Opinion
Docket Nos. 18256 18257 19837.
1951-05-31
ESTATE OF JULIUS I. BYRNE, DECEASED, GUY G. BRATTON, RONALD BALLANTYNE, AND JACK M. CULLERS, EXECUTORS, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.B. D. INCORPORATED (FORMERLY BYRNE DOORS, INCORPORATED), PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.BYRNE DOORS, INC. (FORMERLY J. I. BYRNE, INC.), PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Ralph W. Barbier, Esq., for the petitioners. Cecil H. Haas, Esq., for the respondent.
Ralph W. Barbier, Esq., for the petitioners. Cecil H. Haas, Esq., for the respondent.
1. INCOME— SEPARATE ENTITIES— SOLE PROPRIETORSHIP AND CORPORATION— SECTION 22(a)— SECTION 45.— Net income reported by principal stockholder of taxpayer corporation from his engineering business not properly includible in the income of the corporation under section 22(a) or 45 where the principal stockholder took over from the corporation the sales and engineering services to the corporation at fair and reasonable rates.
2. Id.— Net income of a new corporation of which the individual taxpayer above was the sole stockholder and which he organized to take over the business previously conducted by his sole proprietorship not includible in the income of the taxpayer corporation.
3. DEDUCTIONS— DEPRECIATION— AMORTIZATION OF PATENTS— BASIS— COST.—Patents purchased by a taxpayer corporation from its sole stockholder at their fair market value take their cost as basis for amortization purposes.
4. ACCOUNTING METHOD— HYBRID SYSTEM— CONFORM TO CASH OR ACCRUAL— SECTIONS 41 AND 43.— A hybrid system of accounting is not recognized for Federal tax purposes. A taxpayer, using such a system and failing to show that it more nearly resembles a cash receipts and disbursements basis, must accept adjustments made by the Commissioner allowing deductions for excess profits taxes when the liability was incurred rather than when paid and in reducing accumulated earnings at the end of the year by nondeductible taxes incurred in that year but paid later.
5. EXCESS PROFITS TAX CREDIT— EQUITY INVESTED CAPITAL— ACCUMULATED EARNINGS— EXCESSIVE PROFITS.— Amount of excessive profits determined for any year under renegotiation is to be eliminated from the income of that year and is not properly includible in accumulated earnings as of the close of that year in computing an excess profits tax credit based on invested capital for the following year.
The Commissioner determined deficiencies as follows:
+--------------------------------------+ ¦Estate of Julius I. Byrne, Deceased ¦ +--------------------------------------¦ ¦ ¦ ¦ ¦ +--------------------------------------+
Year Tax Amount 1943 Income $142,722.88 1944 Income 38,423.08 1/1/46-6/2/46 Income 121.07
B. D. Incorporated 1941 ( Income 6,750.27 ( Excess profits 11,906.87 1942 ( Income 10,263.69 ( Excess profits 149,919.06 1943 ( Income 25,295.30 ( Excess profits 211,920.08
Byrne Doors, Inc. 11/16/42-8/31/43 Excess profits 56,017.21
Issues urged for decision include the following:
1. Whether the Commissioner erred by including the income of Julius I. Byrne from his engineering business in the amount of $36,489.64 for December 1941 and $168,348.86 for the period January 1 to November 16, 1942, in the income of B. D. Incorporated for 1941 and 1942;
2. Whether the Commissioner erred by including in the income of B. D. Incorporated for the calendar years 1942 and 1943 the income of Byrne Doors, Inc., computed by the Commissioner on a calendar year basis in the amount of $66,616.41 for the period November 16 to December 31, 1942, and $439,683.94 for 1943, although Byrne Doors, Inc., kept its books and made its returns on a fiscal year basis;
3. The Commissioner, by amended answers in each proceeding, alleges that he erred in respect to the treatment of royalty payments made by B. D. Incorporated to members of Byrne's family in that he should not have allowed deductions to B. D. Incorporated, he should have taxed to Byrne payments to Byrne's family, and he should have taxed some of those same payments to Byrne Doors, Inc., for the period November 16, 1942 to August 31, 1943, and for its fiscal year ended August 31, 1945.
4. The Commissioner, by an amended answer in the case of Byrne Doors, Inc., alleges as an alternative to issue 2 that he erred in allowing deductions for amortization of the patents computed on a basis in excess of $150,000 for the period November 16, 1942, to August 31, 1943, and in excess of $147,750 for the fiscal year ended August 31, 1945;
5. Whether the Commissioner erred in allowing B. D. Incorporated deductions for the years 1941, 1942, and 1943 representing accrued capital stock tax instead of allowing the smaller amounts claimed by the petitioner on its returns representing capital stock taxes paid in those years, in failing to allow as a deduction in computing a net operating loss for 1945 excess profits tax paid during that year in the amount of $53,528.38, and in eliminating from accumulated earnings in the determination of equity invested capital amounts of income and excess profits taxes for each prior year and repayments under renegotiation for the year for which excessive profits were determined rather than in the year in which repayments of the excessive profits were made.
6. Whether in computing a net operating loss deduction for Byrne Doors, Inc., for the period ended August 31, 1943, based upon a net operating loss carry-back from its fiscal year ended August 31, 1945, excess profits taxes for the fiscal year ended August 31, 1944, paid in the fiscal year ended August 31, 1945, may be deducted under section 122(d).
FINDINGS OF FACT.
The decedent, Julius I. Byrne, died on June 2, 1946. His returns were filed with the collector of internal revenue for the first district of Texas.
The petitioners, B. D. Incorporated (formerly named Byrne Doors, Incorporated, and referred to herein as B. D.), and Byrne Doors, Inc. (formerly named J. I. Byrne, Inc., and referred to herein as Byrne, Inc.), are corporations organized and existing under the laws of the State of Michigan which filed their returns for the taxable years with the collector of internal revenue for the district of Michigan. B. D. filed its returns on a calendar year basis, while the returns of Byrne, Inc., were filed on the basis of a fiscal year ending August 31.
The decedent was an engineer who specialized in the designing of doors and mechanical door operating devices for use in large industrial plants and airplane hangars. He secured at least seven patents on such doors and operating mechanisms from 1934 through 1939. He was manager of the Door Division of Detroit Steel Products Company, a corporation manufacturing steel windows, doors, and door operating devices, from 1930 to 1936. He left that company in 1936 and organized B. D. for the purpose of doing the designing of, engineering work on, and selling of his patented doors.
Detroit Steel Products Company agreed in 1936 to sell Byrne-type doors for B. D. for 15 per cent of the sales price of each door. That arrangement continued in effect through 1937, after which B. D. began to handle the sale of the doors.
B. D. did not have facilities for manufacturing the doors during the early years of its existence but had all door parts manufactured by others. B. D. began to manufacture the runners, hinges, castings, and door operating devices some time in 1940 or 1941 because of difficulties experienced with those formerly manufacturing those parts. The door bodies, with few exceptions, were manufactured by others through the taxable years.
The period required to negotiate the sale of a Byrne-type door was from six to eighteen months. It was necessary to contact and negotiate with the owner of the building on which the door was to be used, the architect or engineer who was designing the building, and the general contractor before a contract was obtained. B. D. usually offered engineering services to and collaborated with the architect in designing portions of the building.
Byrne, on December 5, 1939, licensed B. D. to use his patents in consideration of the payment of royalties equal to 12 1/2 cents per square foot of gross door opening on each door contract entered into by B. D. The license agreement was nonexclusive and nontransferable and was to continue in effect throughout the lives of the patents. Byrne was given the right to terminate the agreement in the event that royalties in any year were less than a certain amount. The licensee could avoid such termination by paying the difference within 60 days.
Byrne proposed to the directors of B. D. on November 3, 1941, that a contract be entered into between B. D. and himself under the terms of which he would take over the designing, engineering, and selling of all Byrne products and he would take over all employees engaged in those activities. Byrne performed or supervised the designing, engineering, and selling activities, but had little to do with the manufacturing which was supervised by a capable man. He was formulating plans at that time to transfer control of the corporation to certain of its employees engaged in the manufacturing part of its business. It was Byrne's desire that his inventions, those already patented as well as those in the development stage, be safeguarded from any possible claims which other persons or interests, including B. D., might be able to make in the future. He wanted to hold personally and protect any future patentable developments of his engineering staff. He also felt that his personal services warranted greater compensation than he had been receiving from B. D., but he did not want to impose on the corporation the burden of paying him a larger salary.
A written agreement was entered into on December 1, 1941, between Byrne and B. D. providing that Byrne would do engineering work, all advertising, promotion and sales negotiation, and furnish all designs and engineering services for B. D. for which he was to be paid 18 per cent of the total sales price subject to adjustments in special cases. He was to take over and pay the expenses incident to the main office in Detroit and the three branch offices, but B. D. was to continue to occupy a part of the space in the main office so long as it was sufficient for both. B. D. was to pay Byrne for the space used by it and for its proportionate part of any other expenses paid by Byrne. Byrne agreed to devote sufficient time to the part of the business which he was going to conduct, to keep accurate records and make reports to B. D., and to adhere strictly to all conditions of sales fixed by B. D.
Byrne then took over on his personal payroll the employees of the sales and engineering departments of B. D., and thereafter conducted and bore all the expenses of that portion of the business.
Byrne, as sole proprietor after December 1, 1941, was engaged in doing the designing and engineering work and was selling the doors, while B. D. was engaged exclusively in the manufacture and erection of those doors. The employees of Julius I. Byrne, Consulting Engineer, were salesmen and engineers. Those of B. D. were manufacturing employees and purchasing and accounting personnel. B. D. had no salesmen after December 1, 1941. The employees of B. D. were informed of the change in organization on November 28, 1941.
Byrne received a salary from B. D. of $40,000 in 1941, $4,533.36 in 1942, and $1,800 per annum thereafter.
Byrne caused J. I. Byrne, Inc. (Byrne, Inc.), to be organized on November 16, 1942. A written agreement was entered into on that date between Byrne, B. D., and Byrne, Inc., which provided that Byrne, Inc., should take over the sales, designing, and engineering services which Byrne as an individual had performed since December 1, 1941. Byrne, Inc., was to perform the same services as Byrne had performed and with the same employees. It was also to be compensated at the same time. The change was made partly because of the increased volume of the work. Byrne, at all times material to these proceedings, was president and a director of Byrne, Inc., and owned all of its outstanding stock. He received salaries from that corporation for the fiscal years ended August 31, 1943 to 1946, inclusive, in the respective amounts of $22,628.08, $40,961.38, $40,000, and $18,887.04.
Byrne was president and a director of B. D. from its incorporation until the time of his death. It had two classes of stock outstanding. Byrne owned 73.6 per cent of the common stock on December 31, 1941, and the remainder was owned by his wife, his daughters, and two directors. After December 31, 1942, Byrne owned more than 99 per cent of that stock. His wife and daughters owned 12 per cent of the Class A stock at all times material hereto and Byrne originally owned 88 per cent of that stock, but at some time in 1943 he sold that stock to Byrne, Inc., which thereafter held it.
B. D. occupied three floors of an office building prior to December 1, 1941. A part of the same space after December 1, 1941 was occupied by B. D. and the remainder by Julius I. Byrne, Consulting Engineer, and later by Byrne, Inc. Each organization occupied its part exclusively as its own. Each had a separate lease and paid its own rent. Each maintained separate books and records and each had its own separate bank account. There was no commingling of funds belonging to the different organizations. Each organization paid its own expenses. The employees and payrolls of each organization were separate from those of the other except that a few employees of Byrne and Byrne, Inc., received nominal salaries from B. D. and the accounting department of B. D. kept the books for Byrne and Byrne, Inc. The record does not show whether or not B. D. was paid for keeping the books of Byrne and Byrne, Inc.
B. D. had sales offices in several cities prior to December 1, 1941. They were operated after that date by Byrne and later by Byrne, Inc. B. D. did not bear any of the expenses of maintaining those offices after December 1, 1941.
The doors continued to be sold in the name of B. D. after December 1, 1941, and customers were billed in the name of B. D. and on its stationery. Engineering plans and blueprints submitted to customers carried the name of Julius I. Byrne, Consulting Engineer, after December 1, 1941, and the name of Byrne, Inc., after November 16, 1942. Advertising was supervised and paid for by Byrne and later by Byrne, Inc., but was done in the name of B. D.
The Commissioner disregarded the separate entity of Julius I. Byrne, Consulting Engineer, and included the net income of his business for December 1941 and the period ended November 15, 1942, in the income of B. D. for those years. The business conducted by Byrne was separate and distinct from that of B. D. and the Commissioner erred in including the income of that business in the income of B. D. for 1941 and 1942.
The Commissioner included income of Byrne, Inc., computed on a calendar year basis for the period November 16, 1942, to December 31, 1942, and the year 1943 in the income of B. D. Byrne, Inc., was a separate and distinct entity recognizable for Federal tax purposes and the Commissioner erred in including its income in that of B. D.
Byrne sold all his interests in his patents covering mechanically operated doors to Byrne, Inc., on November 16, 1942, for $300,000. The fair market value of those interests at that time was at least $300,000. Byrne, Inc., accelerated the payments due under the agreement and received a discount of $4,500, making the total purchase price of the patents $295,500. Byrne, Inc., paid Byrne $72,000 in 1942, $163,500 in 1943, and $60,000 in 1944 on account of the purchase price of the patents. Byrne reported those amounts as long term capital gains on the sale of the patents. The Commissioner, in determining the deficiencies against Byrne, held that the payments constituted dividends to Byrne from B. D. The sale of the patents by Byrne to Byrne, Inc., was bona fide and the above amounts received on the purchase price were long term capital gains.
Byrne, at some time prior to the taxable years, assigned to his wife and two daughters an interest in his patents, the exact nature of which is not shown by the record. The sale of his interest in the patents to Byrne, Inc., was subject to that pre-existing assignment. B. D. was informed of the assignment and was instructed to pay the proper royalties to the assignees. B. D. paid royalties to Byrne's wife and two daughters pursuant to the assignments. The payments amounted to $2,800 for 1941, $3,300 for 1942, $3,600 for each of the next 3 years, and $2,125.03 for a part of 1946 prior to Byrne's death. The record does not show that those payments were income either to Byrne or to Byrne, Inc., or that they were not properly deductible by B. D.
B. D. claimed deductions for capital stock taxes for 1941, 1942, and 1943 in the amounts of $4,200.02, $3,750.00, and $5,000.00 paid in those years. The Commissioner allowed B. D. deductions on an accrual basis for those years in the amounts of $7,500, $5,000, and $5,000.
B. D. realized excessive profits as determined through renegotiation, received tax credits therefor, and paid the balances, as follows:
+---+ ¦¦¦¦¦ +---+
Excessive Refund Year profits Tax credit payments 1942 $240,000.00 $128,640.00 1943 90,000.00 54,270.00 1944 $23,200.00 1945 105,793.33 1946 18,096.67 Total $330,000.00 $182,910.00 $147,090.00
Payments made to refund the excessive profits were charged to surplus by B. D. in the years in which paid.
The Commissioner determined that B. D. was on an accrual basis of accounting and adjusted its accounts to accrue liabilities for income, excess profits, and capital stock taxes. He also eliminated excessive profits from income of the years for which they were determined.
The method of accounting used by B. D. was predominantly an accrual method and bore little resemblance to a cash receipts and disbursements method.
B. D., on April 24, 1946, filed a claim for refund of income and excess profits taxes in the total amount of $49,051.43 paid for 1943 and amended returns for 1943 showing no tax liability after deducting and amended returns for 1943 showing no tax liability after deducting $123,994.11 of a net operating loss carried back from 1945 and an unused excess profits credit adjustment of $66,191.51 from 1945. The schedule attached to the amended returns shows that the net operating loss carried back from 1945 in the total amount of $155,732.80 consists of an excess of deductions over gross income in the amount of $102,204.42, plus excess profits tax of $53,528.38. The latter amount represents the excess profits taxes of B. D. for 1944 which were paid in 1945. The $102,204.41 was the excess of deductions over gross income shown on the return for 1945 after eliminating from gross income $17,765.63, representing long term capital gain. The revenue agent in his report covering 1945 proposed the disallowance of deductions of B. D. in the total amount of $10,131.58. The Commissioner has never made any determination with respect to B. D.'s income for 1945. The notice of deficiency dated February 6, 1948, with respect to 1943 contains no reference to the amended returns or the claim for refund filed on April 24, 1946, or to any net operating loss deduction based on a carry-back from 1945.
Byrne, Inc., on its original excess profits tax return for the period November 16, 1942, through August 31, 1943, showed excess profits tax liability of $169,749.12 and claimed that $56,017.21 of that amount should be deferred under section 710(a)(5) because it was claiming an abnormality under section 722.
Byrne, Inc., on April 2, 1946, filed amended returns for the period November 16, 1942, through August 31, 1943, showing no tax liability after claiming a net operating loss deduction of $205,678 carried back from its fiscal year ended August 31, 1945. It also filed a claim, at the same time, for refund of income taxes paid in the amount of $5,505.38 and excess profits taxes paid in the amount of $91,440.88 for the period ended August 31, 1943.
The Commissioner, in the notice of deficiency dated May 18, 1948, denied Byrne, Inc.'s application for relief under section 722 and held that the deficiency for the period November 16, 1942, through August 31, 1943, was the amount of the deferred payment of $56,017.21 as shown on the original return. The notice of deficiency contains no reference to the amended returns or the claim for refund filed on April 2, 1946, to the petitioner's fiscal year ended August 31, 1945, or to any net operating loss deduction based on a carry-back from that year.
The income tax return of Byrne, Inc., for the fiscal year ended August 31, 1945, filed on November 15, 1945, shows an excess of deductions over income in the amount of $72,819.94 and its excess profits tax return for that year shows no excess profits net income, no excess profits tax due, and an excess profits credit of$38,833.68 based on invested capital. The Commissioner has never made any determination with respect to that fiscal year. Byrne, Inc., paid in that fiscal year excess profits taxes for the preceding fiscal year in the amount of $132,858.06 as shown on its return for the preceding year.
The record does not show that the excess profits taxes for the fiscal year ended August 31, 1944, should not have been accrued in that year under a proper use of the system of accounting which Byrne, Inc., was using or under a system of accounting most nearly approximating that system which would correctly reflect its income.
All stipulations of the parties are incorporated herein by this reference.
OPINION.
MURDOCK, Judge:
The Commissioner, in determining the deficiencies against B. D., disregarded the engineering business conducted by Byrne as an individual from December 1, 1941, to November 16, 1942, and added the net income of that business to the income of B. D. for 1941 and 1942. The Commissioner determined a deficiency against Byrne, Inc., for the period November 16, 1942, to August 31, 1943, after Byrne had transferred that business to Byrne, Inc., but also disregarded the existence of the latter corporation disregarded its fiscal year accounting periods, computed its net income on a calendar year basis for the short period in 1942 and all of 1943, and added the amounts thus determined to the income of B. D. for the years 1942 and 1943. The only explanation given was that of the revenue agent that J. I. Byrne, Consulting Engineer, was a legal fiction and that Byrne, Inc., should be disregarded. No provision of the Code is referred to in the notice of deficiency or in the revenue agent's report for the action taken, but the Commissioner in his brief relies on sections 45 and 22(a).
This Court has heretofore held that section 45 does not authorize the addition of the net income of one corporation or business organization to that of another and was not enacted to consolidate two organizations for tax purposes by ignoring one completely. Chelsea Products Corporation, 16 T.C. 840; Cedar Valley Distillery, Inc., 16 T.C. 870. Cf. Seminole Flavor Co., 4 T.C. 1215.
The Commissioner contends that the agreement between B. D. and Byrne dated December 1, 1941, and likewise the agreement involving Byrne, Inc., dated November 16, 1942, were mere shams which should be disregarded for tax purposes, and all of the income reported by Byrne and Byrne, Inc., was in fact earned by B. D. and should be taxed as income of B. D. under section 22(a). He does not seek to tax the income of Byrne, Inc., to Byrne. It has been held that a corporation can be disregarded under some circumstances and the income taxed to the individual owner thereof or to another corporation under section 22(a). Higgins v. Smith, 308 U.S. 473; Gregory v. Helvering, 293 U.S. 465; Crown Cork International Corporation, 4 T.C. 19, affd., 149 F.2d 968. However, the Commissioner would disregard an individual and tax his income to a corporation as if the individual did not exist. Byrne was no fiction. He originated, developed, and was responsible for the success of the business of designing, engineering, and selling. He first formed a corporation and transferred the designing and engineering business to it. The manufacturing and selling was done by others under contracts. Then the corporation undertook some of the manufacturing, and all of the selling. Later, Byrne decided it would be advisable to restrict the corporation to manufacturing while he would be responsible personally for all other activities. Just as he had a right to combine some and later all of the various phases of the business in one corporation, so he had a right to separate them and carry on some as an individual. Buffalo Meter Co., 10 T.C. 83.
He had good and sufficient reasons for his acts, if any such reasons were necessary in order to justify his separation of the manufacturing from the rest of the business and to prevent his earnings from his personal activities from forever being tied up with those of the corporation as corporate earnings. Cf. Buffalo Meter Co., supra. The record shows that the change was not made merely to avoid or evade taxes, and any tax saving which might possibly result was not one of the main considerations. Byrne was not much interested in the manufacturing business. His patents did not belong to and he did not want them to belong to the corporation engaged in manufacturing. Improvements or new inventions might be developed from the designing and engineering activities and he did not want the corporation engaged in manufacturing to have any claim to them. He had some thought of transferring control of the manufacturing company to some of its employees who had nothing to do with the designing and engineering aspects of the business. Also, he felt that the compensation for his personal services should be larger than the amount he was receiving as salary from the corporation and larger than he thought the corporation should pay.
He actually separated the manufacturing business from the designing, engineering, and selling business and thereafter personally carried on the latter business until November 16, 1942. There was no sham or unreality about the separation. B. D. did no selling, designing, or engineering work at any time material hereto after November 30, 1941, and did not earn the income here in controversy which the Commissioner has taxed to it. The Commissioner has not cited any case which supports his disregard of Byrne and Byrne, Inc., as the earners of the income in questions.
The various phases of the business were closely related and Byrne, who dominated all of the activities, could have done about as he pleased. However, the manufacturing was kept separate from the other activities and the earnings were accounted for separately after November 30, 1941. Furthermore, the evidence indicates that the manufacturing business took its fair share of the earnings; the designing, engineering, and selling business received its fair share; and no profits were shifted by overcharges or undercharges, so that the Government has nothing to complain about in those respects. The only question is whether Byrne and Byrne, Inc., are to be wholly disregarded. Byrne was under no obligation to arrange his affairs and those of his corporations so that a maximum tax would result, and the income earned by him and by Byrne, Inc., in actually carrying on the designing, engineering, and selling business was not taxable to B. D. Chelsea Products Corporation, supra; Cedar Valley Distillery, Inc., supra; Seminole Flavor Co., supra; Koppers Co., 2 T.C. 152; Buffalo Meter Co., supra; Miles-Conley Co., 10 T.C. 754, affd., 173 F.2d 958; Moline Properties, Inc. v. Commissioner, 319 U.S. 436.
The Commissioner's contentions that Byrne's earnings as a sole proprietor should be taxed to him as dividends from B. D., B. D. should not be allowed a deduction for compensation of Byrne in excess of $40,000, and one-half of the amounts which Byrne received from Byrne, Inc., for his patents were dividends from B. D., all fall with the holding on issues 1 and 2. It now appears that Byrne did not receive any of the controverted items from B. D. except such amounts as were due him for services rendered by his separate business. The Commissioner conceded that one-half of the payments from Byrne, Inc., to Byrne for the patents represented long term capital gains. Byrne properly reported the entire amount of those payments as long term capital gains. Adjustment will have to be made for renegotiated excessive profits erroneously treated as if they affected B. D. Issues which were raised in the alternative in case the Court held for the Commissioner on issues 1 and 2 require no discussion.
The Commissioner, by amended answer, alleges that the erred in allowing B. D. deductions for the years 1941 to 1946, inclusive, for royalties paid to members of Byrne's family. He did not determine deficiencies against B. D. for any year after 1943 and no good reason appears for deciding whether B. D. is entitled to deductions for any year after 1943 except 1945 from which a carry-back is claimed. Furthermore, he has the burden of proof and he has failed to prove facts and to advance any sound reason for disallowing whatever deductions were claimed. If parts of the royalties were not payable to members of Byrne's family, then, as the Commissioner has alleged in other portions of his amended answers, they were payable either to Byrne or to Byrne, Inc., as sole owner of the patents, so that under no circumstances is there any merit to the contention of the Commissioner that B. D. was not entitled to deductions for the full amount of royalties paid. However, he has failed to sustain his allegations that the royalty payments to Byrne's wife and daughters were taxable to Byrne or were taxable to Byrne, Inc., for any years involved in this case. No issue is raised in regard to royalties due Byrne, Inc., from B. D. if the two are separate taxpayers.
The next question has to do with deductions for amortization of patents. An argument of the Commissioner in regard to deductions for amortization of the patents if the income of Byrne, Inc., is to be combined with that of B. D. needs no discussion in view of the holding against combination of the income. The Commissioner, by an amended answer, alleged that if Byrne, Inc., is recognized as a separate taxpayer from B. D., then he erred in allowing Byrne, Inc., deductions for amortization of the patents computed on a basis in excess of $150,000 for the period November 16, 1942, to August 31, 1943, and in excess of $147,750 for the fiscal year ended August 31, 1945. He has failed to prove that the patents were worth less than $300,000 when sold and he has failed to sustain his burden of proof that the basis of the patents in the hands of Byrne, Inc., was less than cost. The evidence shows, on the contrary, that Byrne, Inc., agreed to pay $300,000 and paid $295,500 for the patents which were worth at least $300,000 and that finding disposes of the issue with respect to deductions for amortization of the patents.
The Commissioner made a number of adjustments in the case of B. D. upon the theory that its accounting for the items upon a cash method did not clearly reflect income and they should have been accrued. These adjustments are all considered together under issue 5. Actually the adjustments for capital stock taxes benefited the petitioner since the amount which he held accruable for each year is larger than the amount deducted as paid within the year. B. D. attempted to meet all of these adjustments by proving that it properly used a cash receipts and disbursements method of accounting and did not accrue any of the items. The general rule is that net income shall be computed in accordance with the method of accounting regularly employed in keeping the books of the taxpayer, but if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does reflect the income. Section 41. Two methods of accounting are generally recognized for income tax purposes. One is the cash receipts and disbursements method under which items are deducted only when paid. The other is an accrual method under which obligations must be accrued and deducted when they are incurred. Section 43. Both parties agree that B. D. used a hybrid method which involved inconsistency. If that method was more like a cash method than it was an accrual method, then adjustments would be in order to make it conform completely to a cash method, but if it was more like an accrual method, then the adjustments made by the Commissioner must stand. Bartles-Scott Oil Co., 2 B.T.A. 16; Maine Dairy Co., 4 B.T.A. 375; John F. Cook, 4 B.T.A. 916; Coatesville Boiler Works, 9 B.T.A. 1242; Schram v. United States, 118 F.2d 541; Hygienic Products Co., 37 B.T.A. 202, affd., 111 F2d 330. The petitioner has filed to show that the method which it used more nearly resembled a cash method than an accrual method. The evidence shows that it more nearly paralleled an accrual method. The Commissioner did not err in disallowing deductions for taxes paid, in allowing deductions for taxes which were incurred and should have been accrued, and in accruing other nondeductible taxes for the purpose of computing the excess profits credit based upon invested capital.
The law requires that amounts determined to be excessive profits for a year under renegotiation be eliminated from income of that year in determining the tax credits to be deducted before the remaining excessive profits must be refunded. Likewise, the amount of excessive profits determined for any year had no place in accumulated earnings as of the close of that year.
If B. D. is entitled to any carry-back from 1943 to 1941, it will be apparent in the settlement under Rule 50. The parties have stipulated that they will take the report of the revenue agent as their starting point in computing any carry-back from 1945 to 1943 to which B. D. may be entitled. It would thus appear that the excess of deductions allowed over gross income as shown on B. D.'s return for 1945 would have to be reduced by $10,131.58, disallowed by the revenue agent and not in controversy herein. Also, the carry-back would not include the 1944 excess profits taxes paid in 1945 since they should have been accrued in 1944.
Byrne, Inc., claims that it is entitled to a net operating loss deduction for the period November 16, 1942, through August 31, 1943, based on a net operating loss deduction for the period November 16, 1942, through August 31, 1943, based on a net operating loss carry-back from its fiscal year ended August 31, 1945. A net operating loss is defined as the excess of deductions allowed over the gross income, with certain exceptions, one of which allows as an additional deduction the amount of excess profits tax ‘paid or accrued within the taxable year.‘ Section 122. The income tax returns of Byrne, Inc., for its fiscal year ended August 31, 1945, were introduced in evidence without objection. The deductions thereon exceed the gross income by $72,819.94. The Commissioner under other issues has failed to sustain his burden of showing either that Byrne, Inc., was taxable with royalties paid by B. D. to Byrne's wife and daughters for 1945 or was not entitled to a 1945 deduction claimed for amortization of the patents which it acquired from Byrne. The returns, under the circumstances of this case, may be taken as prima facie proof of the amount by which the deductions allowed exceeded the gross income. The petitioner claims that that excess should be increased by $132,858.06, representing excess profits taxes for its fiscal year ended August 31, 1944, which were paid in its fiscal year ended August 31, 1945. It alleged in its petitioner, to support that claim, that it kept its books and filed its returns upon the basis of cash receipts and disbursements. The Commissioner denied that allegation in his answer and the petitioner has attempted to prove the allegation.
Both parties agree that the system of accounting used by Byrne, Inc., did not conform either to the cash receipts and disbursements system or to an accrual method, but was a combination of both. The use of a hybrid system is not countenanced by the Code, and where such a system is used, adjustments are made to make it conform with the one which it most closely resembles which will clearly reflect income. See cases cited above. Thus, it was incumbent upon the petitioner to show that its system was more like the cash receipts and disbursements method of accounting than it was like an accrual method. This it has failed to do and, as a consequence, it has failed to show that it is entitled to deduct the excess profits taxes for 1944 in computing the 1945 carry-back. It did not owe any excess profits taxes for 1945 and did not accrue any. Thus, its carry-back is limited to $72,819.94.
Decisions will be entered under Rule 50.