Bressner Radio, Inc. v. CIR

• Citation: 267 F.2d 520
• Decision Date: 28 May 1959
• Docket Number: Docket 25077.,No. 18,18
• Parties: BRESSNER RADIO, INC., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: United States Courts of Appeals. United States Court of Appeals (2nd Circuit)

267 F.2d 520 (1959)

BRESSNER RADIO, INC., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 18, Docket 25077.

United States Court of Appeals Second Circuit.

Argued November 13, 1958.

Decided May 28, 1959.

Bernard Weiss, New York City, for petitioner.

Meyer Rothwacks, Dept. of Justice, Washington, D. C. (Charles K. Rice, Asst. Atty. Gen., Lee A. Jackson and A. F. Prescott, Dept. of Justice, Washington, D. C., on the brief), for respondent.

Before HINCKS, LUMBARD and MOORE, Circuit Judges.

MOORE, Circuit Judge.

The taxpayer (petitioner) petitions for review by this court of a decision of the Tax Court deciding that there were deficiencies in income tax for the fiscal years ending May 31, 1948 and May 31, 1949 of $16,779.08 and $43,196.24 respectively and an overpayment of $4,401.55 for the fiscal year ending May 31, 1950.

The petition presents the question under the Internal Revenue Code of 1939 whether or in what circumstances a taxpayer who has long employed the accrual method of accounting may defer the inclusion in income of prepaid revenues on contracts to render future services over a twelve month period subsequent to the date of receipt.¹ The Commissioner asserted a deficiency for the fiscal years ending May 31, 1948, 1949 and 1950 on the ground that "the method employed does not clearly reflect the income" of petitioner, § 41, Internal Revenue Code of 1939, 26 U.S.C.A. § 41, and demanded the inclusion of all revenues in gross income in the year of receipt in place of the taxpayer's prorata monthly deferral. The Tax Court agreed with the Commissioner that the taxpayer's deferral technique did not clearly reflect its income, and found the above stated deficiencies.

The facts relevant to the decision are as follows. Petitioner, a New York corporation, was in the business of selling radios, television sets, air conditioners, refrigerators, washing machines and household appliances. Its books were kept on the accrual basis of accounting and its income tax returns in question were filed on that basis for the fiscal years ending May 31, 1948 through 1951. During these years petitioner sold a substantial number of television sets and in connection with the sale (undoubtedly as an inducement therefor and to meet competition) entered into a large number of written service contracts entitled "Service Contract for Television Receiver." Petitioner thereby agreed "to service the television receiver * * * and to furnish to the purchaser all labor, replacement of parts and tubes * * * necessary to provide proper operation * * * for a period of 12 months from the date of this contract. * * *" The average price received per contract was between $80 and $100. Payments were made by the purchasers in installments but the contracts were sold by petitioner to a bank for cash. Petitioner's initial cost of installation, which was covered by the contract, was approximately $19, which consisted of $7 for antenna, $10 labor and $2 clerical overhead.

Television sets sold in those comparatively early years had many defects. They required a substantial number of service calls both for the set and for adjustment when new stations commenced telecasting. Petitioner's actual experience showed that 8 to 12 service calls were made during the twelve months in which each contract was in force. Therefore, petitioner "in accordance with the method of accounting regularly employed in keeping the books of such taxpayer" (Sec. 41)² allocated 25% of the service contract price to the installation cost and deferred the balance over the twelve month period of the contract.³

During the taxable fiscal years (1948 and 1949) the money received for the service contracts was not placed in a separate bank account and reserves were not set up on petitioner's books for expenses for servicing in subsequent years.

In each of the years of its business the total service contract obligations of petitioner were as follows:

                                                 No. of         Months falling in
                   Fiscal year      No. of      months of    Current        Following
                      ended       Contracts    obligation      year           year
                  May 31, 1947        352         4,224          890            3,334
                          1948      1,248        14,976        6,585            8,391
                          1949      3,452        41,424       16,560           24,864
                          1950      6,274        75,288       32,598           42,690
                          1951      6,070        72,840       40,585           32,255
                

The actual cost per contract-month of servicing these contracts in the years ending May 31, 1948, May 31, 1949 and May 31, 1950 respectively was $9.81, $11.28, and $6.33.

These facts were found in substance by the Tax Court (28 T.C. 378).

Reference must be made to certain other facts which should be considered in passing upon the merits and the adequacy and accuracy of petitioner's bookkeeping system. These findings were requested by petitioner but denied by the Tax Court as not necessary in deciding the issues but the Court stated that they were fully considered in the preparation of its report.

To meet its obligation to replace parts and tubes petitioner maintained an inventory of service parts sufficient for a 60-90 days period having a value of between $10,000 and $25,000. Although no special fund was established for servicing, petitioner's cash balances were $47,588.98 on May 31, 1948 and $110,997.83 on May 31, 1949. Thus petitioner kept in its possession cash and inventory in excess of the amount of the service contract receipts sought to be deferred, i. e., $41,281.66 and $128,406.35 respectively.

The solution of this tax problem depends upon construction of §§ 41 and 42 of the Internal Revenue Code of 1939. The primary difficulty in the case is presented by a potential conflict between these provisions. Section 41 provides that "the 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 such taxpayer * * *" and thus points strongly away from the transactional or across-the-year approach for determining gross and net income for tax purposes. But § 42 creates an exception. It provides that "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 added. Since the Commissioner contends that the taxpayer's method of deferral of unearned receipts on television service contracts is not one of the "methods of accounting permitted under section 41," the first question to be decided is the standard by which those methods which are acceptable may be identified.

Section 41 further provides that "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." This is the only enumerated basis upon which the Commissioner may disallow a method, and the problem therefore becomes to define the standard which must be applied to decide whether the method adopted does or does not "clearly reflect" income.

The Revenue Act of 1913, 38 Stat. 166 (1913) provided only for a strict cash receipts and disbursements method of accounting. With the passage of the Revenue Act of 1916, 39 Stat. 756 (1916), however, apparently in response to mounting pressure from economists and businessmen to create some coherence in the relation between accounting for income and for income taxation, the accrual basis of accounting was permitted in language which has remained virtually unchanged since that time. Sections 8(g) and 13(d), 39 Stat. 763, 771. See H.R.Rep. No. 922, 64th Cong., 1st Sess. 4 (1916); May, Accounting and the Accountant in the Administration of Income Taxation, 47 Colum.L.Rev. 377, 380-381 (1947).

In United States v. Anderson, 1926, 269 U.S. 422, 46 S.Ct. 131, 70 L.Ed. 347, the Supreme Court surveyed this legislative development and concluded that the changes of 1916 were made "to enable taxpayers to keep their books and make their returns according to scientific accounting principles, by charging against income earned during the taxable period, the expenses incurred in and properly attributable to the process of earning income during that period * * *" (269 U.S. at page 440, 46 S. Ct. at page 134). It applied this standard to require a taxpayer on the accrual basis to accrue in advance of payment taxes imposed for the year 1916 but payable in 1917. The principle has been expressly reaffirmed as recently as Lewyt Corp. v. Commissioner, 1955, 349 U.S. 237, 242-243, 75 S.Ct. 736, 99 L. Ed. 1029. The starting point, therefore, is the standard of "scientific accounting principles" to determine whether the deferral method adopted by the taxpayer here did or did not "clearly reflect" its income.

In order to prevail, petitioner need only establish that the Commissioner improperly asserts that the method it has chosen and defends did not "clearly reflect" its income. Helvering v. Taylor, 1935, 293 U.S. 507, 515, 55 S.Ct. 287, 79 L.Ed. 623. This is not a case in which the taxpayer has sought to change its method of accounting and is therefore subject to the Commissioner's "wide discretion" to reject such a change. Cf. Brown v. Helvering, 1934, 291 U.S. 193, 204, 54 S.Ct. 356, 78 L.Ed. 725. This is rather a case in which an accrual taxpayer has from the start consistently applied the accrual method of accounting. Beacon Publishing Co. v. Commissioner, 10 Cir., 1955, 218 F.2d 697, 701-702.

As an accounting matter petitioner proved that the deferral of these receipts, assuming for the moment that the basis on which the deferral was computed was satisfactory, cf. Automobile Club of Michigan v. Commissioner, 1957, 353...