*18 Decision will be entered under Rule 50.
1. Petitioner, which kept its books and filed its returns on the accrual basis of accounting, received cash or accrued amounts within the taxable years under contracts obligating petitioner to perform services extending beyond the taxable years. Held, the entire amount constitutes income in the year when received or accrued, notwithstanding the fact that a part of the income was "earned" in the following year.
2. Petitioner, during the taxable year, made certain improvements to premises leased by it, the cost of which, in accordance with the terms of the lease, was applied as a credit against the rental due for that year. Held, the full amount of the stipulated rental is deductible by petitioner, the cost of the improvements constituting merely an indirect payment of a part of the rent.
*386 This proceeding involves a deficiency in income and declared value excess profits taxes for the years and in the amounts as follows:
| Declared | ||
| Fiscal year ended -- | Income tax | value excess |
| profits tax | ||
| March 31, 1940 | $ 2,219.22 | $ 1,382.36 |
| March 31, 1941 | 331.97 |
*19 Two questions are presented: (1) Whether amounts received or accrued by petitioner in consideration of services to be performed partly in the following year are includible in income for the year in which received or accrued; and (2) whether the cost of certain improvements to leased property is deductible by petitioner as rent.
FINDINGS OF FACT.
Petitioner, Your Health Club, Inc., is a corporation of the State of New Jersey, with its principal office in Newark, New Jersey. Its returns for the fiscal years ended March 31, 1940, and March 31, 1941, were filed with the collector of internal revenue for the fifth district of New Jersey.
Petitioner commenced business April 3, 1939. Since that time it has been engaged in the business of operating a health club. Its activities consist in furnishing facilities and services for various sport activities; Russian and Turkish baths, massages, and ultra violet ray and solarium treatments. These services and facilities are furnished by petitioner under contracts entered into with its members. The contracts entitle members to avail themselves of petitioner's facilities for a period of one year; once, twice, or three times a week, according *20 to the type of contract selected by the member.
During the fiscal year ended March 31, 1940, membership contracts entered into amounted to $ 48,280.21. Of this amount, $ 42,800.85 was paid in cash and the balance represented accounts receivable, due at the close of the year. Membership contracts entered into during the fiscal year ended March 31, 1941, amounted to $ 38,389.05. Cash received during the year in payment of membership contracts amounted to $ 39,692.39. The fees collected from members are deposited by petitioner in its general account, and are subject to no restrictions as to use or application.
Petitioner kept its books and filed its returns on the accrual basis of accounting. All contracts entered into were immediately entered upon the books of petitioner in full. At the end of the taxable year, in the case of contracts extending beyond the close of the year, the membership fee was allocated in each instance between the expired and unexpired portion of the contract, such allocation being based upon *387 the number of months yet to run under the contract. The amounts allocated to the expired portions of the contracts were carried to gross income and the balance*21 was set up in the form of a "reserve for uncompleted contracts" and excluded from the gross income of the year as "unearned income." The unearned income thus deferred in the fiscal years ended March 31, 1940, and March 31, 1941, was $ 17,391.50 and $ 1,406.70, respectively.
When a contract has reached the end of its term without the member having availed himself of all the visits to which he was entitled, no refund is made. Where, however, prior to the expiration of a contract, a member requests cancellation of the contract and a refund of a portion of the total charge, it is the policy of petitioner to make a refund based upon the number of months yet to run under the contract.
Petitioner's employees are paid fixed weekly salaries, not dependent upon the amount of services rendered during any given period.
The returns for the taxable years ended March 31, 1940, and March 31, 1941, were filed in accordance with petitioner's bookkeeping methods. Respondent, in the case of each year, increased gross income by including therein the deferred amounts carried in petitioner's "reserve for uncompleted contracts."
Petitioner conducted its business on premises leased from the Mational Commercial*22 Title & Mortgage Guaranty Co., such premises consisting of the second floor of a building in Newark. The lease was for a period of ten years, beginning April 1, 1939. Rentals were fixed on a graduated scale; for the first year the rental specified in the lease was $ 4,250, payable in monthly installments. Clause 5 of the lease provided in part as follows:
5. In consideration of the lessee's installing all facilities and equipment for the operation of its business, which shall include plumbing and water lines from whatever point necessary, and all redecoration, repairs and alterations which it has by this lease undertaken, the lessor shall allow to the lessee a credit of One Thousand Five Hundred Dollars ($ 1,500). Said credit shall be applied in twelve (12) equal installments against the first twelve (12) monthly installments of rent to be paid pursuant to this agreement, other than rent payable upon the execution hereof, and shall be allowed only if and when the lessee shall have completed the installations and repairs to be made by it, and when it shall have submitted to the lessor proof that the cost thereof has been paid in full. * * *
This clause was inserted as a result*23 of petitioner's objections to the lack of lavatory facilities on the premises which it was about to lease. During the taxable year ended March 31, 1940, petitioner expended $ 1,374.96 for such improvements and paid to the lessor as rent the difference between that amount and the stipulated rental of $ 4,250. In *388 the return for the fiscal year ended March 31, 1940, petitioner claimed a deduction of $ 4,250 as rent. Respondent disallowed this deduction to the extent of $ 1,374.96, on the ground that such amount represented a capital expenditure and made appropriate adjustments for amortization.
OPINION.
The principal issue for decision concerns the correctness of respondent's action in including in petitioner's income for each of the taxable years involved the amounts carried on petitioner's books as "reserve for uncompleted contracts" and deferred to the following year.
The facts are briefly as follows: During the taxable years petitioner, which kept its books and filed its returns on an accrual basis of accounting, entered into contracts under which it agreed to perform certain services over the course of a year. The consideration for most of the contracts was received*24 in cash. The consideration for the remaining contracts was accrued on petitioner's books as accounts receivable. The amounts paid in cash were deposited in petitioner's general account and were subject to no restrictions as to use or application. The amounts unpaid but accrued constituted accounts receivable as of the close of the taxable year, and were unqualifiedly due and payable. In these circumstances, all such amounts received or accrued must be considered income to petitioner in the year received or accrued. Automobile Underwriters, Inc., 19 B. T. A. 1160; Bradstreet Co. of Maine, 23 B. T. A. 1093; reversed on other grounds, 65 Fed. (2d) 943; Pioneer Automobile Service Co., 36 B. T. A. 213; E. B. Elliott Co., 45 B. T. A. 82; South Tacoma Motor Co., 3 T. C. 411. See Clay Sewer Pipe Assn. v. Commissioner, 139 Fed. (2d) 130, affirming 1 T. C. 529; South Dade Farms, Inc. v. Commissioner, 138 Fed. (2d) 818.*25 See also Brown v. Helvering, 291 U.S. 193">291 U.S. 193.
The rule and its underlying reason have been stated by the Supreme Court in Security Flour Mills Co. v. Commissioner, 321 U.S. 281">321 U.S. 281, as follows:
The rationale of the system is this: "It is the essence of any system of taxation that it should produce revenue ascertainable, and payable to the government, at regular intervals. Only by such a system is it practicable to produce a regular flow of income and apply methods of accounting, assessment, and collection capable of practical operation."
This legal principle has often been stated and applied. The uniform result has been denial both to government and to taxpayer of the privilege of allocating income or outgo to a year other than the year of actual receipt or payment, or, applying the accrual basis, the year in which the right to receive, or the obligation to pay, has become final and definite in amount.
Petitioner's position is mainly that the inclusion of these amounts in the income of the year in which they were received or accrued prohibits *389 a correlation of income and the expenses incident to the earning *26 of that income. Substantially the same contention was made in South Tacoma Motor Co., supra, and rejected on the authority of South Dade Farms, Inc. v. Commissioner, supra. The reasoning of the latter case is completely applicable here.
It may be that this conclusion works hardships upon some taxpayers. Congress, recognizing this, has afforded a measure of alleviation in section 43 of the Internal Revenue Code, which provides, as an exception to the general rule contained therein, that deductions "paid or incurred," or "paid or accrued" may be taken in a period other than the taxable year in which paid, incurred, or accrued, if necessary in order clearly to reflect income. However, even were this a case within the scope of the remedial provisions of section 43 (cf. Security Flour Mills Co. v. Commissioner, supra), petitioner makes no claim under that provision; nor has it complied with the requirements of section 19.43-1 of Regulations 103, 1 implementing section 43 ( Cassatt v. Commissioner, 137 Fed. (2d) 745, affirming 47 B. T. A. 400);*27 and the amount of the expenses actually paid or incurred in the production of the income here involved is not made to appear in this record. Therefore, the determination of the Commissioner as to these items must be sustained.
*28 The second question relates to the deductibility of rent in the amount of $ 4,250 in the fiscal year ended March 31, 1940. The facts show that petitioner had obligated itself to pay rental for that year in the amount of $ 4,250, but that a clause in the lease provided that petitioner might make certain improvements to the premises, the cost of which to the extent of $ 1,500 might be applied to the contractual rental. Petitioner expended $ 1,374.96 in making such improvements, applying this amount as a credit against the total rent due, and paid the lessor the difference, $ 2,875.04. The Commissioner determined that only the latter amount was deductible as rent and disallowed the deduction of the amount of $ 1,374.96, adding it to capital and making proper adjustment for amortization. Petitioner contends that the disallowed item was properly deductible as rent.
*390 Petitioner does not question the general rule that the cost borne by a lessee in making permanent improvements upon leased property is a capital expenditure, but contends that the outlay in this instance was no more than an indirect payment of a part of the stipulated rental, inasmuch as it was agreed that the *29 cost of the improvements should be applied as a credit against the rent for the current year. This appears to us to be a correct interpretation of the facts. Actually, petitioner paid nothing for the improvements; the cost thereof was borne by the lessor through the credit applied against the agreed rental. Consequently, petitioner has no capital investment to amortize or depreciate. The transaction is no different than if the lessor had paid directly for the improvements and the lessee directly paid the full agreed rent. On this issue, therefore, we hold that the determination of the Commissioner was erroneous.
Decision will be entered under Rule 50.
Footnotes
1. Sec. 19.43-1. "Paid or incurred" and "paid or accrued↩." -- * * *. The deductions and credits provided for in chapter 1 (other than the dividends paid credit provided in section 27) must be taken for the taxable year in which "paid or accrued" or "paid or incurred," unless in order clearly to reflect the income such deductions or credits should be taken as of a different period. If a taxpayer desires to claim a deduction or a credit as of a period other than the period in which it was "paid or accrued" or "paid or incurred," he shall attach to his return a statement setting forth his request for consideration of the case by the Commissioner together with a complete statement of the facts upon which he relies. However, in his income tax return he shall take the deduction or credit only for the taxable period in which it was actually "paid or incurred," or "paid or accrued," as the case may be. Upon the audit of the return, the Commissioner will decide whether the case is within the exception provided by the Internal Revenue Code, and the taxpayer will be advised as to the period for which the deduction or credit is properly allowable.