William O. McMahon, Inc. v. Comm'r of Internal Revenue

• Decision Date: 01 December 1965
• Docket Number: Docket No. 672-63.
• Citation: 45 T.C. 221
• Parties: WILLIAM O. McMAHON, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

45 T.C. 221

WILLIAM O. McMAHON, INC., PETITIONER,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 672-63.

Tax Court of the United States.

Filed December 1, 1965.

Dean S. Butler, for the petitioner.

Herbert T. Ikazaki, for the respondent.

Held, petitioner's automotive price information service was not a ‘periodical’ within the meaning of section 455, I.R.C. 1954, and petitioner must report income from sales thereof in the year of receipt or accrual, even though a substantial portion of the costs related to the income was not incurred until the following year. American Automobile Association v. United States, 367 U.S. 687 (1961), and Schlude v. Commissioner, 372 U.S. 128 (1963), followed.

HOYT, Judge:

Respondent determined deficiencies in petitioner's¹ income tax as follows:

+--------------------------------------------+
                ¦Period                         ¦Deficiency  ¦
                +-------------------------------+------------¦
                ¦Sept. 6, 1957-Nov. 30, 1957    ¦$71,157.58  ¦
                +-------------------------------+------------¦
                ¦Fiscal year ended Nov. 30, 1958¦2,124.11    ¦
                +-------------------------------+------------¦
                ¦Fiscal year ended Nov. 30, 1959¦5,273.54    ¦
                +-------------------------------+------------¦
                ¦Total                          ¦78,555.23   ¦
                +--------------------------------------------+
                

The issue for decision is whether certain cash receipts were properly excluded from taxable income by petitioner in each of the periods here involved and income recognition properly deferred beyond the period of receipt. We must determine whether the receipts involved constituted ‘prepaid subscription income * * * from a subscription to a newspaper, magazine, or other periodical’ within the meaning of section 455 of the 1954 Code² and whether petitioner's method of accounting clearly reflected income for Federal income tax purposes. Respondent concedes that if he prevails on these issues petitioner's income for the fiscal period ended November 30, 1957, should be reduced by $42,865, the amount received prior to September 6, 1957, by petitioner's predecessor sole proprietorship and included by petitioner in its income tax return for the fiscal period ended November 30, 1957.

FINDINGS OF FACT

Petitioner was organized as a corporation under the laws of the State of California on September 6, 1957. Until the time of the sale of its principal business on or about July 15, 1963, it conducted its business and maintained its principal offices in Bakersfield, Calif. Prior to petitioner's incorporation that portion of petitioner's business with which we are herein concerned was conducted by William O. McMahon as a sole proprietorship. Following incorporation McMahon was petitioner's sole shareholder until his death on March 25, 1963.

Concurrently with its incorporation petitioner adopted and has maintained a fiscal year ending November 30, and has filed all its Federal income tax returns with the district director of internal revenue, Los Angeles, Calif., in accordance with said fiscal year. For all of the periods herein involved petitioner kept its books and prepared its income tax returns on an accrual basis except as herein stated to the contrary.

Petitioner's principal business, and the operation that produced the income with which we are here concerned, was the compilation and distribution by mail to its customers of charts containing confidential information regarding dealer cost of automobiles and automobile accessories.³ Its customers were banks, financial institutions, and others having a regular need for this kind of information. Petitioner referred to and advertised its business as a ‘service’ offered by ‘subscription’; it referred to its customers as ‘subscribers.’

The principal business of petitioner (hereinafter sometimes referred to as automotive information service, or service) was operated as follows: In the automobile industry a new-car year commences each September upon the public introduction of the new model cars.⁴ At or about the beginning of each new-car year petitioner would prepare and print (on standard 8 1/2-by 11-inch paper) price information ‘charts' for each make and model car of the new-car year. Thereafter throughout the new-car year, if any new models or accessories were introduced or if any changes were made by the manufacturers in previously announced prices or models, petitioner would print a ‘supplement’ chart within 15 days of the factory announcement of each such change.

Petitioner sold its service to customers on the basis of a period corresponding with the new-car year. It received the great majority of its orders during the first 3 months of the new-car year (which corresponded with the last 3 months of petitioner's fiscal year); orders were accompanied with payment of the lump-sum sales price or with an agreement to be billed therefor. Upon receipt of an order petitioner would mail to the customer a looseleaf manual consisting of a plastic looseleaf binder and transparent plastic page protectors in which were inserted the price information charts for all of the automobile makes, models, and accessories introduced for the new-car year.⁵

In addition, upon receipt of an order, petitioner became obligated to furnish the customer a supplement to the manual within 15 days of announcement of any new accessory or model or any price changes if any such changes should occur. This contingent obligation continued throughout the new-car year until the beginning of the next new-car year. The lump-sum price received for the service included the manual and any necessary supplements. The issuance of supplements was solely dependent upon the occurrence of price and/or model changes; the customer was not guaranteed any fixed number of supplements, and if there were no price or model changes throughout the balance of a new-car year, the customer would receive no supplements. The supplements were never furnished by petitioner to its customers at stated or regular intervals of time.

Petitioner's experience during the periods in question was that several supplements had to be mailed each period. During its short fiscal period September 6 to November 30, 1957, it was necessary to distribute 46 supplements in 5 mailings. In its fiscal years ended November 30, 1958 and 1959, 83 and 85 supplements, respectively, were distributed, by 12 and 8 separate mailings. It was commonly necessary for petitioner to prepare as many as 50 different variations of each insert by virtue of the fact that there were approximately 50 zones throughout the United States for the determination of freight variances which would affect the prices, and also because of varying State law requirements which might affect the required equipment on automobiles.

In the 2 full fiscal years here involved more than 70 percent of petitioner's annual income was received in September, the first month of the new-car year, and more than 80 percent was received in the months September through November, the first 3 months of the new-car year and the last 3 months of petitioner's fiscal year. During the years before us petitioner maintained a general checking bank account and deposited therein all receipts from its service business. There were no restrictions on this account with respect to deposits or withdrawals.

Under the method of accounting and reporting of income used by petitioner, the individual subscription price of petitioner's service was posted to a deferred income account when received. Then, at the end of each month during which the service was rendered, an amount of deferred income equal to the direct cost of the service for that month, plus a portion of the balance of the deferred income account, was taken into income by a debit to the deferred income and a credit to regular income. The portion of the balance in the deferred income account which was taken into income, was the ratable portion determined by the number of months remaining in the new-car year.

This system of accounting was devised for petitioner's business by a certified public accountant prior to the formation of the petitioner corporation, and was consistently used in maintaining petitioner's books and records from the time of its incorporation to the date of sale of its business. The system was devised and instituted because substantially all of petitioner's annual subscription income was received during the last 3 months of the fiscal year but its contingent liability to furnish supplements to subscribers extended beyond the close of the year. Direct costs of providing petitioner's service were also greatest during this 3-month period at the end of the fiscal year.

The respondent in his deficiency determination increased taxable income for each year before us by including prepaid subscription income, deferred by taxpayer, as follows:

+----------------------------------------------------------+
                ¦Fiscal period                  ¦Taxable income¦Additional ¦
                +-------------------------------+--------------+-----------¦
                ¦                               ¦reported      ¦income     ¦
                +-------------------------------+--------------+-----------¦
                ¦Sept. 6 to Nov. 30, 1957       ¦$24,383.90    ¦$137,102.15¦
                +-------------------------------+--------------+-----------¦
                ¦Fiscal year ended Nov. 30, 1958¦73,177.82     ¦4,084.83   ¦
                +-------------------------------+--------------+-----------¦
                ¦Fiscal year ended Nov. 30, 1959¦73,190.27     ¦10,141.42  ¦
                +----------------------------------------------------------+
                

In his explanation of the adjustments for the three fiscal periods, respondent stated as follows:

It has been determined that the method of accounting adopted by your corporation is not permitted by section 455 of the Internal Revenue Code of 1954, and that it does not correctly reflect the income earned in any of the taxable years involved. Payments received are, therefore, held, under section 451 of the Code, to be income in the year received.

Prior to the present...