*1178 1. Petitioner is engaged in the outdoor advertising business and keeps its books on the accrual basis. It received advance payments on contracts to be performed after the taxable year. No restrictions were imposed upon petitioner's use of the prepayments. Held, advance payments received by petitioner during the taxable year are includible in gross income of that year.
2. In the taxable year petitioner paid $4,000 in compromise of litigation brought against it involving substantially the same issues as a previous suit which it had won. Both suits attacked petitioner's title to property. Held, the amount paid in compromise of the suit was a capital expense and not deductible.
3. Held, a certain account was not worthless in the taxable year and hence was not deductible as a bad debt.
4. Five years after the taxable year, petitioner received a refund of a portion of an electric bill which had been deducted as an expense on petitioner's return for the taxable year. Held, an allocated portion of the refund is includible in petitioner's gross income for the taxable year.
*82 In this proceeding petitioner requests redetermination of a deficiency in income tax for the year 1934 in the sum of $1,533.31.
The first issue is whether or not advance payments on advertising contracts were income to petitioner in the taxable year. The second issue is whether or not petitioner may deduct from gross income an amount paid in compromise of litigation. The third issue involves a bad debt deduction. The final issue is whether or not petitioner's income for the taxable year should be adjusted to reflect the receipt in a later year of a refund of a portion of a bill for electricity deducted as an expense on its income tax return for the taxable year. Six additional issues raised by the pleadings were abandoned by petitioner at the hearing; one issue was conceded by respondent on brief.
FINDINGS OF FACT.
(1) Petitioner was incorporated in February 1929, under the laws of the State of Florida, and has its principal office in Miami, Florida. It is engaged in the outdoor advertising business, which consists of renting space on land or buildings, erecting*1180 sign structures, and selling an advertising service thereon.
After a desirable location for advertising display has been determined petitioner effects a lease with the owner of the property. *83 Such a lease usually provides that the owner may terminate the contract by sale of the property or by erection of buildings which make the land unusable for advertising. The lease normally contains a provision to the effect that the owner of the property will not cancel the agreement with petitioner in order to allow another advertising concern to use the premises for advertising purposes. After leasing the space, petitioner erects a structure, usually of standard character and type, which is submitted to a potential customer, and petitioner's agents suggest an advertising idea suitable for use on that particular site.
The contracts into which petitioner enters with its customers are from one to three years' duration and provide for the payment of a stipulated sum a month. In those cases where financial responsibility of the customer is questionable or where the erection of the display entails a large expenditure, petitioner requires an advance payment on the contract. In*1181 some instances erection of structures involves considerable expense because city regulations require them to be sufficiently strong to withstand wind pressure of hurricane strength. In the event of loss of a particular location, petitioner submits another site to its customer in an endeavor to give the advertiser an acceptable substitute for the original space. If petitioner and the customer can not agree upon a new location, the contract is canceled and prepayments allocable to the unpaid portion of the contract are refunded.
Petitioner kept its books and filed its returns on the accrual basis. Where customers make initial payments to petitioner on advertising contracts the prepayments are entered on the books of petitioner as "deferred income." As of December 31, 1934, the deferred income account on the books of petitioner showed a balance of $2,570, representing the following initial payments received by petitioner in the year 1934:
| Period | Payments | Total | |
| Hector Supply Co | Jan.-Aug., 1935 | 8 mos. at $150 | $1,200 |
| Hotel Alma | Jan.-Oct., 1935 | 10 mos. at $20 | 200 |
| Nolan Peeler | Jan.-May 1935 | 5 mos. at $150 | 750 |
| Alcazar Hotel | Jan.-Apr., 1935 | 4 mos. at $60 | 240 |
| Halcyon Hotel | Jan.-Apr., 1935 | 4 mos. at $45 | 180 |
| Total | 2,570 |
*1182 The contracts upon which petitioner received the above described initial payments imposed no restrictions upon petitioner's use of the prepayments. The contracts contained no provision for refund of initial payments in the event of nonperformance of the contracts. The prepayments on the advertising contracts are treated by petitioner as deposits and allocable portions of those payments are withdrawn *84 from the deferred income account and taken into current income as the periods to which the deposits are attributable expire. This method of treating initial payments was consistently followed by petitioner during the year 1934, and ever since the that date.
(2) After the date of its organization petitioner purchased certain assets from the Miami Sign Co., a Florida corporation. Later, the Miami Sign Co. became bankrupt and suit was brought in a United States District Court by the trustee in bankruptcy of the Miami Sign Co., hereinafter called the trustee, to set aside as fraudulent the conveyance of the assets purchased by petitioner from the Miami Sign Co. The District Court dismissed the action and the trustee appealed to the Circuit Court of Appeals, which held that*1183 a prima facie case had been established by the plaintiff, so that evidence would have to be submitted by petitioner. The case went back to the District Court, was tried on the merits, and a decision was entered in favor of petitioner. Upon appeal to the Circuit Court of Appeals for the Fifth Circuit the decision of the lower court in favor of petitioner was affirmed. Defense of this suit cost petitioner over $65,000 in legal fees.
A number of months after the termination of the first suit by the trustee, a second action was brought by the trustee raising substantially the same issues that were involved in the first proceeding. The litigation became a matter of harassment to petitioner and petitioner's past experience indicated that if continued it would affect adversely petitioner's standing in the community and its credit with the banks.
Paul D. McGarry, as attorney for petitioner, obtained a compromise settlement of the second suit by arranging that petitioner pay the trustee the sum of $4,000 in exchange for a general release of all claims which the trustee had or might have against petitioner. Petitioner's check for $2,000, dated November 26, 1934, was delivered*1184 to the trustee, together with two promissory notes of $1,000 each, payable on or before 12 months and 15 months from November 26, 1934, respectively. Certain of petitioner's advertising contracts were attached to the notes as security for their payment. A general release signed by the trustee and dated November 24, 1934, was delivered to petitioner simultaneously with the receipt of the check and notes of petitioner and from that date the harassing litigation ceased. The notes were paid by checks of petitioner in the sum of $1,000 each, dated November 26, 1935, and February 25, 1936.
In its income and excess profits tax return for the year 1934 petitioner included the $4,000 paid in compromise of the second suit as part of an item of $5,686.13 entitled "legal fees" which was claimed as a deductible expense. Respondent disallowed the deduction of $4,000.
(3) Petitioner purchased certain of its assets from predecessor companies. One of these assets was a contract to furnish advertising *85 service to the Red Cross Pharmacy, which was owned and operated by the firm of Wright & Co. During the period in which petitioner was involved in litigation with the trustee, this*1185 customer was prohibited by legal proceeding from making payments to petitioner, although petitioner continued to furnish advertising service to the pharmacy. Wright & Co. informed petitioner that it was depositing the amounts due in the Bank of the Bay of Biscayne. Subsequently, that bank failed and Wright & Co. advised petitioner that it was unable to make payments on the contract for the time being. During the entire period in which the account was delinquent petitioner continually attempted to collect the payments due.
Upon receipt of the general release from the trustee the president of petitioner thought that petitioner could collect the pharmacy account in full and so, on October 9, 1934, he addressed an interoffice momorandum to the company's bookkeeper, instructing her to attempt to collect that account. The account was later turned over to petitioner's attorney for collection, who, after examination, was of the opinion that the contract with the pharmacy which petitioner had purchased was nontransferable. The attorney advised petitioner that recovery by suit on the contract was questionable and that an adverse judgment in such an action might impair collection on other*1186 similar contracts owned by petitioner. Petitioner then instructed its attorney to effect the best settlement possible without litigation and to charge off the account on the books of petitioner. No legal action was ever taken against Wright & Co. for collection of the account. This account in the sum of $3,901.52 was charged off on the books of petitioner in the year 1934.
In its income and excess profits tax return for the year 1934 petitioner deducted as a bad debt the sum of $3,901.52, representing the amount due under its account with the Red Cross Pharmacy. Respondent disallowed the deduction. In the year 1935 the attorney for petitioner effected a compromise settlement with Wright & Co. under which approximately one-third of the amount claimed was paid to petitioner. The amount received under this compromise was included as income by petitioner on its income and excess profits tax returns for the year 1935.
(4) During the year 1934 petitioner paid to the Florida Power & Light Co., hereinafter referred to as the Light Co., the sum of $9,141.83 for electric current received, and deducted that amount from gross income as an expense of operation on its income and excess*1187 profits tax return for the year 1934.
The city of Miami, Florida, before 1934 had passed certain ordinances regulating rates for electric current furnished by the Light Co. to its customers in Miami, but these rates were contested by the Light Co. Litigation ensued which lasted several years and ended in the *86 United States Supreme Court's decision on November 7, 1938, that the city of Miami had the right to regulate by ordinance the rates of the Light Co.
Pending the outcome of the litigation, the Light Co. was required by the court to put up a bond or establish a reserve fund for the repayment to its customers of any excess over the amount received under the lawful rate, should the city of Miami win its suit. After the litigation had terminated in favor of the city the court ordered the Light Co. to compute the amount of refund due its customers and allowed it eight months in which to make the computation. On July 31, 1939, pursuant to the order of the court, petitioner received from the Light Co. a refund in the amount*1188 of $10,156.93, which was allocated by the Light Co. to the years 1933 to 1938, as follows:
| 1933 | $1,480.95 |
| 1934 | 2,282.10 |
| 1935 | 2,141.26 |
| 1936 | 1,423.80 |
| 1937 | $1,276.59 |
| 1938 | 1,552.23 |
| Total | 10,156.93 |
Petitioner sought to have its gross income for 1934 increased by the amount allocated to that year.
OPINION.
KERN: (1) The first issue for our consideration is whether advance payments on advertising contracts to be performed after the taxable year are income to petitioner in the year of receipt. Petitioner contends that the prepayments represented advances for the purpose of defraying initial costs of erection of structures and were income only in the year petitioner performed the services for which the advance payments were made. Respondent argues that petitioner was not restricted in its use of the prepaid amounts and that the payments were income to petitioner in the taxable year.
The contracts under which petitioner received the initial payments did not restrict the use of the prepaid funds by petitioner. Nor did the agreements contain any provision with respect to refund of the payments. The payments were in the nature of advance rentals and were*1189 income in the year of receipt.
*87 (2) The second issue concerns the deductibility of the sum of $4,000 paid by petitioner in a compromise settlement of litigation. Petitioner contends that the amount paid is deductible as an ordinary and necessary expense of conducting its business. Respondent asserts that it was made in defense of petitioner's title to property and should be treated as an addition to the cost basis of the property. Petitioner had bought part of the assets of a bankrupt corporation and the trustee in bankruptcy brought suit against*1190 petitioner to invalidate this transfer. Despite a judgment in petitioner's favor by the U.S. District Court, which was affirmed by the Circuit Court of Appeals, the trustee renewed his attack on what he claimed to be a fraudulent transfer. To protect its credit, it is said, petitioner compromised the suit. But it was also to protect the assets which it had acquired, for its credit could not have been affected save through the questionableness of its title to the assets. Such an expense, as we have recently decided in
(3) The third issue is whether or not petitioner is entitled to a bad debt deduction in the sum of $3,901.52. Petitioner claims the deduction on the ground that the Red Cross Pharmacy account was uncollectible and was charged off on petitioner's books during the taxable year. Respondent urges that a deduction for a bad debt is not allowable, since the account was not ascertained to be worthless in the taxable year.
Section 23(k) of the Revenue Act of 1934 provides that deductible bad debts are "debts ascertained to be worthless*1191 and charged off within the taxable year." Here, the account was charged off in the taxable year. In order to obtain the deduction, however, petitioner must show that the debt was reasonably ascertained to be worthless during the taxable year.
(4) The final question before us is whether or not that portion allocable to 1934 of the refund made in 1939 by the Florida Power & Light Co. to petitioner by court order sustaining the city of Miami's lower rate was income to petitioner in the year 1934. Petitioner had in 1934 claimed and been allowed as a deduction the full amount paid by it to the Light Co. It now claims that its gross income*1192 for *88 that year should be increased by the amount of the refund allocable to that year, in correction of what now appears to have been an excessive deduction. Anything unusual in the taxpayer's request to have its taxes increased for the taxable year 1934 is explained, obviously, by a desire not to have the entire sum refunded in 1939 treated as gross income received in that year. Petitioner relies on
Strictly taken, our decision in that case is not authority, for the issue there was conceded by the taxpayer; but our reasoning does support the theory now relied on by petitioner. There the taxpayer had accrued and deducted certain state property taxes in 1932, but actually paid a lesser amount in 1934. Her contention was that the difference should be adjusted as of the earlier year and not treated as income in 1934. We pointed out that, where the earlier years were not open to adjustment by reason of the statute of limitations, so much of the refund as represented the excess over the accrued and deducted tax was "to be treated as taxable income in the year in which the refund is made." The taxpayer, now taking a*1193 different tack, also assigned as error the disallowance in 1934 of the excess of taxes accrued and deducted in that year over the amount actually paid in 1935 and 1936. In other words, the taxpayer objected to the correction made by the Commissioner, where correction was possible under the statute of limitations. The taxpayer on brief conceded the correctness of the Commissioner's action in this regard, but raised the question apparently to show inconsistency in the Commissioner's method. Our opinion set forth the complete answer to this, for had the result of the taxpayer's successful negotiations with the state tax authorities for a reduction of her taxes transpired before the Federal statute of limitations had run, the Commissioner would have completely adjusted the 1932 taxes, as he had already done in part in 1934 on the basis of the facts then known to him. But her concealment of these facts allowed the statute to run, and the Commissioner had no recourse but to treat the refund as income in the year it was received. We said in that opinion that "we have consistently held that where in a given year a taxpayer takes a deduction which, prior to the final determination of his*1194 income tax liability for such year, is ascertained to be excessive, only the correct amount will be allowed in the final determination of his income tax liability."
We are of the opinion that the rule thus stated in Eckstein's case is that which the Board has consistently applied, with the exception of a few distinguishable cases and obiter dicta. While that case and most of the cases thereafter discussed involve refunds of taxes previously deducted, the equitable principle which lies at the root of the rule is equally applicable to the facts of the instant proceeding. We might *89 have laid it down as a basic principle in the beginning that, when the taxpayer on the accrual basis has accrued a valid tax, he shall be entitled to the deduction in that year and any refund shall be treated as income in the year of receipt. That is the respondent's contention here. He points out that the rates charged petitioner by the power company were an absolute obligation of petitioner when laid, and that petitioner was not even itself contesting their validity. The conditions for accruing the obligation, it is said, were present, *1195
Much might be said for such a doctrine, but it is too late to advance it now. We have too long followed a different principle. As early as
It will be observed that all of these cases support petitioner's contention here, since in all we required readjustment of a later refunded deduction in the year in which it was taken. It should be noted that *90 in none of them did the statute of limitations bar such a recomputation of the tax after the transaction was closed.
The validity of the rule laid down in these cases has been recognized either inferentially or explicitly in many of our more recent opinions, the majority of them involving deductions of taxes paid under unconstitutional statutes. Thus, in
In
* * * So long as a case involving the audit and determination of the correct tax liability of a taxpayer is open and under consideration by the Commissioner of Internal Revenue, it is his duty correctly to determine the income *91 of the taxpayer and deductions*1200 to which the taxpayer is entitled.
Four cases which are apparently contrary to the established rule are, in reality, distinguishable on their facts. In *1201
We think it is clear that, despite some apparent departures from it, the rule to be drawn from our decisions is that all refunds of paid taxes are to be adjusted to the years in which the taxes were paid and deductions claimed, as the best method to reflect income; the only proper departure from the rule of adjustment of the refund in the years of payment is where the statute of limitations or some other consideration has made it impossible. In such cases it is obviously inequitable to allow the taxpayer the unjust enrichment which would result and the refund must then be treated as income in the year of receipt. See
*92 We are of the opinion that the rates exacted by the public utility company here were provisionally valid obligations, just as they would hve been if enforced under a statute properly enacted but later*1203 held unconstitutional, and as such they justified the deduction of the amounts accrued and paid under them in the prior years. To the extent that these deductions may be adjusted in the light of our present knowledge of the invalidity of the rates and the consequent refund, this should be done; but where the statute of limitations sets up a bar to such correction, the refund for those years must be treated as income when received.
A concluding word will dispose of
The rationale of the Circuit Court's opinion is that the deductions for prior years were closed because "all the events which rendered respondent [taxpayer] liable for*1205 the full amount of the taxes claimed had occurred", citing
Obviously, then,
Reviewed by the Board.
Decision will be entered under Rule 50.
SMITH, dissenting: Section 41 of the Revenue Act of 1934 provides:
The net income shall*1207 be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income. * * *
The petitioner kept its books of account upon the accrual basis and made its income tax returns in accordance therewith. In connection with such method of reporting, the United States Supreme Court, in
* * * to enable taxpayers to keep their books and make their returns according to scientific accounting principles, by charging against income earned during the taxable period, the expenses incurred in and properly attributable to the process of earning income during that period; * * * [Italics supplied.]
*94 It seems to me that, if the accrual method of accounting employed*1208 by the taxpayer for 1934 is given effect, the solution of the problem involved in this proceeding is very simple. The first three issues should be decided in favor of the petitioner and the last one against it. The only possible question relates to the second issue, viz., whether the $4,000 paid in 1934 in settlement of litigation is a capital expenditure or a deductible expense.
With respect to the first question, the majority opinion holds that moneys deposited by advertisers under advertising contracts are taxable income of the year in which the deposit is made. Petitioner takes such deposits into income as the contracts are performed. I think this method of reporting is proper under the accrual system.
The second question is whether the petitioner is entitled to deduct from gross income the $4,000 which it paid in settlement of litigation. The total amount paid, including expenses, was $5,686.13. The respondent allowed the deduction of $1,686.13, but disallowed the balance. I think that the respondent erred in such disallowance.
In my opinion it is unreasonable to consider that the $4,000 was a capital expenditure. The amount was paid for the purpose of freeing*1209 the petitioner from the harassment of a suit. In substantially a similar case,
The third question is whether petitioner is entitled to deduct from gross income a debt ascertained to be worthless and charged off during 1934. I think there is no question but that it was ascertained to be worthless in that year and there is no question as to the chargo-off. When there was a collection of a portion of the debt in 1935 that amount constituted taxable income of that year.
The fourth question is whether the petitioner's deduction for an electric light bill for 1934 should be adjusted by reason of a refund received in 1939. In my opinion there can be no question but that the amount charged for 1934 was an accruable item of that year. The refund received in 1939 accrued in 1939 and constituted income of that year. Under the rule of the Supreme Court in *1210
VAN FOSSAN, dissenting: I am unable to agree with the holding of the majority on the fourth stated issue.
On the question raised by the fourth issue, I recognize that there has not been entire consistency in the opinions of the Board. I believe, *95 however, that correct principles were announced in
Income tax liability must be determined for annual periods on the basis of facts as they existed in each period. When recovery or some other event which is inconsistent with what has been done in the past occurs, adjustment must be made in reporting income for the year in which the change occurs. No other system would be practical in view of the statute of limitations, the obvious administrative difficulties involved, and the lack of finality in income tax liability which would result. * * *
The majority opinion attempts to distinguish the Block case and the decision in *1211
STERNHAGEN and ARNOLD agree with this dissent.
MURDOCK, dissenting: The petitioner accrued and paid in 1934 the full charge for electric current. It never contested the amount and had no way of knowing in 1934 that any of the amount paid would ever be refunded. The accrual, the deduction claimed, and the allowance thereof for 1934 were all in accordance with proper accounting principles and with the statute. The matter ought to end there. The issue*1212 of whether the taxpayer should be required, at its own instance, to pay more tax than the Commissioner seeks to collect, is a false issue and whatever is said in deciding it must necessarily be obiter. The real question which the petitioner wants us to decide is that the refund was not income when it was received in 1939. But that question can not be decided here.
Furthermore, much that is said on this subject in the majority opinion is wrong. I dissent from the opinion that deductions and income should be permitted to depend upon the wholly unrelated circumstance that the statute of limitations has or has not run. 1 The *96 correct rule, that income tax liability must be determined for annual periods upon the basis of facts as they existed in each such period, is not only inconsistent with the rule favored by the majority, but it has been approved by the highest court and followed many times by the courts and the Board.
The majority recognizes that the statement of any rule in
STERNHAGEN, BLACK, and ARNOLD agree with this dissent.
Footnotes
1. The refund involved other years besides 1934 and, under this decision, parts may be income, parts may not, depending upon whether or not those years were closed when 1939 is being closed and, perhaps, upon how the item was adjusted for those years. ↩