Court Opinion

ID: 4481200
Source: CourtListenerOpinion
Date Created: 2020-01-16 21:14:45.811367+00
Date Added: 2024-06-11T14:54:00.356778
License: Public Domain

Bkuoe, J., dissenting: I agree with the majority opinion regarding the first issue, but strongly disagree with the conclusions and opinion of the majority respecting the application of section 481 for the reasons: (1) That the disallowance of the deduction for subcontractors’ retainage for the taxable year ended in 1961 did not, in my opinion, constitute “a change in method of accounting” within the meaning of section 481; and (2) that the inclusion of $101,869.35, the balance in the subcontractors’ retainage account as of the end of the preceding taxable year, in petitioner’s income for the taxable year ended in 1961 is clearly not “necessary” “in order to prevent amounts from being duplicated or omitted,” as required by section 481. Consequently, section 481 is not applicable. It having been determined that petitioner is not entitled to a deduction for the taxable year ended March 31, 1961, for the amount of “subcontractors’ retainage” withheld from its subcontractors in the taxable year ended March 31, 1961, it becomes necessary to determine whether, under the provisions of section 481, petitioner’s taxable income for the taxable year ended March 31,1961, is to be increased by the balance, as of April 1, 1960, of “subcontractors’ retainage” deducted in preceding taxable years. In the statement attached to the notice of deficiency, respondent explained the increase in petitioner’s taxable year for the taxable year ended March 31, 1961, in the amount of $101,869.35, as follows: It is determined that adjustment (a) above constitutes a change in method of accounting for a material item and that the provisions of section 481 of the Internal Revenue Code of 1954 apply to the balance of “subcontractors retainage” as of April 1, 1960. Accordingly, taxable income is increased by this balance of $101,869.35. Section 481 provides, in pertinent part, as follows: SEO. 481. ADJUSTMENTS REQUIRED BY CHANGES IN METHOD OF ACCOUNTING. (a) General Rule. — In computing the taxpayer’s taxable income for any taxable year (referred to in this section as the “year of the change”)— (1) if such computation is under a method of accounting different from the method under which the taxpayer’s taxable income for the preceding taxable year was computed, then (2) there shall be taken into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted, except there shall not be taken into account any adjustment in respect of any taxable year to which this section does not apply unless the adjustment is attributable to a change in the method of accounting initiated by the taxpayer. (b) Limitation on Tax Wheee Adjustments aee Substantial.— (1) Three year allocation. — If— (A) the method of accounting from which the change is made was used by the taxpayer in computing his taxable income for the 2 taxable years preceding the year of the change, and (B) the increase in taxable income for the year of the change which results solely by reason of the adjustments required by subsection (a)(2), other than the amount of such adjustments to which paragraph (4) or (5) applies, exceeds $3,000, then the tax under this chapter attributable to such increase in taxable income shall not be greater than the aggregate increase in the taxes under this chapter (or under the corresponding provisions of prior revenue laws) which would result if one-third of such increase in taxable income were included in taxable income for the year of the change and one-third of such increase were included for each of the 2 preceding taxable years. For purposes of clarification, it should first be pointed out: (1) That although respondent is barred by limitations from determining “deficiencies” in income tax for any of the years prior to the taxable year ended in 1961, section 481 authorizes adjustment to tax to be made “in the year of change” with respect to amounts omitted or duplicated in closed years, if “necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted” (Hulond R. Byan, 42 T.C. 886, 396 (1964); Graff Chevrolet Co. v. Campbell, 343 F. 2d 568 (C.A. 5, 1965)); (2) the change in method of accounting in the taxable year ended in 1961, if there was one, was initiated by respondent and applied to deductions and not income; and (3), if section 481 is applicable, petitioner has not questioned the correctness of respondent’s computation. Petitioner’s principal contention with respect to this issue is that section 481 is not applicable for the reason that there has been no change in method of accounting. Respondent agrees that petitioner has regularly kept its accounts and reported its income on an overall accrual method of accounting and still does. He contends, however, that the “adjustment” of petitioner’s taxable income for the taxable year ended March 31, 1961, resulting from his disallowance of a deduction for subcontractors’ re-tainage, “constitutes a change in accounting method for a material or significant item” and requires that the balance in petitioner’s subcontractors’ retainage account on April 1, 1960, in the amount of $101,869.35, be included in the taxable year ended March 31,1961, and taxed in accordance with section 481(b) (1). I do not agree. In the first place, the disallowance of the deduction for subcontractors’ retainage for the taxable year ended in 1961 did not involve any change in method of aecov/nting, such as is contemplated by section 481, but resulted solely from respondent’s determination (with which I have agreed) that the amount in question was not in fact accruable in the taxable year simply because the liability and amount thereof had not become fixed and certain and accordingly was not properly deductible under the accrual method of accounting employed by the petitioner in keeping its books and reporting its taxable income. Section 446,1 the “General Rule for Methods of Accounting,” provides that taxable income shall be computed under the method of accounting regularly employed by the taxpayer in keeping his books. Permissible methods enumerated include the cash and accrual methods, any other method permitted by this chapter,2 or any combination of the foregoing methods permitted under regulations prescribed by the Secretary or his delegate. Subsection (e) requires that a taxpayer secure the consent of the Secretary or his delegate before changing his method of accounting and computing his taxable income under such new method. Section 1.446-1 (e) (2) (i) of the regulations,3 promulgated by respondent in 1957 under section 446 (e), states in part : A change in the method of accounting includes a change in the over-all method of accounting for gross income or deductions, or a change in the .treatment of a material item. See also section 1.481-1 (a) (1) of the regulations4 promulgated by respondent in 1959 under section 481 (a). Standing alone, the regulatory language “change in the treatment of a material item” might seem to include the disallowance of an item of expense such as we have here. When considered in the overall context of the regulations, the statutes under which they were promulgated, and the legislative history, however, I think that the word “treatment” has reference to treatment accounting-wise or method of accoumtmg for,5 and that what constitutes a “change in method of accounting” turns upon the materiality of the “change” rather than the materiality of the “item,” the treatment of which is changed.6 When so construed, the mere disallowance of an item of expense on the ground that it had not in fact accrued in the taxable year did not constitute a “change in method of accounting” within the meaning of section 481, or the regulations. This construction of the regulatory language is supported by the legislative history of section 446(e), under which section 1.446-1 (e) (2) (i) of the regulations was promulgated. Referring to subsection (e) of section 446, the report of the Senate Committee on Finance (S. Rept. No. 1622, 83d Cong., 2d Sess., p. 300 (1954)) states: A change in the method of accounting includes a change in the general method of accounting such as a change from the cash receipts and disbursements method to an accrual method, or vice versa, or a change from the cash or an accrual method to the long-term-contract method, or vice versa. It also includes a change in the treatment of a material item such as a change in the method of valuing inventory, or a change from an accrual method without estimating expenses to an accrual method with estimated expenses, or vice versa, or a change in the method of depreciating any property. A change in the method of accounting is a substantial change as distinguished from each change in the treatment of each item. In computing taxable income, a taxpayer who changes his general method of accounting or who treats material items inconsistently must obtain the consent of the Secretary of his delegate unless an express provision of this chapter permits such change at the election of the taxpayer without such consent. Thus, in equating a “change in the method of valuing inventory” and a “change in the method of depreciating any property” to a “change in the treatment of a material item,” the Senate Committee on Finance used the term “change in treatment” in the same sense as a change in method of accowntmg. It also stated “A change in the method of accounting is a substantial change as distinguished from each change in the treatment of each item.” I would hold that the disallowance of the deduction for subcontractors’ retainage for the taxable year ended in 1961 did not constitute a change in method of accounting and accordingly that section 481 is not applicable. In Walter H. Potter, 44 T.C. 159, 171 (1965), the taxpayer inconsistently applied the cash receipts and disbursements method of accounting to certain receipts from the sale of houses which resulted in an improper reflection of income. This Court held that “respondent did not change petitioner’s method of accounting for the purposes of section 446 but merely corrected certain errors in his method which were resulting in the exclusion from gross receipts of certain amounts which should have been included therein. Consequently, the provisions of section 481 do not apply to respondent’s correction of those errors in petitioner’s accounting method.” In W. A. Holt Co., Inc. v. United States, 368 F. 2d 311 (1966), the TT.S. Court of Appeals for the Fifth Circuit held that the taxpayer’s practice of charging off nonworthless accounts was not a “method of accounting” within the meaning of sections 446(c) and 481 dealing with adjustments required by changes in “method of accounting,” since the charging off of accounts which were not in fact worthless prevented clear reflection of income as required by the regulations. The court stated: “Here we are concerned only with improper deductions. We hold that there was no change in method of accounting. Thus, the first condition of § 481 was not met.” A contrary result was reached by this Court in Peoples Bank & Trust Co., 50 T.C. 750 (1968), cited in the majority opinion herein. Neither the Potter nor the Holt case was discussed in that case, nor have they been discussed in the majority opinion herein. In my opinion, the Peoples Bank & Trust Co. case, which is presently pending on appeal to the Seventh Circuit, was erroneously decided and should not be followed. In that case the bank employed an accrual method of accounting and filed its returns on a calendar year basis. Interest on savings accounts and certificates of deposit was computed semiannually and credited to the depositors on May 1 and November 1 of each year. Interest on moneys on deposit during November and December was paid only to the extent all or a portion thereof was on deposit on May 1 of the following year. Thus, at the end of its accounting year the bank had not paid or credited to its depositors any interest payments on deposits held through November and December. For each of these months the bank posted an amount to a reserve and deducted the 2-month total from income on its returns. In the statement attached to the notice of deficiency respondent stated that no deduction was allowable for amounts claimed as accrued interest expense for the months of November and December since no liability for such interest existed as of December 31 of the taxable year and further stated that this was “a change of accounting method in the treatment of a material item” and that in 1962, the year of change, an adjustment was required to prevent duplicate deductions for amounts previously deducted in prior years subject to the Internal Eevenue Code of 1954. The total of these adjustments was $20,878.77, of which $3,545.26 represented the interest deduction disallowed for the year 1962 and $17,333.51 represented interest erroneously deducted in prior years. This Court held that the interest expense for the months of November and December of each of the years in issue (1962, 1963, and 1964) was “improperly accrued” and that respondent made a proper adjustment under the provisions of section 481 (a) (2), stating: The term “method of accounting” includes the accounting treatment of any item. Sec. 1.446-1 (a) (1), Income Tax Regs. The treatment initiated by respondent was a change in the treatment of a material item, thus constituting a change in petitioner’s method of accounting. * * * To the extent that Peoples Bank & Trust Co., supra, holds that the disallowance of the interest expense for 1962 constituted “a change in method of accounting” and that respondent properly increased the Bank’s taxable income for 1962 by the amounts of interest expense deducted in the prior years, I would not follow that decision. The cases cited by respondent, some of which are also cited in the majority opinion, are clearly distinguishable. Hulond R. Ryan, 42 T.C. 386 (1964), and Graff Chevrolet Co. v. Campbell, 343 F. 2d 568 (C.A. 5, 1965), both involved the reporting of dealer reserves as income. In both cases the change in method of accounting was initiated by the taxpayer and the 'basic question was whether the taxpayer was required by section 446 (e) to obtain the consent of the Commissioner before making such change. Wright Contracting Co., 36 T.C. 620 (1961), affd. 316 F. 2d 249 (C.A. 5, 1963), certiorari denied 375 U.S. 879, also involved a taxpayer-initiated change in method of accounting for income — in that case retainage which had been withheld from a contraction contractor — and there, too, the principal issue was whether the taxpayer was required to obtain the consent of the Commissioner before making the change. Dorr-Oliver, Inc., 40 T.C. 50 (1963), involved a change, initiated by the taxpayer, from a cash to an accrual basis in reporting vacation pay, without first obtaining the consent of the Commissioner. In Commissioner v. O Liquidating Corporation, 292 F. 2d 225 (C.A. 3, 1961), reversing a Memorandum Opinion of this Court, certiorari denied 368 U.S. 898, the court held that the taxpayer, which for many years had offset from a deduction for employees’ group-insurance premiums the estimated accrued dividends which were not paid until the following year, made a change in its accounting method requiring the approval of the Commissioner when it did not include accrued dividends in its return for 1953. The requirement prescribed by section 446 (e) that a taxpayer secure the consent of the Commissioner before making a change in his method of accounting is not an issue in the present case. Dearborn Gage Co., 48 T.C. 190 (1967), cited in the majority opinion, involved a change in method of valuing inventory, a type of change specifically mentioned in the report of the Senate Committee on Finance quoted above as constituting a change in method of accounting. It is clearly not applicable under the facts of the instant case. Oberman Manufacturing Co., 47 T.C. 471 (1967), also cited in the majority opinion, is not, in my opinion, controlling upon the question of what constitutes “a change in method of accounting” for the reason that both parties agreed that respondent’s determination disallowing a portion of the vacation pay accrued and deducted by the taxpayer in its taxable year ended December 1, 1962, if correct, constituted a change in the taxpayer’s method of accounting. Consequently, the first condition of section 481 was not in issue. Even if it were to be assumed that the disallowance of the deduction for subcontractors’ retainage did constitute a change in method of accounting within the meaning of section 481,1 am nevertheless of the opinion that respondent erred in including the balance in the subcontractors’ retainage account as of the end of the preceding taxable year in petitioner’s taxable income for the taxable year ended in 1961. The adjustment in question related only to an expense deduction and not the omission or failure to report income which might otherwise escape taxation entirely but for the application of section 481. There is no evidence in the present case that petitioner has attempted or will attempt to deduct again as business expenses the subcontractor’s re-tainage deducted in prior years. Limitations alone would bar such a deduction. Moreover, if such a deduction should be claimed, it would not be allowable for the reason that it had already been taken in previous taxable years. As stated in the report of the Senate Finance Committee, supra at page 307: If there is a change in the method of accounting employed in computing taxable income from the method employed for the preceding taxable year, adjustments must be made in order that every item of gross income or deduction is taken into account and that none are omitted. At the same time no item, is to affect the computation of taaaMe income more than once. It is only those omissions or doubling ups which are due to the change in method which must be adjusted. [Emphasis supplied.] The inclusion of $101,869.85, ¡the balance in the subcontractor’s re-tainage account as of the end of the preceding taxable year, in petitioner’s income for the taxable year ended in 1961 is clearly not “necessary” “in order to prevent amounts from being duplicated or omitted.” Consequently, section 481 is not [applicable. I would deny the adjustment made by respondent under the provisions of section 481.   SEC. 446. GENERAD RULE FOR METHODS OF ACCOUNTING. (a) General Rule. — Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books. (b) Exceptions. — If no method of accounting has been regularly used by the taxpayer, or 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. (c) Permissible Methods. — Subject to the provisions of subsections (a) and (b), a taxpayer may compute taxable income under any of the following methods of accounting— (1) the cash receipts and disbursements method; (2) an accrual method ; (3) any other method permitted by this chapter; or (4) any combination of the foregoing methods permitted under regulations prescribed by the Secretary or his delegate. 4 * * a * * # (e) Requikembnt Respecting Change op Accounting Method. — Except as otherwise expressly provided in this chapter, a 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 income under the new method, secure the consent of the Secretary or his delegate.    For such other methods, see sec. 1.446-1 (c) (1) (iii), Income Tax Regs. See also the Dealer Reserve Act of 1960, Pub. L. 86-459, 86th Cong., 2d Sess.    Sec. 1.446-1 General rule for methods of accounting. (e) Requirement respecting the adoption or change of accounting method. * * * (2) (1) Except as otherwise expressly provided in chapter 1 of the Code and the regulations thereunder, a taxpayer who changes the method of accounting employed in keeping his books shall, before computing his income upon such new method for purposes of taxation, secure the consent of the Commissioner. A change in the method of accounting includes a change in the over-all method of accounting for gross income or deductions, or a change in the treatment of a material item. Consent must be secured whether or not a taxpayer regards the method from which he desires to change to be proper. Thus, a taxpayer may not compute his taxable income under a method of accounting different from that previously used by him unless such consent is secured.    See. 1.481-1 Adjustments in general. (a) (1) Section 481 prescribes the rules to be followed in computing taxable income in cases where the taxable income of the taxpayer is computed under a method of accounting different from that under which the taxable income was previously computed. A change in method of accounting to which section 481 applies includes a change in the over-all method of accounting for gross income or deductions, or a change in the treatment of a material item. For rules relating to changes in methods of accounting, see section 446(e) and paragraph (e) of § 1.446-1. In computing taxable income for the taxable year of the change, there shall be taken into account those adjustments which are determined to be necessary solely by reason of such change in order to prevent amounts from being duplicated or omitted. * * •    Respondent apparently concedes as much. On page 29 of his reply brief, he states: “a change in the method of accounting, for the purposes of section 481, refers not only to a change in a regularly employed overall method of accounting but also includes a change in the method of accounting for a material item.” (Emphasis supplied.)    See Hauser “Recent developments further confuse change of accounting method,” 26 .T. Taxation 133 (1967). Incidentally, the “item,” the amount of subcontractors’ retainage disallowed for the taxable year ended in 1961, was $24,944.14, or 1.8 percent of the total subcontract expense ($1,357,324.86) for that year.