May, Stern & Co. v. Commissioner of Internal Rev.

• Decision Date: 10 April 1950
• Docket Number: No. 9949.,9949.
• Citation: 181 F.2d 407
• Parties: MAY, STERN & CO. v. COMMISSIONER OF INTERNAL REVENUE.
• Court: U.S. Court of Appeals — Third Circuit

181 F.2d 407 (1950)

MAY, STERN & CO. v. COMMISSIONER OF INTERNAL REVENUE.

No. 9949.

United States Court of Appeals Third Circuit.

Argued January 20, 1950.

Decided April 10, 1950.

Charles MacLean, Jr., New York City (Louis Caplan, Pittsburgh, Pa., Laurence F. Casey, Ray I. Hardin, New York City, on the brief), for petitioner.

Irving I. Axelrad, Washington, D. C. (Theron Lamar Caudle, Assistant Attorney General, Ellis N. Slack, Helen Goodner, Special Assistants to the Attorney General, on the brief), for respondent.

Before BIGGS, Chief Judge, and McLAUGHLIN and HASTIE, Circuit Judges.

HASTIE, Circuit Judge.

This is a petition to review a decision of the Tax Court¹ sustaining a determination by the Commissioner of Internal Revenue of a deficiency in the petitioner's excess profits tax for its taxable year ending January 31, 1941. The 31-day difference between the end of the calendar year and petitioner's taxable year is of no consequence in this case. For convenience, therefore, the taxable year in question will be designated as 1940 throughout this opinion.

Petitioner, May, Stern and Company, is a corporation engaged in the home furnishings business. It makes large numbers of installment sales. Its books of account and income tax returns have always been kept on the accrual basis, except that prior to the enactment of the excess profits tax law in 1940 it had elected to report its income from installment sales on the installment basis in accordance with § 44(a) of the Internal Revenue Code, 26 U.S.C.A. § 44(a). The installment basis is essentially a modified cash basis.²

In computing its liability under the excess profits tax law as enacted in 1940, petitioner was required to continue to report its income from installment sales on the installment basis. However, the Revenue Act of 1942 added § 736(a) to the Code, 26 U.S. C.A. § 736(a). Under its terms, taxpayers who had been reporting installment sales income under § 44(a) and whose installment sales volume had substantially decreased were given the election of reporting income from such sales on the accrual basis. But they were, if they chose to exercise the option, put under an attendant obligation to make retroactively certain adjustments of their excess profits tax returns for 1940, and the subsequent years preceding this election, to conform therewith.³

In 1942, petitioner exercised the election under § 736(a) and accordingly filed an amended excess profits tax return for 1940. That amended return is the basis of this controversy.

One of the factors on which petitioner's excess profits tax liability depended was its excess profits credit properly computed as equal to eight per cent of its invested capital.⁴ One of the components of its invested capital was petitioner's accumulated earnings and profits at the beginning of the taxable year.⁵

In its amended return for 1940, the taxpayer used the accrual method of accounting both for the computation of its taxable income from 1940 installments sales and for the computation of its income from past installment sales as that item entered into the earnings and profits component of its credit. This computation resulted in the inclusion of $1,297,745.79 of uncollected profits on pre-1940 installment sales in earnings and profits accumulated at the beginning of 1940. Relying on a Treasury Regulation⁶ the Commissioner ruled that this inclusion was not proper and accordingly determined a deficiency in petitioner's 1940 excess profits tax. The Tax Court decided that the Commissioner was correct.

The propriety of that decision is the question before us.

I. For better understanding of the problem before the court, we consider first what legal impediments prevented this taxpayer from doing in its original excess profits tax return for 1940 that which it now seeks to do retroactively in an amended return after the 1942 enactment of § 736(a).

In its original return the petitioner reported income from installment sales on the installment basis. This had been done for normal tax income in years before the imposition of the excess profits tax. An attempt in 1940 to include uncollected installments of pre-1940 sales in accumulated earnings and profits and thus to compute the excess profits credit on the accrual basis would have been improper. It would have involved both the use of inconsistent accounting methods within the return itself and a violation of applicable statutes and regulations.

This in substance was the holding of the Supreme Court in Commissioner of Internal Revenue v. South Texas Co.⁷ That decision sustained a Treasury Regulation which provided, in material parts, that "* * * the amount of the earnings and profits in any case will be dependent upon the method of accounting properly employed in computing net income. For instance * * * a corporation computing income on the installment basis as provided in § 44 shall, with respect to installment transactions, compute earnings and profits on such basis * * *."⁸

To uphold the regulation the court invoked the "long established congressional policy that a taxpayer generally cannot compute income taxes by reporting annual income on a cash basis and deductions on an accrual basis," and stated explicitly that "such a practice has been uniformly held inadmissible because it results in a distorted picture which makes a tax return fail truly to reflect net income."⁹

The taxpayer had also urged that even if the application of the regulation resulted in consistent accounting, it could not be upheld. Section 115(l) of the Internal Revenue Code provided that: "Gain or loss * * * realized by sale or other disposition of property shall increase or decrease the earnings and profits to, but not beyond, the extent to which such a realized gain or loss was recognized in computing net income under the law applicable to the year in which such sale or disposition was made." It was argued that this section and the regulations thereunder meant that uncollected balances on installment sales entered into earnings and profits at the time of their recognition by law as gain, an eventuality which occurred — it was insisted — at the time of sale. And it therefore followed that the taxpayer's inclusion of these sums in his accumulated earnings and profits was proper.

The court disposed of this argument by construing § 115(l) in conjunction with § 44(a),¹⁰ reasoning that § 44(a), under which the taxpayer reported annual income on the installment basis, effectively postponed recognition of deferred installment payments until the year when such items are reported as taxable income. It followed, of course, that the deferred payments could be included in earnings and profits only as they were received.

Thus the court found in § 115 (l) additional support for its conclusion that the regulation was valid by tieing the computation of earnings and profits for excess profits tax purposes to the recognition of those earnings for income tax purposes.

II. We now consider whether the enactment of § 736(a) and taxpayer's election thereunder removed the above analyzed objections to the inclusion of uncollected gain from pre-1940 installment sales in earnings and profits.

The argument for consistency of accounting method within a single return which, under the doctrine of the South Texas case, impeded the taxpayer before its election, now aids it. In conformity with the election under this section taxpayer, in its amended return, properly reported income from current installment sales on the accrual basis. More particularly, the aggregate amount of such income, including deferred installments which would not be collected until subsequent years, became excess profits taxable income for 1940.

In these circumstances the reasoning of the Supreme Court in the earlier part of the South Texas opinion and the language of the Treasury Regulation there considered are applicable. They clearly state the propriety, absent any statutory requirement to the contrary, of accounting in the amended 1940 return for accumulated earnings and profits as well as annual income on the accrual basis. It is only in this way that this adjustment to taxable income can be placed on the same basis as the computation of income, and the internal consistency of the return, so strongly emphasized in the South Texas case, can be achieved. Indeed, so forceful is the impact of the language and reasoning of the South Texas opinion on this point that it seems necessary to approve taxpayer's use of the accrual method in calculating earnings and profits from past installment sales unless some statutory prohibition necessitates disapproval.

The Commissioner contends that such prohibition is to be found both in the language of § 736(a) itself and in the language of § 115(l) as construed in the South Texas case.

His argument from the language of § 736(a) depends upon these two sentences: "* * * the income from installment sales for each taxable year before the first year with respect to which the election is made but beginning after December 31, 1939, shall be adjusted for the purposes of this subchapter to conform to such election. In making such adjustments, no amount shall be included in computing excess profits net income for any excess profits tax taxable year on account of installment sales made in taxable years beginning before January 1, 1940." He construes this language, in its application to taxpayer, as a prohibition against the inclusion of uncollected profits of pre-1940 installment sales in the computation of the excess profits credit for 1940. The Courts of Appeals for the Fifth and Ninth Circuits have accepted the Commissioner's view even since the argument of this appeal.¹¹

We are unable to accept this construction. The second quoted sentence of § 736(a) refers explicitly and exclusively to the exclusion of amounts on account of pre-1940 installment sales from the computation of "excess profits net income" of...