*1081 A taxpayer having separate accounting systems for separate activities may not in one of such systems on the cash basis deduct taxes and interest when accrued but not paid.
*696 The Commissioner determined deficiencies of $7,492.31 and $1,577.39 in petitioner's income and excess profits taxes, respectively, for 1937. He disallowed deductions for taxes and interest accrued *697 but unpaid, on the ground that petitioner's system of accounting was properly a cash system.
FINDINGS OF FACT.
Petitioner, a Colorado corporation with principal office at Denver, where its return was filed, was organized on March 19, 1935, for immediate financing purposes. It issued 2,000 shares to Julie R. Bennett for assets of a face value of $202,000. It engaged in collecting amounts due on notes and interest and dividends on securities, selling securities, and paying indebtedness and interest. During 1935 and 1936 its income consisted of interest and dividends, and its accounts were kept and income tax returns prepared on the basis entirely of cash*1082 receipts and disbursements.
Among petitioner's assets were the entire capital stock, 2,000 shares, of the Metropolitan Building & Investment Co., which were acquired for cash - 1,999 shares on March 29, 1935, and one share on July 10, 1936. The Metropolitan Co. owned the nine-story Metropolitan office building, and on November 1, 1936, it acquired the Majestic office building, and stock of the Majestic Investment Co. On December 31, 1936, the Metropolitan Co. was liquidated, and as sole shareholder petitioner received the following assets and assumed the following liabilities:
| Assets acquired | |
| Metropolitan Building | $804,433.88 |
| Majestic Building | 538,803.36 |
| Notes receivable of Bennett & Myers Inv. Co | 120,000.00 |
| Account receivable of Horace W. Bennett & Co | 100,891.18 |
| Unexpired value of fire insurance | 1,455.47 |
| 2,500 shares of Majestic | 207,600.29 |
| Total | 1,773,184.18 |
| Liabilities assumed | |
| Mortgage debts on real estate | $1,090,000.00 |
| Delinquent interest on mortgage | 18,959.07 |
| Current accrual of mortgage interest | 14,000.00 |
| 1936 property taxes accrued (payable in 1937) | 28,931.25 |
| Reserve for depreciation, properties | 160,280.53 |
| Total | 1,312,170.85 |
*1083 The excess of the assets over the sum of the liabilities and the book cost of the Metropolitan Co. shares was credited to petitioner's surplus in the amount of $410,913.33. The Metropolitan Co. was dissolved in September 1937.
Because of defaults in payment of the $1,090,000 loans secured by mortgages on the Metropolitan and Majestic buildings, the rents had been assigned to the mortagee insurance company and it designated its local agent to countersign all checks relating to the operation of the buildings. Prior to liquidation the Metropolitan Co.'s method of accounting as to rents and operating expense was on a pure receipt and disbursement basis, and as to general taxes and mortgage interest was on an accrual basis, as it had been since 1923. Petitioner continued the same accounting method in respect of the buildings. It kept funds *698 connected with the buildings separate from other funds. Building income was entered in a separate cash book and was deposited in a separate bank account. Withdrawals from this account remained subject to the countersignature of the insurance company's agent, and were used to pay operating expenses of the buildings and to reduce*1084 the mortgage debts. Income from petitioner's other activities and assets was deposited in another bank, and receipts were recorded in another book.
Postings were made from the two books of original entry to a single ledger which showed petitioner's entire operations. During 1937 petitioner continued to keep its books on the cash receipts and disbursements basis except that it accrued as liabilities general taxes and interest on mortgage bonds.
Petitioner's gross income for 1937 was $214,906.44, of which $202,490.82 was rents from the Metropolitan and Majestic buildings and was reported on its 1937 income tax return. Deductions were taken for accrued taxes and interest connected with the buildings. The Commissioner disallowed deduction of property taxes, $31,153.82, and interest on mortgage bonds, $8,175, relating to the operation of the buildings, accrued in 1937 but not paid in that year.
OPINION.
STERNHAGEN: The controversy, although argued more broadly, is the narrow one, whether the taxpayer, having kept its accounts generally on a cash system, is entitled to deduct taxes and mortgage interest accrued. *1085 This turns upon whether such accounting is a clear reflection of income. Petitioner has not changed its accounting method, for this is the first year of its operation of the buildings. The operation was unlike its established business and activities, and it had the right to keep its accounts relating to such new operations without regard to the method of keeping its accounts for the earlier business, so long as it maintained a clean separation which prevented confusion and resulted in a clear reflection of its entire income, ; ; ; . The system used as to each separate business must, however, be consistent within itself. ; . It should be said that this recognition of the separate accounting systems is not due to any legal right or obligation of petitioner to carry forward the system which had been in use by the preceding*1086 owner of the buildings. When petitioner acquired the buildings, it might with propriety have fitted the accounts of their operations into its established system, and if this had been at variance with *699 the method previously used by the former owner it would not have been significant.
The system of accounting adopted by the petitioner was a permissibly separate and distinct system embracing the operations of the buildings. It is admitted to be generally a cash system with the exception of the two accounts of taxes and interest. These items were accounted for not when they were paid, but when they accrued and before they were paid. Plainly this is inconsistent and results in a distortion of annual income. The Commissioner was empowered to reject such a method and to disallow the deductions which brought about the distortion.
Decision will be entered for the respondent.