The opinion
T.C. Memo. 1997-569
UNITED STATES TAX COURT
DAVID K. STRAIGHT, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 23658-94. Filed December 29, 1997.
David D. Aughtry and Donald P. Lancaster, for petitioner.
William L. Blagg, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COLVIN, Judge: Respondent determined deficiencies in
petitioner's Federal income tax and accuracy-related penalties as
follows:
2
Penalty
Year Deficiency Sec. 66621
1990 $433,706 $86,741
1991 9,741 1,948
1992 4,354 871
1
Respondent concedes that petitioner is not liable for the accuracy-
related penalty.
Petitioner was the sole shareholder of Eagle's Nest Homes,
Inc. (Eagle), an S corporation which sold panelized houses.
Deposits Issue. Eagle, an accrual method taxpayer,
received customer deposits under written purchase agreements.
The deposits issue for decision is whether, as petitioner
contends, Eagle may defer reporting some of its customer deposits
under section 1.451-5, Income Tax Regs., or under other income
tax accounting rules. We hold that it may not.
Procedural Issues. Respondent's revenue agent prepared a
30-day letter in this case. Respondent's revenue agent included
a chart in the 30-day letter with columns for 1990 and 1991
showing the amount of Eagle's gross receipts reported on the
return and per the audit. Respondent's revenue agent later added
a column for 1992 to the chart. Respondent's counsel gave
petitioner a copy of the modified 30-day letter to include in the
stipulation. Respondent's revenue agent initially testified that
she had not added the third column but later testified that she
had added it.
Respondent concedes that the agent's conduct warrants
imposition of a sanction. Respondent contends that the sanction
3
should be to shift the burden of proof to respondent for 1992.
Petitioner contends that we should strike respondent's answer.
The notice of deficiency did not contain the explanation for
respondent's position which respondent had previously stated in
the 30-day letter. Petitioner contends that respondent should
bear the burden of proof because the notice of deficiency did not
state the basis for the tax due as required by section 7522.
Respondent concedes that shifting the burden of proof is
appropriate if section 7522 is violated, but contends that it was
not violated here. The procedural issues for decision are:
1. Whether respondent should bear the burden of proof
because the notice of deficiency did not describe the basis for
the amounts of tax due as required by section 7522, or because of
respondent's agent's conduct in this case. We need not reach
this issue because respondent prevails regardless of which party
bears the burden of proof.
2. Whether striking respondent's answer is an appropriate
sanction for respondent's agent's conduct in this case. We hold
that, instead of striking respondent's answer, we will impose a
$5,000 penalty on respondent.
Section references are to the Internal Revenue Code in
effect for the years in issue. Unless otherwise indicated, Rule
references are to the Tax Court Rules of Practice and Procedure.
4
I. FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
A. Petitioner
Petitioner lived in Alpharetta, Georgia, when he filed the
petition in this case.
B. Eagle's Nest Homes and Timberline Building Systems
1. Formation, Ownership, and Tax Status of Eagle's Nest
Homes
In 1983, petitioner and Lawrence Gandolfi (Gandolfi)
incorporated Eagle's Nest Homes, Inc. (Eagle), in North Carolina.
Eagle sold panelized house kits; i.e., prefabricated houses which
were shipped to homesites to be assembled. Initially, Eagle's
offices were in Kannapolis, North Carolina. In 1987, Eagle moved
to Canton, Georgia. Gandolfi and petitioner each owned 50
percent of Eagle's stock before 1990. Petitioner became the sole
shareholder of Eagle in 1990.
Eagle was a C corporation before July 29, 1990. Eagle
elected to be an S corporation effective July 29, 1990. Eagle
had a short taxable year from July 29 to December 29, 1990.
2. Timberline Building Systems
Petitioner, Michael Goss (Goss), Gandolfi, and others formed
Timberline Building Systems (Timberline) in 1986. Goss was the
president of Timberline. Petitioner owned 50 percent of the
stock of Timberline. Timberline was an S corporation.
5
Timberline manufactured panelized house kits for Eagle and
shipped them to Eagle's customers. Timberline's manufacturing
facilities were in Greenwood, South Carolina.
3. House Purchase Agreement
Persons who wanted to buy a house from Eagle signed a
purchase agreement. The purchase agreement was between Eagle and
the customer. The purchase agreement specified the model to be
built, the square footage, and the price.
a. Front Deposits
Before 1991, a customer paid a $4,000 deposit, which Eagle
and its customers referred to as a "front" or "front deposit",
when he or she signed a purchase agreement. In 1991, Eagle
raised the amount of the front deposit to $5,000. The purchase
agreement stated that the front deposit was nonrefundable.
Eagle paid commissions of $650 to the employee who was
responsible for a sale when it received a $5,000 front deposit.1
The purchase agreement stated that once a customer paid the
front deposit, he or she had 15 days to provide specifications to
Eagle and 60 days to submit a house purchase order, accompanied
by full payment or an acceptable method of paying the balance.
1
Eagle also paid commissions when it received the $4,000
deposits. Eagle deducted these commissions in the year it
received the deposits.
6
Before submitting an order to Eagle, customers began working
with Eagle’s engineering department, selected the final design,
and obtained financing. Eagle produced the blueprints. Some
customers wanted different floor plans, different windows, or
windows in different places than shown on the original plans.
Eagle's engineers prepared the blueprints accordingly.
b. Back Deposits
If a customer did not pay for the house or arrange for
financing within 60 days, the purchase agreement stated that he
or she could pay a second deposit ($4,000, increased to $5,000 in
1991), which Eagle and its customers called a "back deposit" or a
"back". The purchase agreement stated that back deposits were
nonrefundable. Eagle paid commissions of $450 to the person who
was responsible for the sale when it received a $5,000 back
deposit. The purchase agreement provided that if a customer paid
the back deposit, full payment could be made any time until 15
days before the house shipment date. The agreement is silent
about what would happen if a customer failed to pay in full at
that time.
The purchase agreement states that it is the entire
agreement between the parties respecting the purchase of an
Eagle's Nest house.
7
When a customer submitted a purchase order and full payment
(including for shipping), Eagle ordered the house kit from
Timberline. Ninety percent of Eagle's expenses occurred from 30
days before an order was placed to 30 days after Timberline
delivered the house kit to the customer. Timberline usually
delivered the house kit 4 to 6 weeks after a customer placed an
order.
c. Extension of Purchase Agreements and Refunds of
Deposits
Eagle's business practices differed from the purchase
agreement in two ways, primarily to retain goodwill from
potential customers. First, Eagle refunded about $136,000 in
front and back deposits from 1988 to 1992. Second, if Eagle did
not receive full payment in 75 days, Eagle issued a change order
in which Eagle agreed to apply the payments to a purchase of a
panelized house during the next 7 years. If a customer placed an
order for a panelized house kit under a 7-year change order,
Eagle charged the customer the retail price prevailing when the
order was placed.
4. Eagle's Payments to Timberline
Timberline billed Eagle for house kits and was paid when the
customer paid Eagle.
Ninety percent of Eagle's house sales were financed by
letters of credit. When a customer financed a sale by a letter
8
of credit, the customer paid Eagle 3 to 10 days after delivery.
Eagle promptly notified Timberline to send an invoice, which
Eagle paid on receipt.
Some of Eagle's customers paid cash. Those customers paid
Eagle 15 days before delivery. Timberline then sent a bill to
Eagle which Eagle paid on receipt.
Timberline usually sold house kits to Eagle at the price in
effect when Eagle placed the order. Eagle lost money on some
house contracts each year because Timberline's price was not
fixed until Timberline billed Eagle around the time of delivery.
Timberline bought commodities such as lumber and plywood products
to use in the kits. Timberline sometimes changed the prices it
charged Eagle to offset increases in the prices of commodities it
used.
Timberline shipped the house kits to Eagle's customers.
Eagle billed its customers for the shipping costs.
5. Eagle's Accounting Method
a. Accrual Method
Eagle consistently used the accrual method of accounting for
financial and tax purposes.
b. 1990 Study
Eagle's accountant, William E. Gross (Gross), analyzed
Eagle's experience with customer deposits. Gross counted how
9
many purchase agreements had been signed in each year since 1986
that had not been fulfilled by delivery of a house kit (open
agreements) by July 28, 1990. Gross calculated the percentage of
purchase agreements signed in each year that had been fulfilled
by the delivery of a house kit (closed agreements) by July 28,
1990. Gross then applied these percentages to the number of
agreements open on July 28, 1990, to project the number of
contracts that would close within 4 years. Gross estimated that
293 of the 515 contracts open on that date (57 percent) would
never close.
c. Eagle's Accounting for Deposits
Eagle did not maintain a separate bank account for the
deposits. Eagle deposited them in its general operating account
and used them to pay its current expenses.
Eagle first included customer deposits in income based on
the 1990 study for its tax year ending July 28, 1990. For its
tax year ending July 28, 1990, Eagle included in income 57
percent of all unapplied customer deposits at the end of that
year.2 Eagle recorded the 43 percent of customer deposits which
it had not reported as income as a liability.3
2
Unapplied deposits are deposits for houses for which Eagle
did not receive all of the purchase price in that year.
3
Eagle recorded the amount of its unapplied deposits in a
liability account. Eagle reported unapplied deposits in income
(continued...)
10
Eagle recorded the following amounts of customer deposits in
its liability account:
Tax year ending Amount in liability account
July 31, 1989 $1,774,497
July 28, 1990 1,330,830
Dec. 29, 1990 1,505,102
Dec. 28, 1991 1,503,403
Jan. 2, 1993 1,517,037
For the years ending December 29, 1990, and December 28,
1991,4 Eagle included in income (i) the purchase price (including
deposits) of houses delivered that year; and (ii) the percentage
of unapplied deposits on hand at the end of that year which,
based on the 1990 study, Eagle would not apply to a house
purchase within 4 years. For those years, Eagle reported the
amount it paid to Timberline as cost of goods sold. Eagle
recorded customer deposits which it had not included in income as
a liability on its balance sheets and tax returns.
3
(...continued)
when it applied them to a house purchase within 4 years. Eagle
reported customer deposits not included in income as a liability
on its tax returns.
4
We will sometimes refer to Eagle's tax year ending Dec.
29, 1990, as its 1990 tax year, year ending Dec. 28, 1991, as its
1991 tax year, and year ending Jan. 2, 1993, as its 1992 tax
year.
11
For its year ending January 2, 1993, Eagle included in
income (i) the purchase price (including deposits) of houses
delivered in 1992, and (ii) all unapplied deposits on hand at the
end of 1992.
For its 1990 tax year, Eagle reported $275,651 of deposits
in income and deferred reporting $1,505,102 of deposits. For its
1991 tax year, Eagle reported $304,389 of deposits in income and
deferred reporting $1,503,403 of deposits. For its 1992 tax
year, Eagle reported $1,130,830 of deposits in income and
deferred reporting $1,517,037 of deposits.
Eagle prepared financial statements for its tax year ending
July 28, 1990, and its 1991 and 1992 tax years. Eagle prepared
no financial statement for its 1990 tax year.
6. Eagle's Income Tax Returns
Eagle attached a schedule to its 1990, 1991, and 1992
returns on which it reported forfeited deposits5 as income.
Eagle reported as a liability the amount of its customer deposits
at the beginning and end of the year. Eagle reported on each
return that it used the accrual method of accounting. Eagle also
5
Eagle treated a deposit as forfeited if it did not receive
the remainder of the purchase price within 60 days after it
received the deposit and the customer paid no back; or, if the
customer paid a back, 15 days before the house kit was ready to
be shipped and it projected that the contract to which the
deposit related would not close.
12
reported that it used the same method of accounting for book and
tax purposes. Eagle reported that it had no inventory at the
beginning and end of 1990, 1991, and 1992.
C. The 30-Day Letter
Before June 1993, respondent's revenue agent audited
petitioner's 1990 and 1991 tax years. On June 25, 1993,
respondent's revenue agent prepared a 30-day letter. It
contained a detailed explanation of respondent's position
relating to Eagle's method of accounting for customer deposits
for 1990 and 1991. The 30-day letter stated in part as follows:
Treasury Regulation 1.451-5(a) deals with advance
payments for a taxpayer using an accrual method of
accounting for purchases and sales or a long-term
contract method of accounting, pursuant to, and to be
applied against, an agreement: (i) for the sale or
other disposition in a future taxable year of goods
held by the taxpayer primarily for sale to customers in
the ordinary course of his trade or business, or (ii)
for the building, installing, constructing, or
manufacture by the taxpayer of items where the
agreement is not completed within such taxable year.
The taxpayer does not qualify under (i) since the
corporation has no inventory and is never at risk for
loss during shipment. The corporation merely acts as a
broker for homes manufactured by Timberline Building
Systems, Inc. Neither does the business qualify under
(ii) since it does not build, construct, install, or
manufacture the modular homes. Costs are not
accumulated until income is recognized, rather some
costs related to the sale such as commissions are
expensed before the income is recognized.
Since the deposits do not qualify as "advance
deposits", they cannot be included in income as
provided in Treasury Regulation 1.451-5(b)(1)(ii)(a)
namely "in the taxable year in which properly accruable
13
under the taxpayer's method of accounting for tax
purposes if such method results in including gross
receipts no later than the time such payments are
included in gross receipts for purposes of all reports
to third parties." Instead the deposits must be
included in income under the general rule - when
actually received.
Finally, 1.451-5(d) requires that if a taxpayer
accounts for advance payments under (b)(1)(ii), he must
attach to his income tax return for each year an annual
information schedule concerning advance payments. As
already argued, the taxpayer fails to satisfy the
definition for advance payments under this section and,
further, he failed to attach a statement as required by
law.
In a chart on page 6 of the 30-day letter, respondent's
agent said that the following adjustments should be made to
Eagle's customer deposits:
(a) Gross Receipts -- Deferred Income
9012 9112
Per return $1419282 $4147691
Per audit 2934384 4145992
Adjustment $15051021 $ (1699)
1
The correct adjustment for 1990 is $1,515,102. Respondent does not
explain this discrepancy.
Respondent's agent did not provide the 30-day letter to
petitioner or to his representative during 1993 or 1994.
D. Notice of Deficiency
Respondent mailed a notice of deficiency to petitioner on
September 23, 1994. In it, respondent determined that petitioner
was liable for deficiencies in income tax of $433,706 for 1990,
14
$9,741 for 1991, and $4,354 for 1992, and accuracy-related
penalties of $86,741 for 1990, $1,948 for 1991, and $871 for 1992
under section 6662. Respondent determined that petitioner's
distributive share of ordinary income from Eagle for 1990, 1991,
and 1992 should be increased. The notice of deficiency stated as
follows:
It is determined that your distributable share of
ordinary income from the small business corporation
known as "Eagles Nest Homes" is $1,391,539 and $67,822
for the taxable years ended December 31, 1990 and 1992
and your distributable share of ordinary loss is
$21,340 for the taxable year ended December 31, 1991
rather than the loss amounts of $148,582 and $39,713
for the taxable years ended December 31, 1990 and 1991
and the amount of $54,188 for the taxable year ended
December 31, 1992 as was claimed on your returns for
those taxable years. This determination is based on an
examination of the corporate return of "Eagles Nest
Homes" for the taxable years ended December 31, 1990,
1991 and 1992, which is summarized below. A detailed
report has been furnished to the tax matters partner
(person) who should be contacted for additional
information. Accordingly, your taxable income for the
taxable years ended December 31, 1990, 1991 and 1992 is
increased by the respective amounts of $1,540,121,
$18,373 and $13,634.
15
Year 1990 1991 1992
Ordinary income/(loss) per Corp.
Return ($148,582) ($39,713) $54,188
Adjustments to income and expenses
a. Deferred income - customers dep. 1,505,102 (1,699) 13,634
b. Depreciation 3,178 6,975 --
c. Advertising 31,841 13,097 --
Ordinary income/(loss) as determined 1,391,539 (21,340) 67,822
Applicable ownership interest 100% 100% 100%
Your distributive share 1,391,539 (21,340) 67,822
Ordinary income/(loss) as reported (148,582) (39,713) 54,188
Increase (decrease) 1,540,121 18,373 13,634
Respondent's retained copy of the last two pages of the
notice of deficiency contained an alternative tax computation for
tax years 1991 and 1992 (exhibit B of the notice) and a
computation of the accuracy-related penalty for negligence and
substantial understatement of income tax under section 6662(c)
and (d) for tax years 1990, 1991, and 1992 (exhibit C of the
notice). Respondent did not mail those two pages to petitioner.
In summary, the notice of deficiency stated: (1) That
respondent had examined Eagle's tax returns; (2) that respondent
had furnished a detailed report to Eagle's tax matters partner or
person; and (3) for 1990, 1991, and 1992, (a) how much ordinary
income and loss and customer deposit income respondent determined
Eagle had, and (b) the amount of tax respondent determined
petitioner owed.
16
The notice of deficiency stated that a report had been
"furnished to the tax matters partner (person)". This statement
was in error in that respondent's agent had not provided the
report to petitioner, there was no tax matters partner since
Eagle was an S corporation, and Eagle had not named a tax matters
person on its 1990, 1991, and 1992 tax returns, Forms 1120S.
On December 22, 1994, petitioner filed his petition in this
case.
This case had been calendared for an earlier trial session
in Atlanta, Georgia. Respondent moved for a continuance. We
granted respondent's motion.
E. Respondent's Agent's Modification of and Testimony About the
30-Day Report
On October 15, 1996, respondent's counsel sent some
documents to petitioner's counsel to include in the stipulation
of facts. One of the documents respondent sent was a copy of the
revenue agent's June 25, 1993, report, described in paragraph I-
C, above.
Petitioner discovered shortly before trial that the copy of
the June 25, 1993, report which respondent sent to petitioner
differed from the original version in that the chart on page 6 of
the report included a column for 1992, as follows:
17
9012 9112 9212
Per return $1419282 $4147691 $3306595
Per audit 2934384 4145992 3320229
Adjustment $15051021 $ (1699) $ 13634
1
The correct adjustment for 1990 is $1,515,102. Respondent does not
explain this discrepancy.
The copy that respondent sent to petitioner did not disclose
that it differed from the original version. The change makes the
letter appear more likely to be the letter to which the notice of
deficiency refers because the notice of deficiency states that
the letter furnished to the taxpayer was based on an examination
of Eagle's 1990, 1991, and 1992 years.
The Court held a hearing on October 29, 1996, relating to
petitioner's allegation that respondent had provided an altered
document to be included in the stipulation. Respondent's agent
testified that she had not added the 1992 column to the report
and did not know who did. The Court held a second hearing on
October 30, 1996, based on petitioner's allegation that the
revenue agent's testimony was false. At the second hearing,
respondent's agent testified that she had added the 1992 column.
II. OPINION
A. Tax Treatment of Eagle's Customer Deposits
1. Petitioner's Contentions
Petitioner contends that Eagle need not report all of its
customer deposits in the year received. Petitioner contends that
18
Eagle's method of accounting for customer deposits clearly
reflects income, was consistently used over time, conforms to its
method of keeping internal books and records and preparing
financial reports, complies with Generally Accepted Accounting
Principles (GAAP), and qualifies for deferral under section
1.451-5, Income Tax Regs.
2. Background
A taxpayer’s right to use a method of accounting is subject
to the requirement that the method clearly reflect income. Sec.
446(b). The Commissioner has broad discretion to determine
whether a taxpayer's method of accounting clearly reflects
income. RLC Indus. Co. v. Commissioner, 98 T.C. 457, 491 (1992),
affd. 58 F.3d 413 (9th Cir. 1995).
Generally, a taxpayer has the burden of overcoming a
determination by the Commissioner that the taxpayer's method of
accounting does not clearly reflect income. Thor Power Tool Co.
v. Commissioner, 439 U.S. 522, 532 (1979); Ferrill v.
Commissioner, 684 F.2d 261, 263 (3d Cir. 1982), affg. per curiam
T.C. Memo. 1979-501. However, as discussed in paragraphs II-B
and II-C, below, respondent prevails on the customer deposits
issue regardless of which party bears the burden of proof.
We first consider whether petitioner may defer reporting
customer deposits if Eagle is not eligible to defer reporting
deposits under section 1.451-5, Income Tax Regs. We will then
19
consider whether petitioner may do so under section 1.451-5,
Income Tax Regs.
B. Whether Eagle May Defer Reporting of Advance Deposits If
Section 1.451-5, Income Tax Regs., Does Not Apply
1. Standards Applicable If Section 1.451-5, Income Tax
Regs., Does Not Apply
Income must be reported in the taxable year in which the
taxpayer receives it unless, under the taxpayer's method of
accounting, the item of income is properly accounted for in a
different period. Sec. 451(a). Petitioner is an accrual method
taxpayer. Accrual method taxpayers generally must recognize
income when all the events have occurred which fix the right to
receive the income and the amount of the income can be determined
with reasonable accuracy. Schlude v. Commissioner, 372 U.S. 128,
137 (1963); secs. 1.446-1(c)(1)(ii), 1.451-1(a), Income Tax Regs.
Accrual basis taxpayers must include in income in the year
received advance payments for the sale of services that are
unrestricted as to their use, even though those payments may not
be earned until later years. Schlude v. Commissioner, supra;
American Auto. Association v. United States, 367 U.S. 687, 689
(1961); Automobile Club of Michigan v. Commissioner, 353 U.S.
180, 189 (1957). The same principles apply to advance payments
for the sale of goods. S. Garber, Inc. v. Commissioner, 51 T.C.
733, 735-736 (1969); Hagen Adver. Displays, Inc. v. Commissioner,
47 T.C. 139, 146-147 (1966), affd. 407 F.2d 1105, 1107 (6th Cir.
1969); Farrara v. Commissioner, 44 T.C. 189, 191 (1965).
20
In S. Garber, Inc. v. Commissioner, supra, an accrual basis
taxpayer was in the business of selling custom-made fur coats.
The taxpayer required its customers to make advance payments for
coats. The taxpayer treated these payments as liabilities on its
books and deferred reporting them as income until the coats were
finished. There was no restriction on the taxpayer's use of
these payments, and the taxpayer deposited them in its regular
bank account. Id. at 734. We held that the advance payments for
fur coats to be delivered in the future were includable upon
receipt. Id. at 735-736. All of the events had occurred to
accrue the deposits into income, and no further inquiry was
necessary to determine whether the income had been earned. Id.
at 735.
The instant case is substantially like S. Garber, Inc. v.
Commissioner, supra. Eagle received customer deposits for house
kits. Eagle had an unrestricted right to use these payments upon
receipt. Eagle used them to pay its day-to-day expenses. All
the events had occurred that fixed Eagle's right to receive the
income, and the income could be determined with reasonable
accuracy. See Signet Banking Corp. v. Commissioner, 106 T.C.
117, 128 (1996), affd. 118 F.3d 239 (4th Cir. 1997).
Petitioner points out that some of Eagle's contracts lost
money and that Eagle did not know which contracts would be
21
profitable until Timberline delivered the house kits to Eagle's
customers. This fact does not affect the outcome of this case;
the fact that some of Eagle's contracts lose money does not mean
that its customer deposits are not included in income. Standard
Television Tube Corp. v. Commissioner, 64 T.C. 238, 241-242
(1975).
Petitioner argues that section 1.451-1(a), Income Tax Regs.,
establishes that income is includable in the year earned (i.e.,
the year goods are delivered or services are performed) by an
accrual method taxpayer, not the year received. We have declined
to adopt petitioner's position that income is not includable
until earned. In Standard Television Tube Corp. v. Commissioner,
supra, we rejected the theory that reporting of prepaid income
should be deferred until the income is earned, citing Schlude v.
Commissioner, supra, American Auto. Association v. United States,
supra, and Automobile Club, Inc. v. Commissioner, 32 T.C. 906
(1959), affd. 304 F.2d 781 (2d Cir. 1962). See Herbel v.
Commissioner, 106 T.C. 392, 412-417 (1996); cf. Highland Farms,
Inc. v. Commissioner, 106 T.C. 237, 252 (1996) (refundable entry
fees paid to retirement community were not prepaid rent or
advance payments for services that had to be reported in year
received; taxpayer's method of accounting for the entry fees
clearly reflected income because taxpayer reported nonrefundable
portion of fees each year), affd. ___ F.3d ___ (5th Cir., Dec. 8,
1997).
22
2. Petitioner's Expert Witnesses
a. Description of the Testimony
Petitioner called Denton R. Hammond (Hammond) and Gross as
expert witnesses. Respondent called no expert witnesses.
Hammond and Gross are certified public accountants. Hammond
specializes in construction industry accounting. Gross prepared
Eagle’s tax returns for the years at issue in this case and
conducted the study relating to Eagle’s deposits.
Hammond and Gross concluded that: (i) Eagle accounted for
payments it received from customers for panelized house kits
consistently for both financial and tax purposes, (ii) the method
of accounting Eagle used for tax purposes conformed to its books
and records and its issued financial statements, (iii) Eagle's
method of accounting properly matches income and expenses for
financial accounting purposes, and (iv) Eagle's method of
accounting complies with GAAP.
Hammond also concluded that Eagle's method of accounting
clearly reflects its income for the years in issue, is as
accurate in reporting the results of operations as accounting
systems allow, and complies with GAAP as provided in the AICPA’s
Statement of Position 81-1, “Accounting for Performance of
Construction-Type and Certain Production-Type Contracts”. He
also concluded that respondent's method mismatches items of
revenue and expense under GAAP.
23
Gross also concluded that Eagle's method of accounting
conforms to the Statement on Standards for Accounting and Review
Services issued by the AICPA, and that the method of accounting
proposed by respondent materially overstates income for purposes
of GAAP for the tax year ending December 31, 1990.
Respondent called no accounting experts and did not show the
opinions and conclusions of petitioner's experts to be incorrect.
We accept the conclusions of petitioner's experts.
b. Petitioner's Contentions Based on the Expert
Testimony
Petitioner argues that because Eagle consistently applied a
method of accounting that conforms with GAAP and clearly reflects
income, respondent cannot require Eagle to change to another
method of accounting. Petitioner points out that courts have
said that the Commissioner cannot require a taxpayer to stop
using an accounting method that clearly reflects income, even if
another method might more clearly reflect income. Ford Motor Co.
v. Commissioner, 71 F.3d 209, 213 (6th Cir. 1995), affg. 102 T.C.
87 (1994); Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C.
367, 371 (1995). Petitioner also cites section 1.446-1(a)(2),
Income Tax Regs., which states:
A method of accounting which reflects the consistent
application of generally accepted accounting principles
. . . will ordinarily be regarded as clearly reflecting
income, provided all items of gross income and expense
are treated consistently from year to year.
24
Petitioner's reliance on that regulation is misplaced. An
accounting method that conforms with GAAP does not necessarily
clearly reflect income for tax purposes because tax and financial
accounting have different objectives; "a presumptive equivalency
between tax and financial accounting would create insurmountable
difficulties of tax administration." Thor Power Tool Co. v.
Commissioner, 439 U.S. at 540-544; see American Auto. Association
v. United States, 367 U.S. at 693 (accounting that accords with
generally accepted accounting principles is not necessarily
binding on the Treasury). In Schlude v. Commissioner, 372 U.S.
at 134, the Supreme Court held that a method of accounting
similar to petitioner's method did not clearly reflect income
despite unrebutted expert testimony that the taxpayer's method
clearly reflected income under financial accounting principles
and that those principles were followed. This case is
indistinguishable from Schlude, American Auto. Association, and
S. Garber, Inc. v. Commissioner, 51 T.C. 733 (1969).
As in Schlude and American Auto. Association, petitioner
does not prevail despite petitioner's experts' conclusions about
petitioner's accounting method. Thus, for the reasons stated in
paragraph II-B, above, Eagle may not defer reporting customer
deposits in income in the year it received them unless it
qualifies under section 1.451-5, Income Tax Regs., discussed
next.
25
C. Whether Petitioner May Defer Reporting of Deposits Under
Section 1.451-5, Income Tax Regs.
1. Relief Provisions for Accrual Basis Taxpayers
In 1971, the Commissioner issued Rev. Proc. 71-21, 1971-2
C.B. 549, relating to accrual basis taxpayers that receive
advance payments for services, Rev. Proc. 71-21, sec. 1, and the
Secretary issued section 1.451-5, Income Tax Regs., relating to
accrual basis taxpayers that receive advance payments for the
sale of property which they build, construct, install, or
manufacture. Section 1.451-5, Income Tax Regs., provides relief
from Schlude v. Commissioner, supra; American Auto. Association
v. United States, supra; Automobile Club of Michigan v.
Commissioner, 353 U.S. 180 (1957); and Hagen Adver. Displays,
Inc. v. Commissioner, 407 F.2d 1105 (6th Cir. 1969), affg. 47
T.C. 139 (1966).
2. Section 1.451-5, Income Tax Regs.
Petitioner contends that Eagle properly treated some of its
customer deposits as advance payments under section 1.451-5,
Income Tax Regs.
Under section 1.451-5, Income Tax Regs., accrual basis
taxpayers that receive advance payments (e.g., customer deposits)
in one taxable year may, in certain circumstances, defer
reporting the payments in gross income.6 An advance payment is a
6
Sec. 1.451-5, Income Tax Regs., was adopted Mar. 23, 1971.
T.D. 7103, 1971-1 C.B. 138. The regulation was promulgated in
(continued...)
26
payment which is to be applied to a contract not completed during
the taxable year. Sec. 1.451-5(a), Income Tax Regs.7 Advance
payments are includable in income in the taxable year in which
the gross receipts from the contract are properly includable
under the taxpayer's method of accounting. Sec. 1.451-5(b),
Income Tax Regs.8
6
(...continued)
response to Hagen Advertising Displays, Inc. v. Commissioner, 407
F.2d 1105 (6th Cir. 1969), affg. 47 T.C. 139 (1966), which held
that advance payments on the sale of goods were taxable in the
year received. Gas Light Co. v. Commissioner, T.C. Memo. 1986-
118.
7
Sec. 1.451-5(a), Income Tax Regs., provides, in relevant
part, as follows:
§ 1.451-5. Advance payments for goods and long-term
contracts.--(a) Advance payment defined. (1) For purposes of
this section, the term "advance payment" means any amount
which is received in a taxable year by a taxpayer using an
accrual method of accounting for purchases and sales or a
long-term contract method of accounting * * * pursuant to,
and to be applied against, an agreement:
(i) For the sale or other disposition in a future
taxable year of goods held by the taxpayer primarily for
sale to customers in the ordinary course of his trade or
business, or
(ii) For the building, installing, constructing or
manufacturing by the taxpayer of items where the agreement
is not completed within such taxable year.
8
Sec. 1.451-5(b)(1), Income Tax Regs., provides, in
relevant part, as follows:
(b) Taxable year of inclusion.--(1) In general.
Advance payments must be included in income either --
(i) In the taxable year of receipt; or
(ii) Except as provided * * * [for inventoriable
goods].
(continued...)
27
An accrual method taxpayer may defer income on advance
payments received for (a) the sale in a future taxable year of
goods held by the taxpayer primarily for sale to customers in the
ordinary course of business; or (b) the building, installing,
constructing, or manufacturing by the taxpayer of items where the
agreement is not completed within the taxable year. Sec. 1.451-
5(a), Income Tax Regs.
Respondent contends that petitioner may not use section
1.451-5, Income Tax Regs., because Eagle did not hold the house
kits for sale to customers, or build, construct, install, or
manufacture the kits as required by section 1.451-5(a)(1), Income
Tax Regs.
3. Whether Eagle Held the House Kits Primarily for Sale to
Customers in the Ordinary Course of Business
Respondent contends that Eagle did not hold the house kits
for sale to customers; i.e., Eagle had no inventory. Petitioner
contends that it need not own or possess the inventory if its
8
(...continued)
(a) In the taxable year in which properly accruable
under the taxpayer's method of accounting for tax purposes
if such method results in including advance payments in
gross receipts no later than the time such advance payments
are included in gross receipts for purposes of all of his
reports (including consolidated financial statements) to
shareholders, partners, beneficiaries, other proprietors,
and for credit purposes, or
(b) If the taxpayer's method of accounting for purposes
of such reports results in advance payments (or any portion
of such payments) being included in gross receipts earlier
than for tax purposes, in the taxable year in which
includible in gross receipts pursuant to his method of
accounting for purposes of such reports.
28
supplier (i.e., Timberline) holds the goods, relying on Gas Light
Co. v. Commissioner, T.C. Memo. 1986-118. Petitioner argues that
the house kits sold by Eagle were held by the taxpayer as
required by section 1.451-5(a)(1)(i), Income Tax Regs., even
though they were manufactured by Timberline and shipped directly
to Eagle's customers.
We disagree. In Gas Light Co. v. Commissioner, supra, we
held that, under section 1.451-5(a), Income Tax Regs., security
deposits received by a utility company were advance payments
relating to inventoriable goods. In that case, the taxpayer
contended that it never had in its inventory natural gas which
was transmitted by pipeline. We rejected that contention; we
said that natural gas transmitted through pipelines becomes
inventory when it enters the pipeline, relying on Northern
Natural Gas Co. v. Commissioner, 44 T.C. 74, 77-79 (1965), affd.
362 F.2d 781 (8th Cir. 1966), in which the taxpayer admitted that
it owned pipeline gas and was required to use inventories in
computing income. Here, it is undisputed that Eagle did not at
any time own or have title to the house kits; Timberline did.
Thus, unlike the taxpayer in Gas Light Co. v. Commissioner,
supra, Eagle had no inventory.
We conclude that the payments at issue were not advance
payments under section 1.451-5(a)(1)(i), Income Tax Regs.,
because Eagle did not hold the house kits primarily for sale to
customers in the ordinary course of business.
29
4. Whether the Purchase Agreements Were for Building,
Installing, Constructing, or Manufacturing of Items by
Eagle
Respondent contends that the payments at issue are not
advance payments under section 1.451-5(a)(1)(ii), Income Tax
Regs., because Eagle did not build, install, construct, or
manufacture the house kits; Timberline did. Petitioner contends
that Eagle need not be the manufacturer for the payments to
qualify under the regulation. Petitioner points out that Eagle's
subcontractor, generally Timberline, manufactured the house kits
at Eagle's direction. Petitioner also points out that Eagle's
engineers provided design services and produced the blueprints
for the house kits. Petitioner cites no credible authority or
argument to support his contention that Eagle need not be a
manufacturer to qualify under section 1.451-5, Income Tax Regs.
Petitioner points out that we held that a taxpayer qualifies
under Rev. Proc. 71-21, 1971-2 C.B. 549, for deferral of income
from services in a case in which the services were performed by
subsidiaries instead of the taxpayer. Barnett Banks, Inc. v.
Commissioner, 106 T.C. 103, 104-105, 116-117 (1996). However,
there is no indication that the parties in that case raised or
that the Court considered the fact that the services were
performed by subsidiaries.
Petitioner contends that Eagle is a contractor and qualifies
under section 1.451-5, Income Tax Regs. We disagree. To qualify
under that regulation, the taxpayer must build, construct,
30
install, or manufacture property. Eagle did none of those
things.
Before the Secretary promulgated section 1.451-5, Income Tax
Regs., accrual basis taxpayers had to defer the deduction of
inventoriable costs until they sold the goods. As discussed
above, Eagle had no inventory. Eagle's situation is not like the
categories of businesses eligible under section 1.451-5, Income
Tax Regs., which do have inventoriable costs. 1 Alkire, Tax
Accounting, par. 4.02[2], at 4-35 n.86 (1996).
We conclude that Eagle does not qualify under section 1.451-
5(a)(1)(ii), Income Tax Regs., because it did not build,
construct, install, or manufacture the house kits.
5. Reporting of Deposits--Conclusion
We hold that Eagle may not defer reporting of customer
deposits under section 1.451-5, Income Tax Regs.9
D. Whether the Notice of Deficiency Complies With Section 7522
Petitioner contends that the notice of deficiency in this
case did not describe the basis for the amounts of tax due as
required by section 7522(a) and that, as a sanction, respondent
should bear the burden of proving that Eagle may not defer
9
Respondent contends that Eagle may not use sec. 1.451-5,
Income Tax Regs., because (a) the purchase agreements were not
for the sale of goods in a future taxable year as required by
sec. 1.451-5(a)(1), Income Tax Regs., and (b) Eagle did not
attach an information schedule to its returns as required by sec.
1.451-5(d), Income Tax Regs. In light of our conclusion in par.
II-C, we need not decide those issues.
31
reporting its deposits in income under section 1.451-5, Income
Tax Regs. Respondent concedes that shifting the burden of proof
may be proper where the notice of deficiency violates section
7522, but contends that there was no violation here.
We need not decide whether to shift the burden of proof to
respondent under section 7522 because respondent prevails on the
deposits issue regardless of which party bears the burden of
proof.
E. Modification of the 30-Day Letter by the Revenue Agent
Respondent's revenue agent added to the 30-day letter a
column with figures comparing Eagle's return with the results of
the audit for 1992. Respondent's counsel did not know that the
revenue agent had changed it and gave it to the Court to include
in the stipulation. The revenue agent initially testified that
she had not made the change, but later testified that she had.
The parties agree that the Court should sanction respondent
under these circumstances, but disagree about whether the
appropriate sanction is to strike respondent's answer, as
petitioner contends; to shift the burden of proof for tax year
1992, as respondent contends; or some other sanction.10
10
Respondent's revenue agent testified that she mailed the
30-day letter to petitioner's "power of attorney". In view of
the fact that the revenue agent testified incorrectly about
whether she changed the report, had no records that she mailed
it, and did not know to whom she sent it, and petitioner's
counsel stated that he did not see it before 1996, we do not find
her testimony on this point to be credible. Thus, we have found
(continued...)
32
1. Whether To Shift the Burden of Proof
Respondent contends that the appropriate sanction for the
revenue agent's conduct in this case is to shift the burden of
proof to respondent for 1992. We need not consider whether to
shift the burden of proof because, as stated at paragraph II-D,
above, shifting the burden of proof to respondent would not
affect the result in this case.
2. Whether To Impose a Sanction on Respondent
Respondent's agent's testimony was under oath. See sec.
7456. We do not know whether she knew that her initial denial
that she had changed the 30-day letter was incorrect; but even if
she did not know, we think she was not sufficiently mindful of
her obligations to the Court and counsel in this case. The
effect of her conduct was to cause petitioner to incur additional
litigation expenses. As respondent concedes, the agent's conduct
in the instant case warrants some sanction.
Striking respondent's answer, as petitioner requests, would
be equivalent to defaulting respondent. A court should consider
whether less drastic sanctions are more appropriate before
dismissing an action. Halaco Engg. Co. v. Costle, 843 F.2d 376,
381 (9th Cir. 1988).
10
(...continued)
that petitioner did not receive a copy of the 30-day letter in
1993 or 1994. See par. I-C. Similarly, we do not accept
respondent's agent's testimony about when she changed the 30-day
letter.
33
Rule 1(a) directs Judges of this Court to prescribe an
appropriate procedure in matters involving questions of practice
and procedure for which there is no applicable rule of procedure.
Ash v. Commissioner, 96 T.C. 459, 469-470 (1991). Under
appropriate circumstances, we may impose sanctions that are
designed to mitigate the effects of misconduct by one party. See
Rules 104(c), 123; Betz v. Commissioner, 90 T.C. 816, 823-824
(1988) (as a sanction for the Commissioner's failure to timely
file an answer, we deemed established that the Commissioner erred
in determining that additional interest was due under section
6621(c)); Vermouth v. Commissioner, 88 T.C. 1488, 1499 (1987)
(Commissioner not permitted to introduce evidence of fraud
because of failure to timely file an answer); see also Chambers
v. NASCO, 501 U.S. 32 (1991) (District Court properly invoked its
inherent power in assessing as a sanction for the plaintiff's bad
faith conduct the attorney's fees and related expenses paid by
the defendant).
Petitioner contends that respondent changed the 30-day
letter to match it to the 3 years in the notice of deficiency and
submitted it to support respondent's position that the notice of
deficiency described the basis for the tax due as required by
section 7522. Whether or not the agent had that purpose, the
change did not have that effect because respondent conceded that
the contents of the 30-day letter have no bearing on whether the
notice of deficiency described the basis for the tax due as
34
required by section 7522. However, respondent's counsel did not
concede this point until late during the second of two hearings
we held relating to the document. Thus, it was fully appropriate
for petitioner's counsel to pursue this matter. It was unfair to
add that burden to petitioner's normal presentation in this case.
However, we do not believe that petitioner was prejudiced in
presenting the merits of this case by the addition of the 1992
column to the 30-day letter, its submission to petitioner to
include in the stipulation, or the revenue agent's incorrect
testimony. Striking respondent's answer would be excessive under
these circumstances. Betz v. Commissioner, supra at 822-823.
Instead, we impose a sanction on respondent in favor of
petitioner, in the amount of $5,000.
Decision will be entered
under Rule 155.