Schlude v. CIR
| Decision Date | 19 October 1960 |
| Docket Number | No. 16443.,16443. |
| Citation | 283 F.2d 234 |
| Parties | Mark E. SCHLUDE and Marzalie Schlude, Husband and Wife, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. |
| Court | U.S. Court of Appeals — Eighth Circuit |
Robert Ash, Washington, D. C., Carl F. Bauersfeld, Washington, D. C., on the brief, for petitioner.
Harry Marselli, Attorney, Department of Justice, Washington, D. C., Charles K. Rice, Asst. Atty. Gen., Lee A. Jackson, Harry Baum, George F. Lynch, Attorneys, Department of Justice, Washington, D. C., on the brief, for respondent.
Before SANBORN, WOODROUGH, and MATTHES, Circuit Judges.
The Commissioner of Internal Revenue determined that a deficiency existed in the tax liability of petitioners for the years 1952 to 1954, inclusive, as follows:
Mark E. Schlude for 1952 ............ $ 9,264.69
Marzalie Schlude for 1952 ........... 8,971.55
Mark E. and Marzalie Schlude for 1953 83,395.82
Mark E. and Marzalie Schlude for 1954 11,544.32
The Tax Court, with three Judges dissenting, affirmed the action of the Commissioner. See 32 T.C. 1271. Pursuant to §§ 1141, 1142 of the Internal Revenue Code of 1939, 26 U.S.C.A. §§ 1141, 1142, and §§ 7482, 7483 of the 1954 Code, 26 U.S.C.A. §§ 7482, 7483, petitioners have brought the case to this Court for review.
The facts, established by stipulation of the parties and evidence, are detailed in the findings of the Tax Court. Those essential to a proper understanding of the question presented for our determination are: Petitioners, husband and wife, on June 18, 1946, formed a partnership known as Arthur Murray Dance Studio for the purpose of conducting and operating dance studios authorized by certain franchise agreements entered into with Arthur Murray, Inc., of New York City. The venture was carried into effect and the partnership operated studios in the States of Nebraska, Iowa and South Dakota, for the specific purpose of teaching private ballroom dancing to individual students.
Basically, there were two kinds of contracts entered into between the partnership and students desiring dancing instructions. Under one type, a portion of the total tuition was paid in cash when the contract was executed, and the balance in deferred installments. Under the other, a portion of the down payment was paid in cash at the time the contract was entered into, and the balance of the down payment was to be paid in installments, the remainder of the contract price being evidenced by a negotiable note taken from the student, payable in designated installments in accordance with the terms of the note. Under the contract the student agreed to take a designated number of hours of dancing lessons and pay therefor the amount specified as tuition. All types of contracts contained a non-cancellable provision and provided that the student should not be relieved of his obligation to pay the tuition agreed upon. The hours of lessons or instructions contracted for ranged from 5 to 1,000 to 1,200. Some of the contracts were for lifetime courses which meant that, over and above 1,200 specified hours, the student was entitled to 2 hours of lessons per month plus two parties a year for life. By explicit terms, the studio was required to give the number of hours of instruction agreed upon. The contracts, however, did not schedule the dates when the studio was required to give and the student was to receive instructions, this detail being arranged and agreed upon from time to time as lessons were given. Under many of the contracts, lessons extended beyond the fiscal year in which the contract had its inception.
Notes taken from students were transferred with full recourse, to a local bank, which at the time of acquiring a note, would deduct therefrom the interest charges, and give approximately 50% of the balance of the note to petitioners. Installment payments on the remainder of the note were held by the bank in a reserve account, but this reserve was not available to petitioners until the note was paid in full by the student, after which the reserve was transferred to the partnership's general bank account.
A sizeable number of contracts was cancelled annually, the non-cancellable provision to the contrary notwithstanding. In its opinion, the Tax Court conceded that "cancellations were considerable in amount", noting that records of the partnership disclosed that cancellations for the respective years involved were 17%, 15%, and 19% of sales for the respective years.1
A complete double entry bookkeeping system was installed for the partnership by a certified public accounting firm at the time that the partnership was organized, and an accrual system of accounting was employed, with the fiscal year ending March 31. This accounting system was used continually and consistently from the time the partnership was formed. Additionally, individual student record cards were maintained, listing all pertinent information such as name and address of student, type of contract, hours involved, total contract price, history of lessons taught, and payments made under the contract.
Since the method pursued by the partnership with respect to its operations under its accrual system of accounting and the effect thereof from an income tax standpoint are fully and correctly shown in the findings of the Tax Court, we shall forego a repetitious analysis of the manner in which the student transactions were processed insofar as they bear upon the tax question. It is sufficient to say that when a contract was entered into with a student, the "deferred income" account was credited with the total contract price. At the close of each fiscal year, the student record cards were analyzed and determination was made of the number of hours of lessons taught which, multiplied by the rate per hour of each contract, gave the amount of income earned. This amount was then charged to "deferred income" and credited to "earned income." Earned income thus arrived at was reported as income on the partnership's tax return. If there was any gain resulting from cancellation of a contract, this amount was also considered as taxable income and reported as such. Detailed schedules which correctly and precisely reflect the result of the partnership's accrual system of accounting during the years in question appear in the findings of fact of the Tax Court.
The deficiencies under consideration resulted from the Commissioner increasing the ordinary net income of the partnership for the fiscal years ending March 31, 1952, 1953 and 1954, by the amount of the increases in the deferred income account in those years, as follows: $24,602.22 in 1952, $104,798.41 in 1953, and $12,797.97 in 1954. This determination was made and upheld by the Tax Court through application of the "claim of right doctrine," meaning that, for income tax purposes, the full amount of its contract price had to be returned as income in the year in which the contract was entered into, irrespective of any obligation on the part of the partnership to render services under the contract in years subsequent to the year in which the agreement was made.
This case once more brings into sharp focus the question of when income shall be taken into account for tax purposes.2 Section 41 of the Internal Revenue Code of 1939, 26 U.S.C.A. § 41, is the starting point in determining petitioners' "income" for purposes of the internal revenue laws. It directs that net income shall be computed on the basis of taxpayer's annual accounting period, "in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but * * * if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income." Section 42 of the 1939 Code, 26 U.S.C.A. § 42, sets out the period in which items of gross income shall be recognized. It provides:
"The amount of all items of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under methods of accounting permitted under section 41, any such amounts are to be properly accounted for as of a different period." (Emphasis supplied.)
Regulations issued by the Commissioner reiterate the principle that the accounting methods and computations thereunder are to be made in a manner which will clearly reflect the taxpayer's income.3
As permitted by § 41, the practice of accrual accounting has long been recognized for the purpose of tax accounting. See United States v. Anderson, 269 U.S. 422, 46 S.Ct. 131, 70 L.Ed. 347, and § 446 (c) Internal Revenue Code of 1954, 26 U.S.C.A. § 446(c). Generally, under such a system, it is contemplated that income, earned but not yet received, is to be reported, with the corresponding accrual of expenses incurred but not yet paid. It is not surprising that considerable litigation has arisen as to the proper treatment to be given specific items in specific instances.
One line of cases has dealt with the problem of when income accrues, and in this connection, the so-called "claim of right" doctrine first made its appearance, apparently in North American Oil Consolidated v. Burnet, 286 U.S. 417, 52 S. Ct. 613, 76 L.Ed. 1197. In that case, it was conceded that net profits earned by property in receivership during 1916 and paid over in 1917 constituted income. After holding that the income could not be said to have accrued during 1916, inasmuch as there was no constructive receipt of monies, nor right in taxpayer to demand the profits, the court further held that the profits were income for 1917, and not income for the year 1922, the year in which litigation was finally terminated, stating at page 424 of 286 U.S., at page 615 of 52 S.Ct.:
"If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to...
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