*1436 1. The petitioner owned all the capital stock of Schuman Motors, Ltd., and as agent for that corporation deposited its funds in its own bank account. The subsidiary's activities were greatly curtailed after March 14, 1934, and after 1934 its assets were principally in the form of cash and of notes and accounts receivable. It was not dissolved until 1938 and had no intention of liquidating prior to that year. Held, that the petitioner derived no taxable income in 1934 from the cash collections of money belonging to and held by the petitioner for the account of the subsidiary.
2. From March 1, 1913, to December 31, 1934, the petitioner kept its accounts and made its income tax returns upon the accrual basis except with respect to interest income, which was returned upon the cash basis. For 1934 the respondent has held that the interest income should likewise be reported upon the accrual basis and has included in the interest income for that year $18,141.37 which he computed as the amount of the accrued and uncollected interest at the beginning of the year plus the amount accrued during the year. Held, that the respondent did not err in so doing.
*880 This is a proceeding for the redetermination of a deficiency in income tax for 1934 in the amount of $3,984.71. The questions in issue are:
(1) Whether the petitioner realized a taxable gain of $23,967.68 in the year 1934 from the partial liquidation of Schuman Motors, Ltd., a wholly owned subsidiary corporation.
(2) Whether the petitioner in its return for 1934 understated interest income in the amount of $4,787.04.
FINDINGS OF FACT.
1. The petitioner is a domestic corporation, organized on September 4, 1901, under the laws of the Territory of Hawaii, with its principal office and place of business in Honolulu.
2. Throughout the year 1934 the petitioner was the local agent for Buick, Cadillac, LaSalle, and Pontiac automobiles.
3. In connection with its business the petitioner owned all or substantially all of the shares of stock of a number of subsidiary corporations which had the agencies for different makes of automobiles and trucks.
4. On June 30, 1926, the petitioner caused the incorporation*1438 of Schuman Motors, Ltd. (hereinafter called Schuman Motors), under the laws of the Territory of Hawaii, with a capital stock of $100,000 divided into 1,000 shares of a par value of $100 each. The petitioner *881 paid into Schuman Motors $100,000 for all its shares of stock and has at all times been the beneficial owner of all the shares.
5. Schuman Motors held the distributor's franchise of the Studebaker Sales Corporation of America for the Territory of Hawaii from about the time of its incorporation until it gave notice of cancellation of the agency contract on March 14, 1934.
6. Continuously since Schuman Motors was organized and began business in 1926, and throughout the calendar years 1927 to about 1938, the petitioner has had at all times the custody of all of the assets (cash and notes receivable, sales agreements, and other personal property), of Schuman Motors, and the books of Schuman Motors were kept by the accounting staff of the petitioner.
7. The petitioner during the whole period of the existence of Schuman Motors was the agent of Schuman Motors and handled all of its financial affairs.
8. From June 30, 1926, to the final dissolution of Schuman*1439 Motors in 1938, there was no change in the way petitioner acted as agent of Schuman Motors and collected and disbursed moneys for Schuman Motors, nor in the way in which the books of Schuman Motors were kept by it.
9. After the cancellation of the agency contract on March 14, 1934, Schuman Motors transacted very little business. It had on hand some new and some used Studebaker cars. These were all sold during 1934. The petitioner as agent for Schuman Motors transacted the business of that corporation, attending to the collection of accounts and notes receivable, the filing of tax returns, etc.
10. It was the intention of Gustav W. Schuman, who decided the policy of the petitioner and its subsidiaries, to turn over to Schuman Motors at a future date the DeSoto agency held by Honolulu Motors, Ltd., another subsidiary of the petitioner. It was also his intention to utilize Schuman Motors to handle an air-conditioning unit which the Chrysler Corporation was expected to manufacture, and negotiations were carried on between the petitioner and the Chrysler Corporation relative to the acquisition of such agency.
11. Schuman Motors owned two lots of land which were carried in*1440 its balance sheet at December 31, 1933 and 1934, at a value of $1,044.04. This land was not finally disposed of by Schuman Motors until 1937.
12. For the calendar year 1934 Schuman Motors earned a net profit of $1,467.13 and returned for that year $1,743.22.
13. Schuman Motors duly filed with the collector at Honolulu capital stock tax returns for the fiscal years ended June 30, 1933, to June 30, 1939, inclusive, in which the declared value of its stock was as follows:
| 1933 | $100,000.00 |
| 1934 | 50,000.00 |
| 1935 | 31,743.22 |
| 1936 to 1939 (inactive) | None |
*882 14. Schuman Motors duly filed Federal and Territorial tax returns for the calendar and taxable years 1933 to 1938, inclusive.
15. Schuman Motors duly filed with the Treasurer of the Territory of Hawaii corporation exhibits for the calendar years 1934 to 1937, inclusive, pursuant to the requirements of section 6752 of the Revised Laws of Hawaii, 1935.
16. On September 30, 1938, Schuman Motors filed a petition for dissolution in accordance with the laws of the Territory of Hawaii and in accoudance with the authorization of the stockholders at a special meeting held on September 29, 1938, and*1441 on February 3, 1939, a decree of dissolution was issued by the Treasurer of the Territory of Hawaii.
17. At no time prior to 1938 did the directors or stockholders of Schuman Motors consider, either formally or informally, the dissolution of Schuman Motors.
18. Petitioner at all times collected all of the accounts receivable of Schuman Motors and deposited the cash collected in its own bank account. It also made all payments for Schuman Motors from its own bank account. The indebtedness of the petitioner to Schuman Motors was carried upon its books of account as an account payable and upon the books of Schuman Motors as an account receivable.
On July 22, 1933, the petitioner transferred $75,000 from the current account owing to Schuman Motors to a special deposit account of Schuman Motors; and on October 22, 1934, made a similar transfer in the amount of $45,000. The amount of this special deposit account was shown as a liability on the petitioner's books and as an asset on the books of Schuman Motors.
19. On December 21, 1934, a special dividend of $20,000 payable out of surplus was declared at a special meeting of the stockholders of Schuman Motors and the petitioner, *1442 being the sole stockholder, charged the special deposit account of Schuman Motors with $20,000 and credited on the books of Schuman Motors the special deposit account of the petitioner.
20. The special deposit account in the amount of $100,000 was carried as a liability on the petitioner's books and as an asset on the books of Schuman Motors until November 1, 1938. At that time the $100,000 was credited on the petitioner's books on account of its investment in Schuman Motors, together with the sum of $13,590.41, which was carried to its surplus.
21. No part of the special deposit account nor any other amount was applied in liquidation of the stock of Schuman Motors owned by the petitioner prior to 1938.
22. The balance sheets of Schuman Motors at December 31, 1933, 1934, and 1935, as reflected by its income tax returns, show assets and liabilities as follows:
| Dec. 31, 1933 | Dec. 31, 1934 | Dec. 31, 1935 | |
| Assets | |||
| Notes receivable | $28,091.86 | $10,304.26 | $1,692.27 |
| Accounts receivable | 24,609.48 | 2,037.56 | 1,651.02 |
| Automobiles | 7,456.15 | ||
| Prepaid insurance | 100.05 | ||
| Land | 1,044.04 | 1,044.04 | 1,044.04 |
| Special deposit (A) | 75,000.00 | 100,000.00 | 100,000.00 |
| Schuman Carriage Co., Ltd | 3,967.68 | 13,100.22 | |
| Total | 136,301.58 | 117,353.54 | 117,487.55 |
| Liabilities | |||
| Accounts payable | 3,800.30 | 171.42 | 2,722.61 |
| Accrued taxes | 363.30 | 449.76 | |
| Customers' credits | 3,127.25 | 645.00 | |
| Clerical services | 600.00 | ||
| Common stock | 100,000.00 | 100,000.00 | 100,000.00 |
| Surplus | 32,137.98 | 13,605.11 | 13,519.94 |
| Total | 136,301.58 | 117,353.54 | 117,487.55 |
*1443 *883 23. In the computation of the deficiency in income tax for 1934, the respondent determined that the petitioner realized a profit of $23,967.68 from the partial liquidation of Schuman Motors in the following manner:
| Cost of stock | $100,000.00 | ||
| Less: | |||
| Cash receipts in excess of disbursements retained by Schuman Carriage Co., Ltd. to December 31, 1932 | $46,311.43 | ||
| Collections to June 30, 1933 | $90,259.95 | ||
| Less: Payments | 62,794.63 | ||
| 27,465.32 | |||
| Collections July 1 to December 31, 1933 | $66,381.27 | ||
| Less: Payments | 43,235.48 | ||
| 23,145.79 | |||
| Cash retained in excess of disbursements to December 31, 1933 | 96,222.54 | ||
| Unrecovered costs of stock as at January 1, 1934 | $3,077.46 | ||
| Collections in 1934 | $87,095.14 | ||
| Payments in 1934 | 60,050.00 | ||
| Cash receipts retained by you in excess of disbursements | $27,045.14 | ||
| Less: Unrecovered costs, as above | 3,077.46 | ||
| Profit realized in 1934 on partial liquidation of Schuman Motors, Ltd | $23,967.68 |
24. Continuously since the inception of the Revenue Act of 1913 petitioner's accounting has been on the accrual basis, with the sole exception that petitioner's interest income has been accounted*1444 for on the cash receipts basis. Although the respondent during all of the years prior to 1934 knew that the petitioner's returns were being made on the accrual basis with respect to all items except the interest income, no attempt was made in the audit of the returns to adjust the interest income to the accrual basis.
*884 25. In the audit of the petitioner's income tax return for 1934 the respondent added to the interest income reported ($13,354.33), the amount of $4,787.04.
26. The accrued interest outstanding but uncollected at January 1, 1934, amounted to $6,234.11. The interest accruing during the calendar year 1934 amounted to $12,286.40. In its income tax return for 1934 the petitioner reported interest income in the amount of $13,354.33. This was the amount of interest actually collected during 1934. Of this amount $4,601.43 had accrued prior to January 1, 1934. The interest accrued during 1934 but uncollected at December 31, 1934, amounted to $5,166.18.
OPINION.
SMITH: The first question in issue is whether the petitioner derived a taxable gain of $23,967.68 in 1934 from the partial liquidation of Schuman Motors.
The applicable provision of the*1445 statute with regard to distributions in liquidation is section 115 of the Revenue Act of 1934, which reads in material part as follows:
SEC. 115. DISTRIBUTIONS BY CORPORATION.
* * *
(c) DISTRIBUTIONS IN LIQUIDATION. - Amounts distributed in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock, and amounts distributed in partial liquidation of a corporation shall be treated as in part or full payment in exchange for the stock. The gain or loss to the distributee resulting from such exchange shall be determined under section 111, but shall be recognized only to the extent provided in section 112. Despite the provisions of section 117(a), 100 per centum of the gain so recognized shall be taken into account in computing net income. * * *
* * *
(i) DEFINITION OF PARTIAL LIQUIDATION. - As used in this section the term "amounts distributed in partial liquidation" means a distribution by a corporation in complete cancellation or redemption of a part of its stock, or one of a series of distributions in complete cancellation or redemption of all or a portion of its stock.
*1446 In , the Board stated:
* * * There must be a manifest intention to liquidate, a continuing purpose to terminate its affairs and dissolve the corporation, and its activities must be directed and confined thereto. It contemplates an impairment of capital or a retirement of outstanding stock, though a distribution, if one of a series of distributions in liquidation, may be a liquidating dividend even if it, of itself, does not impair capital. * * *
In , it was said:
* * * The fact that a resolution to dissolve has not been adopted at the time of distribution does not of itself prevent a distribution from constituting a *885 liquidating dividend, the determining element being whether the distribution was made with the intent to maintain the corporation as a going concern or with the intent to liquidate the business. * * * [Italics ours.]
See also ; *1447 ; affd., ; certiorari denied, ; ; ; affd., .
As indicated above, in , a resolution to dissolve or to pay a liquidating dividend is not necessary if the facts show an actual liquidation.
It is the contention of the respondent herein that, inasmuch as the petitioner was the sole stockholder of Schuman Motors and received the cash collections of that corporation during 1934, and that after 1934 the activities of Schuman Motors were greatly curtailed, it must be held that there was a partial liquidation of Schuman Motors in 1934.
We do not think that this position can be sustained. The officers of Schuman Motors testified that it was not their intention or the intention of the petitioner prior to 1938 to liquidate Schuman Motors. There is no reason to question their testimony. Schuman Motors surrendered its Studebaker agency in 1934. It was not dissolved, since*1448 it was expected that it would obtain another agency and continue in active business.
The petitioner throughout 1934 and until 1938 acted as fiscal agent for its subsidiary the same as it had prior to 1934. The activities of Schuman Motors were greatly lessened after it canceled its Studebaker agency, but such activities continued until 1938.
Schuman Motors declared and paid "a special dividend" on December 21, 1934. This was paid, however, out of earned surplus. It was not a liquidating dividend. Cf. .
The Schuman Motors did liquidate in 1938. It was clearly taxable in that year upon the gain resulting from that liquidation. In , we held in a comparable case that a loss sustained on the final liquidation was a legal deduction from gross income. This is the converse of that situation.
Upon the entire record we are of the opinion that the respondent erred in his determination that the petitioner realized a taxable gain of $23,967.68 in the year 1934 from the partial liquidation of Schuman Motors.
The second question*1449 in issue is whether the respondent erred in adding to the interest income reported by the petitioner for 1934 the amount of $4,787.04. This amount was added to the net income for the purpose of placing the petitioner upon an accrual basis with respect to its interest income, the other items of income and expense being *886 reported upon the accrual basis. On brief, the respondent claims that the amount which should have been added to the interest income reported is $5,012.04. The computation by which this amount is arrived at is not shown.
It will be noted from our findings that over a long period of years prior to 1934 the petitioner's books of account were kept and its income tax returns made upon the accrual basis except as to interest income. The respondent's agents examined the returns filed for all the years prior to 1934 and, although fully aware of the manner in which the books of account were kept and the returns were made, accepted the returns without placing the interest income upon the accrual basis. The respondent has determined, however, that for the year 1934 the interest income item should be upon the accrual basis and that for 1934 there should be added*1450 to the interest collections in 1934 the amount of $4,787.04.
It is the petitioner's contention herein that, since it has requested no change in the method of reporting its income and has made no change in its bookkeeping methods, the respondent was not authorized to place its interest income upon the accrual basis; secondly, that if the interest income is to be reported on the accrual basis, only the amount of interest which accrued during the calendar year 1934 should be taken into account.
Section 41 of the Revenue Act of 1934 provides in part:
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; 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. * * *
In ; affd. (C.C.A., 6th Cir.), *1451 , the Board said:
* * * The hybrid system of accounting is not proper, ; ; ; affd., ; ; ; and , on appeal to 5th C.C.A.; and the system used being predominantly the accrual method, the respondent was clearly justified in setting up petitioner's income on that basis. The return on its face showed that petitioner has chosen to use such basis. It should not complain because the respondent has done so. * * *
Approval by Congress for the filing of returns upon the accrual basis was first provided for in the Revenue Act of 1916, section 8. In , the Court said that the purpose of permitting taxpayers to file returns upon the accrual basis was "to enable taxpayers to keep their books and make their returns according*1452 to scientific accounting principles, by charging against income earned *887 during the taxable period, the expenses incurred in and properly attributable to the process of earning income during that period."
The Board is not insensible to the fact that many taxpayers keeping their books of account and making their returns on the so-called accrual basis do not accrue every item of income and every item of expense which might be accrued, although the aim of the accrual system is to reflect the net income earned during a given period. The accrual system is often not employed to its full extent. This is especially so in the case of small businesses and of small items of income and expense. Thus, we find that in the case of smaller corporations interest income upon notes receivable and accounts receivable is often not computed at the end of the taxable period and taken into account. It is not worth while to make such computations and the net income over a period of years is substantially the same whether such interest income is reported upon a cash basis or upon the accrual basis. We also find that in many cases taxes are deducted from gross income and paid and many other*1453 items of expense are claimed and allowed as deductions when paid, although the total expense is not strictly allocable to the taxable period. Thus, it is common for a taxpayer on the accrual basis to treat as an expense of the taxable year the full amount of the premium paid on a three-year fire insurance policy and the full amount paid for supplies purchased, although the supplies may not all be consumed during the taxable period. Where the accrual system is more fully developed the prepaid insurance is carried as an asset at the end of the taxable year as are also the supplies on hand. It is also to be noted that the respondent in his regulations recognizes that there are certain overlapping items, both of income and expense, which do not materially distort the income, and he has ruled that they may be included in the year in which the taxpayer, pursuant to a consistent policy, takes them into his accounts. Article 43-2, Regulations 86. He has also provided in article 41-3 as follows:
Methods of accounting. - 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*1454 systems of accounting as are in his judgment best suited to his purpose. Each taxpayer is required by law to make a return of his true income. He must, therefore, maintain such accounting records as will enable him to do so. * * *
The courts have generally recognized the fact that under the provisions of the income tax law the respondent has a large discretion as to whether the method of accounting employed by a taxpayer correctly reflects his income. See ; ; affd., . Where his discretion is not abused the courts will sustain his determination.
*888 In his deficiency notice the respondent gives as the reason for placing the petitioner's interest income upon the accrual basis the following:
Your books of account were kept and your return was rendered on the accrued basis. (Schedule 1-a(b) of Revenue Agent's report).
You state in your brief, page 13(b), that although your accounting has been on the accrual basis, you have made an exception in respect of your interest income which has*1455 been recorded when, and as, received, and that this practice has been followed consistently since your business began in 1901.
In this connection, you are advised that it has been held that:
"* * * a system of accounting having been adopted by a taxpayer, such system will determine when, and in what manner his income shall be taxable." .
"Where a relatively small part has been on the cash basis, it must by held that the income should have been reported on the accrual basis." (, affirmed ; Cumulative Bulletin VIII-2, pp. 320, 321).
"Minor deviations from the method in keeping the books are not sufficient to cause the books to be placed on another basis." (; Prentice Hall - 1937 - #6069).
In view of the foregoing it is held that the interest accrued on your books in 1934 is taxable in that year.
It is evident that what the respondent means by the last quoted sentence is that there shall be included in the interest income for 1934 the amount of the interest*1456 collections in that year plus the uncollected interest at December 31, 1934, which, as shown by an exhibit attached to the deficiency notice, was determined to be $4,787.04. We think that it is immaterial that the stipulated facts in this case show that the petitioner has never recorded in its books of account interest accrued but only interest collected. The question in issue upon the pleadings is whether the respondent erred in adding to the interest income reported the amount of $4,787.04.
It seems clear to us that the respondent made the adjustment in the petitioner's interest income for 1934 because in his opinion the method of accounting employed by the petitioner did not clearly reflect its income for that year.
The second argument of the petitioner is that, if its interest income for 1934 is to be reported upon the accrual basis, there should be taken into gross income on account of interest only $12,286.40, which is the stipulated amount of interest which accrued over the 12-month period ended with December 31, 1934. The petitioner states that it included in interest income its interest collections for 1934, which were in the amount of $13,354.33, and it insists that*1457 no greater amount of interest income should be included in the gross income.
It is the respondent's position that if the uncollected interest at the end of 1934 is not taken into income in 1934, the year in which the respondent has adjusted the petitioner's interest income to an accrual basis, it will never be taken into income.
*889 A case presenting a situation somewhat analogous to that presented by the instant proceeding is In that case the taxpayer prior to 1926 had made its returns upon a cash basis. It was engaged in a merchandising business. In 1926 the taxpayer asked permission of the respondent thereafter to make returns upon the accrual basis. The respondent advised it that no such permission was necessary, inasmuch as the nature of its business required it to make returns upon the accrual basis, and he amended the return filed on the cash basis for 1925 to the accrual basis and added to the gross income on such basis the amount of the accounts receivable outstanding at the beginning of the year. The action of the respondent was sustained by the Board. The Board's decision was affirmed by the United*1458 States Circuit Court of Appeals for the Second Circuit upon the point involved, Hardy, Inc. v. Commissioner, wupra. The court pointed out that, unless the accounts receivable at the beginning of the year were included in the gross income for 1925 and returns were thereafter to be made upon the accrual basis, the taxpayer's income included in the accounts receivable would never be reflected in the returns of net income made by the taxpayer. The court observed: "There is no provision in the law which permits their escape from taxation, if received."
Of course, it may be that for all years prior to 1934 the petitioner has reported as large an amount of interest income as it would have reported if interest income had been reported on the accrual basis. We have no knowledge upon this point. The fact, are, however, that there was an amount of accrued interest income upon the petitioner's books of account at January 1, 1934, which had never been returned for taxation. Manifestly, this amount must be included in the gross income of some year. The failure of the petitioner to make its returns consistently upon the accrual basis may place it in an unfortunate position. But for*1459 this situation the petitioner is alone to blame.
As indicated above, the respondent on brief contends that the amount which he should have added to the interest income returned is $5,012.04. Of this amount only the item of $4,787.04 is contested. We hold that the respondent did not err in adding to the interest income reported the amount of $5,012.04, which consists of the $4,787.04 item contested, and the $225 item not contested.
Reviewed by the Board.
Decision will be entered under Rele 50.
,LEECH dissents on the first point.
MURDOCK, dissenting: The majority opinion, I believe, reaches an incorrect result on both issues. The Commissioner determined that the petitioner realized a profit in 1934 from the partial liquidation of its *890 wholly owned subsidiary, Schuman Motors. The determination is supported by the following evidence: Schuman Motors' only business, the distribution of Studebaker cars, was terminated in 1934, when it gave up the Studebaker franchise and completely closed out its stock of cars; it then had no further business purpose, no employees, and practically no assets except the amount owed it by the petitioner; it*1460 dissolved a few years later without ever again engaging in any business; it declared a special dividend of $20,000 at the end of 1934 and could have declared a larger one in the full amount owed it by the petitioner; and the petitioner, at all times material hereto, had custody of all assets of Schuman Motors, was its agent in all business transacted, kept its books, handled all of its financial transactions through the petitioner's own bank account, and controlled Schuman Motors completely. The evidence that there was no resolution to dissove and no complete dissolution until later is not necessarily inconsistent with the determination of the Commissioner that there was a partial liquidation in 1934. W. F. Kennemer,35 B.T.A. 415">35 B.T.A. 415; affd., 96 Fed.(2d) 177. The selfserving testimony of officers that they did not intend to dissolve Schuman Motors but intended to use it for a new purpose later is not sufficient, with the other evidence, to show that the Commissioner erred.
The second issue has really two parts - (a) whether the taxpayer must report its interest for 1934 upon an accrual basis, and (b) if it must use the accrual basis, whether any amount*1461 in excess of the interest which actually accrued during the year may be included in interest for 1934. I agree with the majority that interest must be reported upon an accrual basis. The interest which actually accrued in 1934 has been stipulated to be less than the amount reported on the cash basis and less than $18,141.37, the amount which the Commissioner has included as interest for 1934. Consequently, unless some adjustment is to be made to correct an error of the petitioner in failing to report for taxation interest which accrued in prior years, the change from the cash to the accrual method of reporting interest will really benefit the taxpayer. The Commissioner has not made claim for any increase in the deficiency. It must be remembered that the taxpayer has not requested permission to change its method. The change is entirely involuntary upon its part. The case of Hardy, Inc. v. Commissioner, relied upon in the majority opinion, was one in which the taxpayer asked permission to change and, of course, the Commissioner had a right to make the necessary adjustments under such circumstances. But the adjustment was made there for the earlier year of change. *1462 Thus, the holding of the majority is without adequate authority to support it. Not only is there an absence of any request to change from the method which the taxpayer has guilelessly used, but the Commissioner has known for years that the taxpayer was using that inconsistent method. The Commissioner may not arbitrarily choose 1934 as *891 the year in which to make up for possible errors of the past. ; ; ; ; . Cf. ; .
VAN FOSSAN, TURNER, and MELLOTT agree with this dissent.