*1159 Where the petitioner filed its returns for the years 1928 and 1929 on the basis of completed contracts, which method it had consistently followed for several years, and its net income computed on such basis was readily ascertainable from its books, held, that the respondent erroneously changed its returns for those years to show income reported on the accrual basis.
*1369 These proceedings, duly consolidated, are for the redetermination of deficiencies for the calendar years 1928 and 1929 in the amounts of $1,718.16 and $4,856.23, respectively. The only issue raised by *1370 the pleadings is whether the petitioner correctly reported its income from certain building and construction contracts upon the basis of the contracts completed in each year or whether, as the respondent contends, the petitioner should have reported income upon the straight accrual basis.
FINDINGS OF FACT.
The petitioner is a corporation engaged in the contracting and building business at Hartford, *1160 Connecticut. Its contracts are generally of three kinds, described as "flat contract price," "fixed fee with upset price," and "flat percentage." The petitioner's profits usually amount to about 8 or 10 per cent of the total contract price.
The petitioner's system of accounting provides for a cost or contract ledger wherein a separate account is opened for each contract. In this account are entered the contract price, the detailed costs of all labor, material, and other direct expenses connected with the particular contract, and the amounts of cash received thereon. The general ledger account is not closed into profit and loss account until the particular contract is substantially completed and final payment thereon received. Any subsequent costs, usually due to minor defects covered by the guaranty clause, are closed into profit and loss when incurred. About 90 per cent of the petitioner's contracts carry a guaranty clause holding the petitioner liable for any structural defects appearing in the work within one or two years after completion. Under the contract agreements a certain percentage of the contract price, amounting usually to 10 or 15 per cent, is withheld by the*1161 owner as a guaranty until 30 or 60 days after substantial completion of the contract.
The petitioner had eight uncompleted contracts at December 31, 1928, and three uncompleted contracts at December 31, 1929, where the elapsed time was considerably more than one year to the date of substantial completion, and others where more than one year elapsed prior to the date of final entry of costs.
The petitioner closes its books annually. At the end of each month there is prepared a profit and loss statement which contains the profits on all completed contracts and the estimated profits on all completed work on contracts in process at the end of the month. From these monthly statements an annual profit and loss statement is prepared and entered in the journal at the close of each year. This closing profit and loss statement includes the 10 or 15 per cent of the profits withheld by the owners under the guaranty clause. Computed on that basis the closing journal entries at December 31, 1928, show a profit of $9,425.51, which amount was posted to the surplus account in the general ledger. The journal entry for 1929 *1371 shows a profit of $39,378.13, which was treated in the*1162 books in the same manner.
In its returns for 1928 and 1929 the petitioner did not report any of the estimated profits on uncompleted or partially completed contracts, but reported in each year only the profits from the contracts that were finished in that year, regardless of the length of time required for their completion. It had consistently followed that method of preparing its income-tax returns since it began operations in 1921. Accordingly, the petitioner's return for 1928 shows a loss of $9,775.31 instead of a gain of $9,425.51, as reflected by its closing journal entry, and the 1929 return shows a net income of $4,248.40, and, after deduction of the 1928 net loss, no taxable income, instead of a gain of $39,378.13.
The petitioner filed with its 1928 and 1929 returns the following statements of income:
| INCOME & DISBURSEMENT STATEMENT FOR YEAR 1928 | |
| INCOME | |
| Value of Work in Process completed | $390,195.00 |
| Cost of Work in Process completed | 363,551.69 |
| Earned profit | 26,643.31 |
| Profit on Completed Contracts | 33,843.89 |
| Interest Received | 1,831.49 |
| Rent | 420.00 |
| Purchase Discount | 1,041.24 |
| White Truck Receipts | 4,733.94 |
| Reo Truck Receipts | 3,630.90 |
| Sundry Receipts | 2,464.69 |
| 74,609.46 | |
| Less Earned Profit Work in Process, | |
| Jan. 1, 1928 | 4,910.74 |
| GROSS INCOME | 69,698.72 |
| INCOME & DISBURSEMENT STATEMENT FOR THE YEAR ENDING DECEMBER 31, 1929 | |
| INCOME | |
| Value of Work in Process Completed | $1,020,492.88 |
| Cost of Work in Process Completed | 955,303.48 |
| Earned Profit in Process Completed | 65,189.40 |
| Rent | 490.00 |
| Purchases Discount | 1,768.13 |
| White Truck | 4,971.17 |
| Reo Truck | 3,371.93 |
| Sundry Receipts | 1,547.10 |
| Interest Received | 1,974.85 |
| 135,592.09 | |
| Less Earned Profit Work in Process, | |
| Jan. 1, 1929 | 26,643.31 |
| GROSS INCOME | 108,948.78 |
*1372 The expense schedules, also filed with the returns, show total expenses of $60,273.21 for 1928 and $69,570.65 for 1929. All of the figures from which the above statements were prepared were taken from the ledger accounts, except the amounts representing the value of work in process completed, which amounts represent a compilati0n of the monthly estimates made by the accountant and the petitioner's vice president and treasurer.
In his deficiency notice the respondent has computed the petitioner's taxable income for 1928 at $17,318, stating that, "The principal cause of the additional tax is the inclusion in income of earned profit on work in process, same being carried into profit on the*1164 books, but not reported as taxable income." Likewise, the respondent's deficiency notice for 1929 shows a net income of $44,147.50, due principally to the inclusion in taxable income of that year of the earned profits on contracts in process of completion at December 31, 1929. The taxable income for each of the years as determined by the respondent represents the income as shown by the closing journal entries appearing in the petitioner's books, with certain minor adjustments which are not in issue in these precedings.
OPINION.
SMITH: The respondent's contentions in these proceedings are that the petitioner kept its books upon the straight accrual basis; that under such method of bookkeeping the earned profits on the uncompleted contracts at the end of each year constituted items of accrued income of that year; that the petitioner did not have any "long-term contracts" as defined in article 334 of Regulations 74, and that the petitioner is not entitled under the regulations to report its income on the so-called long-term contract basis, but must report on the straight accrual basis, in accordance with the method of bookkeeping regularly employed by it.
The pertinent provisions*1165 of the Revenue Act of 1928 and of the Commissioner's regulations are as follows:
SEC. 41. GENERAL RULE.
The net income shall 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. * * *
SEC. 42. PERIOD IN WHICH ITEMS OF GROSS INCOME INCLUDED.
The amount of all items of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under methods of accounting permitted under section 41, any such amounts are to he properly accounted for as of a different period.
*1373 [Art. 334, Regulations 74.] Long-term contracts. - Income from long-term contracts is taxable for the period in which the income is determined, such determination depending upon the nature and terms of the particular contract. *1166 As used herein the term "long-term contracts" means building, installation, or construction contracts covering a period in excess of one year. Persons whose income is derived in whole or in part from such contracts may, as to such income, prepare their returns upon the following bases:
(a) Gross income derived from such contracts may be reported upon the basis of percentage of completion. In such case there should accompany the return certificates of architects or engineers showing the percentage of completion during the taxable year of the entire work to be performed under the contract. There should be deducted from such gross income all expenditures made during the taxable year on account of the contract, account being taken of the material and supplies on hand at the beginning and end of the taxable period for use in connection with the work under the contract but not yet so applied. If, upon completion of a contract, it is found that the taxable net income arising thereunder has not been clearly reflected for any year or years, the Commissioner may permit or require an amended return.
(b) Gross income may be reported in the taxable year in which the contract is finally*1167 completed and accepted if the taxpayer elects as a consistent practice so to treat such income, provided such method clearly reflects the net income. If this method is adopted there should be deducted from gross income all expenditures during the life of the contract which are properly allocated thereto, taking into consideration any material and supplies charged to the work under the contract but remaining on hand at the time of completion.
Where a taxpayer has filed his return in accordance with the method of accounting regularly employed by him in keeping his books and such method clearly reflects the income, he will not be required to change to either of the methods above set forth. If a taxpayer desires to change his method of accounting in accordance with paragraphs (a) and (b) of this article, a statement showing the composition of all items appearing upon his balance sheet and used in connection with the method of accounting formerly employed by him, should accompany his return.
The evidence shows, and we have found as a fact, that at the end of each of the years 1928 and 1929 the petitioner had several uncompleted contracts which covered a period of more than*1168 one year and which were therefore "long-rerm contracts" within the meaning of the regulations. The petitioner was therefore entitled under the regulations to report the income from all of its contracts either upon the basis of percentage of completion in each year (art. 334(a) ), or to report all of the income from each contract in the year when the contract was completed (art. 334(b) ). The petitioner chose the latter method and reported in its returns for each of the years 1928 and 1929 the actual profits on contracts substantially completed within the taxable year.
Article 334 of Regulations 74, quoted in full above, gives the taxpayer the option of preparing its returns upon the so-called completed-contract basis. It imposes no condition except that the method of reporting shall clearly reflect the true net income. It makes no *1374 mention of bookkeeping methods except to provide that, "Where a taxpayer has filed his return in accordance with the method of accounting regularly employed by him in keeping his books and such method clearly reflects the income, he will not be required to change to either of the methods above set forth. * * *"
*1169 We see no reason why, as a general proposition, the use of the accrual method of keeping the books should be said to preclude the use of the long-term contract method of reporting income as provided in article 334. In ; affirming , the court said:
* * * In the choice of the accrual or cash basis method of accounting, the matter is left to the discretion of the taxpayer regardless of the actual effect upon the amount of the tax, and there seems no good reason why in the special cases of long term contracts the taxpayer should not have the right to suspend in the job account both expenses and receipts until it is ascertained whether on the whole job there has been a profit or loss. That was done by the taxpayer in this case. * * *
It seems to us that under the law and the regulations the method regularly employed in making the returns is a more important consideration than the method of keeping the books, and that where a taxpayer has for any year filed a return, consistent with its method in prior years, which clearly reflects its net income as readily ascertainable from its*1170 books and records, it should neither be required nor permitted to change the return to show a different taxable income computed by some other method which is said more nearly to conform to the book income.
The facts in the instant proceedings are similar to those in , where we refused to permit the taxpayer to change his returns, in which he had reported his income upon the accrual basis, to a completed-contract basis. To the same effect is . We found in the H. Stanley Bent case, though not in the Ellis case, that the returns were prepared strictly in accordance with the method of bookkeeping employed by the taxpayer, which is perhaps not the situation in the instant case since the income shown on the return was not the same as that shown in the closing journal entries, but it appears nevertheless that the returns were prepared in accordance with the final and correct general ledger entries. It is apparent that the net income as reported in the returns was readily ascertainable from the figures contained in the petitioner's books and in our opinion there was a substantial conformity in*1171 the method of keeping the books and making the returns.
It further appears that there was a considerable variance in many of the contracts between the estimated profit, which was computed *1375 monthly and carried to the closing profit and loss statement, and the actual profit as determined upon final completion of the contracts. We held in , that where accounts are so kept that taxable income can be accurately computed on the accrual basis and can not be estimated on the installment basis, the accrual and not the installment basis should be used. The situation here is parallel. The petitioner's accounts were so kept that its income could be accurately computed upon the completed-contract basis and only estimated inaccurately upon the accrual basis.
Upon the facts before us we would feel compelled to deny the petitioner's contention, if made, for the right to change its return from the completed-contract to the accrual basis. Likewise, we are of the opinion that the respondent is in error in his requirement that the petitioner's returns should be so changed.
Judgment will be entered under Rule 50.