rodin, as to the reason why the return was not filed in time, which statement was attached to the return, and reads in material part as follows: Being first duly sworn, R. M. Rodin, Managing Director of the Pioneer Automobile Service Company, deposeth and says that: The Federal Income Tax return attached hereto, could not be filed within the time required by law, on account of the fact that business conditions prevented the keeping of sufficient clerical help to compile the information. And that throughout the months of February, March and April of this year it was necessary to use the regular clerical help in distributing both City and State Automobile License plates, thus making it impossible to close the books and compile the information sooner. Johnson embezzled some of the funds of the petitioner and misrepresented the facts to its officers concerning the extension of time for filing the return; no extension*762 of time was secured. The return for the year 1931 was filed on June 24, 1932. OPINION. HILL: The principal issue here involves the question, broadly speaking, of how petitioner's taxable income should be computed in the light of the peculiar facts relating to the income accrued, and the expenses incurred in the earning of such income. The essential facts, briefly summarized, show that during the taxable years petitioner entered into contracts with automobile owners whereby for a stated consideration, payable in installments, petitioner obligated itself to render certain services during the lives of *219 the respective owners. These contracts are referred to as life memberships. Petitioner kept its books of account and made its income tax returns on an accrual basis. It accrued and included in gross income for each year the full amount of the consideration paid or to be paid on each contract executed during the year; and in computing the deficiencies respondent likewise included in gross income the full amount of such consideration. Petitioner set up on its books a "reserve for life memberships", and annually made additions to this reserve on the basis of the*763 number of contracts written each year. The additions made for the taxable years to the "reserve for life memberships" petitioner deducted from gross income. These deductions were disallowed by respondent, giving rise in part to the deficiencies. Petitioner's first contention is that the amounts of the additions to the reserve constituted a trust fund set aside and to be administered by it for the benefit of the contract holders, and that such amounts should be excluded from gross income. In the alternative, petitioner says that, if the reserve was not a trust fund, then its taxable income should be recomputed on a strictly cash basis in order to reflect clearly its true income. We can not agree with either of these contentions. The applicable revenue acts require that net income shall be computed upon the basis of the taxpayer's annual accounting period in accordance with the method of accounting regularly employed in keeping the books of the taxpayer, unless the method employed does not clearly reflect income, in which event the computation shall be made in accordance with the method that does clearly reflect the income. Sec. 41, Revenue Acts of 1928 and 1932. It does*764 not appear from the record before us that a computation on the basis of cash receipts and disbursements would more clearly reflect petitioner's income than on an accrual basis. The cash basis, therefore, may not under the statutes be used. But there are also other serious objections to petitioner's alternative contention. Respondent's Regulations 74 and 77, article 322, the validity of which is not questioned here, require taxpayers to make application for permission to change from one method of accounting to another, and to furnish certain information in that connection. This petitioner did not do. Cf. ; , affirming , affirming . Finally, petitioner has furnished no evidence respecting the items of income and deductions to be reflected in a recomputation of its taxable income on the cash basis. Petitioner's alternative contention can not be sustained. *220 Likewise, we find little difficulty in rejecting petitioner's main contention that the reserve constituted a trust fund. An extended discussion of this*765 point is not deemed necessary. It is sufficient to point out that none of the elements of a trust is present. The parties have stipulated, and we have so found, that all the assets listed on petitioner's balance sheets for the taxable years were under the domination and control of the corporation, and that nothing was done to establish a trust with respect to those assets except as such trust might arise under the resolutions of the board of directors. It is true that the directors adopted a motion to provide for some form of a trust arrangement, but nothing further was done about the matter. Petitioner's assets, including the cash reserve funds, were used for general corporate purposes, and it made no agreement with the contract holders to establish a trust. Each contract merely contained the statement that "The Service Life Memberships are secured by a Reserve Fund which guarantees the servicing of this membership for life." This did not constitute the reserve a trust fund, nor did petitioner, so far as shown, otherwise declare that it held the reserve fund in trust, or treat it as such a fund. Cf. *766 ; ; affd., ; . The burden of petitioner's complaint is that if the total consideration paid or to be paid on each contract written for the taxable years is accrued as gross income, and if the additions to the reserve are not excluded from gross income as a trust fund or the gross income otherwise reduced by deductions for future costs of servicing the contracts, its taxable net income will not be clearly reflected. The principle is authoritatively recognized that where a taxpayer's books are kept on an accrual basis, the fact that the exact amount of the liability had not been definitely fixed in the taxable year would not prevent the deduction from gross income for that year of the amount later paid on account of such liability. . However, here, as in the cited case, there are other obstacles which prevent application of the doctrine referred to. In the case before us the record is wholly insufficient*767 to sustain a conclusion that the additions to the reserve for life memberships represent accruals, ascertained or ascertainable, of amounts of future expense for which a liability was incurred by petitioner under its contracts. The amount of the reserve represents only an estimate. We are not called upon under the facts here to determine whether a deductible accrual of ordinary business expense can rest upon a mere estimate for the reason that there is no evidence in the record that the *221 amount of the future expense is reasonably estimated. It is not clear from the petitioner's brief whether the additions to the reserve for the taxable years constituted a fund which petitioner estimated would produce suffcient income to pay the future expense, or whether it was estimated that the entire amount of such additions would be required to cover the cost of future service. In any event, there is no evidence of the reasonableness of an estimate on either basis. Respondent's determination of the first issue is approved. Under the second issue, petitioner contends that respondent erred in asserting the 25 percent delinquency penalty for failure to file its income tax return*768 for the year 1931 within the time prescribed by law. Section 291 of the Revenue Act of 1928 provides that in case o any failure to make and file the required return within the time prescribed by law, or by the Commissioner in pursuance of law, 25 percent of the tax shall be added to the tax, except that when a return is filed after such time and it is shown that the failure to file it was due to reasonable cause and not due to willful neglect, no such addition shall be made to the tax. Petitioner's return for 1931 was required by law to be filed not later than March 15, 1932. It was filed three months and nine days later, on June 24, 1932. In the early part of 1932, presumably prior to March 15, petitioner's president inquired about the filing of the 1931 return of an employee who acted in the capacity of auditor and attended to the filing of its income tax returns. The employee stated that he had obtained an extension of time for the filing of the return, when as a matter of fact he had not done so. Later he embezzled some of petitioner's funds, but at that time was a trusted employee. This same employee prepared the return which was filed on June 24, 1932. Attached to*769 the return was a statement signed by the petitioner's president to the effect that the return could not be filed within the time prescribed by law because of the fact that business conditions prevented the keeping of sufficient clerical help to compile the necessary information. The matters urged as an excuse, we think, are wholly insufficient. The duty of preparing and filing a corporate return rests upon the responsible executive officers of the corporation, and Congress plainly expressed an intention that such responsibility is not to be lightly taken. The use of available clerical help in carrying on the activities of a corporation does not, in our opinion, excuse it for failure to file its return on time; nor do we think it a sufficient excuse to say that the president of the corporation, without doing anything further, merely spoke to a trusted employee about the *222 matter, and that such employee misrepresented the facts as to having obtained an extension of time within which to file the return. It was primarily the duty of the officer and not of the employee to see to it that the return was prepared and filed timely. *770 Furthermore, we think it is clear that the employee in question was guilty of willful neglect, and since the preparation and filing of the return was within the scope of his duties, this neglect is chargeable to the corporation. ; . In , the petitioner delegated authority to an accountant to execute and file its return. The Board held that the fact that the accountant did not know that the return for the fiscal year was required to be filed prior to the filing of returns for the calendar year within which the fiscal year ended, did not constitute the accountant any less the agent of the taxpayer, or become a mitigating circumstance, and upheld the imposition of the delinquency penalty. In , one of the petitioners admitted that his income tax return was not timely filed, but stated that he thought another person had looked after it. The person who was supposed to file the return forget it. The Board held that the delinquency penalty should be collected. The*771 penalty was sustained on similar facts in . And see also . It is not a sufficient excuse for the tardy filing of the return that the corporation's agent believed that no return was required to be filed until after an audit had been made. . On the second issue, respondent's action is approved. Reviewed by the Board. Judgment will be entered for the respondent. LEECH LEECH, dissenting: The deficiencies here result from respondent's treating the taxpayer's receipts from life contracts on the accrual basis and its expenditures in carrying out those contracts, on the cash basis. Obviously, that method does not reflect the taxpaye's income supporting the contested tax. Such receipts and expenditures must be computed on the same basis. Bonded Mortgage Co. of Baltimore v. Commissioner, 70 Fed.(2d) 345. *223 Likewise, it deducted its estimated costs of meeting its admitted liability under those contracts for those years. If those estimated costs were reasonable, I think, *772 the deductions of them were proper. Lucas v. American Code Co.,280 U.S. 445; United States v. Anderson,269 U.S. 422; General Outdoor Advertising Co. v. Commissioner, 89 Fed.(2d) 862. Nothing disclosed in the majority opinion appears to establish the unreasonableness of those deducted estimated costs. And, even if it did, since the present record clearly reveals the contested deficiencies to be wrong, they can not stand - at least without a further hearing. .