*2152 The proper method of computing the income of the partnership of Howell & Graves for the years 1922 and 1923, determined.
*1318 These proceedings, which were duly consolidated for hearing and decision, are for the redetermination of deficiencies in income tax asserted by the respondent as follows:
| 1922 | 1923 | |
| Calvin T. Graves | $36,267.01 | $43,129.85 |
| Alfred L. Howell | 44,400.75 | 42,691.27 |
*1319 The petitioners allege that the respondent erred in computing the net income, and therefore their distributive shares, of the partnership of Howell & Graves of which they were members.
FINDINGS OF FACT.
The petitioners were during the years 1922 and 1923, members of the partnership of Howell & Graves, which had its principal office at New York City. The partnership in the years 1922 and 1923 was engaged in the business of subdividing, developing and marketing real estate located at Muscle Shoals, Ala. In 1922 the partnership purchased 160 acres, and in*2153 1923, 100 acres of unimproved land at that place. It then proceeded to develop the property by subdividing it, laying out, grading and paving streets, constructing sidewalks, curbs and gutters, installing a lighting system and water system, including storage tank, water mains and laterals and fire plugs, and setting out shade trees. When these improvements had been made the lots so laid out were offered for sale and written instruments relative thereto were entered into by the partnership. The lots were offered for sale at an average price of $1,800 per lot, and, pursuant to the written instruments, 25 per cent of the purchase price was paid to the partnership by the prospective purchaser and the remainder was to be paid in monthly installments. The written instruments covering the lots were, except as to the name of the prospective purchaser, the amount of the purchase price, and the number of the lot, identical, and were as follows:
HOWELL & GRAVES
MUSCLE SHOALS CENTER NO. 2
This agreement made and entered into this day of , 192 , by and between Howell & Graves, of Detroit, Michigan, of the first part, and of the second part, WITNESSETH:
That for the consideration hereinafter*2154 named, the said Howell & Graves agree for themselves, their successors and assigns, to convey by general Warranty Deed, and furnish abstract showing merchantable title, to the second party heirs, and assigns the following described real estate, to wit:
All that tract or parcel of land situate in Colbert County, State of Alabama, known and distinguished as lot number of Howell & Graves Muscle Shoals Center Addition No, 2, of the N. 1/2 of the N.E. 1/4 of Section 36, Town 3, Range 11 W., as laid down on a map filed in the office of the Probate Judge, Colbert County, Alabama, upon the prompt and punctual performance by the said party of the second part of the following terms and conditions; that the party of the second part shall pay to Messrs. Howell & Graves for such land the sum of $ as follows: $ in case upon the execution and delivery of this agreement, the receipt whereof is hereby *1320 acknowledged, and the balance, to-wit, the sum of $ with interest thereon at the rate of six per cent (6%) per annum, by the payment of at least the sum of $ on the first day of each month hereafter until the whole amount thereof, together with the interest thereon on all unpaid balance, *2155 has been fully paid it being understood and agreed that out of each monthly payment so made there shall first be deducted the accrued interest and the balance remaining to be credited on principal. The said parties of the first part agree to accept additional payments before due and agree to give five per cent discount for cash in thirty days, or two per cent discount if paid in one year from date hereof.
It is further agreed that if the party of the second part defaults in the monthly payments herein provided, for a period of thirty days after any of said payments shall become due and payable, that then the balance remaining unpaid, together with the interest thereon as above provided, shall immediately become due and payable, anything herein contained to the contrary notwithstanding, or the said parties of the first part may at their option, declare this agreement at an end, and thereupon the said party of the second part agrees, upon receipt of written notice from the said parties of the first part of their election to declare this agreement at an end to surrender possession of said premises and to surrender the duplicate of this agreement properly cancelled without foreclosure*2156 proceedings or other process of law.
It is further conditioned that the first party shall pay all city, county, and state taxes legally assessed against said premises, which are due and payable up to date, and upon full payment of the purchase price, together with any payments of interest that may be due on deferred payments, to execute and deliver a good and sufficient Warranty Deed excepting from said warranty all liens and encumbrances which may have accrued on said land or buildings subsequent to the date hereof by or through the acts of negligence of said party of the second part, or his assigns, which deed shall contain the same building restrictions, if any, contained in this agreement.
It is further guaranteed and made a part of this contract, that the party of the first part agrees to install sidewalks, water mains, shade trees, and graded streets, at no additional cost to the party of the second part, the installation of said improvements to be started at a time not later than when the Government factories at Muscle Shoals nitrate plant number two begin operations.
It is further understood and agreed that the said party of the second part shall pay all taxes and*2157 special assessments levied against said premises subsequent to the date of execution and delivery of this agreement.
This agreement is not assignable by the second party without the consent in writing of the first party first had and obtained.
It is further understood and agreed that the premises herein agreed to be sold, are sold subject to the following restrictions, to which the said party of the second part agrees to conform, to wit:
Said premises shall not be sold or leased to, or occupied by, any person other than of the Caucasian race.
No advertising sign or billboards larger than three (3) feet square shall be erected on any of said lots, except advertising signs of Howell & Graves.
Only single dwelling houses, duplex, or double houses and their appurtenances shall be erected on any of said lots numbered (491) to (730) both inclusive, and the front foundation walls of said residences exclusive of bay windows, porches, or cornice, shall be erected on said lots not nearer than twenty feet *1321 to the front lot line thereof, and that all residences erected on said lots shall cost not less than ($2,500).
The side foundation walls of all residences erected*2158 on said lots shall be placed not nearer than four (4) feet to the side lines of said lots.
Only business houses or business blocks shall be erected on lots numbered (1 to 490), both inclusive, and all buildings erected on said lots shall cost not less than $2,500, and no building or other structure shall be erected on said lots nearer than five feet to the front line thereof.
Second party also shall pay to the said Howell & Graves during the month of December in the years 1923, 1924, 1925 and 1926, the additional sum of Five Dollars for each lot purchased. Said Howell & Graves agree that the money so received shall be expended in the unkeep and improvement of said subdivision.
It is expressly agreed that no obligation is, by the terms of this option imposed upon the party of the second part to perform any of the conditions hereof, but that upon a failure of said second party to perform or observe any one or more of said conditions the said first party shall have the right to declare this option terminated, void and of no effect, and to retain all payments made hereon as liquidated damages. Notice of such termination may be given said second party by mail or by posting on*2159 the premises or any part thereof. The nonexercise by the first party of this right of termination shall not be held to prevent its exercise in the event of any other or subsequent failure to perform a condition hereof.
All the terms of the foregoing agreement shall be binding upon the heirs, administrators, executors, successors and assigns of the parties hereto, and for their benefit.
The party of the first part assumes no responsibility for statements or representations made by any of their agents which are contrary to this agreement.
IN TESTIMONY WHEREOF the parties have hereunto subscribed their names at , this day of , 192 .
HOWELL & GRAVES.
(L.S.)
(L.S.)
No note or any kind of security was received by the partnership for the unpaid part of the purchase price, and the partnership delivered neither title to nor possession of any lot until the purchase price had been paid in full. It was the plan of the partnership to secure monthly payments of 2 per cent of the purchase price, but the monthly payments in fact varied and usually ran from 1 per cent to 1 1/2 per cent of the purchase price of the lots. The full purchase price of a lot was not received by the*2160 partnership, if at all, until four to six years from the date of the written instrument. In the event that the prospective purchaser failed to make the payments as provided by the written instrument, the amount he had theretofore paid to the partnership was retained by the partnership.
The petitioners' books of account were as follows:
(1) Cashier's Receipt Book, containing a daily record of all cash receipts, the amount thereof, the allocation to interest and principal, the name of the payor, the subdivision and lot numbers, and statements of the year in which payments were received for lots.
*1322 (2) Cash Receipts Book, which was a summary of the daily totals of the cashier's records, and a record of unusual and non-routine transactions.
(3) Cash Disbursements Book, showing all disbursements and the purposes for which they were made.
(4) Sales Book, setting forth the details of the lot transactions and containing the name of the customer, the date of sale, the amount of the sale price, the subdivision and lot numbers, and the amount of commissions due salesmen.
(5) Purchase Journal - discontinued late in the year 1922.
(6) A journal, which was the miscellaneous*2161 daily entry book, taking care of all entries for which there was no other place provided.
(7) Accounts Payable Ledger, which showed the amount due each salesman.
(8) Accounts Receivable Ledger, which showed the amount unpaid on each lot contract.
(9) General Ledger, which was composed of an asset ledger, a liability ledger, an income ledger, and an expense ledger. This ledger was not complete in itself, but was controlled by the Private Ledger, which was the real controlling book of the partnership.
(10) Private Ledger, which set up the gross amount of lot transactions and the cost thereof, the receipts from such transactions, the gross profit therefrom, and the amount of profits taxable in each year. This ledger showed the amount of profits on the basis of actual receipts from the lot transactions, allocated to cost and profit in the proportion that each bore to the selling price. Expenditures were entered on this book in summary showing only actual disbursements. Cash receipts were entered opposite to the gross amount of the lot transactions.
The petitioners' books were kept in the following manner: There were entered therein all cash received and all cash paid*2162 out, and the gross and net profits were computed on a prorated basis; that is, cash received on each lot was allocated between cost and profit in the proportion that each bore to the total amount specified in the written instrument covering the lot.
The partnership of Howell & Graves filed returns of income for the years 1922 and 1923, reporting their income for those years as computed on the installment basis of accounting. The respondent, upon audit of the returns, determined that the income of the partnership should be computed on the accrual basis and that there should be included in gross income for each year the face value of the written instruments entered into in that year relative to the sale of lots.
In the year 1922 written instruments of the form above set forth, were entered into relative to the sale of lots by the partnership of Howell & Graves and prospective purchasers in the amount of $443,650. The total receipts of the partnership in that year were $134,897.88, of which amount $7,637.50 was received on transactions in which not to exceed 25 per cent of the purchase price was paid in the taxable year, $1,423.96 represented forfeited options, and $5,812 represented*2163 income from sources other than the sale of property. The cost of the lots with respect to which the written instruments were executed was $116,616.28. The actual expenses paid out by the partnership in carrying on the business in 1922 were $114,631.53.
*1323 In the year 1923 the partnership and prospective purchasers executed written instruments of the form above set forth, relative to the sale of lots, the face value thereof being $866,550. The instruments in which not more than 25 per cent of the purchase price was paid in the taxable year were of the face value of $133,380, and on these the partnership received $33,345. Forfeited "options and contracts" were in the amount of $48,104.04, and $8,543.26 was received from sources other than the sale of property. The total receipts of the partnership were $412,019.72. The cost of the lots with respect to which the written instruments were executed was $326,472.32. The amount actually paid out by the partnership in the taxable year in carrying on its business was $314,579.
OPINION.
MARQUETTE: The issue herein is as to the proper method of computing the income of the partnership of Howell & Graves, of which the petitioners*2164 were members. The respondent has computed the income of the partnership upon the accrual basis and has included in income for 1922 and 1923 the face value of the written instruments executed by the partnership and prospective purchasers of lots in those years. The petitioners contend that the written instruments in question were mere options, or, if not options, installment contracts which did not bind the purchaser to make any payments; that, therefore, there was no income to accrue; that the income from the transactions in which not more than 25 per cent of the purchase price was received by the partnership within the taxable year in which the transactions were entered into should be computed on the installment basis; and that the other transactions should be considered as deferred payment sales not on the installment plan in which the deferred payments have no readily realizable market value.
We do not deem it necessary to indulge in an extended discussion as to the nature of the written instruments involved herein. It is sufficient to say that by their terms the partnership was obligated to convey to the prospective purchaser certain lots, if and when the purchaser paid to*2165 the partnership certain specified amounts. The prospective purchaser was under no obligation to make any payment subsequent to the initial payment. He could not be compelled to continue the payment and an action could not be maintained against him for the unpaid amount. He was subject only to forfeiture of payments already made. Until payment was made in full, the partnership retained both title and possession of the lots.
In view of these facts, it seems clear that the respondent erred in computing the partnership income on the accrual basis. As we understand the meaning of accrual, an item of income or expense *1324 accrues when it becomes an obligation receivable or payable, as the case may be. In this case there was no obligation on the part of the prospective purchaser to make the subsequent payments and there was, in our opinion, nothing to accrue.
Since the partnership should not be required to compute its income on the accrual basis, we must determine upon what basis its income should be reported. Under the peculiar facts of the case it is indeed difficult to determine what method will fairly reflect the true income of the partnership, and any method that*2166 may be adopted may not be entirely satisfactory. We are of the opinion, however, that in the case of those transactions in which not to exceed 25 per cent of the purchase price was received by the partnership within the taxable year, the income therefrom should be computed on the installment basis, which practice is now authorized and validated as to the years 1922 and 1923 by section 212(d) and section 1208 of the Revenue Act of 1926.
In the transactions in which more than 25 per cent of the purchase price was received by the partnership in the fiscal year, the deferred payments clearly had no fair market value and were not the equivalent of cash to any extent. We are therefore of the opinion that these transactions should be treated as deferred payment sales, not on the installment plan, in which the deferred payments had no readily realizable market value.
All payments forfeited to the partnership should be included in income of the year in which the forfeiture occurred to the extent that they had not theretofore been reported as income.
Reviewed by the Board.
Judgment will be entered under Rule 50.