Potter v. Comm'r of Internal Revenue , Docket Nos. 81795

• Decision Date: 13 May 1965
• Docket Number: 96259.,Docket Nos. 81795
• Citation: 44 T.C. 159
• Parties: WALTER H. POTTER AND GLADYS L. ERICKSON (FORMERLY GLADYS L. POTTER), PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE RESPONDENTWALTER H. POTTER AND MARY D. POTTER, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

44 T.C. 159

WALTER H. POTTER AND GLADYS L. ERICKSON (FORMERLY GLADYS L. POTTER), PETITIONERS,
v.
COMMISSIONER OF INTERNAL REVENUE RESPONDENTWALTER H. POTTER AND MARY D. POTTER, PETITIONERS,
v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket Nos. 81795

96259.

Tax Court of the United States.

Filed May 13, 1965.

[44 T.C. 159]

J. Everett Blum, for the petitioners.

Robert L. Gnaizda, for the respondent.

Petitioner was in the business of building and selling houses. Upon the sale of each house he would receive a small downpayment plus a note, secured by a first deed of trust, for the balance of the price. Each year petitioner included the face amount of all the notes in gross receipts and then deducted therefrom an arbitrary number of such notes which were designated ‘deferred contracts.’ All the deeds and notes were identical in all relevant respects. The respondent required, and petitioner agreed, that all of the notes should have been included in the computation of taxable income for the years in which they were received at their fair market value of 83 percent of face value. Held: (1) Respondent's adjustments to petitioner's inconsistent treatment of the first trust deed notes did not constitute a change in method of accounting. (2) Respondent did not prove the first trust deed notes were installment obligations. (3) The first trust deed notes were not speculative and thus 17 percent of each payment on each note should be reported as discount income.

TRAIN, Judge:

In these consolidated proceedings, respondent determined deficiencies in income tax of $328,563.55 in docket No. 81795 for 1955 and of $22,668.56 and $28,307.22 in docket No. 86259 for 1956 and 1957, respectively. These deficiencies arise mainly from respondent's inclusion in petitioners' 1955 and 1956 taxable income of the outstanding balance of certain first trust deed notes which petitioners received in years prior to 1955, and in 1955 and 1956, but excluded by them from the computation of taxable income for such

[44 T.C. 160]

years. ¹ The parties have stipulated that for the taxable year 1957 an overassessment in favor of the petitioners may occur. The amount of overassessment, if any, will be determined under Rule 50 of this Court.

As respects 1955, petitioners maintain that respondent's adjustment constituted a change in petitioner's method of accounting and that to the extent the deficiency is attributable to amounts still due on notes received prior to January 1, 1954, it is barred by the provisions of section 481(a)(2) of the Internal Revenue Code of 1954.²

By amended answer filed in docket No. 81795, respondent admitted error in the inclusion of certain items³ in petitioner's 1955 taxable income and determined that certain dispositions of trust deed notes between petitioners, incident to a division of community property,⁴ were taxable dispositions of installment obligations.⁵ The adjusted deficiency for 1955 set forth in the amended answer is $260,860.07.⁶

The parties have agreed that 83 percent of the face value of all first trust deed notes represented the fair market value of those notes and should have been included in income in the years the notes were received. Thus, the final issue for decision is whether the 17-percent discount income received by petitioners is taxable as payments on the first trust deed notes are received, or only after the receipt of the 83-percent capital.

Several other issues have been settled by stipulation of the parties, conceded or abandoned. Consequently, decisions will be entered under Rule 50.

FINDINGS OF FACT

Most of the facts have been stipulated and the stipulations of facts, together with the exhibits attached thereto, are incorporated herein by this reference.

Petitioners Walter H. Potter (hereinafter referred to as petitioner) and Gladys L. Erickson (formerly Gladys L. Potter and hereinafter referred to as Gladys) were husband and wife during the year 1955 and filed their joint income tax return for the calendar year ended

[44 T.C. 161]

December 31, 1955, with the district director of internal revenue at Los Angeles, Calif. Petitioner and Mary D. Potter were husband and wife during the years 1956 and 1957 and filed their joint income tax returns for those years with the district director of internal revenue at Los Angeles, Calif. The returns for the years in question were prepared essentially on the cash receipts and disbursements basis. The profit-and-loss schedules (Schedule C) for those years were prepared on a basis similar to a completed-contract basis. However, in the profit-and-loss schedule certain first trust deed notes received in 1955 and 1956 were included in gross receipts in the years received and then deducted therefrom so that they were not included in the computation of taxable income for those years.

Petitioner was in the business of building and selling houses in 1955, 1956, and 1957 and for many years prior thereto. His usual method of selling houses was to receive a small cash payment plus a note, secured by a deed of trust on the individual house sold, to cover the balance of the sale price. Generally, the costs of construction of the houses so built were financed by borrowing from financial institutions and giving to the institutions notes secured by first deeds of trust. In these instances petitioner received second deeds of trust. Occasionally, petitioner used his own capital to finance the cost of construction of the houses he built and received notes secured by first deeds of trust.

The first trust deed notes received by petitioner were payable monthly for periods of as long as 18 years. The parties have stipulated that all first trust deed notes received by petitioner in 1955, 1956, and 1957 had a fair market value of 83 percent of face value. The parties have also stipulated that the second trust deed notes had ‘a fair market value on the date received by petitioner of zero— that is, they had no fair market value.’ The face value of first trust deed notes received by petitioner in 1955 and 1956 was $219,950.04 and $186,861.57, respectively. All of these first trust deeds and first trust deed notes were identical in all relevant respects.

All of the first trust deed notes received by petitioner in 1955 and 1956 were included in gross receipts at face value. However, approximately 42 percent ($93,000) of the face value of the 1955 notes and 15 percent ($28,408) of the face value of the 1956 notes were then deducted by petitioner from gross receipts. All costs incurred in completing the houses for which notes secured by first trust deeds were received in 1955 and 1956 were deducted in the year the deeds and notes were received (including the costs allocable to the first trust deed notes not included by petitioner in his computation of taxable income).

In examining and auditing petitioner's 1955 income tax return, respondent required, and petitioner agreed, that all first trust deed

[44 T.C. 162]

notes received by petitioner in 1955 and subsequent years should have been included in the computation of taxable income at their fair market value of 83 percent of face value.

Petitioner's manner of treatment, for income tax purposes, of the first trust deed notes he received was initiated in approximately 1947. The principal from the notes which was deducted from gross income on petitioner's returns when the notes were received, was included in the computation of taxable income on petitioner's returns for the years in which payments on the notes were received. Principal from first trust deed notes received before 1954 and not included in income before 1954 was in the amount of $188,081.31 as of January 1, 1955. The parties have stipulated that, if it is determined that respondent changed petitioner's method of accounting, this amount will never be included in petitioner's taxable income because of the provisions of section 481.

The sum of $11,662.02, representing return of principal received in 1956 on pre-1954 first trust deed notes, was included in taxable income in 1956. The parties have stipulated that, if it is determined in docket No. 81795 that respondent changed petitioner's method of accounting, this amount should be excluded from income in 1956. The sum of $9,852.38 was received in 1956 from second trust deed notes taken in prior years; the parties have stipulated that this sum should be included in 1956 income. The sum of $13,093.70 was received in 1957 from second trust deed notes taken in prior years; the parties have stipulated that this sum should be included in 1957 income. (These two sums were reported in income by the petitioners. However, respondent's amended answer excluded one-half of each of these sums from 1956 and 1957 income. Based upon the stipulation of facts filed in docket No. 81795, the parties have agreed that the amended answer is superseded and these sums are to be fully included in 1956 and 1957 income.)

In 1956 and 1957 petitioner collected principal in the amounts of $925.41 and $966.57, respectively, from first trust deed notes received prior to 1954. The parties have stipulated that, if it is determined in docket No. 81795 that respondent changed petitioner's method of accounting, none of these amounts are ever to be included in income. The parties also have stipulated that, if it is determined that respondent did not change petitioner's method of accounting, the entire amounts will be included in income in 1956 and 1957 except that, if it is determined in docket No. 81795 that the first trust deed notes disposed of in 1955 between petitioner and Gladys were installment obligations, only one-half of these amounts will be included in income.

On December 1, 1955, petitioner and Gladys divided their community property. This division occurred as a result of a property settlement included in a decree of divorce dated April 16, 1956. The

[44 T.C. 163]

division of community property included a disposition by Gladys of first trust deed mtes in the fact...