Patchen v. Commissioner of Internal Revenue

• Decision Date: 23 July 1958
• Docket Number: No. 16981.,16981.
• Citation: 258 F.2d 544
• Parties: Josef C. PATCHEN and Aleyne E. Patchen et al., Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Fifth Circuit

258 F.2d 544 (1958)

Josef C. PATCHEN and Aleyne E. Patchen et al., Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 16981.

United States Court of Appeals Fifth Circuit.

July 23, 1958.

Randolph W. Thrower, Atlanta, Ga., Sutherland, Asbill & Brennan, Atlanta, Ga., of counsel, for petitioners.

Karl Schmeidler, Atty., Dept. of Justice, Washington, D. C., Charles K. Rice, Asst. Atty. Gen., Lee A. Jackson, Frederick B. Ugast, A. F. Prescott, Attys., Dept. of Justice, Nelson P. Rose, Chief Counsel, Internal Revenue Service, John M. Morawski, Sp. Atty., Washington, D. C., for respondent.

Before RIVES, BROWN and WISDOM, Circuit Judges.

JOHN R. BROWN, Circuit Judge.

Presented by this appeal from a decision of the Tax Court adverse to all members (and their wives) of a professional consulting engineering partnership is the question whether the Commissioner could require computation of distributable partnership income for the years 1948-1951 on the accrual rather than cash basis as used in all returns since 1946. Additionally, in the case of one such partner, there is the further question whether penalties for failure to file a declaration of estimated tax, Section 294(d) (1) (A), 26 U.S.C.A., and for substantial underestimate of the tax, Section 294(d) (2), can both be imposed in the same taxable year.

I.

Taxpayers in 1946 organized a partnership for performance of professional engineering services. The partnership maintains no inventories and its activities are confined to the practice of professional engineering. This covers a wide field including the design and engineering-construction supervision for large projects, governmental and industrial, such as airports, sewerage systems, chemical plants and the like. As business developed, the fee arrangements fell into four main classifications: (1) lump sum fee, (2) hourly rate for work performed, (3) cost-plus lump sum, and (4) percentage of cost of construction.

At the outset, the books and records for 1946 and 1947 were essentially the cash receipts and disbursements method of accounting. The Cash method was definitely used in the first and all subsequent income tax returns. Presumably because of complications in the diverse types of billings¹ to clients under the four classifications for fees, these "bookkeeping records * * * were limited and incomplete" in the sense that the partnership accountants, in compiling the necessary information for Income Tax Returns for 1946 and 1947 "* * * had to make a complete analysis of every transaction * * *." There is no showing or finding, however, that the partnership's Cash method books did not clearly reflect its income or that extraneous materials were essential or that extraneous adjustments were made.

In 1948 the partnership directed its Certified Public Accountants to install a method of bookkeeping showing the cost of each job done by the partnership for use in billing under the various fee arrangements. This new system was essentially an Accrual method of accounting. However, the new system included² partners' salaries and other charges to various reserves which were not deductible for Federal income tax purposes under any method of accounting. Through the use of the so-called Jobs in Progress Account and transfers from it into the Job Cost Account, the system also provided for deferring to a later year certain expenses on uncompleted jobs which, on either a Cash or Accrual method were properly deductible only in the current year.³

That the new system was intended to serve a limited function and was definitely not intended to supplant the Cash records or method of reporting its income tax returns, is shown by the Tax Court's findings:

"At the end of each of the years here involved, the accounting firm employed by it audited its books and determined its income according to an accrual method. On its returns for these years, the partnership continued to use the cash receipts and disbursements method. It did not, at any time, request permission from the Internal Revenue Service to change its method of accounting from the cash to an accrual method, and it did not desire to change the method used in preparing its returns. In preparing the partnership income tax returns for the years in issue, the partnership\'s accountants prepared memorandum journal entries converting all elements of income and expense to the cash receipts and disbursements method. Such adjusting entries are shown in the accountants\' working papers, but are not entered on the partnership\'s books. These working papers and memorandum journal entries were kept by the accountants as a permanent part of their records and were available and furnished to the respondent\'s examining officers in the course of their examination. Without such working papers, the partnership\'s net income on the cash method was not readily ascertainable from its records."

Recasting the last sentence of this excerpt into an affirmative form, the Tax Court holds that "with * * * such working papers, the partnership's net income on the cash method was * * * readily ascertainable from its records."

The Tax Court then proceeded to hold that since the current books regularly kept by the partnership were on an Accrual basis, it was, under Section 41 of the Code⁴ "* * * entirely proper for the Commissioner to determine that the partnership income should have been reported on the Accrual method for the years here in issue.⁵

But no sooner had this been said, than the Tax Court saw that it was faced with the dilemma: what was to be done with the Regulations,⁶ stated in mandatory terms, prohibiting a change in the method of keeping books unless done with the Commissioner's consent and on the terms imposed by him? The Court did not try to meet this by minimizing the effective force of this Regulation or denying that, under it, the Commissioner could have rejected returns⁷ on an Accrual basis had they been filed.

On the contrary, the Tax Court forth-rightly recognized that here was a clash between the literal requirement of conformity to the method of accounting regularly employed and the further requirement of consistency as between current return and prior returns. The solution eschewed a relative weighing of the two, or the formulation of any guide which might with some reliability be followed either by taxpayers, the Commissioner, Revenue Agents, Tax or reviewing Courts. The solution was to introduce for the first time in this field the existence of an option in the Commissioner:

"But the taxpayers\' difficulty is of their own making and they are in no position to complain, as they do, that this result gives the Commissioner the option of accepting cash basis returns which are consistent with those previously filed, or of requiring that the returns be prepared on the accrual method in conformity with the partnership\'s books. If the accrual method proved to be a more accurate method for the taxpayers, then the Commissioner should also be entitled to the benefits of this increased accuracy. * * * It is not enough to say that either the cash method used by the partnership in its returns or the accrual method proposed by the Commissioner will clearly reflect income, and that consistency requires the continued acceptance of the partnership returns on the cash method. The requirements of section 41 are clear and must be followed. (Emphasis supplied.)

As we view the case, we need not determine whether such an option can be claimed, or its reaches if it exists. We must say, however, that in many respects the assertion of such an indefinable privilege is comparable to similar efforts by the Commissioner to read into the operation of Section 41 and Reg. 29.41-1-4 the right to impose on a taxpayer whose tax is coercively recomputed by the Commissioner on an Accrual rather than the reported Cash basis because the method of keeping books has changed or the return was not consistent with the books as kept, the same terms and conditions which would have been imposed had the taxpayer sought and obtained the Commissioner's consent. Except for vacillations in the Tax Court and reviewing Courts attempting to find and then apply as a basis for distinguishing the holding pronounced by Judge Learned Hand in William Hardy, Inc., v. Commissioner, 2 Cir., 1936, 82 F.2d 249, a distinction which that eminent jurist first expatriated as 121 volumes and 17 years later he overruled the case itself, Commissioner of Internal Revenue v. Dwyer, 2 Cir., 203 F.2d 522, nearly all such efforts⁸ have met with a singular lack of success. Goodrich v. Commissioner, 8 Cir., 243 F.2d 868.

The existence of any such option has far-reaching and, in some ways, disturbing implications. As an option, it recognizes that where the taxpayer has changed his method of keeping books without consent but, in compliance with the Regulations which prohibit computation of income tax returns on the new method prior to consent, has continued to use the old basis for the return, the Commissioner may nevertheless recompute the taxes as though consent had been asked and obtained and as though the tax return had been made on the new basis conforming to the new bookkeeping method. But, as an option, it also recognizes that he might not, so that the Commissioner would continue to hold the taxpayer to the prior basis for making the tax return until consent is given.

The consequences of a choice either way cannot be forecast. They can be determined only after the event. What will the guide be for its exercise? The temptations, of course, would be present to adopt whichever course produces the greater revenue. That purpose is certainly not the philosophy which Congress reflects generally in the income tax law. For those taxpayers who read, and understand, and then religiously attempt to follow the Regulations forbidding a change in computation of the income tax return until consent is given, it also subjects them to the...