Opinion ID: 357068
Heading Depth: 2
Heading Rank: 3

Heading: the use of an annual accounting period

Text: 100 The final problematic aspect of the district court's treatment of the constructive dividend issue centers on that court's decision to utilize a calendar year period for the measurement of the amount of the constructive dividend. That is, in reaching a figure for the value of the constructive dividend arising from the clearing operation, the lower court compared the costs incurred by the Corporation in a given calendar year with the payments received from the partnership in that same calendar year. 101 There are two time frames within which the district court could have measured the constructive dividend, assuming one was properly found to exist the time frame of annual units (fiscal or calendar) or the time frame beginning with the commencement of the project and ending with the project's termination. It appears, from the district court's findings, that it assumed that the only proper manner of computation was the calendar year basis. In support, the Government asserts that the use of any period but an annual period would cut against the notion of annual accounting ingrained in our tax laws. We disagree. 102 26 U.S.C. § 446 outlines the permissible methods of accounting under the tax law. One of the methods recognized as acceptable is the completed contract approach. When a taxpayer operates under this approach, he reports taxable income from a project upon its completion. Daley v. United States,243 F.2d 466 (9th Cir. 1957), cert. den. 355 U.S. 832, 78 S.Ct. 46, 2 L.Ed.2d 44, Reg. 1.451-3; Reg. 118, § 39.42-4; and Reg. 111, § 29.42-4. The concept of the completed contract method of accounting was alluded to as far back as Burnet v. Sanford, 282 U.S. 359, 51 S.Ct. 150, 75 L.Ed. 383 (1931). 103 While this method is recognized as an acceptable mode of accounting for tax purposes, it cannot be utilized capriciously by a taxpayer. A corporation must request permission from the Commissioner in order to utilize it. See, Reg. 1.451-3(c); Wright Contracting Co. v. Commissioner of Internal Revenue, 316 F.2d 249 (5th Cir. 1963), cert. den. 375 U.S. 879, 84 S.Ct. 147, 11 L.Ed.2d 110. Because taxpayers did not seek such consent here, they cannot argue that this method must be used to evaluate their clearing operation in terms of its tax consequences. However, the Commissioner is invested with the discretion to utilize such a method in rendering his computation of the taxpayers' tax liability. 26 U.S.C. § 446(b). 104 Under 26 U.S.C. § 446(b), the Commissioner is directed, in auditing a taxpayer's return, to use the method chosen by the taxpayer to measure income. 54 But, 105 if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary or his delegate, does clearly reflect income. 106 26 U.S.C. § 446(b). See, Commissioner of Internal Revenue v. Hansen, 360 U.S. 446, 79 S.Ct. 1270, 3 L.Ed.2d 1360 (1959); Burck v. Commissioner of Internal Revenue, 533 F.2d 768 (2d Cir. 1976); Stephens Marine, Inc. v. Commissioner of Internal Revenue, 430 F.2d 679 (9th Cir. 1970). 107 Given the discretion with which the Commissioner is invested to choose a method of measurement most capable of accurately reflecting a transaction, blind adherence to the accounting method chosen by the taxpayers or the corporation performing the work would not be consistent with the overriding spirit of the law. Consistency alone in the accounting method used by a taxpayer cannot satisfy the requirement that there be a clear reflection of income. Photo Sonics Inc. v. Commissioner of Internal Revenue, 357 F.2d 656 (9th Cir. 1966). The discretion with which the Commissioner is invested may not be abused. Whitaker v. Commissioner of Internal Revenue, 259 F.2d 379 (5th Cir. 1968). 108 Underlying the entire fabric of the tax structure is a desire to accurately portray the events that have transpired. Indeed, even a combination of accounting methods is permitted under the tax law if such a hybrid approach more clearly reflects income. Reg. 1.446-1(c)1(iv). 55 109 While abuse of this discretion by the Commissioner must be proven by a clear showing, Wood v. Commissioner of Internal Revenue, 245 F.2d 888 (5th Cir. 1957), it would seem that such a showing could be predicated upon a decision to use an accounting method that is inaccurate under the circumstances. While we express no opinion as to the manner in which the district court ultimately should resolve this issue, we do note that in the present case, the measurement of the dividend on an annual basis appears to produce a patently unjust result. If most purchasers of land clearing services do not pay for these services until the project is completed, 56 then the use of an annual accounting method to measure a constructive dividend arising from such services would work a severe hardship on the beneficiary of a clearing operation that spanned several years. The unjust nature of this choice of measurement method is underscored by the fact that it is the Corporation that chooses the date on which to declare its costs. If it has chosen the completed contract method, then the taxpayer is benefitted. But if it has not, then costs will be registered on an annual basis, in all likelihood, and payments will not be registered until the completion of the operation, years later. Given that the excess payment in one year is not transferrable to offset a prior year's costs, the taxpayer will not be able to recover from the corporation's choice. 110 There is much authority supporting an approach which breaks free from the moorings of annual accounting in the present case. That authority prescribes that the lodestar by which the court must be guided in its treatment of the measurement issue is the pursuit of substance over form. The basic tenet of tax requires . . . a substance-over-form practical construction 'it is the underlying essence of a transaction that determines its taxability.'  Crosby, 496 F.2d at 1389 (cit. omit.). 111 An application of this tenet may be found in Gibbs, supra. Gibbs provides an example of the pursuit of accuracy that reached fruition in a cumulative approach to the measurement issue. In this case, Judge Bell emphasized that the proper manner in which to measure the constructive dividend arising from property improvements was to focus on the sale price of the alterations and improvements less payments made, if any. 362 F.2d at 398. This formula, which rests on a cumulative approach to measurement, was tailored to the factual context confronting the Gibbs court one in which the subject of the constructive dividend was leasehold improvements made over a period exceeding one year. It is, in short, a formula premised on accuracy; a formula which takes cognizance of a series of events which are not neatly confined to an annual span. 112 An application of this tenet which produced a different result precisely because the factual circumstances were different may be found in Benes v. Commissioner, 42 T.C. 358, aff'd 355 F.2d 929 (6th Cir. 1966). In Benes, the focus on substance-over-form supported the measurement of a constructive dividend on an annual basis because the court found that the stockholder had no intention of ever paying his corporation for the cost of the improvements rendered by it on property found to have been built primarily for his benefit. Thus, the use of an annual accounting period in Benes was wholly consistent with the overriding judicial desire to choose a method of measurement most capable of accurately depicting the essence of the underlying transaction. 113 A final noteworthy example of the continuing effort to procure a more accurate treatment of the measurement question is provided by the court's management of the constructive dividend issue in Honigman, supra. In Honigman, a piece of property was sold to stockholder's corporation by a corporation in which stockholder possessed a 35% interest. The court found a constructive dividend and measured it as the excess of the property's fair market value over the purchase price, where the purchase price was calculated as a lump sum figure. This lump sum characteristic is particularly important because the payments comprising it were not made within one year's time. The purchase was consummated via the assumption of a mortgage on the property; the assumption of a $21,000 tax liability; and the payment of $50,000 cash. Significantly, the fact that the taxpayer was not following a completed contract method of accounting did not prevent the court from explicitly recognizing the piecemeal quality of the transaction and from measuring the payment component of the constructive dividend in a cumulative manner. 57 114 We urge the district court to reconsider the propriety of utilizing an annual accounting method in a situation where the parties do not intend to match costs and payments on an annual basis. 115 In a judicial determination of tax liability, the value of consistency cannot be disregarded, but the value of accuracy must be foremost. Whatever method is used must be followed in reporting and determining taxable income, unless some adjustment of the method used is required in the particular case in order to clearly reflect income. 2 Mertens, Law of Federal Income Taxation (1974 rev.) § 12.02. In this regard, we cannot disregard the advice of an eminent tax authority who has unequivocally indicated that in the reporting of income from a long-term contract, the completed contract method is essential. Id., § 12-130-135. 116 The court has discretion to utilize that method of accounting most apt to render an accurate narration of the tax events that transpired. The completed contract method, or a comparable cumulative approach, is best suited for a transaction spanning several years where payment is not expected concurrent with the accrual of costs and the constructive receipt of income by the taxpayer is established on the basis of the accounting scheme chosen by the corporate entity. Notwithstanding the failure of the parties to have utilized such a method in reflecting this transaction on paper, the district court must consider whether the determination of a deficiency in the context sub judice mandated an examination from a non-annual perspective.