1931 BTA LEXIS 2157">*2157 1. CONTINGENT RESERVES NOT DEDUCTIBLE. - Where petitioner set up on its books during a taxable year certain reserves for the payment of salesmen's commissions which should come due in the following year when and if the accounts upon which they are based are paid, held, such reserves are not deductible in determining taxpayer's net income.
2. INVENTORIES used in computing the cost of goods sold must be computed at the beginning and end of each year on substantially the same basis. Respondent's action in excluding items amounting to $86,814.20 from petitioner's opening inventory in 1923 and failure to exclude similar items from petitioner's closing inventory in 1923, resulting in increasing petitioner's income for 1923 by $86,814.20, was error. Thomas Shoe Co.,1 B.T.A. 124">1 B.T.A. 124, followed.
22 B.T.A. 175">*175 The respondent determined deficiencies for the year 1923 of $9,165.26 and for 1924 of $888.03. Petitioner seeks redetermination and alleges certain errors which will be fully stated in the opinion.
FINDINGS OF FACT.
The petitioner is1931 BTA LEXIS 2157">*2158 an Illinois corporation, with its principal office at 352 East 22nd Street, Chicago, Ill. It is engaged in the business of publishing classified business telephone directories under an arrangement with various local companies of the Bell Telephone System, including New York and Chicago. Petitioner receives no compensation from the companies, nor from the telephone subscribers, but delivers its books free to telephone subscribers. Its compensation is derived from advertising matter and extra listings of subscribers. There are no sales of the books, but the advertising space is sold through its soliciting agents. In some cities these books are published and distributed twice in each year and in others only once.
22 B.T.A. 175">*176 Prior to 1923 the petitioner kept its accounts on what is described in the evidence as partly cash and partly accrual, and under this system in the year 1922 it charged to expense and received deduction for certain items of overhead expense incurred in directories not published in 1922 but "in process," amounting to $86,814.20.
In the latter part of 1922 petitioner employed a firm of reputable certified public accountants for the purpose of revising its1931 BTA LEXIS 2157">*2159 accounting system and placing it upon a complete accrual basis. Prior to 1923 the inventories included only direct charges against the publication and officers' salaries and wages and such items of physical property as the petitioner actually owned. In 1923 this so-called inventory was extended so as to include all costs, direct and indirect, relating to the publications not published but "in process" at the end of the year and thus show complete work in process on the publications at the end of each year. In the opening inventory for 1923 petitioner added $86,814.20 representing certain overhead items or charges which had been charged to expense in 1922 and allowed as a deduction and which related to directories not published in 1922 but in process at the end of that year. The same class of charges was included in petitioner's closing inventory for 1923. The respondent disallowed this item of $86,814.20 and added it to income for 1923, but made no corresponding adjustment in petitioner's closing inventory for 1923. Petitioner's opening inventory for the year 1923 was $333,689.45 and its closing inventory for 1923 arrived at on the same basis was $362,452.78. Petitioner's opening1931 BTA LEXIS 2157">*2160 inventory for 1924 was $362,452.78 and the closing inventory for the year 1924 arrived at on the same basis was $227,040.25. None of the overhead items which were added to the opening inventory for 1923 represented tangible property.
The contracts for advertising or extra listings were obtained by soliciting agents or salesmen who were paid on a commission basis, against which they had drawing accounts. This commission was not payable until the charge for the advertising was collected from the customer. In 1922 and prior years these commissions were treated on the books on a strictly cash basis and were not charged on the books as an expense until actually paid to the salesmen. In 1923 and 1924 under petitioner's changed system of accounting, liabilities for these salesmen's commissions were set up on the books by way of a reserve against such commissions as soon as the directory was published and delivered, although a large part of the accounts had not been collected from the advertisers. These reserves related only to the publications actually published and commissions on contracts under which the customers were liable. At the end of 1923 there was set up as a liability1931 BTA LEXIS 2157">*2161 of petitioner to its salesmen a reserve 22 B.T.A. 175">*177 of $12,931.18, although the accounts against customers on which this sum was payable as commissions had not been collected. For the following year 1924 the amount set up in such reserve was $29,954.18. These reserves for unpaid commissions were disallowed by the respondent and added to income for the respective years.
In November, 1923, the taxpayer applied to the Commissioner for permission to adopt the new method of accounting explained above in making its return for the year 1923. The Commissioner replied that it did not appear that the change of method of accounting was the sort of change contemplated by article 23 of Income Tax Regulations 62 and that therefore the application for permission to make the change was unnecessary.
Respondent computed the deficiencies as follows:
| 1923 | ||
| Net income reported | $60,691.80 | |
| Additions: | ||
| 1. Excess reserve for bad debts | 50,540.14 | |
| 2. Bad debts allowed in 1922, hence excess in 1923 | 30,783.42 | |
| 3. Reduction in opening inventory | 86,814.20 | |
| 4. Increase in salesmen's commissions accrued disallowed | 12,931.18 | |
| Total | $241,760.74 | |
| Deductions: | ||
| 5. Additional deduction for bad debts | $104,009.84 | |
| 6. Additional collection expense applicable to 1923 | 1,363.51 | |
| 7. Additional depreciation | 2,373.49 | |
| 107,746.84 | ||
| Net income adjusted | $134,013.90 |
1931 BTA LEXIS 2157">*2162 Explanations
* * *
3. Inasmuch as the opening inventory is reduced, the cost of goods sold is likewise reduced and the net income increased accordingly.
4. Since the reserve for salesmen's commissions accrued is an estimated amount it is a true reserve and the increase therein does not constitute an allowable deduction.
* * *
| Computation of Tax | ||
| Net income subject to tax at 12 1/2% | $134,013.90 | |
| Tax liability | 16,751.74 | |
| Tax assessed | 7,586.48 | |
| Deficiency | 9,165.26 | |
| 1924 | ||
| Net income reported | $82,114.84 | |
| Additions: | ||
| 1. Overstatement of collection expense | 30,080.37 | |
| 2. Increase in salesmen's commissions | 29,954.18 | |
| Total | $142,149.39 | |
| Deductions: | ||
| 3. Additional allowance bad debt reserve | $50,540.14 | |
| 4. Additional depreciation | 2,390.20 | |
| 52,930.34 | ||
| Net income adjusted | 89,219.05 | |
| Computation of Tax | ||
| Net income subject to 12 1/2% | $89,219.05 | |
| Tax liability | 11,152.38 | |
| Tax assessed | 10,264.35 | |
| Deficiency | $888.03 |
22 B.T.A. 175">*178 OPINION.
BLACK: Petitioner complains of two errors committed by the respondent. (1) The action of respondent in disallowing as a deduction, reserves of $12,931.18 for the year 19231931 BTA LEXIS 2157">*2163 and $29,954.18 for the year 1924, set up on the books of the petitioner to pay commissions to salesmen on advertising contracts which they had secured for petitioner; (2) the action of the respondent in adding $86,814.20 to petitioner's income for 1923 by reducing petitioner's opening inventory for 1923 in that amount.
Section 212(b) of the Revenue Act of 1921, which was applicable to the return of the taxpayer for the year 1923, reads as follows:
The net income shall be computed upon the basis of the taxpayer's annual accounting period * * * in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; * * *
Regulations 62, which were applicable to that return, contained the following provisions:
It is recognized that no uniform method of accounting can be prescribed for all taxpayers, and the law contemplates that each taxpayer shall adopt such forms and systems of accounting as are in his judgment best suited to his purpose. (Article 24.)
Approved standard methods of accounting will ordinarily be regarded as clearly reflecting income. (Article 23.)
The Act provides two tests to which each inventory must conform: (1) It must1931 BTA LEXIS 2157">*2164 conform as nearly as may be to the best accounting practice in the trade or business, and (2) it must clearly reflect the income. It follows, therefore, that inventory rules cannot be uniform but must give effect to trade customs which come within the scope of the best accounting practice in the particular trade or business. * * * An inventory that can be used under the best 22 B.T.A. 175">*179 accounting practice in a balance sheet showing the financial position of the taxpayer can, as a general rule, be regarded as clearly reflecting his income. (Article 1582.)
The 1924 Act and regulations thereunder are substantially the same as above.
During the taxable years petitioner kept its books on the accrual basis and undoubtedly would have the right to accrue on its books any expense liability which it had actually incurred but had not paid during the taxable year. Such expense liability to have been properly accrued, however, must have been one which was fixed and definite and not merely contingent. Any system of bookkeeping which accrues contingent liabilities as expense items does not correctly reflect income. 1931 BTA LEXIS 2157">*2165 Crescent Cap Co.,10 B.T.A. 1">10 B.T.A. 1; Kaufmann Department Stores, Inc.,11 B.T.A. 949">11 B.T.A. 949.
It is true, when petitioner published its directories, the amounts due it from customers on their advertising contracts were immediately charged to such customers' accounts and accrued as income on the books of the petitioner and went into its gross income for that year. It may be inquired why such items should be accrued as income and the amounts due salesmen as commissions on these advertising contracts should not be accrued as expense. We think the answer lies in the fact that the accounts for advertising were unconditionally due when the directories were published, whereas the amounts due salesmen for commissions were contingent upon the customers paying their accounts.
The uncontradicted evidence in this proceeding was to the effect that the commisions to be paid the salesmen for procuring advertising contracts were not due until the advertisers had actually paid the accounts. If the advertiser never paid for his advertising space, the salesman never got any commission on that particular contract. It is true the salesmen were given drawing accounts and were1931 BTA LEXIS 2157">*2166 permitted to draw certain sums of money to meet their running expenses, prior to the collection of the accounts, but no salesman was credited any commission for having procured an advertising contract until that account was actually paid.
Petitioner cites American National Co. v. United States,274 U.S. 99">274 U.S. 99, in support of his contention. We do not think that case supports petitioner's contention. In that case, as stated by the Court, "The company consistently kept its books of accounts from year to year on an accrual basis. Under the practice followed from the inception of its bonus method of doing business, whenever a loan note was sold it charged on its books, as an expense incurred in the sale, the aggregate amount of the payments called for in the bonus contract, computed at one per cent per annum to the maturity of the note 22 B.T.A. 175">*180 and credited the investor on its books with a like amount, in a subsidiary bills-payable ledger. The total amount of this liability on the bonus contracts was carried on its general ledger under a control account called the Guarantee Fund Account."
In the instant case the petitioner did not charge on its books as an1931 BTA LEXIS 2157">*2167 expense incurred, the unpaid commissions to these salesmen, nor did it credit to the accounts of such salesmen the commissions on contracts for which payment had not yet been made. On the contrary, it was distinctly understood that no salesman was entitled to a credit to his commission account for any particular contract until payment had been made in settlement of that contract. What petitioner did was to set up a reserve on its books to take care of these contingent liabilities when and if they matured by the customers paying their accounts, and it contends for the right to deduct these reserves from its gross income in the taxable years. We have held in numerous cases that such reserves are not deductible. William J. Ostheimer,1 B.T.A. 18">1 B.T.A. 18; Uvalde Co.,1 B.T.A. 932">1 B.T.A. 932; H. V. Green Co.,5 B.T.A. 442">5 B.T.A. 442; Horn & Hardart Baking Co.,19 B.T.A. 704">19 B.T.A. 704. A deduction may not be accrued if it is wholly uncertain whether, at the end of the year, the amount will ever have to be paid or if the amount is contingent upon later events. 1931 BTA LEXIS 2157">*2168 Lucas v. American Code Co.,280 U.S. 445">280 U.S. 445.
The action of the respondent in disallowing these reserves as deductions is approved.
We will next discuss petitioner's second assignment of error. In this assignment, petitioner complains because respondent has reduced its opening inventory for 1923 in the amount of $86,814.20 and has made no corresponding adjustment in the closing inventory of 1923, thereby adding that much to its income. Petitioner had the right to change its method of bookkeeping, so long as the method adopted correctly reflects income. In November, 1923, petitioner sought permission from the Commissioner to change its method of bookkeeping, but the Commissioner informed petitioner that the contemplated change was not such a one as to require permission from his office. The Commissioner however, in the same letter cautioned petitioner that any such changed method must correctly reflect income and that if it did not, it would not be recognized by the Commissioner's office. The Commissioner on audit of petitioner's tax returns for the years in question has determined that petitioner's books did not correctly reflect income for those years and1931 BTA LEXIS 2157">*2169 has asserted certain deficiencies against petitioner, which we have already enumerated. The burden of proof is on petitioner to show that this determination of the Commissioner is wrong. Has it met this burden of proof? We think it has.
22 B.T.A. 175">*181 The taxpayer's business was not such a business as could be satisfactorily shown by the accounting methods appropriate for taxpayers dealing in merchandise. The "work in process" method of accounting adopted by the taxpayer seems to be the method best suited to this purpose in a business in which its income was derived from contracts, which it performed by publishing and distributing directories. In each year there was "work in process" on these directories and the change in the taxpayer's accounting method was designed to conform the taxpayer's annual accounts to this work in process.
The work in process method required that the inventories of the taxpayer include all charges against the publications in process, including the items of overhead in question. Therefore these items had to be included in the closing inventory. But to include them in the closing inventory only would clearly distort income, for it would increase income1931 BTA LEXIS 2157">*2170 by the amount of the items added. The items would become income rather than a deduction, as the taxpayer was entitled to treat them, under its old system of bookkeeping.
The correct thing to do, it seems to us, was what the taxpayer did, namely, set up a new opening inventory for the year 1923 on the new basis by including therein corresponding items of overhead carried over from the preceding year.
This did not distort income. Income would be affected only to the extent of the change of these items of overhead from year to year. The result upon income would be substantially the same as if the taxpayer had continued the previous method of taking deductions for these overhead items. Therefore the exclusion of the items from the opening inventory alone, as is proposed by the Commissioner, would necessarily greatly distort income.
It seems to us clear that if the Commissioner is to be permitted to exclude from petitioner's opening inventory for 1923 the amount of $86,814.20, representing certain overhead items, he would be required to exclude from the closing inventory of 1923 items of the same nature, and to do this would leave petitioner's income substantially the same1931 BTA LEXIS 2157">*2171 as shown on its original return for 1923 but would have the effect of throwing it back to its old method of bookkeeping - part cash and part accrual. Petitioner has the right to change its method of bookkeeping so long as such change correctly reflects income. Any system of bookkeeping which does not give consistent treatment to both opening and closing inventories of the taxable year will not correctly reflect income.
In Justus & Parker Co.,13 B.T.A. 127">13 B.T.A. 127, we said:
At the hearing it was stated by counsel for the petitioner, and not denied, that the respondent adjusted the 1920 closing inventory and did not make a corresponding adjustment of the 1920 opening inventory, and that had the opening 22 B.T.A. 175">*182 inventory been correspondingly adjusted no increase in net income would have resulted. We have held in a number of cases that the adjustment of the closing inventory by the respondent, without a corresponding adjustment of the opening inventory, was improper and resulted in a distortion of income, which could not be approved. (1931 BTA LEXIS 2157">*2172 Thomas Shoe Co.,1 B.T.A. 124">1 B.T.A. 124; Sinsheimer Bros., Inc.,5 B.T.A. 918">5 B.T.A. 918; Boyne City Lumber Co., supra. )
Respondent's action in adjusting petitioner's opening inventory for 1923 by decreasing same $86,814.20 and making no corresponding adjustment to petitioner's closing inventory for 1923, thus adding $86,814.20 to petitioner's income for 1923, was error and petitioner's assignment of error with respect thereto is sustained.
Decision will be entered under Rule 50.