Joseph Gann, Inc. v. Commissioner
| Decision Date | 01 March 1982 |
| Docket Number | Docket No. 14244-78. |
| Citation | 1982 TC Memo 104,43 TCM (CCH) 682 |
| Parties | Joseph Gann, Inc. v. Commissioner. |
| Court | U.S. Tax Court |
William Gabovitch, 40 Court St., Boston, Mass. and Steven A. Gabovitch, for the petitioner. Barry J. Laterman, for the respondent.
Memorandum Findings of Fact and Opinion
Respondent determined the following deficiencies in petitioner's Federal income taxes:
Taxable year ended Deficiency
October 31, 1973 ....... $ 80,766.51
October 31, 1974 ....... 138,203.51
October 31, 1975 ....... 83,193.72
We must determine whether during the taxable year ended October 31, 1973, petitioner had gross receipts more than 20 percent of which was from passive investment income and, if it did, whether its election to be treated as a small business corporation was terminated for 1973 and the subsequent years.
Some of the facts have been stipulated and are found accordingly.
At the time it filed its petition herein, petitioner's principal place of business was Boston, Massachusetts. For each of the taxable years ended October 31, 1973, October 31, 1974, and October 31, 1975, petitioner filed its Federal income tax returns with the Director, Internal Revenue Service Center, Andover, Massachusetts.
During the years in issue, petitioner was engaged in selling jewelry at both wholesale and retail. Petitioner's issued and outstanding stock was owned by Joseph Gann, his wife, Rae Gann, and their three children, Herbert Gann, Beverly Bavly, and Shirley Saunders. For its taxable year beginning November 1, 1971, petitioner elected pursuant to section 13721 to be taxed as a small business (subchapter S) corporation.
From 1966 through 1968, petitioner purchased 2,000 shares of stock in Bearings, Inc. (Bearings), a publicly traded corporation, for $61,383.66. During 1969, the first 3,225 shares of Bearings stock petitioner purchased cost $128,586.76. After these purchases, petitioner bought additional stock of Bearings. On September 11, 1971, Bearings stock split two-for-one. As a result, petitioner's 2,000 and 3,225 shares referred to above became 4,000 and 6,450 shares, respectively. During the taxable year ended October 31, 1973, petitioner sold 4,000 shares of Bearings stock. On November 14, 1973, Bearings stock again split two-for-one and petitioner's 6,450 shares became 12,900 shares. During the taxable year ended October 31, 1974, petitioner sold 12,900 shares of stock in Bearings.
Petitioner utilized the average-cost method to determine its bases in the stock it sold, i.e., the total cost of a particular security was divided by the total number of shares to arrive at a cost per share. At all times relevant hereto, petitioner has consistently used the average-cost method for both book and tax purposes. Under petitioner's method, the average cost of the Bearings shares sold in the taxable years ending October 31, 1973, and October 31, 1974, is $88,428 and $142,545, respectively. Using the average-cost method to compute the bases of the Bearings stock sold, petitioner's "passive investment income," pursuant to section 1372(e)(5), for the taxable year ended October 31, 1973, is 19.06 percent of petitioner's gross receipts.
Under the first-in, first-out (FIFO) method, the cost bases of the Bearings stock sold by petitioner in the taxable years ended October 31, 1973, and October 31, 1974, are $61,383.66 and $128,586.76, respectively, and petitioner's passive investment income constitutes 20.87 percent of its gross receipts for the taxable year ended October 31, 1973.
OpinionThe parties in this case disagree as to the proper method for determining petitioner's bases in the Bearings stock. Section 1012 states simply that the basis of property is its cost. When a taxpayer acquires shares of the same stock at different prices and sells only some of the shares, the problem arises of establishing the cost of the shares which were sold. Section 1.1012-1(c)(1), Income Tax Regs., provides that, unless the particular lot from which the stock is sold can be adequately identified, "the stock sold or transferred shall be charged against the earliest of such lots purchased or acquired in order to determine the cost." Respondent argues that, since there is no evidence identifying which shares were sold, the regulations mandate that petitioner use FIFO to determine its bases in the shares sold.
Petitioner presents several alternative arguments: (1) section 1.1012-1(c)(1), Income Tax Regs., cannot be applied to petitioner, since respondent has not alleged, as petitioner contends is required by section 446(b), that petitioner's use of average cost does not clearly reflect income; (2) if the 1973 increase in petitioner's passive investment income is spread over three years, as petitioner urges is mandated by section 481(b), petitioner's subchapter S election does not terminate; (3) equitable considerations dictate that we permit petitioner to utilize average cost.
Section 446(a) states the general rule that "taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books." Subsection (b) contains an exception for situations where the taxpayer's method does not clearly reflect income; in those cases the Commissioner may prescribe a method of accounting which does clearly reflect income. "Method of accounting" as used in section 446 includes not only the taxpayer's overall method of accounting (in this case, accrual) but also the accounting treatment of particular items. See section 1.446-1 (a)(1), Income Tax Regs. Since the parties have not argued otherwise, we will assume for purposes of discussion that the use of average cost or FIFO to determine basis constitutes a "method of accounting."
Petitioner argues that section 446 evinces the intent of Congress to permit a taxpayer to use any method of accounting as long as it clearly reflects income. Because respondent argues only that the method of accounting used fails to comply with the regulations under section 1012, and not that it fails to clearly reflect income, petitioner contends that respondent has no grounds to require petitioner to change its method of determining basis from average cost to FIFO. In connection with this argument, petitioner states that section 1012 and section 446 read together leave no question as to how a taxpayer is to calculate cost for tax purposes, i.e., by the same method the taxpayer uses for his books. Thus, petitioner argues that the Commissioner's regulation requiring that cost be calculated by FIFO (when the particular lot from which the security is sold cannot be identified) is inconsistent with section 446 and accordingly invalid.
For the reasons stated below, we disagree with petitioner's contention and hold that, since the particular lot from which the Bearings stock was sold cannot be identified, respondent properly determined the bases of the Bearings stock by the FIFO method.
Initially, we note that petitioner does not contend that section 1.1012-1(c)(1), Income Tax Regs., is invalid because it is unreasonable or inconsistent with section 1012. Granted that the FIFO rule "is an arbitrary one, and it may effect hardships," Vawter v. Commissioner 36-1 USTC ¶ 9225, 83 F. 2d 11, 13 (10th Cir. 1936), affg. Dec. 8831 31 B.T.A. 884 (1934), its adoption does not create a situation where the Commissioner has made an unreasonable choice among the available alternatives. Compare United States v. Cartwright 73-1 USTC ¶ 12,926, 411 U.S. 546, 557 (1973). See also Fort Howard Paper Co.v. Commissioner Dec. 28,712, 49 T.C. 275, 286 (1967), where we expressly rejected the concept that "a taxpayer has a right to choose between alternative generally accepted methods of accounting or that respondent may not, under some circumstances, require a taxpayer to accept his determination as to a preferred selection among such alternatives." Cf. Thor Power Tool Co.v. Commissioner 79-1 USTC ¶ 9139, 439 U.S. 522 (1979), discussed infra at pp. 12-13. The validity of the FIFO regulation "has been recognized and is not open to question," Vawter v. Commissioner, supra; the regulation "provides a useful and reasonable rule for ascertaining what stock was sold in cases where there is no proof, or lack of satisfactory proof, of the fact." Helvering v. Rankin 35-1 USTC ¶ 9343, 295 U.S. 123, 130 (1935). See also Snyder v. Commissioner 35-1 USTC ¶ 9344, 295 U.S. 134 (1935).2
Petitioner's argument, however, takes a different tack, namely, that the FIFO regulation is invalid because it conflicts with the general rule of section 446(a). We note that the adoption of petitioner's argument would have far reaching consequences. The Commissioner would be unable to apply any regulation (which did more than repeat the words of the Code) to compel a taxpayer to treat an item differently for tax and book purposes without first showing that the taxpayer's method of treating the item did not clearly reflect income. We do not believe that this interpretation of section 446 is mandated by the words of the section nor that this was Congress' intention in enacting section 446.
Section 446(a) provides a general rule but, in many instances, the statute itself either requires or permits a taxpayer to treat a particular item differently for tax purposes than for book purposes. See, e.g., sections 162(f), 167, 265(2), 453, 456. In other instances, a Code provision explicitly empowers the Commissioner to promulgate regulations which may have the effect of requiring different treatment of an item for tax purposes. See, e.g., sections 471, 611. If the Code requires that a particular item be treated differently for tax purposes than for book purposes, it is not a sufficient answer that the taxpayer's method of accounting for that item clearly reflects income. We believe section 1012 is an example of such a...
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