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 accuracyrelated 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

1 Eagle also paid commissions when it received the $4,000

deposits. Eagle deducted these commissions in the year it

received the deposits.

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.
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

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...)

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
10

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.

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.
11

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.

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
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 IC, 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).
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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

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...)

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
26

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...)

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
27

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.

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
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

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.

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
31

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...)

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
32

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.

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).
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.