*880 1. The petitioner is a contractor and files its income tax returns on the calendar year basis. Some contracts are begun and completed within the taxable years. Others are begun in one taxable year and completed in the next. In keeping its books and filing its income tax returns, it computes income on the basis of completed contracts. Held, that it may not take a deduction in the taxable year 1937, as a reserve for loss, of an amount estimated as the loss sustained in that year on a contract begun in that year and completed in 1938.
2. In 1937 petitioner purchased for $200 a dredge that had been lying on the bottom of Lake Erie for three months and expended $9,480.73 in raising the dredge and putting it into serviceable condition. Of the amount so expended, $7,537.35 was deducted by the petitioner on its return as business expense. Petitioner now concedes that $7,414.54 representing the cost of raising the dredge and rearranging and rebuilding the house part thereof was not a business expense, but does contend that the remaining $2,066.19 expended in reconditioning and restoring the hull and the motor to the condition they were in at the time the dredge was sunk is deductible. *881 Held, that the deduction so claimed does not represent an ordinary and necessary business expense within the meaning of the statute and is not allowable.
*302 The Commissioner determined a deficiency of $20,019.59 in the petitioner's income tax and of $1,703.97 in its excess profits tax for 1937. The only questions for decision are whether the petitioner is entitled to deduct (1) $61,031.40 as a reserve for loss on a construction contract begun by it in 1937 and completed in 1938, and (2) $2,066.19 as a business expense.
FINDINGS OF FACT.
The petitioner is a Delaware corporation, with its principal office in Cleveland, Ohio. It filed its income tax return for 1937 on the *303 calendar year basis, with the collector of internal revenue for the eighteenth district of Ohio.
Since 1926 the petitioner has been engaged principally in marine construction work embracing dredging, the building of breakwaters, and the performance of subaqueous work of all kinds, and filed its income tax returns on the calendar year*882 basis. During this period the petitioner has undertaken on an average of from 45 to 50 projects annually. Prior to 1935 all projects begun during a given year were completed within that year. In 1935 it began 1 project which was not completed until the succeeding year. In 1936 it began 4 projects which were completed in 1937. In 1937 it began 2 projects which were completed in 1938. So far as disclosed none of the contracts under which projects were begun in one year and completed in the following year contemplated or required a period in excess of 12 months for completion.
One of the projects begun in 1937 and completed in 1938 was the construction of an intercepting sewer and sewage treatment project at Buffalo, New York, sometimes referred to as the Buffalo project. The contract for the project was with the Buffalo Sewer Authority, sometimes referred to as the authority, and was awarded to the petitioner under competitive bidding. The contract was approved on August 14, 1937. It provided for the completion of the project in 225 consecutive calendar days from the date of notice by the authority to proceed with the work, unless such period should later be extended by the*883 authority. The specifications and contract contemplated completion of the project as a whole, and that was petitioner's understanding in submitting its bid. The project was shown, however, in 17 separate items, and as to 4 payment was to be made on the lump sum basis, while as to the others payment was to be made at a unit price. At the time the petitioner entered into the contract it was estimated that the total amount to be received for the completion of the project would be $382,249.02, and the performance bond given by the petitioner to the authority was for that amount.
The petitioner began work on the Buffalo project on August 16, 1937, and completed it on or about July 10, 1938. Under the contract the petitioner received monthly payments from the authority based on progress estimates made by the engineers for the authority, which in turn were predicated upon the work done and materials furnished. Only 90 percent of the amount of the monthly progress estimates was currently payable or paid to the petitioner, the remaining 10 percent being retained until the completion of the contract and subject to forfeiture in event of its nonfulfillment. During November 1937, the*884 petitioner encountered subsurface difficulties which *304 resulted in greater labor and material costs than it originally had anticipated. At the time the petitioner prepared its bid it estimated labor costs of $99,000 for the entire project. By December 31, 1937, the progress estimates made by the authority's engineers indicated that the project was 46.96 percent completed and totaled $182,189.62. By that time the petitioner's labor costs had amounted to $100,349.18 and its total costs to $244,369.30, or $62,179.68 in excess of the total of progress estimates. After it had encountered the unanticipated difficulties petitioner filed complaints with the authority as the work progressed, in order to lay a basis for a formal claim if it should later decide to make a claim for compensation in excess of that provided for in the contract. Under the existing contract, however, the responsibility for judging the sufficiency of its estimates of costs and conditions affecting the execution of the project rested entirely on the petitioner. No formal claim for additional compensation was filed in 1937, but in 1938, when the work was completed, the petitioner did file with the authority*885 formal claim for compensation beyond that provided in the contract to cover the unanticipated costs it incurred in completing the project. Labor costs alone for the entire job amounted to $222,177.93. In final settlement the authority, without the contract so providing, paid the petitioner approximately $24,000 in addition to the $382,249.02 originally estimated to be paid under the contract. The petitioner's loss on the project after making allowance for the receipt of the $24,000 was $95,343.26.
On or after December 31, 1937, the petitioner debited an account on its books designated "Cost of Jobs - Miscellaneous" with an amount of $61,031.40, with the following explanation:
| Buffalo Sewer Authority Job in progress as of Dec. 31, 1937 - Cost | $244,369.30 |
| Estimates allowed on 46.96% of project completed to Dec. 21, 1937 | 182,189.62 |
| Cost is 134% of estimates allowed. | |
| Completed contract price is 382,249.02 Continued loss at 134% would cost 512,213.68 to complete causing a loss of 129,964.66. | |
| 46.96% of 129,964.66 represents known loss as of Dec. 31, 1937. |
In its income tax return for 1937 the petitioner deducted as a reserve for loss on the contract the $61,031.40, *886 computed in the foregoing manner. In determining the deficiency the respondent disallowed the deduction on the ground that the loss was not evidenced by a closed and completed transaction.
With respect to projects begun in one year and completed in the subsequent year, even though on a unit price basis, it has been the practice of the petitioner to enter currently on its books the receipts from such projects and the expenditures incurred thereon, but under the method of accounting employed by it the profit or loss on such *305 projects was not reflected in its income until the year of completion of the projects. It has been the practice of the petitioner in filing its income tax returns to report in the year of completion the gain or loss resulting from projects begun in the preceding year and completed in the current taxable year. In conformity with that practice the petitioner, in filing its 1937 return, completely ignored the Buffalo project so far as income and expenditures were concerned except to deduct as a reserve the $61,031.40. In its income tax return for 1938 the petitioner showed the total receipts and the total expenses of the Buffalo project and from the*887 expenses subtracted the $61,031.40 taken in its 1937 return, thereby taking as a loss in 1938 on the project the difference between $95,343.26, loss actually sustained, and $61,031.40, deducted as a reserve in 1937, or the amount of $34,311.86. After thus taking the $34,311.86 as a loss the petitioner reported a loss in 1938 of about $20,000.
In 1937 the petitioner purchased for $200 from a salvage association representing certain underwriters a 12-inch suction dredge called the "Gala Water." At the time the petitioner purchased the dredge it was on the bottom of Lake Erie and under about 30 feet of water, where it had been for about three months. In negotiating the purchase of the dredge the petitioner estimated that an expenditure of about $2,500 would be required to raise the dredge and put the motor in a serviceable condition, and that an expenditure of about $2,000 would be required to rebuild the house part of the dredge and to do certain other things necessary to make the dredge usable. The petitioner had never before undertaken the raising of a dredge and did not have much experience in activities relating thereto. The actual cost to the petitioner of raising the dredge*888 and putting it in usuable condition was $9,480.73, of which $1,914.54 represented the cost of rearranging and rebuilding the house.
Of the $9,480.73 expended on or in connection with the raising of the dredge, the petitioner treated the $1,914.54 on its books as representing additions and betterments and therefore a capital expenditure. Of the remainder, it treated $7,537.35 as an expense and deducted that amount in its income tax return for 1937 as repairs to dredge. The record is silent as to the treatment accorded $28.84 representing the balance of the $9,480.73. In determining the deficiency the respondent disallowed the $7,537.35 as a deduction on the ground that it constituted a capital expenditure.
OPINION.
TURNER: The petitioner contends that it kept its books and filed its income tax returns on the accrual basis; that the Buffalo contract, which did not contemplate or require in excess of twelve months for *306 completion, was not a "long-term" contract as defined by the respondent's regulations, and that therefore the deduction of $61,031.40 taken in its 1937 return as a reserve for loss should be allowed in order to clearly reflect its income. The respondent*889 contends that, since the petitioner has consistently reported its taxable income from contracts begun in one year and completed in the following year on the completed contract basis, and since the Buffalo project was not completed until 1938, the allowance of the deduction sought by the petitioner would result in a distortion of its taxable income for both 1937 and 1938.
The evidence shows that the first of the petitioner's contracts on which work was begun in one year and completed in the following year was in 1935. So far as disclosed, none of petitioner's contracts of that type covered a period in excess of twelve months from beginning until completion. The testimony of its secretary-treasurer, who had charge of its books, shows that under the petitioner's method of accounting for and reporting income from such contracts it was its practice to report the income received and the costs incurred with respect to specific projects in its return for the year of completion. Such a practice contradicts the petitioner's contention that it kept its books and filed its returns on the accrual basis. For as we said in *890 ; affd., :
* * * When, as here, the specific project accounts have been withheld from profit and loss until the completion of the project and this in disregard of and intervening annual period, it can not be said that the taxpayer's accounting method is one of the annual accrual of net income.
From the evidence it is apparent that the petitioner accounted for and reported its income by the completed contract method. So far as disclosed, the respondent has consistently accepted such method as correctly reflecting the petitioner's income and, we think, properly so. ;; affd., ; ; ; affirmed on this point, ; certiorari denied, ; .
With respect to the Buffalo project the petitioner, under the guise of a reserve for loss, seeks to depart from its established practice of accounting for*891 and reporting income and to deduct in its 1937 return an amount representing a prorated portion of its total estimated loss on the project. Where, as here, the method of accounting employed by the taxpayer clearly reflects income, to permit such departure would not result in the petitioner's net income being computed "in accordance with the method of accounting regularly employed in keeping the books of such taxpayer", as is required by the statute. *307 Sec. 41, Revenue Act of 1936. The allowance of such departure would, as respondent contends, result in a distortion of income for both 1937 and 1938. We are of the opinion that the action of the respondent with respect to this issue is correct, and it is therefore sustained.
The petitioner contends that the decisions in the H. Stanley Bent, Alfred E. Badgley, Russell G. Finn, Executor, and Fort Pitt Bridge Works cases, supra, cited by respondent, were predicated on article 36 of Regulations 45, relating to the 1918 Act, and did not specifically define "long-term contracts"; that article 42-4 of Regulations 94, relating to the 1936 Act, which is applicable*892 here, defines "long-term contracts" as "building, installation, or construction contracts covering a period in excess of one year"; that the Buffalo contract did not cover a period in excess of one year and that to hold as applicable here the completed-contract method of reporting income involved in said decisions and specifically provided for in article 42-4(b) of Regulations 94, would nullify the obvious intent of the regulation as disclosed in the definition of long term contracts. It is true that the decisions in the cases mentioned, except the Badgley case, involved taxable years controlled by the Revenue Act of 1918. However, the D. L. Wheelock case involved years controlled by the 1918 and 1921 Acts and the Badgley case involved years controlled by the Revenue Acts of 1921, 1924 and 1926. The regulations under all acts since the Act of 1918 contain the same definition of long term contracts as appears in article 42-4 of Regulations 94. The rule in the above mentioned cases is grounded not on the length of time covered by the contracts, but on the taxpayer's method of keeping books and reporting income, and, as we said in the Bent case, "The fact that some*893 of the contracts were performed within a year and some took longer creates no inconsistency in the method and does not detract from a clear reflection of income." The petitioner has consistently reported the income from the various projects in the year in which the particular project was completed and there is nothing in the facts to indicate that such method consistently followed does not clearly reflect income, and certainly there is no justification for according the Buffalo project any different treatment from that accorded to other contracts begun in one year and completed the year after.
The petitioner has alleged that the respondent erred in disallowing the deduction of $7,537.35 taken as repairs to the dredge, Gala Water. The petitioner now concedes that $5,500 of the amount in question represented cost of raising the dredge and is not deductible. It is contended that the remaining amount of $2,066.19 is deductible because expended in reconditioning and restoring the hull and the *308 motor to the condition they were in prior to the time the dredge sank, citing *894 .
Assuming, as petitioner contends, that $2,066.19 was expended for the purpose alleged, the Zimmern case is not authority for the allowance of the deduction claimed. In that case the taxpayer owned and was using in its business a coal barge which sank during a storm in 1918. The court held that an expenditure made by the taxpayer in 1920 for restoring the barge to the condition it was in at the time it sank was an ordinary and necessary expense and therefore deductible for the year in which made. The facts in the instant case are materially different. Here the petitioner purchased a dredge which had been lying on the bottom of Lake Erie for three months and was in an unusuable condition. It was for the dredge in that location and in that condition that the petitioner paid $200. Without further expenditures the dredge would have continued in the same location and in the same condition. Clearly what the petitioner had after making the expenditures here involved was not a sunken dredge in its then useless condition, but one that was afloat and serviceable. So far as disclosed, the expenditures made by the petitioner*895 gave the dredge a useful life of many years beyond the taxable year. Under these circumstances we are unable to hold that the portion, now claimed, of the amount deducted by the petitioner constituted an allowable deduction. Cf. . The situation here presented is entirely different from that of a taxppayer who repairs damage which has occurred to property owned and being used by him and who after such repairs has no greater asset than he originally owned.
Decision will be entered for the respondent.