Hartley v. Comm'r of Internal Revenue
| Decision Date | 24 November 1954 |
| Docket Number | Docket No. 47967. |
| Citation | 23 T.C. 353 |
| Parties | HARRY HARTLEY AND CAREY HARTLEY, HUSBAND AND WIFE, PETITIONERS, V. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
R. F. Roberts, Esq., for the petitioners.
W. B. Riley, Esq., for the respondent.
Petitioners, during 1949 and 1950, were engaged in the business of buying old motor blocks, rebuilding, and then selling them. They kept their books on an accrual basis except that inventories of old and rebuilt motor blocks were not taken into account in determining income. Held:
1. The accounting method was a hybrid method which did not clearly reflect income but which most closely resembled an accrual method. Therefore, an accrual method, taking into account inventories of the old and rebuilt motor blocks must be used. Elsie SoRelle, 22 T.C. 459. The aforementioned accounting treatment is also required by the specific provisions of Regulations 111, sections 29.22(c)-1 and 29.41-2.
2. Respondent did not err in adjusting petitioners' income to reflect the motor block inventories by failing to take into account 1949 opening inventories of those items since there was no evidence that such opening inventories existed. Furthermore, this Court will not consider evidence concerning the existence of such inventories in the Rule 50 proceedings. Bankers Pocahontas Coal Co. v. Burnet, 287 U.S. 308.
3. Respondent is not estopped from recomputing petitioners' income for 1949 and 1950 pursuant to an accrual accounting method by the fact that he never objected to petitioners' method of reporting income prior to those years. Caldwell v. Commissioner, (C.A. 2) 202 F.2d 112.
4. Petitioners were required to file declarations of estimated tax for 1949 and 1950 but failed, without reasonable cause, to do so. They are, therefore, liable for the estimated tax penalties prescribed under sections 294(d)(1)(A) and 294(d)(2) of the 1939 Code.
The Commissioner has determined deficiencies in petitioners' income taxes and asserted penalities, as follows:
+-----------------------------------------------------+
¦ ¦ ¦Estimated tax penalties ¦
+------+------------+---------------------------------¦
¦Year ¦Deficiency ¦[Sec. 294 (d) (1) (A), (d) (2)] ¦
+------+------------+---------------------------------¦
¦1949 ¦$14,090.88 ¦$2,328.95 ¦
+------+------------+---------------------------------¦
¦1950 ¦39,750.00 ¦3,012.54 ¦
+-----------------------------------------------------+
Some of the issues raised by the Commissioner's adjustments in the reported net income of petitioners were either settled by stipulation or not contested. They will be given effect in the Rule 50 computation. The remaining issues involve petitioners' accounting method and their liability for estimated tax penalties. The accounting method issue results from the following adjustments in the deficiency notice:
In 1949 and 1950 you claimed as part of the cost of goods sold cost of auto blocks and cost of rebuilding motors, but did not take into consideration the beginning and ending inventories of these items. In order to clearly reflect taxable income it is held that the value of all items on hand at the beginning and end of the taxable year must be included therein. Accordingly, your income for the taxable years 1949 and 1950 has been adjusted as follows:
+-----------------------------------------------------------------+
¦ ¦1949 ¦1950 ¦
+------------------------------------------+----------+-----------¦
¦Inventory of blocks 12-31-49 * * * ¦$6,025.00 ¦($6,025.00)¦
+------------------------------------------+----------+-----------¦
¦Inventory of rebuilt motors 12-31-49 * * *¦23,775.18 ¦(23,775.18)¦
+------------------------------------------+----------+-----------¦
¦Inventory of blocks 12-31-50 * * * ¦ ¦16,725.00 ¦
+------------------------------------------+----------+-----------¦
¦Inventory of rebuilt motors 12-31-50 * * *¦ ¦62,122.00 ¦
+------------------------------------------+----------+-----------¦
¦Total increase in income ¦$29,800.18¦$49,047.42 ¦
+-----------------------------------------------------------------+
Petitioners by an appropriate assignment of error contest the correctness of the foregoing adjustments both for 1949 and 1950, and also by an appropriate assignment of error contest the determination of the Commissioner in imposing penalties under section 294(d)(1)(A) and 294(d)(2), Internal Revenue Code of 1939.
The facts were all stipulated except the income tax returns of petitioners, which were introduced in evidence. Those stipulated facts are adopted as part of our findings and are incorporated herein by reference.
Petitioners Harry Hartley (hereinafter sometimes referred to as Harry) and Carey Hartley are husband and wife who, during 1949 and 1950, resided in Houston, Texas. For each of those years they filed joint Federal income tax returns with the collector of internal revenue for the first district of Texas. In their 1949 return they reported adjusted gross income of $5,112.97, of which $3,912.97 was from sources other than wages; and in their 1950 return they reported adjusted gross income of $42,339.48, all of which was from sources other than wages.
Since October 1947, Harry has been engaged in the business of rebuilding motor blocks. This involves purchasing or acquiring old motor blocks, rebuilding them in his plant, then selling them. His books have always been kept in the manner described below. In 1949 and 1950, Harry was doing business under the name of International Motor Rebuilding Company (hereinafter sometimes referred to as the company).
The company purchased and used new parts and materials in rebuilding old motor blocks. An inventory of those new parts and materials was maintained on its books. The amounts of that inventory at the beginning and end of each years, along with purchases made during the year, were taken into account in determining cost of goods sold.
The inventories of old motor blocks and rebuilt motor blocks on hand at the beginning and end of each year were not taken into account as such in determining cost of goods sold, but the cost of old motor blocks purchased during the particular year was included in the purchases figure used in determining cost of goods sold. Inventory sheets reflecting the number of old and rebuilt motor blocks on hand at the beginning and end of each year were maintained. However, no entries with respect to those inventory sheets were made on the company's books. The company's inventories of those motor blocks during the years in issue were as follows:
+-------------------------------------------------------+
¦ ¦Dec. 31, 1949— ¦ ¦
+--------------------+------------------+---------------¦
¦ ¦Jan. 1, 1950 ¦Dec. 31, 1950 ¦
+--------------------+------------------+---------------¦
¦Old motor blocks ¦$6,025.00 ¦$16,725.00 ¦
+--------------------+------------------+---------------¦
¦Rebuilt motor blocks¦23,775.18 ¦62,122.60 ¦
+-------------------------------------------------------+
There is no evidence that there were any old or rebuilt motor blocks on hand January 1, 1949.
The company both made sales and purchased old motor blocks, materials, supplies, etc., on credit as well as for cash. Its accounts for purchases, sales, and expenses were maintained on an accrual basis and such items were accrued in the determination of net income for income tax purposes. For example, in determining cost of goods sold, all credit purchases made during the year but not paid for by the year's end, including credit purchases of old motor blocks, would be included in the calculation. Accrued accounts receivable and payable were recorded on the company's books and their balances, for the years in issue, were as follows:
+-----------------------------------------------------------+
¦ ¦Dec 31, 1949 ¦Dec. 31, 1950 ¦
+----------------------------+--------------+---------------¦
¦Customer accounts receivable¦$32,675.30 ¦$30,216.04 ¦
+----------------------------+--------------+---------------¦
¦Trade accounts payable ¦15,462.57 ¦38,706.70 ¦
+-----------------------------------------------------------+
The method of accounting used by Harry in 1949 and 1950 for determining the company's net income conformed to an accrual method in every respect except that inventories of old and rebuilt motor blocks were not taken into account in determining cost of goods sold. It was, consequently, a hybrid method which did not clearly reflect income, but which most closely resembled an accrual method. An accrual method clearly reflects the company's income.
Petitioners failed to file declarations of estimated tax for the years in issue. Those failures were not due to reasonable cause but were due to willful neglect.
Respondent has determined that, in order to clearly reflect income for the years in issue, petitioners must take into account the inventories of old and rebuilt motor blocks in computing cost of goods sold of the business carried on under the name of International Motor Rebuilding Company. Sec. 41, I.R.C. 1939.1
In Elsie SoRelle, 22 T.C. 459, filed June 7, 1954, we said:
Two methods of accounting are generally recognized for income tax purposes—cash receipts and disbursements method and accrual method. It is well settled that hybrid methods of accounting which do not clearly reflect the taxpayer's income are improper. Massachusetts Mut. Life Ins. Co. v. United States, 288 U.S. 269; United States v. Anderson, 269 U.S. 422; Security Flour Mills Co. v. Commissioner, 321 U.S. 281; Estate of Julius I. Byrne, 16 T.C. 1234; Regs. 111, sec. 29.41-2.2 If, therefore, a taxpayer...
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