Petition for Writ of Certiorari — Streight Radio & Television, Inc. v. Commissioner (No. 507)

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e

COPY . | Office Sueme Court US.

FILes

OCT 25 1950.

a-

DIN Th, JAMES R. BROWNING. Clerk

> SUPREME COURT UF THE UMPED SFATES

. OCTOBER TERM, 1960

No. 50 7

ePREIGHT RADIO AND TELEVISION, INC.

> Patitiom ar

es

COMMISSIONER OF INTERNAL REVENUE,

Respond nt

>.

PETITION FOR WRIT OF CERTIORARI TO THE

; UNITED STATES COURT OF APPEALS FOR THE

SEVENTH CIRCUIT

ALFRED [2 SCANLAN, P

. CEE i tteenth Street, VIE:

Washington 3. ]). e*

Jounedde ( MELAnA,:

512 Indiana Bielding,

Indianapolis th, Lidiana,

lore ys tor Petitioner,

Filed: Ocronen 2), 1960.

TABLE OF CONTENTS

Opinions Below

Jurisdiction

Question Presented

Statutes Involved

Statement of the Case

1. Proceedings Below

2. Findings and Decision of the Tar Court

3. The Taxpayer's Operating Experi ne:

4. The Deferral of Income

d. The Opinions Below

einai for Granting The Writ

Conclusion 7

Appendix A

Appendix B

Appendix C

CITATIONS

Cases: ’

Ame ‘can Automobile Association v. United States,

181 F. Supp. 255 (Ct. CL, 1960), cert. granted, No.

-288, 1960 Term

Automobile Club of Michigan v. C sa secgeoibde rol lu.

ternal Rev enue, 20 T.C. 1035 (1993), PF. 2d os

(CLA. 6, 1956), att’. 353 U.S. 180 (1957) > # AD,

selenite Club of New York vi € ommissioner, 32

T.C. 906 (1959)

Bayshore Gardens, Inc. v. Commissioner of Internal

Revenue, 267 F.2d 55 (CLA. 2. 1999)

Bressner Radio, Inc. v. Commissioner of Internal

Revenue, 267 F.2d 520 (C. A.2 2, 1959)

wis ists =

Dade WS

New Jersey Automobile Club v. nited States, 11.

F. Supp. 259 (Ct. CL. 1960), pet. for cert. filed June

11, 1960, No. 140, 1960 Term

—2590-8 ° -

il INDEX

Statutes:

Section 41, ‘Internal ae enue Cede of 1939

Section 446(b), Internal Mevenne Code of 1954

Nisce eens

Rey. Rul. 60-85, 1960, IRB-10, ps 14

ae

IN THE -

SUPREME COURT OF THE UNITED STATES

OCTOBER TERM, 1960

| No.

STREIGHT RADIO AND TELEVISION, INC.

: : Petitioner,

. ot

COMMISSIONER OF INTERNAL REVENUE,

Respondent

PETITION FOR WRIT OF CERTIORARI .TO THE

UNITED STATES COURT OF APPEALS FOR THE |

SEVENTH CIRCUIT

Pe titioner prays that a writ of ce rtiorari issue to review

be judgment of the United States Court of Appeals for

the Seventh Cireuit entered in the above-entitled case on

July 28, 1960. s. ae

*’ Opinions Below

The opinion of the Tax Court, printed in Appendix A

attached: hereto, is reported at 33. T. C. 127. The opinion

of the Court .of ‘Appeals, printed in Appendix B attached

hereto, is reported at VSO F. 2d 883.

(1)

ra

te

: ee Jurisdiction

The jurisdiction of this Court is invoked under 2s U SL.

1254(1). The judgment of the-C ourt of Appeals Was eh-

. ren on July 28, 1960. . ’

»

Question Presented °

Petitioner, an accrual basis taxpayer, deferred amounts

charged for servicing contracts on television sets sold, in

proportion to the number of montlis the contracts entered

» into during the taxable year would extend into the follow-

ing year. The Commissioner, coltending that petitioners

method of accounting did not clearly reflect income, changed

the taxpayer's method of accounting, disallowing pel

tioner’s deferral of such charges. The Court below, Ke ject:

ing a contrary result reached by the Seeond Circuit on

. identical faets, upheld the Tax Court in sustaining the

Commissioner's action on the basis ef what it presumed

to be the controlling authority of 4 utomobile Club of Mick

gan v. Commissioner of Internal Revenue, 353 U.S. 1s.

These basie facts present for decision in this case the ques:

»tion of whether the Commissioner can change a method of

accounting of an-acerual basis taxpayer under which in:

come is deferred te the period in which it is earned and in

_ which, based on thé taxpayer's operating experience, the

expenses of producing that income are to be ineurred.

a

Statutes Involved _ . ;

Section 41, Internal Revenne Code of 1989, and. section

446(b), Internal Revenue Code of 1954, printed i in Appendix

C attached her eto,

Statement of the Case

1. Proceedings Below. This case comes to this Court

from the affirmance by the Court of Appeals for the Seventh

Circuit of a judgment of the Tax Court of the United States

determining a deficiency in income taxes of the petitioner

for the taxable year énded October a1, 1950 in the amount

of ~— 82. ,

2. Findings and Decision of < Tax Court. This defi-

ciency resulted from the Tax Courts decision (1) disallow-

ing a deduction of a service warranty reserve established

by the petitioner to reflect its liability to furnish service

and parts on warranty contracts sold in conjunction with

sales of television sets, to the extent that such liability was

to be discharged in a period subsequent to the close of the

taxable vear, and (2) disallowing a deduction establishing

a had debt reserve. Petitioner has conceded the issue re-

" specting the bad debt reserve, but it contests the remaining

issue,

3. The Taxpayer's Operating Experience. Petitioner ts

an Indiana corporation, organized August 1, 1949, with its

‘principal office in Gary, Indiana. (App. 28). The taxpayer,

during the year. involved, was engaged in the sale and

servicing of television sets... In 1950, television was rela-

-tively new in the area where taxpayer's business was lo-

eated. Reception was poor, and since the engineering ot

television receivers was in its infancy, most television sets

sold by taxpayer in that year required service. Of the

thousands of sets sold by taxpayer.in the year concerned,

the Tax Court found that less than 100 did not require

service (App. oO). .*

ie in the’vear involved, taxpayer offered a tele-

Vision service warranty agreement in conjunction with

the sale of new television sets. The charge for this agree-

4 .

ment for one year’s parts-and service varied from $65.00

to $100.00, depending’ upon the type of,set, and included

the cost of installing ‘the set and antenna, computed at

$22.50 per set. The Tax Court found that not more than

ten per cent of the sets were sold without: a one vear

warranty. (App. 34).

_ At this time there were certain types of service ‘which

it Was necessary to perform periodically on all television

. Sets sold, particularly the cleaning of the picture tube, the:

"

glass in front of the tube, and the tuner contacts. This

type of servicing involved removal of the chassis and -was

required about every two to six months, but it was not

performed until the customer called for the service, (App.

2%). In addition, of course, many. other formes of servicing

were required,

4. The Deferral of Income. The taxpaver’s accountant

testified that he determined that the average percentage

of the total cost of television sets Which was represented

by the cost of the service Warranty was 14.7%. There-

fore, he took 15% of total sales as’ being represented DY

amounts paid on warranty agreements, On the assump

tion that the average cost of installation of $LL.507 rep.

resented approximately ‘one-third of the total amount paid

for the Warranty agreement, he established a reserve of

two-thirds of 45% of the sales for each month, eliminat-

ing one-twelfth of this figure as representing service attril:-

utable to the month of sale. In each of the eleven months

following the month of: sale, the accountant earried ints

current income one-twelfth of the amount. so reserved. Ou

October 31, 1950, a balance of $43,471.33 remained in this

reserve, which amount was claimed as a deduction from

income in that Year. (App. 37). . )

The Tax Court found that the books and records of the

taxpayer reflected that the actual cost of television service

os]

* in comparison with television sales and service charges was

as follows: *

Fiseal*Year Ended

“Vetober 31, 1950 October 31, 1951

: Total Sales: ‘

Television Sales (includes es

Service Contracts). . 31.044, 554 ; $458,712

Service shd Repairs ; 37 890 84,417

“Voted. centan 1,082.44 * 543, 130

Serviee Sales:

Service Contracts... |. - 156,247 68 , 807

Less: “Service Guarantee”. 43.471 (21.735)

Other Services and Repairs... 37,890 84,417

. $150,666 $174,959

Service Costs: a, eee

Materials... Sen 60. 266 69 , 984

Labor. . ©. ; 87 SAO 91,693

Truck Maintenance... 3.720 4,989

Depreciation ae 2,033 _:.* *s3 a

153,559. 170,002

(2,893) ; 4,957

The Tax Court.also found that $25,834.44 of the $49,-

471.00 of income attributable to service contracts had not

even been received in the taxable year, but represented

uncollected amounts of one type or another.

Thus, under petitioner's method of accounting whereby

a pro rata portion ($43,471.00) of the income attributable

to service contracts was deferred, petitioner sustained a

loss of $2,893.00 oa its service operations during the tax

year in question because of the substantial servicing costs

($153,559.00) it ineurred during that vear. That these

costs were not unusually high ean be.seen by the $170,002.00

item representing service costs during the following tax-

able year. This illustrates whry, as the Court of Appeals

stated :

‘*Petitioner’s main’ purpose in offering thé service

contracts was to induce potential customers to pur-

6

chase their sets from it. Petitioner, was not in the

‘business of servicing, and it did not service television

‘sets sold by other concerns, as it knew from the ex-

perience of such competitors that such a service busi-

ness was not profitable.’’ 280 F. 2d at 885.

The disapproval of petitioner's method of reporting

income results, of course, in greatly augmenting’ peti-

tioner’s income during a year in which the corresponding

expenses were:not incurred, on the one hand, and inflat-

ing petitioner's expenses during the following Year in

which the corresponding income is not to be reflected, on

the other. ;

. The Opinions Below. In the Tax: Cgurt, the Comnis-

sioner supported his disallowance of the $43,471.00 income

deferral on the theory that petitioner had received the:

income in. question under a ‘claim of right’? without any

restriction as to its use, regardless of the fact that peti:

‘tioner had not fully discharged its contractual liabilities

with respect to the service contracts in question and pre-

dictably. would incur substantial expenses in so doiny.

Undex indistinguishable factual circumstances, the Court

of Appeals for the Second ‘Circnit had rejected the same

_ contention by the Commissioner. Bressner Radio, Ine. v.

Commissioner of Internal Revenue, 267 F. 2d 520 (1959).

The Tax Court attempted to distinguish Bressner by avoid.

ing the sweeping theory of the Commissioner and decid

ing that petitioner’ had not established a precise enough

basis for predicting future costs allocable to the deferred

income; but the Court of Appeals for the Seventh Circuit

pointedly ignored this rationale and instead! rested its

decision squarely upon the Commissioner’s ‘telaim of

right’ theory, thereby establishing a rule in, direet con-

flict with that which prevails in the See ond Circuit.

Reasons for Granting the Writ

A. The decision of the court below raises a clear con-

‘fliet between Circuits, a contliet, which has been created

by the conscious efforts of the Commissioner to secure

rejection of the Bressner doctrine, Consequently, it is

evident that the conflict: will be dispelled only through

review by this, Court.

The seminal case, so far as the decisions here in ques-

tion are concerned, is Automobile Club of Michigan v. Com-

missioner of Internal Revenue, 353 U.S. 180. The peti-

tioner in that ease had collected membership dues in ad-

vance for one year and had apportioned them on its books

in such a‘way that one-twelfth of the amount collected had

been credited té income during each month of membership:

The Commissioner, advancing his ‘‘claim of right’’ theory,

maintained that.all of these prepaid dues should be con-

sidered as income when received. This Court held that,

under the circumstances of that ease, the Commissioner

was éntitled’ to conclude that the petitiorier’s method of

accounting did not clearly reflect income within the mean.’

ime of section 41 of the 1939 Code,’ because ‘The pro

rata allocation ... . is purely artificial and bears no rela-

tion to the services which petitioner may in fact be called

upon to render for the member.*?-7d., at 189. The Court's

opinion makes it perfectly clear that it was adopting a

practical approach grounded upon factual considerations

of predictable allocability, and that it was not sanction-

“$41. The pet income shall be computed upon the basis of the tax

payer's annual accounting period (fiseal vear or caléndar year, as the

tase uiay be) in accordance with the method of accounting © regularly

emploved. in keeping the books of such taxpayer; but if mo suek method

of accounting has been so employed, of if the method employed does

not clearly retleet the income, the computation shall be made in accord

“ance with such method as in the opinion of the Commissioner does clearly

reflect the income. .

z

“? .

8 . .

ing the ‘‘claim of right’* theory, which ignores established.

principles of accrual acountinge.

It is this construction of lutomobile ’ Club which the

Second Circuit adopted in Bressner. In that case, appel-

dant, who had entered into ayia (including T.V.) sery-

ice contracts similar to petitioner's, had az lopted a deferral

system. of income allocation virtually ‘identical to peti-

tioner’s, Once again the Commissioner pressed his “claim

of right’ notiMn.. This time he contended that it was now

the law.of the land under Autotébile Club. Perceiving

without difficulty the true basis for the Automobile Club

decision, the Court of Appeals stated:

“It is apparent from the decision of. the Ma jority

that at least for purposes of the decision of the eas» it,

assumed that a realistic deferral would have been per-

missible, and found ouly that no realistic deferral was

made. It thus did not pass on the issue which concerns

us here. “The Commissioner's treatment of the Club's

receipts on a cash basis, which followed from his claim

of right analysis, was permitted only “after the Court

determined that the Club’s accounting me ‘thod did net

clearly reflect its income. .... . The majority appears

to have proceeded from an soshiaptiin that accrual

accounting would be acceptable tax practice."’ 267 F.

2d, at 526-527 |

The court then earefully analyzed the facts relevant te

appellant's accounting ‘pes and determined that, in

contrast to petitioner in sdutomobile Club, appellant. lad

demonstrated ‘that it was subjected-to a reasonably uti-

form demand ‘for services," so that its deferral system

‘*matehed [revenues] with foreseably, related expenses,”

Which is the essential purpose of accrual aeeounting.’* 17.

at D2S,

J

9

The Commissioner did not pet ition for certiorari in

Bressner, despite the fact that it conflicted with the lower

court decision in Automobile Club, 230 ‘F. 2d 085 (GA. 6,

1956), but instead has waged a vigorous campaign to

persuade other courts to reject the Second Circuit .rule.

In Rev. Rul. 60-85, 1960, IRB-10, p. 14, the ‘Internal

Revertue Service announced that it would continue to

adhere to ‘a general policy of taxing prepaid income in

the year of receipt, regardless of whether the period of

proration is definite or indefinite. The ruling Asserted that ¢

Bressner ‘conflicts in principle with a long line of judicial

authority holding that where a taxpayer receivts prepaid

income under a claim of right and without restriction as

ws

“to its disposition, it — report the entire amount eres

"

\ each vear as income.*

an The -efforts of the Commissioner, together with what

"some éourts apparently have regarded as inconelusive lan-

guage in Automobile Club, lave produced persisting con-

fusion in the lower courts. Prior to the decision in the

case at bar, both the Tax Court and the Court of Claims

had grappled with the problem. In American Automobite

Association vy. United States, 181 F. Supp. 255 (1960),

cert. aranted, No. 288, 1960 Term, the Court of Claims

sef forth the Commissioner's ‘‘claim of right’’ theory.

It then noted that the opposite view was expressed in the,

dissenting opinion in Automobile. Club of Michigan, but,

concluded that it was net necessary to resolve the dispute,

since in any event the method of accounting used ‘by plain-.

tiff was essentially the same as the method employed by.

petitioner in Automobile Club of Michigan, so that under.

any view of that decision it was controlling... In pass- .

ing, however, the court remarked that ‘tit would appear

10 *

that Automobile Club of Michigan does not expressly rule

out deferral of income.’’ /d., at 258. The court followed

essentially the same approach in New Jersey Automohile

Club v. United Stqtes, 181 F. Supp, 259 (1960), pet. for

cert, filed June 11, 1960, No. 140, 1960 Term. |

The most vivid illustration ‘of the discord which prevails

in the lower courts is fhe melange of Tax € ourt opinions

in’ Automobile Club of New York v. Commissioner, 32

T. C. 906 (1959). There, the majority opinion. affirmed,

the Commissioner’s position, stating: si

*

‘This Court has consistently held that the Commis-

sioner has authority to require that prepaid income

be reported no later than the vear in which it is re

ceived, provided such income is subject to unrestricted

use by ‘the taxpayer. This rule applies to taxpayers

on an accrual basis as well as to those on the cash basis:

it applies even though the’ income’ may in-a sense “he

regarded as ‘earned’ in a vear subsequent to the year

of receipt, and even though s@me systems of account.

‘ing in the business world: may recognize deferral

such cireumstances."* Jd., at 911. '

With respect to Automobile Clreb of Michigan, the court

said, ‘*{NJotwithstanding certain language relied upon by

petitioner, we cannot say that there was an intenfion’ os:

the part of the Supreme Court to disapprove the theor:

om which this Jong line of eases has been bottomed.’’ [d,.

at 913. A dissenting judge asserted that the Tax Court’

application of the ‘‘claim of right’? doctrine had been ‘tab

solute and inflexible—even when such application conflicts

with sound business aceounting practice’? Td... at 919.

Ife. pointed out that the case at bar was appealable to the

Court of Appeals for the Second Circuit, which had desided

Bressner ‘in direct confliet’’ with the Tax Court's deci-

11

.

sion. He also adopted the Bressner construction of Auto-

‘mobile Club ef Michigan and concluded that, so far as this

Court is concerned, the ‘‘claim of right’’ question is ‘tan

open one.’’. A coneurripg judge disputed the asserted con-

sistency of Tax Court deeisions and stated that Auto-

mobile Club of Mu! gan did not alleviate the ‘*uncertainty

and capriciousiess in What should be a rational and pure-

ly practical area.’’ Zd., at 916. But, although he agreed

with the taxpayer's position, he felt bound by Atitomobile

Club, not because of the ‘‘elaim of right”* theory, but

because the methods of accounting were the sanfe in both

cases, Two-other concurring judges ’also took this view

of Autamobile Clubof Michigan, but rejected the inflexible

majority approach, : i" 7

It is this state of ‘confusion which the decision ‘of the

Court of Appeals for the Seventh Circuit has exacerbated.

Eschewing the factual approach of the Second Circuit,

Judge Schnackenberg's opinion in the ease at bar unquali-

fiedly endorses the ‘‘elaim of right’” theory; and does <0

on the ground that this. Court subscribed to it in Auto-

mobile Club. -In the words of Judge Schnackenberg,

| ‘ “ar

‘The Supreme Court pointed out ..., that the Com-

missioner determined that the Ciub received the ,pre-

. paid dues under a clajm of right, without restriction

as to their disposition, and therefore the entire amount

received in, each year should be reported as income.”

28O°F. 2d, at 887.

i ; | :

Thus, the status of the lower court authorities is now,

as follows: the Tax Court? the Seventh Cireuit, and. the

2 The fact that even the Tax Court avoided”the “claim of right” theory

in this case, at least in part, may be due to the fact that the bulk of the

income in question had’ not even been received by petitioner, so that the,

“money in hand” approach of the Gommissioner and the Court of Ap-

peals was even more arbitrary than in the normal deferral situation.

a Pili sos

12

Sixth Circuit (in its Automobile ‘Club decision, 230° F. a

585) ares arrayed against the. Second +'ircuit,? while the

Court of Claims is uncertain, The adamant efforts of the

Commissioner to secure rejection of Bressner, his suceoss.-

in the Fax Court, and the full-fledyed adaption of his por

tion.in the Seventh and Sixth Cireuits combine to ae

to this Court a deep-seated conflict of lower court authority:

in most striking form.

B. Kven if there were no conflict, the decision of the

court below constitutes such a manifestly incorrect con

struction and application of Automobile Club, as has bees

demonstrated, that review py this Court would be neces.

sary. 6 ,

- The court below has not only misconstrued fit:

ue Club and rejected Bressner, but its decision will

“engendey further confusion -and inequity in an area of

pervasive infportanee in the administration of the Iiterna!

Revenue laws. Presumably it need not be emphasized that

a substantial portion of the hpuseheld applianees sob,

each vear in the Uuited States are sold pursuant to servier

contracts of the Ivpe invelvecl in this ease. Uiasmuch its

the pertinent provisions of section 41 have been carrie!

Lover inte seetion 446(b) of the 1954 ¢ ‘ode, the deetsion o!

the Seventh Cirenit has created a situation inowhieli kiee

Humbers’ of taxpayers will eeeeive dis sparate treatment,

and those whose cases arise in that Cirénit. and pre stil

ably in the Sixth Cirenit, will we belie ‘ve, le subjected

an Mnreasonable interpretation GY the statute. Not on!

does the case at bar provide this Conrt with the opyer

tunity to clarify the law, but it doex-so,in the context of

a particularly egregious application of the elaimof right”

¢

3 The Seed Cirenit also vejeeted the elany of Hight theory an inoth:

tase, which gs sented the issue in a slightly different context. Ravi

Gardens, Ine, . Comrdissiimer of Internal Recenue, 267 F.2d 55 619508),

-

. .

. bd . . .

. .

_alochtinecinasnaich asever half of the amount in question

had not even been received by: petitioner, and consequently

could not under any theory qualify as money subject: to

taxpayer's unrestricted dispo ition, ; ,

J). Beeanse of the differences between the case at bar

andl faverican ” futomobile Association, we respectfully re

quest that this petition not be held pending disposition

of that ease, but rather that dt be seanted. One distin-

guishiny feature bas already been noted-- petitioner was

taxed under the ‘claim of right’ theory for a large amount

af mieney at hated met even recerved,. Keven nore important,

for present) urpeses, is the fact that the lower court in

American Autonioial Asscciuton avoided passing on the

validity of the ‘telaim of right’? theory. Consequently,

i! petitioner dn that ease were to lose for the reasons ad-

vanced by the lower court, the * claim of. right’ que-tion,

which is determinative of he instant case, wonld remain ’

Unducided. Moreover, even wt this Cou were. to reject

The analysis of the lower court in clmerican Antomobile

Association, the Court might decide to remand the ease

ty the Court of Claim~ tor consideration of the ‘‘elain of

right ** ther. omsequentiy, itt the interest of sound tas

Uitiwistration. petitioner urves that certiorari be granted

in the instant ease in order to assnre speedy determination -

of the vexing ‘elaim/ot fight" problem,

e -

+ BD Moreoves, inagmoaeh a. the Court is to review cfmers -

cin Automobile Association petitianer. presents as an

issue, in addition te the ‘claim of right’? question, the,

propriety of its methed of income deferral, This general

subject Appears tor be thre principal Issue in American

Automeobils Baneeiadives, anil petitioner believes that thre:

Court would be materially as-isted in its deiiherations by

consideration of the instant case, which poses the issue

noun entirely different factual’ context. We submit that,

fe)

1+ ,

:

the. Tax Court's analysis offthe question was entirely

erroneous, and we call the Court’s attention to the: persua-

sive Bressner discussion of the’ propriety of: a deferral

system indistinguishable from petitioner’s. Moreover, as.

indicated in the Statement of the Case; the Tax Court's

findings demonstrate that petitioner's .deférral method

resulted) in an exceptionally close matehing of service

sales and expenses tur the tax year and the sueceeding

year, ' Surply this ix a reliable indieation of reasenable

reflection-of income, Finally, it is evident that the Govern.

ment could not contend that the instant*case is controlled

byetulomabile Club— though of course we do not sugeest

that such an “‘argunvent is valid even ii élmerican Auto-

mobile Assoc tation.

Conclusion

Mor the foregoing reasons, this petition for writ of certi-

orari should be eranted.

4

Respectfully submitted,

Aurrep L, Scant AN,

734 Fifteenth Stree f. i, W

Washington 5, 1 €.

Joun H. O'Hara,

512 Indiana Building,

ludianapolis §, Indiana,

‘ Afhorneys for’ Petitioner.

Filed Qeroner 25, 1960.

\

io.

APPENDIX A

Opinion of the Tax Court

Traits, Judge: Respondent determined a deficieney in

petitioner’s income tax for the fiseal year ended October

31, 1950, in the amount of $14,245.82.

(The issues are:

(1) Whether petitioner may exclude from gross income

for the fiseal vear 1950 the amount of $43,471.33 or any

part thereof, the gmount deferred by. petitioner as un-

earned income resulting from. ‘tService Guarantee ;"* and

2) Whether petitioner is entitled to a bad debt deduc-

tion for the fiscal vear 1950 in the amount of $14,502.46,

Which amount was claimed as an addition to a previously

non-existent reserve for bad debts.

FINDINGS OF Fact

Some of the facts are stipulated and are here by round

“as stipulated.

The petitioner is a corporation organized on August 1,

1949, and existing under the laws of the State of Indiana

With its principal office in Gary, Indiana, It kept its books

and filed its corporate income tax returns for the period

from August 1, 1949, to Oetober 31, 1949, and the fiscal

vears ended October 31, 1950 and 1951 on an accrual basis

of accounting with the collector of internal revenue for th

district of Indiana. :

Bugene R. Streight, petitioner *s peveidtat, hereinafter

referred to as Streight, owned 62 shares, and a member

of his family, Christine Streight, owned the remaining 61

shares of petitioner's capital stock,

Streight had worked in the radio business from 922

until the gig of World War TI.) During the war, *

served in the Navy and gained knowledge of television

through working with radar. In 1946, he started a radio

and television business in Gary, an individual proprietor-

slip Which petitioner took over on August 11949,

Because of a flood in the basement of petitioner's bnsi-

hess pretuises, detailed records of petitioner were not

re,

16

made available to respondent for any periods -prior to

Mareh 1, 1950, All records relevant to the instant Case”

Which petitionerthad in its possession«were made available

‘to respondent either on the first or the subsequent ocea-

sions on which he examined petitioner's records.

Issue 1

Petitioner, during the taxable year, was eneaged. in the

business’ of selling television sets and of servicing the sets

sold. :

Most of thé television sets sold by petitioner in 1950

weré designed by their manufacturers so that, periodically,

the chassis would have to be removed, and the tuners, glass,

and picture tube cleaned. This serviee was required every

two to six months, depending On the amount of seot and

dirt in the air which varied according to the distance be-

tween the Igeation of the set and the steel plant in Gary.

Petitioner rendered this periodic cleaning service irpren

call by its customers. Furthermore, television Was rela-

tively new in the Gary area, and a local station had con-

‘siderable difficulty with a tow signal and: other problems

which adversely atfeeted television reception; consequentls,

petitioner’s customers would often call! upon petitioner

for services; being under the impression that these re-

ception difficulties were due to some fault of their. te-

ceivers. Less than 100 of the several thousands of tele.

vision sets sold during the taxable year did not require

service of one kind or another. ee

Petitioner advertised its television sets at the list price,

Which was the manufacturer's sugested retail price, How.

-ever, beginning with and during the entire taxable vear

and during the foilowing year when customers called to

purchase sets, petitioner would offer an ‘Installation and

Service Contract’’ for an additional consideration, which

varied in amount from 635. to S100, depending on the

mnake and model of the reeciver sold. The price of the

service contract was the same standard price charged by

the different manufacturers for performing the same sers

.

17

ices. Petitioner added the charge for the service contract

to the list price to arrive at-a single total sales price for

the set.

These service contracts provided, inter alia, as follows:

“In consideration of the payment by the Purchaser to

the undersigned Streight Television of the sum of

¢-—, the Dealer agrees to furnish a Standard. In-

stallation (including antenna) for the television re-

ceiver designated above at the Purchaser’s address

shown below and to furnish to the Purchaser all labor,

materials, replacement parts and tubes (ineluding

the picture tube) necessary for the proper operation

and maintenance of said television receiver and of

antenna at the point of original installation for a

period of —— from the date of installation to satis-

factorily receive television broadcasts from those ex-

isting stations within a normal television broadcast

service area which are in scheduled operation at the

time of this installation, provided that no person other

than said Dealer or his authorized representative

has rendered service on or installed materials in said

receiver or antenna. This agreement does not apply,

however, to services. rendered or parts furnished to

remedy damage occasioned by other than normal

usage of the receiver or antenna or by misuse or abuse

of the same, or by fire, storm or other casualty, for

which an extra charge will be made.

In the event that special circumstances at the. point

of original installation require a Special: Installation

(including antenna) for the proper operation of such

television receiver, the Dealer will promptly notify the

Purchaser of such fact and of the additional charges

to the Purchaser for providing such Special Installa-

tion. If the Purchaser then authorizes the Dealer to

proceed with such Special Installation, the Purchaser

agrees to pay to the Dealer -the additional charges

therefor; otherwise this contract shall he considered,

cancelled and the Dealer will refund to the Purchaser

so much of the contract price‘as has been paid. The

18

Purchaser understands and accepts as a part of this

contract all of the conditions forming a part of this

contract contained on the reverse side hereof.

Among the nine numbered conditions on the reverse side

of the contract were the following:

3.

The Dealer. will install, adjust, and place the equip

ment in proper operating condition, instructing the

Purchaser in the operation and care of the receiver

_The Dealer will service and maintain the receiver

in normal working order for a period of one vear

from date of installation, provided that such serv.

ice and maintenance are necessitated by normal

usage, replacing all defective materials, _— and

‘tubes.

The Dealer agrees to make such adjus tments within

one year after installation as inay be Necessary to.

receive telecast from new stations. It is agreed,

however, that if it. heeomes tnec OSSary to remove,

add to or replace any part of the antenna svstem, i!

will be done on the basis of a reasonable eh; arge for

additional materials and labor,

This agreement covers the installation wee ori:

inally installed, and the Dealer assumes no respon

sibility Tor its performance if moved to any other

location, .

* . _ * . oe *. .

It is also, understood that anv repairs or altera

ions made mec cessary by reason of conditions |.

vond the contral at the Dealer shall be made by th.

Dealer at a reasonable charge for labor and mute

rials,

Petitioner gave the service eoutracts to its customers.

without having any copies made for itself, The enstomer

was also given a sales ticket, whieh retlected the total sale-

price, asa receipt! The faet that a service warranty had

been given was often not recorded on the sales ticket “gi

to the rapid manner in which the sales were made, If

Bae +

eastomer ee a set, he would receive notice of the

warranty even if it was not recorded on the sales ticket

because evidence of it would be recorded on the delivery

eard. A delivery card was made up for each television set

sold by petitioner during the taxable year.

These delivery cards were always in the same standard

from, providing spaces for the customer's name and ad-

dress, a description of the receive r sold, the name of the

salesman, the names of petitioner's employees installing

the set and the antenna, and the dates that delivery was

ordered and installation was completed, Further, it) pro-

vided two adjoining spaces designated “Parts? and

“Time” and two other spaces immediately below them des-

ignated **Serviee™’ and **Time’’. Where a-service con-

tract was sold alone with the set, these spaces. were

filled in-to designate the warranty period, that is, the

period during which the service contract provided free

service and partss The delivery cards further provided,

inter alia:

Use This Picket If Installing Instrument Ordered.

° ; i a, yeas eo

I/we the purchasers hereby agree that Television, Ra-

dio, Reeord/ Player, now installed. is the one ordered,

the antenna was installed in atworkmanlike manner

‘and the above instrument was in good working condi-

tion at the time ot installation.

Purchaser Sign Here

Petitioner kept the deliyery. eards as its record of the

service contract. These cards for sales made after March

lof the taxable year were available to respondent for exam-

ination, While the sales tickets were put into daily packets

and stored in the basement of petitioner *s premises, some

of these tiekets representing sales in the taxable year were

also available to respondent fer examination. Respond-

ent's agents examined, 25 sales tickets which represented

two days* sales; 18 of these tickets did not contain any

‘20

reference to any Warranty. However; five of these latter

18 tickets were checked by respondent's agent against the

corresponding five delivery cards: one of those delivery

cards showed a 90-day service and parts warranty, with

one-year warranty on the pieture tube, another dis-

closed (a ‘*eoupon”? warranty, one showed a one-yveur

parts warranty, and two provided for ‘a’ one-year serv

ice warranty. Respondent's agent examined the delivery

eards for customers with initials .\ through BE, approy-

imately 200 ecards. All but 22 of these delivery cards dis-

closed a one-year service warranty. Of those 22. eards,

ane did not record any “arranty, one recorded a one-vea,

parts warranty, and 20 disclosed 0-day warranties, either

On parts or service. or on both.

A. few sets-sold for cash were sold Without any service

.

contracts. Tlowever, none of the sets sold on credit: were

sold without a serviee contract beeanse otherwise, if such

aset failed to work properly, the customer probably would

have refused to continne payinents. The main reason that

80-day rather than one-year service contracts were oven:

sionally viven was that a customer would not want to pay

the additional $65 for the one-year contract, A relative:

Insignificant number of sets were -old with the 90-dav

rather than the one-year <ervice contract, and usually,

petitioner’s customers wanted the service and were willine

to pay for the one.vear contract. All but tem per cent of

the sets sold hy petitioner during the year in question were

sold with a one-ver® service contract,

Petitioner’s main \urpose in offering the service cor

tracts was to induce potential Customers to purchase their

sets from petitioner, Petitioner was net in. the Dasinies-

of servicing, and it lid noi Service television Sets sole

by other concerns, as it knew from the experience of sueh

competitors that such a service business was not profitable.

When a customer called for service on his set, petitioner

‘determined whether or not the eustomer was entitled to

free service by checking the date of purchase as recorded

on the delivery card to see if. the Warranty period had

elapsed. Generally, a eu&tomer would be charged for any

services rendered after the warranty period provided in

21 aon

the service contract had expired. However, if a customer

had not-reeceived any services during the warranty period

and this period had only expired a few months before -the

service call was made, he would usually not be charged. In

some eases, if little or no service had been rendered during

the warranty period, petitioner would extend gratuitously

the warranty period for another eight months, or give the

customer a refund er credit on account, in the amount of

£15 or $20, |

According to the books and records and ineome tax re-

turns of petitioner, its television, service contract, and other

service and repairs sales, and the costs of producing those

sales, for its 1950 and 1951 fiseal years, were as follows:

Fiseal Year Ended

October 31, 1050), October 31, 1951

Total Sales: '

Television Sales = (includes

Servier Contreet:) $1044 554 * 2458.712

Service and Repairs : 37 800 84.417

Total ae 1.082. 344 ” ott.. 130,

Service Sales:

Service Contracts 16 247 OS SOT

» Less: “Service Guarantee MSA 121.735)

Other Services and Repairs 37 800 é RE417

Total... S150 BR $174.959

Service Costs:

Materials 60.266 60984

Labor R7 540 _ Ob. 608

Truck Maintenance 3.720 - : 1 O80

Depreciation 2.033 8. 33h

Total 153.559 170.002

Service Gain (or loss) aire (2.893) $2957

The manufacturers of the sets warranted the picture tube.

for an undisclosed period, and the other tubes for three

months, —

Louis Goedeckeyan accountant, was an employee of a firm

of certified public accountants employed by petitioner but

Was not himself a certified public accountant. Goedecke

Juade the monthly posting entries from the monthly sum-

maries to the general ledger of petitioner, and prepared

>

.

bY

22

petitioner's income tax returns for the fiseal periods ended

October 31, 1949,-1950 and 1951.

While the charges for the service contracts varied in

amount from $65 to $100, most of the contracts, were

sold’ for 865. The list prices of the sets varied from

$249 to $725. The charges for the serviee contracts had -

heen ineluded in total sales without allocation. - Goedecke

computed the amount of income from the service contracts

to be deferred in the following manner. It was: deter-

mined that the service contract charge, on the average,

constituted 14.7 per cent of: the total price. This computa

tion was made without weighine the different total prices

according to the relative quantity of each type of -reeciver

sold. Goedecke then teok 1 oper cent af each month's

total sales as representing amounts charged for the serv”

iee contract. Antenna and labor costs of installation, cov:

fred by the serviee contract, were estinuited to be S$22.50

per set installed, or almost one-third of $65, which was

assumed to be the total amount eharged: for the sery jee

contract. The amounts charged for the service contracts

for cach month were aceordingly reduced by one-third, on

the theory that the amount of $22.50 of the t65 charged

for the contract represented income earned af the time of

‘installation. The remaining balance for each mouth, which

thus equaled ten per cent of television sales for the month,

was then divided by 12. the serviee contract period. in

months, and the cesultine monthly figure was multiplied by

the number of months the serviee eontract. woulk re

main in-etfeet after the close of the fiscal vear. The tets!

of these feures was then deferred as unearned ineonse:

During the taxable vear. petitioner’. television <a

wud charges for service ‘contracts, less refunds ino the

amount of $7,908.42 totaled S1,041,640.50, This ameun!

(toes not Include other une Ypiained sales of approximately

$2,905, and service and repair income not covered te

service contracts in the amount of S87 890.26. At the end

of the fiseal vear, total uneollected contracts receivable

had been redueed to S287 049.50,

The following schedule prepared hv Streight. and (io

decke at the end of the taxable year for the purpose of

ee =. ;

‘ 23

reporting petitioner's income for that year discloses the

amounts deferred as unearned income and tlie. computation

of those amounts: ;

: Schedule of Deferred Income 10-31-50.

: . Service Antenna - Months

Months (‘ontract ~- Instal- s Remaining

of Total Income lation Per Next Deferred*’

Year - Sales 15°, . iy Balance Month Year .income

Nov. $140,474 56 $21,071 = 37.023 ST S14.047 5 :

Dees 147.916 OF 22.187 7.395 S40 14.791 56 $1 252 68 DS 1282.63

Jan. 52Z.92R 44 TOY > 2.64642 Post wos 2 - B82 14

Feb. = 107.203 60) 16,080 54. 5.360 220 MT20 520 NHS 86S BRD 09

Mar, 87.972 77 13.195 OEY 4.308 TE S797 2000 738 IO 2982 42

Apr. C5175 68 OW TTBS BERT SIT Ot SS Oe 2.715 65

May 52.02 35 7S 85 2.O81 65 528 UO BS 6 6 2.631 61

June 42.818 65 6.42279 2H OU F.28I SE S5682 0 TB 4UT 74

July 61.621 5S 92S 2ST ROSE GGL TZ IS SL 84108 OR,

\ug. 81.861 70 9 12.2725 $003 00 S INH 16 6S2 18 4 6.1389 62

Sept, M$. 313 BR. RUT OO 4.665.088 881 B20 TTT HL 7.978 10-

Vet 1OT.T20. TH GSO GE 5.386 GE 1077S OO NNT TK OTL W875 25

$1.04] 649 50 $156 247 AT 852.082 94 S1OF 164 15 $43.471 33

”* Headings of columns added or clarified.

n its return for the taxable vear, petitioner deferred

the amount of S43 471.05 charged for service contracts.

hy ineluding that amount in its cost “of eeods sold. In

his notice of deficienev, respondent determined ‘that the

deduction fer service guarantee ° * * ereated by setting

up a contingent lability aecount * * ° ts net an allowable:

deduetion * * *** and increased petitioner’s-income accord.

ingly.

Incconsideration of the amounts charged by petitioner

for the service contracts, petitioner was obligated tp re nder

any of the services required over the periods provided hy

the contracts. Since seme af these periods extended into

the subsequent taxable vear, petitioner was obligated to

that extent to render services beyoud the taxable veay.

Because ten per cent of petitoner’s sales were made

without serviee contracts, the amount deferrable according

io petitioner's theory as representing petitioner's future

obligations, $43,471.33, should be reduced by ten per cent,

‘to the figure of $89.124.20. For Ese sme reasoh, while

tale pe sales as of the end of the year totaled

S2S7.049.50, only the amount of -$2: 58384.3 of sugh anles

—s

: 24°

are found to have been made with service contracts. Boe-

cause, after exclusion of the antenna installation charges.

the aniount deferred represented ten per cent of sales, ap-

plying the same percentage “to uncollected sAles, only

$25,834.44 of the amount deferrable by petitioner's the-

ory (corrected to $39,124.20) was uncollected as of. the

end of the year.. The difference between the amount actu-

ally deéferred, @%8,471.32, and: dhe uneolleected amount,

$20,854.44, or $17,626.50, whs received during the taxable

year without restriction as to use. ie /

At the time of entering into the service contracts, peti-.

tioner acquired oa substantially fixed and ‘unconditional

right to receive the amounts chareed therefor.

’ e

4° eS

When petitioner téok over the business of the sole pro

prictorship-of Strbieht, it accepted accounts receivable in

the amount -of £4,800 representing service charges and mis-

~ eotlancous accounts, On Aneust 1, 1949, accounts regeiv-

- able were increased to #602057, the additional, $1,220.57

representing advances to Streight. "Petitioner’s balance

sheet as of October 31, 1949, did not list a reserve for bad

debts,

During vetitionor’s fiseal period ended October 31, 1942.

“it discounted its contracts receivable with recourse with the

Connneretal Credit: Company. The predecessor propiie-

~torship had also followed this practice and. petitioner had.

assumed the proprietorship's liabilities to the Commercial

Credit Company, Petitioner was required to purchase back

from the credit company an undetermined number. of

these contracts representing sales made by Streight Jin

his individual proprietorship prior to incorporation,

When. customers failed to make paynients. When contracts

Were so returned to petitioner, it would repossess the sets,

and sell them at their fair inarket value. ,

In preparing petitioner's income tax return for the fiseal

eriod end October 31, 1949, Goedecke did not establish 7

a bad debt reserve because he did not know of any bad

debts incurred by -petitioner for that period. At the time

7

* aan

7)

of the trial, petitioner did not have available any records

of bad debts it may have incurred prior to Mareh 1, 1950.

During the taxable vear, petitioner carried its contracts

receivable itseff instead of discounting them with a conr-

meretal house. Since Marel. 1, 1950, petitigner has main-

tained a daily sunvnary sheet which ifteluded the day's

receipts for cash and contract sales and services and also

any **charge-offs”’ due to returned mere ‘handise, bad debts,

and miscellaneous reasons. These charge-offs were applied

to the dail®@ receipt totals and the resulting figure was re-

corded on petitioner hooks as the.daily sales figure. This

figure was-entered ona monthly summary, the totals of

which werg posted to the ledger. During the taxable year,

nos} Tite bad debts we re charged on petitioner's hooks to

its bad debt account”

When a television set was repossessed for failure to

make payments, the balanes owing on that account was

written off by the making of an Approper ate journal credit;

this amount was then charged against sales on the daily

stmimary: sheet, thus reducing daily sales by the amount

uncollected, Tf a repossessetl set was sold, the sale was

entered in the sales account at the price for which the set

Was then sold. Phvariably, the fam market value of a re-

possessed set was less than the balance owing on it, and

usually’ losses were realized on sneh transactions. Upon

repossession or resale of a set, its then fair maftket value

Was not recorded’ at its cost; instead, costs of merchan-

dise sold were determined by taking inventory at the end

of the year. The result of this “wethod of recording the

repossessions and resales was that any losses resulting

therefrom were refleeted in-a corresponding reduction in

daily sales, and thus ineome. ae gi.

On October 31, 1950, petitioner's contracts receivable

totated $287,049.30, On that date, Goedecke set up a re-

serve for bad debts on petitioner’. books by making en-

tries to a bad debt expense account and to the reserve

in amounts equal to five per cent of the ontstanding con-

tracts receivable, or $14,952.46.

The reserve for the following vear was also computed at

i 26

. a rg rn » —-

five per cent of outstanding contraets receivable: the

amount by which _the reserve Was _reduced accordingly ”

was taken into income for that year.

é . Otaee

o , } Issue 1

Petitioner contends t! at responde ut erred in ieethindit

the amount deferred in gross income of the taxable veu

on the ground that it represented unearned and unreceives|

income, that the deferral thereof cle: irly refleeted income,

in accordance with the anethod of accounting re ‘eul: ily em

ploved,' and further, that its inclusion results in a distor

tion of lucome, because the eXpenses incident therete

shad not yet been incurred. Respondent contends that Nie

amount deferred. was preperly ‘ineludible in income of

the taxable vear because received nider a ‘claim of right”

-without. any Say gona as to its use, Automobile Clad,

of iia he eh LO (1953), affd. 880 FL 2d Js

(CLA. 6, 1946), affd. as U.S. 180 (1957).

While we do not agree with respondent that the entire

' The relevant statutory provisions of the Internal Revenue Cote.

1939 are the foliowing sections :

Sec. 41+ General Rule. m4

The net income shall be computed upon the. basis of the tanner

a.aual accounting period (fiseal year or calendar vear, as the ease

be) in aceordance with the method of accounting re gularly eripeler eel

“Keeping the books of such taxpayer; but if no such method of ges!

ing has been So employed, or if the method emploved does not eles!

reflect the income, the vémputation shall be made in aceordanes wt

sueh method as in the opinion of the Commissioner doe. clearly reflect

the income. *, * °

See.42. Pernod in Which Items of Gross Income Jneluded-

(a) General Rule-—The amount of all items of gross imeome shal!

included in the yvross income for the taxable vear in whch received |

the taxpayer, unless under methods of accounting permitted under seetu

41, any such amounts gre to be properly accounted for as of a different

period. r ,

All references to sedtions are to sections of the Internal Revenue ¢.

of 1939.

Pm

“amount was received defring the vear,oawe do agree that

it is ineludible cin income tor the taxable vear. ; ;

Petitioner ceferred the amount of S43. 471.228 as unearned

income from service evantract>.. We have found that onty

the amount Of S30, 224.20 represented amounts charged for -

service contracts; accordingly, the ditference, in the aumount

of $4,347.13, isnot deferrable, according to pMtitioner’s

theory, or In amy event, and we are hes re concerned. ot ly

with the corres ‘tel amount of 829 ae

Both- “parties hides aes stared tht Mie qnestiogn Gf whether

ar not the amount was reeeived during Yhe tan: uae Vihar

isof paramount importance in deeklite whether the anrnaount

is properly aecruable accordingly. we buave made findine<

disposing of thelr respectg@e contentions regarding that

question, ‘ - a . :

However, unedey this Court’. deersions, the qnestion of:

receipt Is net cootralh teedn the dnetsaet ease, The deat.

sive questign is the iatiinm: of petitioner’. right Ti, the

contract amounts when the oerviee eontracts were en

tered inte, Tf oat thaw! tine, Whieh either earr npn’

toor tals ideal ee Tt bh ere oF itstanes of e ontractimeg, poet

oMoner’s right to the coniract- amount was <whstantially:

fined and defermined, Sach aoeunt was then properly ca

erunhle, ane presenter later reece ipt is mmmatertal, Mark

B.S hlad. aud Verrcahie , Lluad . 4 at, ae a. t. A Sep

tergiher US PUG). . .

While the amonnt in qMestion Wits unearnedy as. peti

Homer contends. ina striet accounting sense, in that the

petitioner had not sttistied the corresponding contractual

liability te render future servicers, this faet is not meees

sarily controlling of the isstie Before as. Our only con

gernois whether or not respondent abused “his statutory

discretion ‘in determining that deferral of the amount did

het clearly reflect imeome, section 41. see fafmarobile Clab-

of Mi heaven, Sree . whe ho depends on the nature of peti

tioner*s rieht to Feceive the amount when Contracted for,

as stated above, an inquiry invelving factual and ‘prae tieal

considerations, ; ;

Petitioner has proved only that it bad assumed a -lia-

hility te perforin services of indetinite extent in the future.

wn

It has not proved even the approxnate amount of such

liability, or shown that it was capable of estimation. To.’

tal service costs Were $193,009; however, petitioner did

not attempt by any method to segregate service costs

allocable to services rendered pursuant to the service

contracts, and those rendered independently of suet con

tracts, which were considerable, accounting for service

sales in the amount ‘of $87,s90,: Except for the periodic

cleaning services, we know only that most of the sets soli

wouk] require some service at some indefinite time. While

petitioner had ‘a policy of making refunds. where little o

nd service was given duting the warranty period, it was

not obliged to make them, and there is. no evidence that

ii set aside any funds for this purpose, Petitioner has

this failed to prove that the method of deferral used bore

any ,~ignificant relation to the services to be performed.

Acfordingly, petitioner has: failed-to prove that respond

ent has abused his diseretion i deterndning that accrual

rather than deferral of the amount. in question in. the

taxable year clearly reflected income. See. 415 see fir

tomobile Club of Michigan, supra. For these same rea

sons, Bressyes Radio, Tie. vy. Commissioner, 267 Fo 2d

O20 (CLAS 2, 1959), reversing 28 T. CL 378 (1957) is fae

fually distinguishable, ~~

Petitioner has proved that the amount in question was

included in and considered a part of total credit. <ale-

(to what extent they were deferred payment or install

nent sales is not known). However, proving that thi-

‘nount was uncollected and would become due and payable

as apart of credit sales does not justify deferral be-

cause it in no way alters the’ nature of ‘these charge

us amounts owing on contracts receivable.- 4

It is true that this amount was owed in consideration

of service contracts not yet expired but this in no way

affected. petitioner's unconditional right to receive it, be-

catise it did-not affect the customers” obligations to mike

payment of such amount. Petitioner's customers, When

they contracted to purchas + the*sets and the service con-

tracts, became obligated to pay the full sales price, which.

included the service contract charges. While petitioner

.

*.

-

29

‘had not performed and it was conceivable that it might

not be able to perform the services contracted for in the

future, that contingency is so slight in the factual situa-

tion presented that it did not materially affect petition-

er’s right to the amount in the taxable year. Tax account-

ing does not concern itself with the -fine question of whéther

items have beén ‘tearned’’ in the acéounting sense, see

Automobile Club of New York, Inc., 32. T. C.——(July

720, 1999), and this is true whether the item in question

has been received, or is merely a receivable: Mark E.

Schlude and Marzalie Schlude, et al., supra,

We have decided on the facts before us that petitioner's

right to this amount was substantially fixed’and uncondi-.

tional in the taxable year, whether payment was to be made

presently or in the-future, according to whatever credit

agreements Were made, and the entire amount in ques---

‘tion is’ properly aceruable in the taxable year. Mark E.

Schlude and, Magzalie Schlude, et al., supra; ef. Your

Health Club. Inc.. 4°. C385 (1944).

In his deficieney notice, responder it determined that ‘the:

deduction for service guarantee *% * created by setting

wpa contingent lability account * * * is not an allowable

deduction * * *."" However, in fact, petitioner did not

compute or claim a deduetion ‘tin accordance with the

method of accounting regularly emploved"* but instead, in-

cluded in its cost of goods sold, the amount of income it

considered properly deferrable. Petitioner now contends

that if the amount received is held te be ineludible in in-

come of the taxable year, it is entitled to a deduction for

estimated expenses arising from its liability to render the

future services. Sees, 23(a)(1)4 A) and 43. Petitioner's

ability was to render fiture serviees, the extent of which

Was largely contingent. upon customers ealling for such

services, Further, as previously stated, petitioner has

failed to prove that the amount of such expenses was

reasonably ascertainable. Petitioner has failed to prove

that ‘tall the events’ fixing liability and the amount there-

of with reasonable certainty occurred during the taxable

year; aévordingly, we hold that the expenses were not in-

curred and were not properly aceruable inthe taxable

30 -

year, Brown y. Helvering, 291 af S.493 (1934): United

States v. Anderson, 269 U.S, 429 (1926).

Issue 2

Petitioner contends that it did not deduct any bad debts

for the fiseal period ended October 31, 1949, and it is there.

fore not preeluded from deducting an addition to a re-

serve for bad debts for the taxable year. Respondent maiv-

tains that petitioner directly charged off bad debts on the

daily summary sheet for the fiseal period ended October

31, 1949, as well as for the taxable year, and having elected

this method, it cannot use the reserve metliod Without ob-

taining permission from respondent. Further, he con-

tends that petitioner cannot, in any event, reduce sales

by specific bad debts and also claim an additional to a re-

serve for bad debts in the taxable year, See. 23(k)(1):

Regulations 111, see. 2U22(k)-1{a): Union Bleachery x.

United States, 176°F. 2d SIT (CLA. 4. 1949); Rogan v.

Commercial Discount Co., 149 F. 2d 585 (CLA. 9, 1945).

We agree with respondent. .

The statute prevides that the respondent-.may, in his

discretion, allow as a‘deduction an addition to a reserve

for bad debts in lieu of a deduction for debts actually be

coming worthless within the taxable vear?

2 See. 23. Deduetions from Gross Ineome.

In computing net income there shall ‘be allowed as deductions:

(k) Bad debts.— °

(1) General rule.—Debts which became worthless within the tar

able vear; or (in the diseretion of the Commissioner) a reasonable

addition to-a reserve ‘or bad debts; * * * :

Regulations 111, see. 29.23(k)-1(a)(2).«

°e* «@ ‘e . @ 7 e .

Taxpayers were given a similar option for 1921 to select either of the

methods mentioned for treating such debts. (See article 151, Regulations

62.) . . . A taxpayer filing a first return of income MAY select either

of the two methods subject to approval by the Commissioner upon-exami-

nation of the return. If the method selected is approved, it must be

‘followed in returns for subsequent years, except as permission mav be

granted by the Commissioner to change to another method. Application

for permission to efange the method of treating bad debts-shall be made

e,

31

Petitioner’s contention that’ it suffered and deducted

no bad debts during the fiseal period ended. October 31,

1949, has not been proven. During that period it as-

signed its sales contracts receivable with reeourse to a

coumercial. house and assumed the, proprietorship lia-

bilities for similar assignments. It had to repurchase

an indefinite number of these receivables anid repossess the

sets, which, invariably had fair market values less* than

the amounts owing, upon failure to collect the amounts due.

Petitioner then sold the sets at their fair market values,

which usually resulted ,in not recovering the full amount

owing on the original <ale. As stated in our findings, pe-

tioner’s method of recording such repossessions, and re-

sales resulted in a reiluction of sales by the amount of the

debt never collected, and consequently a bad debt re-

duction for thetperiods when such events occurred. Pe-

litionér has.not proved ‘that these events did not. occur

during the fiseal. period ended October 31, 1949; it, has

not been proven that some other .method was used during

that period. Therefore, petitioner has failed to prove that

it did not deduct bad debts direetly through such reductions:

in sales during the fiscal period ‘ended October 31, 194.

In the absence of such proof, we hold that petitioner was

subject to the rule requiring permission from respondent

to change to. the method of deducting bad debts by an ad-

at least 30 days prior to the ‘close of the taxable year for which the

change is to be effective. * *° *

. ° a e . + . “N e

* See, 20.23(k)-5. Reserve for Bad Debts.--Taxpayvers who have estab-

hshed the reserve method of treating bad debts and maintained proper

reserve aceounts fer bad debts, or who, in aecordance with seetion

29.23(k)-1, adopt the reserve method of treating bad debts, may de-

duet*from gross income a reasonable addition to a reserve for had debts

in lieu of a deduction for specifie bad debt items.

> _° e e ° e :. .

A taxpayer using the reserve method should make a statement in his

return.showing the vqlume of his charge sales (or other business tran--

actions) for the vear and the percentage of the reserve to such ampunt.

the total amount of notes and accounts receivahle at the beginning and

the close of the taxable year, and the amount of the debts which have

beeome ‘wholly or partially worthless and have been charged against the

reserve account.

32

dition to the reserve... Regulations 111, see. 29.9 3(k)-1(a),

supra, footnote 2. Petitioner has neither ‘requested nor

obtained such* permission.

further, since the record discloses affirmatively that

such repossessions and resales did occur during the tax.

able year, petitioner has in_ effect deducted specific

bad debts throygh the corresponding reduction in daily

sales for such year. The statute and relevant reg-

ulations provided the general rule that a direct deductiou

for bad debts, and a deduction for ai addition to the re-

serve are allowed only in the alternative. Even assuming,

arguendo, that petitioner neither incurred nor deducted

bad debts in the preceding fiscal period, so that the «ues-

tion of obtaining permission for a change in method is not

present, petitioner has suggested no reason nor introduced

evidence to suggest any reason why an — to the

general rule should be made. .

We hold that petitioner has failed to prove that it is en-

titled to a deduction for an addition.to the reserve, or to

any further deduction for bad debts for the taxable year.

Decision will be entered for the respondent.

33

APPENDIX B

Oprxton or THE Unxtrep States Court oF APPEALs-

FoR THE SEVENTH Circuit

Before Hastings, Chief Judge, Durry and ScunackeEn-

neRG, Circuit Judges,

SCHNACKENBERG, Circuit Judge. Streight Radio and Tele-

vision, Inc. an Indiana corporation, petitioner, seeks a

review of a decision of the Tax Court of the United States,

33 T.C’. , that there is a deficiency of $14,245.82 in in-

come tax owing by petitioner for the fiseal year ending

> October 31, 1950.

The basie facts are not in dispute.

During the taxable’ year, petitioner was engaged in the

business of selling television sets and of servicing the sets

sold. a

Most of the sets sold by petitioner were designed by

their manufacturers so that, every 2..to 6 months, the

chassis would have to be removed, wu the tuners, lass,

and picture tube cleaned. Petitioner rendered this service

upon call by its customers. Less than 100 of the several

thousand sets sold during the taxable year did: not require °

service of one kind, or another,

In addition to its advertised list price, petitioner offered

an ‘Installation and Service Contract’’ for an additional

consideration, which varied in amount from $65 to $100,

depending on the make and model of the receiver. sold.

-* Petitioner added the charge for the service contract to

the list price to arrive at a single total Sales price for the

set. The customer was also given a sales ticket, which

reflected the total: sales price, as a receipt. A delivery

card was made up for each television set sold during the

taxable year.

Respondent's agents examined 25 sales tickets which

represented 2 days* sales; 18 of these tickets did not con-

/ tain any reference to any warranty, However,.5 of these

> latter 18 tickets were checked by respondent's agent against

re

- 34 :

the corresponding 5 delivery cards; 1 of those delivery

cards showed a 90-day service and parts warranty, with

a I-year warranty on the picture tube, another disclosed

a **coupon’” warranty, 1 showed a 1-year parts. warriinty,

and 2 provided fora 1-year service warranty, Respondent's

agent examined the delivery ecards for customers with

initials A through BE, approximately 200 cards. All but

~2 of these delivery cards disclosed a 1-year service war-

ranty. Of those 22 cards, 1 did not record any warranty,

1 recorded a 1-year parts warranty,,.and 20 diselosed {).

day warranties, either’ on parts or service, or on both.

A few sets sold for cash were sold without any service

contracts. All but 10 per cent of the sets sold by petitioner

during the year in question were sold with a l-year service

contract. aS ae ,

Petitioner’s main purpose in offering’ the service con-

tracts was to induce potential customers to purchase their

sets from it. Petitioner was not in the business of servic.

ing, and it did not service television sets sold by other

concerns, as it knew from the experience of such com-

petitors that such a service business was not profitable. .

Louis Goedecke, an accountant, made monthly posting

entries from monthly summaries to the general ledver of

petitioner, arid prepared petitioner's income tax returns.

The charges for service contracts having been included in

total sales without allocation, Goedecke computed — the

amount thereof to be deferred, in the manner indicated

in the footnote.'

iwi the charges for the service contracts varied in amount from

. $65 to $100, most of the contracts were sold for #65. The list prices

of the sets varied from $249 to $725. It was determined that the service

contract charge, on the average, constituted 14.7 per cent of. the total

price. This computation was made without weighing the different tor

“prices according to the relative quantity of eath type of reeeiver <old

Qoedecke then took 15 per cent of each month's total sales as repre

venting amounts charged for the service contract. Antenna and laber

costs of installation, covered by the service contract, were estimated tt

be $22.50 per set installed, or almost one-third of $65, which was as

sumed to be the total amount charged for the service contract. The

amounts charged for the service contracts for each month were ac

Oo

During the taxable year, petitioner's television sales

and charges for service contracts, less refunds in’ the

amount of $7,908.42, totaled $1,041,649.50.° This amount

* does not Include other unexplained sales of approximately

$2,905, and service and repair income not. covered by

service contracts in the amount of $37,890.26. At the end

of the fiscal vear, total uncollected contracts receivable

had been reduced to $287,040.30.

The Tax Court found that Goedecke used a ‘*Schedule

of Deferred Income 10-81-50"? in preparing petitioner's

tax return. . ‘

The:Tax Court found that, according to the books and .

records and income tax returns of ‘petitioner, its -televi-

sion, service contract, and other service and repairs sales,

and the costs of producing those .sales, for its 1950 and

1951 fiscal years, were as follows:

—_— —__ Se — - — — —

cordingly reduced by one-third, on the theory that the amount of $22.50

of the #65 charged for the contract represented income earned at the

time of installation. The remaining balance for each month, which thus

equaled 10 per cent of television sales for the month, was then divided

by 12, the serviee contract period, in months, and the resulting monthly

figure- was multiplied by the number of months tlie service contracts

would remain in effect after the close of the fiscal vear. The total of

these figures was then deferred as unearned income.

* This schedule is as follows:

Service Antenna Months

Months Contract Instal- Remaining

of Total . Income lation Per Next Deferred*

Year Sales 15° ly Balance Month Year Income

Nov. $140,474 56 $21,071 18 $7.023 87 $14,047 31

Dee. 147,916 O4 «22.187 40 7.395 84) 14.791 56 $1,232 63) 1 $ «1,232 63

Jan. 52,928 44 7,989 26 2.64642 5.202 84 441 07—2 R82 14

Feb, 107.2038 60) «16.080 54 56.360 22. :10.720 32. 893.360 32 680 09

Mar 87.972. 77 13.495 OF «4.308 71 9 8.797 2000 733.10 42,932 42

A 65.175 69 9.776 35° 3.258 79 6.517 56 543.13 5 2.715 65

May 52.632.35 7.80485 2.63165 5.26320 438 60° 6 2.631 61

June 42.818 65 6.42279 2.14095 4.281 84 35682 7 2,497 74

July 61.621 58 9.243 23 3,081 I 6.162 12 51351 & 4,108 08

Aug 81.861 70 12.270 25 4.09309 8.186-16 682 18 9 — 6.139 62

Sept 93.313 38 13.907 00 4.665 68 9.331 32 777 61 10 7.776 10

Oct 107.730 74 16.150 61) 6.386 61 10.773 00 807 75 11 WO 875 25

Total $1,041,649 50 $156,247 37 $52,082 94 $104,164 43 $43.471°. 33

u.

—

= Headings of columns added or clarified

"36

‘Fiseal Year Ended

October 31, 1950 October 31, 19351

Total Sales:

Television Sales (includes

Service Contracts) .. $1,044,554 ; $458,712

Service and Repairs 37 890 84.417

Total 1.082, 444 543.130

Service Sales: : .

Service Contracts. 156, 247 G8 807

Less: “Service Guarantee” 43.471 21 , 735)

Other Services and Repairs ; 37 890 B4.417

Total 3150, 666 $174 459

Service Costs: i

Materials. , 60 , 266 69, OR4

Labor. |... a 87 540 91,693

Truck Maintenance 3,720 4,989

Depreciation 2.033 3.336

(Rey 153,559 170 002

Service Gain (or loss). (2,893) 4.957

The manufacturérs of the sets warranted the picture

‘ube for an undisclosed period, and the othe

months.

The Tax Court further found as follows:

r tubes for 3

On ifs return for the taxable year, petitioner de-

ferred the amount of $43,471.33 charged for service

contracts by including that amount in its cost of goods

sold. In his notice of deficiency, respondent determined

‘that the deduction for service guarantee * * * created

by setting up a contingent liability account * * * js

not an allowable deduction’? and increased petitioner's

income accordingly,

At the time of entering into-the service contracts,

petitioner aequired a substantially fixed and uneondi

tional right to receive the amounts charged therefor.

Petitioner, an acerual basis taxpayer, contends that it-

method of deferral was not artificial but had a reasonable

relationship to the services to be performed, thet the

"=

“claim of right’ doctrine is not applicable to the instant

ease because: ¢1) the income was not earned in the year

of receipt and (2) the income was not, in fact, received

in the year in which the contracts were executed, and

further, that respondent does not have authority to change

the method of accounting of a taxpayer except when the

method emploved does not clearly retleet meome.

On the other hand, respondent urges that it is the rieht

to reeeive ‘and not the actual receipt of an item of income

Which determines its ineludibility. in gross income under

the acerual method of aceounting, regardless of whether

it is ultiteately retained or offset lv expenditures, that

the concept of an annual accounting requires that the coi.

putation of ineome for tax purposes show the net result

of all the taxpayer’s transactions duving the vear rather

Mian the net result of any particular transaction, which:

ay extend beyond that period. Phe further iiaintains

that the ‘‘elaim of right’* sloetrine is primarily a rule

designed te determine when? and not whether receipts are

taxable; it is apphieable to accrual bas sis TaNpavers,

The principles governing this case were fscussed in

Automobile Cliab vy. Commissioner, 3593 US. S80. A similar

question arose in that case where the Club had collected

membership dues one vear in advanee, for whieh the meri.

bers were entitled to vurious «luh Services, While the dues

when collected were not segregated from the Club's veneral

funds but were, used for general corporate purposes, it

ippeared thet for bookkeeping purposes the dies: uport’

receipt were eredited to an account carried as a lability

account and «designated t*Unearned Members hip Dues”

During the first month of membership and each of the

following eleven months, one-twelffh of the amount pid

Was eredited to an account designated ** Membership In-

coue™. The Club reported in its income tax returns the

amount credited in each vear to this account.

The Supreme Court pointed out, at 188, that the Coi-

liissioner determined that the Club received the prepaid

dues under a claim of right, without restriction as to

‘their disposition, and therefore the entire amount received

ineach year should be reported as ineome.

38

The Court, at 189, said:

‘The petitioner does not deny that it has the un.

restricted use of the dues income in the 'vear of. receipt,

but contends that its accrual method of. accounting:

clearly reflects its’ income, and that the Commissioner

is therefore bound to accept its method of reporting

membership dues. We do not agree. Section 41 of the

Internal Revenue Code of 1939 required that “(tthe

net income shall be computed... in accordance with

the method of accounting regularly emploved in keep.

ing the books... but... if the method employed

. does not clearly reflect the-ineome, the computation

shall be made in accordance With such method js in

the opinion of the Commissioner does Clearly reflect

the income... .°°) The pro rata allocation of the mem

bership dues in monthly amounts is purely artificia!

and bears no relation’to the services which petition:

may in faet be called tipon to render for the member.

Section 41 vests the Commissioner with diseretion to

determine whether the petitioner's method of aeeonnt.

ing clearly reflects income. We eannot savy in the

circumstances here, that. the discretionary action of

the Commissioner, sustained by both the Tax Cour

aud the Court of Appeals, exceeded permissible limit.

See Brown ve Melrerina, “1 US. 193, 2Ng.005.°°

”

In Weiss ve Wiens Pe U.S, eet, aid, the Court said:

“The income tax laws do not profess: to embod:

perfect eeononic theory, They ignore some things the

either a theorist or a business han would take jnte

account in determinine the pecuniary condition of th:

wmaparer, ~-* **s 5 ery

/«

* 26 US.CL40 6 41,1939.

The net ineome shall he computed Upon the hasis of the tan prin

annual accounting period (fiseal Year or calendar vear. as the ease +

he) in aveordanee with the method of deeounting regularly emploved:

keeping the books of such taxpaver; but if ne sueh method of gqeeannt

Ing has ‘been «o emploved, or-if the methec! emploved does net elearh

reflect the ineome, the computation snall be dade insaceordanee wit

such method as in the opinion of the Commission does clearly rethet

the income. * * @

. .

A ;

39 , °

In ‘Guaranty Trust Co. ve Commissioner, 303 US. 492, '

48, it is. said:

° ‘

ee

> It is true ‘that thee acts of Congress taxing

- income oF consistently” laid the tax upon the net

income received by or acerued to. the taxpayer ina

‘taxable year,’ Which is either the calendar year or a

different fiscal vear, as the taxpayer may elect.» But

they. have never undertaken to-limit,the income tax?

able in any one year to that derived from the taxe

payer's activities occuring in that or any-other single

vear. The items of gross income and of allowed de-

ductions to be included in the income return, are those"

of the taxpayer for his taxable vear, even though

they may have resulted from or be affected by his

business transactions of other vears, ° °°"

It, instead of acsvstem of annual accounting, a basis of

finally ascertained resilts of partieular transactions is to

“be substituted, € ongress and not the courts: must previde

“it, Burnet ve Sanford & Brooks Co 282 US2 359, 367:

Baird vo Commissioner, 256 F.2d O18, O24) affirmed, 360

US: 446.

For the reasons herein exp iressed, the decision of the

Tax Court is aftirmed. ;

>

a)

. 40

APPENDIX C_ “ets

Section 41 of the Internal Revenue Code ot 1ey9

The net income shall be computed .upon the basis of

the taxpayer's annual accounting period (fiscal year or

calendar year, as the case may be) in accordance with the

method of aecounting regularly employed. in keeping the

books of such taxpayer; but if no such method of account.

ing has been ‘so employed; ‘or if. the method émploved

does not clearly reflect the incofie.’ the computation shall

be nfade in accordance with such method as‘in the opinion

of the Commissioner does clearly reflect the income. I!

the taxpayer's annual accounting’ period is other thar a

fiscal year as defined in Seetion 48 or if the taxpayer ha-

ho annual accounting period or does not keep books, the

vet income shall be computed on the basis of the calendar

vear.

Section 446 of the Internal Revenue Code of, 19934

fa) General rule Taxable income shall be comiprited

Under the method of accountitig on the basis of which the

taxpayer crecularly computes his income in keeping his

books.

(bh) Exceptions. —If no method of accounting has her

regularly used by the taxpayer, or if the method used does

hot clearly retleet income, the computation of taxable ir

come shall be made uiider such method as. in the Opinio

of the Secretary or his delegate, does clearly veflect ir

COLL, , : 0

(¢) Permissible methods. —Subject to the ‘provisions o!

subsections (a) and ¢b), a taxpaver may compute taxable

income wider any of the following methods of accounting

(1) the cash receipts and disbursements method:

(2) an acerual method;

(3) any other method permitted by this chapter; o

(4) any combination of the foregoing methods pertmiitted

under revulations prescribed by the Secretary or his dele

wate. a

41

(d) Taxpayer engaged in more -than one business. A

taxpayer engayed in more than one trade or business may,

in computing taxable income, use a different method of

accounting for each trade or business.

(e) Requirement respecting change of accounting

method. Except as otherwise expressly provided in this

chapter, & taxpayer who changes the method of accounting

on the basis of which he regularly computes his income in

keeping his books shall, before computing his taxable in-’

come under the new method, secure the consent of the

Secretary or his delegate. 3

(2590-8)