Commissioner of Internal Revenue v. Hecht Co.

• Decision Date: 19 July 1947
• Docket Number: No. 5595.,5595.
• Citation: 163 F.2d 194
• Parties: COMMISSIONER OF INTERNAL REVENUE v. HECHT CO.
• Court: U.S. Court of Appeals — Fourth Circuit

163 F.2d 194 (1947)

COMMISSIONER OF INTERNAL REVENUE v. HECHT CO.

No. 5595.

Circuit Court of Appeals, Fourth Circuit.

July 19, 1947.

Newton K. Fox, Sp. Asst. to Atty. Gen. (Sewall Key, Acting Asst. Atty. Gen., and Lee A. Jackson, Sp. Asst. to Atty. Gen., on the brief), for petitioner.

I. Herman Sher, of Washington, D. C. (R. A. Bartlett, of Washington, D. C., on the brief), for respondent.

Smith, Kilpatrick, Cody, Rogers & McClatchey, of Atlanta, Ga. (Marion Smith and Louis Regenstein, Jr., both of Atlanta, Ga., on the brief), amici curiae.

Before PARKER and SOPER, Circuit Judges, and CHESNUT, District Judge.

SOPER, Circuit Judge.

The Commissioner of Internal Revenue appeals from a decision of the Tax Court whereby Section 30.736(a)-3 of Treasury Regulations 109 was declared invalid insofar as it prohibits the allowance of deductions (including deductions for bad debts) in the computation of excess profits net income for any excess profits taxable year on account of installment sales made before January 1, 1940, by a taxpayer who has been computing its income from installment sales on the installment basis and has elected to change its method of accounting and compute its income on the accrual basis as provided by Section 736 of the Internal Revenue Code, 26 U.S.C.A. Int. Rev.Code, § 736.¹ The opinion of the Tax Court, reported in 7 T.C. 643, is based on reasons clearly and concisely set forth in its opinion concurrently filed in Mackin Corp. v. Commissioner, 7 T.C. 648.

The Hecht Company, at the close of its fiscal year ended January 31, 1943, became eligible to make the election provided by Section 736 of the Internal Revenue Code, and desiring to avail itself of the privilege, filed an amended excess profits tax return for the year ended January 31, 1941. It had previously computed its income from installment sales under the method provided by Section 44(a) of the Internal Revenue Code, 26 U.S.C.A. Int.Rev.Code, § 44(a), which permits the return as income from such sales in any tax year "that proportion of the installment payments actually received in that year which the gross profit realized or to be realized when payment is completed, bears to the total contract price." Having made the election, Section 736 required the taxpayer to adjust its income from installment sales for the preceding excess profits tax years to conform to the election. "In making such adjustments", the section declares, "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." Accordingly, the taxpayer did not include any part of the installment payments received in the fiscal year ending January 31, 1941, on account of sales made before January 1, 1940, when the excess profits tax law went into effect; but the taxpayer deducted from gross income for the year ending January 31, 1941, $55,392.45 for bad debts found to be uncollectible in that year upon installment sales made prior to February 1, 1940; and the taxpayer also deducted $33,211.22 for collection expenses attributable to installment sales made before that date. The Tax Court allowed the deduction for collection expenses but held that the taxpayer was not entitled to deduct the full amount of the bad debts since no tax had been paid on the expected profits, and reduced this deduction to the sum of $34,771.77, which represented the unrecovered cost of the bad debts, and as the result of these changes ascertained a deficiency in the excess profits tax of $10,333.03. The taxpayer accepted this ruling, but the Commissioner claimed a deficiency in the sum of $30,592.35 on the ground that the deductions thus approved by the Tax Court were erroneously allowed.

The Commissioner does not deny that the deductions allowed were proper for income tax purposes, but asserts that they were not allowable for excess profits tax purposes under the provisions of Section 30.736(a)-3 of Treasury Regulations 109 which provides, in part, as follows:

"Sec. 30.736 (a)-3 (as added by T. D. 5257) Computation of Income on Straight Accrual Basis. — If the taxpayer has elected under section 736 (a) and section 30.736 (a)-2 to compute for excess profits tax purposes its income from installment sales on the basis of the taxable year for which such income is accrued, in lieu of the basis provided by section 44(a), the gross income of the taxpayer from installment sales shall be computed upon such accrual basis. Likewise all deductions under section 23 allowable in computing net income and attributable to such sales, shall be computed upon the straight accrual basis. However, no income or deductions (including deductions for bad debts) shall be included in the computation of 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. * * *"

The Tax Court held the concluding sentence of the quoted portion of the regulation invalid insofar as it purports to deny the deduction of such losses and expenses as were taken by the taxpayer in this case, and the propriety of that ruling is the only question before us. It was pointed out by the Tax Court in its opinion in Mackin Corp. v. Commissioner, that Section 736 (a) was passed for the express purpose of affording relief for installment basis taxpayers who had been hit by changes in the credit restrictions adopted by the Government in 1941 which swelled their tax liability by increasing their income in one or more tax years without normal offsetting selling costs. In like manner we showed in Kimbrell's Home Furnishings v. Commissioner, 4 Cir., 159 F.2d 608, 610, that the statute was passed to place eligible installment sellers on an equal footing with taxpayers on an accrual basis so far as the excess profits tax was concerned. Without the new statute this result could not have been obtained because under the regulations theretofore existing Reg. 103, Sec. 19.41-2; Reg. 111, Sec 29.41-2, a taxpayer on the installment basis could change to the accrual basis only with the consent of the Commissioner, and in such event, was met with the following requirement, to wit:

"The foregoing requirements relative to a change of accounting method are not applicable if a taxpayer desires to adopt the installment basis of returning income * * * but are applicable if a taxpayer desires to change from such basis to a straight accrual basis. In cases where permission to make such change is granted, the taxpayer will be required to return as additional income for the taxable year in which the change is made all the profit not theretofore returned as income pertaining to the payments due on installment sales contracts as of the close of the preceding taxable year."

This provision was not unreasonable when promulgated, for if it had not been made, the installments received during the year of change on sales made in prior years would have escaped taxation altogether; but the application of the provision to a taxpayer changing from an installment basis to an accrual basis in 1943 would have imposed an excess profits income tax upon sales which took place before January 1, 1940, when the excess profits tax went into effect. Obviously the regulation was not suited to the situation which Congress desired to ameliorate, and accordingly, when Congress provided that an installment taxpayer who elected to accrue his income under Section 736 (a) must adjust his income from installment sales for each tax year after December 31, 1939, Congress also declared, as shown in the quotation above set out, that in making such adjustments no amount should be included on account of installment sales made before the effective date of the excess profits tax.

With respect to the controversy which has arisen as to the meaning of this provision, we are in accord with the view of the Tax Court that the language relates merely to profits on installment sales to be included in computing the excess profits net income, but has no effect on the deductions therefrom to be allowed in determining that net income. In its choice of language, Congress followed the pattern of the Internal Revenue Code which customarily speaks of the inclusion or exclusion of items of income and the allowance or disallowance of items of deduction. Compare, for example, the provisions of Sections 711 (a) (1)(C), 711 (a)(2)(E) and 711 (b)(1)(C) of the Internal Revenue Code, 26 U.S.C.A. Int.Rev.Code, §§ 711 (a)(1)(C), (2)(E), (b)(1)(C), where Congress is dealing with the exclusion of items of excess profits net income, with the provisions of Sections 711 (a)(1)(A), 711 (a)(1)(J) and 711 (a) (2)(C) of the Internal Revenue Code where Congress is dealing with the disallowance of deductions therefrom. If deductible items had been...