T.C. Memo. 1996-486
UNITED STATES TAX COURT
ELECTRIC CONTROLS AND SERVICE CO., INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 23672-93. Filed October 29, 1996.
William S. Fishburne III and Sidney T. Philips, for
petitioner.
Linda J. Wise, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
SWIFT, Judge: Respondent determined a deficiency in
petitioner's 1989 corporate Federal income tax of $218,015 and an
addition to tax under section 6651(a)(1) of $66,778.
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Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for 1989, and all Rule
references are to the Tax Court Rules of Practice and Procedure.
After settlement, the primary issue for decision is the
proper accrual in petitioner's taxable year ending February 28,
1989, of amounts billed but not received under a long-term
construction contract.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
Petitioner is an Alabama corporation with its principal
place of business in Birmingham, Alabama. Petitioner is engaged
in the construction of industrial plants and buildings.
Petitioner's taxable year ends on February 28 of each year.
In early 1987, Clinch River Corp. (Clinch River)
incorporated for the purposes of purchasing, renovating, and
operating a paper mill that it purchased later that year. In
October of 1987, Clinch River hired petitioner to substantially
renovate the mill. The mill had been built in the early 1900's
but had been closed in 1985 upon bankruptcy of the former owner
and operator of the mill.
Under the long-term, cost-plus contract that was entered
into on October 23, 1987, between Clinch River and petitioner
(October 1987 contract), Clinch River was to reimburse petitioner
the costs of labor, materials, and subcontractor fees, and to pay
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petitioner a fee of 15 percent in excess of labor and material
costs and subcontractor fees. Clinch River had little startup
capital and was required to take out lines of credit to finance
the mill renovation.
Under the October 1987 written contract, total payments due
petitioner for renovation of the mill were estimated at
$2,730,000, and completion of the renovation was estimated for
March 1, 1988. Payments were to be made by Clinch River to
petitioner periodically as renovation of the mill progressed, and
final payment was to correspond with the completion of the
renovation.
Not until July of 1988, however, did petitioner complete
renovation of the mill, and, by the time the renovation was
complete, total payments due petitioner from Clinch River under
the cost-plus contract had increased to $5,136,000.
Because of the large increase in the costs of renovation
over the $2,730,000 that petitioner initially had estimated and
because of financial difficulties that Clinch River experienced
during renovation of the mill, Clinch River did not make timely
payments to petitioner, and both Clinch River and petitioner
recognized that Clinch River would have difficulty making the
full payment due petitioner for petitioner's renovation of the
mill. By letter dated April 18, 1988, petitioner wrote Clinch
River and offered to make adjustments in the payments due
petitioner from Clinch River for renovation of the mill.
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Between January and July of 1988, under the October 1987
contract, Clinch River made payments to petitioner totaling
$3,180,000, leaving a balance of $1,956,000 ($5,136,000 less
$3,180,000 equals $1,956,000) to be paid upon completion of the
mill renovation which balance, in July of 1988, was accrued as
income on petitioner's books and records.
Upon completion of the renovation, the mill reopened, and
Clinch River began operating the mill 7 days a week. Clinch
River, however, failed to pay the $1,956,000 balance due
petitioner under the October 1987 cost-plus contract.
By letter dated July 11, 1988, Clinch River wrote petitioner
and acknowledged the $5,136,000 total bill for renovation of the
mill, but Clinch River also requested additional time to pay the
$1,956,000 balance due. Specifically, Clinch River represented
that by October 30, 1988, it would make an additional payment of
$603,000 to be financed from additional loan proceeds. Clinch
River made no representation as to when it would pay the amount
due in excess of $603,000.
By letter dated October 25, 1988, Clinch River informed
petitioner that it would not be able to pay the $603,000 promised
by October 30, 1988. Clinch River had no capital, operating
funds, or credit from which to make the payment.
Due to Clinch River's financial condition, petitioner and
Clinch River renegotiated certain aspects of the cost-plus
contract relating to renovation of the mill and specifically
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relating to payment of the $1,956,000 balance due petitioner.
Under a written agreement dated November 23, 1988 (November 1988
contract), Clinch River agreed, among other things, to pay
petitioner:
(1) $400,000 by January 15, 1989;
(2) beginning with the mill's first profitable quarter, $5
per ton for each salable ton produced, for a period of up to
24 months, up to a maximum total additional payment under
this provision of $400,000; and
(3) in each month of 1989 that is profitable for the mill,
an additional $5 per ton for all tons produced in each
month;
(4) in the event Clinch River sells the mill and receives
from the sale less than $12 million, an additional amount so
that the total amount paid petitioner for renovation of the
mill would equal $4.4 million. Alternatively, if a sale of
the mill realizes for Clinch River more than $12 million, an
additional amount so that the total amount paid petitioner
for renovation of the mill would equal $4.5 million.
Because of the above alteration of the October 1987
contract, on January 4, 1989, an adjustment reducing accrued
income by $724,975 was made on petitioner's management reports
with respect to its renovation of the mill to reflect that, as of
November 30, 1988, petitioner had the potential to receive a
total of only $4,411,025 from its work on the mill -- $5,136,000
(total contract amount as of completion of the renovation) less
$4,411,025 (approximate minimum that petitioner was scheduled to
receive, under the November 1988 contract, on sale of the mill)
equals $724,975.
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On January 15, 1989, Clinch River failed to make the
$400,000 payment due petitioner on that date under the November
1988 contract.
On February 2, 1989, petitioner and Clinch River
renegotiated in writing certain aspects of the November 1988
contract (February 1989 contract). Under the February 1989
contract, in lieu of the $400,000 that was due petitioner on
January 15, 1989 (under the November 1988 contract), Clinch River
agreed to pay directly to various suppliers and subcontractors
$340,148 that was owed by petitioner to the suppliers and
subcontractors for their work on the mill renovation, and Clinch
River agreed to pay petitioner only the $59,852 balance of the
$400,000 that was scheduled to be paid on January 15, 1989
($400,000 less $340,148 equals $59,852). Under the February 1989
contract, the two other provisions of the November 1988 contract
that made additional payments from Clinch River to petitioner
contingent upon Clinch River's profitability and production
remained in effect. The provisions of the November 1988 contract
relating to a possible sale of the paper mill are not mentioned
in the February 1989 contract.
From the time of initial startup of the mill in July of 1988
through the end of petitioner's 1989 taxable year, Clinch River's
financial statements reflected a total net operating loss of
$4,340,926 and no profit from operation of the mill. Petitioner
received copies of Clinch River's monthly financial statements
from July of 1988 through the end of Clinch River’s fiscal year
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ending July 2, 1989. Each of these monthly financial statements
reflected total liabilities in excess of total assets and a net
operating loss for Clinch River that increased significantly for
almost every month, as set forth below:
Total Total Net Operating
Month Ending Assets Liabilities Loss (To Date)
July 31, 1988 $10,812,640 $12,231,286 $ (609,170)
Aug. 28, 1988 10,623,865 12,798,253 (1,309,637)
Sep. 25, 1988 10,745,749 13,978,696 (2,352,740)
Oct. 23, 1988 11,430,129 15,014,491 (2,651,004)
Nov. 20, 1988 10,468,891 14,703,381 (3,234,931)
Dec. 18, 1988 10,571,153 15,344,598 (3,704,189)
Jan. 15, 1989 10,518,158 15,573,595 (3,935,168)
Feb. 13, 1989 10,325,572 15,893,548 (4,340,926)
Mar. 12, 1989 9,200,617 15,190,987 (4,704,722)
Apr. 9, 1989 9,123,278 15,722,158 (5,206,418)
June 4, 1989 9,086,060 16,568,885 (5,938,446)
July 2, 1989 9,072,587 17,057,265 (6,372,108)
In order to cover expenses associated with production, the
paper mill apparently had to produce and sell at least 170 tons
of paper per day. As of January 25, 1989, the paper mill was
apparently producing only 150-170 tons of paper per day, dropping
to 123 tons per day as of April 9, 1989, and rising to 140 tons
per day as of July 30, 1989.
In summary, with regard to payments due from Clinch River,
as of February 28, 1989, the close of petitioner's 1989 taxable
year, petitioner had not received from Clinch River the
$1,956,000 balance due under the original October 1987 contract,
the $400,000 due under the first provision of the November 1988
contract, nor the $59,852 due under the first provision of the
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February 1989 contract. The $340,148 that Clinch River owed
suppliers and subcontractors under the February 1989 contract was
never paid, and petitioner never received any payments under the
provisions of the November 1988 contract that were dependent on
the mill's profitability and production.
By February 28, 1989, several priority deeds of trust had
been filed in Tennessee by other creditors against Clinch River
and perfected against the mill and other property of Clinch River
in the total amount of $4,469,999.
On March 19, 1989, yearend closing adjustments were made on
petitioner's books and records with respect to petitioner's
taxable year ending February 28, 1989, reflecting a reduction in
the contract price for petitioner's renovation of the mill from
the original $5,136,000 to $4,500,000. On petitioner's books and
records, petitioner recorded this adjustment as a debit (or
reduction) of $636,000 in accrued income and as a credit (or
decrease) of $636,000 in petitioner's accounts receivable with
respect to Clinch River ($5,136,000 less $4,500,000 (maximum
amount that petitioner would receive under the November 1988
contract on sale of the mill) equals $636,000).
Petitioner also made a yearend closing adjustment on its
books and records with respect to petitioner's taxable year
ending February 28, 1989, to reflect the $340,148 that petitioner
would not receive because Clinch River had agreed to pay the
$340,148 directly to suppliers and subcontractors but that
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petitioner had previously accrued as income as part of the total
$5,136,000 contract price under the cost-plus contract with
Clinch River. This adjustment was reflected as a further debit
(or reduction) of $340,148 in accrued income and as a credit (or
decrease) of $340,148 in petitioner's accounts receivable with
respect to Clinch River.
Lastly, as a further yearend closing adjustment on its books
and records with regard to its contract with Clinch River,
petitioner "wrote-down" the original $5,136,000 contract price by
an additional $600,000 to reflect what petitioner perceived as
the unlikelihood of receiving any further payments under the
November 1988 and February 1989 contracts with Clinch River that
were dependent on profitability and production of the mill. This
adjustment was reflected by a $600,000 debit (or increase) to a
bad debt expense account and by a $600,000 credit (or decrease)
to petitioner's accounts receivable with respect to Clinch River.
On July 11, 1989, petitioner filed suit against Clinch River
in the Chancery Court for Roane County, Tennessee, seeking to
recover $1,956,000 (the balance due under the original October
1987 contract between Clinch River and petitioner) with respect
to its renovation of the paper mill.
On April 9, 1990, Clinch River filed for chapter 11
bankruptcy in the U.S. Bankruptcy Court (Bankruptcy Court) for
the Southern District of Ohio. As of the date of trial, Clinch
River was operating under a plan of reorganization that was
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confirmed by the Bankruptcy Court on July 19, 1993. As indicated
above, petitioner never received any additional payments from
Clinch River.
Petitioner filed an untimely corporate Federal income tax
return for its taxable year ending February 28, 1989 (the 1989
return). The 1989 return was originally due on May 15, 1989, but
petitioner on that date obtained a filing extension until
November 15, 1989. Respondent, however, did not receive
petitioner's 1989 corporate Federal income tax return until
June 25, 1990.
On the application for automatic extension of time to file
its 1989 return, petitioner reported a tentative tax liability of
$80,000, an estimated tax payment of $20,000, and an estimated
balance due of $60,000. The $60,000 payment that was to
accompany petitioner's extension request was not received by
respondent until May 17, 1989.
Consistent with the above yearend closing adjustments that
were made on petitioner's books and records with regard to
payments due from Clinch River, on petitioner’s 1989 corporate
Federal income tax return, petitioner accrued $4,159,8521 in
income, and petitioner claimed a $600,000 bad debt deduction with
1
$5,136,000 (initially accrued on petitioner's books and
records) less $636,000 (for first contract price adjustment) less
$340,148 (for amount to be paid by Clinch River directly to
suppliers and subcontractors) equals $4,159,852.
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respect to payments not received from Clinch River for
petitioner's renovation of the mill.
On audit, respondent accepted petitioner's reductions of
$636,000 and $340,148 to the originally accrued total income of
$5,136,000 relating to petitioner's contract with Clinch River.
Respondent, however, issued a notice of deficiency disallowing
the claimed $600,000 bad debt deduction on the ground that
petitioner had not established that the balance of the debt still
owed to petitioner from Clinch River was wholly or partially
worthless.
In the notice of deficiency, respondent also determined that
petitioner was liable for an addition to tax under section
6651(a)(1) for failure to timely file a 1989 corporate Federal
income tax return. Because petitioner's $60,000 estimated tax
payment due with the May 15, 1989, extension request was not
received by respondent until 2 days after that date, this $60,000
payment was not included by respondent in the computation under
section 6651(b) of the amount of the delinquency addition to tax
under section 6651(a)(1).
Petitioner now argues, in the alternative, that either the
$600,000 claimed bad debt deduction should be allowed or the 1989
yearend accrued income of $4,159,852 relating to the contract
with Clinch River should have been, and should now be, reduced by
an additional $600,000 because of the contingencies associated
with Clinch River's obligation to make further payments to
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petitioner and because of substantial doubt, as of February 28,
1989, as to collectibility of any further payments from Clinch
River. Petitioner also makes other alternative arguments.
OPINION
Generally, under section 451(a) and the regulations
thereunder, an accrual basis taxpayer is required to accrue for
each year income where, during that year, all events have
occurred that fix the taxpayer's right to receive the income and
where the amount can be determined with reasonable accuracy.
Secs. 1.446-1(c)(1)(ii), 1.451-1(a), Income Tax Regs. The time
when income accrues is largely a question of fact. San Francisco
Stevedoring Co. v. Commissioner, 8 T.C. 222, 226 (1947).
Income that satisfies the all-events test of the accrual
method of accounting is generally accruable even though later
events may postpone, even until a subsequent year, actual payment
and receipt of the amount fixed and due. Harmont Plaza, Inc. v.
Commissioner, 64 T.C. 632, 648, 649 (1975), affd. 549 F.2d 414
(6th Cir. 1977); Georgia School-Book Depository, Inc. v.
Commissioner, 1 T.C. 463, 468 (1943).
A limited exception to the above general rule regarding the
accrual of income may apply when, in the same year that a
taxpayer's right to income arises, collection and receipt of the
income become sufficiently doubtful or when it becomes reasonably
certain that the income will not be collected. Clifton
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Manufacturing Co. v. Commissioner, 137 F.2d 290, 292 (4th Cir.
1943), revg. on the facts 1 T.C. 71 (1942); Corn Exch. Bank v.
United States, 37 F.2d 34, 35 (2d Cir. 1930); Harmont Plaza, Inc.
v. Commissioner, supra at 649-650; Chicago & N.W. Ry. v.
Commissioner, 29 T.C. 989, 996 (1958); Georgia School-Book
Depository, Inc. v. Commissioner, supra at 468-469; Atlantic
Coast Line R.R. v. Commissioner, 31 B.T.A. 730, 749 (1934), affd.
81 F.2d 309 (4th Cir. 1936); Johnson v. Commissioner, T.C. Memo.
1982-517, affd. without published opinion 729 F.2d 1447 (3d Cir.
1984); Cappuccilli v. Commissioner, T.C. Memo. 1980-347, affd.
668 F.2d 138 (2d Cir. 1981).
Mere financial difficulty of the debtor, however, or the
fact that a lapse of time is contemplated before payment is
possible will not be regarded as establishing the requisite
doubtful collectibility. Harmont Plaza, Inc. v. Commissioner,
supra at 650; Commercial Solvents Corp. v. Commissioner, 42 T.C.
455, 470 (1964); Automobile Ins. Co. v. Commissioner, 72 F.2d
265, 267-268 (2d Cir. 1934).
Accrual of income also may not be required if the right to
receive income is contingent upon the happening of a future
event. See Guarantee Title & Trust Co. v. Commissioner, 313 F.2d
225, 227 (6th Cir. 1963), revg. on the facts T.C. Memo. 1961-122.
Where receipt of income is contingent on realization of profits
or net income by the payor, the income may be regarded as
contingent and nonaccrual in the current year may be justified.
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Pierce Estates, Inc. v. Commissioner, 195 F.2d 475, 477 (3d Cir.
1952), revg. on the facts 16 T.C. 1020 (1951).
Respondent cites Spring City Foundry Co. v. Commissioner,
292 U.S. 182 (1934), for the proposition that an absolute rule
exists that once an accrual method taxpayer has earned income,
the income must immediately be accrued, and subsequent events
occurring within the same year affecting collectibility of the
income can never justify nonaccrual of the income in that year.
Respondent’s interpretation of Spring City Foundry Co. v.
Commissioner, supra, is not followed by the above-cited case
authority, and we do not so interpret it herein.
In the instant case, the record establishes that by
November 23, 1988 (the date of the November 1988 contract),
Clinch River's obligation to pay petitioner the $600,000 in issue
had become contingent and, by February 28, 1989, of very doubtful
collectibility. The unprofitability of the mill, the low level
of production of the mill, and the serious financial condition
and apparent insolvency of Clinch River, make clear the strong
unlikelihood that petitioner would receive a payment under the
two contingent provisions of the November 1988 and the February
1989 contracts with Clinch River. No realistic prospect of a
sale of the mill was evident, and, in light of the failure to
mention, in the February 1989 contract, the sale provisions of
the November 1988 contract, those provisions appear not to have
been included in the February 1989 contract.
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The doubtful collectibility of the $600,000 in dispute is
established by the contingent nature of petitioner's right to
receive any further payments and by Clinch River's serious
financial condition and history of delinquent payments under the
various contracts.
These factors taken together constitute and are to be
regarded as more than mere obstacles postponing payment and
receipt of the $600,000 in dispute. The combination of the
contingent nature of the payments that were due and the severe
financial condition of Clinch River created serious and
reasonable doubt as to whether petitioner would ever collect any
portion of the $600,000 in dispute and justify, in this case,
nonaccrual of this $600,000 in petitioner's 1989 taxable year.
The fact that petitioner, in subsequent years, sued Clinch
River for recovery of the full balance due under the original
October 1987 contract does not alter our conclusion herein. Such
legal action, in this case, must be regarded as merely protective
and perfunctory. It did not alter or eliminate the price
reductions that had occurred and that respondent recognizes
herein, and it did not alter or eliminate the unlikelihood that
petitioner would receive any additional payment from Clinch
River.
Because we hold for petitioner as to nonaccrual of the
$600,000 in dispute, we need not address petitioner's alternative
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argument regarding the claimed $600,000 bad debt deduction and
other alternative arguments.
With respect to the addition to tax under section 6651(a)(1)
for petitioner's failure to timely file its 1989 corporate
Federal income tax return and the computation of that addition to
tax, we hold for respondent. Petitioner has offered no evidence
to establish reasonable cause for its failure to timely file its
1989 corporate Federal income tax return nor any evidence to
establish that the $60,000 estimated tax payment was made on
May 15, 1989, the due date of the estimated tax payment for
purposes of computing the amount of the addition to tax under
section 6651(a)(1). We sustain respondent on these issues.
Decision will be entered
under Rule 155.