Commissioner of Internal Revenue v. Mackin Corp., 4247.

• Decision Date: 04 December 1947
• Docket Number: No. 4247.,4247.
• Citation: 164 F.2d 527
• Parties: COMMISSIONER OF INTERNAL REVENUE v. MACKIN CORPORATION.
• Court: U.S. Court of Appeals — First Circuit

164 F.2d 527 (1947)

COMMISSIONER OF INTERNAL REVENUE v. MACKIN CORPORATION.

No. 4247.

Circuit Court of Appeals, First Circuit.

December 4, 1947.

Newton K. Fox, Sp. Asst. to the Atty. Gen. (Theron L. Caudle, Asst. Atty. Gen., Sewall Key and A. F. Prescott, Sp. Assts. to Atty. Gen., of counsel), for the Commissioner.

Myron S. Winer and Helmar M. Raphael, both of Boston, Mass., for Mackin Corporation.

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

Before MAGRUDER, MAHONEY, and WOODBURY, Circuit Judges.

WOODBURY, Circuit Judge.

This is a petition by the Commissioner of Internal Revenue for review of decisions of the Tax Court which failed to sustain his determination of certain deficiencies in the respondent's excess profits taxes for the years 1940 and 1941. The facts have been stipulated.

The respondent, Mackin Corporation, ever since its organization under the laws of Maine in 1929, has been regularly engaged in Portland in the business of selling clothing and jewelry at retail on the installment plan. It reported its income for Federal tax purposes for the taxable years 1938 to 1942, inclusive, on the installment method of accounting pursuant to § 44(a) of the respective Revenue Acts applicable to those years and of the Internal Revenue Code.¹ In conformity with its practice in prior years, it filed its income and excess profits tax returns for the taxable years 1940 and 1941 on the same method of accounting.

Subsequently, having qualified under the Commissioner's regulations, it elected and was permitted to compute its income for excess profits tax purposes for the taxable year 1942 on the accrual method of accounting as permitted by § 736(a) of the Internal Revenue Code, as added by § 222 (d) of the Revenue Act of 1942.² In addition, as required by § 736(a), it filed amended returns for excess profits tax purposes for its taxable years 1940 and 1941 (its taxable year has always been the calendar year), reflecting its income for those years for the purposes of that tax on the accrual method of accounting also. In these amended returns for 1940 and 1941 it deducted as bad debts the unrecovered out-of-pocket cost of goods which it had sold on the installment plan prior to January 1, 1940, the obligations for payment of which became worthless in 1940 and 1941 respectively. The Commissioner disallowed these deductions and determined deficiencies for both years accordingly. The respondent filed separate petitions with the Tax Court for redetermination of these deficiencies, which the Tax Court consolidated, and, disagreeing with the Commissioner, entered decisions favorable to the respondent with respect to the above deductions. The Commissioner thereupon brought this petition for review.

The question presented is whether a taxpayer, which was reporting its income for the purpose of federal taxation on the installment basis pursuant to § 44(a) of the Internal Revenue Code, but which elected and was permitted under § 736(a) of the Code to report its income for excess profits tax purposes on the accrual basis for 1942, is entitled to deduct as bad debts in its amended returns for 1940 and 1941 the unrecovered costs of goods sold by it in 1939, the obligations for the purchase of which became worthless and were charged off during the years in which the deductions were taken.

This question arises because of the taxpayer's permitted change in the method of reporting its income. To understand it reference must be made to the accounting systems involved and to the reasons which prompted Congress in 1942 to give taxpayers a larger measure of freedom than they had previously enjoyed in changing from the installment to the accrual system in so far as excess profits taxes were concerned.

The installment system of accounting is like the cash system in that amounts received are taken into income as they are paid, irrespective of the year in which the goods were sold. But if such a concern is on the installment basis of accounting for purposes of taxation it will not return the gross amount of all installments received by it during a taxable year as its gross income for that year. The reason for this is that a portion of each installment received represents a portion of the cost of the item sold, and the remaining portion of the installment represents a portion of the profit attributable to the sale. And the division of each installment payment into the cost of the goods sold and the gross profits of the transaction is the same for each installment, and is determined by the ratio of cost to total contract price. Thus if the mark-up on an item sold by an installment seller accounting on the installment basis is 100%, one-half of each installment it receives for the item will represent a portion of the cost of the goods sold and the other half a portion of the gross profits on the sale.

Consequently, when an installment account becomes uncollectible, the total amount of outstanding installments is not deductible as a bad debt since a portion of those outstanding installments represents a profit which has never been reported as income and taxed accordingly. On the installment basis, uncollectible installments are deductible only to the extent that the cost of the goods sold has not been recovered from the defaulting purchaser at the time of his default.

The accrual system of accounting differs from the installment system in that the entire sales price of goods sold is reported as income as of the date of sale even though payment for the goods may be in installments extending over a period of years thereafter. Therefore on the accrual basis uncollectible installments are deductible in full as bad debts since the total profit on the sale has been taken into income and taxes paid thereon.

The time when losses are deductible is the same under both systems of accounting. It is in the taxable year in which "paid or accrued" or "paid or incurred" (§ 43, Internal Revenue Code, 26 U.S.C.A. Int.Rev. Code, § 43) and losses on account of bad debts accrue or are incurred "within the taxable year" in which they "become worthless" (§ 23(k) (1) of the Code) regardless of the year in which the debt arose. It is conceded by the Commissioner that the question presented would not have been raised if the taxpayer had accounted on either one basis or the other consistently throughout the tax years involved. It is raised by the Commissioner only because the taxpayer changed from the installment to the accrual basis under the relief provisions of § 736(a), supra.

We therefore turn to the reasons which moved Congress to enact that section and to a consideration of its provisions.

Under the law as it stood prior to the enactment of § 736(a) a qualifying taxpayer electing to report its income on the installment basis pursuant to § 44(a) could not thereafter elect to change to the accrual basis. It could make such a change only with the consent of the Commissioner. In the event that a taxpayer obtained consent for such a change; however, the Commissioner required the taxpayer "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." Reg. 103 § 19.41-2.

The purpose of this requirement obviously was to prevent income which had in fact "accrued" to a taxpayer while on the installment basis during the years preceding its change to the accrual basis from escaping taxation altogether. But this regulation necessarily had the result of "bunching" the income of installment basis taxpayers in the year of their change to the accrual basis. "Bunching" the income of sellers of personal property on the installment plan during the war years, however, even the inevitable "bunching" of the income of concerns in that business caused by the impact of the war economy upon them, was what Congress intended to relieve so far as excess profit taxes were concerned by the provision of § 736(a) italicized above that taxpayers in adjusting their returns for excess profits tax taxable years prior to their election to change systems of accounting shall not include any amount "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."³

This provision of § 736(a) clearly deals with the inclusion of income, not the taking of deductions. But the Commissioner in his regulation promulgated pursuant to the section has taken the position that to permit a taxpayer in changing from the installment to the accrual basis to take deductions arising out of pre-1940 sales while not including profits from such sales in its income, would give it a tax advantage which Congress could not have intended to confer by the section. Therefore he provided in § 30.736(a)-3 of his Regulations 108 that:

"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." (Italics supplied.)

As the Tax Court pointed out, the portion of his regulation which we have italicized "precisely covers"...